Statement of Cash Flows - Fuqua School of Business

DUKE UNIVERSITY, FUQUA SCHOOL OF BUSINESS ACCOUNTG 441: Financial Statement Analysis1

Professor Qi Chen

Note on the Statement of Cash Flows

I.

Overview of the Statement of Cash Flows

The Statement of Cash Flows (SCF) shows the sources (inflows) and uses (outflows) of cash during a fiscal period. Current authoritative guidance (Statement of Financial Accounting Standard No. 95, "Statement of Cash Flows" [SFAS No. 95]) requires that firms separate cash inflows and cash outflows into three categories: cash flows from operations, cash flows from investing and cash flows from financing. Cash flows from operations (CFO) are the cash inflows and outflows from the firm's operating activities. Cash flows from investing (CFI) are the cash inflows and cash outflows associated with the activities necessary to maintain operating levels. Cash flows from financing (CFF) are the cash inflows and cash outflows associated with the activities engaged in by the firm to obtain cash or to use excess cash.

Cash flows are not easily categorized into one of the three groups, and SFAS No. 95 affords companies discretion in many (but not all) categorizations. It is also the case that SFAS No.95 requires certain categorizations which, from a valuation perspective, appear inconsistent. For example, SFAS No.95 requires that firms treat interest expense on debt obligations as an operating activity and treat dividends paid to common or preferred shareholders as a financing activity. As we will see later in the course, most valuation models do not treat interest expense as operating activity, since it represents a capital structure (or financing) choice by the firm.

The SCF focuses on cash inflows and outflows only. Any transactions which do not involve cash will not be included in the SCF; they are, however, required to be disclosed in a note to the financial statements. Non-cash transactions include activities such as acquiring land, property, plant or equipment by assumption of a liability; converting debt into stock, .....

Most SCFs that you will come across (in life and certainly in this course) use the indirect method of calculating cash flows; the alternative method is the direct method. The indirect method starts with net income (as reported on the statement of income), and adjusts for non-cash items affecting net income. The direct method does not begin with net income, but rather examines the cash received from customers and paid to suppliers, creditors and others. The indirect method tends to be most common because it is based on the same accrual accounting principles that underlie generally accepted accounting principles (GAAP). In contrast, the direct method presumes the use of cash basis accounting.

Mechanically, the SCF shows you the breakdown of the difference between the beginning and ending balance in the cash account from one period to the next. Given this algebraic identity and the fact that we know that Assets = Liability + Owners' Equity,, it must be the case that we can prepare a SCF from simply taking the changes in all of the non-cash asset accounts and all liability and equity accounts.

1 Based on note written by Professors Jennifer Francis and Per Olsson. 1

Sparkle Company Balance Sheets

Assets Cash Accounts receivable Inventories Total current assets Gross property, plant & equipment Accumulated depreciation Total assets

2000

$100 260 140 500 2,400 (400) $2,500

Liabilities and shareholders' equity Accounts payable Short term borrowings Salaries payable Total current liabilities Bonds payable Common stock at par Additional paid in capital Retained earnings Total liabilities & shareholders' equity

$250 50 100 400 500 1,000 200 400 $2,500

Sparkle Company Income Statements

Sales Cost of goods sold Selling, general and administrative Depreciation expense Operating income Interest expense Pretax income Income tax expense Net income Dividends

2001 $2,760 (1,573) (510) (120)

557 (500)

57 (17) $40 $4

2001

$76 360 300 736 3,720 (520) $3,936

2002

$40 460 460 960 4,860 (660) $5,160

$300 70 130 500 500 1,500 1,000 436 $3,936

$350 100 150 600 1,000 1,600 1,200 760 $5,160

2002 $3,100 (1,798) (590) (140)

572 (100) 472 (142) $330

$6

2003 $4,750 (2,803) (750) (180) 1,018 (160)

858 (257) $600 $10

2003

$170 760 830 1,760 5,630 (840) $6,550

$500 200 200 900 1,500 1,600 1,200 1,350 $6,550

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Solution: Statement of Cash Flows for Sparkle Corporation

Cash flows from operations Net income Depreciation expense (Increase) decrease in accounts receivable (Increase) decrease in inventories Increase (decrease) in accounts payable Increase (decrease) in salaries payable Cash flows from operations

2001

$40 120 (100) (160) 50 30 (20)

2002

$330 140 (100) (160) 50 20 280

2003

600 180 (300) (370) 150 50 310

Cash flows from investments Additions to PP&E Cash flows from investing

(1,320) (1,140) (770) (1,320) (1,140) (770)

Cash flows from financing

Increase (decrease) in short term borrowings 20

30

100

Issuance (payments) of bonds payable

0

500

500

Issuance of common stock

1,300 300

0

Dividends paid

(4)

(6)

(10)

Cash flows from financing

1,316 824

590

Net increase (decrease) in cash Beginning cash balance Ending cash balance

(24)

(36)

130

100

76

40

76

40

170

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II. What the Statement of Cash Flows Tells You

The SCF provides three broad categories of information, some of which is available elsewhere in the financial statements (e.g., in the income statement or in the footnotes) and some of which is not. The three categories are:

1. Information about accruals versus cash flows (e.g., depreciation expense, gain on disposal of asset or segment).

2. Information about whether a given cash inflow or outflow reflects operating, investing and financing (e.g., operating versus financing receivables)

3. Disaggregate information (e.g., payments and issuances of debt; purchases and dispositions of property, plant and equipment)

Item 1 makes sure that we understand the total cash flows. It stresses adjustments to net income for non-cash transactions, which are necessary when using the indirect method to prepare a statement of cash flows. Net income may reflect expenses which have not yet used cash (an example is the recognition of an accrued liability for a reported expense) or an expanse which will never consume cash (an example is depreciation expense). Net income may also reflect revenues which have not yet generated cash (an example is unearned revenue) or a revenue item which will never generate cash (an example is a [book] gain on the sale of property).

Item 2 stresses proper identification of the components of total cash flows, for example, into the operating, investment and financing elements, is important because all cash flows are not created equal. Some valuation models care about some types of cash flows more than (sometimes to the exclusion of) other cash flows. For example, free cash flow calculations care a lot about cash flows from operations (CFO), care some about cash flows from investing (CFI) [in particular, about parts which are due to normal recurring aspects of the core business] and care not at all about cash flows from financing (CFF).

Item 3 (disaggregation) is intended to help readers of the financial statements understand the gross transactions the firm engaged in. Knowing gross versus net transactions is informative because it provides more information about the variability of the business. For example, knowing that the firm borrowed $50 million and paid down debt of $40 million in 2001, tells you more than a statement that their net borrowings were $10 million.. It tells you that at one point in the year the firm had $40 million in cash with which to pay down the debt (early or on schedule), and that at another point in time (and perhaps it is the same point in time) it needed to borrow $50 million. In addition to gross reporting telling you more about the underlying volatility of cash flows, it may also tell you more about the firm's ability to access debt markets. That is, the gross reporting in the above example tells you that this firm is able to borrow $50 million, not just the net reported amount of $10 million. The disaggregated information gives you more information with which to make an assessment ? in this case, the assessment is of their credit worthiness. [Of course, this is but one piece of information you would want to examine in determining a firm's credit worthiness.]

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III. Mechanically-Calculated versus Reported Statements of Cash Flows If you've ever tried to calculate a SCF using just the income statement and balance sheets reported in a firm's annual report, then you know that your mechanically-computed SCF often looks quite a bit different from the one reported by the firm. There are several reasons for the differences including: 1. Firms are not required to tell you (on the balance sheet or in note disclosures) how they

classify assets and liabilities as operating, investing and financing. SFAS No.95 contains some rules about classification, but there is almost always discretion that will make it extremely difficult (if not impossible) for you to discern management's categorizations from information reported elsewhere in the financial statements. Generally speaking, the more difficult cases involve not knowing (from the balance sheet or footnotes disclosures) whether a particular account reflects operating or investing activities. A good example is the classification of a change in receivables: if the receivables relate to credit sales to customers (a classic account receivable), they are included as part of the working capital accounts included in calculating CFO; however, if the receivable reflects a finance receivable .... 2. Firms are not required to report many of the disaggregated items elsewhere (besides in the SCF) in their financial statements. For example, firms are not required to show you the breakdown of the change in debt accounts to reflect payments separately from issuances.

III. Example: Microsoft As an illustration of the differences between mechanically-calculated and reported SCFs, examine Microsofts' financial statements for the period ending June 30, 2000 (shown on the attached pages). Look closely at the items and values reported in their SCF and see which (if any) tie to values you mechanically-calculate from their 1999 and 2000 balance sheets and their 2000 income statement.

References: 1. Bahnson, Miller and Budge, "Nonarticulation in Cash Flow Statements and Implications for

Education, Research and Practice," Accounting Horizons (December 1996). 2. Read Nurnberg and Largay, "More Concerns Over Cash Flow Reporting Under FASB

Statement No.95," Accounting Horizons (December 1996).

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