CHAPTER No. All public companies report it because the statement of cash flows is a required statement with a required format.

Transcription

1 CHAPTER No. All public companies report it because the statement of cash flows is a required statement with a required format. 5-2 A cash flow statement shows the sources of changes in cash balances and: a) aids in predicting future cash flows and evaluating how management's decisions generate and use of cash; b) aids in determining a company's ability to pay dividends and interest and to pay debts when due; c) aids in understanding and identifying changes in the mix of productive assets. 5-3 Cash equivalents are highly-liquid, short-term investments that can be converted easily to cash with little delay. Examples include money market funds and treasury bills. 5-4 Operating activities, investing activities, and financing activities are the three major types of activities summarized in the statement of cash flows. 5-5 Major operating activities include: Collections from customers (for sales) from investees (interest & dividends) Payments to suppliers (for inventory) to employees (for wages) to creditors (interest) to government (taxes) Chapter 5 Statement of Cash Flows 191

2 5-6 Major investing activities include: a) sales and purchases of property, b) sales and purchases of securities that are long-term investments, c) making and collecting long-term loans. 5-7 Major financing activities include: a) borrowing from (nontrade) creditors, b) repaying (nontrade) creditors, c) issuing equity securities, d) repurchasing equity securities, and e) paying dividends. 5-8 Interest paid or received appears in the operating activities section. Some commentators favor showing interest paid elsewhere since it is associated with financing. 5-9 Only increasing long-term debt increases cash. Both repurchasing common shares and paying dividends decrease cash Selling fixed assets for cash and collecting a loan increase cash. Purchasing equipment decreases cash. Purchasing fixed assets by issuing debt does not affect cash, but it should be shown in a schedule of noncash investing and financing activities that is part of the statement of cash flows When liabilities increase, the firm has either raised cash and promised to pay it back later or it has preserved cash rather than paying it out to reduce growing accounts payable. So more liabilities lead to more cash. Likewise, increases in noncash assets require cash. Either cash is spent to get the asset or an asset is recorded instead of receiving cash Noncash investing and financing activities generally could have been accomplished identically in substance (though not in form) 192

3 by cash transactions. For example, issuing debt to purchase an asset could have been accomplished by issuing debt for cash and then using the cash to purchase the asset. Companies should not be able to prevent disclosure of such a transaction to readers of the statement of cash flows simply by using a noncash form of transaction This transaction should not be shown in the body of the statement of cash flows because it involves no cash flows. However, it should be reported in an accompanying schedule. Why? The transaction could have been accomplished by issuing stock for cash and then buying the fixed asset, whereby it would be in the statement of cash flows. Readers of statements of cash flows should be informed about such transactions Yes. It is important to know of the periodic need to pay off and refinance debt. Companies with large short-term debt levels often find it an inexpensive way to borrow, but when interest rates rise or a company's financial condition worsens, refinancing may be both difficult and expensive The direct method and the indirect method are the two major ways of computing net cash flow from operating activities The information for the direct-method cash flow statement comes directly from entries into a company s cash account The required adjustments are to add noncash expenses and losses, deduct noncash revenues and gains, add decreases in operating assets and increases in operating liabilities, and deduct increases in operating assets and decreases in operating liabilities. Chapter 5 Statement of Cash Flows 193

4 5-18 Sales revenue is recognized on the accrual basis when it is earned and realized, not when cash is received. Therefore, cash collections from customers will not ordinarily equal sales revenue during any given period. Sometimes cash from customers arrives before it is earned (creating a liability to perform) or after it is earned (collection eliminates an account receivable) Changes in the inventory and accounts payable accounts explain the difference between cost of goods sold and cash payments to suppliers Strictly speaking, net losses, by themselves, do not drain cash. A net loss is an excess of expenses over revenues; it is an income statement item rather than an item on a statement of cash flows. As an extreme example, equipment may be sold below its book value and cause a net loss, but cash proceeds resulting from the transaction would be an addition to cash, not a cash drain Cash + Noncash assets = Liabilities + Paid-in capital + Retained earnings Cash = Liabilities + Paid-in capital + Retained earnings Noncash assets 5-22 The erroneous impression is that depreciation is a source of cash because it is added to net income to determine cash flow from operations. Depreciation is an allocation of an asset s original cost to expense that does not entail a current cash outlay; that is, depreciation is a noncash expense. It is added to net income when using the indirect method only to offset its deduction in computing net income The newsletter reinforces the widely held erroneous impression that depreciation provides cash. See the solution to

5 5-24 Under the indirect method of preparation, depreciation is very prominent in the calculation, although not directly a source of cash. Depreciation belongs in a supporting schedule when using the direct method. Depreciation is one of the items that reconciles net income to net cash flow from operating activities Profitable companies often lack for cash because they are growing quickly and must acquire inventory for future sales while waiting to collect growing receivable balances. New firms in industries such as computers, electronics, and bio-tech might experience this Large, non-cash expenses such as depreciation could cause this. The airline industry might be a good example I would be concerned about this company. Negative cash flow from operations and new investing is not uncommon among new, high growth firms. However, at that stage in the growth pattern the financing is generally from equity and longer-term debt. The significant use of short-term debt with covenants that will restrict further debt issues and other actions of the firm suggests that the equity and long-term debt markets are not and will not be open to this client. Unless profitability and positive cash flow from operations are around the corner, this company could have serious problems raising additional capital. This may not be a good investment. Chapter 5 Statement of Cash Flows 195

6 5-28 It is always hard to know what is in a manager s mind. Microsoft experienced explosive growth. It is bought companies on a regular basis, but its available cash and liquid investments continued to grow. It does not make sense to continue to manage low yielding investments in government bonds and such. Microsoft chose to distribute this capital to investors as share buybacks and a very large one-time dividend, with a commitment to continue paying dividends. Prior to Microsoft s decision to pay dividends, many analysts feared that Microsoft would choose to make even larger and perhaps ill-advised purchases of other companies Until 2002 Amazon had negative cash flows from operations, and it used cash for investing activities. The positive cash flow from operations indicates that Amazon is maturing. In fact, having cash flow from operations exceeding investment needs (that is, positive free cash flow) is a sign that Amazon is entering a stage where growth may be slowing but profitability is increasing This attitude would prevent anyone from ever investing in a brand new company with a great idea. Since these companies are often risky, this strategy might be quite appropriate for investors who were retired and relied on investments for living expenses. However, for a younger person with more ability to take risk, an appropriate exposure to young, dynamic growth companies might be quite appropriate. The characteristics referred to in the question identify the target investments as young growth companies for the most part but do not reveal much about other investment decision variables such as the industry, the age of the firm, the nature of the product, and so on. 196

7 5-31 (10 min.) BREMERHAVN SHIPPING COMPANY Statement of Cash Flows from Financing Activities For the Year Ended December 31, 20X8 Cash flows from financing activities: Proceeds from issue of long-term debt 200,000 Payment to retire long-term debt (160,000) Payment to retire common stock (35,000) Dividends paid (11,000) Net cash used for financing activities (6,000) Notice especially that both proceeds from the new issue and the payment to retire long-term debt are listed. Presenting only the net amount, 40 of proceeds, is not permitted. Also, the interest is omitted because it is an operating activity, not a financing activity (5-10 min.) FAR-EAST TRADING COMPANY Statement of Cash Flows from Investing Activities For the Year 20X5 Purchases of fixed assets $(160,000) Proceeds from the sale of fixed assets 20,000 Investment in Repulski Company (60,000) Net cash used for investing activities $(200,000) Chapter 5 Statement of Cash Flows 197

8 5-33 (5-10 min.) POULSBO BAY COMPANY Schedule of Noncash Investing and Financing Activities Note payable issued for acquisition of fixed assets 191,000 Common stock issued on conversion of preferred shares $340,000 Mortgage assumed on acquisition of warehouse 630, (5 min.) The split between cash and credit sales is irrelevant for purposes of this problem. Sales $750,000 Less increase in accounts receivable (30,000) Cash received from customers $720, (5 min.) Cost of goods sold $500,000 Add increase in inventory ($150,000 $100,000) 50,000 Deduct increase in accounts payable ($45,000 $24,000) (21,000) Cash paid to suppliers $529,

9 5-36 (5-10 min.) Wage and salary expense $195,000 Cash paid to employees 180,000 Increase in accrued wages and salaries payable $ 15,000 Beginning balance, accrued wages and salaries payable $ 18,000 Increase in accrued wages and salaries payable 15,000 Ending balance, accrued wages and salaries payable $ 33, (5-10 min.) ORION STRATEGY, INC. Statement of Cash Flows from Operating Activities For the Year Ended December 31, 20X6 Collections from customers ($470,000 $5,000) $465,000 Cash expenses ($285,000 $35,000) 250,000 Net cash provided by operating activities $215,000 Chapter 5 Statement of Cash Flows 199

10 5-38 (5-10 min.) ORION STRATEGY, INC. Reconciliation of Net Income to Net Cash Provided by Operating Activities For the Year Ended December 31, 20X6 Net income $185,000 Add depreciation, which was deducted in computing net income but does not affect cash 35,000 Deduct increase in accounts receivable (5,000) Net cash provided by operating activities $215,

11 5-39 (10 min.) 1. Sales $880,000 Nondepreciation expenses [570, ,000] (470,000) Depreciation (100,000) Net income $310,000 Add back depreciation 100,000 Net cash provided by operating activities $410, Sales $ 880,000 Nondepreciation expenses [570, ,000] (470,000) Depreciation (300,000) Net income $ 110,000 Add back depreciation 300,000 Net cash provided by operating activities $ 410,000 Notice that the additional depreciation did not affect net cash provided by operating activities. The direct method clearly shows this phenomenon: Direct method: Sales for cash $ 880,000 Operating expenses in cash (470,000) Net cash provided by operating activities $ 410,000 Chapter 5 Statement of Cash Flows 201

12 5-40 (5-10 min.) a. Financing f. Financing b. Financing g. Operating c. Operating h. Operating d. Investing i. Financing e. Financing Because net income and depreciation appear in the body of the statement of cash flows, AT&T must use the indirect method for reporting cash flows from operating activities (10-15 min.) ELI LILLY AND COMPANY Statement of Cash Flows from Financing Activities For the Year Ended December 31, 2002 (In Millions) Dividends paid (1,335.8) Purchase of common stock and other capital transactions (385.2) Stock issuances 64.6 Decrease in short-term borrowings (18.0) Additions to long-term debt 1,259.6 Repayments of long-term debt (7.2) Net cash used for financing activities $(422.0) 202

13 5-42 (10-15 min.) KLM ROYAL DUTCH AIRLINES Statement of Cash Flows from Investing Activities For the 2003 Fiscal Year (in millions) Net capital expenditure on intangible fixed assets (28) Capital expenditures on aircraft (637) Investments in affiliated companies (33) Disposals of aircraft 308 Net capital expenditures on other tangible fixed assets (53) Sales of investments 7 Net cash used for investing activities (436) 5-43 (10-15 min.) Items 3 and 6 are completely cash transactions and would be shown on the body of a statement of cash flows. The others all entail some noncash investing or financing activity. Schedule of Noncash Investing and Financing Activities Exchange of assets $ 6,000 Issue 6-month note to retire long-term debt* $ 30,000 Assumption of mortgage on building purchased** $100,000 Conversion of debt to common stock $ 60,000 * The $20,000 cash payment would be in the body of the statement of cash flows. ** The $20,000 cash payment would be in the body of the statement of cash flows. Chapter 5 Statement of Cash Flows 203

14 5-44 (10-15 min.) NORTHWEST COMMUNICATIONS Statement of Cash Flows For Six Months Ended June 30, 2004 (In Millions) Operating Activities: Receipts from customers $ 9,355 Payments to suppliers and employees (7,499) Interest paid, net (140) Taxes Paid (167) Cash provided by operating activities 1,549 Investing Activities: Capital expenditures for property and equipment (1,710) Sales of marketable securities 191 Other (134) Cash used for investing activities (1,653) Financing Activities: Issuance of long-term debt 135 Retirement of long-term debt (160) Issuance of common stock for employee stock plans 251 Dividend payments (17) Purchase of treasury stock (193) Cash provided by financing activities 16 Net (decrease) increase in cash and cash equivalents (88) Cash and cash equivalents, beginning balance 200 Cash and cash equivalents, ending balance $

15 5-45 (15-20 min.) POOLS, INC. Statement of Cash Flows For the Year Ended December 31, 20X7 (In Thousands) Cash flows from operating activities: Cash collections from customers $1,400 Cash payments: To suppliers $(825) To employees (200) For other expenses (100) For interest ( 11) For income taxes (35) Cash disbursed for operating activities (1,171) Net cash provided by operating activities 229 Cash flows from investing activities: Purchase of plant and facilities (435) Cash flows from financing activities: Issued long-term debt 110 Paid dividends (41) Net cash provided by financing activities 69 Net decrease in cash (137) Cash, December 31, 20X6 176 Cash, December 31, 20X7 $ 39 Chapter 5 Statement of Cash Flows 205

16 5-46 (15-25 min.) KOBE EXPORTS, INC. Statement of Cash Flows For the Year Ended December 31, 20X5 (In Millions) Cash flows from operating activities Cash collections from customers 2,413 Cash payments: To suppliers (1,653) To employees (305) For other operating expenses (94) For interest (26) For income taxes (108) Cash disbursed for operating activities (2,186) Net cash provided by operating activities 227 Cash flows from investing activities: Purchase of warehouse (540) Proceeds from sale of equipment 47 Net cash used in investing activities (493) Cash flows from financing activities: Issued common stock 28 Retired long-term debt (25) Dividends paid (98) Net cash used in financing activities (95) Net decrease in cash (361) Cash, January 1, 20X5* 368 Cash, December 31, 20X5 7 *X 361 = 7 X = (15-25 min.) 206

17 ARROYO MANUFACTURING COMPANY Statement of Cash Flows For the Year Ended December 31, 20X4 (In Thousands) Cash flows from operating activities Cash collections from customers ($371 + $15) $ 386 Cash payments: To suppliers ($209 $5 $5) $(199) To employees (82) For other expenses (15) For income taxes (8) Cash disbursed for operating activities (304) Net cash provided by operating activities $ 82 Cash flows from investing activities: Purchase of machinery $(125) Proceeds from sale of old machines 5 Net cash used for investing activities (120) Cash flows from financing activities: New issue of long-term debt $ 100 Payment of dividends* (10) Net cash provided by financing activities 90 Net increase in cash $ 52 Balance, cash and cash equivalents, December 31, 20X3 45 Balance, cash and cash equivalents, December 31, 20X4 $ 97 *$15 net income dividends = $5 increase in retained earnings Chapter 5 Statement of Cash Flows 207

18 5-48 (20-25 min.) 1. J. M. SMUCKER COMPANY Statement of Cash Flows For the Year Ended April 30, 2003 (In Millions) Cash Flows from operating activities: Cash received from customers ($1,311 $43) $1,268 Cash paid for operating expenses ($1, ) (1,069) Cash paid for other expenses ($9 $12) 3 Taxes paid ($59 $23) (36) $ 166 Cash flows from investing activities: Additions to property, plant, and equipment $(49) Business acquired (11) Disposal of property, plant, and equipment 7 (53) Cash flows from financing activities: Issuance of common stock $ 7 Dividends paid (34) (27) Increase in cash $ Operating cash flows substantially exceeded dividend payments plus Smuckers investing activities. No additional financing was required. The $7 million of common stock issued was probably part of executive stock option plans or employee stock purchase plans. 208

19 5-49 (15-20 min.) FIRENZE, S.A. Statement of Cash Flows For the Year Ended December 31, 20X1 (In Millions of Euros) Cash flows from operating activities: Cash collections from customers [910 90] 820 Cash payments: To suppliers [ ] (420) For operating expenses (220) For interest (15) For taxes (25) Cash disbursed for operating activities (680) Net cash provided by operating activities 140 Cash flows from investing activities: Purchase of fixed assets (315) Proceeds from sale of fixed assets 100 Net cash used for investing activities (215) Cash flows from financing activities: New issue of long-term debt 65 Dividends paid (30) Net cash provided by financing activities 35 Net decrease in cash (40) Cash balance, December 31, 20X0 60 Cash balance, December 31, 20X1 20 Chapter 5 Statement of Cash Flows 209

20 5-50 (15 min.) 1. CSR LIMITED Statement of Cash Flows For the Fiscal Year 2003 (In Millions) Cash flows from operating activities: Receipts from customers A$7,572.7 Payments to suppliers and employees (6,281.3) Dividends and interest received 78.3 Income taxes paid (197.6) Net cash from operating activities 1,172.1 Cash flows from investing activities Purchase of property, plant, and equipment (315.2) Proceeds from sale of property, plant, and equipment 97.7 Other investing activities (897.6) Net cash used in investing activities (1,115.1) Cash flows from financing activities Proceeds from issue of shares 42.8 Repurchase of shares (6.7) Net proceeds from borrowings Dividends paid (245.1) Interest paid (111.4) Net cash from financing activities Net increase in cash A$ Interest paid is an operating item in U.S. cash flow statements. 3. Interest paid is a cost of financing the company s activities. Like dividends are a return to suppliers of equity capital, interest is the return to suppliers of debt capital. Therefore, it is a legitimate item to be included among financing activities. 4. The FASB decided that because interest is an expense in the income statement it should be included with the other expenses among the operating activities. 210

21 5-51 (15 min.) KANSAI ELECTRIC Statement of Cash Flows Year Ended March 31 (in Billions of Yen) Cash flows from operating activities: Operating revenues 2,545 Non-operating revenues 109 Operating expenses (1,954) Non-operating expenses (140) Net cash provided by operating activities 560 Cash flows from investing activities Cost of construction (672) Net cash used for investing activities (672) Cash flows from financing activities Bond issue 236 Increase in loans 1,546 Repayment of bonds (262) Repayments of loans (1,419) Net cash provided by financing activities 101 Net decrease in cash (11) Cash balance at beginning of the period 72 Cash balance at end of the period 61 Chapter 5 Statement of Cash Flows 211

22 5-52 (10-15 min.) POOLS, INC. Supporting Schedule to Statement of Cash Flows Reconciliation of Net Income to Net Cash Provided by Operating Activities For the Year Ended December 31, 20X7 (In Thousands) Net income $ 314 Adjustments to reconcile net income to net cash provided by operating activities: Add: Depreciation, which was included in computing net income but does not affect cash 45 Deduct: Increase in accounts receivable (100) [1,500 1,400] Deduct: Increase in inventory (50) [ ] Add: Increase in accounts payable 25 [ ] Deduct: Decrease in salaries and wages payable (10) [ ] Add: Increase in income taxes payable 5 [ 40 35] Net cash provided by operating activities $

23 5-53 (10-15 min.) Amounts are in millions. Net Earnings $514 Add expenses not requiring cash: Depreciation $191 Other Adjust for changes in operating current assets and current liabilities: Decrease in accounts receivable $ 17 Increase in inventories (11) Increase in prepaid expenses (1) Decrease in accounts payable (84) Increase in income taxes payable 71 Increase in other accrued liabilities (54) (62) $ (10-15 min.) SUMITOMO METAL INDUSTRIES, LTD. Statement of Cash Provided by Operating Activities For the Year Ended March 31, 2003 (In Billions of Yen) Net earnings 17.1 Add depreciation and amortization 93.0 Add other noncash revenues and expenses, net 16.4 Adjust for changes in operating current assets and current liabilities Add decrease in receivables 30.6 Add decrease in inventories 30.7 Add increase in payables 2.8 Less other changes in current assets and current liabilities (29.5) Net cash provided by operating activities Chapter 5 Statement of Cash Flows 213

24 5-55 (10 min.) TANG COMPANY (In Millions) 1. Income Statement Sales $380 Nondepreciation expenses ($350 $25) $325 Depreciation (Revised) Net income $ 10 Reconciliation of net income to net cash provided by operating activities: Net income $ 10 Add noncash expenses: Depreciation 45 Deduct net increase in noncash operating working capital (17) Net cash provided by operating activities $ An increase in depreciation does not affect net cash flow from operating activities. The $20 million increase in depreciation decreases net income by $20 million and increases the add back by $20 million. The net effect is zero. Depreciation is added to net income merely to offset its deduction when computing net income, not because it provides cash. 214

25 5-56 (10-20 min.) KOBE EXPORTERS, INC. Supporting Schedule to Statement of Cash Flows Reconciliation of Net Income to Net Cash Provided by Operating Activities For the Year Ended December 31, 20X5 (In Millions) Net income 254 Adjustments to reconcile net income to net cash provided by operating activities: Add: Depreciation 151 Deduct: Increase in accounts receivable (2,510 2,413) (97) Deduct: Increase in inventory (56) Add: Increase in accounts payable (1, ,653) 2 Deduct: Decrease in wages payable (24) Deduct: Decrease in income taxes payable ( ) ( 3) Net cash provided by operating activities 227 Chapter 5 Statement of Cash Flows 215

26 5-57 (10-20 min.) ARROYO MANUFACTURING COMPANY Statement of Cash Flows For the Year Ended December 31, 20X4 (In Thousands) Cash flows from operating activities Net income $ 15 Adjustments to reconcile net income to net cash provided by operating activities: Add noncash expenses: Depreciation $ 40 Add decreases in current assets: Accounts receivable 15 Inventories 5 Add increases in current liabilities Accounts payable 5 Interest payable 2 67 Net cash provided by operating activities 82 Cash flows from investing activities: Purchase of machinery $(125) Proceeds from sale of old machines 5 Net cash used for investing activities (120) Cash flows from financing activities: New issue of long-term debt $ 100 Payment of dividends (10) Net cash provided by financing activities 90 Net increase in cash 52 Balance, cash and cash equivalents, December 31, 20X3 45 Balance, cash and cash equivalents, December 31, 20X4 $

27 5-58 (20-30 min.) SALINAS COMPANY Statement of Cash Flows For the Year Ended December 31, 20X1 (In Millions) Cash flows from operating activities: Net income $ 60 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 40 Increase in receivables (35) Increase in inventories (44) Increase in current liabilities 75 Net cash provided by operating activities $ 96 Cash flows from investing activities: Purchase of fixed assets (240) Cash flows from financing activities: Issue of long-term debt $150 Dividends paid (12) Cash provided by financing activities 138 Net decrease in cash $ (6) Cash balance, December 31, 20X0 21 Cash balance, December 31, 20X1 $ Dear Mr. Salinas: Severe shortages of cash often accompany rapid corporate growth. Profitable operations usually produce heavy supplies of cash. But the insatiable demand for cash to expand receivables, inventories, and fixed assets may deplete the cash on hand despite profitable operations. In your case, the substantial increase in the fixed asset levels was perhaps the dominant factor in consuming cash generated by operations. Chapter 5 Statement of Cash Flows 217

28 5-59 (30-40 min.) 1. ROSENBERG COMPANY Statement of Cash Flows For the Year Ended December 31, 20X4 (In Millions) Cash flows from operating activities: Cash collections from customers ($275 $14) $261 Cash payments: To suppliers ($165 + $20 $14) $(171) For general expenses ($51 + $1) (52) For taxes ($10 $1) (9) Cash disbursed for operating activities (232) Net cash provided by operating activities 29 Cash flows from investing activities: Acquisition of plant assets $ (98) Proceeds from sale of plant assets 6 Net cash used for investing activities (92) Cash flows from financing activities: Issue long-term debt $ 50 Pay cash dividends (2) Net cash provided by financing activities 48 Net decrease in cash (15) Cash balance, December 31, 20X3 20 Cash balance, December 31, 20X4 $ 5 218

29 5-59 (continued) 2. Reconciliation of Net Income to Net Cash Provided by Operating Activities Net income $ 9 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 40 Increase in accounts receivable (14) Increase in inventory (20) Increase in prepaid general expenses ( 1) Increase in accounts payable for merchandise 14 Increase in accrued tax payable 1 Net cash provided by operating activities $ Rosenberg s stress may be reduced but not eliminated. The statement of cash flows has shown why cash has fallen by $15 million. Operating activities provided $29 million, and financing activities provided an additional $48 million, a total of $77 million. However, $92 million was needed for the net acquisition of plant assets. Severe crunches on cash commonly accompany quick corporate growth. There may be substantial net income and working capital provided by operations, but heavy demands for cash to expand receivables, inventories, and plant assets diminish the cash on hand despite profitable operations. Hence, most "growth" companies pay skimpy or no dividends. Chapter 5 Statement of Cash Flows 219

30 5-60 (10-15 min.) Amounts are in millions of dollars. Cash = Retained Noncash Liabilities + Earnings Assets Sales = (+ 275) Cash collections from customers = ( 261) Cost of goods sold = 165 ( 165) Purchases = (+ 185) Payments to suppliers 171 = 171 Payments for general expense 52 = 51 (+ 1) Tax expense = Payments for taxes 9 = 9 Net cash provided by operating activities (a subtotal) 29 Expenses not requiring cash: Depreciation = 40 ( 40) Net income (a subtotal) 9 Purchase of plant assets 98 = (+ 98) Proceeds from sale of plant assets + 6 = ( 6) Long-term debt issued + 50 = + 50 Dividends paid 2 = 2 Net changes 15 = (+ 87) 220

31 5-61 (40-60 min.) This problems includes the complication of gains and losses on asset sales and debt retirement. ADIRONDAK TOYS, INC. Statement of Cash Flows For the Year Ended December 31, 20X4 (In Thousands) Cash flows from operating activities: Cash collections from customers ($9,739 + $19) $ 9,758 Dividends received 152 $ 9,910 Cash payments: To suppliers and employees $ (8,074) For interest ($144 $15) (129) For taxes (390) Cash disbursed for operating activities (8,593) Net cash provided by operating activities $ 1,317 Cash flows from investing activities: Purchase property, plant & equipment $ (1,986) Purchase stock in Lake Placid Toy (3,848) Proceeds from sale of property 500 Net cash used by investing activities (5,334) Cash flows from financing activities: Issue common stock $ 3,300 Cash received on exercise of stock options 170 Issue long-term debt 1,906 Retire long-term debt (850) Buy treasury stock (249) Cash dividends paid (240) Net cash provided by financing activities 4,037 Net increase in cash and cash equivalents $ 20 Note that (h) regarding the money market fund is irrelevant; it merely rearranges the composition of the total cash holdings. The non-cash purchase of new equipment in (d) would be shown in an accompanying schedule. Similarly for transactions (f) and (j). Chapter 5 Statement of Cash Flows 221

32 5-61 (continued) Reconciliation of Net Income to Net Cash Provided by Operating Activities Net income $ 672 Adjustments to reconcile net income to net cash provided by operating activities: Add: Depreciation and amortization 615 Add: Loss on sale of fixed assets ( ) 76 Deduct: Gain on extinguishment of debt ( ) (50) Deduct: Increase in inventories (72) Add: Decrease in accounts receivable 19 Add: Increase in accounts and wages payable 7 Add: Increase in interest payable 15 Add: Increase in taxes payable 35 Net cash provided by operating activities $1,317 Schedule of Noncash Investment and Financing Activities Issue note payable for purchase of equipment $ 516 Issue common stock for conversion of long-term debt $ 960 Issue common stock to acquire Sanchez Musical Instruments Co. $

33 5-62 (20 min.) NORDSTROM, INC. Statement of Cash Flows Cash flows from Operating Activities For the Year Ended January 31, 2003 (In Millions) Cash collections from customers $5,917 (a) Other cash collections 74 Total Collections 5,991 Cash Payments: To suppliers $4,098 (b) For selling, general and administrative expenses 1,484 (c) For interest 82 For taxes 48 (d) Total cash payments 5,712 Net cash provided by operating activities $ 279 (a) $5,975 $58 (b) $3,971 + $117 + $10 (c) $1,814 $288 - $1 $24 $17 (d) $92 $44 Chapter 5 Statement of Cash Flows 223

34 5-63 (15-20 min.) Amounts are in millions. 1. Kellogg's free cash flow each year was: (In Millions) Operating cash flow $ $1,132.0 $ Additions to properties (253.5) (276.5) (230.9) Free cash flow before dividends Dividends (412.6) (409.8) (403.9) Free cash flow after dividends $ $ $ Kellogg s has plenty of cash flow from operations each year to pay its capital investment needs and its dividends. It s best free cash flow was in 2001, and it fell slightly in

35 5-64 (20-25 min.) Amounts are in millions of dollars. The McDonald's Corporation cash flow statement is presented on the following page with all brackets in place and with the original values for a, b, and c. From a solution perspective the following procedural matters may be useful. 1. & 2. Most of the descriptions are obvious because they use phrases such issuances or repayment. In this instance all have the same sign as in the prior year. In both investing and financing, the sign of "other" can only be determined by calculating once the others are determined. While "other" has the same sign as in the prior year, this is not reliable. Also, the sign of net short-term borrowings (repayments) is not obvious. While the total could be either positive or negative, the caption for the total is unambiguous, cash used for financing. Only a negative $606.8 million will give a total of $511.2 million as cash used for financing. 3. A. = $2, $2, $511.2 = -$87.7 million (a decrease). B. = $418.1 million, the ending balance from the prior year. C. = A + B = $-87.7 million + $418.1 million = $330.4 million. 4. Beginning Balance + net earnings dividends = ending balance. $18,608.3 million +$893.5 million -$297.4 million =$19,204.4 million 5. McDonalds' cash flow provided by operations has exceeded its investing needs over the two years. Therefore, there has been no need for extra financing. Chapter 5 Statement of Cash Flows 225

36 5-64 (continued) Although not required as part of the problem, we provide here the complete statement of cash flows for reference: MCDONALD s CONSOLIDATED STATEMENT OF CASH FLOWS (In millions) Years ended December 31, Operating activities Net income $ $ 1,636.6 Adjustments to reconcile to cash provided by operations Depreciation and amortization 1, ,086.3 Changes in operating working capital items Accounts receivable 1.6 (104.7) Inventories, prepaid expenses and other current assets (38.1) (62.9) Accounts payable (11.2) 10.2 Taxes and other liabilities Other (147.6) Cash provided by operations 2, ,688.3 Investing activities Property and equipment expenditures (2,003.8) (1,906.2) Purchases of restaurant businesses (548.4) (331.6) Sales of restaurant businesses and property Other (283.9) (206.3) Cash used for investing activities (2,466.6) (2,068.2) Financing activities Net short-term borrowings (repayments) (606.8) (248.0) Long-term financing issuances 1, ,694.7 Long-term financing repayments (750.3) (919.4) Treasury stock purchases (670.2) (1,068.1) Common stock dividends (297.4) (287.7) Other Cash used for financing activities (511.2) (623.7) Cash and equivalents increase (decrease) (87.7) (3.6) Cash and equivalents at beginning of year Cash and equivalents at end of year $ $

37 5-65 (20 min.) 1. Brookline has a large and growing cash balance. Both sales and income are declining, indicating that Brookline has not successfully developed products to replace those responsible for its peak sales in The company is apparently managing a declining situation, selling more fixed assets than it is building or acquiring. In fact, rather than investing in producing assets, Brookline seems to be putting any extra cash into passive investments such as the equity securities of other corporations. Of the $1,050,000 of net income, $1,500,000 ($900,000 + $600,000) was investment revenue. $2,100,000 was a gain on the sale of fixed assets, and these were offset by a $1,200,000 loss on the building fire. The ongoing business was generating a deficit. Without the two nonrecurring items and the investment revenue, there would have been negative net income (i.e. a loss) of $1,350,000 (= $1,050,000 $1,500,000 $2,100,000 + $1,200,000). Even after taking account of the $600,000 of depreciation and amortization, net cash flow from operations would have been a negative $750,000. Only by reducing working capital by $375,000 and receiving $900,000 in dividends did Brookline get a positive $525,000 of cash flow from operating activities. Notice that the two largest sources of cash for Brookline are the insurance proceeds on the fire and cash from the sale of fixed assets. Although these items have generated a healthy increase in cash this year, they cannot be expected to reoccur regularly. Chapter 5 Statement of Cash Flows 227

38 5-65 (continued) 2. Brookline s Statement of Cash Flows follows generally accepted accounting principles. However, it appears that the company may be trying to manage its operations to maintain a positive cash flow from operations. The intent of the operating activities section of the statement of cash flows is to highlight items that are likely to be maintained into the future. It seems that most of the positive cash flow items for Brookline are items that will not be maintained in the future. There do not seem to be any violations of ethical standards in Brookline s financial reports. Users of the reports should be able to interpret them correctly and to see the unfavorable situation in which Brookline finds itself, despite the overall increase in cash and the positive cash provided by operating activities. Nevertheless, if Brookline had used the direct method instead of the indirect method in its Statement of Cash Flows, its situation may have been more clearly communicated to users of the statements. 228

39 5-66 (15-20 min.) An important lesson in learning to understand statements of cash flow is to recognize operating, investing, and financing activities. Terminology can differ from company to company. This exercise will expose students to a variety of items included in companies cash flow statements. It would be desirable, though probably unlikely, that at least one company selected by the students uses the direct method. If so, the amount of learning will increase. By listing the items included in operating, investing, and financing categories by a variety of companies, students will begin to see the types of items included. By pruning the list to eliminate duplicates, they will learn to recognize different ways of expressing the same thing. Requirement 4 is not necessary, but it will reinforce the group learning that took place in the first three requirements. It will also allow students to start to recognize the most common elements of cash flow statements and also to try to interpret some that are quite unusual (45-60 min.) Each solution will be unique and will change each year. This problem focuses on interpretation of the cash flow statement, especially comparing net cash from operating activities with net income. Chapter 5 Statement of Cash Flows 229

40 5-68 (30 min. or more) 1. The major reason for the increase in Starbucks net cash provided by operating activities is the increase in net earnings. In addition, depreciation and amortization significantly increased. The increases in operating assets was mainly offset by increases in operating liabilities, so the net effect was not large. 2. The main use of the $566 million was to support investing activities. In total Starbucks used $499 million for investing activities, $357 million of which was used for net additions to property plant, and equipment. 3. Starbucks certainly generated enough cash to pay cash dividends in However, apparently management decided that a better use of those funds was to use them for internal expansion both buying property, plant, and equipment and investing in the securities of other companies, such as the purchase of Seattle Coffee Company. It is not true that the shareholders got nothing. Shareholders gain returns in two ways, dividends and stock price appreciation. As Starbucks grows, its stock price grows, also. Thus, the shareholders will benefit from increases in the stock price, even though they do not get any return in the form of dividends (30-60 min.) NOTE TO INSTRUCTOR. This solution is based on the web site as it was in late Be sure to examine the current web site before assigning this problem, as the information there may have changed. 1. Nike used the indirect method. We know that because the statement begins with net income and adjusts for noncash items included in net income. 230

41 5-69 (continued) 2. Management indicated that cash provided by operations increased from $922 million in 2003 to $1.5 billion in The two main reasons for the increase were the increased net income and better control of working capital. By better supply chain management Nike reduced its accounts receivable and increased its accounts payable, resulting in the freeing up of additional cash. 3. Cash provided by operations exceeds net income by almost $570 million. About half of this is caused by adding back depreciation to the net income. The other half is primarily a result of better control of working capital. 4. Nike, like every company using the indirect method, adds depreciation and amortization to net income to offset their deduction in computing net income. Depreciation and amortization are expenses, but they are not cash outflows. They are correctly subtracted from revenues in computing net income, but they should not be deducted from cash receipts in computing cash from operations. Adding both back to net income just cancels the deductions taken when computing net income. 5. There were three main investing activities that used cash, purchases of short-term investments, additions to property, plant, and equipment, and acquisition of a subsidiary (Converse). 6. Nike used cash for three main financing activities, including just over $50 million net reductions in long-term debt ($153.8 million million = -$52.8 million), repurchases of stock exceeding new issues by more than $160 million ($419.8 million - $253.6 million = $166.2 million), and cash dividends paid of nearly $180 million. Chapter 5 Statement of Cash Flows 231