DUKE UNIVERSITY, FUQUA SCHOOL OF BUSINESS ACCOUNTG 441: Financial Statement Analysis 1 Professor Qi Chen

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1 DUKE UNIVERSITY, FUQUA SCHOOL OF BUSINESS ACCOUNTG 441: Financial Statement Analysis 1 Professor Qi Chen Note on the Statement of Cash Flows I. Overview of the Statement of Cash Flows The Statement of Cash Flows (SCF) shows the sources (inflows) and uses (outflows) of cash during a fiscal period. Current authoritative guidance (Statement of Financial Accounting Standard No. 95, Statement of Cash Flows [SFAS No. 95]) requires that firms separate cash inflows and cash outflows into three categories: cash flows from operations, cash flows from investing and cash flows from financing. Cash flows from operations (CFO) are the cash inflows and outflows from the firm s operating activities. Cash flows from investing (CFI) are the cash inflows and cash outflows associated with the activities necessary to maintain operating levels. Cash flows from financing (CFF) are the cash inflows and cash outflows associated with the activities engaged in by the firm to obtain cash or to use excess cash. Cash flows are not easily categorized into one of the three groups, and SFAS No. 95 affords companies discretion in many (but not all) categorizations. It is also the case that SFAS No.95 requires certain categorizations which, from a valuation perspective, appear inconsistent. For example, SFAS No.95 requires that firms treat interest expense on debt obligations as an operating activity and treat dividends paid to common or preferred shareholders as a financing activity. As we will see later in the course, most valuation models do not treat interest expense as operating activity, since it represents a capital structure (or financing) choice by the firm. The SCF focuses on cash inflows and outflows only. Any transactions which do not involve cash will not be included in the SCF; they are, however, required to be disclosed in a note to the financial statements. Non-cash transactions include activities such as acquiring land, property, plant or equipment by assumption of a liability; converting debt into stock,.. Most SCFs that you will come across (in life and certainly in this course) use the indirect method of calculating cash flows; the alternative method is the direct method. The indirect method starts with net income (as reported on the statement of income), and adjusts for non-cash items affecting net income. The direct method does not begin with net income, but rather examines the cash received from customers and paid to suppliers, creditors and others. The indirect method tends to be most common because it is based on the same accrual accounting principles that underlie generally accepted accounting principles (GAAP). In contrast, the direct method presumes the use of cash basis accounting. Mechanically, the SCF shows you the breakdown of the difference between the beginning and ending balance in the cash account from one period to the next. Given this algebraic identity and the fact that we know that Assets = Liability + Owners Equity,, it must be the case that we can prepare a SCF from simply taking the changes in all of the non-cash asset accounts and all liability and equity accounts. 1 Based on note written by Professors Jennifer Francis and Per Olsson. 1

2 Sparkle Company Balance Sheets Assets Cash $100 $76 $40 $170 Accounts receivable Inventories Total current assets ,760 Gross property, plant & equipment 2,400 3,720 4,860 5,630 Accumulated depreciation (400) (520) (660) (840) Total assets $2,500 $3,936 $5,160 $6,550 Liabilities and shareholders' equity Accounts payable $250 $300 $350 $500 Short term borrowings Salaries payable Total current liabilities Bonds payable ,000 1,500 Common stock at par 1,000 1,500 1,600 1,600 Additional paid in capital 200 1,000 1,200 1,200 Retained earnings ,350 Total liabilities & shareholders' equity $2,500 $3,936 $5,160 $6,550 Sparkle Company Income Statements Sales $2,760 $3,100 $4,750 Cost of goods sold (1,573) (1,798) (2,803) Selling, general and administrative (510) (590) (750) Depreciation expense (120) (140) (180) Operating income ,018 Interest expense (500) (100) (160) Pretax income Income tax expense (17) (142) (257) Net income $40 $330 $600 Dividends $4 $6 $10 2

3 Solution: Statement of Cash Flows for Sparkle Corporation Cash flows from operations Net income $40 $ Depreciation expense (Increase) decrease in accounts receivable (100) (100) (300) (Increase) decrease in inventories (160) (160) (370) Increase (decrease) in accounts payable Increase (decrease) in salaries payable Cash flows from operations (20) Cash flows from investments Additions to PP&E (1,320) (1,140) (770) Cash flows from investing (1,320) (1,140) (770) Cash flows from financing Increase (decrease) in short term borrowings Issuance (payments) of bonds payable Issuance of common stock 1, Dividends paid (4) (6) (10) Cash flows from financing 1, Net increase (decrease) in cash (24) (36) 130 Beginning cash balance Ending cash balance

4 II. What the Statement of Cash Flows Tells You The SCF provides three broad categories of information, some of which is available elsewhere in the financial statements (e.g., in the income statement or in the footnotes) and some of which is not. The three categories are: 1. Information about accruals versus cash flows (e.g., depreciation expense, gain on disposal of asset or segment). 2. Information about whether a given cash inflow or outflow reflects operating, investing and financing (e.g., operating versus financing receivables) 3. Disaggregate information (e.g., payments and issuances of debt; purchases and dispositions of property, plant and equipment) Item 1 makes sure that we understand the total cash flows. It stresses adjustments to net income for non-cash transactions, which are necessary when using the indirect method to prepare a statement of cash flows. Net income may reflect expenses which have not yet used cash (an example is the recognition of an accrued liability for a reported expense) or an expanse which will never consume cash (an example is depreciation expense). Net income may also reflect revenues which have not yet generated cash (an example is unearned revenue) or a revenue item which will never generate cash (an example is a [book] gain on the sale of property). Item 2 stresses proper identification of the components of total cash flows, for example, into the operating, investment and financing elements, is important because all cash flows are not created equal. Some valuation models care about some types of cash flows more than (sometimes to the exclusion of) other cash flows. For example, free cash flow calculations care a lot about cash flows from operations (CFO), care some about cash flows from investing (CFI) [in particular, about parts which are due to normal recurring aspects of the core business] and care not at all about cash flows from financing (CFF). Item 3 (disaggregation) is intended to help readers of the financial statements understand the gross transactions the firm engaged in. Knowing gross versus net transactions is informative because it provides more information about the variability of the business. For example, knowing that the firm borrowed $50 million and paid down debt of $40 million in 2001, tells you more than a statement that their net borrowings were $10 million.. It tells you that at one point in the year the firm had $40 million in cash with which to pay down the debt (early or on schedule), and that at another point in time (and perhaps it is the same point in time) it needed to borrow $50 million. In addition to gross reporting telling you more about the underlying volatility of cash flows, it may also tell you more about the firm s ability to access debt markets. That is, the gross reporting in the above example tells you that this firm is able to borrow $50 million, not just the net reported amount of $10 million. The disaggregated information gives you more information with which to make an assessment in this case, the assessment is of their credit worthiness. [Of course, this is but one piece of information you would want to examine in determining a firm s credit worthiness.] 4

5 III. Mechanically-Calculated versus Reported Statements of Cash Flows If you ve ever tried to calculate a SCF using just the income statement and balance sheets reported in a firm s annual report, then you know that your mechanically-computed SCF often looks quite a bit different from the one reported by the firm. There are several reasons for the differences including: 1. Firms are not required to tell you (on the balance sheet or in note disclosures) how they classify assets and liabilities as operating, investing and financing. SFAS No.95 contains some rules about classification, but there is almost always discretion that will make it extremely difficult (if not impossible) for you to discern management s categorizations from information reported elsewhere in the financial statements. Generally speaking, the more difficult cases involve not knowing (from the balance sheet or footnotes disclosures) whether a particular account reflects operating or investing activities. A good example is the classification of a change in receivables: if the receivables relate to credit sales to customers (a classic account receivable), they are included as part of the working capital accounts included in calculating CFO; however, if the receivable reflects a finance receivable. 2. Firms are not required to report many of the disaggregated items elsewhere (besides in the SCF) in their financial statements. For example, firms are not required to show you the breakdown of the change in debt accounts to reflect payments separately from issuances. III. Example: Microsoft As an illustration of the differences between mechanically-calculated and reported SCFs, examine Microsofts financial statements for the period ending June 30, 2000 (shown on the attached pages). Look closely at the items and values reported in their SCF and see which (if any) tie to values you mechanically-calculate from their 1999 and 2000 balance sheets and their 2000 income statement. References: 1. Bahnson, Miller and Budge, Nonarticulation in Cash Flow Statements and Implications for Education, Research and Practice, Accounting Horizons (December 1996). 2. Read Nurnberg and Largay, More Concerns Over Cash Flow Reporting Under FASB Statement No.95, Accounting Horizons (December 1996). 5

6 Microsoft: Income Statements In millions, except earnings per share Year Ended June Revenue $ 15,262 $ 19,747 $ 22,956 Operating expenses: Cost of revenue 2,460 2,814 3,002 Research and development 2,601 2,970 3,775 Acquired in-process technology 296 Sales and marketing 2,828 3,231 4,141 General and administrative ,009 Other expenses Total operating expenses 8,848 9,819 12,019 Operating income 6,414 9,928 10,937 Investment income 703 1,803 3,182 Gain on sales Income before income taxes 7,117 11,891 14,275 Provision for income taxes 2,627 4,106 4,854 Net income $ 4,490 $ 7,785 $ 9,421 Earnings per share: Basic $ 0.92 $ 1.54 $ 1.81 Diluted $ 0.84 $ 1.42 $ 1.70 See accompanying notes. 6

7 Microsoft: Balance Sheets In millions June Assets Current assets: Cash and equivalents $ 4,975 $ 4,846 Short-term investments 12,261 18,952 Total cash and short-term investments 17,236 23,798 Accounts receivable 2,245 3,250 Deferred income taxes 1,469 1,708 Other 752 1,552 Total current assets 21,702 30,308 Property and equipment, net 1,611 1,903 Equity and other investments 14,372 17,726 Other assets 940 2,213 Total assets $ 38,625 $ 52,150 Liabilities and stockholders equity Current liabilities: Accounts payable $ 874 $ 1,083 Accrued compensation Income taxes 1, Unearned revenue 4,239 4,816 Other 1,602 2,714 Total current liabilities 8,802 9,755 Deferred income taxes 1,385 1,027 Commitments and contingencies Stockholders equity: Convertible preferred stock shares authorized 100; shares issued and outstanding 13 and Common stock and paid-in capital shares authorized 12,000; shares issued and outstanding 5,109 and 5,283 13,844 23,195 Retained earnings, including other comprehensive income of $1,787 and $1,527 13,614 18,173 Total stockholders equity 28,438 41,368 Total liabilities and stockholders equity $ 38,625 $ 52,150 See accompanying notes. 7

8 Microsoft: Cash Flows Statements In millions Year Ended June Operations Net income $ 4,490 $ 7,785 $ 9,421 Depreciation, amortization, and other noncash items 1, Write-off of acquired in-process technology 296 Gain on sales (160) (156) Stock option income tax benefits 1,553 3,107 5,535 Unearned revenue 3,268 5,877 6,177 Recognition of unearned revenue from prior periods (1,798) (4,526) (5,600) Other current liabilities 208 1,050 (445) Accounts receivable (520) (687) (944) Other current assets (88) (235) (775) Net cash from operations 8,433 13,137 13,961 Financing Common stock issued 959 1,350 2,245 Common stock repurchased (2,468) (2,950) (4,896) Put warrant proceeds Preferred stock dividends (28) (28) (13) Net cash used for financing (999) (862) (2,192) Investing Additions to property and equipment (656) (583) (879) Cash portion of WebTV purchase price (190) Cash proceeds from sale of Softimage, Inc. 79 Purchases of investments (19,114) (36,441) (43,158) Maturities of investments 1,890 4,674 4,025 Sales of investments 10,798 21,080 28,085 Net cash used for investing (7,272) (11,191) (11,927) Net change in cash and equivalents 162 1,084 (158) Effect of exchange rates on cash and equivalents (29) Cash and equivalents, beginning of year 3,706 3,839 4,975 Cash and equivalents, end of year $ 3,839 $ 4,975 $ 4,846 See accompanying notes. 8

9 Microsoft: Stockholders Equity Statements In millions Year Ended June Convertible preferred stock Balance, beginning of year $ 980 $ 980 $ 980 Conversion of preferred to common stock (980) Balance, end of year Common stock and paid-in capital Balance, beginning of year 4,509 8,025 13,844 Common stock issued 1,262 2,338 3,554 Common stock repurchased (165) (64) (210) Structured repurchases price differential 328 (328) Proceeds from sale of put warrants Stock option income tax benefits 1,553 3,107 5,535 Balance, end of year 8,025 13,844 23,195 Retained earnings Balance, beginning of year 5,288 7,622 13,614 Net income 4,490 7,785 9,421 Other comprehensive income: Net unrealized investment gains/(losses) 627 1,052 (283) Translation adjustments and other (124) Comprehensive income 4,993 8,906 9,161 Preferred stock dividends (28) (28) (13) Immaterial pooling of interests 97 Common stock repurchased (2,631) (2,886) (4,686) Balance, end of year 7,622 13,614 18,173 Total stockholders equity $ 16,627 $ 28,438 $ 41,368 See accompanying notes. 9