Chapter 12 & 13

Direct and Indirect Reporting of Operating cash Flows

Two alternative methods may be used when presenting the operating activities section of the statement of cash flows: 1. The direct method reports the total cash inflow or outflow from each main type of transaction (that is, transactions with customers, suppliers, employees, etc.) The difference between these cash inflows and outflows equals the Net cash Provided by (Used in) Operating Activities. 2. The indirect method starts with net income from the income statement and adjusts it by eliminating the effects of items that do not involve cash (for example, depreciation) and including items that do have cash effects. Adjusting net income for these items yields the net Cash Provided by (Used in) Operating Activities.

Common Stock

Under Armor did not repurchase stock during the year, but it did issue stock for $190 million cash. This stock issuance fully accounts for the change in Common Stock, as shown in the following T-account, this cash inflow is listed in the schedule of financing activities.

Horizontal (trend) Analysis

help financial statement users recognize financial changes that unfold over time. This approach compares individual financial statement items from year to year with the general goal of identifying significant changes. Because this type of analysis results over a series of periods, it is sometimes called time-series analysis. regardless of the name, trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. A year-to-year percentage of the prior year's total by using the following calculation:

Ratio Analyses

help financial statement users understand relationships among various items reported in the financial statements. These analyses compare the amounts for one or more line items to the amounts for other line items in the same year. Ratio analyses are useful because they consider differences in the size of the amounts being compared, similar to common size statements. In fact, some of the most popular ratios, such as net profit margin and the debt-to-assets ratio, are taken directly from the common size statements. Ratios allow users to evaluate how well a company has performed given the level of its other resources.

The point to remember about the direct and indirect methods is that they are....

simply different ways to arrive at the same number. Net cash flows provided by (used in) operating activities is always the same under the direct and indirect methods. Also, the choice between the two methods affects only the operating activities section of the statement of cash flows, not the investing and financing sections.

Increase in Accounts Payable

Cash Flow from operations must reflect cash purchases, but not all purchases are for cash. Purchases on account increase Accounts Payable and cash paid to suppliers decreases Accounts Payable. Accounts Payable increased by $210 million, which means that purchases on account were greater than cash payments to suppliers. Thus, to show the lower cash outflow, the increase in Accounts Payable must be added back in

Cash Flows from Operating Activities: Outflows

Cash Used for: - Purchasing services (electricity, etc.) and goods for resale - Paying salaries and wages - Paying income taxes - Paying Interest

Liquidity Ratios (Receivables Turnover)

Most home improvement retailers have low levels of accounts receivable relative to sales revenue because they either collect the majority of their sales immediately in cash or sell credit card receivables to finance companies. Consequently, the receivables turnover ratio is not terribly meaningful for Lowe's or The Home Depot.

Retained Earnings

Net Income increase Retained Earnings and any declared dividends decrease Retained Earnings. Net Income has already been accounted for as an operating cash flow. The declared dividends were $60 million, which decreased Retained Earnings as shown in the following t-account. Because the balance sheet does not report Dividends Payable, we assume all of these declared dividends were paid in cash. This cash outflow is reported in the financing section of the statement of cash flows

Profitability (Net Profit Margin)

Net profit margin represents the percentage of revenue that ultimately makes it into net income, after deducting expenses.

- Decreases in current liabilities

Subtracting decreases in current liabilities serves two purposes. First, it eliminates the effects of transactions that increased net income but did not affect cash. For example, a company decreases Deferred Revenue and increases net income in the current period it fulfills prior obligations to provide services, but cash is not affected. To eliminate these non cash effects, we subtract decreases n current liabilities. Second, subtracting decreases in current liabilities allows us to include the cash affects of other transactions that did not affect net income in the current period but did decrease cash. For example, Cash decreases when a company pays wages that were incurred and expensed in the previous period. These cash outflows captured by subtracting decreases in current liabilities.

- Increases in current assets

Subtracting increases in current assets similarly serves two purposes. First, it eliminates the effects of transactions that increased net income but did not affect cash in the current period. For example, net income increases when a company provides services on account, but cash is not affected. We eliminate these non cash effects by subtracting increases in current assets. Second, subtracting increases in current assets allows us to include the cash effects of other transactions that did not affect net income in the current period but did decrease cash. For example, Cash decreases when a company prepays its insurance or rent, but net income isn't affected until these assets are used up. The cash outflows can be captured by subtracting the increase in these current assets.

Profitability (Price/Earnings (P/E)) Ratio

The P/E ratio relates the company's stock price to its EPS, as follows

Note Payable

The additional data indicates Notes Payable (long-term) was affected by both cash inflows and outflows, as shown in the T-account. These cash flows are reported separately in the schedule of financing activities

Liquidity Ratios

The analyses in this section focus on the company's ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due.

Profitability Ratios

The analyses in this section focus on the level of profits the company generated during the period. We will analyze ratios (1) through (6). The first two ratios come right from the common size income statement

Increase in Prepaid Expenses

The income statement reports expenses of the period, but cash flow from operating activities must reflect the cash payments. Cash prepayments increase the balance in prepaid expenses, and recording of expenses decreases the balance in prepaid expenses.

Increase in Inventory

The income statement reports the cost of goods sold during the period, but cash flow from operating activities must report cash purchases of inventory. As shown in the T-account on the left, purchases of goods increase the balance in inventory, and recording the cost of goods sold decreases the balance in inventory. The T-account on the right shows a $140 million inventory increase, which means that the cash outflow for inventory purchases is more than the cost of goods sold deducted on the income statement. The extra cash outflow must be subtracted to convert net income to cash flow from operating activities

Net Income

When determining operating cash flows using the indirect method, start with net income as reported on the last line of the company's income statement. By starting with net income, it's as if we are assuming all revenues results in cash inflows and all expenses resulted in cash outflows. But we know this is not true, so we add and subtract various amounts to convert that net income number into cash flows from operating activities. The addition and subtractions are explained below.

+ Depreciation

When initially recording depreciation in the accounting system, we increase Depreciation Expense (with a debit) and increase Accumulated Depreciation (with a credit). Notice that this entry for depreciation does not involve cash. To eliminate the effect of having deducted Depreciation Expense from net Income in the income statement, we add it back in the statement of cash flows.

Determine Operating Cash Flows Using the Indirect Method

When using the indirect method, operating cash flows are calculated as follows. We explain each of these items below and then we demonstrate how to use Under Armor's financial information to crease such a schedule.

Cash Flows from Operating Activities

are the cash inflows and outflows related directly to the revenues and expenses reported on the income statement. Operating activities involve day to day business activities with customers, suppliers, employees, landlords, and others.

Cash Flows from Investing Activities

are the cash inflows and outflows related to the purchase and disposal of investments and long-lived assets.

Vertical (common size) analysis

focuses on important relationships within a financial statement. When a company is growing or shrinking overall, it is difficult to tell from the dollar amounts whether the proportions within each statement category are changing. Common size financial statements provide this information by expressing each financial statement amount as a percentage of another amount on that statement. in a common size balance sheet, each asset appears as a percent of total assets, and each liability or stockholders equity item appears as a percent of total liabilities and stockholders equity.

horizontal (trend) analyses are conducted to help financial statement users recognize....

important financial changes that unfold over time.

Vertical analyses focus on....

important relationships between items on the same financial statement

Cash flows from Financing Activities

include exchanges of cash with stockholders and cash exchanges with lenders (for principal on loans).

Ratio analyses are conducted to understand relationships among....

various items reported in one or more of the financial statements

To prepare a statement of cash flows, you need the following:

1. Comparative balance sheets: showing beginning and ending balances, used in calculating the cash flows from all activities (operating, investments, and financing) 2. A complete income statement: used primarily in calculating cash flows from operating activities 3. Additional Data: concerning selected accounts that increase and decrease as a result of investing and-or financing activities.

Preparing the statement of Cash Flows

1. Determine the change in each balance sheet account. From this years ending balance, subtract this years beginning balance (i.e. last years ending balance) 2. Identify the cash flows category or categories to which each account relates. Be aware that some accounts may include two categories of cash flows. Retained Earnings, for example, can include both financing cash flows (paying dividends) and operating cash flows (generating net income). Similarly, Accumulated Depreciation can be affected by operating activities (depreciations for using equipment in daily operations) as well as investing activities (disposing of equipment). 3. Create schedules that summarize operating, investing, and financing cash flows. Create schedules that summarize operating, investing, and financing cash flows.

Most analysts classify ratios into three categories:

1. Profitability ratios, which relate to the company's performance in the current period - in particular, the company's ability to generate income. 2. Liquidity ratios, which relate to the company's short-term survival - in particular, the company's ability to use current assets to repay liabilities as they become due. 3. Solvency ratios, which relate to the company's short-term survival - in particular, the company's ability to repay lenders when debt matures and to make required interest payments prior to the date of maturity.

Intangible and Other Assets

A similar approach is used to determine cash flows associated with intangible assets. For example, analysis of under Armour detailed records indicates the company did not have any reductions in its intangible assets as a result of disposals, impairments, or amortization during the year. however, under Armor did purchase intangible assets for $10 million cash, as noted in the additional data. This cash outflow is subtracted in the schedule of investing activities

Increase in Accounts receivable

Accounts receivable increases when sales are made on account and it decreases when cash is collected from customers. An overall increase in this account, then, implies cash collections were less than sales on account. To convert from the higher sales number that is included in net income to the lower cash collected from customers, we subtract the difference ($100 million). Another way to remember to add or subtract the difference is to think about whether the overall change in the account balance is explained by a debit or credit, the adjustment in the cash flow schedule is reported like a corresponding debit to cash (added). In Under Armor's case, the increase in Accounts Receivable is explained by a debit, so the adjustment in the cash flow schedule is reported like a credit to cash (a decrease), as follows:

+ Decrease in Current Assets

Adding decrease in current assets serves two purposes. First, it eliminates the effects of some transactions that decreased net income but did not effect cash in the current period. For example, when Suppliers are used, net income decreases but cash is not affected. To eliminate these non cash effects from our cash flows computations, we must add back decreases in Supplies and other current assets allows us to include the cash effects of other transactions that did not affect net income in the current period but did increase cash. For example, Cash increases when Accounts Receivable are collected. These cash inflows are captured by adding the amount by which this current asset has decreased.

+ Increases in current liabilities... why is cash not effected? because they are liabilities and have been paid yet?

Adding increases in current liabilities serves two purposes. First it eliminates the effects of transactions that decreased net incomes but did not affect cash. For example, when interest is accrued on a bank loan, a company decreases net income, but its cash is not affected. To eliminate these non cash effects, we add back increases in current liabilities. Second, adding increases in current liabilities allows us to include the cash effects of other transactions that did not affect net income in the current period but did increase cash. For example, Cash and Deferred Revenue increase when the company receives cash in advance of providing services. Adding the crease in current liabilities captures these cash inflows.

Ways to classify cash flows into operating, investing, and financing categories is....

Although expectations exist, a general rule is that operating cash flows cause changes in current assets and current liabilities, investing cash flows affect non current assets, and financing cash flows affect concurrent liabilities or stockholders' equity accounts.

Cash Equivalents

Are short-term, highly liquid investments purchased within three months of maturity. They are considered equivalent to cash because they are both (1) readily convertible to known amounts of cash and (2) so near to maturity their value is unlikely to change.

Interpreting Ratio Analyses

As shown throughout other chapters, benchmarks help when interpreting a company's ratios. These benchmarks can include the company's prior year results, as well as the results of close competitors or the average for the industry. In a competitive economy, companies strive to outperform one another, so comparisons against industry competitors can provide clues about who is likely to survive and thrive in the long run.

Cash flows from Financing Activities: inflows

Cash provided by: - Borrowing from lenders through formal debt contracts - Issuing stock to owners

Cash Flows from Operating Activities: Inflows

Cash provided by: - Collecting from customers - Receiving dividends - Receiving Interest

Cash Flows from Investing Activities: Inflows

Cash provided by: - sale or disposal of equipment - sale or maturity of investments in security

Cash Flows from Investing Activities: Outflows

Cash used for: - Purchase of equipment - Purchase of investments in securities

Cash flows from Financing Activities: Outflows

Cash used for: - Repaying principal to lenders - Repurchasing stock from owners - Paying cash dividends to owners

Equation says changes in cash must be accompanied by and can be accounted for by the changes in liabilities, stockholders equity, and non cash assets

Changes in Cash = Change in (Liabilities + Stockholders Equity - Noncash Assets)

Profitability (Earnings per Share EPS))

Earnings per Share indicates the amount of earnings generated for each share of outstanding common stock. Consistent with the increase in ROE, the EPS ratio increased from $2.73 in 2015 to $3.48 in 2016/

Net Income + Depreciation

Net incomes and depreciation are the first two lines to appear in a statement of cash flows prepared using the indirect method. They begin the process of converting net income to operating cash flows. They also begin the process of explaining the change in cash by accounting for changes in the other balance balance accounts. In the case of Under Armour, the $260 million of net income accounts for the increase in Retained Earnings (the decrease caused by dividends are reported later, in the financing cash flows section). The $110 million of depreciation accounts for the change in Accumulated Depreciation (assuming the company had no disposals) The depreciation add back is not intended to suggest depreciation creates an increase in cash. Rather, it's just showing that depreciation does not cause a decrease in cash. This is a subtle, but very important, difference in interpretation.

Liquidity Ratios (Current Ratio)

The current ratio compares current assets to current liabilities

Solvency Ratios (Debt-to-Assets)

The debt-to-assets ratio indicates the proportion of total assets that creditors finance. Remember that creditors must be paid regardless of how difficult a year the company may have had. The higher this ratio, the risker is the company's financing strategy.

Profitability (Fixed Asset Turnover)

The fixed asset turnover ratio indicates how much revenue the company generates for each dollar invested in fixed assets, such as store buildings and the property they sit on.

Profitability (Gross Profit Percentage)

The horizontal analysis indicated that Lowe's gross profit increased from 2015 to 2016 in terms of total dollars, as a result of a greater number of sales transactions. However, it did not indicate whether that increase was caused solely by greater total sales volume or also by more profit per sale.

Decrease in Accrued Liabilities

The income statement reports all accrued expenses, but the cash flow statement must reflect only the actual cash payments for expenses. Recording accrued expenses increases the balance in Accrued Liabilities and cash payments for the expenses decreases Accrued Liabilities. Under Armour's Accrued Liabilities decreased by $10 million, which indicates that more expenses were paid than accrued. Consequently, this difference (representing more cash paid) must be subtracted. By scanning the example you can see that you have now considered the changes in all balance sheet accounts that step in determine the net cash flow provided by (used in) operating activities is to calculate a total. the combined effects of all operating cash flows is a net inflow of $310 million.

Liquidity Ratios (Inventory Turnover)

The inventory turnover ratio indicates how frequently inventory is bought and sold during the year. The measure "days to sell" converts the inventory turnover ratio into the average number of days needed of days needed to sell inventory. Turnover ratios vary significantly from one industry to the next. Companies in the food industry (restaurants and grocery stores) have high inventory turnover ratios because their inventory is subject to spoilage. Companies that sell expensive merchandise (automobiles and high fashion clothes) have much slower turnover because sales of those items are infrequent, but these companies tend to carry lots of inventory so that customers have a wide selection to choose from when they do buy.

Profitability (Return on Equity (ROE))

The return on equity ratio compares the amount of net income earned for common stockholders to the average amount of common stockholders equity. (The amount of net income earned for common stockholders is net income minus any dividends on preferred or "participating" stock) Like the interest rate on your bank account, ROE reports the net amount earned during the period as a percentage of each dollar contributed by common stockholders and retained in the business.

Under Armours Financing Cash Flow Calculations

This section of the cash flow statement includes changes in liabilities owed to owners (Dividends Payable) and financial institutions (Note Payable and other types of debt), as well as changes in stockholders' equity accounts. Interest is considered an operating activity so it is excluded from financing cash flows. The following relationships are the ones you will encounter most often. To compute cash flows from financing activities, you should review changes in all debt and stockholders equity accounts. Increases and decreases must be identified and reported separately. Under Armor's balance sheet indicates that Note Payable, Common Stock, and Retained Earnings changed during the period as a result of financing cash flows

Equipment

To determine the cause of the change in the equipment account, accountants would examine the detailed accounting records for equipment. Purchases of equipment increase the account and disposals of equipment decrease it. the additional data indicate under Armour purchased equipment for $370 million cash. This purchase is a cash outflow, which we subtract in the schedule of investing activities. In our example, this purchase fully accounts for the change in the equipment balance, as shown in the equipment t-account.

Under Armor's Investing Cash Flow Calculations

To prepare the investing section of the statement of cash flows, you must analyze accounts related to long-lived tangible and intangible assets. Unlike the analysis of operating activities, where you were concerned only with the net change in selected balance sheet accounts, an analysis of investing (and financing) activities requires that you identify and separately report the causes of both increases and decreases in account balances. The following relationships are the ones you will encounter most

The statement of Cash flows shows the major types of business activity that caused a company's cash to.....

increase or decrease during the accounting period.

Solvency Ratios (Times Interest Earned)

the times interest earned ratio indicates how many times the company's interest expense was covered by its operating results. This ratio is calculated using accrual-based interest expense and net income before interest and income taxes