Chapter 5

1. Chapter 5 Reporting and Interpreting Cash Flows Aside: before you record income you should be reasonably assured that you will be able to collect the amount.

2. Business Background Positive cash flows permit a company to . . . pay dividends to owners expand its operations replace needed assets take advantage of market opportunities. Expand into other markets Financial analysts consider cash flow an important indicator of a company’s financial health. GAAP focuses on accruel income. Cash however is the lifeblood of the company. Without Cash we can’t survive, can’t pay employess, bills, etc.s

3. Cash Equivalents Currency Classifications on the Cash Flow Statement Cash Short-term (90 or 30 days), highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes. Were not just talking Cash, rather highly liquid investments. *Not dependant on market rates*.

4. Classifications on the Cash Flow Statement The Cash Flow Statement must include the following three sections: • OperatingActivities • InvestingActivities • FinancingActivities

5. Statement continued . . . The indirect method is used by most companies. This is the second way, and we will focus on this because it is the most used method. The other method is the direct method. (only 2/200 use direct method) Sleeman Breweries uses the indirect method.

6. This ending cash balance should be the same amount that appears on the balance sheet. This is the bottom half of the previous page. It ends with net cash flow and balance @ end of period. It doesn’t have a beginning of the period. That’s because the starting cash flow is zero and has been omitted. This is rare, and will normally be there.

7. Cash Flows from1) Operating Activities 1st Section The section that directly relates to the Cash inflows and outflows that directly relate to income from normal operations reported on the income statement.

8. Cash Flows from Operating Activities note: they have different starting points, and dfferent details in body, and *net cash flows from operating activities* is the same result of both, with same value The Direct Method of presenting the Operating Activities section of the cash flow statement reports components of cash flows from operating activities as gross receipts and gross payments. Total cash brought in, total payments, etc. We need to dig a little deeper to get this information. The Indirect Method of presenting the Operating Activities section of the cash flow statement adjusts net income to compute cash flows from operating activities. Start with net income and adjust it for none-cash changes in income. Ex. Amortization: use of capital assets to achieve matching concept (this doesn’t reqiure cash). All the accruels and deferrals as they would have already been recorded. (ex: income accruel entry for something sold, but not yet paid for). Look for None cash income and charges (mainly gains and losses and amortization and accruels and defferrals)… and essentially make a cash income statement.

9. Cash Flows from Operating Activities The CICA Handbook recommends the direct method, but it is rarely seen in practice. (remember 2/200 use indirect method). This is odd where the handbook recommends one choice but everyone chooses something else. Many financial executives have reported that they do not use it because it is more expensive to implement than the indirect method. Textbook questions give you the info, in real life its harder to get the info.

10. + _ Cash Flows from Operating Activities - Direct Method Cash Inflowsfrom: • Sales to customers • Interest and dividends received • (buy inventory, utilities, payroll) • (normal operations) Cash Flows from Operating Activities Outflowsto: • Purchase goods (for resale) and services • Salaries and wages • Income taxes • Interest on liabilities

11. Changes in current assets and current liabilities (depreciation added in to counteract us taking out amortization). Must remove all the non-cash items that were on our income statement. + Losses and - Gains + Non-cash expenses such as amortization Cash Flows from Operating Activities - Indirect Method The indirect method adjusts net income by eliminating non-cash items. Cash Flows from Operating Activities - Indirect Method Net Income From income statement

12. Inflowsfrom: Sale or disposal of property, plant, and equipment. Sale or maturity of investments in securities + _ Cash Flows from Investing Activities Cash Flows from Investing Activities Outflowsto: • Purchase property, plant, and equipment. • Purchase investments in securities.

13. Inflowsfrom: Borrowing on notes, mortgages, bonds, etc. from creditors Issuing equity securities to shareholders + _ Cash Flows from Financing ActivitiesWhere did we get money to do the investing section items?Closely linked with investing section Cash Flows from Financing Activities Outflowsto: • Repay principal to creditors (excluding interest) • Repurchase equity securities from owners • Pay dividends to shareholders

14. Relationships to the Balance Sheet and the Income Statement Information needed to prepare a cash flow statement: • Comparative Balance Sheets (this period and last periods balance sheet so we can see the changes in these) • Income Statement (detailed, so we can pull out non-cash items, gains, losses, amortization) • Additional details concerning different types of transactions and events (not shown on financial statements: postings on individual accounts, possibly all the way back to the source journal entry) If you have a set of statements missing the cash flow statements then you have most of the tools needed to create one

15. Derives from thje always balanced equation: Assets = Liabilities Shareholders’ Equity Relationships to the Balance Sheet and the Income Statementthe book skips this relationship a lot. Here we see cash assets + non-cash assets = total assets  Cash = Liabilities Shareholders’ Equity Non-cash Assets (there are a lot of them)

16. Relationships to the Balance Sheet and the Income Statement Use this table when adjusting Net Income to Operating Cash Flows using the indirect method.

17. Cash Flow Statement Although the operating section can be prepared in one of the two formats (Direct or Indirect Method) we will discuss the Indirect Method, the method most commonly used, in the following example. There will be a few Q’s on the direct method, but on exam short answer and computational will notbe direct. Multiple choice will be direct method. Using Sleeman Breweries Ltd., let us examine the preparation of the Cash Flow Statement for the quarter ended on September 27, 2003.

18. The Statement of Cash Flows will begin with Sleeman’s Net income from the Statement of Earnings.

19. The Net income number will be adjusted for non-cash items. In the case of Sleeman’s, those adjustments included depreciation and amortization expense ($1,648) These numbers may not be obvious in the Income Statement, so often they must be derived from other sources, such as the Notes to the Financial Statements, or the General Ledger Trial Balance.

20. With the indirect method, always 1) start with the net income or net loss for the period. Next, adjust for the non-cash items included in net income.

21. To complete the Cash flows from operating activities section, you must examine a comparative balance sheet to determine the changes in current assets and current liabilities from the beginning of the period to the end of the period.

22. Now, make adjustments for changes in current assets and current liabilities using the decision table below. (page 234 of book for balance sheet on Sleeman. The book pushes the memorization of the chart)

23. Add the $5,209 decrease in Accounts Receivable. A = L + SE how did theis affect cash? A/R is an asset Cash + A/R = L + SE If A/R decreases -5209, with no change in L and SE, then Cash must be + 5209

24. Subtract the $440 increase in Inventory. Decrease account balance, same as A/R Inventory is an asset, so A = cash + inventory If Cash + Inventory = L + SE Then Cash had to go up by +440 to match -440 on inventory

25. Add back the $881 decrease in Prepaid Expenses. Cash + prepaid expenses = A So prepaid expense decreases by 881 Then we must increase cash by 881 to balance it

26. Subtract the $3,999 decrease in Accounts Payable and Accrued Liabilities. (from page 245) A/P + Accrued Liabilities decreased by 3,999 over the year, SE didn’t change. We have to increase L by 3,999 and increase cash by 3,999 to balance it. (the plus miniuses here might be wrong)

27. Statement continued . . .

28. Investing section: The balance sheet indicates that Property, Plant and Equipment (PPE) decreased by $1,350 during the quarter. If PPE starts at 72,359 and ends at 72,693, the net change is an increase of 334$. We’re told they purchased 1,350. Thus, they amoritized the equipment by 1,016. That balances the eq’n). We break it down because they appear in different sections of statements. A = L + SE Cash + PPE(purchases) = L + SE Changes: -1,350 + 13,50 = 0 + 0 The other part of the amortization could be to the intangible assets.

29. Long-term investments increased by a net $248 during the quarter. Start(7586) – end (7338) = 248 (net disposal proceeds went down) Long term inv is an Asset. (LHS). They went down. So Cash must go up to counteract

30. $4,653 was repaid against a line of credit during the period. Ending balance was 0. Is this a plus or minus to the cash? Intuitively, it’s an outflow. Bank loan is a liability. (goes down by 4,653) with SE staying the same => decrease in cash.

31. Now we can reconcile the change in cash to the ending cash balance that appears on the Balance Sheet. (page 243 of text). The 1,970 should also be the last number of the statement of cash flows.

32. A Comparison of the Direct and Indirect Methods • Net cash flowis the same for both methods. Same result, different details. • The direct method providesmore detailabout cash from operating activities, where its coming from, and going to. Instead of change in accounts, it shows gross amounts payed out and brought in. • Theinvesting and financing sectionsare identical for the two methods.

33. Exercise 5-9 in text • Compute cash from using indirect method (only operating section) • 1) label all the items with section, and in/out flow Net loss (8,782) Depreciation (Amortization) 32,915 Accounts Recievable up -> cash down (170) Decrease in inventory 643 Increase in PPD exp (664) Decrease in A/P (2282) Decrease in Accliab (719) Income Taxes Payable 1861 NET effect (inflow from operating activities) 22,802 Note: we omitted the bottom two items. They don’t count, as they are in Financing and Investment sections What do we see? Net loss on accruel basis, but in Cash, we see an in flow. Therefore in previous years we know they bought a lot of equipment (spent a lot of cash) and their assets are depreciating. That is good, but will it continue? Looking at that, it will continue so long as they have not fully depreciated their assets. We want positive cash flows form operations in the long run for it to survive.

34. Exercise 5-13 in text • Investing and financing sections of the statement of cash flows Investing purchase of PPE (1,077) purchase of mineral property (17,815) purchase of shares of company (65) sale of short term investments 14 SUBTOTAL cash outflow (18,943) Financing proceeds for issuance of shares 4,649 proceeds from bank loans 10,043 NET CASH FLOWS FROM FINANCING ACTIVITIES 14,692 This snippet tells us that the company is growing, buying equipment and property to produce more, paying for it by getting more investors and bank loans