Lecture08 Spring 2009 v2

Lecture08 Spring 2009 v2 - Lecture 8 Spring 2009 Statement...

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Unformatted text preview: Lecture 8 Spring 2009 Statement of Cash Flows Goals of Today’s Class • Understand the three sections of the Statement of Cash Flow • Learn how the Statement of Cash Flow is Prepared Business Background Positive cash flows permit a company to… Pay dividends to owners. Take advantage of market opportunities. Expand its operations. Replace needed assets. Purpose of the Statement of Cash Flows • To report about how the entire firm’s operating, investing, and financing activities have affected its cash balances during the period covered by the statement. • In this context, “Cash” is defined as cash balances plus marketable securities with original maturities of three months or less. • The cash flow statement should display all of the cash inflows within each of the three categories 1. Operations 2. Investing 3. Financing Net Income ($2,278.5) ≠ change in Cash ($887) Why? Differences between Change in Cash and Net Income Net Income almost never reflects the actual change in cash­on­hand Accruals change net income without changing cash For example, depreciation expense lowers net income with no related change to cash­on­hand Purchases and sales can change cash without changing net income For example, purchasing equipment for cash lowers the cash balance but it does not immediately change net income Obtaining or paying off debt can change cash without changing net income For example, obtaining a new loan will increase cash without an immediate change in net income Issuing or repurchasing equity can change cash without changing net income For example, repurchasing Treasury Stock will decrease cash without a change in net income Net Income includes a bunch of non­cash accruals that are a normal part of business operations The firm spent or obtained cash when buying or selling assets (which only partially impacts net income through gain or loss) The firm expended or obtained money from borrowing or paying off debt and/or from issuing or repurchasing equity (which typically does not impact net income) Statement of Cash Flows Purpose of Statement of Cash Flows is to reconcile why Net Income is different than change in Cash balance Stated differently, the Statement shows us how the change in Cash balance materialized The Statement of Cash Flows is broken down into three sections: Cash Flows from Operations Cash Flows from Investing Cash Flows from Financing What do we learn by partitioning cash flows this way? Statement of Cash Flows: Cash Flows from Financing Let’s start from the bottom up, since the bottom two categories are the easiest Cash Flows from Financing include all cash flows in and out related to Obtaining non­payables debt (acting as a borrower) Paying off principal related to non­payables debt Issuing or repurchasing equity Paying dividends Payables are considered to generate from normal business operations, so they show up in the Cash Flows from Operations section Interest expense payments do not belong in this section. They are considered part of normal business operations, so they show up in the Cash Flows from Operations section Statement of Cash Flows: Cash Flows from Financing Example: X Corp. issues 10,000 shares of common for $100,000. It also pays off $40,000 in long­term debt, and issues dividends of $10,000 Net Cash Flows from Financing = $100,000 ­ $40,000 ­ $10,000 = $50,000 Increase in cash Decrease in cash (in parentheses) Statement of Cash Flows: Cash Flows from Investing Cash Flows from Investing include cashflows in and out related to Purchasing or selling longer­term productive assets (land, equipment, etc.) Purchasing or selling investment securities (stocks, derivatives, bonds, etc.) Interest cash receipts relating to purchased debt belongs in Cash Flows from Operations Statement of Cash Flows: Cash Flows from Investing Example: X Corp. purchases equipment with cash for $75,000. It also issues a loan of $25,000 and receives interest on that loan of $1,000 Net Cash Flows from Investing = ($75,000) + ($25,000) = ($100,000) Net Outflow Decrease in cash (in parentheses) Increase in cash Cash Flows from Operations Two Basic Methods of Reporting ­­ Two Basic Methods of Reporting ­­ 1. the indirect method ­ derives cash flows from accrual basis statements 2. the direct method ­ determines cash flows directly for each source or use of cash. The indirect method is used extensively in practice, as shown below. The indirect is favored by companies for 2 reasons: 1. 2. it is easier to prepare and it focuses on the differences between net income and net cash flow from operating activities. Indirect Method Reconciles net income and cash flows For cash from operating activities: Starts with net income adjust for revenues/gains not providing cash adjust for expenses/losses not using cash adds/subtracts changes in working capital accounts (we don’t see cash collected on sales like we would in the direct method) For cash from investing activities: Summarizes cash inflows and outflows For cash from financing activities: Summarizes cash inflows and outflows Indirect Method More on adjustments to get from Net Income to Cash Flows from Operations We add back expenses that were taken to net income but that did not reduce our cash balance (like depreciation) We add back decreases in non­cash assets (inventories, receivables, etc.) We add back increases in payables and other related liabilities We add back losses on sales of assets We subtract increases in non­cash assets (inventories, receivables, etc.) We subtract decreases in payables and other related liabilities We subtract gains on sales of assets Where to the cash proceeds related to a gain or loss appear? Statement of Cash Flows: Cash Flows from Operations Rationale for the Add­backs: non­cash expenses We begin with reported Net Income We add back depreciation expense since Net Income was reduced but cash was not Assume you run a cash­only business operation Cash revenues = $100; Cash expenses = $50. Net change in cash = $50 If you report depreciation expense of $20, then Net Income = $30 Since depreciation is a non­cash expense, we need to add it back to Net Income to recover the net change in cash for the period: $30 NI + $20 add back = $50 Statement of Cash Flows: Cash Flows from Operations Rationale for the Add­backs: decreases in non­cash assets Implicitly, when we decrease our non­cash assets, like receivables, we receive cash (Debit) Cash $1,000 (Credit) Accounts Receivable $1,000 This type of transaction is not reflected in Net Income, so we must add back decreases in this type of non­cash asset Similarly, when we decrease our inventory we typically see this: (Debit) Cash $2,500 (Credit) Sales $2,500 (Debit) Cost of Goods Sold $2,000 (Credit) Inventory $2,000 Net Income = $500 Notice that Net Income only includes the $500 increase associated with the reduction in inventory. The remaining $2,000 of actual decrease in inventory value must be added back to Net Income to arrive at the $2,500 of cash actually received Statement of Cash Flows: Cash Flows from Operations Rationale for the Add­backs: increases in payables Implicitly, when we increase our payables, we hoard cash (Debit) Salary Expense $1,000 (Credit) Salaries Payable $1,000 This type of transaction is reflected by a non­cash reduction to Net Income, so we must add the increase in payable back to reflect the lack of $1,000 outflow in cash Statement of Cash Flows: Cash Flows from Operations Rationale for the Add­backs: losses on asset sales We add back losses on asset sales to avoid double counting the transaction and to make sure all cash flows related to the asset sales are in the Cash from Investing Section (Debit) Cash $1,000 (Debit) Accum Depr: Equipment $8,800 (Debit) Loss on Equip Sales $200 (Credit) Equipment $10,000 Net Income reports $200 loss We would report the cash inflow of $1,000 in the Cash Flow from Investing section But, in the operations section, Net Income is also showing the $200 loss We need to add back the loss, to remove it from the Operations section because the loss did not involve a cash outlay. Statement of Cash Flows: Cash Flows from Operations Rationale for the Subtractions: increases in non­cash assets Implicitly, when we increase our non­cash assets, like receivables, we either do not receive or we actually expend cash (Debit) Accounts Receivable $1,000 (Credit) Sales $1,000 This transaction reflected as an increase in Net Income, but it did not provide a cash inflow. So, we must subtract it out to arrive at the actual change in cash Similarly, when we increase our inventory we typically see this: (Debit) Inventory $2,500 (Credit) Cash $2,500 This transaction involves a net outflow of cash that is not included in Net Income. We have to subtract it from Net Income because it involved cash to arrive at the actual change in cash. What if we purchase the inventory on account? There’s an increase in inventory of $2,500 which is a subtraction but there’s also an increase in a current liability of $2,500 which is an addition, so there’s zero net effect. Statement of Cash Flows: Cash Flows from Operations Rationale for the Subtractions: decreases in payables Implicitly, when we decrease our payables, we actually expend cash (Debit) Accounts Payable $1,000 (Credit) Cash $1,000 This transaction involves a net outflow of cash that would not be captured by Net Income. So we have to subtract it from Net Income to arrive at the actual change in cash. Statement of Cash Flows: Cash Flows from Operations Rationale for the Subtractions: gains on asset sales We subtract gains on asset sales to avoid double counting the transaction and to move all cash flows related to the asset sales to the Financing Section (Debit) Cash $1,000 Net Income reports $200 gain (Debit) Accum Depr: Equipment $9,200 (Credit) Gain on Equip Sales $200 (Credit) Equipment $10,000 We would report the cash inflow of $1,000 in the Cash Flow from Investing section But, in the operations section, Net Income is also showing the $200 gain We need to subtract the gain, to remove it from the Operations section Statement of Cash Flows: Cash Flows from Operations Cash Flow from Operations = Net Income adjusted for: Item Non­cash expenses (like depreciation and amortization) Decrease in non­cash current assets (inventory, receivables, etc.) Increase in payables and related short­term liabilities Losses on asset sales Increase in non­cash current assets (inventory, receivables, etc.) Decrease in payables and related short­term liabilities Gains on asset sales Add­back Subtract X X X X X X X 1. Add back non­cash expenses 2. Subtract increase in non­cash assets 3. Add back increase in payables and accrued short term liabilities 4. Subtract non­cash gain 1 4 2 2 3 3 3 1 Non Cash Activities Significant non cash activities must be disclosed!!! o Issuance of common stock to purchase assets. o Conversion of bonds into common stock. o Issuance of debt to purchase assets. o Exchanges of plant assets Such activities are reported in either 1 a separate schedule at the bottom of the SCF or 2 in a separate note or supplementary schedule to the financial statements. An Approach to Preparing the Statement of Cash Flows The information to prepare this statement usually comes from three sources: • Comparative balance sheet—Information in this statement indicates the amount of the changes in assets, liabilities, and stockholders’ equities from the beginning to the end of the period. • Current income statement—Information in this statement helps the reader determine the amount of cash provided or used by operations during the period. • Additional information—Additional information includes transaction data that are needed to determine how cash was provided or used during the period. Preparing the SCF – Indirect Method • Obtain Beginning and Ending Balance Sheets • Classify each line item as relating to operating, investing or financing (note some activity in accounts such as PPE may fall under both ­­ ) • Explain the changes in each account • For some accounts such as the working capital accounts (A/R, A/P, Inv.), we need just the changes • For others, we explain the changes in more detail Investments – cash amount purchased and sold PPE – need purchases, cash sales and depreciation Debt – need cash received and cash paid back­ Contributed Capital – issuances and repurchases Retained Earnings – net income and dividends • Change in cash should "fall out" Problem P13­5 adapted from Cash 18 Inventory A/R - Net 29 36 27 30 Fixed Assets, net A/P 72 22 75 25 Wages Payable Notes Payable 1 0.8 38 Common Stock 60 44 48 Reatined Earnings 24 80 32.2 NCF Operations: Statement of CF: Net Income + Deprec + Decr A/R + Decr Inv + Incr A/P − Decr Wg/P 12,000 6,000 2,000 6,000 3,000 (200) NCF Operations 28,800 NCF Investing (9,000) NCF Financing 6,200 Net CF 28,800 Net Change in Cash NCF Investing: Bought Assets (9,000) Net CF (9,000) NCF Financing: Sold Stock 20,000 Paid Note (10,000) Paid Divs (3,800) Net CF 6,200 26,000 Prepare T­accounts 1. Prepare a master T­account for cash. Make this a relatively large account because you will use this account to record the cash inflows (debits) and outflows (credits). 2. Prepare T­accounts for all of the other balance sheet accounts. 3. In all of the T­accounts, including the cash account, enter the beginning and ending balances. Analyze the accounts 4 a) Determine the changes (debit/credit) in each of the non­cash accounts and enter them in the accounts, appropriately. b) Complete each entry by recording an appropriate amount in the cash account. That is, for each debit (credit) you record in a non­cash account, record a credit (debit) amount in the cash account (if appropriate). c) Make sure that each of your entries balances. That is, make sure that the total of the debits that you have recorded equalsthe total of the credits. Report the cash inflows and outflows 5. If you have specific information that a financing or investing transaction was wholly or partly a non­cash transaction, enter the information in the non­cash accounts appropriately. Again, make sure that your entry balances. 6. If you have done the analysis correctly, the cash account contains all of the cash inflows (debits) and outflows (credits). 7. Prepare the cash flow statement. Organize and report the inflows and outflows as operating, financing and investing. ...
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This note was uploaded on 02/02/2012 for the course ACCT 101 taught by Professor Armstrong during the Spring '09 term at UPenn.

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