Case study for key company issues

The Introduction section gives an overview of the Fox Factory Holding Corporation. You will play the role of the divisional manager of the new e-bike division of the company. The business plans to sell electric bikes to consumers in the United States (note that this is a fictitious assumption for the case study). The product has been designed but is not yet in production. The divisional manager is preparing to request funding to introduce the product and begin sales. Three options have been identified:

Produce the new e-bike internally.

Outsource manufacturing to another manufacturer.

License the design to an existing company for royalties on future sales

• Summarize the company’s financial information.
• Summarize your perception of their outlook for the next three years.
• Elaborate on the three potential options that will be evaluated in the case.

Evaluate two factors that might impact the decision to pursue each option.

1
What Are Financial Statements and How Can
You Use Them?
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Learning Objectives
After reading this chapter, you should be able to:
1. List and explain the types of financial statements and the individuals who use them.
2. Describe the purpose of the annual report and the elements that it comprises.
3. Describe the purpose of the Form 10-K and the elements that it comprises.
4. Define the concept of generally accepted accounting principles (GAAP) and explain how they are used in practice.
5. Identify accounts that make up the annual report and Form 10-K.
Introduction
You are probably at least a little familiar with financial statements, and you may have used or created them as part of your financial responsibilities as a manager or
employee. But to be a truly effective manager, it’s important to understand more than just the basics. And that’s what this book is all about: understanding how you
can use financial statements to make better and more informed decisions as a manager.
One key responsibility for many managers is the regular preparation of a budget. In fact, all companies must plan a budget prior to the start of a new year. Most
companies pick managers from various departments to spearhead the budget process.
In this text, we’ll follow a fictional committee at the fictional Best General Company that was formed to create a budget for the coming fiscal year. Let’s first meet the
members of the committee: Bob, a financial analyst at the company, has been asked to form the budget committee. He chooses three other employees to join him:
Susan, a marketing manager; Juan, a sales manager; and Mai, the purchasing manager.
Together this group will need to review the year-to-date spending and compare it to the budget to analyze how well the company is doing. As part of their research,
they will also need to compare their company’s financial results to similar companies in the same sector. This will help them determine how they are performing
against their competitors.
After reviewing the previous year’s results, they will also be able to determine areas where improvement is needed, or, conversely, identify areas in which their
company excels. Using all of this information, committee members will be able to develop a framework that department heads can use to develop a budget for the
next year. This will include a projection of revenues—that is, whether revenues are expected to go up or down. Revenues drive the budget because resources the
company can use during the next year will depend on the revenue that is expected to be generated.
For example, if the budget committee projects an increase of 10% in revenues, it can instruct managers that they can increase their expenses by a certain percentage.
On the other hand, if the economic conditions lead the budget committee to project lower revenue than the previous year, managers will be asked to reduce their
expenses by a certain percentage.
The profit goals will drive the percentage of budget increases and decreases as well. For example, if the company is expected to increase its revenue by 10%, the
executive committee may want to increase expected net profit by a certain percentage. Therefore, managers will not be given leeway to increase expenses by the full
10% of expected revenues.
The budget committee may also recommend to the executive committee expansion in certain divisions or departments that are producing the best results—and
possibly a reduction in resources to departments whose contribution to revenue is decreasing.
In this book, we will follow the Best General Company budget committee and give examples of how it can use financial statements to determine how well the
company is doing and make appropriate decisions. As part of this process, we will introduce financial statements and how they can be used to manage the finances of
each department discussed.
Along the way, we will explore who reads financial reports and what they hope to gain by reading them. By analyzing such reports, readers learn not only whether a
company made money during a given period, but also how efficiently the company used its resources. Let’s get started by discussing financial statements and why
they are so important.
4
Elements of a Statement of Cash Flows
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Learning Objectives
After reading this chapter, you should be able to:
1. Explain how a statement of cash flows is calculated.
2. Discuss how cash is used for company operations.
3. Explore how cash is used for company investment opportunities.
4. Assess how cash is raised or spent from financing activities.
5. Explain how to analyze a statement of cash flows.
Introduction
In Chapter 3, we examined the income statement, which indicates a company’s financial results based only on the revenue it earns, with the bottom line showing
whether the company made a profit. However, because accrual accounting allows companies to recognize sales on the date of completion, even if cash has not yet
changed hands (review Chapter 3 for more information on revenue recognition), a company can show profitability on the income statement but still be cash poor. The
statement that looks at how cash flows into and out of the business is the statement of cash flows.
In this chapter, we will explain how the statement of cash flows is calculated and explore how information is used from the balance sheet and income statement to
prepare this statement. The Best General Company budget committee would likely review this statement to determine if there are flow issues that need to be
addressed.
4.1 What Is a Statement of Cash Flows?
The most common reason cash on hand is lower than profit from operations is that a company’s customers have not yet paid their outstanding bills. Another common
reason is that more inventory was purchased than the company was able to sell.
Managers need to review the inflow and outflow of cash shown on the statement of cash flows to determine whether there is a cash flow problem. The bottom line of
the statement of cash flows shows managers whether the company actually increased or decreased the cash on hand from all its activities during the reporting
period.
The statement of cash flows also indicates how a company is getting and using its cash. Like the income statement, the statement of cash flows shows the operating
results throughout the period being reported. However, as noted, it also details how cash flowed into and out of the company from other activities, such as investing,
which could include the purchase or sale of long-term assets, and financing, which could include taking on a new loan or issuing stock.
The statement of cash flows details the flow of cash from three types of financial activities:
1. Operating Activities: This section provides a manager with information about the company’s cash through the sales of its products or services. It also indicates
how the company used cash to pay for needed goods or services to operate the business.
2. Investing Activities: This section provides a manager with details about the company’s investments. It indicates whether the company used cash to purchase
securities, or raised cash by selling securities or other long-term assets, such as a building or a division. It also provides details about cash spent on capital
investments, such as upgrades to major assets held, which can include upgrades to a factory or renovation of a building.
3. Financing Activities: This section provides a manager with information about transactions that raised cash through adding long-term debt or issuing new stock. It
includes information about cash used to pay down debt or buy back stock. The payment of dividends is also found here.
Figure 4.1 shows the statement of cash flows for the year 2013 for Best General Company. To comply with SEC rules, companies normally show three years of results
on the statement of cash flows.
Figure 4.1: Statement of cash flows for Best General Company
This statement shows the flow of cash into and out of the company.
Possible Formats
The statement of cash flows can be organized into either the direct format or indirect format. The difference between these is the amount of detail provided. They
both provide the same conclusion about how much cash was added to the business or deducted from it, but they offer different details about how cash flowed into
and out of the business:
Direct Method: This method groups major classes of cash receipts and cash payments separately. For example, cash from customers is grouped separately
from cash received on interest-earning savings accounts, or from dividends paid on stock. Major groupings of cash payments include cash paid to buy
inventory, cash disbursed to pay salaries, cash paid for taxes, and cash paid to cover interest on loans. This method is preferred by the Financial Accounting
Standards Board (FASB) because research studies have shown that the additional information is useful for making decisions. The direct method improves the
ability of financial report readers to predict future operating cash flows and earnings (Broome, 2004; Orpurt & Zang, 2009).
Indirect Method: This method focuses on differences between net income and net cash flow from operations, and is used by most companies. The Securities
and Exchange Commission (SEC) only requires the detail provided by the indirect method.
Differences between these methods can be seen only in the Operating Activities section of the statement of cash flows, which is always the first section of the
statement. Figure 4.2 provides a sample of the direct method as might be used by Best General Company, whereas Figure 4.3 shows the indirect method. As shown in
Figure 4.2, the direct method provides a good deal of information, such as cash received from customers or cash paid to suppliers and employees. That detail cannot
be found on the balance sheet or income statement.
Meanwhile, as shown in Figure 4.3, the statement using the indirect method makes no mention of cash from sales or cash paid to buy supplies. It also does not show
cash paid for salaries or the amount of cash gleaned in income tax refunds. What is shown are the results from various calculations using the income statement and
balance sheet.
Figure 4.2: Operating activities—direct method
This section of the statement of cash flows shows how cash flowed into and out of the business from
operating activities. More detail about cash from customers and cash paid to suppliers is shown in the
direct method of this statement.
Figure 4.3: Operating activities—indirect method
This section of the statement of cash flows shows how cash flowed into and out of the business from
operating activities. The indirect method does not show detail about cash from customers or cash paid
out to suppliers and vendors.
Companies often prefer the indirect method because of the limited amount of information it provides—this is an advantage when it comes to thwarting competitors’
ability to mine significant details from the company’s public statements. We will focus on this method in this chapter, since almost all companies use it, and managers
are most likely to see it when reading financial reports.
How the Statement of Cash Flows Is Calculated
A statement that uses the indirect method starts with net income from the income statement. Adjustments are then made for line items in which cash was used. At
the bottom of each of the three sections (Operating, Investing, Financing) is a line item that shows cash provided by or used for line items in that section, as shown in
Figure 4.1.
In order to compile a statement of cash flows using the indirect method, all a manager needs is two years’ worth of balance sheets and income statements. The
manager then develops a cash flow worksheet, similar to the one in Figure 4.4.
The line items included in this worksheet are line items from the balance sheet. This worksheet is used to determine the change in value of each of these items on the
balance sheet. For example, Cash and Cash Equivalents went down by $1,100, while Accounts Receivable increased in value by $600.
In addition to these line items, the manager would also need the Net Income line item from the income statement, as well as Depreciation Expenses and Income Tax
Expenses. If a company used cash for one-time investing activities (such as the purchase of new property, plant, or equipment) or financing activities (such as taking
on a new loan obligation or issuing new stock), that information also would be needed to calculate net cash on hand at the end of the period. For this simple example,
we did not include these more complex transactions.
Once the manager completes the worksheet, he or she will see that some accounts went up in value from year to year, while others went down. How these changes
affect cash will vary depending on the type of account.
When an asset account increases in value, it means there was an outflow of cash. For example, the Accounts Receivable account increased in value by $600. That
means that there was an increase in the amount due from customers who have not yet paid their bills. Therefore, the cash not yet received from customers will
reduce cash received from operating activities by $600. Sales were reported as revenue, but the cash was not collected. Accounts Receivable will be shown as a
negative number on the statement of cash flows, as can be seen in Figure 4.3, to reflect the reduction in cash received in the current year.
Figure 4.4: Cash flow worksheet for Best General Company
This worksheet shows the changes in the values of assets, liabilities, and equity from one year to the
next.
Cash used to pay bills, as indicated in the Accounts Payable line under Liabilities in Figure 4.4, decreased in value by $500. That means cash was used to pay bills
incurred in the previous accounting period. This, too, reflects an outflow of additional cash, and that number will appear as a negative number in the Operating
Activities section of the statement of cash flows, as shown in Figure 4.3.
How can a manager predict if a number will be a negative or positive number on the statement of cash flows? Table 4.1 can be a helpful guide for managers who need
to make that determination.
Table 4.1: Effect of inflows and outflows of cash by account type
Inflow of cash
Outflow of cash
Decrease in an asset account
Increase in an asset account
Increase in a liability account
Decrease in a liability account
Increase in an equity account
Decrease in an equity account
An inflow of cash will show as a positive number on the statement of cash flows, which means the company received additional cash. An outflow of cash will show as
a negative number on the statement of cash flows, which means the company received less or spent more cash.
4.2 Operating Activities
The Operating Activities section of the statement of cash flows that uses the indirect method includes two parts. The adjustment part of this section shows
adjustments to cash on hand for expenses that do not require the use of cash, such as depreciation. The remainder of that section shows the changes needed to
reflect cash on hand after the additions and subtractions for balance sheet account changes from one period to another. Figure 4.3 shows increase or decrease in
Accounts Receivable, Inventories, Accounts Payable, and Accrued Liabilities.
We will start with the adjustments based on the income statement.
Adjustments
The adjustments are changes to cash flow based on items on the income statement that do not require the use of cash, such as depreciation and amortization or
deferred income taxes.
Depreciation and Amortization
The first line item in the adjustment section of the Operating Activities is usually Depreciation or Depreciation and Amortization (see Chapter 2 for a review of these
concepts). Best General Company reported $2,400 in depreciation expenses.
Depreciation expenses do not involve the use of cash; rather, they indicate the gradual reduction in the value of an asset to match expenses with revenue. The cash
only changes hands when the asset is initially purchased. When an asset is bought using a loan, then cash also changes hands when the debt based on the asset is
paid. Debt payoffs are shown in the financing activities section of the statement of cash flows.
Because depreciation expenses do not require the cash, the number is added back in to show an increase in cash on hand. Managers then know that there is more
cash available with this adjustment. Depreciation does lower the net income, as shown in a line item on the income statement.
Deferred Income Taxes
Another line item in the Operating Activities section of the statement of cash flows is Deferred Income Taxes. These are tax expenses that were incurred, but cash was
not yet used to pay them. According to GAAP rules, a company must match expenses to the year incurred, even if cash is not paid out, so income tax expenses would
be reported on the income statement even if cash was not yet paid to the government. Best General Company showed no deferred taxes on its financial statements.
Accounts Receivable
As we discussed above, the difference in the value for Accounts Receivable shown on the balance sheet between the current year and the previous year indicates
whether customers have added to the amounts owed the company or decreased the amounts owed the company. If the number shows an increase, more customers
owe money to the company and less cash was received from sales made with store credit. If the number shows a decrease, customers paid down accounts receivable
from the prior year, plus paid additional cash for new credit sales.
On the statement of cash flows in Figure 4.3, we see that Best General Company shows an increase of $600 in the value of its accounts receivable. This means the
company has less cash on hand. The $600 must be subtracted from net income to discover how much cash is actually available to the company. Managers must be
aware there is less cash available, and they may need to adjust spending or find a source of cash, such as a line of credit, when waiting for cash to be paid by
customers.
In order to improve cash on hand, managers may need to consider incentives for earlier cash payment from customers. They may also want to ask the accounting
department for an aging schedule (discussed in Chapter 2) to find out which customers are behind on paying their invoices, and possibly cut off those customers from
new purchases until their previous charges are paid.
Inventories
The Inventories line in the Operating Activities section on the statement of cash flows shows whether more or less cash was used to buy inventory. If the balance
sheet indicates that a company’s inventory decreased from the previous year, this means that some of the inventory was bought in the previous year. Thus, some of
the sales involved inventories that were paid for in a previous year. This will result in an increase in cash on hand.
If the opposite is true, and the balance sheet indicates that inventories increased, this means that more money was spent on inventory, which was not sold. In this
case, cash on hand would be decreased because it was used to buy inventory that is still on the books.
For example, Best General Company’s inventory at the end of 2012 was $38,000, and it increased to $40,000 at the end of 2013. That means $2,000 of cash was used
for additional inventory not sold, which reduces the cash on hand. The Cost of Goods Sold item on the income statement only includes the cost of inventory sold, so
the cash on hand must be reduced to show the additional purchase of inventory. The cash spent for that additional inventory is shown by the difference between the
current year and the previous year on the balance sheet.
Best General’s managers need to determine why more inventory was bought that could not be sold in 2013 than in 2012. They would need to determine whether this
was caused by a downturn in the economy, a lack of customer interest in some of the inventory on hand, a reduction in the number of customers, or some other
reason.
Another possibility for why the cash spent on inventory increased is that the purchase price of the inventory went up. That, too, would need to be investigated by
managers. They would need to determine whether a new vendor should be found to reduce costs, or whether the company needs to consider raising prices to
maintain the profit margins. If managers determine that they must consider an increase in prices, the marketing and sales team would need to weigh in on what
impact an increase in price may have on future sales.
Accounts Payable
The Accounts Payable line item reflects what is in the Accounts Payable account, which tracks invoices that have not yet been paid. This means that cash will need to
be paid out in a future accounting period.
An increase in the Accounts Payable number over the previous year indicates that there is more cash on hand. Bills will need to be paid during the next accounting
period, but cash has been held back until they are due. The expenses that were incurred when these invoices were received by the company were shown as expenses
on the income statement in order to match expenses with revenues earned in the same period. This means the income statement showed less profit, even though
cash was not used to pay these expenses.
For example, the Accounts Payable line item for Best General Company decreased by $500 from $9,400 in 2012 to $8,900 in 2013, as shown in Figure 4.4. This means
that an additional $500 in cash was used in 2013 to pay invoices for expenses that were incurred in 2012. This reduced the cash on hand by $500, so this reduces the
amount of cash on hand that was generated from 2013 net income.
Managers might want to ask for detail about the invoices not yet paid. If the value of Accounts Payable increases from the previous year, it could be a sign the
company is having difficulty making payments. Invoices not yet paid will impact cash available during the next accounting period, when those invoices must be paid.
Other Assets or Other Liabilities
Any items not shown on an individual line item on the balance sheet or income statement will be found in line items called Other Non-Current Assets or Other NonCurrent Liabilities. Accrued Liabilities (as seen in Figure 4.1) and Income Taxes Payable are two of the line items that would normally fall under Other Liabilities. When
calculating how much cash is on hand, cash flow changes follow the same guidelines as individual items, as shown in Table 4.1.
A decrease in the Other Assets line item from the previous year to the current year will mean that additional cash flowed into the business and would be added to net
income. An increase in Other Liabilities would also increase cash on hand, so that difference would be added to net income. In both cases, the cash on hand would be
increased.
Outflows of cash, which means the amount of cash on hand is reduced, would be seen when there is an increase in an Other Assets account or a decrease in an Other
Liabilities account. In both cases, this would mean that the cash on hand would be decreased.
Bottom Line: Net Cash Provided by Operating Activities
The bottom line of the Operating Activities section shows how much cash the company generated or spent from its operating activities. When looking at the bottom
line of the Operating Activities section for Best General Company (Figure 4.1), we find that the total of cash on hand from operating activities is $3,450. This means
the company generated just $3,450 from its operations.
Managers should take a closer look at the numbers to see what is draining the company’s cash. If Accounts Receivable has gone up dramatically, it might mean that
customers are slowing their payments. Another critical number to review is Inventories. If inventories are increasing, cash is being used to buy and store those
inventories that are not selling. This could mean sales are slowing or there could be another cause.
Managers must take a closer look at the transactions involving inventory to determine what is causing the problem. Wherever there are significant differences from
year to year, managers should investigate the reasons by asking for detailed reports from their accounting liaison so they can review the transactions used to generate
the line items on the financial statements.
A competent manager would also want to investigate the line items that indicate reduced cash available to find out what can be done to improve the cash flow and
limit or eliminate the drain on cash. The Operating Activities section of the statement of cash flows is useful to determine which numbers account for the drain. This
can be a critical factor in the company’s ability to continue operations and pay its vendors, suppliers, and employees. If operations do not generate enough cash, a
company could be headed for disaster.
If cash flows increases, then discovering why this happened and what can be done to continue improving the generation of cash from the activities involved is also an
important step for the manager. Anything that can be done to expand activities that generate more revenue or more cash will help the company’s net income and
cash on hand.
Task Box 4.1: Investigating Operating Activities
Analyzing Industry Competitors, Part G
Review the Operating Activities sections of the statements of cash flows for the two companies you chose to investigate in Chapter 2 (see Task Box
2.9 (http://content.thuzelearning.com/books/AUOMM622.14.1/sections/sec2.3#task2.9) ). Answer the following questions:
1. What have been the primary line items that increased cash on hand?
2. What have been the primary line items that decreased cash on hand?
3. Which company do you think did a better job of generating cash from its operations? Why?
4.3 Investing Activities
The Investing Activities section of the statement of cash flows looks at what cash has been used to make improvements to the company’s operations or to grow the
company. In some cases, this section will show cash provided by investing activities, such as the sale of long-term assets. Line items found in this section can include:
Purchase or sale of property, plant, and equipment
Mergers or acquisitions
Major improvements to existing buildings
Major upgrades to existing factories and equipment
Purchase or sale of marketable securities
Figure 4.5 shows the Investing Activities section of the Best General Company statement of cash flows. Since the company’s revenues are falling, it would not likely
have the resources to spend on new investing activities. For this reason there were no major purchases or improvements in the current year.
Figure 4.5: Investing activities section of the Best General Company statement
of cash flows
This section shows the cash activities from the investing section of the company.
Property, Plant, and Equipment
Property, Plant, and Equipment is often the first line item in the Investing Activities section of the statement of cash flows. Best General Company shows no changes to
its Property, Plant, and Equipment.
Changes in this section would show the use of cash to buy new property, plant, or equipment. If the company sells property, plant, or equipment it already owns, the
cash generated by the sale of these assets would be shown in this section of the statement of cash flows as a positive figure. For example, if Best General Company
decides to invest money in a new store, the cash used for that investment would be shown in this section of the statement as a negative figure.
Managers likely would already be aware of major sales or purchases of property, plant, and equipment prior to the preparation of this statement, but they may not
know the full cash impact until they see it listed here.
Investment in Assets
Often, the next line that could be found in the Investing Activities section is Investment in Assets, which is different from the Property, Plant, and Equipment account
in that it shows the detail of other investment activities to grow the company. For example, the company may invest cash for research and development of a new
product line.
This can be critical information that reveals what types of investments a company is making to grow its business or expand into new business areas. Explanations for
these expenditures would be found in the management’s discussion and analysis, or in the notes to the financial statements. The company’s investor relations office
can also provide more details about a line item on the company’s financial statement. Best General Company does not show any investment in assets.
Marketable Securities
Like individual investors, companies do not want to sit on significant amounts of cash that are not earning a return, so they sometimes buy and sell marketable
securities throughout the year. Generally, these transactions involve placing cash in a financial instrument that will provide a better return than a low-interest savings
account.
Best General Company does not indicate investments in marketable securities, but many companies will show cash being held in marketable securities. Usually the
financial management team will manage these investment activities and be certain that cash is available for operating activities when needed.
Acquisitions and Dispositions
Some companies decide to grow their business by acquiring another company already operating in the industry in which they want to expand. Other companies may
decide they no longer want to continue operations in a particular part of their business and decide to sell that part to another company. Occasionally, a company may
sell off a major segment of its operations to streamline the company. This could result in more cash taken in than laid out.
Acquisitions are purchases of another company. Dispositions are sales of a portion of the assets of a company, such as the sale of a division or a factory.
When a company acquires another company, it usually uses cash as part of that purchase agreement. The value of other assets may also be impacted by an
acquisition or disposition. For example, details about changes to other assets—such as inventory; marketable securities; property, plant, and equipment; intangible
assets; and goodwill—are located in the notes to the financial statements. The notes also contain details regarding liabilities acquired, such as accounts payable, other
debt, and deferred taxes.
Reading the details about acquisitions and divestitures can provide insight into changes the company is making that might affect future operations. Considering what
the company is selling and what the company is buying can be particularly informative. Reading through management’s discussion and analysis of these entities can
provide additional clues as to how the acquisitions will fit into the company’s long-term plans.
The primary reason to review this section of the statement of cash flows is to see how the company is managing its cash to buy, sell, or upgrade its assets. If the
company shows significant cash expenditure in this section, it indicates plans have been carried out to expand operations or to make improvements to company
operations.
An important question managers should seek to answer when reviewing this section is whether the company is using most of its cash for investments to keep existing
factories operating or whether it is using the cash to upgrade its assets in order to keep up with technology. Best General Company does not indicate any acquisitions
or dispositions.
Task Box 4.2: Investing Activities
Analyzing Industry Competitors, Part H
Review the Investing Activities sections for the two companies you have chosen to analyze. Answer these questions:
1. Which company is using more cash to upgrade its facilities? What types of upgrades is each company doing?
2. Is either company using cash to merge or acquire other companies? How are they using their cash for this purpose?
3. Is either company buying or selling marketable securities? Is this a significant portion of their use of cash? Explain.
4. Is either company acquiring new businesses? Is either company selling portions of its business? How do you think these changes will affect the
company’s operations and its profitability in the future? Do you think these changes are good or bad for the company?
The Bottom Line: Investing Activities
The bottom line of the Investing Activities section of the statement of cash flows shows the total amount of cash used for investing activities, and it will read “net cash
used in investing activities.” Some companies may have taken in more cash than they used. In that case, the bottom line would be “net cash provided by investing
activities.”
However, if a manager sees a positive number in this section, it warrants a closer look. A company that sells off assets because it’s having difficulty paying its bills is
not enjoying strong performance. One sure sign that the company is having financial difficulty would be a negative cash outflow from operations and a positive cash
inflow from investing activities. This would likely mean the company is not getting enough cash from its operations and is selling off assets to continue to exist. Once
the company is out of assets to sell, it will likely go bankrupt.
4.4 Financing Activities
When a company needs a major influx of cash to expand operations or fund its current operations and it can’t secure enough from operating activities, it will seek to
raise money from outside sources. This might involve issuing stock to raise money from new investors or taking out a loan. Companies can also sell bonds, which are
another form of debt, to raise cash. Any cash raised or invested related to these types of funding activities can be found in the Financing Activities section of the
statement of cash flows.
Figure 4.6 shows Best General Company’s Financing Activities section of the statement of cash flows. This section would show the proceeds from any new debt issued.
It would also show short-term borrowings followed by repurchases of stock that has already been sold on the market, if the company made any of those transactions.
Best General did not issue debt or repurchase stock, and reduced long-term debt and other non-current liabilities. No dividends were paid to shareholders. Let’s take
a closer look at each of these types of transactions.
Figure 4.6: Financing activities section of the statement of cash flows for Best
General Company
This section of the statement of cash flows shows the inflow and outflow of cash from the company’s
financing activities.
Common Stock Transactions
Common stock transactions can include cash raised from the issuance of new stock or cash used to buy back stock from investors. Best General Company showed no
changes in cash from the sale or purchase of stock.
Managers would want to be aware of major new cash raised from new investors or a cash outflow to buy back common stock held by investors. Both types of
transactions will impact the cash available for ongoing operations.
If the managers have significant holdings of common stock, such as through an employee compensation program, the value of their holdings will be impacted by
common stock transactions. A new stock issue would increase the number of shares among which the profits must be split, which could lower the value of the stock
held by managers. A buyback of stock being held by investors would decrease the number of shares among which profits must be split, which could raise the value of
the stock held by managers.
Short-Term Borrowings
Companies also raise cash throughout the year using lines of credit and other types of short-term borrowings or loans. These types of short-term loans are for 90 days
or less. Since cash is raised and cash is used throughout the year, the number found on the statement of cash flows is the net of these borrowings. Best General
Company shows no change in the amount of its short-term loans.
Long-Term Debt
When companies need cash for periods of more than 12 months, such as a mortgage for the purchase of new property or a loan for the purchase of new equipment,
cash raised from this new debt can be seen on this line item. Sometimes cash is raised by the issuance of new bonds, which will also be shown in the long-term debt
section of the statement of cash flows. Details about this new debt can often be found in the notes to the financial statement.
Cash Dividends Paid
Some companies pay out a portion of their profits in cash to their shareholders. This payout of cash is called dividends. Best General Company did not pay out any
cash dividends in the operating period reported. See “New World of Financial Report Oversight” in this chapter for differences between U.S. and international
companies’ reporting of cash dividends paid.
New World of Financial Report Oversight
Cash dividends can appear in different sections of the statement of cash flows, depending on whether a company is based in the United States or
abroad. The U.S. GAAP require dividends paid out to shareholders be shown in the Financing Activities section of the statement of cash flows.
Dividends received from the company’s investments (such as stock owned in another company) are shown in the operating activities section of the
statement of cash flows.
The International Financial Reporting Standards (IFRS) rules allow companies to show dividends in either the operating activities section or the
financing activities section, as long as the way they are shown is consistent as either operating or financial activities.
There is no time frame for when the U.S. rules will converge with the international rules, but when reading financial statements from non-U.S.
companies, look carefully for information about dividends in both the operating activities and financial activities sections of the statement of cash
flows. If the company paid out dividends, this can be a significant difference to consider when comparing cash flows.
Consider This:
1. Review a statement of cash flow for a non-U.S. company and one for a U.S. company.
2. Do you see any differences in how the statement is shown internationally?
The Bottom Line: Financing Activities
The bottom line of the Financing Activities section of the statement of cash flows is shown as “net cash used in financing activities” if more cash was used than taken
in or as “net cash provided by financing activities” if more cash was taken in than used.
Often, an older, well-established company will use the cash raised to reduce debt or buy back stock on the market. A younger company may show that it raised more
cash from issuing new stock or taking a new debt.
Managers should review this section to determine how much cash was raised by borrowing additional funds and how much was raised by taking on new debt. If the
company is substantially increasing its debt, this could be explained by the purchase of new assets to grow the company or it could be a sign that the company is
having problems raising enough cash for operations. By reviewing this section in conjunction with the Operating Activities section and the Investing Activities section,
a manager should be able to determine how the company’s cash is being raised and how it is being invested. (See “World of Business” for cases that show why all
three sections are important to analyze when considering the financial health of a company.)
Task Box 4.3: Financing Activities
Analyzing Industry Competitors, Part I
Compare the Financing Activities sections of the statements of cash flows for the two companies you have chosen. Answer the following questions:
1. Are your companies using cash or raising cash from their financing activities?
2. If a company is raising cash, what information can you find in the management’s discussion and analysis about the plans for this cash?
3. Are the companies buying back stock or issuing stock? How do they plan to use this cash?
4. Are the companies taking on more debt or paying down debt? If they are taking on more debt, how does the company plan to use this cash?
World of Business
Cash and Bankruptcy: WorldCom and Lehman Brothers
The statement of cash flows used to be the key statement for judging financial performance.
That changed in 2002 when it was discovered that American telecommunications giant
WorldCom had hid expenses and inflated its cash flow by $3.8 billion. To make it look like it
was taking in more cash from operations, the company moved day-to-day expenses into the
category of capitalized expenses. By doing this, WorldCom showed the use of that cash in the
Investing Activities section of its statement of cash flows, rather than in the Operating
Activities section. WorldCom also “capitalized” these expenses by writing them off over
several years. Ultimately, in 2002, this manipulation resulted in the largest corporate
bankruptcy in the history of the United States up to that time.
Suzanne Plunkett/Associated Press
WorldCom filed for the largest bankruptcy in U.S.
history after senior executives falsely reported inflated
cash flows.
However, this record was beaten in 2008 by both banking giant Washington Mutual, which
lost billions because of its mortgage financing activities, and financial services firm Lehman
Brothers. Interestingly, Lehman Brothers did not hide its cash flow problem. Instead, it
showed net income increasing each year, even though cash from operations kept decreasing.
For example, in 2007, net income was $4.19 billion, while cash from operations was a negative $45.6 billion. The company survived during that period
by borrowing more each year to cover its cash needs. The Financing Activities section of the cash flow statement included this information. (Thapa,
2007)
The lesson: Managers should not review solely the results from the Operating Activities section to determine a company’s cash flow. Rather, they
should always be sure to look at all three sections of a company’s statement of cash flows for changes in cash.
Consider This:
1. What would you do if you discovered that the company at which you are employed was not accurately reporting cash flow?
2. Should banks that manage people’s money face more scrutiny in their cash flow reporting?
The Bottom Line for Cash Flows
A summary of cash inflows and outflows is shown in the bottom section of the statement of cash flows. Figure 4.7 shows this summary for Best General Company.
Figure 4.7: Bottom lines of the statement of cash flows for Best General
Company
The bottom lines of a statement of cash flows reveal whether there is an increase or decrease in cash,
followed by additional detail regarding cash paid for interest or taxes.
Often managers will focus on this bottom line and not carefully review the changes to cash in each of the three sections: operations, investing, and financing.
Managers must pay attention to key changes in each of three sections and not just look for the bottom line in order to make decisions about the company’s cash flows
for future operations. As discussed in each section above, different accounts impact the inflow and outflow of cash. Managers need to review the details of those
accounts to further analyze any cash flow opportunities or problems.
4.5 Analyzing a Statement of Cash Flows
We discussed many ways to analyze the information on the statement of cash flows within each section of the statement. Now we will take a look at a way to
summarize the net cash inflows and outflows and determine how a company is raising and using most of its cash. This is similar to the common-sized balance sheet
and income statement we discussed in previous chapters. We will collect all line items that generated cash in one section of this analysis and collect all items that used
cash in the second section. Then we will determine the percentage of cash raised and used by each type of activity.
Figure 4.8 shows the results for Best General Company using the template described above.
Figure 4.8: Percentage of cash inflows and outflows for 2013 for Best General
Company
The chart summarizes the key changes in cash inflows and outflows for Best General Company for the
year ended 2013.
To determine the percentage of cash inflows, we divide the cash inflows for each line item by the total cash inflows. To determine the percentage of cash outflows, we
divide the cash used for each line item by the total cash outflows. For example, to determine the percentage of cash outflows for Accounts Payable at Best General
Company, look at Figure 4.8, where the company shows a $500 outflow of cash for Accounts Payable. The total for net cash outflows was $7,650. To find the
percentage, divide $500 by $7,650. The percentage of cash outflows for the Accounts Payable account is 6.5%.
The purpose of this analysis is to determine the primary sources of cash inflow and outflow by type of account. In most cases, the line item for net cash from
operating activities will be zero in the outflows section, but occasionally, if the net cash from operating activities is a negative number, that means operating activities
contributed to the outflow of cash. If that occurs, the inflows section will show zero cash from operations.
Best General Company showed an increase of $3,450 for net cash from operating activities, so we include that in the Inflows of Cash section.
A manager looking at this analysis would see that cash was used for building up inventories and paying down debt. No cash was used to increase revenues, even
though not enough cash was generated from sales to cover the company’s operating expenses. Best General Company’s budget committee would need to address this
major problem as part of budget planning for the next year. What activities should the committee recommend to improve cash generated from revenues? (The
downloadable template we have developed can make it easier to answer this question.)
In addition to showing cash inflows and outflows, some transactions do not include cash. The World of Business gives examples of non-cash transactions.
Task Box 4.4: Analyze Cash Flow Trends
Analyzing Industry Competitors, Part J
Use the downloadable template to analyze the cash flows of the two companies you have chosen. Compare the use of cash and the cash flow trends
and answer these questions:
1. Do both companies have a positive or negative cash flow from operations? If not, why do you think that is so?
2. What are the primary uses of cash for each of your companies?
3. What trends do you see in the use of cash?
World of Business
Reporting Non-Cash Transactions
Sometimes at the bottom of a statement of cash flows, managers will see a section called
non-cash transactions. The types of information that could be shown here include:
Net change in the fair value of investments. For example, if inventory dropped in
value, this loss in value would be shown here.
If the company made a significant donation of assets, the value of that donation
would be shown here.
If the company borrowed money using a capital lease purchase arrangement, that
transaction’s value would be shown here.
If the company exchanged non-cash assets or liabilities for other non-cash assets or
liabilities, details about the exchange would be shown here. For example, the
acquisition of a company often includes non-cash assets or liabilities.
Fuse/Thinkstock
If the value of a company’s inventory decreases, the
company can show the loss in the non-cash
transactions section of the statement of cash flows.
NEXT
Summary and Resources
Chapter Summary
The purpose of the statement of cash flows is to determine how cash flowed into and out of the company during a certain period of time. The statement can
be in either direct or indirect format; the indirect format is more commonly used because it reveals less financial information to financial report readers
outside the company. The direct method requires companies to reveal additional information about how cash is used, such as amounts for cash received from
customers or cash paid out to vendors. The statement has three sections: operating activities, investing activities, and financing activities.
The Operating Activities section: This section summarizes the inflows and outflows of cash from operating activities of the company, such as cash received from
customers based on changes to the value of the accounts receivable account or cash paid out to vendors based on changes in value to the accounts payable
account.
The Investing Activities section: This section summarizes the outflows of cash used for investments to grow the business or the inflows of cash received from
selling major assets.
The Financing Activities section: This section summarizes financing activities, such as cash inflows from taking on new debt or issuing new stock. It also
summarizes outflows for the paydown of outstanding debt or the buyback of stock from investors.
The bottom line of this statement indicates whether cash on hand increased or decreased from the company’s operating, investing, and financing activities
during the accounting period being reported.
We demonstrated how to do a quick analysis of the statement of cash flows. Reading the notes to the financial statements and the management’s discussion
and analysis can provide additional information about the company’s cash inflows and outflows.
Takeaways for Chapter 4
Be sure to review all three sections of the statement of cash flows to determine how cash flows into and out of the business. Don’t just look at the bottom line
or focus solely on operating activities.
If operating activities result in a net cash outflow, there is cause for concern because it means the company’s operations are not generating enough cash to
operate the business.
Managers should be aware of how cash is being used to grow the business or if cash was raised by selling off parts of the business.
Managers must be aware if the company is taking on major new debt or selling additional shares of the company to investors. Both actions will impact the
value of the company’s shares. This can be especially important for managers whose compensation is partially based on stock incentives.
Discussion Questions
1. Why is it important to analyze the statement of cash flows?
2. What problems would you look for if the net cash flows from operating activities were negative?
3. What questions would you seek to answer if the company’s net cash from financing exceeded the net cash from operations?
4. What questions would you seek to answer if the net change in cash reduced cash holdings?
5. What can you learn from the use of cash in the Investing Activities section?
Further Reading/Resources
Broome, O. W. (2004, March/April). Statement of cash flows: Time for change! Financial Analysts Journal, 60(2), pp. 16–22.
Robero, S., & Berenson, A. (2002, June 26). WorldCom says it hid expenses, inflating cash flow $3.8 billion. New York Times. Retrieved from
http://www.nytimes.com/2002/06/26/business/worldcom-says-it-hid-expenses-inflating-cash-flow-3.8-billion.html
(http://www.nytimes.com/2002/06/26/business/worldcom-says-it-hid-expenses-inflating-cash-flow-3.8-billion.html)
Siegel, M. A. (2006, March). Accounting shenanigans on the cash flow statement. The CPA Journal, 76(3), pp. 38–43.
Key Terms
Click on each key term to see the definition.
dispositions
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Sales of a portion of the assets of a company, such as the sale of a division or a factory.
financing activities
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Cash that flowed into or out of the business from transactions involving debt or stock.
investing activities
(http://content.thuzelearning.com/books/AUOMM622.14.1/sections/cover/books/AUOMM622.14.1/sections/cover/books/AUOMM622.14.1/sections/cover/books/AUOMM622.14.1/sections/co
Cash that flowed into or out of the business from transactions involving the purchase or sale of long-term assets.
operating activities
(http://content.thuzelearning.com/books/AUOMM622.14.1/sections/cover/books/AUOMM622.14.1/sections/cover/books/AUOMM622.14.1/sections/cover/books/AUOMM622.14.1/sections/co
Cash that flowed into or out of the business from transactions involving the day-to-day operations of the business.