The statement of cash flows is divided into three sections

Accounting Case Writeup

Statements of Cash Flows: Three Examples

. J~hn 5tacey, a sales engineer for Aldhus Corporation, was worried. A flight delay had caused ~ to ~ss laSt week's acco~ting class in the evening MBA program in which he had er:irolled at the

ggestion of the personnel director at Aldhus a growing manufacturer of computer penpherals. The class he had missed had been devoted to a Iec~re and discussion of the statement of cash flows, and he was s~re the material he had missed would be covered in the weekly quiz that was part of each class sess_ion. A classmate had faxed Stacey some notes distributed by their instructor, but they were too cryptic to be understood by anyone who had missed the class.

In desperation, John called Lucille Barnes, the assistant controller at Aldhus, to ask if she could take a few minutes to point him in the right direction toward understanding the statement of cash flows. She seemed delighted by the request, and they agreed to meet that afternoon.

The Meeting

At 2:00 P.M. John Stacey went to the office of Lucille Barnes with his notes and questi0ns- After they had exchanged greetings, Lucille handed John three cash flow statements from the ann~al reports of o~her high-technology companies (Exhibits 1, 2, and 3). John was worried that Lucille would ask him to explain them, and that she would see how confused he still was about some aspects of accounting; instead, Lucille began explaining.

Lucille Barnes (Assistant Controller): The statement of cash flows is really a very useful part of the set of three statements companies are required to prepare. In some cases, it tells more about what is actually happening in a business than either the balance sheet or income statement. The statements of cash flows that I have given you are very revealing. Let me give you a brief overview of the structure and content of cash flow statements, and then you take some time to study these statements. I have prepared some questions to guide your study. Then, we can meet again tomorrow to discuss what you have learned and to answer any questions that remain. I do not think you have to worry about your next quiz because if you understand how balance sheets and income statements are prepared, much about the statement of cash flows will seem pretty obvious.

John Stacey: I hope you are right. I really like the accounting course, and I want to do well in it and to really learn the material. That's why I panicked when I could not understand the notes our instructor passed out last week.

Professors Julie H. Hertenstein and William /. Bruns prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © 1993 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http:/ / www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwise-without the permission of Harvard Business School.

1

50

193-103 examples Statements of Cash Flows: Three

t \uc:i~e Ba~es: Forget those notes for a while and just concentrate on studying_ the sta em~n s . a_v_e gi:en you. Notice that the statement of cash flows is divided into three sections: operating activities investing " · • . th h inflows

d h h fl I acuv1ties, and financing activities. Each section shows e cas

an t e cas out ows associated with that type of activity.

Operating ti .. · f . . . ac vi hes shows the inflows and outflows related to the fundamental operations 0 the basic !me or Imes of bus· th h . . . • 1 d h receipts mess at t e company 1s m. For example, 1t would me u e cas from the sale of goods or services and the cash outflows for purchasing inventory, and paying wages, taxes and rent.

InveSting activ!ties shows cash flows for the purchase and sale of assets not generally held for :esale _and for th~ _mak.i~g and collecting of loans. (Maybe it should more appropriately be called the m~es~mg and dismvest~g activities section.) Here is where you would see if the compan_y s?ld_ a butldi_ng, purchased equipment, made a loan to a subsidiary, or purchased a piece of eqmty m its supplier.

. , . Final_ly, financing activities shows the cash flows associated with increasing or decreasing the ~irm s fma~c~g, for example, issuing or repurchasing stock and borrowing or repaying loans. It also '.ncludes_ dividends, which are cash flows associated with equity. However, ironically, it does not mclude interest payments; these are included in operating activities.

John Stacey: That seems strange to me. Since loans are the reason interest payments are made, why are they not included in the financing activities section? You know, interest is to loans as dividends are to equity?

Lucille Barnes: Actually in some other countries such as the United Kingdom interest is included in the financing activities section! But in the United States the Financial Accounting Sta_n~ards Board voted that interest payments should be in the operating activities section in~tead. This 15 one of these situations where you might have to do some adjusting if you were trying to compare a U.K. company like British Petroleum to a U.S. company like Exxon.

John Stacey: That is interesting! How can I use each section of the statement?

Lucille Barnes: The operating activity section is the cash-flow engine of the company. When this engine is working effectively, it provides the cash flows to cover the cash needs of operations. In a healthy, growing company, we would expect growth in operating working capital accounts such as inventory and accounts receivable (uses of cash) as well as in accounts payable and other operating payables (sources of cash). Obviously there can be quite a bit of variability in working capital accounts from period to period, but on average inventories, receivables, and accounts payable usually grow in growing companies. In addition, th.is operating cash-flow engine provides cash for needed investments, to repay debt, and to pay dividends. There are exceptions, of course. Start-up companies, for example, usually have negative cash flows from operations because they have not gotten their cash-flow engines up to speed. Companies in cyclical industries may have negative operating cash flow in a "down" year; a company that has experienced an extensive strike could also be expected to have negative cash flow from operations. Although an occasional year of negative operating cash flow does not spell disaster, nonetheless, we should expect operating cash flow, on average, to be positive.

Investing activities are a different story. Whereas we expect positive operating cash flow, we also expect a healthy company to continually invest in more plant, equipment, land, and other fixed assets to replace the assets that have been used up or have become technologically obsolete, as well as to expand and grow. Although companies often sell assets that are no longer of use to them, we would normally expect them to purchase more capital assets than they sell. As a result, in general, we expect negative cash flows from investing activities. Like operating activities, exceptions occur, especially if the firm divests a business or subsidiary.

2

51

Statements of Cash Flows: Three Examples 193-103

Cash flows from financing activities could as easily be positive as negative in a healthy company, and they are likely to change back and forth. If the company's need for cash to invest exc~eds the cash flow generated by operating activities, this will requi~e extra financing by deb~ or equity, therefore a positive financing cash flow. On the other hand, 1f cash flow from operating activities exceeds the investing needs, the firm will have excess cash to repay debt or pay more dividends, producing negative cash flows from financing.

John Stacey: I am beginning to see why you said that the statement of cash flows is so useful. Where do you start your review and analysis?

Lucille Barnes: A way to approach the cash-flow statement is to begin with cash flows from operating activities. If this is the cash-flow engine, then the first question is, "Is cash flow from operating activities greater, or Jess, than zero?" Also of interest is the trend: is it increasing or decreasing?

John Stacey: As you were talking, I glanced at the cash flows from operations sections of the first two statements (Exhibits 1 and 2) you gave me. They look very different. On the first, depreciation seems to provide cash flows, but there is no mention of depreciation on the second.

Lucille Barnes: Oops! I forget to mention that there are two ways operating cash flows can be presented. Sometimes they are presented using the indirect method as in the first statement I gave you (Exhibit 1). Using that method, net income is adjusted for all noncash revenues and expenses, one of which is depreciation. Depreciation is never a source of cash, but it is deducted to compute net income, so it must be added back. Likewise, operating cash flows not included in net income, such as purchases of inventory not sold, have to be added or subtracted.

When the direct method is used to present cash flows from operations, that section of the report looks much more like a summary from the operating cash account as it does in the second report I gave you (Exhibit 2).

John Stacey: Which of the methods is better?

Lucille Barnes: I think the direct statement of cash flows from operations is easier to understand, but few companies present their operating cash flows that way. Most of the statements you will see will use the indirect method. The reason for this is that if the direct method is used, a reconciliation of income to cash flows from operations is also required (see Exhibit 2), so most companies simply use the reconciliation as their summary of cash flows from operations.

But let's get back to how I approach the statement of cash flows.

Assuming operating cash flows are greater than zero, the next challenge is to decide whether they are adequate for important, routine expenditures. Again, our expectations are tempered by our understanding of the company and its situation. Just like we do not expect a start-up company to have positive operating cash flows, we also do not expect a company still in a very rapid growth phase to have enough cash flow from operations to cover its investments. However, for a mature company, we expect operations to generate enough cash to "keep the company whole." This would include the amount of investment required to replace those fixed assets that are used up, worn out, or technologically obsolete as well as cash required to pay the annual dividend which the shareholders have come to expect. It is hard to know precisely how much cash is required to keep the company's fixed assets "whole," and the cash-flow statement does not separate investing cash flows for replacement and renewal from those investing cash flows for expansion and growth. However, the annual depreciation amount is a very rough surrogate for the amount of fixed assets that need to be replaced each year. In periods when prices are rising, we should expect that the cost to replace assets would be somewhat greater than the cost of older assets that are being depreciated. Thus, it is

3

52

I I J J

J

I

193-103 Statements of Cash Flows: Three Examples

common to expect the portion of investing activities related to the purchase of fixed assets to exceed the annual depreciation.

After considering whether operating cash flows cover capi~~l _expenditures and dividends, I look to sec whether there are other major cash needs such as ac1uis'.~ons, stock repurchase, or debt repayment. If so, how do these cash needs fit with the avat!ab1hty of cash? Are these needs discretionary, like acquisitions?

If there are cash shortfalls, J investigate how they are being funded . ls it by issuing_ st~ck? By borrowing? By selling businesses or assets? In each ca~e, I consid~r whether the ~ompany 1s li~ely to be able to continue such funding, and for how Jong. Will t~c funding source continue _to be avat!able, or are we likely nearing the limit? Will continuing to use this source hurt the company in any way?

John Stacey: Do you always have to look at all of those things in every case?

Lucille Barnes: No. But if you stop short of a full review, you may miss an important part of the story.

In evaluating the cash-flow statement, you are evaluating many pieces of evidence to produce an overall picture. However, it would be rare to find a company where all of the evidence is positive, or where all of the evidence is negative. To do a balanced evaluation, you must search out both the good news and the bad news in each cash-flow statement. To reach an overall conclusion you need to judge the relative importance of each piece of evidence and assess its relationship to the overall picture. Like in a legal case, your conclusion needs to be based on the "weight of the evidence."

I think the best way to learn about statements of cash flow is to study some carefully. The sta~ements I have given you are a place to start. I wrote out some questions to guide your study (the ~ss_ignme~t). Try to develop answers, and we can meet tomorrow to discuss them. By the time we finish, I think you will be well prepared for the quiz in your next class.

The Assignment

Exhibits 1, 2, and 3 contain cash-flow statements from three companies. Each cash-flow st

atement has thr~e years of data. Examine the contents of these cash-flow statements carefully. Answer the following questions about each of the three cash-flow statements.

I. For each of the years on the Statement of Cash Flows:

1.

2.

3.

What were the firm 's major sources of cash? Its major uses of cash?

Was _cash flm~ from operations1 greater than or less than net income?2 Explain in detail the rna1or reasons for the difference between these two figures .

Wa~ the firm able to generate enough cash from operations to pay for all of its capital expenditures?3

; ~~eti~es !called net cash ~rovided by operating activities, or cash flow from continuing operations

3 ernative _Y referred to as rncome or loss from continuing operations. · Also called mvestm ts · d · b 4 en m eprecza le assets, or purchases of plant, property, and equipment.

53

I I J r '

Statements or Cash Flows: Three Examples

4. Did the cash flow from operations cover both the capital expenditures an d the

firm's dividend payments, if any?

5. If it did, how d id the firm invest its excess cash?

6. If not, what were the sources of Ci!Sh the firm used to pay for the capi tal

expenditures and / or d ividends?

7. Were the working capital (current asset and current liability) accounts other than cash and cash equivalents primarily sources o f cash, or users of cash?

8. What other major items affected cash flows?

II. What was the trend in:

9. Net income?

10. Cash flow from (continuing) opera tions?

I 1. Capital expenditures?

12. Dividends?

13. Net borrowing (proceeds less payments of short- and long-tenn debt)?

14. Working capital accounts?

193-103

Ill. ~ased. on the evidence in the Statement of Cash Flows a lone, what is your assessment o f the frnancraJ s treng th of this business? Why?

5

54

Statements of Cash Flows: Three Examples

193-103

Exhibit 1 Alpha Corporation, Consolidated Statements of Cash Flows($ millions)

Year Ended June 30,

1991 1990 1989

Operating Activities $(377.9) $(623.5) $(320.6) Loss from continuing operations 168.4 220.1 263 .4 Depreciation 41 .4 58.2 39.1 Amortization of capitalized software Gain from sale of investments and other assets

(16.6) (119.0)

Restructuring and other unusual Items, net 135.5 384.1 125.3

Changes in other accounts affecting operations 160.8 73.4 (45.2)

Accounts receivable Inventory

80.2 100.9 (3.0)

Other current assets 17.0 (1.2) (13.0)

Accounts payable and other current liabilities (91.3) (21.3) 41 .0

Other 2.8 14.1 (10.5)

Net cash provided by continuing operations 120.3 85.8 76.5

Net cash provided by (used in) discontinued operations 4.9 3.5 (29.7)

Net cash provided by operating activities 125.2 89.3 46.8

Investing Activities Investment in depreciable assets (129.7) (174.4)

(303.6)

Proceeds from disposal of depreciable and other assets 157.0 242.0 94.1

Proceeds from the sale of discontinued operations 25.3 407.3

Investment in capitalized software (27.8) (43. 1) (59.5)

Other (6.0) (13.0) 14.2

Net cash provided by (used in) investing activities 18.8 418.8 (254.8)

Financing Activities (Decrease) increase in short-term borrowings (2.6) (222.6) 139.8

Proceeds from long-term debt 44.4 167.7 305.0

Payments of long-term debt (126.5) (544.8) (91.7)

Proceeds from sale of Class B common stock 5.0 8.7 17.5

Purchase of treasury stock (.3) (.6) (18.8)

Dividends paid (7.2) (26.0)

Net cash provided by (used in) financing activities (80.0) (598.8) 325.8

Effect of changes in foreign exchange rates .1 1. 1 (3.9)

Increase (decrease) in cash equivalents 64.1 (89.6) 113.9 Cash and equivalents at beginning of year 169.1 258.7 144.8

Cash and equivalents at end of year $233.2 $169.1 $258.7

6

55

193-103

Statements of Cash Flows: Three Examples

Exhibit 2 Beta Corporation, Consolidated Statements of Cash Flows($ thousand)

Cash Flows from Operating Activities: Cash received from customers Cash paid to suppliers and employees

Interest received Interest paid Income laxes paid

Nel cash generated by operating activities

Cash Flows from Investing Activities: Capital expenditures Marketable securities purchases

Ne\ cash used in investing activities

Cash Flow from Financing Activities: Net payments under working capital line of credit Net payments under equipment line of credit Principal payments under capital lease obligations Proceeds (payment) of subordinated debt Proceeds from the issuance of common stock

Net cash provided by (used in) financing activities Eflect of exchange rate changes on cash Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

Reconciliation ot Net Income to Net Cash Generated by Operating Activities:

Net income

Adjustments to Reconcile Net Income to Net Cash Consumed by Operating Activities:

Bad debt provision Depreciation and amortization Amortization of original issue discount Loss on disposition of assets Compensation expense related to stock grants

Changes in Assets and Liabilities: (Increase) in accounts receivable (Increase) decrease in inventory (Increase) decrease in deposits and other assets Increase (decrease) in accounts payable and

accrued expenses Total adjustments Net cash generated by operating activities

Year Ended December 31 , 1991 1990 1989

$83,865 (77,820)

643 (536)

(2,233)

3,919

(6,031) (8,000)

(14,031)

(985) (169)

(5,000) 23,082 16,928

(4) 6,812 5,375

$12,187

S 6,323

99 4,028

208 17 40

(10 ,837) (951) (665)

5,657 ( 2,404) $3,919

56

$73,273 (65,480)

355 (1 ,046)

(102)

7,000

(4,600)

(4,600)

(2,000) (126) (213)

141 (2,198)

14 216

5,159 $5,375

$5,201

47 2,701

324 9

85

(613) (810)

366

(310)

1,799

$7,000

$51,110 (46,589)

132 (908)

(75)

3,670

(3,650)

(3,650)

(860) (388) (276)

4,400 639

3,515

3,535 1,624

$5,159

$ 417

98 2 ,231

68

58

(1 ,550) 1,043 (762)

2 ,067

3,253 $3,670

7

193-103 Statements of Cash Flows: Three Examples

Exhibit 3 Gamma Corporation, Consolidated Statemen ts of Cash Flows (S thousand)

8

Cash Flows from Operating Activities: Net lncome/(loss)

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation and amortization Other adjustments to income (lncrease)/decrease in accounts receivable ( lncrease)/decrease in inventories (lncrease)/decrease 1n prepaid expenses lncrease/(decrease) in accounts payable (Decrease) in taxes

Increase in deferred revenues and customer advances Increase in restructuring reserve Increase in other liabilities

Total adjustments

Net cash flows from operating activities

Cash Flows from Investing Activities: Purchase of plant, property, and equipment (Increase) of other assets. net Purchase of Kienzle business

Net cash flows from investing activities

Net cash flows from operating and investing activities

Net Flows from Financing Activities: Proceeds from issuance of debt Payments to retire debt Purchase of treasury shares Issuance of treasury shares, including tax benefits

Net cash flows from financing activities

Net increase/(decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year

Cash and cash equivalents at end of year

June 29, 1991

$ (617,427)

828,560 189,077 105,977

18,616 (47,239) (17,694)

(105,614) 92,222

593,160 1,263

1,658,328 1,040,901

(737,548) (55,782)

(233,261)

(1,026,591)

14,310

14,249 (112,426) (240,719) 239,653

(99,243)

(84,933) 2,008,983

$1,924,050

57

Years Ended

June 30, 1990

$74,393

796,201 92,329

(241,357) 99,743

(90,602) 107,001

(201,560) 69,207

443,544 285,175

1,359,681 1,434,074

(1,027,625) (75,489)

(1,103,114)

330,960

17,661 (20,896)

(270,231) 296.225

22,759

353,719 1,655,264

$2,008,983

July 1, 1989

$1 ,072.610

686,738 49,702

(373,248) (62,942) 18,965 30.645

(75,502) 105,847

26,576

406,781 1,479,391

(1,223,038) (67,624)

(1,290,662)

188,729

40,425 (153,245) (814,958) 230,733

(697,045)

(508,316) 2 ,163,580

$1 ,655,264