FINANCIAL STATEMENTS,
DEPRECIATION, AND
CASH FLOW
III
Describe the purpose and basic components of the stockholders' report.
IIJ
Review the format and key components of the income statement and the balance sheet, and
interpret these statements.
II
Identify the purpose and basic content of the statement of retained earnings, the statement of
cash Rows, and the procedures for consolidating international financial statements.
III
Understand the effect of depreciation and other noncash charges on the firm's cash flows.
II
Determine the depreciable value of an asset, its depreciable life, and the amount of deprecia­
tion allowed each year for tax purposes using the modified accelerated cost recovery system
(MACRS) .
Analyze the firm's cash flows, and develop and interpret the statement of cash flows.
ACROSS tlte
DISCIPLINES
CHAPTER 3 IS IMPORTANT TO
• accounting personnel who calculate MACRS depreciation for tax
•
•
•
•
16
purposes and determine the best depreciation method for
tinancial reporting purposes.
information systems analysts who will design the financial infor­
mation system necessary to prepare the financial statements.
management, because it will maintain a dual focus on the com­
pany's cash Rows and profit and loss..
the marketing department, because its decisions will have signifi­
cant effects on the firm's cash flows and financial statements.
operations, whose actions will significantly impact the compa­
ny's cash Rows and profit and loss.
O
DAVID A. RANE
Vice President and Chief Financial Officer
Calloway Golf
Carlsbad, California
veryone in business , regardless of
position , needs to understand the
four key fi nancia l statements: the
income statement, balance sheet, statement
of reta ined earn ings, statement of cash
flows, and their footnotes. These statements
are the quickest woy to get a basic under­
sta nding of a company. Within genera lly
accepted accounting principles (GAAP),
compan ies have flexibility to choose meth­
ods and principles that best represen t the
operating resu lts and fin ancia l position of
the company. Therefore, the footnotes are
cri tica l to proper interpretation, provid ing
va luable information about the methods a
company uses to prepa re its fi nancia l state­
ments.
M ost compa nies use reports or models
other than basic fin ancia l statements, pre­
pa red at different levels of deta il and/or
focus, to manage their business. Ca lloway
G olf, a rapidly growing manufactu rer of
golf equipment, including Big Bertha golf
clubs, uses manageria l financia l reports
that include on ly the costs for wh ich a par­
ticular person is responsible. Our monthly
budgetary reports exclude depreciation or
overhead but include an interest charge fo r
use of capita l. Beca use these reports are
based on GAAP, our managers know how
the numbers were developed . So under­
stand ing basic fi nancia l statements gives
philosoph ies that reduce the amount of net
cash flow over the short term. For example,
Callaway has extended longer payment
terms to customers during the fall, our slow
season, so that they will purchase more
product, a nd lowered product prices to
increase market share-even though both
of these tactics may have a negative shortterm impact.
The statement of
cash flows is very valu­
able for management
and investors.
Measuring the sources
and uses of cash over
a given period pro­
The .four key
.financial
statements .
vides insight into how
are the quickest
well the company is
managing financ ially
way to get a basic
and identifies potential
problems. If you look at
C a llaway Golf's state­
ment of cash flows for
understanding of a
company.
1995 , you'd see that
we generated over
$95 mill ion positive cash flow from opera­
tions. This is important because, ultimately,
positive cash flow from operations pays the
bi lls.
you a head start wi th other fin ancia l
reports.
The ulti mate purpose of any business is
to generate cash flow over the long term.
This may req uire adoptin g management
David A. Rane, Vice President and Chief Rnancial Officer of
Calloway Golf, received his B.S. in Accounting. from Brigham
Young University.
77
78
PART 1
Introduction to Managerial Finance
II
generally accepted
accounting principles
(GAAPI
The practice and procedure guide­
lines used to prepare and main­
tain financial records and reports;
authorized by the Financial
Accounting Standards Board
(FASB).
Financial Accounting
Standards Board (FASBI
The accounting profession's rule­
setting body, which authorizes
generallyacceptedaccounting
principles (GAAP).
publicly held corpora­
tions
Corporations whose stock is
tradedon either an organized
securities exchange or the over­
the-counter exchange and/or
those with more than 55 million
in assets and 500 or more stock­
holders.
THE STOCKHOLDERS' REPORT
Every corporation has many and varied uses for the standardized records and
reports of its financial activities. Periodically, reports must be prepared for regu­
lators, creditors (lenders), owners, and management. Regulators, such as federal
and state securities commissions, enforce the proper and accurate disclosure of
corporate financial data. Creditors use financial data to evaluate the firm's abili­
ty to meet scheduled debt payments. Owners use corporate financial data to
assess the firm's financial condition and to decide whether to buy, sell, or hold its
stock. Management is concerned with regulatory compliance, satisfying creditors
and owners, and monitoring the firm's performance.
The guidelines used to prepare and maintain financial records and reports
are known as generally accepted accounting principles (GAAP). These account­
ing practices and procedures are authorized by the accounting profession's rule­
setting body, the Financial Accounting Standards Board (FASB). Publicly held
corporations are those whose stock is traded on either an organized securities
exchange or the over-the-counter exchange and/or those with more than $5 mil­
lion in assets and 500 or more stockholders. ' These corporations are required by
the Securities and Exchange Commission (SEC}-the federal regulatory body
that governs the sale and listing of securities-and by state securities commis­
sions to provide their stockholders with an annual stockholders' report. This
report, which summarizes and documents the firm's financial activities during
the past year, begins with a letter to the stockholders from the firm's president
and/or chairman of the board followed by the key financial statements . In addi ­
tion, other information about the firm is often included.
Securities and Exchange
Commission (SEC)
THE LETTER TO STOCKHOLDERS
The federa lregulatory body that
governs the sale and listing of
securities.
The letter to stockholders is the primary communication from management to
the firm 's owners. Typically, the first element of the annual stockholders' report,
it describes the events that are considered to have had the greatest impact on the
firm during the year. In addition, the letter generally discusses management phi­
losophy, strategies, and actions as well as plans for the coming year and their
anticipated effects on the firm's financial condition. Figure 3.1 includes the letter
to the stockholders of Intel Corporation, a major supplier (1995 sales of about
$16.2 billion) to the personal computing industry of chips, boards, systems, and
software that are the "ingredients" of the most popular computing architecture.
About 75 percent of the personal computers in use around the world today are
based on Intel-architecture microprocessors. The letter appears in Intel's 1995
annual stockholders' report. It discusses the firm's 1995 results, basic strategies,
business focus, competitive position, and challenges at the close of its fiscal yea r
ended December 30, 1995.
stockholders' report
Ann ual report required of publicly
held corporations that summa­
rizes and documents for stock­
holders the firm's fina ncial
activities during the past year.
letter to stockholders
Typically, the first element of the
annual stockholders' report and
the primary communication from
management to the firm's
owners.
'Although the Securities a nd Exchange Commission (SEC ) does nor have an official definition of
"publicly held, " thes e financial measures mark the cutoff point it uses to require informational
reporting, rega rdless of whether the firm publicl y sells its securities. Firms that do not meet these
requirements are commonly called "closely held" firms.
CHAPTER 3
FIGURE 3.1
Financia l Statements, Depreciation, and Cash Flow
Letter to Stockholders
Intel Corporation's 1995 letter to stockholders
to report our S·xt
ear of both record
Revenues totaled S16.2 billion, up 41 percent from $11.5 billion in
1994. Earnings per share rose 54 percent over last year, to S4.03.
Our strong performance in 1995 was rooted in growing demand
for PCs based on our Pentium' processors. The PC market continued its remarkable growth, with approximately 60 mi I! ion
PCs sold worldwide this year, up about 25 percent from 1994.
We were pleased to see the increased popularity of the Internet
and other communications applications this year. In particular, we
are very excited by the opportunities represented by the booming
World Wide Web. Witb more than 180 million units in use world·
wide, PCs are the predominant gate",ay to the World Wide Web.
We believe that this easy-ta-use, graphicaI!y based Internet interface will continue to attract new users and investments in the
PC communications world, helping to expand the PC's role as a
consumer communications device and driving future PC sales.
At Intel, our most important job is to make high-performance
microprocessors for the computing industry. To do this, we follow four basic strategies:
3. Remove barriers to technology flow. We believe
that if computers work better, do more and are easier to use,
more PCs will be sold and more Intel processors wiI! be needed.
We therefore work with other industry leaders to develop new
PC technologies, such as the PCl "bus;' which has been widely
adopted. This technology removes bottlenecks to provide greatly
enhanced graphics capabilities. We incorporate our chips into
PCI building blocks, such as PC motherboards, to help com­
puter manufacturers bring their products to market faster. We
also work closely with software developers to help create rich
applications, such as PC video conferencing and animated 3D
Web sites, that make the most of the power of Intel processors.
4. Promote the Intel brandw We continue to invest in
education and marketing programs that describe the benefits of
genuine Intel technology. Our Intel Inside* program expanded
in 1995 to include broadcast advertising. Hundreds of OEMs
worldwide are participating to let users know that there are
genuine Intel microprocessors inside their PCs.
New PC communications applications and emerging markets
1. Develop products quickly. We try to bring new tech­
nology to the market as quickly as possible. In 1995, we intro­
duced the new high-end Pentium" Pro processor. This came less
than three years after the introduction of the Pentium processor,
which is now the processor of choice in the mainstream PC
market. Together, these products provide computer buyers with
a wide spectrum of computing choices.
2. Invest in manufacturing. We believe Intel's state­
of-the·art chip manufacturing facilities are the best in the
industry. We spent 53.6 billion on capital in 1995, up 45 per­
cent from 1994. These heavy investments are paying off: in
1995, " 'e were able to bring our new 0.35-micron manufacturing
process into production months earlier than originally planned.
Our newest facility, the most advanced in the microprocessor
industry, makes our highest speed Pentium and Pentium Pro
processors. In the end, these investments benefit PC buyers
directly in the form of more powerful, less expensive com­
puting options.
Beyond our primary task of making microprocessors, we
invest in a range of computing and communications applications
that support our core business. Our supercomputer and network
server efforts take advantage of the flex.ibility and power of the
Intel architecture, whi le our f1asb memory business supports
booming communications applications such as cellular phones.
These product areas are detai led on the following pages.
Overall, our focused strategies have kept us on the right track.
Of course, we continue to attract competition, both from makers
of software-compatible microprocessors and from makers of
alternative-architecture ch.ips. We will try to stay nimble to
maintain our position in the industry.
This is a particularly exciting time to be in the computing
industry. New applications like the Internet are driving increased
demand for computers, and emerging markets around the world
are quickly adopting the latest computer technology. We look
forward to meeting the challenges of this business as the com­
puter's role continues to expand.
G OROOI'lo' E . M OORE
A N DR EW S. GROVE
CR AIG R . B AR RETT
Chairman
Presidenl and
Chief b ec:u[j\,c Officer
Exel;1Jli.."e Vicc Presidenl and
Chief Opcmting Officer
Source: Intel Corporation, 1995 Annual Report, p. 2. Reprinted by permission.
79
80
PART 1
Introduction to Managerial Finance
CPRACTICE
Picture Perfect
Don't underestimate the significance of a company's annual report to stock­
holders. In a study by Yankelovich Partners Inc., institutional and individual
investors ranked various sources of corporate information on a scale of 1 to 6.
Annual reports scored 4.7, second only to quarterly reports at 4.8. Well down
the list were news stories (4.2) and newsletters (3.3). Sixty-six percent of port­
folio managers and 54 percent of security analysts consider annual reports the
most important of all company documents.
T he presentation of the report also carries weight, contributing to the com­
pany's image with investors. You'll lose credibility if individual investors per­
ceive that the report is made of poor-quality materials; it's considered a sign
that company performance is declining. Leaving out pictures is another bad
move; 60 percent of respondents termed such reports as boring. •
FINANCIAL STATEMENTS
Following the letter to stockholders will be, at minimum, the four key financial
statements required by the Securities and Exchange Commission (SEC). These
statements are (1) the income statement, (2) the balance sheet, (3) the statement
of retained earnings, and (4) the statement of cash flows. 2 The annual corporate
report must contain these statements for at least the three most recent years of
operation (2 years for balance sheets). Following the financial statements are
N otes to Financial Statements-an important source of information on the
accounting policies, procedures, calculations, and transactions underlying entries
in the financial statements. H istorical summaries of key operating statistics and
ratios for the past 5 to 10 years are also commonly included with the financial
statements. (Financial ratios are discussed in Chapter 4.)
OTHER FEATURES
T he stockholders' reports of most widely held corporations also include discus­
sions of the firm's activities, new products, research and development, and the
like. M ost companies view the annual report not only as a requirement, but also
as an important vehicle for influencing owners' perceptions of the company and
its future o utlook. Because of the information it contains, the stockholders'
report may affect expected risk, return, stock price, and ultimately the viability
of the firm.
R e\'irw Qut'stions
3-1 W hat are generally accepted accounting principles (GAAP)? Who autho­
rizes GAAP ? What role does the Securities and Exchange Commission (SEC)
play in the financial reporting activities of corporations?
'Whereas these statement titles are consistently used throughout this text, it is important to recognize
that in practice, companies frequently use different statement titles. For example, General Electric
uses "Statement of Earnings" rather than "Income Statement" and "Statement of Financial Position"
rather th an " Bala nce Sheet"; Bristol Myers Squibb uses " Statement of Earnings and Retained
Earnings" rather than " Income Statement"; and Pfizer uses "Statement of Shareholders' Equity"
rather than "Statement of Retained Earnings. "
CHA PTER 3
Financial Statements, Depreciation, and Cash Flow
81
3-2 Describe the basic contents, including the key financial statements, of the
stockholders' reports of publicly held corporations.
II.
BASIC FINANCIAL STATEMENTS
Our chief concern in this section is to understand the factual information pre­
sented in the four required corporate financial statements. The financial state­
ments from the 1997 stockholders' report of a hypothetical firm, Baker
Corporation, are presented and briefly discussed in what follows. In addition,
the procedures for consolidating international financial statements are briefly
described.
INCOME STATEMENT
income statement
The income statement provides a financial summary of the firm's operating
Provides a financial summaryof
results during a specified period. M ost common are income statements covering
the firm's operating resultsduring a I-year period ending at a specified date, ordinarily December 31 of the calen­
a specified period.
dar year. (Many large firms, hmvever, operate on a 12-month financial cycle, or
fiscal year, that ends at a time other than December 31. ) Monthly statements are
typically prepared for use by management, and quarterly statements must be
made available to the stockholders of publicly held corporations.
Table 3.1 presents Baker Corporation's income statement for the year ended
December 31, 1997. The statement begins with sales revenue-the total dollar
amount of sales during the period-from which the cost of goods sold is de­
ducted. The resulting gross profits of $700,000 represent the amount remaining
to satisfy operating, financial, and tax costs after meeting the costs of producing
or purchasing the products sold. Next, operating expenses, which include selling
expense, general and administrative expense, and depreciation expense, are
deducted from gross profits. 3 The resulting operating profits of $370,000 repre­
sent the profits earned from producing and selling products; this amount does
not consider financial and tax costs. (Operating profit is often called earnings
before interest and taxes, or EBIT.) Next, the financial cost-interest expense­
is subtracted from operating profits to find net profits (or earnings) before taxes.
After subtracting $70,000 in 1997 interest, Baker Corporation had $300,000 of
net profits before taxes.
After the appropriate tax rates have been applied to before-tax profits, taxes
are calculated and deducted to determine net profits (or earnings) after taxes.
Baker Corporation's net profits after taxes for 1997 were $180,000. Next, any
preferred stock dividends must be subtracted from net profits after taxes to
arrive at earnings available for common stockholders. This is the amount earned
by the firm on behalf of the common stockholders during the period. Dividing
earnings available for common stockholders by the number of shares of common
stock outstanding results in earnings per share (EPS). EPS represents the amount
' Depreciation expense can be, and frequentl y is, included in manufacturing costs---cost of goods
sold-to calculate gross profits. Depreciation is shown as an expense in this text to isolate its impact
on cash flows.
82
PART 1
Introd uction to M anagerial Finance
,
TABLE 3.1
Baker Corporation Income Statement ($000) for the Year
Ended December 31, 1997
Sales revenue
$1 ,700
Less: Cost of goods sold
1,000
Gross profits
$ 700
Less; Operating expenses
Selling expense
General and administrati ve expense
Depreciation expense
$ 80
150
100
330
Total operating expense
Operating profits
$ 370
Less: Interest expense
70
Net profits before taxes
$ 300
Less; Taxes (ra te =40 % )
120
Less; Preferred srock dividends
$ 180
10
Earnings available for common stockholders
$ 170
Earnings per share (EPS)b
$ 1.70
Net profits after taxes
aInterest expense incl udes the interest compon ent of the annua l fin ancial lease payment as specified by the
Financial Accounting Standards Board (FASB ).
bCalcul ated by dividing the earnings available for common stockholders by t he number of shares of
common stock outsta nd ing ($ 170,000 .;.100,000 sha res = $1.70 per share) .
earned during the period on each outstanding share of common stock. In 1997,
Baker Corpora tion earned $1 70,000 for its common stockholders, which rep re­
sents $1.70 for each outstanding share. (The earnings per share amount rarely
equals the amount, if any, of common stock dividend s paid to shareholders.)
BALANCE SHEET
balance sheet
Summary statement of the firm!s
financial position at a given point
in time.
current assets
Short-term assets! expectedto be
converted intocash within 1year
or less.
current liabilities
Short-term liabilities! expectedto
be converted intocash within 1
year or less.
The balance sheet presents a summary statement of the firm's financial position
at a given point in time. T he statement balances the firm's assets (wha t it owns)
against its financing, wh ich can be either debt (what it owes ) or equity (what was
prov ided by owners). Baker Corpo ra tion 's bala nce sheets on Decem ber 31 of
1997 and 1996 are presented in Table 3.2. They show a variety of asset, liability
(debt ), and equity accounts. An important distinction is made between short­
term and long-term assets and liabil ities. The current assets and current liabilities
are short-term assets an d liabilities _T his means that t hey are expected to be con­
verted into cash within 1 year or less. All other assets and liabilities, along with
stockholders' equity, which is assumed to have an infinite life, are considered
long-term, or fixed, because they are expected to remain on the fi rm' s books for
1 year or more.
A few points about Baker Corporation's ba lance sheets need to be highlight­
ed. As is customary, the assets are listed beginning with the most liquid down to
CHAPTER 3
TABLE 3.2
83
Financial Statements, Depreciation, and Cash Flow
Baker Corporation Balance Sheets (SOOO)
December 31
Assets
1997
1996
$ 400
$ 300
Current assets
Cash
Marketable sec urities
600
200
Acco unts receiva ble
400
500
Inventories
Total current assets
600
900
$2,000
$1,900
$1,200
$1,050
Gross fixed assets (at cost)
Land and buildings
Machinery and equipment
850
800
Furniture and fixtures
300
220
Ve hicles
100
80
Other (includes certain leases )
50
50
---
$2,500
$2,200
1,300
1,200
$1,200
$1,000
$3,200
$2,900
$ 700
$ 500
Total gross fixed assets (at cost)
Less: Accumulated depreciation
et fixed assets
T ota I assets
Liabilities and stockholders ' equity
Current liabilities
Accounts payable
Notes payable
600
700
Accruals
100
200
Total current liabili ties
Long-term debt
Tota l liabilities
$1,400
$1,400
$ 600
$ 400
$2,000
$1,800
$ 100
$ 100
120
120
Stockholders' equ ity
Preferred stock
Common stock- $1.20 par, 100,000 shares outstanding
in 1997 and 1996
Paid-in capita l in excess of pa r on commo n stock
380
380
Retained earnings
600
500
$1,200
$1,100
$3,200
$2,900
Total stock holders' equity
Total liabilities and stockholders ' equity
the least liquid. Current assets therefore precede fixed assets. Marketable securi­
ties represent very liquid short-term investments, such as U.S. Treasury bills or
certificates of deposit, held by the firm. Because of their highly liquid nature,
84
PART 1
Introduction to Managerial Finance
par value
Per-share value arbitrarily
assignedto an issue of common
stock primarily for accounting
purposes.
paid-in capital in excess
of par
The amount of proceeds in excess
of the par value received from
the original sale of common
stock.
retained earnings
The cumulative total of all earn­
ings, net of dividends, that have
been retained and reinvestedin
the firm since its inception.
statement of retained
earnings
Reconciles the net income earned
during a given year, andany cash
dividends paid, with the change in
retained earnings between the
start and end of that year.
marketable securities are frequently viewed as a form of cash. Accounts receiv­
able represent the total monies owed the firm by its customers on credit sales
made to them. Inventories include raw materials, work in process (partially fin­
ished goods ), and finished goods held by the firm. The entry for gross fixed assets
is the original cost of all fixed (long-term) assets owned by the firm.4 Net fixed
assets represent the difference between gross fixed assets and accumulated depre­
ciation-the total expense recorded for the depreciation of fixed assets. (The net
value of fixed assets is called their book value.)
Like assets, the liabilities and equity accounts are listed on the balance sheet
from short-term to long-term. Current liabilities include accounts payable,
amounts owed for credit purchases by the ~i,m; notes payable, outstanding
short-term loans, typically from commercial banks; and accruals, amounts owed
for services for which a bill may not or will not be received. (Examples of accru­
als include taxes due the government and wages due employees.) Long-term debt
represents debt for which payment is not due in the current year. Stockholders'
equity represents the owners' claims on the firm. The preferred stock entry shows
the historic proceeds from the sale of preferred stock ($100,000 for Baker
Corporation) . Next, the amount paid in by the original purchasers of common
stock is shown by two entries--common stock and paid-in capital in excess of
par on common stock. The common stock entry is the par value of common
stock, an arbitrarily assigned per-share value used primarily for accounting pur­
poses. Paid-in capital in excess of par represents the amount of proceeds in
excess of the par val ue received from the original sale of common stock. The sum
of the common stock and paid-in capital accounts divided by the num ber of
shares outstanding represents the original price per share received by the firm on
a single issue of common stock. Baker Corporation therefore received $5.00 per
share [($120,000 par + $380,000 paid-in capital in excess of par) + 100,000
shares] from the sale of its common stock. Finally, retained earnings represent
the cumulative total of all earnings, net of dividends, that have been retained and
reinvested in the firm since its inception. It is important to recognize that retained
earnings are not cash but rather have been utilized to finance the firm's assets.
Baker Corporation's balance sheets in Table 3.2 show that the firm's total
assets increased from $2,900,000 in 1996 to $3,200,000 in 1997. The $300,000
increase was due primarily to the $200,000 increase in net fixed assets. The asset
increase in turn appears to have been financed primarily by an increase of
$200,000 in long-term debt. Better insight into these changes can be derived
from the statement of cash flows, which we will discuss shortly.
STATEMENT OF RETAINED EARNINGS
T he statement of retained earnings reconciles the net income earned during a
given year, and any cash dividends paid, with the change in retained earnings
between the start and end of that year. Table 3.3 presents this statement for
Baker Corporation for the year ended December 31, 1997. A review of the state­
ment shows that the company began the year with $500,000 in retained earnings
and had net profits after taxes of $180,000, from which it paid a total of
' For convenience the term fixe d assets is used throughout thi s text to refer to wh at, in a st rict
accounting sense, is captioned "property, plant, and equipment." This simplification of terminol ogy
permits certain financial concepts to be more easily devel oped.
CHAPTER 3
TABLE 3.3
8S
Financial Statements, Depreciation, and Cash Flow
Baker Corporation Statement of Retained Earnings 1$000) for
the Year Ended December 31/ 1997
Retained earnings balance (January 1, 1997)
$500
Plus: Net profits after taxes (for 1997)
180
Less: Cash dividends (paid during 1997)
Preferred srock
($10 )
Common stock
( 70 )
(80)
T otal di vidends paid
Retained earnings balance (December 31,1997)
$600
$80,000 in dividends, resulting in year-end retained earnings of $600,000. Thus,
the net increase for Baker Corporation was $100,000 ($180,000 net profits after
taxes minus $80,000 in dividends) during 1997.
STATEMENT OF {ASH FLOWS
statement of cash flows
Provides asummary of the firm's
operating, investment, and
financing cash flows and recon·
ciles them with changes in its cash
and marketable securities during
the period of concern.
The statement of cash flows provides a summary of the cash flows over the
period of concern, typically, the year just ended. The statement, which is some­
times called a "source and use statement," provides insight into the firm 's oper­
ating, investment, and financing cash flows and reconciles them with changes in
its cash and marketable securities during the period of concern. Baker
Corporation's statement of cash flows for the year ended December 31, 1997, is
presented in Table 3.10 on page 99. However, before we look at the preparation
of this statement, it is helpful to understand various aspects of depreciation.
CPRACTICE
What's Value Really Worth?
When Mitsubishi Motor Sales of America based its 1990 decision to acquire
Value Rent-A-Car on financial reports certified by Coopers & Lybrand, it
assumed that the statements presented Value's financial performance fairly.
Soon after, however, Mitsubishi dis covered that Value was worth negative $10
million, not the negative $5.9 million shown on its 1989 balance sheet.
Mitsubishi and Value's former owners settled their dispute, but in 1994,
Mitsubishi sued the Big Six accounting firm, charging that it allowed Value to
hide its poor financial condition. Mitsubishi said Coopers changed audit work
papers-long considered proof of an outside auditor's independence-a year
after the audit to protect against possible negligence charges. Mitsubishi
claimed it would not have purchased Value had it seen the revised work papers.
Coopers countered that only insignificant changes were made to the work
papers and that Mitsubishi should have focused instead on the audit report,
which questioned the rental company's value as a going concern . •
86
PART 1
Introduction to Ma nagerial Finance
CONSOLIDATING INTERNATIONAL FINANCIAL STATEMENTS
Financial Accounting
Standards Board (FASB)
Standard No. 52
Ruling by FASB-the policy-set­
ting body of the U.S. accounting
profession-that mandates that
U.S.-based companies must trans­
late their foreign-currency­
denominated assets and liabilities
into dollars using the current rate
(translation) method.
current rate (translation)
method
Technique used by U.S.-based
companies to translate their for­
eign-currency-denominated assets
and liabilities into dollars (for
consolidation with the parent
company's fin ancial statements).
cumulative translation
adjustment
Equity reserve account on parent
company's books in which trans­
lation gains and losses ore accu­
mulated.
Example
So far, this chapter has discussed financia l statements involving only one curren­
cy, the U.S. dollar. How do we interpret the financial statements of companies
that have significant operations in other countries and cash flows denominated
in one or more foreign currencies? As it happens, the issue of how to handle con­
solidation of a company's foreign and domestic financial statements has bedev­
iled the accounting profession for many years, and the current policy is described
in Financial Accounting Standards Board (FASB ) Standard No. 52. This ruling
by the policy-setting body of the accounting profession mandates that U.S.-based
companies must translate their foreign-currency-denominated assets and liabili­
ties into dollars (for consolidation with tl~ e parent company's financial state­
ments ) using a technique called the current rate (tr.ans lation) method.
Under the current rate (translation) method, all of a U.S. parent company's
foreign-currency-denominated ass ets and liabilities are converted into dollar
values using the exchange rate prevailing at the fiscal year ending date (the cur­
rent rate). Income statement items are treated similarly, although they can also
be translated by using an average exchange rate for the accounting period in
question. Equity accounts, on the other hand, are translated into dollars by using
the exchange rate that prevailed when the parent's equity investment was made
(the historical rate). Retained earnings are adjusted to reflect each year's operat­
ing profits or losses, but this account does not reflect gains or losses resulting
from currency movements. Instead, translation gains and losses are accumulated
in an equity reserve account on the parent company's books labeled cumulative
translation adjustment. Translation gains increase this account balance, and
tra nslation losses decrease it and can even result in a negative balance. H owever,
the gains and losses are not "realized " (run thro ugh the income statement and
consolidated to retained earnings) until the parent company sells or shuts down
its foreign subsidiary or its assets. Although international accounting rules and
managerial issues will be discussed in more detail in Chapter 20, an example can
be used to briefl y describe how translation gains and losses occur.
Suppose that an American company owns a subsidiary operating in Germany.
(The German currency is Deutsche marks, noted DM .) Suppose the subsidiary
has total assets worth DM 10,000,000, total liabilities of DM 5,000,000, and
DM 5,000,000 in equity. Suppose further that the exchange rate at the beginning
of the fiscal year was DM 2.00/U5$, which also equals the reciprocal of this,
US$.5 0IDM . Therefore, at the beginning of the period, the dollar value of the
subsidiary's assets, liab ilities, and equity is $5,000,000, $2,500 ,000, a nd
$2,500,000, respectively.
Now suppose that by the end of the fiscal year the German mark had depre­
ciated to a val ue o f DM 2.50/U5 $ , or US$ .40/D M. When the subsidiary's
accounts are then trans lated into dollars, the assets will have declined in va lue by
$1 ,000,000 to $4,000,000 (DM 10,000,000 x US$.40IDM). The subsidiary's lia­
bilities w ill also have declined in dollar valu e, but only by $500,000 to
$2,000,000 (DM 5,000,000 x US$.40IDM), and the dollar va lue of the equity
accounts remains unchanged at $2,500,000 . Because the parent company experi­
enced a decline in the dollar value of its foreign assets that exceeded the decline
in the dollar value of its li abilities, it has experienced a translation loss of
$500,000 ($1,000,000 decline in asset value minus $500,000 decline in the value
CHAPTER 3
Financial Statements, Depreciation, and Cash Flow
87
of liabilities). This $500,000 translation loss is recorded as a deficit in the parent
company's cumulative translation adjustment account.
R e\' iew Questions
3-3 What basic information is contained in: a. income statement; h. balance
sheet; and c. statement of retained earnings? Briefly describe each.
3-4 What role does Financial Accounting Standards Board (FASB) Standard
No. 52 play in the consolidation of a company's foreign and domestic financial
statements? W hat is the current rate (translation) method and the cumulative
translation adjustment?
DEPRECIATION
11111
depreciation
The systematic charging of a por­
tion of the costs of fixed assets
against annual revenues over
time.
modified accelerated
cost recovery system
(MACRS)
System used to determine the
depreciation of assets for tax pur­
poses.
noncash charges
Expenses deducted on the income
statement that do not involve an
actual outlayof cash during the
period.
Business firms are permitted to systematically charge a portion of the costs of
fixed assets against annual revenues. This allocation of historic cost over time is
called depreciation. For tax purposes, the depreciation of business assets is regu­
lated by the Internal Revenue Code, which experienced major changes under the
Tax Reform Act of 1986. Because the objectives of financial reporting are some­
times different from those of tax legislation, a firm often will use different depre­
ciation methods for financial reporting than those required for tax purposes. (An
observer should therefore not jump to the conclusion that a company is attempt­
ing to "cook the books" simply because it keeps two different sets of records.)
Tax laws are used to accomplish economic goals such as providing incentives for
business investment in certain types of assets, whereas the objectives of financial
reporting are of course quite different.
Depreciation for tax purposes is determined by using the modified accelerated
cost recovery system (MACRS),s whereas for financial reporting purposes, a vari­
ety of depreciation methods are available. Before discussing the methods of depre­
ciating an asset, we must understand the relationship between depreciation and
cash flows, the depreciable value of an asset, and the depreciable life of an asset.
DEPRECIATION AND CASH FLOWS
The financial manager is concerned with cash flows rather than net profits as
reported on the income statement. To adjust the income statement to show cash
flow from operations, all noncash charges must be added back to the firm's net
profits after taxes. Noncash charges are expenses that are deducted on the income
statement but do not involve an actual outlay of cash during the period.
Depreciation, amortization, and depletion allowances are examples. Because
'This system, which was first established in 1981 with passage of the Economic Recovery Tax Act,
was initially called the "accelerated cost recovery system (ACRS)." As a result of modifications to
this system in the Tax Reform Act of 1986, it is now commonly called the "modified accelerated cost
recovery system (MACRS)." Although some people continue to refer to this system as " ACRS, " we
correctly call it "MACRS" throughout this text.
88
PART 1
Introduction to Managerial Finance
depreciation expenses are the most common noncash charges, we shall focus on
their treatment; amortization and depletion charges are treated in a similar fashion.
The general rule for adjusting net profits after taxes by adding back all non­
cash charges is expressed as follows:
Cash flow frolll operati()m = net pr()fits after taxes + noncash charges
(3 .1)
Applying Equation 3. 1 to the 1997, income statement for Baker Corporation
presented in Table 3.1 yields a cash flow from operations of $280,000 due to the
noncash nature of depreciation:
N et profits after taxes
Plus: Deprecia tion expense
Cash flo w fro m operations
$180,000
100,000
$280,000
(This value is only approximate, because not all sales are made for cash and not
all expenses are paid when they are incurred. )
Depreciation and other noncash charges shield the fi rm from taxes by lower­
ing taxa ble income. Some people do not define depreciation as a source of funds;
however, it is a source of funds in the sense that it represents a "nonuse" of funds.
Table 3.4 shows the Baker Corporation's income state~ent prepared on a cash
basis as an illustration of how depreciation shields income and acts as a nonu se of
funds. Ignoring depreciation, except in determining the firm's taxes, res ults in
cash flow fro m operations of $280,000-the value obtained before. Adjustment
of the firm's net profits after taxes by add ing back noncash charges such as depre­
ciation will be used on man y occasions in this text to estimate cash flo w.
TABLE 3.4
Baker Corporation Income Statement Calculated on a Cash
Basis ($000) for the Year Ended December 31 1 1997
Sales revenue
$1,700
Less: Cost of goods sold
1,000
Gross profits
$ 700
Less: Opera ting expenses
Selling expense
$ 80
General a nd administrative expense
150
Depreciation expense (no nca sh charge)
0
Total opera ting expense
230
Less: Interest expense
$ 470
70
Net profits before ta xes
$ 400
Operating profits
Less: Taxes (fro m T able 3.1 )
Cash flow from opera ti ons
120
$ 280
CHAPTER 3
Financial Statements, Depreciation , and Cash Flow
89
DEPRECIABLE VALUE OF AN ASSET
Under the basic MA CRS procedu res the depreciable value of an asset (the
amount to be depreciated) is its full cost, including outlays for installation. 6 N o
adjustment is required for expected salvage value.
Example
Baker Corporation acquired a new machine at a cost of $38,000, with installa­
tion costs of $2,000. Regardless of its expected salvage va lue, the depreciable
value of the machine is $40,000: $38,000 cost + $2,000 installation cost.
DEPRECIABLE LIFE OF AN ASSET
depreciable life
Time period over which an asset is
depreciated.
recovery period
The appropriate depreciable life
of a particular asset as deter­
mined by MACRS.
T he time period over which an asset is depreciated-its depreciable life-can sig­
nificantly affect the pattern of cash flows. The shorter the depreciable life, the
more quickly the cash flow created by the depreciation write-off will be received.
Given the financial manager's preference for faster receipt of cash flows, a short­
er depreciable life is preferred to a longer one. However, t!1e firm must abide by
certain Internal Revenue Service (IRS) req uirements for determining depreciable
life. T hese MACRS standards, which apply to both new and used assets, require
the taxpa yer to use as an asset's depreciable life the appropriate MACRS recov­
ery period, except in the case of certain assets depreciated under the alternative
depreciation system. 7 There are six MACRS recovery periods-3, 5, 7, 10, 15,
and 20 years-excludi ng real estate. As is cus tomary, the property classes
(excluding real estate) are referred to, in accordance with their recovery periods,
as 3-, 5-, 7-, 10-, 15-, and 20-year property. The first four property classes­
those routinely used by business- are defined in Table 3.5.
TABLE 3.5
Property class
(recovery period )
First Four Property Classes Under MACRS
Definition
3 years
Research and expe rimenr equ ipment and certain special tools.
5 yea rs
Co mputers, typewriters, copiers, duplicating equipment, cars,
light-duty trucks, qualified technologica l equipment, and simila r
assets.
7 yea rs
Office furniture, fixtures, most manufacturing equ ipment, railroad
track, and single-purpose agricul tu ral and horticu ltural struc­
tures .
10 years
Equipmenr used in petro leum refining or in the manufacture of
tobacco products and certain food products.
' Land va lues are not depreciable. Th erefore, to determine the depreciable va lue of real estate, the
value of the land is subtracted from the cost o f the real estate. In other words, only buildings and
other improvements are deprecia ble.
' For convenience, the deprec iation of assets under the alternative depreciation system is ignored in
this text.
90
PART 1
Introd uction to M anagerial Finance
CPRACTICE
Depreciation Counts When Buying a Car
If you understand how depreciation relates to car prices you can get a better
deal on your next car. The average new car depreciates 28 percent as soon as
you drive it away from the dealer. So, if you want a new car but can't afford the
model you love, consider buying it "nearly new" instead-12 to 24 months old.
With the increasing popularity of short-term car leases, you'll find a good
supply of well-maintained late-model used cars, and you won't pay for the high
depreciation in the early years.
Depreciation also plays a key role in the leasing process. When you lease a
car, the payment is based on the amount the car depreciates in the time covered
by the lease. To calculate your monthly lease payment, start with the cost of the
car (which you negotiate as you would for a straight cash purchase). Then sub­
tract the residual value, the estimated (depreciated) value of the car at the end
of the lease period, to get the depreciation . Your total lease payments will equal
the depreciation plus an interest factor. So with a higher residual value, you pay
for less depreciation. •
DEPRECIATION METHODS
For tax purposes, using MACRS recovery periods, assets in the first four proper­
ty classes are depreciated by the double-declining balance (200 percent) method
using the half-year convention and switching to straight-line when advantageous.
Although tables of depreciation percentages are not provided by law, the approx­
imate percentages (i.e., rounded to nearest whole percent) written off each year
for the first four property classes are given in Table 3.6. Rather than using the
percentages in the table the firm can either use straight-line depreciation over the
asset's recovery period with the half-year convention or use the alternative depre­
ciation system. For purposes of this text we will use the MACRS depreciation
percentages given in Table 3.6, because they generally provide for the fastest
write-off and therefore the best cash flow effects for the profitable firm.
Because MACRS requires use of the half-year convention, assets are assumed
to be acquired in the middle of the year, and therefore only one-half of the first
year's depreciation is recovered in the first year. As a result, the final half-year of
depreciation is recovered in the year immediately following the asset's stated
recovery period. In Table 3.6, the depreciation percentages for an n-year class
asset are given for n + 1 years. For example, a 5-year asset is depreciated over 6
recovery years. (Note: The percentages in Table 3.6 have been rounded to the
nearest whole percentage to simplify calculations while retaining realism.)
For financial reporting purposes a variety of depreciation methods-straight­
line, double-declining balance, and sum-of-the-years'-digits S-can be used.
Because primary concern in managerial finance centers on cash flows, only tax
depreciation methods will be utilized throughout this textbook. The application
of the tax depreciation percentages given in Table 3.6 can be demonstrated by a
simple example.
' For a review of these depreciation methods as well as other aspects of financial reporting, see any
recently published financial accounting text.
CHAPTER 3
TABLE 3.6
91
Fi nancial Statements, Depreciation, and Cash Flow
Rounded Depreciation Percentages by Recovery Year Using
MACRS for First Four Property Classes
Percentage by recovery year"
Recovery year
3 years
5 years
7 years
10 years
1
33%
20%
14%
10%
2
45
32
25
18
3
4
15
7
19
18
14
12
12
12
5
12
9
9
6
7
5
9
8
7
9
8
4
6
9
6
10
6
4
11
Totals
100%
100%
100%
100%
"These percentages have been rounded to the nearest whole percent to simplify calculations while retaining
rea lism. To calculate the actual depreciation for tax purposes, be sure to apply the actual unrounded per­
centages or directly apply double-declining balance (200 %) depreciation using the half-year convention.
Example
Baker Corporation acquired, for an installed cost of $40,000, a machine having
a recovery period of 5 years. By using the applicable percentages from Table 3.6,
the depreciation in each year is calculated as follows:
Year
Cost
(1)
Percentages
(from Table 3.6)
(2)
Depreciation
[(1) x (2)]
(3)
$40,000
20%
$ 8,000
2
40,000
32
12,800
3
4
40,000
19
7,600
40,000
12
4,800
5
40,000
12
4,800
6
40,000
5
2,000
100%
$40,000
Totals
Column 3 shows that the full cost of the asset is written off over 6 recovery
years.
92
PA RT 1
Introduction to Managerial Finance
I n · iew Questions
3-5 In what sense does depreciation act as cash inflow? How can a firm's after­
tax profits be adjusted to determine cash (low from operations?
3-6 Briefly describe the first four modified acce lerated cost recovery system
(MACRS) property classes and recovery periods. Explain how the depreciation
percentages are determined by using the MACRS recovery periods.
ANALYZING THE FIRM'S CASH FLOW
II
The statement of cash (lows, briefly described earlier, summarizes the firm's cash
flow over a given period of time. Because it can be used to capture histo ric cash
flow, the statement is developed in this section. First, however, we need to dis­
cuss cash flow through the fi rm and the classification of sources and uses.
THE FIRM'S CASH FLOWS
operating flows
Cash flowsdirectly related to pro­
duction and sale of the firm 's
products and services.
investment flows
Cash flows associated with pur­
chase and sale of both fixed
assets and business interests.
financing flows
Cashflows that result from debt
and equity financing transactions;
includes incurrence and repay­
ment of debt, cash inflowfrom
the sale of stock, andcash out­
flows to repurchase stock or pay
cash dividends.
Figure 3.2 illustrates the firm 's cash flows. N ote th at both cash and marketable
securities, which, because of their highly liquid nature, are considered the same
as cas h, represent a reservoir of liquidity th at is increased by cash inflows and
decreased by cash outflows. Also note tha t the firm's cash flo ws have been d ivid­
ed into (1) operating flows, (2) investment flows, and (3) financing fl ows. The
operating flows are cash flows- inflows and outflows-directly related to pro­
duction and sale of the firm's products and services. These flows capture the
income statement and current account transactions (excl uding notes paya ble)
occurring during the period. Investment flows are cash flows associated with
purchase and sale of both fixed assets and business interests. Clearly, purchase
transactio ns would resu lt in cash ou tflo ws, whereas sales transactions would
generate cash inflows. The financing flows result from debt and equity financing
tra nsacti ons. Incurring and repaying either short-term debt (notes payable) or
long-term debt would resu lt in a correspond ing cash inflow or outflow .
Similarly, the sale of stock wo uld result in a cash inflow, whereas the repurchase
of stock or payment of cash dividends would result in a financing outflow. In
combination, the fi rm's operating, investment, and financing cash flows during a
given period will increase, decrease, or leave unchanged the firm's cash and mar­
ketable securities balances.
CLASSIFYING SOURCES AND USES OF CASH
The statement of cash flows in effect summarizes the sources and uses of cash
during a given period . (Table 3.7 on page 94 classifies the basic sources and uses
of cash. ) For example, if a firm's accounts payable increased by $1,000 during
the year, this change would be a source of cash. If the firm's inventory increased
CHA PTER 3
FIGURE 3.2
93
Fi nan cial Sta te me nts, Depreciation, a nd Cash Flow
Cash Flows
The firm's cash flows
(1 ) Operating Flows
(2) Investment Flows
,------------------------------------,------------------------------------­I
.....
Accrued
Wages
~.. ..
labor
Payment af Accruals
~.........................~
Payment ~
of Credit
j'urchases ~
1
Raw
~.... Accounts
Payable ................ : :
Materials .....
~ ~
Depreciation
I .........
Purchase
!........................................................
~.~!~...... .......................
F" ed A
ssets
IX
1 :
:
~
Work in
Process
Overhead
Expenses
~..··..
Business
Interests
' ::
:.1::
,""ho~
Fi nished
Goods
i
• • •• ••••••• •• ••••• ••••• ••••• •• • •••• ••••• ••••• •• •• ••• •• ••••••• 1
Sale
.................................................................
,~
~
O perating (incl.
Depreciation) and
Interest Expense
--------------------------------~
~....... ;
Cash
~............................................... Ma~:~able
(3) Financing Flows
Securities
Borrowing
..............................................
Repayment
..............................................
~
...............................................
..................................................
~
Taxes
t
Sales
Payment
~
· · : I ~:~: "·~ · · · ·J 1
~ .
: :
l l....................................................
:
~
Sale of Stock
Repurchase of Stock
...................................................
..
Payment of Cash Dividends
,....................................................... .
~
Accounts
Rece ivable
Debt
(Short-Term and
long-Term)
:
Equity
I
I
I
I
I
I
I
I
I ____________________________________ J• ____________________________________ _I
........................................................... ,
by $2,500, the change would be a use of cash, meaning that an additional $2,500
was tied up in inventory.
A few additional points shou ld be made with respect to the classification
scheme in Ta ble 3.7:
1. A decrease in an asset, such as the firm's cash balance, is a source of cash
flow because cash that has been tied up in the asset is released and can be
used for some other purpose , such as repaying a loan. O n the other hand, an
94
PART 1
Introduction to Managerial Fi nance
TABLE 3.7
The Sources and Uses of Cash
Sources
Uses
Decrease in any asset
Increase in any lia bility
Decrease in any liability
Increase in any asset
Net profits after taxes
Net loss
Depreciation and other noncash charges
Dividends paid
Sale of stock
Repurchase or retirement of stock
increase in the firm's cash balance is a use of cash flow, because additional
cash is being tied up in the firm's cash balance.
2. Earlier, Equation 3.1 and the related discussion explained why depreciation
and other noncash charges are considered cash inflows, or sources of cash.
Adding noncash charges back to the firm's net profits after taxes gives cash
flow from operations:
Cash flow from operat ions = net profits after taxes + noncas h charge s
Note that a firm can have a net loss (negative net profits after taxes) and still
have positive cash flo w from operations when noncash charges (typically
depreciation) during the period are greater than the net loss. In the statement
of cash flows, net profits after taxes (or net losses) and noncash charges are
therefore treated as separate entries.
3. Because depreciation is treated as a separate source of cash, only gross rather
than net changes in fixed assets appear on the statement of cash flows. This
treatment avoids the potential double counting of depreciation.
4. Direct entries of changes in retained earnings are not included on the state­
ment of cash flows. Instead, entries for items that affect retained earnings
appear as net profits or losses after taxes and dividends paid.
DEVELOPING THE STATEMENT OF CASH FLOWS
The statement of cash flows can be developed in five steps: (1,2, and 3) prepare
a statement of sources and uses of cash, (4) obtain needed income statement
data, and (5 ) properly classify and present relevant data from Steps 1 through 4.
With this five-step procedure we can use th e financial statements for Baker
Corporation presented in Tables 3.1 and 3.2 to demonstrate the preparation of
its December 31, 1997, statement of cash flows.
PREPARING THE STATEMENT OF SOURCES AND U SES OF :::ASH (STEPS 1, 2,
AND 3)
The first three steps in the statement of cash flow preparation process guide the
preparation of the statement of sources and uses of cash.
Step 1 Calculate the balance sheet changes in assets, liabilities, and stockhold­
ers' equity over the period of concern. (N ote: Calculate the gross fixed
CHA PTER 3
Fi nancial Statements, Depreciation, and Cash Flow
95
asset change for the fixed asset account along with any change in accu­
mulated depreciation.)
Step 2 Using the classification scheme in Ta ble 3.7, classify each change calcu­
lated in Step 1 as either a source (S) or a use (U). (N ote: An increase in
accumulated depreciation would be classified as a source, whereas a
decrease in accumulated depreciation would be a use. Changes in stock­
holders' equity accounts are classified in t he same way as changes in lia­
bilities-increases are sources, and decreases are uses.)
Step 3 Separately sum all sources and all uses found in Steps 1 and 2. If this
statement is prepared correctly, total sources should equal total uses.
Example
Baker Corporation's balance sheets in Table 3.2 can be used to develop its state­
ment of sources and uses of cash for the year ended December 31, 1997.
Step 1 The key entries from Baker Corporation's balance sheets in Table 3.2
are listed in a stacked format in Table 3.8. Column 1 lists the account
name, and columns 2 and 3 give the December 3 1, 1997 and 1996
values, respectively, fo r each account. In column 4, the change in the
balance sheet account between December 31, 1996, and December 31,
1997, is calculated. N ote that for fixed assets, both the gross fi xed asset
change of +$300,000 and the accum ulate d depreciat io n change of
+$100,000 are calculated.
Step 2
Based on the classification scheme from Table 3.7 and recognizing that
changes in stockholders' equity are classified in the same way as changes
in liabilities, each change in colu mn 4 of Ta ble 3.8 is classified as either a
source in column 5 or a use in col umn 6.
Step 3 The sources and uses in columns 5 and 6, respectively, of Table 3.8 are
totaled at the bottom. Because total sources of $1,000,000 equal total
uses of $1,000,000, it appears that the statement has been correctly pre­
pared.
OBTAINING INCOME STATEMENT D ATA (STEP 4)
Step 4 involves obtaining three important inputs to the statement of cash flows
from an income statement for the period of concern. These inputs are (1) net
profits after taxes, (2) depreciation and any other noncash charges, and (3) cash
dividends paid on both preferred and common stock.
Step 4
Net profits after taxes and depreciation typically can be taken directly
from the income statement. Dividends may have to be calculated by
using the following equation:
Dividends = net profits after taxes - change in retained earnings
(3 .2 )
PART 1
96
TABLE 3.8
Introduction to M anagerial Finance
Baker Corporation Statement of Sources and Uses of Cash ($000) for the Year Ended
December 31, 1997
Account balance
December 31
(from Table 3.2)
Change
Classification
(1)
1997
(2)
1996
(3)
[(2) - (3)]
(4)
Assets
Cash
$ 400
$ 300
+$100
200
Accounts receiva ble
600
400
500
+ 400
- 100
$ 100
Inventories
600
900
- 300
300
2,500
2,200
+ 300
1,300
1,200
+ 100
100
Accounts payable
700
600
500
700
+ 200
- 100
200
Notes payable
Accruals
100
200
- 100
Long-term debt
600
400
+ 200
100
100
120
120
Account
Marketable securities
Gross fixed assets
Accumulated depreciation
a
Source
Use
(5)
(6)
$ 100
400
300
Liabilities
100
100
200
Stockholders' equity
Paid-in capital in excess of par
380
380
a
a
a
Retained earnings
600
500
+ 100
100
Totals
$1,000
Preferred stock
Common stock at par
aBecause accum ulated depreciation is treated as a deduction from gross fixed assers , a n increase in it is classified as a sou rce; any decrease would
be c1assi fied as a use.
The value of net profits after taxes can be obtained from the income
statement, and the change in retained earnings can be found in the state­
ment of sources and uses of cash or can be calculated by using the begin­
ni!1g- and end-of-period balance sheets. T he dividend value could be
obtained directiy from the statement of retained earnings, if available.
Example
Baker Corporation's net profits after taxes, depreciation, and dividends can be
found in its financial statements.
Step 4
Baker Corporation's net profits after taxes and depreciation for 1997
can be found on its income statement presented in Table 3.1:
Net profits after taxes ($000)
Depreciation ($000)
$180
$100
CHA PTER 3
Financial Statements, Depreciction, and Cash Flow
97
Substitu ting the net profits after taxes value of $1 80,000 and th e
increase in retained earnings of $1 00,000 from Baker Corporation's
statement of sources and uses of cash for the year ended December 31,
1997, given in Table 3.8, into Equation 3.2, we find the 1997 cash divi­
dends to be
Dividends ($000) = $180 - $100 = $80
Note that the $80,000 of dividends just calculated could have been drawn
directly from Baker's statement of retained earnings, given in Table 3.3.
CLASSIFYING AND PRESENTING RELEVANT D ATA (STEP 5)
The relevant data from the statement of sources and uses of cash (prepared in
Steps 1, 2, and 3) along with the net profit, depreciation, and dividend data
(obtained in Step 4) from the income statement can be used to prepare the state­
ment of cash flows.
Step 5
Classify relevant data into one of three categories:
1. Cash flow from operating activities
2. Cash flow from investment activities
3. Cash flow from financing activities
These three categories are consistent with the operating, investment, and
financing cash flows depicted in Figure 3.2. Table 3.9 lists the items that
TABLE 3.9
Categories and Sources of Data Included in the Statement of
Cash Flows
Data source
Categories and data items
S/U =Statement of sources
and uses of cash
IJS =Income statement
Cash Flow from Operating Activities
Net profits (losses) after taxes
Depreciation and other noncash charges
Changes in all current assets other than cash and
marketa ble securities
Cha nges in all current liabilities other than notes pa ya ble
IIS
IIS
SfU
SfU
Cash Flow from Investment Activities
Changes in gross fixed assets
Changes in business interests
SfU
SfU
Cash Flow from Financing Activities
Changes in long-term debt
SfU
SfU
Changes in stockholders' equity other than retained
earnings
SfU
Dividends paid
IIS
Changes in notes payable
98
PART 1
Introduction to Ma nagerial Finance
would be included in each category on the statement of cash flows . In
addition the source of each data item is noted. By reviewing Ta ble 3.9, it
can be seen that all current asset changes other than cash and mar­
ketable securities and all current liab ility changes other than accounts
payable are included under "Cash Flow from Operating Activities." The
cash and marketable securities changes are excluded because they repre­
sent the period's net cash flow to which the statement is reconciled.
N otes payable are included in "Cash Flow from Financing Activities"
because they reflect deliberate financing actions rather than the sponta­
neous financing that resu lts from o t her current liabil ities such as
accounts payable and accruals.
Relevant data shou ld be listed in a fa shion consistent with the order
of the categories and data items given in Tab le 3.9. All sources as well as
net profits after taxes and depreciation would be treated as positive
values-cash inflows-whereas all uses, any losses, and dividends paid
would be treated as negative va lues-cash outfl ows. The items in each
category-operating, investment, and fina ncing-should be totaled, and
these three totals should be added to get the "net increase (decrease) in
cash and marketable securities" for the period. As a check, this value
should reconcile with the actual change in cash and marketa ble securi­
ties for the year, which can be obtained from either the beginning- and
end-oF-period ba la nce sheets or the statement of so urces and uses of cash
for the period.
Example
T he relevant data developed for Baker Corporation for 1997 can be combined by
using the proced ure described before to create its statement of cash flows.
Step 5
Classifying and listing the relevant data from earlier steps in a fashion
consistent with Ta ble 3 .9 result in Baker Corporation's Statement of
Cash Flows, presented in Table 3. 10. On the basis of this statement, the
firm experienced a $500,000 increase in cash and marketable securities
duri ng 1997. Looking at Baker Corporation's Decem ber 31, 1996 and
1997 balance sheets in Ta ble 3.2 or its sta tement of sources and uses of
cash in Tab le 3.8, we can see that the fir m' s cash increased by $1 00,000
and its marketa ble securities increased by $400,000 between December
31, 1996, and December 31, 1997. The $500,000 net increase in cash
and marketable securities from the statement of cash flows therefore rec­
onciles with the total change of $5 00,000 in these accounts during 1997.
The statement is therefore believed to have been correctly prepared.
INTERPRETING THE STATEMENT
The statement of cash flows allows the financia l manager and other interested
parties to analyze the firm's past and possibly future cash fl ow. The manager
should pay special attention to both the major categories of cash flow and the
individual items of cash inflow and outflow to assess w hether any developments
have occurred that are contrary to the company's financial po licies. In addition,
the statement ca n be used to evaluate the fu lfill ment of projected goals . Specific
links between cash infl ows and outflows cannot be made by using this statement,
but the statement can be used to isolate inefficiencies. For example, increases in
CHAPTER 3
TABLE 3.10
Fina ncial Statements, Depreciation, and Cash Flow
99
Baker Corporation Statement of Cash Flows 1$000) for the
Year Ended December 31, 1997
Cash Flow from Operating Activities
Increase in acco unts payable
$180
100
100
300
200
Decrease in accruals
(100 )a
Net profits after taxes
Deprecia tion
Decrease in accounts rece iva ble
Decrease in inventories
$780
Cash provi ded by operating activities
Cash Flow from Investmen t Activities
Increase in gross fixed assets
($300)
Changes in business interests
o
(3 00 )
Cash provided by in vestment activi ties
Cash Flow from Financing Activities
Decrease in notes payable
Increase in long-term debts
Changes in stockho lders' equi tyb
Dividends pa id
Cash provided by financing activities
Net increase in cash and marketable securities
($1 00 )
200
o
~
20
$500
aAs is customa ry, parentheses arc used to denote a negative number, which in this case is a cash outflow.
bConsistent with this data item in Table 3.9, retained earn ings are excluded here, because their change is
actually reflected in the combination of the net profi ts after taxes and dividend entries.
accounts receivable and invento ries resulting in major cash outflows ma y signal
cred it or inventory problems, respectively.
In addition, the financia l manager can prepa re and analyze a statement of
cash flo ws developed fro m projected, or pro forma, financial statements. This
approach can be used to determine whether planned actions are desirable in view
of the res ulting cash flows.
Example
Analysis of Baker Corporation'S statement of cash flows in T able 3.10 does not
seem to indicate the existence of any majo r problems for the company. Its
$780,000 of cash provided by operating activities plus the $20,000 provided by
fi na ncing activities were used to invest an additional $300,000 in fixed assets
and to increase cash and marketable securities by $500,000. The individual items
of cash inflow and outflow seem to be distributed in a fashion consistent with
prudent financial management. The firm seems to be growing, because (1) less
than half of its earnings ($ 80,000 out of $ 180,000) was paid to owners as divi­
dends and (2) gross fixed assets increased by three times the amount of historic
cost written off through depreciation expense ($300,000 increase in gross fixed
100
PART 1
Introduction to Manageria l Fi nance
assets versus $1 00,000 in depreciation expense). M aj or cash inflows were real­
ized by decreasing inventories and increasing accounts payable. The major,)Ut­
flow of cash was to increase cash and marketable securities by $500,000 and
thereby improve liquidity. Other inflows and outflows of Baker Corporation
tend to support the fact that the firm was well managed financially during the
period. An understanding of the basic financial principles presented throughout
this text is a prerequisite to the effective interpretation of the statement of cash
{lows.
R eliew Questions
3-7 Describe the overall cash flow through the fi rm in terms of: a. operating
flows; b. investment flows; and c. financing flows.
3-8 List and describe sources of cash and uses of cash. Discuss why a decrease
in cash is a source and an increase in cash is a use.
3-9 Describe the procedure (the first three steps for developing the statement
of cash flows) used to prepare the statement of sources and uses of cash. How
are changes in fixed assets and accumulated depreciation treated on this state­
ment?
3-10 What three inputs to the statement of cash flows are typically obtained (in
Step 4) from an income statement for the period of concern? Explain how the
income statement and statement of sources and uses of cash can be used to deter­
mine dividends for the period of concern. What other methods can be used to
obtain the value of dividends?
3 -11 Describe the general format of the statement of cash fl ows. W hy are
cash and marketable securities the only current assets and notes payable the
only current liability excluded from the "Cash Flow from Operating
Activities" ?
3-12 Review the final step (Step 5) involved in preparing the statement of cash
flows. How can the accuracy of the final statement balance, "net increase
(decrease) in cash and marketable securities," be conveniently verified?
3-13 How is the statement of cash flows interpreted and used by the financial
manager and other interested parties?
SUMMARY
III
Describe the purpose and basic components
of the stockholders' report. The annual stock­
holders' report, which publicly traded corporations
are required to provide to their stockholders, sum­
marizes and documents the firm's financial activi­
ties during the past year. It includes, in addition to
the letter to stockholders and various subjective and
factual information, four key financial statements:
(1) the income statement, (2) the balance sheet, (3)
the statement of retained earnings, and (4) the state­
ment of cash flows. Notes describing the technical
aspects of the financial statements follow them.
_
Review the fo rmat and key components of the
IiiiY income statement and the balance sheet, and
interpret these statements. The income statement
summarizes operating results during the period of
concern, by subtracting costs, expenses, and taxes
CHAPTER 3
from sales revenue to find the period's profits. The
balance sheet summarizes the firm's financial posi­
tion at a given point in time by balancing the firm's
assets (what it owns) against its financing, which
can be either debt (what it owes) or equity (what
was provided by owners). The statement makes an
important distinction between short-term (current)
and long-term assets and liabilities.
It'll Identify the purpose and basic content of the
. , statement of retained earnings, the statement
of cash flows, and the procedures fo r consolidating
international financial statements. The statement of
retained earnings reconciles the net income earned
during a given year and any cash dividends paid
with the change in retained earnings between the
start and end of that year. The statement of cash
flows provides a summary of the cash flows over
the period of concern, typically the year just ended.
The statement provides insight into the firm's oper­
ating, investment, and financing cash flows, and
reconciles them with changes in its cash and mar­
ketable securities during the period of concern.
Financial statements of companies that have opera­
tions in other countries where their cash flows are
denominated in one or more foreign currency
follow Financial Accounting Standards Board
(FASB) Standard No. 52, which requires use of the
current rate (translation) method to translate for­
eign-currency-denominated assets and liabilities
into dollars.
ItII Understand the effect of depreciation and
IiiiiIIIIII other noncash charges on the firm 's cash
flows. Depreciation, or the allocation of historic
cost, is the most common type of noncash expendi­
ture made by business. To estimate cash flow from
SELF-TEST PROBLEM
••
•
ST 3-1
Financi al Statements, Depreciation, and Cash Flow
101
operations, depreciation and any other noncash
charges are added back to net profits after taxes.
Because they shield the firm fro m taxes by lowering
taxable income without an actual outflow of cash,
noncash charges act as a source of funds to the firm.
1m Determine the depreciable value of an asset,
IiiI its depreciable life, and the amount of depre­
ciation allowed each year for tax purposes using
the modified accelerated cost recovery system
(MACRS). The deprecia ble value of an asset and
its depreciable life are determined by using the
modified accelerated cost recovery system
(MACRS ) standards set out in the federal tax code.
MACRS groups assets (excluding real estate) into
six property classes based on length of recovery
period-3, 5, 7, 10, 15, and 20 years-and can be
applied over the appropriate period by using a
schedule of yearly depreciation percentages for
each period.
1m Analyze the firm's cash fl ows, and develop
_
and interpret the statement of cash flows.
T he statement of cash flows is divided into oper­
ating, inves tment, and financing flows. It can be
developed in five steps . The first three steps guide
the preparation of a statement of sources and uses
of cash; the fou rth step involves obtaining needed
income statement data; and th e fifth and final
step is to properly classify and present the rele­
vant data from Steps 1 through 4. Interpretation
of the statement of cash flows requires an under­
standing of basic financial principles and involves
eva luation of both the major categories of cash
flow and the individual items of cash inflow and
outflow.
(Solution in Appendix C)
Depreciation and cash flow A firm expects to have earnings before deprecia­
tion and taxes (EBDT) of $1 60,000 in each of the next 6 years. It is considering
the purchase of an asset costing $1 40,000, requiring $1 0,000 in installation
costs, and having a recovery period of 5 years.
a. Calculate the annua l depreciation for the asset purchase using the MACRS
depreciation percentages in Table 3.6 on page 91.
102
PART 1
Introduction to M anagerial Finance
b. Calculate the annual operating cash flows for each of the 6 years. Assume
that the new asset is the firm 's only depreciable asset and that it is subject to
a 40 percent ordinary tax rate.
c. Compare and discuss your findings in a and b.
PROBLEMS
1111
3-1
Reviewing basic financial statements The income statement for the year ended
December 31, 1997, the balance sheets for December 31, 1997 and 1996, and
the statement of retained earnings for the year ended December 31, 1997, for
Technica, Inc., are given on this and the following page. Briefly discuss the fo rm
and informational content of each of these statements.
Income statement
T echnica, Inc.
for the year ended December 31,1997
Sales revenue
Less: Cost of goods sold
$600,000
460,000
Gross profits
$140,000
Less: Operating expenses
General and ad ministrative expense
$30,000
Depreciation expense
30,000
Total opera ting expense
Operating profits
60,000
$ 80,000
Less: Interest expense
10,000
Net profits before taxes
$ 70,000
Less: Taxes
Earnings available ·for common stockholders
Earnings per share (EPS)
2 7,100
$ 42,900
$2.15
CHAPTER 3
Financial Statements, Depreciation, and Cash Flow
Balance sheets
T echnica, Inc.
December 31
Assets
1997
1996
Cas h
$ 15,000
$ 16,000
Ma rketable securi ties
Acco unts receivable
7,200
8,000
34,100
42,200
Inve ntories
82,000
50,000
$138,300
$11 6,200
Total current assets
La nd and bu ildings
$150,000
$150,000
Machinery and eq uipment
200,000
190,000
Furni ture and fixtures
54,000
50,000
O ther
11,000
10,000
$415,000
$400,000
Total gross fixed assets
Less: Accumulated depreciation
145,000
115,000
$270,000
$285,000
$408,300
$401,200
Accou nts payable
$ 57,000
$ 49,000
Notes payable
13,000
16,000
Accrua ls
5,000
6,000
$ 75,000
$ 71,000
150,000
$160,000
$1 10,200
$120,000
73,100
50,200
et fixed assets
Total assets
Liabil ities and stockholders ' equity
Total current liabilities
Long-term debt
Stock holders' equity
Co mmon stock equity (shares ou tstanding:
19,500 in 1997 and 20,000 in 1996)
Reta ined earnings
Total stock holders' equity
Total lia bilities and stockholders' eq uity
$183,300
$170,200
$408,300
$401,200
Statement of retained earnings
Technica, Inc.
for the year ended December 31 , 1997
Retained earnings balance (janua ry 1, 1997)
$50,200
Plus: Net profits after taxes (for 1997)
42,900
Less: Cash dividends (paid du ring 1997)
(20,000)
Retained ea rnings balance (December 31, 1997)
$73,100
103
104
PART 1
Introduction to Managerial Finance
3-2
Financial statement account identification M ark each of the accounts listed in
the following table as follows:
a. In column (1), indicate in which statement-income statement (IS) or balance
sheet (BS)-the account belongs.
h. In column (2), indicate whether the account is a current asset (CA), current
liability (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue
(R), or stockholders' equity (SE).
Account name
(1)
(2)
Statement
Type of account
Accounts payable
Accounts receivable
Accruals
Accumulated depreciation
Administrative expense
Buildings
Cash
Common stock (at par)
Cost of goods sold
Depreciation
Equipment
General expense
Interest expense
Inventories
Land
Long-term debts
Machinery
Marketable securities
Notes payable
Operating expense
Paid-in capital in excess of par
Preferred stock
Preferred stock dividends
Retained earnings
Sales revenue
Selling expense
Taxes
Vehicles
3-3
Income statement preparation Use the appropriate items from the following
list to prepare in good form Perry Corporation's income statement for the year
ended December 31, 1997.
CHAPTER 3
Financial Statements, Depreciation, and Cash Flow
Item
Accounts receiva ble
Accumulated depreciation
Cost of goods sold
Depreciation expense
General and administrative expense
Interest expense
$350
205
285
55
60
25
10
Sales revenue
525
35
265
Stockholders' equity
Taxes
••
Values (SOOO) at or
for year ended
December 31,1997
Preferred stock dividends
Selling expense
lOS
rate =40%
3-4
Income statement preparation On December 31, 1997, Cathy Chen, a self­
employed certified public accountant (CPA), completed her first full year in
business. During the year she billed $180,000 for her accounting services. She
had two employees: a bookkeeper and a clerical assistant. In addition to her
monthly salary of $4,000, Ms. Chen paid annual salaries of $24,000 and
$18,000 to the bookkeeper and the clerical assistant, respectively. Employment
taxes and benefit costs for M s. Chen and her employees totaled $17,300 for the
year. Expenses for office supplies, including postage, totaled $5,200 for the
year. In addition, M s. Chen spent $8,500 during the year on tax-deductible
travel and entertainment associated with client visits and new business develop­
ment. Lease payments for the office space rented (a tax-deductible expense)
were $1,350 per month. Depreciation expense on the office furniture and fix­
tures was $7,800 for the year. During the year, Ms. Chen paid interest of
$7,500 on the $60,000 borrowed to start the business. She paid an average tax
rate of 30 percent during 1997.
a. Prepare an income statement for Cathy Chen, CPA, for the year ended
December 31, 1997.
h. How much cash flow from operations did Cathy realize during 1.997?
c. Evaluate her 1997 financial performance.
3-5
Calculation of EPS and retained earnings Philagem, Inc., ended 1997 with net
profit before taxes of $218,000. The company is subject to a 40 percent tax rate
and must pay $32,000 in preferred stock dividends before distributing any earn­
ings on the 85,000 shares of common stock currently outstanding.
a. Calculate Philagem's 1997 earnings per share (EPS).
h. If the firm paid common stock dividends of $.80 per share, how many dol­
lars would go to retained earnings?
3-6
Balance sheet preparation Use the appropriate items from the following list to
prepare in good form Owen Davis Company's balance sheet at December 31,
1997.
106
PART 1
Introduction to Manageria l Finance
Item
Val ue (SOOO ) at
December 31, 1997
Accounts payable
$ 220
Accounts receivable
450
Accruals
55
Accumulated depreciation
265
Buildings
225
Cash
215
Common stock (a t par )
Cost of goods sold
Depreciation expense
45
Equipment
140
Furniture and fixtures
170
General expe nse
320
In ventories
375
La nd
100
Long-term debts
420
Machinery
420
Marketab le securities
75
Notes payable
475
Pa id-i n capital in excess of par
360
Preferred stock
100
Retain ed earnings
210
Sales revenue
Vehicles
II
3-7
90
2,500
3,600
25
Initial sale price of common stock Beck Corporation has one issue of preferred
stock and one issue of common stock outstanding. Given Beck's stockholders'
equity accou nt that fo llows, determ ine the original price per share at which the
firm sold its single issue of common stock.
Stockholders' equity (SOOO)
Preferred stock
Common stock ($.75 par, 300,000 shares outstanding )
Paid-in capital in excess of par on common stock
Retained earni ngs
Total stockholders' equity
II
3-8
$ 125
225
2,625
900
$3,875
Financial statement preparation The balance sheet for Rogers Industries for
December 31, 1996, follows . Information relevant to Rogers Industries' 1997
opera tions is given fo llowing the balance sheet. Using the data presented:
a. Prepare in good fo rm an income statement for Rogers Industries for the year
en ded December 31, 1997. Be sure to show ea rni ngs per share (EPS).
CHAPTER 3
107
Financial Statements, Depreciation, and Cash Flow
h. Prepare in good form a balance sheet for Rogers Industries for December 31,
1997.
Balance sheet (SOOO)
Rogers Industries
December 31,1996
Assets
Liabilities and stockholders' equity
$ 40
Accounts payable
S 50
Marketable securities
10
Notes payable
80
Accounts receivable
80
Accruals
10
Cash
Inventories
Total current assets
Gross fixed assets
Total current liabilities
100
-­
$230
$140
Long-term debt
$270
$ 40
$890
Preferred stock
Less: Accumulated
depreciation
240
Common stock ($ .75 par,
80,000 shares)
Net fixed assets
Total assets
$650
$880
Paid-in capital in excess of par
Retained earnings
60
260
110
-­
Total stockholders' equity
$470
Total liabilities and
stockholders' equity
$880
Relevant information
Rogers Industries
1. Sales in 1997 were $1,200,000.
2. Cost of goods sold equals 60 percent of sales.
3. Operating expenses equal 15 percent of sales.
4. Interest expense is 10 percent of the total beginning balance of notes payable and long-term
debts.
5. The firm pays 40 percent taxes on ordinary income.
6. Preferred stock dividends of $4,000 were paid in 1997.
7. Cash and marketable securities are unchanged.
8. Accounts receivable equal 8 percent of sales.
9. Inventory equals 10 percent of sales.
10. The firm acquired $30,000 of additional fixed assets in 1997.
11. Total depreciation expense in 1997 was $20,000.
12. Accounts payable equalS percent of sales.
13. Notes payable, long-term debt, preferred stock, common stock, and paid-in capital in excess
of par remain unchanged.
14. Accruals are unchanged.
15. Cash dividends of $119,000 were paid to common stockholders in 1997.
II
3-9
Statement of retained earnings Hayes Enterprises began 1997 with a retained
earnings balance of $928,000. During 1997, the firm earned $377,000 after
108
PART 1
Introduction to Managerial Finance
taxes. From this amount, preferred stockholders were paid $47,000 in divi­
dends. At year-end 1997, the firm's retained earnings totaled $1,048,000. The
firm had 140,000 shares of common stock outstanding during 1997.
a. Prepare a statement of retained earnings for the year ended December 31,
1997, for Hayes Enterprises. (Note: Be sure to calculate and include the
amount of common stock dividends paid in 1997.)
b. Calculate the firm's 1997 earnings per share (EPS).
c. H ow large a per-share cash dividend did the firm pay on common stock
during 1997?
.
III
111
III 111
3-10 Translation of foreign subsidiary's balance sheet Cummings Products, a multi­
national producer of men's clothing, has a major manufacturing subsidiary
operating in Switzerland. (The Swiss currency is francs, noted Sf.) The sub­
sidiary has total assets worth Sf 9,000,000, total liabilities of Sf 6,000,000, and
Sf 3,000,000 in equity. The exchange rate at the beginning of 1997 was Sf
1.50IUS$, or alternatively, US$ .67/Sf. At the end of 1997, the Swiss franc had
appreciated to a value of Sf 1.40IUS$, or US$.77/Sf.
a. Find the value in US$ of the Swiss subsidiary's assets, liabilities, and equity at
the beginning of 1997.
b. Find the value in US $ of the Swiss subsidiary's assets and liabilities at the end
of 1997.
c. Compare your findings in a and b, and determine the amount, if any, of
translation gain or loss experienced by Cummings Products on its Swiss sub­
sidiary during 1997.
d. How should any translation gain or loss found in c be treated by Cummings
Products?
3-11
Cash flow A firm had earnings after taxes of $50,000 in 1997. Depreciation
charges were $28,000, and a $2,000 charge for amortization of a bond discount
was incurred. What was the firm's cash flow from operations during 1997?
3 12 Depreciation On January 1, 1997, Norton Systems acquired two new assets.
Asset A was research equipment costing $17,000 and having a 3-year recovery
period. Asset B was duplicating equipment having an installed cost of $45,000
and a 5-year recovery period. Using the M ACRS depreciation percentages in
Table 3.6 on page 91 , prepare a depreciation schedule for each of these assets.
3 13
-
Depreciation and cash flow A firm in the third year of depreciating its only
asset, originally costing $180,000 and having a 5-year MACRS recovery period,
has gathered the following data relative to the current year's operations.
Accruals
Current assets
Interest expense
Sales revenue
Inventory
Total costs before depreciation, interest, and taxes
Ta x rate on ordinary income
$ 15,000
120,000
15,000
400,000
70,000
290,000
40%
CHA PTER 3
109
Financial Statements, Depreciation, and Cash Flow
a. Use the relevant data to determine the cash flow from operations for the cur­
rent year.
h. Expl ain the impact that depreciation, as well as any other noncash charges,
has on a firm 's cash flows.
. 3-14
Classifying sources and uses Classify each of the following items as a source
(5) or a use (U) of funds, or as neither (N ).
Change
Change
Item
($)
Cash
+100
- 1,000
+500
- 2,000
+200
+400
Accounts pa yab le
N otes payable
Long-term debt
Inventory
Fixed assets
. 3-15
. 3-16
Item
Accounts receivable
Net profits
Depreciation
Repurc hase of srock
Cash dividen ds
Sale of stock
(S)
-700
+600
+100
+600
+800
+1 ,000
Finding dividends paid Colonial Paint's net profits after taxes in 1997 totaled
$1 86,000. The firm's year-end 1997 and 1996 retained earnings on its balance
sheet totaled $812,000 and $736,000, respectively. How many dollars, if any, in
dividends did Colonial pay in 1997?
Preparing a statement of cash flows Given the balance sheets and selected data
fro m the income statement of Keith Corporation that follow:
a. Prepare the firm's statement of cash flows for the year ended December 31,
1997.
h. Reconcile the resulting "net increase (decrease ) in cash and marketable
securities" with the actual cha nge in cash and marketable securities for the
year.
c. Interpret the statement prepared in a.
110
PART 1
Introduction to Managerial Finance
Balance sheets
Keith Corporation
December 31
Assets
1997
1996
Cash
$ 1,500
$ 1,000
Marketable securities
1,800
1,200
Accounts receivable
2,000
1,800
2,900
2,800
$ 8,200
$ 6,800
Gross fixed assets
$29,500
$28,100
Less: Accumulated depreciation
14,700
13,100
Inventories
Total current assets
Net fixed assets
Total assets
$14,800
$15,000
$23,000
$21,800
$ 1,600
2,800
$ 1,500
2,200
200
300
$ 4,600
$ 4,000
Liabilities and stockholders' equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
$ 5,000
$ 5,000
Common stock
$10,000
$10,000
Retained earnings
3,400
2,800
$13,400
$12,800
$23,000
$21,800
Total stockholders' equity
Total liabilities and stockholders' equity
Income statement data (1997)
Depreciation expense
Net profits after taxes
$ 1,600
1,400
CHAPTER 3
11
CASE
Financial Statements, Depreciation, and Cash Flow
111
3 17 Preparing a statement of cash flows Using the 1997 income statement and the
1997 and 1996 balance sheets for Technica, Inc., given in Problem 3-1 on page
102, do the following:
a. Prepare the firm's statement of cash flows for the year ended December 31,
1997.
b. Reconcile the resulting "net increase (decrease) in cash and marketable
securities" with the actual change in cash and marketable securities for the
year.
c. Interpret the statement prepared in a.
Analyzing Cline Custom Bicycles' Cosh Flows
Chapter 3
Darin Cline, formerly an internationally renowned professional bicycle racer,
owns and operates Cline Custom Bicycles-a firm that builds and markets
custom bicycles to shops throughout the United States. Darin has just received
his firm's 1997 income statement, balance sheet, and statement of retained earn­
ings, shown in what follows along with the firm's 1996 balance sheet. Although
he is quite pleased to have achieved record earnings of $106,000 in 1997, .')arin
is concerned about the firm's cash flows. Specifically, he is finding it more and
more difficult to pay the firm 's bills in a timely manner. To gain insight into the
firm's cash flow problems, Darin is planning to have the firm 's 1997 statement of
cash flows prepared and evaluated.
Income statement (SOOO)
Cline Custom Bicycles
for the year ended December 31,1997
Sales revenue
$2,200
Less: Cost of goods sold
1,420
Gross profits
$ 780
Less: Operating expenses
Selling expense
$300
General and administrative expense
270
Depreciation expense
30
Total operating expense
600
Less: Interest expense
$ 180
29
Net profits before taxes
$ 151
Operating profits
Less: Taxes (30%)
Net profits after taxes
45
$ 106
112
PART 1
Introduction to Managerial Finance
Balance sheets (SOOO)
Cline Custom Bicycles
December 31
Assets
199 7
1996
$
$
Current assets
Cash
30
50
10
20
Accounts receivable
320
350
Inventories
460
320
$ 820
$ 740
$ 560
$ 520
180
150
Marketable sec uriti es
Total cu rrent assets
Gross fixed assets
Less: Accu mulated depreciation
Net fi xed assets
Total assets
$ 380
$ 370
$ 1,200
$1,110
$ 390
$ 320
Liabilities and stockholders' equity
Current liabilities
Accou nts payable
Notes payable
110
90
Accruals
20
20
$ 520
$ 430
Total current liabilities
Long-term debt
Total liabili ties
$ 320
$ 350
$ 840
$ 780
$ 100
$ 100
150
150
Stockholders' equity
Commo n stock (500,000 shares at $.20 par value )
Paid-in capital in excess of par
Retained ea rnings
Tota l stockholders' equi ty
Total lia bilities and stockholders' equity
110
80
$ 360
$ 330
$1,200
$1,1 10
Statement of retained earnings (SOOO )
Cline Custom Bicycles
for the year ended December 31 ,1997
Retained earnings balance (January 1, 1997)
$ 80
Plus: Net profits after taxes (fo r 1997)
106
Less: Cash dividends on common stock
(pa id during 1997)
(76 )
Retained earnings balance (December 31,1997)
$110
CHAPTER 3
Fi nancial Statements, Depreciation, and Cash Flow
113
Required
a. Use the financial data presented to prepare Cline Custom Bicycles' statement
of cash flows for the year ended December 31, 1997.
b. Evaluate the statement prepared in a in light of Cline's current cash flow diffi­
culties.
c. On the basis of your evaluation in b, what recommendations might you offer
Darin Cline?