Teaching Notes: The Statement of Cash Flows (SCF) is a gold mine of information about a company s operating, financing, and investing activities. We acknowledge that learning (and teaching) the Statement of Cash Flows is a challenge. The Weis Markets case introduces students to the statement and its uses, highlights the mechanics behind statement presentation, and probes potential insights that may be drawn from the SCF. The Concepts part of the case highlights the differences between the SCF and the income statement and introduces the three sections of the SCF. The differences among the three parts of the SCF can be reinforced by relating each balance sheet account to one or more of the parts. If students understand which assets and liabilities relate to operations, investing, and financing, preparation of the SCF becomes easier. In the Process part of the case, students are asked to create the entire SCF. The Weis Markets, Inc., financial statements are sufficiently straightforward to permit this exercise. Additional information is provided as needed. The preparation methodology we encourage emphasizes that the changes in cash can be explained by examining the changes in each of the other accounts on the balance sheet. This fact can be encouraging to students who are overwhelmed by the mechanics of preparing a cash flow statement. If each account on the balance sheet is taken in turn and the year-over-year change in that account is explained, the statement will balance. We have included worksheets of T- accounts for each balance sheet account to assist students in analyzing the accounts. We note that other tools, such as a spreadsheet of accounts, may be useful approaches as well. Instructors should be aware that we have reclassified two items in the actual Weis Statement of Cash Flows to allow students to more easily reconcile the changes in balance sheet accounts in preparing the SCF: 1. The Depreciation expense added back in the operating activities section of Weis actual SCF does not include amortization expense on leasehold improvements. Instead, Weis includes the amount in the Amortization expense adjustment to the SCF. To facilitate linking these expense amounts with the Property and Equipment and Intangible Assets accounts, we included the amortization on leasehold improvements with depreciation. (in thousands) 2007 2006 2005 Actual SCF: Depreciation $ 47,511 $ 45,000 $ 43,875 Amortization 7,331 6,020 6,231 Total $ 54,842 $ 51,020 $ 50,106 Reclassified amounts in case: Depreciation and amortization of PP&E 54,187 50,288 49,215 Amortization of intangible assets 655 732 891 Total $ 54,842 $ 51,020 $ 50,106 1 Copyright 2012 by Cambridge Business Publishers, LLP. All rights reserved. No part of this publication may be reproduced in any form for any purpose without the written permission of the publisher.
2. The line items for Proceeds from maturities of marketable securities, and Proceeds from sale of marketable securities have been combined into one line to facilitate the reconciliation. Also, the adjustment called Other in the Operating Section is related to activity in the Marketable Securities account. This amount has been reclassified to the Investing Section and included in the line item Proceeds from sales and maturities of marketable securities. Since most students will not yet have exposure to the accounting for marketable securities at this point in the course, our goal in this case is to keep this reconciliation as simple as possible the case provides guidance to accomplish the reconciliation of the marketable securities account (including the gain/loss and the accumulated other comprehensive income and related tax effects) so that lack of knowledge of these notions will not create a problem in preparing the SCF. (in thousands) 2007 2006 2005 Actual SCF: Operating section Other $ 345 $ (201) $ (98) Investing section: Proceeds from maturities of marketable securities 13,780 15,745 0 Proceeds from sale of marketable securities 7 6,010 1,000 Total $ 14,132 $ 21,554 $ 902 Reclassified amounts in case: Proceeds from sale and maturities of marketable securities $ 14,132 $ 21,554 $ 902 Two solution approaches are presented. The first uses T-accounts blank T- accounts are included with the case for students use. In class, a large T- account for cash can be drawn on a side board and entries made as students work through the problem in class. The smaller T-accounts can also be handled on side boards with the SCF on the center board. Alternatively, the SCF outline can be projected onto a screen with an overhead and updated as the Cash and other T-accounts are filled in. The second approach uses a spreadsheet list of accounts. Students can be given a copy of the blank spreadsheet in advance so that they can come prepared to complete the SCF during class. The spreadsheet takes an algebraic approach which appeals to certain students more than the visual approach (the T-accounts). Both approaches can be prefaced with the following (brief) algebraic explanation: Consider the accounting identity (A = L + E). Splitting assets into cash and other assets we have: Cash + Other Assets = L + E. Rearranging terms, we isolate cash on the left side. Cash = L + E - Other Assets. If this relation holds at the beginning and end of the period, it then follows that the changes in each non cash account must sum to the change in cash. Algebraically (letting denote the change), this can be written with an equation that captures the SCF: Cash = L + E - Other Assets. 2
The change in cash must equal the changes in liability and owners equity accounts minus the change in all of the other assets. Regardless of the approach taken in class, students will have different ways of creating the SCF. Many students work from the operations section down. Others prefer to deal with each balance sheet account in order regardless of which SCF section it pertains to. Calling on students to handle one item at a time (either on the SCF or on the Cash T-account) allows for their diversity of approaches. The case concludes with some basic analysis and interpretation of key cashflow items, with an emphasis on comparing accrual Net income to Net cash provided by operating activities. Students are encouraged to also use information in the statement to evaluate a firm s investing and financing decisions. 3
Note: All amounts are in thousands unless otherwise noted a. The Statement of Cash Flows (SCF) shows the cash that was provided from and used for the three main business activities: operating, investing, and financing. In contrast, the Income Statement (I/S) shows amounts related to operating activities (with few exceptions). Another important difference is that the SCF shows (indirectly) the cash actually received and paid during the one-year period; whereas the I/S shows amounts earned and costs expensed over the one-year period, regardless of when the cash was actually received or paid. This latter difference is due to the concept of accrual accounting. b. The two methods of preparing the Statement of Cash Flows are the indirect method and the direct method. Weis Markets uses the indirect method. The statement begins with Net income and reconciles that accrual figure to a cash-based figure Net cash provided by operating activities. There are two cost-related reasons that explain why most companies use the indirect approach. First, the cost of producing direct information can be much higher. For example, all cash flows would have to be separately identified as operating, investing, or financing. The additional expense of reprogramming a company s bookkeeping and accounting-information system could outweigh the benefit of providing the information. Second, the indirect method information is required to be included in the reconciliation at the bottom of a direct method statement. Including this information creates additional cost to produce direct-method SCF. c. The three sections of the Statement of Cash Flows are 1) the operating section where net income determined on an accrual basis is reconciled to a cash-based figure, 2) the investing section where the company s activities in asset acquisitions and divestitures are detailed, and 3) the financing section that explains the uses and sources of cash related to the company s debt and equity financing. Interest expense is defined as an operating cash flow, dividends as a financing cash flow. d. The three sections of the SCF relate to the balance sheet in a straightforward way. In general, the current assets and liabilities relate to cash from operations. Exceptions include short-term investments (which are included in the investing section) and the current portion of long-term debt and lease obligations (which are financing cash flows). The long-term assets and changes in those accounts relate, for the most part, to the investing section. Fixed assets are the investments Weis Markets makes to earn income. Last, the financing section is tied to long-term debt and the shareholders equity. The liabilities and equity portion of the balance sheet comprises the sources of funds Weis Markets has tapped to finance its operations and its investment in long-term assets. e. Highly liquid investments with an initial maturity of 90 days or less are considered cash equivalents. This includes short-term commercial paper and 90-day certificates of deposit. Such instruments are so liquid that they are essentially equivalent to cash. Weis Markets, Inc. Statement of Cash Flows 1 Copyright 2012 by Cambridge Business Publishers, LLP. All rights reserved. No part of this publication may be reproduced in any form for any purpose without the written permission of the publisher.
f. Net income is the first line item on Weis Markets statement of cash flows (SCF) because the statement is prepared using the indirect approach. SCFs prepared under the direct approach do not have net income as the first line item. However, reconciliation of accrual-based net income with cash flows from operations is such an important concept that the FASB requires this reconciliation as a supplemental disclosure for firms using the direct approach (i.e., these firms must disclose more information about cash flows than firms that use the indirect method). Net income is reconciled with cash flows from operations because financial statement users benefit from knowing the amount of cash generated (or used) by the company s operations. Items in the operating section of the SCF are the same items used to compute accrual-based net income. The accruals outlined in the reconciliation help investors determine the quality of the company s earnings. Some analysts argue that earnings with a large proportion of accruals relative to cash flow are of lower quality. g.1. Property and equipment, at cost balance 1,181,927 Additions 64,233 16,782 Disposals (plug) Ending bal. 1,229,378 Accumulated depreciation 689,384 Disposals (plug) 13,439 54,187 balance Depreciation expense 730,132 Ending bal. g.1.i. Depreciation on fixed assets is included in the operating section because it is an operating expense on the income statement. The indirect method SCF begins with net income and makes adjustments for non cash expenses, like depreciation. Depreciation does not generate cash, it is simply the amount added back to net income to arrive at operating cash flow. During the year, this was $54,187. g.1.ii. During the year Weis acquired new property and equipment in the amount of $64,233. This is recorded in the investing section. g.1.iii. During the year Weis disposed of old property and equipment and received proceeds of $11,374. This amount will appear in the investing section of the SCF. g.1.iv. The T-accounts above include all the needed information to determine the gain or loss on the disposal of PPE during the year. Proceeds on disposal $ 11,374 Less: Original cost of property disposed of during the year 16,782 Depreciation on property disposed of during the year ( 13,439) Net book value 3,343 Gain on disposal of property and equipment $8,031 2
Weis included the gain on disposal of property and equipment in determining net income for the year. It is a non cash gain in that Weis did not receive cash for the gain. Further, since it relates to the investment in property, it is investing in nature thus, it is not an operating item. Therefore, to reconcile net income to cash from operations, we need to deduct the non cash gain. Had Weis experienced a loss on the disposal (because the proceeds were less than the net book value of the property disposed of) the loss would have been added back because losses are like non cash expenses. g.2. Intangible assets, net balance 4,804 New assets acquired 0 655 Amortization expense Ending balance 4,149 g.3. Marketable securities balance 38,163 Adjustment to market value 2,145 14,126 Ending balance 26,182 Sales during the year Accumulated Other Comprehensive Income 6,084 balance Change in net 1,255 unrealized gains/losses on marketable sec. 7,339 Ending balance g.4. Deferred taxes (current and long-term) 18,743 balance Income tax provision 1,252 Adjustment for 890 marketable securities 18,381 Ending balance 3
g.5. Dr. Retained earnings 452 Cr. Income taxes payable 452 To record inventory purchases. Other current adjustments, net (plug) Income taxes payable 865 1,317 452 balance Prior period adjustment 0 Ending balance Retained earnings 760,531 balance Prior period adjustment 452 50,990 Net income Dividends declared (plug) 31,309 779,760 Ending balance 4
WEIS MARKETS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) For the Fiscal Years ended December 29, 2007, December 30, 2006 and December 31, 2005 2007 (52 weeks) Cash flows from operating activities: 2006 (52 weeks) 2005 (53 weeks) Net income $ 50,990 $ 56,010 $ 63,421 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization expense 54,187 50,288 49,215 Amortization of intangible assets 655 732 891 (Gain) loss on disposition / impairment of fixed assets (8,031) 974 519 Gain on sale of marketable securities (6) (431) (422) Changes in operating assets and liabilities: Accounts receivable (6,575) (3,509) (2,318) Inventories (4,264) (10,086) (14,338) Prepaid expenses 615 2,144 (1,106) Income taxes recoverable (8,074) 0 1,729 Accounts payable and other liabilities 5,696 4,964 5,152 Accrued expenses 729 2,228 (558) Accrued self-insurance 664 1,225 1,381 Payable to employee benefit plans (35) (11,052) 1,661 Income taxes payable (1,317) (1,155) 2,020 Retirement benefits obligation 1,115 12,912 0 Deferred income taxes (1,252) (5,762) (2,845) Net cash provided by operating activities 85,097 99,482 104,402 Cash flows from investing activities: Purchase of property and equipment (64,233) (99,975) (55,468) Proceeds from the sale of property and equipment 11,374 2,696 291 Purchase of marketable securities 0 (33,020) (8,248) Proceeds from sale and maturities of marketable securities 14,132 21,554 902 Net cash used in investing activities (38,727) (108,745) (62,523) Cash flows from financing activities: Proceeds from issuance of common stock 1,235 224 172 Dividends paid (31,309) (31,344) (30,270) Purchase of treasury stock (2,654) (1,372) (715) Net cash used in financing activities (32,728) (32,492) (30,813) Net increase (decrease) in cash and cash equivalents 13,642 (41,755) 11,066 Cash and cash equivalents beginning of year 27,545 69,300 58,234 Cash and cash equivalents end of year $ 41,187 $ 27,545 $ 69,300 5
The T-accounts for all the balance sheet accounts are as follows: Cash Opening balance 27,545 Operating activities Net income 50,990 6,575 Increase in A/R, net 4,264 Increase in Inventory Depreciation and amortization on property and equipment Amortization on intangible assets 54,187 8,074 Increase in income taxes recoverable 655 1,252 Decrease in Deferred income taxes, net Decrease in Prepaid expenses 615 Increase in Accounts payable 5,696 35 Decrease in Payable to employee benefit plans Increase in Accrued expenses 729 1,317 Decrease in Income taxes payable Increase in Accrued selfinsurance Increase in Postretirement benefit obligations 664 8,031 Gain on sale of Property and equipment 1,115 6 Gain on sale of Marketable securities Investing activities Proceeds from sale of Property and equipment Proceeds from sales and maturity of Marketable securities 11,374 64,233 Purchases of property and equipment 14,132 Financing activities Proceeds from issuance of common stock to employees 1,235 31,309 Dividends Paid 2,654 Purchase of Treasury stock Closing balance 41,187 6
T-accounts for all the balance sheet accounts (continued): Marketable Securities Accounts Receivable, net Inventory 38,163 41,885 189,468 2,145 14,126 6,575 4,264 26,182 48,460 193,732 Prepaid Expenses Income taxes recoverable Property and equipment, gross 3,932 0 1,181,927 615 8,074 64,233 16,782 3,317 8,074 1,229,378 Accumulated Depreciation Goodwill Intangibles and Other Assets, net 689,384 15,722 4,804 13,439 54,187 0 655 730,132 15,722 4,149 Accounts Payable Accrued Expenses Accrued Self-Insurance 105,859 22,307 22,778 5,696 729 664 111,555 23,036 23,442 Payable to Employee Benefit Plans Income Taxes Payable Deferred Income Taxes (current + long-term) 1,435 865 18,743 1,252 890 35 1,317 Adj. 452 1,400 0 18,381 Postretirement benefit obligations Common Stock Retained Earnings 12,912 8,595 760,531 1,115 1,235 Adj. 452 50,990 31,309 14,027 9,830 779,760 7
Accumulated other comprehensive income 6,084 146,047 1,255 2,654 Treasury Stock 7,339 148,701 h. While sales have grown at just over 4% for the two-year period, Weis Markets has experienced declining profitability in recent years. In dollar terms, profit has dropped nearly 20% over the three year period, from $63,421 in 2005 to $56,010 in 2006 and to $50,990 in 2007. Profit margin has also fallen, from 2.85% in 2005 to 2.20% in 2007. The Statement of Income suggests that the declining profitability is due to a decline in gross profit percentage Cost of sales has increased from 73.6% in 2005 to 74.0% in 2007. While the difference of 0.4 percentage points may not seem large, it can make a significant difference in total profits. For example, if Weis Cost of sales as a percentage of sales for 2007 had remained at the 2005 level (73.6%), Cost of sales would have been lower by $9,970 which would have increased Net income from $50,990 to approximately $57,500 (adjusting for the estimated tax effect). The two-year decline in Net income would be 9.3% - less than half of the actual decline noted above. Net cash provided by operating activities has also experienced a decline 18.5% over the two-year period. Operating cash flow is consistently higher than Net income each year due largely to non cash depreciation and amortization expenses. Most key current asset and liability accounts have increased each year. Despite the decline in Net income and Cash provided by operating activities, the overall cash position remains healthy and working capital levels are consistently steady. The current ratio (current assets divided by current liabilities) has remained stable at just under 2.0. Continued declines in Net income, however, would likely put pressure on Weis cash situation in future years. i. From the Statement of Cash Flows, we can compare two numbers each year that will help us address this question. In the operating section of the statement, depreciation and amortization charges relating to property and equipment are reported as $54,187, $50,288 and $49,215 for 2007, 2006 and 2005, respectively. For the same years, acquisition of property and equipment was $64,233, $99,975, and $55,468. Weis appears to be expanding its capacity by acquiring assets at a faster rate than they are being used up (via depreciation). j. Weis is in a comfortable position to take on increased capital expenditures. Historically, Weis has covered its capital expenditure needs with operating cash flows. If Weis starts to feel a pinch in operating cash flows, it has the capacity to borrow monies to fund capital expenditures as of the end of 2007, Weis has no short or long-term debt outstanding. 8
Alternate Solution for part a: The basic premise behind preparing an indirect-method statement of cash flows (SCF) is to explain the change in the cash balance through the changes in the other balance sheet accounts. Consider the accounting identity (A = L + E). Splitting Assets into cash and other assets we have Cash + Other Assets = L + E. Rearranging terms, we isolate cash on the left side -> Cash = L + E - Other Assets. If this relation holds at the beginning and end of the period, it then follows that the changes in each non cash account must sum to the change in cash. Algebraically (letting denote the change), this can be written with an equation that captures the SCF -> Cash = L + E - Other Assets. The change in cash must equal the changes in liability and owners equity accounts minus the change in all of the other assets. One way to start this process is to enter the current and prior years balance sheet information into a spreadsheet and compute the differences in account balances. This spreadsheet also allows a way to check that every balance sheet account change has been incorporated into the SCF. Here s the spreadsheet for Weis 2007 balance sheet: 9
Weis Cash Flow Worksheet - Blank Balance Transactions Ending Balance Debits Credits Debits Credits Debits Credits Cash & equivalents 27,545 41,187 Operating Investing Financing Marketable securities 38,163 26,182 Accounts receivable 41,885 48,460 Inventory 189,468 193,732 Prepaid expenses 3,932 3,317 Income taxes recoverable 0 8,074 PP&E at cost 1,181,927 1,229,378 Accumulated depreciation 689,384 730,132 Goodwill 15,722 15,722 Intangible & other, net 4,804 4,149 Accounts payable 105,859 111,555 Accrued expenses 22,307 23,036 Accrued self-insurance 22,778 23,442 Payable-emp. ben. plans 1,435 1,400 Income taxes payable 865 0 Deferred taxes 18,743 18,381 Postretirement benefit obligations 12,912 14,027 Common stock 8,595 9,830 Retained earnings 760,531 779,760 Accumulated other comprehensive income 6,084 7,339 Treasury stock 146,047 148,701 Total debits & credits 1,649,493 1,649,493 1,718,902 1,718,902 10
Weis Cash Flow Worksheet - Completed Balance Transactions Ending Balance Debits Credits Debits Credits Debits Credits Cash & equivalents 27,545 41,187 Operating Net income 50,990 Depreciation and amortization on PPE 54,187 Amortization on intang. 655 Gain on sale of PP&E 8,031 Gain on sale of marketable securities 6 Accounts receivable, net 6,575 Inventory 4,264 Prepaid expenses 615 Income taxes recoverable 8,074 Accounts payable 5,696 Accrued expenses 729 Accrued self insurance 664 Employee ben. plans 35 Income taxes payable 1,317 Deferred income tax 1,252 Postretirement benefit obligations 1,115 Investing Payments for PP&E 64,233 Proceeds from PPE sale 11,374 Proceed from sales of marketable securities 14,132 Financing Issuance of common stk 1,235 Dividends 31,309 Purchase treasury stock 2,654 Marketable securities 38,163 2,145 14,126 26,182 Accounts receivable 41,885 6,575 48,460 Inventory 189,468 4,264 193,732 Prepaid expenses 3,932 615 3,317 Income taxes recoverable 0 8,074 8,074 PP&E at cost 1,181,927 64,233 16,782 1,229,378 Accumulated depreciation 689,384 13,439 54,187 730,132 Goodwill 15,722 15,722 Intangible & other, net 4,804 655 4,149 Accounts payable 105,859 5,696 111,555 Accrued expenses 22,307 729 23,036 Accrued self-insurance 22,778 664 23,442 Payable-emp. ben. plans 1,435 35 1,400 Income taxes payable 865 1,317 452 0 Deferred taxes 18,743 1,252 890 18,381 Postretirement benefit obligations 12,912 1,115 14,027 Common stock 8,595 1,235 9,830 Retained earnings 760,531 31,761 50,990 779,760 Accumulated other comprehensive income 6,084 1,255 7,339 Treasury stock 146,047 2,654 148,701 Total debits & credits 1,649,493 1,649,493 277,141 277,141 1,718,902 1,718,902 11