Foundations of Financial Management: An Analysis (part 6)

I'm involved in the stock market, which is fun and, sometimes, very painful.

Regis Philbin

Review of Accounting (part C)

by

Charles Lamson

Statement of Cash Flows

The accounting profession designates the statement of cash flows as the third required financial statement, along with the balance sheet and income statement. Referred to as Statement of Financial Accounting Standards (SFAS) No. 95, it replaces the old statement of changes in financial position.

The purpose of the statement of cash flows is to emphasize the critical nature of cash flow to the operations of the firm. According to accountants, cash flow represents cash or cash-equivalent items that can easily be converted into cash within 90 days (such as a money market fund).

The income statement and balance sheet, that were introduced in the two previous posts, are normally based on the accrual method of accounting, in which revenues and expenses are recognized as they occur, rather than when cash actually changes hands. For example, a $100,000 credit sale may be made in December 2018 and shown as revenue for that year despite the fact the cash payment will not be received until March 2019. When the actual payment is finally received under accrual accounting accounting, no revenue is recognized (it has already been accounted for previously). The primary advantage of accrual accounting is that it allows us to match revenues and expenses in the period in which they occur in order to appropriately measure profit; but a disadvantage is that adequate attention is not directed to the actual cash flow position of the firm.

Say a firm made a $1 million profit on a transaction but will not receive the actual cash payment for two years. Or perhaps the $1 million profit is in cash, but the firm increased its asset purchases by $3 million (a new building). If you merely read the income statement, you might assume the firm is in a strong $1 million cash position; but if you go beyond the income statement to cash flow considerations, you would observe the firm is $2 million short of funds for the period.

As a last example, a firm might show $100,000 loss on the income statement, but if there were a depreciation expense write-off of $150,000, the firm would actually have $50,000 in cash. Since depreciation is a non-cash deduction, the $150,000 deduction in the income statement for depreciation can be added back to net income to determine cash flow.

The statement of cash flows addresses these issues by translating income statement and balance sheet data into cash flow information. A corporation that has $1 million in accrual based accounting profits can determine whether it can afford to pay a cash dividend to stockholders, buy new equipment, or undertake new projects.

Developing an Actual Statement

We shall use the information previously provided for Kramer Corporation in previous posts to illustrate how the statement of cash flows is developed.

But first, let's identify the three primary sections of the statement of cash flows: (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities.

Figure 1  Illustration of concepts behind the statement of cash flows

After each of these sections is completed, the results are added together to compute the net increase or decrease in cash flow for the corporation. An example of the process is shown in Figure 1. Let's begin with cash flows from operating activities.

Determining Cash Flows from Operating Activities 

Basically, we are going to translate income from operations from an accrual to a cash basis. According to SFAS 95, there are two ways to accomplish this objective. First, the firm may use a direct method, in which every item on the income statement is adjusted from accrual accounting to cash accounting. This is a tedious process, in which all sales must be adjusted to cash sales. All purchases must be adjusted to cash purchases, and so on. A more popular method it is the indirect method, in which net income represents the starting point and then adjustments are made to convert net income to cash flows from operations. This is the method we will use. Regardless of whether the direct or indirect method is used, the same final answer will be derived.

We follow these procedures in computing cash flows from operating activities using the indirect method. These steps are Illustrated in Figure 2 as follows.

Figure 2  Steps in computing net cash flows from operating activities using the indirect method

*Start with net income.

*Recognize that depreciation is a non-cash deduction in computing net income and should be added back to net income to increase the cash balance.

*Recognize that increases in current assets are a use of funds and reduce the cash balance (indirectly)---as an example, the firm spends more funds on inventory.

*Recognize that decreases in current assets are a source of funds and increase the cash balance (indirectly) that is, the firm reduces funds tied up in inventory.

*Recognize that increases in current liabilities are a source of funds and increase the cash balance (indirectly)---the firm gets more funds from creditors.

*Recognize that decreases in current liabilities are a use of funds and decrease the cash balance (indirectly) that is, the firm pays off creditors.

We will follow these procedures for the Kramer Corporation, drawing primarily on the previously presented Table 1 from part 4 (see below) and from Table 2 (also see below) (which shows balance sheet data for the most recent two years).

Table 1

Table 2

The analysis is presented in Table 3 (see below). We begin with net income (earnings after taxes) of $110,500 and add back depreciation of $50,000. We then show that increases and current assets (accounts receivable and inventory) reduce funds and decreases in current assets (prepaid expenses) increase funds. Also, we show increases in current liabilities (accounts payable) as an addition to funds and decreases in current liabilities (accrued expenses) as a reduction of funds.

Table 3 Cash flows from operating activities

We see in Table 3 that the firm generated $150,500 in cash flows from operating activities. Of some significance is that this figure is $40,000 larger than the net income figure shown on the first line of the table ($110,000). A firm with little depreciation and a massive buildup of inventory might show lower cash flow then reported net income. Once cash flows from operating activities are determined, management has a better feel for what can be allocated to investing or financing needs (such as paying cash dividends).

Determining Cash Flows from Investing Activities

Cash flows from investing activities represent the second section in the statement of cash flows. The section relates to long-term investment activities in other issuers' securities or, more importantly, in plant and equipment. Increasing Investments represent a use of funds, and decreasing Investments represent a source of funds.

Examining table 2 for the Kramer Corporation, we show the information in table 4.

Table 4 Cash flows from investing activities

Determining Cash Flows from Financing Activities

In the third section of the statement of cash flows, cash flows from financing activities, we show the effects of financing activities on the corporation. Financing activities apply to the sale or retirement of bonds, common stock, preferred stock, and other corporate securities. Also, the payment of cash dividends is considered a financing activity. The sale of the firm's securities represents a source of funds, and the retirement or repurchase of such securities represents a use of funds. The payment of dividends also represents a use of funds. 

In Table 6 (below) the financing activities of the Kramer Corporation are shown using data from Table 1 (above), the previously presented Statement of Retained Earnings from Part 4 (Table 5, below), and Table 2 (above).

Table 5

Table 6 Cash flows from financing activities

Combining the Three Sections of the Statement

We now combine the three sections of the statement of cash flows to arrive at the one overall statement that the corporation provides to security analysts and stockholders. The information is shown in table 7.

Table 7

We see in Table 7 that the firm created excess funds from operating activities that were utilized heavily in investing activities and somewhat in financing activities. As a result, there is a $10,000 increase in the cash balance, and this can be reconciled with the increase in the cash balance of $10,000 from $30,000 to $40,000, as previously indicated in table 2.

One might also do further analysis on how the buildups in various accounts were financed. For example, if there is a substantial increase in inventory or accounts receivable, is there an associated buildup in accounts payable and short-term bank loans? If not, the firm may have to use long-term financing to carry part of the short-term needs. An even more important question might be: How are increases in long-term assets being financed? Most desirably, there should be adequate long-term financing and profits to carry thoee needs. If not, then short-term funds (trade credit and bank loans) may be utilized to carry long-term needs. This is a potentially high-risk situation, in that short-term sources of funds may dry up while long-term needs continue to demand funding.

*MAIN SOURE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 31-37*

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