engg 401 x2 fundamentals of engineering management spring 2008 chapter 3: statement of cash flow...

ENGG 401 X2ENGG 401 X2Fundamentals of Engineering ManagementFundamentals of Engineering Management

Spring 2008Spring 2008

Chapter 3:Chapter 3:

Statement of Cash FlowStatement of Cash Flow

Dave LudwickDave Ludwick

Dept. of Mechanical EngineeringDept. of Mechanical Engineering

University of AlbertaUniversity of Albertahttp://members.shaw.ca/dave_ludwick/

Dave Ludwick, Dept. of Mech. Eng.Statement of Cash Flow

Summer 20082

ENGG 401 X2 – Fundamentals of Engineering Management

Sources and Uses of FundsSources and Uses of Funds

• Logical questions in understanding any business.– How much funds did we get?– Where did we get them from?– What did we use them for?

• Like the income statement, these questions only make sense over a period of time.– The period must be reasonable.

• Year over year or month over month changes in a balance sheet can tell us where funds came from, and where they go to.


Summer 20083


Sources and Uses of Funds (3)Sources and Uses of Funds (3)

• Comparing two successive balance sheets shows us where a company’s funds came from and where they went over a period of time.

• Reflect on the sources of funds and how they’re used.– Of the funds used, how much comes from debt versus operating

activities?

• AssetsAssets from one period to another should always equal Liabilities and EquityLiabilities and Equity over the same time period.– If not, there’s been a mistake made in the balance sheet or in the

analysis (check for a sign error i.e., application to a wrong column).


Summer 20084


Sources and Uses of Funds (2)Sources and Uses of Funds (2)

• Assets measure real things of value.– An increase in an asset account is a useuse of funds (you had to have

funds to get the extra assets).– A decrease in an asset account is a sourcesource of funds.

• Liabilities measure real obligations to pay someone else.– An increase in a liability is a sourcesource of funds (you are borrowing

more from someone else).– A decrease in a liability is a useuse of funds.

• From a cash flow point of view, there are other sources of funds as well:– An increase in equity or retained earnings is a sourcesource of funds.– Depreciation is a sourcesource of funds, since it is a non-cash expense.


Summer 20085


Example: Goodco versus BadcoExample: Goodco versus Badco

• Goodco and Badco have the same income statement for a one year period.– This means that the operational side of their businesses (i.e., its

ability to create value) is identical.

• Goodco and Badco have the same balance sheet last year, which means they start from the same position.– They own the same things and drew the money from the same

sources.

• Goodco and Badco have very different balance sheets this year.– Management decisions about the business were fundamentally

different.


Summer 20086


Example: Goodco versus Badco (2)Example: Goodco versus Badco (2)

Year 1 Year 2 Year 1 Year 2AssetsCurrent Cash 9 22 9 22

Receivables 95 120 95 120Inventory 75 88 75 88Prepaids 40 28 40 28

Total current 219 258 219 258

Fixed Cost 700 760 700 760Less depreciation 140 210 140 210

Net 560 550 560 550

Total assets 779 808 779 808

LiabilitiesCurrent ST Credit 51 24 51 174

Accounts Payable 30 48 30 48Accrued Expenses 25 9 25 9

Taxes Payable 8 2 8 2Cur. Port. of LT Debt 20 20 20 20

Total current 134 103 134 253

Long Term Debt 170 175 170 225

Shareholders' EquityCapital Shares 350 375 350 175

Retained Earnings 125 155 125 155

Total Liabilities plus Equity 779 808 779 808

Goodco Badco


Summer 20087


Revisiting Working Capital DeficiencyRevisiting Working Capital Deficiency

• Working capital deficiency is the major cause of business failure and is an “above the line” problem.

• Questions:– What can Badco do to get back onside?

• How effective is reducing receivables and inventory?

• …stretching payables?

• …borrowing more LT debt?

• …raising more equity?

• Acting above the line reduces short term borrowing but does not change the level of working capital.– Working capital deficiencies require correction below the line, by

long-term debt, grant, or an increase in shareholder equity.


Summer 20088


Purpose of the Cash Flow StatementPurpose of the Cash Flow Statement

• A CaCash sh FFlowlow Statement Statement documents the changes in a company’s cash position over an accounting period.– Makes the reflection on the sources and uses of funds easier to see.

• Purpose: to report detailed info about the major cash receipts and cash payments during the period

• Generally there are 3 types of activities that generate or consume cash– Operating– Investing– Financing

• Although one of the more complex statements, this Cash Flow Statement, or the Statement of Changes in Financial Position (SCFP), is one of the most important statements


Summer 20089


Why is cash important?Why is cash important?

• Cash is the grease that allows the company to move and articulate its resources to achieve goals

• Cash is needed to– Pay debts– Meet unexpected obligations– Pursue unexpected opportunities– Plan day-to-day operating activities– Make long-term investment decisions

• The Statement of Changes in Financial Position (SCFP) can help answer:– How does the company obtain cash– How does it spend cash– What is the change in the cash balance


Summer 200810


Cash and Cash EquivalentsCash and Cash Equivalents

• Lets also remember that this statement needs to cover both cash and cash equivalents:

• Cash Equivalents:– Assets that are readily convertible to a known amount of cash– Significantly close to maturity (within roughly 3 months) that its

eventual cash value is determinable


Summer 200811


3 Types of Activities: Operating3 Types of Activities: Operating

• Operating: the principal revenue generating activities of the business

• Examples:– Production of goods and services for sale– Purchase of raw materials and labour– Admin expenses, taxes– Collection of loan principal

• Generally, the Operating activities involve the top of the balance sheet (Current Assets and Current Liabilities)


Summer 200812


3 Types of Activities: Investing3 Types of Activities: Investing

• Investing: these are activities that generally affect long-term assets

• Investing activities typically involve– Purchase or sale of capital assets– Purchase or sale of investments, other than cash equivalents– Lending and collecting on loans (long-term notes receivables that

were created for activities other than operating activities)

• Generally the Investing activities involve the lower left side of the balance sheet (Capital or Fixed Assets)


Summer 200813


3 Types of Activities: Financing3 Types of Activities: Financing

• Financing: these are activities that affect a company's owners and creditors

• Financing activities include– Obtaining/disbursing cash as a result of debt incurred/debt paid off– Obtaining cash from or distributing cash to owners

• Note: – Interest expense usually incurred to support the company’s ability to

generate revenue.• Therefore it is deducted from revenue to get Net Income on the Income

Statement. This is considered an Operating activity

– Accounts payable are also incurred to purchase raw materials• Therefore, paying AP is considered Operating activities

• Generally the Financing activities involve the lower right side of the balance sheet (LT Debt and Equity)


Summer 200814


A sample Cash Flow StatementA sample Cash Flow Statement

Statement of Changes in Financial Position

Cash flows from Operating Activities

Cash received from customers 50000

Cash paid for inventory (15000)

Cash paid for wages and benefits (20000) 15000

Cash flows from Investing Activities

Cash paid for equipment (5000) (5000)

Cash flows from Financing Activities

Cash paid for dividends (5000) (5000)

Net cash increase 5000

Cash balance at beginning of period 10000

Cash balance at end of period 15000


Summer 200815


A sample Balance SheetA sample Balance Sheet

Balance Sheet

Current Assets

Cash 10000

Current Liabilities

Accounts Payable 5000

Accounts Receivable 20000 Wages Payable 25000

Notes Receivable 15000 Utilities Payable 2000

Marketable Securities 25000 Long-Term Debt

Inventory 120000 Notes Payable 20000

Capital Assets Bonds Payable 600000

Equipment 250000 Owner’s Equity

Buildings 500000 Common Stock 300000

Goodwill 60000 Retained Earnings 48000

Total Assets 1000000

Total Liabilities + OE 1000000Investing

Financing

Operating


Summer 200816


Cash Flow StatementsCash Flow Statements

• To complete a cash flow statement, two balance sheets (start of period and end of period) and the income statement for the intervening time period must be used.– The sources and uses of funds are balanced to cash (including

short term debt)

• The cash flow statement answers the question “where did where did our money come from, and where did it goour money come from, and where did it go?”


Summer 200817


What Do We Look for in Cash Flow Statements?What Do We Look for in Cash Flow Statements?

• Profitable? Steady profits?• How much cash is coming from operations?• Non cash WC growing? Justified by sales (IS)?• Dividend? Steady? What fraction of income?• Investment relative to depreciation:

– Larger (hence growing)– ~Same (stable)– Smaller (blowdown of assets)

• Financing– Locking in or paying back long term debt?– Issuing or buying back shares? Common or preferred?


Summer 200818


Operational vs. Financial ManagementOperational vs. Financial Management

• All businesses require that management address two areas:– Operational health: does our underlying business activity create

value independent of how we finance the business?– Financial health: have we raised money in a way that can sustain

the business?

• The income statement is the primary source of evidence of operational health.– Contribution margin is a critical measure.

• The balance sheet is the primary source of evidence of financial health.– Working capital is important here

• The statement of cash flow links income statements and balance sheets.


Summer 200819


Sample ProblemSample Problem

Nissen Corp’s Comparative Balance Sheet

Assets

Cash

2007

75425

2006

107275

Accounts Receivable 91000 69475

Inventory

Prepaid Expenses

383250

7525

353500

8750

Equipment 223300 154000

Accumulated Depr (48475) (61600)

Total Assets 732025 631400

Liabilities and Owner’s Equity

Accounts Payable 123375 163275

ST Notes Payable 14000 8750

LT Notes Payable 131250 75250

Common Shares 281750 218750

Retained Earnings 181650 165375

Total Liabilities and OE 732025 631400


Summer 200820



Nissen Income Statement For Year Ended Dec 31, 2007

Sales 694750

COGS 350000

Gross Profit 344750

Operating Expenses

Amortization Expense 26250

Other Expenses 191100

Total Operating Expenses 217350

Loss on Sale of Equipment (7175)

Income from Operations 120225

Income Taxes (16975)

Net Income 103250


Summer 200821



• Other information regarding Nissen– All sales are credit sales– Purchases to merchandise are on credit– All debits to accounts payable result from payments to merchandise– The only decrease to income taxes payable is for a tax payment– The other expenses are paid in advance and are initially debited to

Prepaid Expenses– Equipment costing 65625 with accumulated depreciation of 39375 is

sold for 19075– Equipment costing 134925 is purchased by paying cash of 35000 and

signing a long-term note payable for the balance– Borrowed 5250 by signing a Short-Term Note Payable– Paid 43925 to reduce Long-Term Note Payable– Issued 3500 common shares for $18 cash each– Declared and paid cash dividends of 86975

engg 401 x2 fundamentals of engineering management spring 2008 chapter 3: statement of cash flow...

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