Kelley School of Business Example Application of the Cash Flow Identity, p.1 Prof. Durham

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1 Kelley School of Business Example Application of the Cash Flow Identity, p.1 Prof. Durham This next set of materials is intended to give you a master accounting equation that any of you should be mindful of in your professional lives regarding the firm for which you work (or the firm that you own). My goal in providing you with these resources is so that you can learn to understand how every decision within a firm has financial statement implications and, even more importantly, has cash flow implications. Remember, the Cash Flow Identity is CF from Assets = CF to Creditors + CF to Stockholders. As covered in the earlier handout on the derivation of the Identity, CF from Assets can be expanded to Operating CF [which itself = Oper. Inc. + Deprec'n Exp. Tax Exp.] Δ Net Working Cap. [which itself is Δ the various Current Asset accounts Δ the various Current Liab. accounts] Net Capital Spending [which itself = Δ Net Fixed Assets + Deprec'n Exp. Gain on Sale of Asset + Loss on Sale of Asset]. Also, CF to Creditors = Δ Long term Debt + Interest Expense and CF to S'holders = Δ Comm. Stock + Dividend Expense. On the next page, you ll see roughly 15 examples of typical transactions within (or by) a firm; of course, the types of typical transactions are endless. But, you want to learn to think about the cash flow implications of any transaction. When you study the following transactions, think about how each one affects CF from Assets, CF to Creditors, and CF to S'holders. (In many cases, the net effect will be a 0.) Suppose that these transactions were in the very first year of the firm's existence. Thus, we can construct a beginningof year balance sheet, an income statement for the year, and an end of year balance sheet. Remember from the earlier derivation of the Cash Flow Identity that Δ Retained Earnings = Additions to Ret. Earnings = Net Income Dividend Exp. = Operating Inc. Interest Exp. + Gain Loss Tax Exp. Dividend Exp. Here are what the statements would look like. Assets Beg. of Yr.1 End of Yr.1 Income Stmt. Year1 Cash M Revenues 1.4M Accts. Rec ble 0 300K CostOfGoodsSold 750K Inventory 0 1.0M SG&A Expenses 410K GrossFixedAssets 0 1.5M Deprec n Exp. 150K Accum d Deprec n 0 150K Operating Inc. 90K Net Fixed Assets M Interest Expense 40K Total Assets M Gain on Sale n/a Loss on Sale n/a Liab s & Own. Eq. Beg. of Yr.1 End of Yr.1 Taxable Inc. 50K Accts. Payable 0 70K Tax Expense 17K Wages Payable 0 20K Net Income 33K Taxes Payable 0 17K Long term Debt 0 800K Dividend Expense 10K Common Stock 0 4.0M Add ns to Ret. Earn. 23K Retained Earnings 0 23K Total Liab s & OE M Next, let's imagine that we did not have access to the roughly 15 transactions from inside of the firm and could only see these financial statements. Let's finish by constructing a Cash Flow Identity for Year 1: CF from Assets = Oper. Inc. + Depr. Exp. Tax Exp. ΔNWC [ Δ Net Fixed Assets + Deprec'n Exp. Gain + Loss ] = $90K + $150K $17K (+$3.473M) [ (+$1.35M) + $150K n/a + n/a ] = $4.75M. Cash Flow to Creditors = Δ Long term Debt + Interest Exp. = (+$800K) + $40K = $760K. Cash Flow to S'holders = Δ Comm. Stock. + Dividend Exp. = (+$4.0M) + $10K = $3.99M. Check. Cash Flow from Assets, indeed, equals Cash Flow to Creditors + Cash Flow to S'holders. Interpretation: the firm's complex mix of long term assets and working capital (i.e., all current assets and current liabilities) "sucked in" $4.75M in the first year. The creditors pitched in $800K and received $40K; the s'holders pitched in $4.0M and received $10K.

2 Kelley School of Business Example Application of the Cash Flow Identity, p.2 Prof. Durham Transaction Accounts Op. + Depr. Tax ΔNet NetCap. ΔLT + Int. ΔCom. + Div. by Firm Affected Inc. Exp. Exp. WC Spend. Debt Exp. Stock Exp. 1. Issue 4.0M Cash 4.0M, (+4.0M) (+4M) + 0 stock for cash Com.Stk. 4.0M 2. Issue 800K Cash 800K, (+800K) (+800K) + 0 LTD for cash LTDebt 800K 3. Buy 900K in Invent. 900K, vent. on credit Accts.P. 900K 4. Buy ware GrossFA 1.2M 1, ( 1.2M) (+1.2M) house for 1.2M Cash 1.2M 5. Buy truck GrossFA 300K 1, ( 300K) (+300K) fleet for 300K Cash 300K 6a. Sell prod Revenues = uct for 1.4M, 1.4M, Accts. 1.4M (+1.4M) all on credit Rec. 1.4M 6b. Use up 750 CostOfGoodsS. K of finished = 750K, Inven 750K ( 750K) product tory 750K 7. From custo Cash 1.1M, mers in #6a, Accts.Rec collect 1.1M 1.1M 8. To vendors Cash 830K, who sold in #3, Accts.P ble pay 830K 830K 9. Buy 850K Inventory more invent 850K, Cash ory, w cash 850K 10. Pay 40K in Cash 40K, terest exp. on InterestExp ( 40K) K debt (from #2) = 40K 11a. Deprec. Depr.Exp. = the warehouse 120K, Accum. 120K +120K by 120K Depr. 120K 2 11b. Deprec. Depr.Exp. = the trucks 30K, Accum. 30K + 30K by 30K Depr. 30K Wage (SG SG&A Exp. = &A Exp.) = K, Cash 410K ( 410K) K, 390K paid 390K, Wages with cash P ble 20K 13. Yr. end tax Tax Exp. = exp. = 17K 3, 17K, Taxes K ( 17K) paid next year P ble 17K 14. Yr. end Dividend div. exp. = 10K, Exp. = 10K, ( 10K) K paid w cash Cash 10K

3 Kelley School of Business Example Application of the Cash Flow Identity, p.3 Prof. Durham Footnotes to accompany the table on page 2: 1 Remember: Δ Gross Fixed Assets does not appear explicitly in either the Cash Flow Identity or the Statement of Cash Flows. However, it is part of the term Δ Net Fixed Assets: Δ Net Fixed Assets = Δ Gross Fixed Assets Δ Accum'd Depreciation. 2 Remember: Δ Accum'd Depreciation does not appear explicitly in either the Cash Flow Identity or the Statement of Cash Flows. However, it is part of the term Δ Net Fixed Assets: Δ Net Fixed Assets = Δ Gross Fixed Assets Δ Accum'd Depreciation. 3 Perhaps the firm's average tax rate is 34%, so if Taxable Income (calculated further below) is $50K, then the Tax Expense would be $17K. Next, let's do another year's worth of transactions to continue to demonstrate the impacts of typical transactions on this important Cash Flow Identity. Please see the next page for a complete table and then return here for a continuation of the discussion. Assets Beg. of Yr.1 End of Yr.1 End of Yr.2 Income Stmt. Year1 Year2 Cash 0 2.8M 3.87M Revenues 1.4M 2.0M Accts. Rec ble 0 300K 210K CostOfGoodsSold 750K 960K Inventory 0 1.0M 150K SG&A Expenses 410K 440K GrossFixedAssets 0 1.5M 1.2M Deprec n Exp. 150K 150K Accum d Deprec n 0 150K 240K Operating Inc. 90K 450K Net Fixed Assets M 960K Interest Expense 40K 30K Total Assets M 5.19M Gain on Sale n/a 30K Loss on Sale n/a n/a Liab s & Own. Eq. Beg. of Yr.1 End of Yr.1 End of Yr.2 Taxable Inc. 50K 450K Accts. Payable 0 70K 110K Tax Expense 17K 153K Wages Payable 0 20K 40K Net Income 33K 297K Taxes Payable 0 17K 153K Long term Debt 0 800K 600K Dividend Expense 10K 33K Common Stock 0 4.0M 4.0M Add ns to Ret. Earn. 23K 264K Retained Earnings 0 23K 287K Total Liab s & OE M 5.19M As we did for Year 1, let's again imagine that we did not have access to the transactions from inside of the firm and could only see these financial statements. Let's again construct a Cash Flow Identity, this time for Year 2: CF from Assets = Oper. Inc. + Depr. Exp. Tax Exp. ΔNWC [ Δ Net Fixed Assets + Deprec'n Exp. Gain + Loss ] = $450K + $150K $153K (+$454K) [ (+$390K) + $150K $30K + n/a ] = $263K. Cash Flow to Creditors = Δ Long term Debt + Interest Exp. = ( $200K) + $30K = $230K. Cash Flow to S'holders = Δ Comm. Stock. + Dividend Exp. = n/a + $33K = $33K. Again, check. Cash Flow from Assets does equal Cash Flow to Creditors + Cash Flow to S'holders. Interpretation: the firm's complex mix of long term assets and working capital (i.e., all current assets and current liabilities) produced ("popped out") $263K in the 2nd year. The creditors received $230K and the s'holders received $33K. WHAT S THE TAKEAWAY?: The Cash Flow Identity tells a story. CF from a firm s Assets is associated with the firm s investments (captured by activity in the long term asset section of the balance sheet) and with the firm s operations (captured by operating income (from the income statement) and activity in the bal. sheet s working capital accounts) and with the government s stake accounted for (via the tax expense (on the inc. stmt.). Cash Flow from Assets must be equal to the sum of the Cash Flow to the firm s Creditors (captured by interest expense (on the inc. stmt.) and activity in the balance sheet s long term debt section) plus the Cash Flow to the firm s Shareholders (captured by dividend expense (on the inc. stmt.) and activity in the common stock account on the bal. sheet).

4 Kelley School of Business Example Application of the Cash Flow Identity, p.4 Prof. Durham Transaction Accounts Op. + Depr. Tax ΔNet NetCap. ΔLT + Int. ΔCom. + Div. by Firm Affected Inc. Exp. Exp. WC Spend. Debt Exp. Stock Exp. 1. Buy back Cash 200K, ( 200K) 0 ( 200K) K LT Debt LTDebt 200K 2. Collect on Cash 290K, K of A/R A/R 290K 3. Pay off three Cash 107K, curr. liab s from Accts.P. 70K, end of yr. 1 WP 20K, TP 17K 4a. Sell product Rev s = 2.0M, for 2.0M, all but Accts.Rec M (+2.0M) K on credit M, Cash 100K 4b. Use up 960 CostOfGoodsS. K of finished = 960K, Inven 960K ( 960K) product tory 960K 5. From custo Cash 1.7M, mers in #4a, Accts.Rec collect 1.7M 1.7M 6. Purchase Inventory 110K more inv 110K, Accts entory, on cred. P ble 110K 7. Pay 30K in Cash 30K, terest exp. on InterestExp ( 30K) K debt = 30K 8a. Deprec. Depr.Exp. = the warehouse 120K, Accum. 120K + 120K by 120K Depr. 120K 2 8b. Deprec. Depr.Exp. = the trucks 30K, Accum. 30K+ 30K by 30K Depr. 30K 2 9. Wage (SG SG&A Exp. = &A Exp.) = K, Cash 440K ( 440K) K, 400K paid 400K, Wages with cash P ble 40K 10. For 270K, GrossFA sell the trucks 300K, Accum. (which have a Depr. 60K, (+270K) ( 270K) K book Cash 270K, value 4 ) Gain = 30K Yr. end tax Tax Exp. = exp. = 153K 5, 153K, Taxes K ( 153K) paid next year P ble 153K 12. Yr. end Dividend div. exp. = 33K, Exp. = 33K, ( 33K) K paid w cash Cash 33K

5 Kelley School of Business Example Application of the Cash Flow Identity, p.5 Prof. Durham Footnotes to accompany the table on page 4: 4 Two depreciation expenses puts the trucks' net book value (net fixed asset value) at $240K. Gain on Sale of Asset = Selling Price ($270K) Net Book Value at Time of Sale ($240K) = $30K. Also worth noting is that Δ Net Fixed Assets, not Δ Gross Fixed Assets and Δ Accum'd Deprec'n, is in the Cash Flow Identity. But Δ Net Fixed Assets = Δ Gross Fixed Assets Δ Accum. Deprec'n, which for this transaction = ( 300K) ( 60K) so that Δ Net Fixed Assets = 240K. 5 Perhaps the firm's average tax rate is 34%, so if Taxable Income (calculated further below) is $450K, then the Tax Expense would be $153K.