1 © 2007 by Nelson, a division of Thomson Canada Limited. CHAPTER 4: Measuring and Evaluating Cash...

1 © 2007 by Nelson, a division of Thomson Canada Limited.

CHAPTER 4:CHAPTER 4:

Measuring and Measuring and EvaluatingEvaluatingCash FlowCash Flow


Main topics in Chapter 4:

Why cash flow analysis is useful; What the cash flow statement looks like and contains; How to prepare a simple cash flow statement from account

information; How to interpret a cash flow statement; Brief comments on the importance of cash flow to the manager; To continue the accounting analysis and reconciliation thread,

an example of reconciling cash and accrual figures.

CHAPTER 4Measuring and Evaluating Cash Flow

Management Cash Flow

Internal Control

Financial Position

Disclosure

Income

Financial Analysis

Ch. 1,2,3,4,5,10 Ch. 1, 4, 10

Ch. 2, 3, 4, 5, 8, 9, 10

Ch. 1, 3, 6, 8, 9Ch. 2, 6, 8, 9

Ch. 7

Ch. 2, 3, 4, 5, 10

Plugged Into the

Economic Events of the World

Book’s Coverage of Book’s Coverage of Financial AccountingFinancial Accounting

Methods Ch. 1, 2, 3, 4, 6, 7, 8, 9

Accounting System Ch 1, 2, 3, 7

Standards Principles

Ch. 5, 6, 7, 8, 9


The Purpose of Cash Flow AnalysisThe Purpose of Cash Flow Analysis

An important aspect of performance is managing the inflow and outflow of cash so that the enterprise has enough cash to pay bills, finance growth, and keep its borrowing under control. This is just as important as generating accrual income.

It is important for present and potential investors and creditors to have information about a firm’s cash inflows and outflows and its resulting cash position.


Accrual Income vs. Cash NeedsAccrual Income vs. Cash Needs

Many new and established firms have had positive net income but have still run out of cash and had serious, even fatal, liquidity or solvency problems. E.g. High tech internet companies

A positive accrual income does not necessarily mean there is enough cash to cover immediate expenses and accounts payable that are due, as we’ll see.

As a result, it is important for present and potential investors and creditors to have information about a firm’s cash management and the resulting cash position.


Two Important Cash Flow TermsTwo Important Cash Flow Terms

o Solvency:

The ability of a firm to meet all its debts and other obligations whenever they become due

o Liquidity:

The ability of a firm to cover its immediate debts and other obligations through the use of cash and short-term assets

It is not efficient to have excess idle cash. Have to balance too much versus too little. This is a central task of cash management.


The cash flow statement (older name: statement of changes in financial position (SCFP)) has been developed to describe what has been going on in the company’s cash during the year.

The cash flow statement provides information about a firm’s use of cash and highly liquid short-term assets, and, therefore assists in evaluating the firm’s financial viability.

The Cash Flow StatementThe Cash Flow Statement


Cash Income- Does it tell the whole story?Cash Income- Does it tell the whole story?

Cash income is not a complete measure of what has happened to cash.

Certain flows (such as dividends or a purchase of land) are not part of the day-to-day process of generating revenue and incurring expenses, so they would not be covered even by a cash income measure.

They reflect management decisions beyond generation of income in the current period.


How is the cash flow statement useful?How is the cash flow statement useful?

It generates a measure of performance based on the day-to-day cash flow (cash generated by ordinary business activities), instead of accrual accounting’s net income performance measure.

It provides a complete description of how the firm’s cash was managed during the period. This is accomplished by incorporating other non-operating cash inflows and outflows, and showing the beginning and ending balances of cash.

Some Important Features of the Cash Flow Some Important Features of the Cash Flow Statement Format!Statement Format!

1) The cash flow statement covers the same time period as the IS.

2) Cash includes some equivalents that can be turned into cash without any risk of loss, such as short-term bank deposits.

3) Cash may include temporary negative bank balances if the bank balances regularly vary from positive to negative.

4) The cash flow statement has accompanying notes.

5) The CF stmt follows rules to ensure that its focus is on cash.

6) Non-cash transactions are excluded from the CF statement.

7) Any number in the CF statement may be positive or negative.

8) Deriving the cash flow from day-to-day operations is one of the main reasons for having the cash flow analysis.


Cash Flow Statement Standard FormatCash Flow Statement Standard Format

Operating Activities:

Cash generated by operations, from day-to-day cash receipts and payments related to the activities that generated income.



Operating Activities

Cash used to invest in additional non-current assets, including investments in other companies, minus any cash proceeds obtained by disposing of such assets.

Investing Activities:



Investing Activities

Cash obtained from borrowing and from issuing share capital, minus borrowing repaid or shares redeemed. Any cash transactions in retained earnings (not included in calculating net income) are also included here, especially dividends and share issue costs.

Financing Activities:






Financing Activities

Net sum of the above three categories.

Change in cash (and equivalents) for the period:






Change in cash (and equivalents) for the period

Brought forward from last period’s cash flow statement and balance sheet.

Cash (and equivalents) at the beginning of the period:






Change in cash (and equivalents) for the period

Cash (and equivalents) at the beginning of the period

Equals what is shown on the balance sheet at the end of the period.

Cash (and equivalents) at the end of the period:

Cash from Operations- 2 MethodsCash from Operations- 2 Methods

Indirect Method Direct Method

Start with accrual net income Start with operating

cash receipts

Remove the effects on income of non-cash expenses (especially amortization) and

revenues (especially gains on sale)

Remove the effects on income of uncollected revenues, unpaid expenses, and other items in

working capital

Cash generated from operations

Deduct operating

cash payments


Cash on hand at the beginning of the year $813,430Cash receipts for the year: Cash sales $73,320 Collections from customers for credit sales 17,894,530 Proceeds from sale of land 1,200,000 Proceeds from issue of new bonded debt 5,300,000 Proceeds from issue of new shares 840,000 25,307,850

$26,121,280

Sparky Industries Inc.Sparky Industries Inc.



Cash payments (disbursements) for the year: Expenses paid in cash $49,210 Payments to suppliers and employees 14,992,860 Income tax paid 765,500 Paid to acquire new non-current assets 6,733,310 Repayments on non-current debt 3,112,300 Costs of new share issue 21,340 Dividends paid 400,000 26,074,520Cash on hand at the end of the year $46,760

$26,121,280

From previous slide



Cash Flow Statement for This Year (Direct Method)

Operating Activities: Operating cash receipts ($73,320 + $17,894,530) $17,967,850

Operating cash payments ($49,210 + $14,992,860 + $765,500) (15,807,570)

Cash obtained from operations $2,160,280



Operating Activities: Cash obtained from operations $2,160,280




Investing Activities:

Acquisitions of new non-current assets ($6,733,310)

Proceeds from sale of land 1,200,000


Cash used for investing ($5,533,310)



Operating Activities Cash obtained from operations $2,160,280


Investing Activities Cash used for investing (5,533,310)





Financing Activities:

Proceeds from issue of new bonded debt $5,300,000

Proceeds from issue of new shares 840,000

Repayments on non-current debt (3,112,300)

Costs of new share issue (21,340)

Dividends paid (400,000)

Cash obtained from financing $2,606,360


Operating Activities Cash obtained from operations $2,160,280


Investing Activities Cash used for investing (5,533,310)

Change in cash for the year ($766,670)

Cash at beginning of year 813,430

Financing Activities Cash obtained from financing 2,606,360

Cash at end of year $46,760

Analysis Results: Cash went down almost to zero during the year, because

Sparky spent more cash acquiring new assets than it raised through operations and financing.

The largest inflows and outflows of cash were from day-to-day operations, but the net contribution of operations to the company’s cash supply was smaller than the net contribution through financing.

A sixth of the cash needed for the new assets was raised by selling land.

Financing was primarily accomplished through debt. As a result, the company is further in debt (D/E ratio increased).

Cash reserves were almost exhausted by paying for new assets and paying dividends.


Another Example- Christine Inc.Another Example- Christine Inc.

Cash on hand at the beginning of the year $51,000Cash receipts for the year: Cash sales $124,000 Collections from customers for credit sales 3,153,000 Proceeds from sale of land 50,000 Proceeds from issue of non-current debt 200,000 Proceeds from issue of new shares 25,000 3,552,000

$3,603,000



Cash payments (disbursements) for the year: Expenses paid in cash $63,000 Payments to suppliers and employees 2,528,000 Income tax paid 70,000

Paid to acquire new non-current assets 440,000 Repayments on bonded debt 265,000 Costs of new share issue 5,000 Dividends paid 85,000 3,456,000Cash on hand at the end of the year $147,000

$3,603,000

From previous slide



Operating Activities: Operating cash receipts ($124,000 + $3,153,000) $3,277,000 Operating cash payments ($63,000 + $2,528,000 + $70,000) (2,661,000)

Cash obtained from operations $616,000





Investing Activities: Acquisitions of new non-current assets ($440,000) Proceeds from sale of land 50,000

Cash used for investing ($390,000)




Financing Activities: Proceeds from issue of non-current debt $200,000 Repayments on bonded debt (265,000) Proceeds from issue of new shares 25,000 Costs of new share issue (5,000) Dividends paid (85,000)

Cash used for financing ($130,000)




Operating Activities Cash obtained from operations $616,000Investing Activities Cash used for investing (390,000)Financing Activities Cash used for financing (130,000)

Cash at the beginning of the year 51,000Change in cash for the year $96,000

Cash at the end of the year $147,000


What is the Indirect Method?What is the Indirect Method?

The indirect method relies on the fundamentals of double entry accounting: change in accounts.

We can analyze cash changes by looking at changes in all the other accounts in the balance sheet: those changes will tell us what the company did with its cash.

Construct the cash flow statement by placing all balance sheet account changes in the appropriate categories of the cash flow statement, after adjusting for all non-cash components of those account changes.

Basic Approach:


Deriving the Cash Flow RelationshipDeriving the Cash Flow Relationship

Assets = Liabilities + Equity

Cash + Other Assets = L + E

Cash = L + E – Other Assets

Cash = L + E - (Other Assets)

To find how cash has changed during the year, we simply have to look at the changes in

all of the balance sheet accounts.


Why use the Indirect Method?Why use the Indirect Method?

Most companies use the indirect method in preparing their cash flow statements (traditional method).

Digging out the details of cash receipts and payments over a whole year (as required by the direct method) can be a large task, especially if there are several or many cash and bank accounts.

The indirect method provides a detailed and informative operations section.


The Cash Flow Statement (Indirect)The Cash Flow Statement (Indirect)

Operating ActivitiesStart with net income for the period (part of the retained

earnings change)Adjustments to eliminate non-cash components of

income:o Remove revenues and expenses that are entirely

non-cash:1. Gains and losses2. Write-downs and write-offs of investments


Start with net income for the period (part of the retained earnings change)

Adjustments to eliminate non-cash components of income:

o Remove revenues and expenses that relate to non-current past or future cash flows:1. Amortization (asset cost paid in the past)2. Future costs to be paid (future income taxes,

warranties, pension costs, etc.)




Start with net income for the period (part of the retained earnings change)

Adjustments to eliminate non-cash components of income:

o Remove the effects on accrual income of working capital account changes:

1. Accounts receivable2. Inventories3. Prepaid expenses


4. Accounts payable5. Estimated accrued liabilities6. Prepaid expenses



Additions to plant and equipment and intangible and other assets, minus any amounts not yet (or ever) paid in cash and so still showing as payable

Proceeds for disposal of plant and equipment and intangible and other assets (accounts changes due to elimination of cost and accumulated amortization of disposed assets are ignored because they are not cash items)

Investing Activities (same as direct method)

Additions to and proceeds of disposal of mainly non-current investments



Financing Activities (same as direct method)

Changes in current and non-current debt financing, minus any parts not involving cash (such as exchanges for shares or non-cash assets)

Changes in share capital, minus any parts not involving cash (such as exchanges for debt or non-cash assets)

Changes in retained earnings other than net income for this period: dividends, share issue costs, etc., minus any parts not paid in cash (e.g. stock dividends or dividends payable)


Tracking ChangesTracking Changes

Liabilities or Equity =

Cash

Liabilities or Equity =

Cash

Assets = Cash

CashAssets =

Income = Cash

CashIncome =


Some Final Points!Some Final Points!

The indirect cash from operations calculation starts with net income and removes all the accruals that make it different from cash income

Losses and write-downs are added back to the net income in operating activities; gains on disposal are deducted from the net income in operating activities; cash proceeds are included in investing activities

Gain/Loss on Sales

DR Cash (Proceeds)CR Asset CostDR or CR Loss or Gain


The indirect method highlights issues in the operations section that are not obvious from the direct method

Differences between the Direct and Indirect MethodsDifferences between the Direct and Indirect Methods

The difference between accrual and cash income

The changes in working capital accounts (accounts receivable, accounts payable, and inventories)

Let’s look at Sparky and Christine AGAIN using the indirect method


Sparky Industries Inc.Balance Sheet Changes

(This Year Minus Last Year)

ASSETSCurrent assets: Cash down ($766,670) Accounts receivable up 2,875,870 Inventory down (1,225,770)Non-current assets: Asset cost up 6,328,310 Accum. Amortization up (3,794,630)TOTAL CHANGES $3,417,110


Sparky Industries Inc.Balance Sheet Changes


LIABILITIES AND EQUITYCurrent liabilities: Accounts payable down ($1,359,410) Dividend payable up 100,000 Equipment payable up 220,000Non-current liabilities: Bonded debt up 5,300,000 Other debt down (3,112,300)Equity: Share capital up 840,000 Retained earnings up 1,428,820TOTAL CHANGES $3,417,110


Sparky Industries Inc.Income Statement For the Year

Revenue $20,843,720Expenses: COGS, etc. $14,390,490

Gain on land sold 575,000

Income tax expense 1,283,440

Operating income $2,658,600

Income before tax $3,233,600

Net income $1,950,160

Amortization 3,794,630 $18,185,120


Sparky Industries Inc.Retained Earnings Changes For the Year

Add net income $1,950,160Deduct dividends declared (500,000)Deduct costs of share issue (21,340)NET CHANGE $1,428,820


Sparky Industries Inc.Cash Flow Statement for This Year (Indirect Method)

Operating Activities:Net income for the year $1,950,160Deduct non-cash revenue: Gain on sale of land (575,000)Add back non-cash expense: Amortization 3,794,630Deduct increase in A/R (2,875,870)Add back reduction in inventory 1,225,770Deduct decrease in A/P (1,359,410)Cash obtained from operations $2,160,280



Investing Activities:Acquisition of new non-current assets ($6,733,310)Proceeds from sale of land 1,200,000Cash used for investing ($5,533,310)



Financing Activities:Proceeds from issue of new bonded debt $5,300,000Repayments on non-current debt (3,112,300)Proceeds from issue of new shares 840,000Cost of new share issue (21,340)Dividends paid (400,000)Cash obtained from financing $2,606,360



Operating Activities:Cash obtained from operations $2,160,280Investing Activities:Cash used for investing (5,533,310)

Cash at the beginning of the year 813,430

Financing Activities:Cash obtained from financing 2,606,360Change in cash for the year ($766,670)



Christine Inc.Balance Sheet Changes


ASSETSCurrent assets: Cash up $96,000 Accounts receivable down (235,000) Inventory up 121,000Non-current assets: Asset cost up 330,000

Accum. Amortization up (210,000)TOTAL CHANGES $102,000


Christine Inc.Balance Sheet Changes


LIABILITIES AND EQUITYCurrent liabilities: Accounts payable up $130,000 Income tax payable unchanged 0 Dividend payable up 15,000 Equipment payable down (40,000)Non-current liabilities: Bonded debt down (65,000) Future tax liability up 10,000Equity: Share capital up 25,000 Retained earnings up 27,000TOTAL CHANGES $102,000


Revenue $3,042,000Expenses: COGS, etc. $2,600,000

Loss on land sold 20,000

Income tax expense 80,000

Operating income $232,000

Income before tax $212,000

Net income $132,000

Amortization 210,000 $2,810,000

Christine Inc.Income Statement For the Year


Add net income $132,000Deduct dividends declared (100,000)Deduct costs of share issue (5,000)NET CHANGE $27,000

Christine Inc.Retained Earnings Changes For the Year


Christine Inc.Cash Flow Statement for This Year (Indirect Method)

Operating Activities:Net income for the year $132,000Add back non-cash revenue: Loss on sale of land 20,000Add back non-cash expense: Amortization 210,000Add back increases in future tax liability 10,000Add back decrease in A/R 235,000Deduct accumulation in inventory (121,000)Add back increases in A/P 130,000Cash obtained from operations $616,000



Investing Activities:Acquisition cost of new non-current assets ($400,000)More spent to decrease equipment payable ($40,000)Proceeds from sale of land 50,000Cash used for investing ($390,000)



Financing Activities:Repayments on bonded debt ($65,000)Proceeds from issue of new shares 25,000Cost of new share issue (5,000)Dividends paid (85,000)Cash used for financing ($130,000)



Operating Activities:Cash obtained from operations $616,000Investing Activities:Cash used for investing (390,000)Financing Activities:Cash used for financing (130,000)

Cash at the beginning of the year 51,000Change in cash for the year $96,000



Canadian Pacific Railway LimitedStatement of Consolidated Cash Flows

2004 2003 2002

Cash provided in operating activities 786.0 305.7 763.5

Cash used in investing activities (666.1) (700.3) (551.0)

Cash provided by (used in)

financing activities 98.4 244.4 (484.5)

Increase (decrease) in net cash 218.3 (150.2) (272.0)

Net cash at beginning of year 134.7 284.9 556.9

Net cash at end of year 353.0 134.7 284.9

Year ended December 31 (in millions)


Some Important PointsSome Important Points

• CPR’s cash showed a big increase from 2003

• CPR’s cash from operations was much larger than its accrual income.

• CPR generated enough cash from operations to finance its new investments.

• CPR spent more renewing its property than the estimated value consumed as the property was used (depreciated and amortized).


Some Important PointsSome Important Points

• CPR had to pay back a large amount of its capital to the old parent company as part of the corporate break-up.

• CPR significantly rearranged and increased its borrowing.

• CPR borrowed to pay back its parent and improve its working capital. It relied on cash from operations to finance its new investments.

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