Chapter 7--Learning Objectives 4 1.Understand how the statement of cash flows assists users in...
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Transcript of Chapter 7--Learning Objectives 4 1.Understand how the statement of cash flows assists users in...
Chapter 7--Learning Objectives
1. Understand how the statement of cash flows assists users in evaluation of firm performance
Current operating cash flowsa major user need
Current operating cash flows
(COCF)
is cash available from
normal operations
Current operating cash flowsmust be adequate for: 1. Permanent working capital 2. Seasonal working capital 3. Net fixed (and other long-term) assets 4. Repayment of debt principal &
interest 5. Payment of dividends
Permanent working capital
a firm’s permanent investment in net operating asset
receivables and inventory less the amount of this investment financed by trade creditors through accounts payable
Seasonal working capital
increases in inventory levels required by seasonally increased demands for the firm’s product or service
Adequacy ratios
The following ratios help assess the adequacy of COCF to meet firm needs:
Capital acquisition ratio Debt coverage ratio Dividend coverage ratio Cash flow adequacy ratio
Adequacy ratios (cont.)
Capital Financing Reinvestment Cash-Interest Coverage Dividend Payout
Performance and quality ratios
Cash flow return on assets Cash flow return on common equity Quality of sales ratio Quality of income ratio (2) Cash flow per share
Cash flow return on assets
COCF before interest and taxes *
Average total assets
* inclusion of taxes varies in practice
Cash flow return on common equity
COCF - preferred dividends
Average common equity
Quality of sales ratio
Cash from sales
Sales
Quality of income ratio # 1
Current operating cash flows
Operating income
Quality of income ratio # 2
C O C F before interest and taxes
Income before interest, taxes & deprec.
Cash flow per share*
C O C F - preferred dividends
Average number of common shares
*explicitly prohibited from disclosure in annual report
Chapter 7--Learning Objectives
2. Interpret the format and content of the statement of cash flows
Statement of cash flows
The purpose of the cash flow statement is to show the sources and uses of cash
Where did the cash come from ?Where did it go ?
Statement of cash flows
The statement has three principal sections: 1. Operating activities 2. Investing activities 3. Financing activities And two ancillary sections 1. Noncash investing / financing 2. Reconciliation
Statement of cash flows
The statement can be prepared two ways 1. The indirect method 2. The direct method
Operating activities
Routine inflows and outflows from regular operations
Net income used as a starting point in indirect method
Net income must be adjusted for items which affect income but not cash and for noncash items
Adjustments to net income in the operating section Items which affect income but not cash -- Depreciation and amortization
Noncash items -- Changes in current asset accounts (except certain investments) -- Changes in current liability
accounts
Relationships to remember
An increase in another asset account
results in a decrease in cash
ANOTHER ASSET UP -- CASH DOWNANOTHER ASSET DOWN -- CASH UP
Relationships to remember
Similarly, a decrease in a liability account results in a decrease in cash
LIABILITY DOWN -- CASH DOWNLIABILITY UP -- CASH UP
Investing activities
Investments in our own business Purchase of operational assets Sale of operational assets Investments in other businesses Purchase of securities Sale of securities Making loans to other entities Collecting such loans
Financing activities
Transactions involving owners Sale of stock Payment of dividends Treasury stock transactions Transactions involving creditors Borrowing long-term Repaying long-term debt
Some special cases
Purchase and sale of investments, whether short-term or long-term are INVESTING activities
Dividends and interest received from investments are considered to be OPERATING activities
More special cases
Interest paid to creditors is considered to be an OPERATING activity
Dividends paid to stockholders are considered to be a FINANCING activity
Noncash investing and financing activities Transactions in which no cash is involved
Example: Purchase of equipment with no down payment by issuing a long-term note payable
The direct method
Starts with cash received from customers Subtracts cash paid to Suppliers Employees Creditors (interest payments) Governments (taxes) Others (for operations)
A separate reconciliation
from net income
to
net cash flow from operating activities
is required
when the direct method
is used
The indirect method
Begins with net income Adjusts for items which affect income but
not cash and for noncash items Only the operating section is different
between the indirect and direct methods The investing and financing sections are
identical
Chapter 7--Learning Objectives
3. Derive cash flow information analytically from accrual information
Accrual based financial statements do not reveal cash received from customers or cash paid to suppliers
We have to dig this information out for ourselves
What do we know ?
From the income statement, we know sales revenue
From the balance sheet, we know beginning and ending accounts receivable
These numbers can be used to work toward cash received from customers
Sales revenue
Plus: Beginning accts. receivable
Less: Ending accts. receivable
Less: Accts. receivable written off
Equals: Cash recd. from customers
(Now how do we get accounts written off?)
Cash received from customers
Account receivable write-offs
Beginning Allow. for Bad Debts
Plus: Bad Debt Expense
Less: Ending Allow. for Bad Debts
Equals: Accounts written off
What about cash paid to suppliers ?
Purchases
Plus: Beginning Accts. Payable
Less: Ending Accts. Payable
Equals Cash paid to suppliers
If necessary, Purchases is calculated
Cost of Goods Sold
Plus: Ending Inventory
Less: Beginning Inventory
Equals: Purchases
Chapter 7--Learning Objectives
4. Differentiate between the direct and indirect method of presentation
East-West IndustriesStatement of Cash Flows - Direct Method
For the year ended June 30, 1995
Cash flows from operating activities
Collections from customers $200,000
Payments to vendors (60,000)
Payments to employees (40,000)
Payments to creditors (20,000)
Payments to utilities (20,000)
Payments to governments (30,000)
Cash flow from operations $30,000
East-West IndustriesStatement of Cash Flows - Direct Method
(continued)
Cash flows from investing activities
Proceeds from sale of PP&E 100,000
Proceeds from sale of land 110,000
Proceeds from sale of patents 70,000
Purchase of PP&E (200,000)
Purchase of land ( 50,000)
Purchase of intangibles ( 20,000)
Cash flow from investing 10,000
East-West IndustriesStatement of Cash Flows - Direct Method(continued)Cash flows from financing activities
Sale of stock 30,000
Issuance of bonds 100,000
Repurchase of stock (90,000)
Retirement of debt (10,000)
Payment of dividends (20,000)
Cash flow from financing 10,000
Net increase in cash 50,000
Balance, June 30, 1994 120,000
Balance, June 30, 1995 170,000
Operating Section - Indirect Method
Cash flows from operating activities
Net income $97,000
Depreciation expense 48,000
Amortization of patents 4,000
Depletion of natural res. 6,000
Deferred income taxes 17,000
Noncash interest expense 19,000
Gain on sale of land (47,000)
Loss on sale of PP&E 12,000
Gain on debt retirement (40,000) 19,000
Operating Section - Indirect Method--continued
Cash flows from operating activities
Gain on debt retirement (40,000) 19,000
Decrease in accts. receivable 9,000
Increase in AFBD 3,000
Increase in inventory (60,000)
Decrease in accts. payable (30,000)
Decrease in wages payable (12,000)
Increase in utilities payable 4,000
Net cash flow from operations $30,000
Chapter 7--Learning Objectives
5. Prepare a statement of cash flows