know that its cash decreases when a business pays down its debt, returns some of the capital that its owners had previously invested in the business, and invests in new fixed assets (buildings, machines, equipment, vehicles, and so on). Most people also know there is another important source of cash: making profit. However, things get a little tricky regarding this source of cash. One problem is this: Instead of saying that a business “earns profit,” people say that a business “makes money.” Therefore, many people assume that the bottom-line profit for the year increases cash exactly the same amount — no more, and no less. Not true: The actual amount of cash flow from making profit is invariably different than the amount of profit earned for the period. Earning profit and generating cash flow from the profit are two different things. You’re talking about apples and oranges when you’re talking about profit and cash flow from profit. Here’s a very brief explanation of why profit and cash flow from profit are different amounts. When a business makes sales on credit, sales revenue is recorded before cash is collected from customers. Cash inflow from credit sales takes place after recording the sales revenue. Also, many expenses are recorded before cash is paid for the liabilities incurred by the expenses. So, cash outflow for the expenses takes place after recording the expenses. Furthermore, the recording of depreciation expense does not require a cash outlay in the period. You could simply add back depreciation expense to bottom-line profit to get a rough (and I mean rough) measure of cash flow from making profit. But this shortcut ignores the other factors that affect cash flow from profit, and I don’t recommend it. Note: Because I use the same business example in this chapter that I use in Chapters 4 and 5, you may want to take a moment to review its 2009 income statement in Figure 4-1. And you may want to review Figure 5-1, which summarizes how the three types of activities changed its assets, liabilities, and owners’ equity accounts during the year 2009. (Go ahead, I’ll wait.) Suppose the president of the business asks me, the chief accountant (con- troller), for an executive summary of the company’s sources and uses of cash during the year ended December 31, 2009. The president does not want a formal, detailed financial statement with all the bells and whistles. He wants a very brief summary that speaks to him as the very busy chief executive of the business. Here’s what I would prepare for him: 120 Part II: Figuring Out Financial Statements 11_246009 ch06.qxp 4/17/08 12:28 AM Page 120 Executive Summary for Company’s President Sources and Uses of Cash During the Year 2009 Cash flow from making profit $1,515,000 Cash distributions from profit ($750,000) $765,000 to shareowners Cash flow from increasing debt $250,000 Cash flow from capital invested by owners $150,000 Cash available for general business purposes $1,165,000 Capital expenditures during year ($1, 265,000) Cash decrease during year ($110,000) The president would do a critical review of the strategic decisions that were made during the year. For example, was it prudent to take on more debt? Why did the shareowners invest an additional $150,000 in the business, and will they invest additional capital during the coming year? Should the business have distributed about half of the cash flow from profit to its owners? I return to these issues in the last section of the chapter, “Being an Active Reader.” You may be wondering how I got the information to prepare the executive summary of cash flows for the president. I extracted the relevant information from the company’s asset, liability, and owners’ equity accounts. I examined the increases and decreases entered in the accounts during the year to deter- mine the amounts you see in the executive summary. This is no problem; I’m an accountant, you know. Accountants prepare detailed spreadsheets in which changes in the asset, liability, and owners’ equity accounts are ana- lyzed and classified in order to prepare a statement of cash flows, or an exec- utive summary such as the one I show here. Computer software programs can be used for this purpose. The president of the business can request any particular accounting report or summary that he wants. The president is not limited or restricted to the format and content of the three financial statements that are prepared for external reporting. If the president wants an executive summary of cash flows, as opposed to a formal statement of cash flows as it is presented in the external financial report of the business, then as controller I prepare the executive summary. I know which side my bread is buttered on. There are no restrictions regarding how to report cash flows internally (inside the busi- ness to its managers). If the president doesn’t like or doesn’t understand the information I give him in the executive summary of cash flows, he will let me know in no uncertain terms. 121 Chapter 6: Reporting Cash Flows 11_246009 ch06.qxp 4/17/08 12:28 AM Page 121 You may be wondering in particular how I got the $1,515,000 amount for cash flow from making profit (see the executive summary). And, you may be won- dering why this cash flow amount is different than the $1.69 million bottom- line profit number reported in the company’s income statement for the year (see Figure 4-1 in Chapter 4). One purpose of the statement of cash flows is to report the cash flow from making profit and to explain the difference between the cash flow number and the bottom-line profit number in the income statement. The cash flow number is based on actual cash inflows and outflows; the profit number is based on accounting for sales revenue and expenses. Remember the follow- ing points: ߜ If a business makes credit sales, the total cash inflow from customers is different than the total sales revenue recorded in the year (unless the business collects all its credit sales before the end of the year). ߜ The total cash outlay for expenses during the year is different than the total amount of expenses recorded in the year. The statement of cash flows begins with the cash flow from making profit, or cash flow from operating activities as accountants call it. Operating activities is the technical term that accountants have adopted for sales and expenses, which are the “operations” that a business carries out to earn profit. I don’t think it’s the best term in the world, but we are stuck with it; it’s part of the official language of accounting. Meeting the Statement of Cash Flows I hate to start out like this, but I have to tell you that a business has its choice between two quite different methods of reporting cash flow from operating activities in its statement of cash flows. Financial reporting standards permit either approach. I first show you the preferred method, and then the alterna- tive. Figure 6-1 presents the statement of cash flows for our business example dressed to the nines, in formal attire. This is not a condensed version; it’s the real thing, not an executive summary. One main difference, as compared with the executive summary of cash flows I prepared for the president, is seen in the first section, Cash Flows from Operating Activities. What you see in the first section of the statement of cash flows is called the direct method for reporting cash flow from operating activities. I think the term “direct” is meant to refer to the cash flows connected with sales and expenses. For example, the business collects $25.55 million from customers during the year, which is the direct result of making sales. 122 Part II: Figuring Out Financial Statements 11_246009 ch06.qxp 4/17/08 12:28 AM Page 122 Note in Figure 6-1 that cash flow from operating activities for the year is $1,515,000, which is $175,000 less than the company’s $1,690,000 net income for the year (refer to Figure 4-1). When issuing the financial reporting standard for the statement of cash flows, the Financial Accounting Standards Board (FASB) thought that financial report readers would compare cash flow from operating activities with net income, and they would want some sort of expla- nation for the difference between these two important financial numbers. Therefore, the FASB decreed that the statement of cash flows should also include a reconciliation schedule to explain the difference between cash flow from operating activities and net income. Or, a business can use the alterna- tive method for reporting cash flow from operating activities. The alternative Typical Business, Inc. Statement of Cash Flows for Year Ended December 31, 2009 (Dollar amounts in thousands) Cash Flows from Operating Activities Collections from sales Payments for products Payments for selling, general, and administrative costs Payments for interest on debt Payments on income tax Cash flow from operating activities $25,550 ($24,035 $1,515 ) ) ($15,025 ($7,750 ($375 ($885 ) ) ) ) )) ) $100 $150 $150 ($750 Cash Flows from Investing Activities Expenditures on property, plant, and equipment ($1,275 Cash Flows from Financing Activities Short-term debt increase Long-term debt increase Capital stock issue Dividends paid stockholders Decrease in cash during year Beginning cash balance Ending cash balance ($350 ($110 $2,275 $2,165 Figure 6-1: The statement of cash flows — using the direct method for presenting cash flow from operating activities. 123 Chapter 6: Reporting Cash Flows 11_246009 ch06.qxp 4/17/08 12:28 AM Page 123 method starts with net income, and then makes adjustments in order to rec- oncile cash flow from operating activities with net income. This alternative method is called the indirect method, which I show in Figure 6-2. Typical Business, Inc. Statement of Cash Flows for Year Ended December 31, 2009 (Dollar amounts in thousands) Cash Flows from Operating Activities Net income Adjustments to net income for determining cash flow: Accounts receivable increase Inventory increase Prepaid expenses increase Depreciation expense Accounts payable increase Accrued expenses increase Income tax payable increase Cash flow from operating activities $1,690 ($175 $1,515 ($450 ($725 ($75 $775 $125 $150 $25 ) ) ) ) ) ) ) ) Cash Flows from Investing Activities Expenditures on property, plant, and equipment ($1,275 $100 $150 $150 ($750 Cash Flows from Financing Activities Short-term debt increase Long-term debt increase Capital stock issue Dividends paid stockholders Decrease in cash during year Beginning cash balance Ending cash balance ($350 ($110 $2,275 $2,165 Figure 6-2: The statement of cash flows — using the indirect method for presenting cash flow from operating activities. 124 Part II: Figuring Out Financial Statements 11_246009 ch06.qxp 4/17/08 12:28 AM Page 124 The indirect method for reporting cash flow from operating activities focuses on the changes during the year in the assets and liabilities that are connected with sales and expenses. I explain these connections in Chapter 4. (You can also trace these changes back to Figure 5-1, which includes the start-of-year and end-of-year balances of the balance sheet accounts for the business example.) While there are obvious differences in the first section of the statement of cash flows between the two methods for reporting cash flow from operating activities, the other two sections of the statement — cash flow from investing activities and cash flow from financing activities — are the same. The level of detail disclosed in these two sections varies from business to business. For example, some companies report one aggregate amount for all capital expen- ditures (investments in new long-term operating assets), whereas others give a more detailed breakdown. Dissecting the Difference Between Cash Flow and Net Income A positive cash flow from operating activities is the amount of cash gener- ated by a business’s profit-making operations during the year, exclusive of its other sources of cash during the year. Cash flow from operating activities indicates a business’s ability to turn profit into available cash — cash in the bank that can be used for the needs of business. As you see in Figure 6-1 or Figure 6-2 (take your pick), the business in our example generated $1,515,000 cash from its profit-making activities in the year. As they say in New York, “That isn’t chopped liver.” The business in our example experienced a strong growth year. Its accounts receivable and inventory increased by relatively large amounts. In fact, all its assets and liabilities intimately connected with sales and expenses increased; their ending balances are larger than their beginning balances (which are the amounts carried forward from the end of the preceding year). Of course, this may not always be the case in a growth situation; one or more assets and lia- bilities could decrease during the year. For flat, no-growth situations, it’s likely that there will be a mix of modest-sized increases and decreases. The following sections explain how the asset and liability changes affect cash flow from operating activities. As a business manager, you should keep a close watch on the changes in each of your assets and liabilities and under- stand the cash flow effects caused by these changes. Investors should focus on the business’s ability to generate a healthy cash flow from operating activ- ities, so investors should be equally concerned about these changes. In some situations these changes can signal serious problems! 125 Chapter 6: Reporting Cash Flows 11_246009 ch06.qxp 4/17/08 12:28 AM Page 125 I realize that you may not be too interested in the details that I discuss in the following sections. With this in mind, at the start of each section I present the punch line. If you wish, you can just read this and move on. But the details are fascinating (well, at least to accountants). Note: Instead of using the full phrase “cash flow from operating activities” every time, I use the shorter term “cash flow” in the following sections. All data for assets and liabilities are found in the two-year balance sheet of the business (see Figure 5-2). Accounts receivable change Punch Line: An increase in accounts receivable hurts cash flow; a decrease helps cash flow. The accounts receivable asset shows how much money customers who bought products on credit still owe the business; this asset is a promise of cash that the business will receive. Basically, accounts receivable is the amount of uncollected sales revenue at the end of the period. Cash does not increase until the business collects money from its customers. The business started the year with $2.15 million and ended the year with $2.6 million in accounts receivable. The beginning balance was collected during the year, but the ending balance had not been collected at the end of the year. Thus the net effect is a shortfall in cash inflow of $450,000. The key point is that you need to keep an eye on the increase or decrease in accounts receivable from the beginning of the period to the end of the period. Here’s what to look for: ߜ If the amount of credit sales you made during the period is greater than what you collected from customers during the period, your accounts receivable increased over the period, and you need to subtract from net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, an increase in accounts receivable hurts cash flow by the amount of the increase. ߜ If the amount you collected from customers during the period is greater than the credit sales you made during the period, your accounts receiv- able decreased over the period, and you need to add to net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, a decrease in accounts receivable helps cash flow by the amount of the decrease. 126 Part II: Figuring Out Financial Statements 11_246009 ch06.qxp 4/17/08 12:28 AM Page 126 In our business example, accounts receivable increased $450,000. Cash col- lections from sales were $450,000 less than sales revenue. Ouch! The busi- ness increased its sales substantially over the last period, so you shouldn’t be surprised that its accounts receivable increased. The higher sales revenue was good for profit but bad for cash flow. The “lagging behind” effect of cash flow is the price of growth — managers and investors need to understand this point. Increasing sales without increas- ing accounts receivable is a happy situation for cash flow, but in the real world you usually can’t have one increase without the other. Inventory change Punch Line: An increase in inventory hurts cash flow; a decrease helps cash flow. Inventory is usually the largest short-term, or current, asset of businesses that sell products. If the inventory account is greater at the end of the period than at the start of the period — because unit costs increased or because the quantity of products increased — the amount the business actually paid out in cash for inventory purchases (or for manufacturing products) is more than what the business recorded in the cost of goods sold expense for the period. In our business example, inventory increased $725,000 from start-of-year to end-of-year. In other words, to support its higher sales levels in 2009, this business replaced the products that it sold during the year and increased its inventory by $725,000. The business had to come up with the cash to pay for this inventory increase. Basically, the business wrote checks amounting to $725,000 more than its cost of goods sold expense for the period. This step- up in its inventory level was necessary to support the higher sales level, which increased profit even though cash flow took a hit. Prepaid expenses change Punch Line: An increase in prepaid expenses (an asset account) hurts cash flow; a decrease helps cash flow. A change in the prepaid expenses asset account works the same way as a change in inventory and accounts receivable, although changes in prepaid expenses are usually much smaller than changes in those other two asset accounts. 127 Chapter 6: Reporting Cash Flows 11_246009 ch06.qxp 4/17/08 12:28 AM Page 127 The beginning balance of prepaid expenses is charged to expense this year, but the cash for this amount was actually paid out last year. This period (the year 2009 in our example), the business pays cash for next period’s prepaid expenses, which affects this period’s cash flow but doesn’t affect net income until next period. In short, the $75,000 increase in prepaid expenses in this business example has a negative cash flow effect. As it grows, a business needs to increase its prepaid expenses for such things as fire insurance (premiums have to be paid in advance of the insurance coverage) and its stocks of office and data processing supplies. Increases in accounts receivable, inventory, and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets. The depreciation factor Punch Line: Recording depreciation expense decreases the book value of long-term operating (fixed) assets. There is no cash outlay when recording depreciation expense. Each year the business converts part of the total cost invested in its fixed assets into cash. It recovers this amount through cash collections from sales. Thus, depreciation is a positive cash flow factor. The amount of depreciation expense recorded in the period is a portion of the original cost of the business’s fixed assets, most of which were bought and paid for years ago. (Chapters 4 and 5 explain more about depreciation.) Because the depreciation expense is not a cash outlay this period, the amount is added to net income to determine cash flow from operating activi- ties (see Figure 6-2). For measuring profit, depreciation is definitely an expense — no doubt about it. Buildings, machinery, equipment, tools, vehicles, computers, and office furniture are all on an irreversible journey to the junk heap (although build- ings usually take a long time to get there). Fixed assets (except for land) have a limited, finite life of usefulness to a business; depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue. In our example, the business recorded $775,000 depreciation expense for the year. Instead of looking at depreciation as only an expense, consider the investment-recovery cycle of fixed assets. A business invests money in its fixed assets that are then used for several or many years. Over the life of a fixed asset, a business has to recover through sales revenue the cost invested in the fixed asset (ignoring any salvage value at the end of its useful life). In a real sense, a business “sells” some of its fixed assets each period to its customers — it factors the cost of fixed assets into the sales prices that it charges its customers. 128 Part II: Figuring Out Financial Statements 11_246009 ch06.qxp 4/17/08 12:28 AM Page 128 For example, when you go to a supermarket, a very small slice of the price you pay for that quart of milk goes toward the cost of the building, the shelves, the refrigeration equipment, and so on. (No wonder they charge so much!) Each period, a business recoups part of the cost invested in its fixed assets. In the example, $775,000 of sales revenue went toward reimbursing the business for the use of its fixed assets during the year. In short, deprecia- tion is a positive cash flow factor. The depreciation amount is imbedded in sales revenue, and sales revenue generates cash flow. The business in our example does not own any intangible assets and, thus, does not record any amortization expense. (See Chapter 5 for an explanation of intangible assets and amortization.) If a business does own intangible assets, the amortization expense on these assets for the year is treated the same as depreciation is treated in the statement of cash flows. In other words, the recording of amortization expense does not require cash outlay in the year being charged with the expense. The cash outlay occurred in prior periods when the business invested in intangible assets. Changes in operating liabilities Punch Line: An increase in a short-term operating liability helps cash flow; a decrease hurts cash flow. The business in our example, like almost all businesses, has three basic liabil- ities inextricably intertwined with its expenses: ߜ Accounts payable ߜ Accrued expenses payable ߜ Income tax payable When the beginning balance of one of these liability accounts is the same as its ending balance (not too likely, of course), the business breaks even on cash flow for that account. When the end-of-period balance is higher than the start-of-period balance, the business did not pay out as much money as was recorded as an expense in the year. In our business example, the business disbursed $640,000 to pay off last year’s accounts payable balance. (This $640,000 was the accounts payable balance at December 31, 2008, the end of the previous fiscal year.) Its cash this year decreased $640,000 because of these payments. But this year’s ending balance sheet (at December 31, 2009) shows accounts payable of $765,000 that the business will not pay until the following year. This $765,000 amount was recorded to expense in the year 2009. So, the amount of expense was $125,000 129 Chapter 6: Reporting Cash Flows 11_246009 ch06.qxp 4/17/08 12:28 AM Page 129 [...]... assets, liabilities, and owners’ equity of the business (reported in its balance sheet) For instance, how much would you pay for a business that has never made a profit and whose liabilities are more than its assets? There’s no simple formula for calculating the market value for a business based on its profit performance and financial condition But, quite clearly, the profit performance and financial condition... independent CPA auditor to examine the company’s recordkeeping and accounting system, to determine whether the accounts of the business are complete, accurate, and in conformity with generally accepted accounting principles (GAAP) The CPA should also test for possible fraud and any accounting shenanigans in the financial statements (I discuss accounting and financial reporting fraud in Chapter 15.) As the potential... different accounting methods and if the business had not tweaked its financial statements Therefore, you see only one version of the financial performance and position of the business But behind the scenes the controller and managers know that the company’s financial statements would have been different if different accounting methods Chapter 7: Choosing Accounting Methods: Different Strokes for Different... A business has choices among different accounting methods for recording the amounts of revenue and expenses ߜ A business can make pessimistic or optimistic estimates and forecasts when recording certain revenue and expenses ߜ A business has some wiggle room in implementing its accounting methods, especially regarding the precise timing of when to record sales and expenses ߜ A business can engage in... this information differently, but all would agree that the information in this section of the cash flow statement is very important Certain long-lived operating assets are required for doing business For example, Federal Express and UPS wouldn’t be terribly successful if they didn’t have airplanes and trucks for delivering packages and computers for tracking deliveries When these assets wear out, the business... Choosing Accounting Methods: Different Strokes for Different Folks The “A” in Version A stands for actual and aggressive What I mean by aggressive is that the business adopted accounting methods that maximize its recorded profit, and it used certain techniques to make its year-end financial condition look as positive as possible Some businesses go the opposite direction They adopt conservative accounting. .. to record profit performance, and they wouldn’t think of tinkering with their financial statements at the end of the year, even when their profit performance falls short of expectations and their financial condition has some trouble spots In Figure 7-1, the “C” in Version C stands for conservative and cautious Now, you may very well ask, “Where in the devil did you get the numbers for Version C?” The... what the future may hold for the company Major new investments are the sure signs of expanding or modernizing the production and distribution facilities and capacity of the business Major disposals of long-term assets and shedding off a major part of the business could be good news or bad news for the business, depending on many factors Different investors may interpret this information differently,... at how the income statement and balance sheet depend on which accounting methods a business chooses and on whether the financial statements are tweaked to make them look better (while staying within the boundaries of accounting and financial reporting standards) The amounts reported in the financial statements of a business are not simply facts that depend only on good bookkeeping Here’s why: ߜ A business... which accounting methods it uses (See Chapter 12 for getting a financial report ready for release.) Contrasting aggressive and conservative numbers As the potential buyer of a business, you have to decide on an offering price You have to decide what the business is worth Generally speaking, the two most important factors are the profit performance of the business (reported in its income statement) and . company’s $1,690,000 net income for the year (refer to Figure 4- 1). When issuing the financial reporting standard for the statement of cash flows, the Financial Accounting Standards Board (FASB) thought. the indirect method for presenting cash flow from operating activities. 1 24 Part II: Figuring Out Financial Statements 11_ 246 009 ch06.qxp 4/ 17/08 12:28 AM Page 1 24 The indirect method for reporting. sales and expenses, and it obviously ignores that most of interest and income tax expenses are paid in cash during the period 1 34 Part II: Figuring Out Financial Statements 11_ 246 009 ch06.qxp 4/ 17/08