chap 011

Chapter 11 The Statement of Cash Flows

CHAPTER 11THE STATEMENT OF CASH FLOWS

Changes from Twelfth Edition

Updated from the Twelfth Edition. Great Valu Variety Stores has been dropped.

Approach

This is a topic that has always been difficult for students. The indirect method of developing the amount of cash flow from operating activities is particularly difficult. The hearings prior to FASB 95 indicated that the investment analyst community would press companies to continue using the indirect (reconciliation) method; the primary supporters of the direct method were bankers. Thus, it appears that students will not be well served in this subject area unless they gain an understanding of the indirect method.

Since students were introduced to the difference between cash flows and accrual accounting’s revenues and expenses way back in Chapter 3, this should be reinforcement at this point, but it usually seems to be a new revelation to at least a subset of the class. For those who never succeed in fully understanding the rationale for the adjustments, Illustration 11-4 now gives them a rote approach to which they can revert.

Cases

Medieval Adventures Company is an armchair case intended to dramatize the difference between operating cash flow and income.

Amerbran Company (A) illustrates preparation of the cash flow statement from the other two statements and supplemental information.

Problems

Problem 11-1

2010 sales................................................................................................................................................................................................$8,337,000Less: Change in accounts receivable....................................................................................................................................................... (130,000)Cash generated from sales during 2003..................................................................................................................................................$8,207,000

Problem 11-2

a. Use of $2 million cash to purchase equipment is an investment use of cash.

b. Cash proceeds from the issuance of common stock is a financing source of cash. The use of cash to retire mortgage bonds is a financing use of cash.

c. No cash effect.

d. No cash effect.

e. Cash proceeds from the sale of machinery is an investment source of cash.

The above responses assume the direct method is used to present its cash flow of statement.

11-1


Problem 11-3

Kids’n CaboodleStatement of Cash Flows

Cash received from customers................................................................................................................................................................$155,000Cash used in operations........................................................................................................................................................................... (146,900)

Cash from operations........................................................................................................................................................................... $8,100

Equipment............................................................................................................................................................................................... (10,500)Cash used for investments.................................................................................................................................................................... (10,500)

Loan......................................................................................................................................................................................................... 21,000Cash from financing............................................................................................................................................................................. 21,000

Increase in cash....................................................................................................................................................................................$ 18,600

Problem 11-4

Net loss....................................................................................................................................................................................................$(11,000)Depreciation............................................................................................................................................................................................ 26,400

15,400Accounts receivable (reduced)................................................................................................................................................................ 17,600Accounts payable (increased).................................................................................................................................................................. 8,800Accrued salaries (increased).................................................................................................................................................................... 3,300Other accruals (increased)....................................................................................................................................................................... 2,200

Cash flow from operations...................................................................................................................................................................... 47,300

Investments.............................................................................................................................................................................................. 0

Long-term debt (reduced)........................................................................................................................................................................ (29,700)

Change in cash..................................................................................................................................................................................... 17,600Beginning cash..................................................................................................................................................................................... 4,400Ending cash..........................................................................................................................................................................................$22,000

Problem 11-5

Operating ActivitiesCash received from customers.............................................................................................................................................................$62,100Interest received................................................................................................................................................................................... 345Operating cash payments..................................................................................................................................................................... (54,165)Interest payment................................................................................................................................................................................... (1,035)Net cash provided by operations.......................................................................................................................................................... 7,245

Investing ActivitiesSale of old machine.............................................................................................................................................................................. 3,105Down payment on new truck............................................................................................................................................................... (3,450)

Net cash used in investing activities.................................................................................................................................................... (345)

Financing Activities

11-2


Payment of debt................................................................................................................................................................................... (3,450)Net cash used in financing activities.................................................................................................................................................... (3,450)

Increase in cash.................................................................................................................................................................................... 3,450Beginning cash..................................................................................................................................................................................... 3,450Ending cash..........................................................................................................................................................................................$ 6,900

Cases

Case 11-1 Medieval Adventures Company *

Note: This case is unchanged from the Twelfth Edition.

Approach

This (obviously) is an armchair case, intended to show dramatically the difference between profit and cash flow from operations. The case has mechanistic patterns built into it to help students see what is going on: relatively rapid growth is causing cash to be tied up in receivables and inventories faster than it is regenerated from collections. Although the case may seem trivial (at least after the calculations have been made) because of these mechanistic patterns, in fact many businesses have had severe (sometimes fatal) financial crises because management did not anticipate the basic phenomenon that this case develops. The graph included herein can be used in class to help illustrate this phenomenon.

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

11-3


Question 1

The required monthly statements are shown on the following pages. The peak need comes by the end of July, when a $40,000 loan would be needed to maintain a zero cash balance. In August, cash generated by operations finally turns positive, enabling partial repayments of the loan. October’s $27,500 cash generated by operations enables making the final $15,000 loan repayment and ending the month with a $12,500 cash balance.

Question 2

This question is the key one in terms of student insight from this case. The company has been paying its costs currently, but allowing customers two months to pay. This, coupled with constant growth, causes large net operating outflows for several months, which collectively eat up the firm’s initial capital. It is important for students to understand why it is that this situation eventually turns around: the unit margin is $20 and the monthly nonproduction costs are fixed at $10,000; thus, the continued unit sales growth eventually (in August) causes the current inflows (from sales two months ago) to exceed the current outflows (production costs for next month’s sales plus $10,000). In other words, as the income statement shows, the firm is profitable, and eventually those profits get realized in cash.

This need could have been avoided by projecting the cash flow figures that the students have developed after the fact. Then the company could have arranged the necessary line of credit. Banks are happy to provide such funds for companies that anticipate the need because that anticipation reflects good financial management. On the other hand, banks are hesitant to lend to a firm that has been taken by surprise by a cash shortage. Of course, a no-cost method to avoid the problem was also probably feasible. The company could have arranged credit with vendors to help finance the inventory, and could have been more aggressive in collecting from its customers in accord with the stated 30-day terms. If the company delayed its payments by 30 days and accelerated receivable collections from 60 to 30 days (thus shortening its “cash cycle” by 60 days), the operating cash flow would have turned positive in March and no cash crisis would have occurred.

Question 3

The purpose of this question is to give students practice in deriving a cash flow statement from the income statement and balance sheets. Because of the work done in question 1, where cash flows were dealt with directly, students can gain some confidence in these derivation procedures before they apply the procedures in more complex and realistic cases. The statements are as follows (in somewhat simplified format, befitting this introductory problem):

11-4


March May JulyNet income...................................................................................................................................................................................................................$30,000 $50,000 $70,000Increase in accounts receivable.................................................................................................................................................................................... (55,000) (55,000) (55,000)Increase in inventory.................................................................................................................................................................................................... (17,500) (17,500) (17,500)Cash from operations................................................................................................................................................................................................... (42,500) (22,500) (2,500)Proceeds of debt........................................................................................................................................................................................................... -0- 22,500 2,500Cash increase (decrease).............................................................................................................................................................................................. (42,500) 0 0Beginning of month cash balance................................................................................................................................................................................ 72,500 0 0End of month cash balance...........................................................................................................................................................................................$30,000 $ 0 $ 0

OPERATING BUDGET

Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct.Sales.............................................................................................................................................................................................................................$55,000 $82,500 $110,000 $137,500 $165,000 $192,500 $220,000 $247,500 $275,000 $302,500Cost of Sales................................................................................................................................................................................................................. 35,000 52,500 70,000 87,500 105,000 122,500 140,000 157,500 175,000 192,500Gross Margin................................................................................................................................................................................................................ 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 100,000 110,000Other Expenses............................................................................................................................................................................................................. 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000Net Income................................................................................................................................................................................................................... 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 100,000

CASH BUDGET

Cash lnflows:Cash forwarded............................................................................................................................................................................................................$146,250 $111,250 $ 72,500 $ 30,000 $-0- $-0- $-0- $-0- $-0- $-0-Collections.................................................................................................................................................................................................................... 27,500 41,250 55,000 82,500 110,000 137,500 165,000 192,500 220,000 247,500

Loan from bank......................................................................................................................................................................................................... --- --- --- 2,500 22,500 12,500 2,500 --- --- ---Total......................................................................................................................................................................................................................$173,750 $152,500 $127,500 $115,000 $132,500 $150,000 $167,500 $192,500 $220,000 $247,500

Cash Outflows:Costs & expenses.........................................................................................................................................................................................................$ 62,500 $ 80,000 $ 97,500 $115,000 $132,500 $150,000 $167,500 $185,000 $202,500 $220,000

Loan payback............................................................................................................................................................................................................ --- --- --- --- --- --- --- 7,500 17,500 15,000Cash balance.........................................................................................................................................................................................................$111,250 $ 72,500 $ 30,000 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 12,500

Memo:Net operating cash flow................................................................................................................................................................................................

$(35,000) $(38,750) $(42,500) $(32,500) $(22,500) $(12,500) $(2,500) $ 7,500 $ 17,500 $ 27,500Cash balance w/o loan..................................................................................................................................................................................................$111,250 $ 72,500 $ 30,000 $ (2,500) $(25,000) $(37,500) $(40,000) $(32,500) $(15,000) $ 12,500

11-5


BALANCE SHEET

Dec.31st

Jan.31st

Feb.28th

Mar31st

Apr.30th

May31st

June30th

July31st

Aug.31st

Sept.30th

0ct.31st

Assets:Cash...........................................................................................................................................................................................................................$146,250 $111,250 $ 72,500 $ 30,000 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 12,500Accounts Receivable................................................................................................................................................................................................. 68,750 96,250 137,500 192,500 247,500 302,500 357,500 412,500 467,500 522,500 577,500Inventory................................................................................................................................................................................................................... 35,000 52,500 70,000 87,500 105,000 122,500 140,000 157,500 175,000 192,500 210,000

Total.......................................................................................................................................................................................................................$250,000 $260,000 $280,000 $310,000 $352,500 $425,000 $497,500 $570,000 $642,500 $715,000 $800,000

Liabilities and Equity:Note Payable.............................................................................................................................................................................................................$ --- $ --- $ --- $ --- $ 2,500 $ 25,000 $ 37,500 $ 40,000 $ 32,500 $ 15,000 $ ---Common Stock.......................................................................................................................................................................................................... 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000Retained Earnings....................................................................................................................................................................................................._______ 10,000 30,000 60,000 100,000 150,000 210,000 280,000 360,000 450,000 550,000Total..........................................................................................................................................................................................................................$250,000 $260,000 $280,000 $310,000 $352,500 $425,000 $497,500 $570,000 $642,500 $715,000 $800,000

11-6


Case 11-2 Amerbran Company (A) *

Note: This case is unchanged from the Twelfth Edition.

Approach

This case is based on actual financial statements of American Brands, Inc. Although the numbers have been changed from those reported, the magnitudes and relationships have been preserved. This case provides additional practice in preparing a statement of cash flows. Since specific information is not given on cash collections and operating disbursements, it is expected that students will use the indirect approach in developing the cash generated by operations amount. The statements in Exhibit I also provide the raw data for the (B) case, which is a ratio analysis case that appears in Chapter 13.

Answer to Question

The required cash flow statement appears below. The explanatory notes to the statement are as follows:

Note 1 This is the net of the following components:

Increase in accounts receivable ..............................................................................................................................................................$(68,827)Increase in inventories ............................................................................................................................................................................ (19,510)Decrease in prepaid expenses ................................................................................................................................................................. 1,027Increase in accounts payable .................................................................................................................................................................. 33,075Increase in accrued expenses payable .................................................................................................................................................... 194,728

$ 140,493

Note 2. The two components of this acquisition, as given in the case, could be shown separately.

Note 3. The decrease in long-term debt is less than the decrease in long-term liabilities because the latter also includes deferred taxes.

Note 4. Lacking specific information to the contrary, it is assumed that reissuance of treasury stock for bonuses generated no cash. The stock dividend was, in effect, a 2-for-1 stock split. The only difference is that if it were a stock split, the total shown for common stock at par would have remained $161,417 rather than doubling to $322,834.

Note 5. The three major categories of cash flows generated a net of $11,785 of cash. Since the increase to be explained is only $4,960, “miscellaneous activities” must have used $6,825 of cash. Some students may include this line in operating activities, rather than as a fourth category; if they do, the net cash flow from operations becomes $567,303.

AMERBRAN COMPANYStatement of Cash Flows

For the year ended December 31, 20x1(in thousands)

Net cash flow from operating activities:Net income...........................................................................................................................................................................................$328,773Noncash items included in income:

Depreciation and amortization.......................................................................................................................................................... 115,974Deferred taxes................................................................................................................................................................................... (17,548)

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

11-7


Net change in receivables, inventories, and payables (Note 1)........................................................................................................ 140,493Write-off of obsolete equipment....................................................................................................................................................... 66,046Income from subsidiary.................................................................................................................................................................... (59,610)

Net cash flow from operating activities............................................................................................................................................... (574,128)Cash flows from investing activities:

Acquisitions of property, plant, and equipment................................................................................................................................... (260,075)Proceeds from disposals....................................................................................................................................................................... 33,162Acquisition of Company X (Note 2).................................................................................................................................................... (133,721)

Net cash used by investing activities................................................................................................................................................ (360,634)Cash flows from financing activities:

Increase in short-term debt................................................................................................................................................................... 79,664Decrease in long-term debt (Note 3).................................................................................................................................................... (34,606)Dividends paid..................................................................................................................................................................................... (216,158)Purchase of treasury stock (Note 4)..................................................................................................................................................... (30,609)

Net cash used by financing activities................................................................................................................................................ (201,709)Cash flows from miscellaneous activities (Note 5)................................................................................................................................. (6,825)Net increase in cash................................................................................................................................................................................. 4,960Cash at beginning of year........................................................................................................................................................................ 23,952Cash at end of year..................................................................................................................................................................................$ 28,912

11-8

chap 011

Documents