CHAPTER 5: CASH FLOW STATEMENT PROBLEM SOLUTIONS
Assessing Your Recall
5.1
Because income recognition is done on an accrual basis the recognition of
revenues and expenses either leads or lags cash inflows and outflows to some
degree. Therefore, the income statement is not as useful in determining the
cash situation of the company. Since cash is such an important commodity
and the company cannot operate without an adequate supply of it, the cash
flow statement provides useful information to the reader. The cash flow
statement also reports on activities not covered (or partially covered) by the
income statement (investment and financing activities).
5.2
Knowledge of the timing of the collection of receivables and the payment of
payables as well as the level of inventories can help the reader of the
financial statements understand the leads and lags between the recognition
of income and the related cash flows. For instance, the more time the
company gives its customers to pay (Accounts Receivable policy) the greater
the lag will be between the recognition of the sale for income purposes and
the recognition of the cash inflow. The higher the level of inventories
required at the end of each period, the bigger the gap will be between the
outflow of cash to pay for inventory and the recognition of those costs as
expenses at the time of sale. The accounts payable policy also introduces a
lag between the recognition of costs and the cash outflow.
5.3
The lead/lag relationship means that the cash flows of the company, for
expenses and revenues, may either lead or lag the recognition of these
expenses and revenues for income statement purposes. For this reason the
cash flow statement provides different information from the income
statement.
5.4
There are many reasons a company may have a cash flow problem. Listed
below are some of the reasons and some potential solutions.
a) Collection of Receivables (A/R Policy) – This problem involves the
accounts receivable policy of the company. The longer the lag between the
time of sale and the collection of the receivable the more of a problem cash
flow can be. Possible solutions are to change the A/R policy so as to shorten
it. This may have the negative side effect of turning customers away.
Another alternative would be to offer a discount for prompt payment.
Whether this solves the cash flow problem or not depends on how much the
discount is and whether it is effective. The company gets the cash in sooner
but it gets less. Another alternative would be to sell the accounts receivable.
Again the benefit of receiving the cash sooner must be balanced with the fact
that less cash is received.
1
b) Inventory Policy – Inventory requires cash to make or buy and the longer
it remains unsold the bigger the lag between cash outflow and cash inflow
from the sale. One possibility to reduce the cash outflow would be to reduce
inventory levels. The cost of doing this, of course is that there is increased
risk of stocking out of inventory and losing customers. This risk must be
weighed against the cost of keeping too high a level of inventory. Many
companies have attempted to implement different production/buying
strategies that minimize inventories. The just-in-time strategies have the
effect of reducing inventory levels, sometimes significantly so.
c) Account Payable Policy – The longer the company can wait to pay its own
bills the better off it will be from a cash flow perspective. This puts the cash
outflows to acquire new inventory closer to the cash inflows from the sales of
the goods available for sale. A company may try to negotiate better credit
terms from its suppliers or find another supplier that is willing to give better
terms.
d) Expenses – The expenses of the company may be too high, regardless
of the lead/lag relationships discussed above. Cost cutting measures can be
implemented to reduce costs. Care must be exercised so as not to reduce the
quality of the product.
e) Revenues – The selling price of the good can be increased to improve
cash flows. Whether this works or not depends on whether the customers
are willing to accept the price increase. This, of course, depends on the
supply and demand characteristics of the marketplace.
f) Cash Resources – Sometimes a cash flow problem is temporary and will
eventually turn around. In the meantime, however, the company may need
to cover several periods of negative cash flows. The larger the balance in
cash the easier this will be. Alternatives here are to either borrow more
money (the company would then have to factor in the cash flows for the
repayment of the loan) or to raise cash by issuing more equity.
5.5
The three major categories of cash flows are:
Operating Activities – These cash flows are those associated with the daily
operations of the company in selling goods and services to customers.
Financing Activities - These cash flows are those associated with raising
funds (cash) for the company to operate. These funds come from two major
sources, debtholders, and shareholders. Repayments to the debtholders
(principal repayments) and shareholders (repurchase of shares and
dividends) are also shown in this section.
Investing Activities – These cash flows are associated with the long-term
investment of cash. The two major categories of items that fit in this section
are the investment in property, plant, and equipment and the investment in
other companies through acquisitions.
2
5.6
The direct method for constructing the operating section of the cash flow
statement determines and reports the actual gross cash collections from
customers and cash payments to suppliers. The indirect method arrives at
the same total cash flow from operations but reports the total as the net
income for the period adjusted for all of the items that adjust net income to
its cash flow equivalent.
5.7
Amortization is not a source of cash. Cash flows related to property, plant,
and equipment occur when the property, plant and equipment is purchased
or when it is sold. During the time that it is held, its original cost is
expensed periodically through the amortization entry, but there is no cash
flow when this entry is recorded. Amortization does look like a source of
cash in the indirect approach to preparing the cash flow statement. It is an
addback to the net income in this section. Appearances are deceiving,
however, since the reason for adding back the amortization is to correct for
the fact that amortization, which is imbedded in the net income number,
does not affect cash flows and must therefore be removed from net income in
order to arrive at cash flow from operations.
5.8
a)
b)
c)
d)
e)
Investing
Financing
Operating
Financing
Investing
f) Financing
g) Operating
h) Operating
i) Gain/loss would be an adjustment in the
Operating section. There would also be an
entry in the investing section for the cash
proceeds which include the gain/loss.
5.9
a)
b)
c)
d)
e)
f)
g)
h)
Financing
Investing
Operating
Financing
Investing
Financing
Investing
While the collection of an individual receivable would be excluded, the
change in total receivables would be included in the cash flow from
operations under the indirect method
i) Does not appear on the cash flow statement because the declaration of
dividends has no impact on the cash position of a company until the
dividends are paid
j) Investing
3
Applying Your Knowledge
5.10
Possible sources of cash are:
1. Sale of tickets for performances
2. Grants from the city or government
3. Donations from patrons
4. Borrowing of money
Possible uses of cash are:
1. Construction of sets and costumes
2. Payment of salaries of the employees
3. Costs for the upkeep of the theatre
4. Payments for advertising
5. Purchase of equipment
5.11
A high sales growth rate can cause a company cash flow problems if there is
a significant lead/lag relationship between the expenditure of costs and the
receipt of revenues. The high growth rate causes the company to larger
quantities of inventory which incurs a significant amount of cost. If there is
a lag between purchase and sale and then sale and collection these costs do
not get covered by corresponding revenues in the short run. The high growth
rate exacerbates any lead/lag relationship that already exists. Depending on
the characteristics of inventory purchase and the lead/lag relationship there
is, in fact, a growth rate beyond which a company will perpetually be in need
of infusions of cash. Most companies cannot sustain these high growth rates
for long but during the early high growth years of many startup companies
the demand for cash is great.
5.12
Cash outflows related to property, plant and equipment are typically at the
date of purchase although if the purchase is financed then the cash flows for
the purchase may be spread out over several years. During the use of the
equipment the only cash outflows are for the normal maintenance and
service of the equipment. The cash inflow for the property, plant and
equipment comes at the date of sale or retirement. By way of contrast, the
income statement shows the expense of using the property, plant and
equipment over its useful life and not at the beginning or end of its life
although it is possible that the company could show a gain or loss when the
property, plant and equipment is sold.
5.13
Interest cash flows are classified as operating activities on the cash flow
statement, because interest is deducted in the calculation of net income, and
net income is used to derive cash flows from operations. Conceptually, this is
not appropriate because interest represents payments to debt-holders, which
is a financing activity.
4
5.14
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
no effect
no effect
decreases cash
increases cash
decreases cash
increases cash
no effect
decreases cash
no effect
decreases cash
decreases cash
5.15
a.
Cash
Accumulated
amortization
Asset
Gain on sale of asset
80,000
b.
Asset
Cash
Notes payable
350,000
c.
Interest expense
Cash
80,000
Decreases cash:
80,000 $80,000
(reflected in operating
activities through net
income)
d.
Amortization expense
Patent
16,000
No effect on cash
16,000 Operating activities:
add back the $16,000
because it has been
deducted from net
income
e.
Income tax expense
Cash
Taxes payable
130,000
Decreases cash:
95,000 $95,000
35,000 Operating activities: if
taxes payable increased
from the prior year, add
the difference
95,000
Increases cash: $80,000
Operating activities:
deduct gain of $10,000
165,000 Investing activities:
10,000 report cash inflow of
$80,000
Decreases cash:
50,000 $50,000
300,000 Investing activities:
report cash outflow of
$50,000
5
5.16
a) and b)
Trans.
No.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
Cash
-32,000
+58,000
-2,000
-2,800
Activity
Other
Current
Assets
+35,000
Noncurrent
Assets
+60,000
-39,000
-58,000
operating
financing
investing
-600
-575
+10,000
+2,000
-1,325
financing
operating
financing
operating
operating
Shareholders’
Equity
+60,000
-39,000
+2,500
-2,000
operating
investing
-350
+10,000
+700
Noncurrent
Liabilities
+35,000
-32,000
Operating
operating
Current
Liabilities
+2,800
-1,200
+5,000
-2,500
-1,200
+5,000
-350
+10,000
-700
+750
-600
-750
+575
+10,000
+2,000
-1,325
6
5.17
a) and b)
Trans.
No.
Cash
Activity
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
+100,000
-80,000
+3,000
+25,000
financing
investing
operating
operating
+250,000
-175,000
operating
operating
-1,500
-360,000
-2,500
-10,000
+100,000
investing
investing
operating
operating
financing
Other
Current
Assets
Noncurrent
Assets
Current
Liabilities
Noncurrent
Liabilities
+100,000
+40,000
+120,000
+3,000
+25,000
+185,000
-25,000
+185,000
-25,000
+100,000
+350,000
-175,000
-10,000
-10,000
+1,500
+360,000
+100,000
-40,000
operating
+10,000
-7,500
-15,000
-2,000
-10,000
-25,000
financing
investing
operating
-2,500
+15,000
-25,000
+50,000
-7,500
Shareholders’
Equity
+5,000
-15,000
-7,000
+10,000
-25,000
7
5.18
Cash Flow from Operations
Net Income (loss)
Add:
Amortization
expense
Decrease in inventories
Decrease in accounts
receivable
Decrease in prepaid
expenses
Increase in salaries
payable
Increase in interest
payable
Increase in accounts
payable
Less:
Increase in inventories
Increase in Accounts
Receivable
Increase in prepaid
expenses
Decrease in salaries
payable
Decrease in interest
payable
Decrease in accounts
payable
Cash Flow from Operations
I
26,500
II
13,300
III
14,800
3,000
8,000
20,000
10,000
2,000
500
1,000
2,000
4,000
4,000
5,000
3,500
800
15,000
1,000
1,800
3,000
1,000
7,000
500
9,000
21,500
23,800
17,800
8
5.19
Cash Flow from Operations
Net Income (loss)
Add:
Amortization expense
Loss on sale
Decrease in
inventories
Decrease in accounts
receivable
Increase in interest
payable
Increase in accounts
payable
Less:
Gain on sale
Increase in
inventories
Increase in Accounts
Receivable
Decrease in interest
payable
Decrease in accounts
payable
Cash Flow from Operations
I
52,000
II
13,000
III
34,500
20,000
15,000
2,000
5,000
10,000
10,000
4,000
100
1,000
1,500
500
15,000
5,000
500
3,500
700
2,000
74,500
39,300
27,100
9
5.20
Dennison Company
Cash Flow Statement
Year ended December 31, 2001
Operations
Net Income
Add back amortization
Add back loss on sale of equipment
Decrease in accounts receivable
Increase in inventories
Decrease in accounts payable
Decrease in salaries payable
Cash flow from operations
Investing
Acquisition of property, plant,
and equipment
Proceeds from sale of property,
plant, and equipment
Cash flow from investing
Financing
Repayment of bank loan
Dividends
Cash flow from financing
Net Change in Cash
$13,500
23,500
5,000
24,000
(20,000)
(10,100)
(12,000)
$23,900
(50,000)
25,000
(25,000)
(10,000)
(10,000)
(20,000)
($21,100)
See the t-account analysis that follows.
10
A-Cash

25,500
Operations:
Net income
(1)
Amortization
(2)
Decr. In Acc. Rec. (3)
Loss on Sale of Eq.(7)
13,500
23,500
24,000
5,000
20,000
10,100
12,000
(4)
(5)
(6)
Incr. In Inv.
Decr. In Acc. Pay.
Decr. In Sal. Pay.
Investing:
Proceeds from sale
of PP&E
(7)
25,000
50,000
(8)
Acq. of PP&E
10,000
10,000
(10)
(9)
Financing:

4,400
A-Accounts Receivable

59,000

35,000
24,000
A-Inventories
(3)
A-PP&E

(8)
165,000
50,000

180,000
35,000

(4)
30,000
20,000

50,000
XA-Accumulated Amortization
(7)
(7)
L-Accounts Payable
38,600
(5)
10,100
28,500
Dividends
Repmt. of Loan
5,000
61,900
23,500

(2)
80,400

L-Salaries Payable


(6)
24,000

12,000

12,000
11
L-Bank Loan
(9)
50,000

100,000

40,000

100,000

10,000
(10)
SE-Common Shares
SE-Retained Earnings
5,000
10,000
13,500
8,500

(1)

12
5.20
Matrix Incorporated
a)
Matrix Incorporated
Statement of Income and Retained Earnings
For the year ended December 31, 2001
Sales Revenues
Expenses:
Cost of Goods sold
Amortization Expense
Rent Expense
Interest Expense
Salary Expense
Net Income
Retained Earnings
December 31, 2000
Retained Earnings
December 31, 2001
$350,000
$275,500
10,000
12,000
15,000
24,000
336,500
13,500
2,500
$16,000
13
b)
Matrix Incorporated
Balance Sheet
December 31, 2001
Assets:
Cash
Accounts receivable
Prepaid rent
Inventories
Total current assets
Property, plant and equipment
Accumulated amortization
Net property, plant and equipment
Total Assets
Liabilities
Accounts payable
Interest payable
Salaries payable
Current liabilities
Bonds payable
Total liabilities
Shareholders’ Equity
Common shares
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders’ equity
$
2,900
12,500
6,000
18,900
40,300
160,000
(45,500)
114,500
$154,800
$ 13,800
9,000
6,000
28,800
10,000
38,800
100,000
16,000
116,000
$154,800
14
c)
Matix Incorporated
Cash Flow Statement
For the year ended December 31, 2001
Operations
Net income
Add back Amortization
Increase in Accounts Receivable
Increase in Prepaid Rent
Decrease in Notes Receivable
Decrease in Inventories
Increase in Accounts Payable
Increase in Interest Payable
Decrease in Salaries Payable
Cash flow from operations
Investing
Cash flow from investing
Financing
Repayment of Bonds
Cash flow from financing
Net Change in Cash
$13,500
10,000
(2,500)
(6,000)
5,0001
1,600
8,800
9,000
(12,000)
27,400
0
(40,000)
(40,000)
($12,600)
1 This
would have been classified as an investing activity if it had
not arisen as a result of the sale of inventory.
A-Cash
Operations:
Net income
Amortization
Decr. In Inv.
Decr. in Note Rec
Incr. In Acc. Pay
Incr. In Int. Pay.

15,500
(1)
(2)
(4)
(5)
(7)
(9)
13,500
10,000
1,600
5,000
8,800
9,000
2,500
6,000
12,000
Financing:
40,000 (10)


(3)
(3)
(6)
(8)
A-Accounts Receivable
10,000
2,500
Incr. In Acc. Rec.
Incr. In Prepd. Rt.
Decr. In Sal. Pay.
Repmt. of Debt
2,900

A-Inventories
20,500
1,600
(4)
15


12,500
18,900
A-Trade Notes Receivable

5,000
5,000
(5)

(6)
A-Prepaid Rent
0
6,000

0

6,000

A-PP&E
160,000

160,000
XA-Accumulated Amortization
35,500

10,000
(2)
45,500
L-Accounts Payable
5,000
8,800
13,800
L-Interest Payable
0
9,000
9,000
SE-Retained Earnings
2,500
13,500
16,000

(7)


(9)


(1)

L-Salaries Payable
18,000
(8)
12,000
6,000
L-Bonds Payable
50,000
(10) 40,000
10,000
SE-Common Shares
100,000
100,000







16
5.22 a)
Athabasca Company
Cash Flow Statement
Year Ended December 31, 2001
Operations
Net Income
Add back amortization
Decrease in accounts receivable
Increase in wages payable
Increase in inventory
Decrease in accounts payable
Cash flow from operations
Investing
Acquisition of building / equipment
Cash flow from investing
Financing
Issue of shares
Repayment of bonds
Dividends
Cash flow from financing
Net Change in Cash
$61,000
40,000
20,000
5,000
(60,000)
(10,000)
$56,000
(90,000)
(90,000)
70,000
(50,000)
(35,000)
(15,000)
(49,000)
b) The working capital did not change by the same amount as cash
generated by operations. It decreased $4,000 ($330,000 - $326,000).
The cash balance in working capital is affected by more than just
operating activities. Financing and investing activities also affect it.
17
5.23
Crescent Manufacturing Company
Cash Flow Statement
Year ended December 31, 20x1
Operations
Net Income
Add back amortization
Increase in Accounts receivable
Decrease in Prepaid Insurance
Increase in Inventories
Increase in Accounts Payable
Decrease in Interest Payable
Gain on sale of temp. invest.
Cash flow from operations
Investing
Sale of temporary investments
Purchase of Property, plant and
equipment
Cash flow from investing
Financing
Repurchase of common shares
Dividends
Repayment of mortgage
Cash flow from Financing
Net Change in cash
Cash position beginning of year
Cash position end of year
$50,000
50,000
(31,000)
6,000
(50,000)
2,400
(2,400)
(25,000)
$
-0-
125,000
(75,000)
50,000
(10,000)
(20,000)
(25,000)
(55,000)
(5,000)
17,800
$12,800
18
5.24
Simcoe Company
Cash Flow Statement
Year ended December 31, 20x1
Operations
Net Income
Add back amortization
Increase in accounts receivable
Decrease in inventories
Increase in accounts payable
Increase in wages payable
Cash flow from operations
Investing
Purchase of property, plant and
equipment
Cash flow from investing
Financing
Issue of bonds
Issue of common shares
Cash flow from financing
Net Change in cash
Cash position beginning of year
Cash position end of year
$ 35,000
25,000
(14,000)
10,000
17,000
10,000
$83,000
(115,000)
(115,000)
25,000
25,000
50,000
18,000
10,000
$28,000
19
5.25
Janxen Jeans Company
Cash Flow Statement
Year ended December 31, 20x2
Operations
Net Income
Add back amortization
Decrease in accounts
receivable
Increase in notes receivable
Increase in inventories
Decrease in accounts payable
Increase in interest payable
Cash flow from operations
$151,000
105,500
13,000
(9,000)
(113,000)
(13,000)
7,500
$142,000
Investing
Purchase of land
Purchase of machinery
Sale of machinery
Cash flow from investing
(25,000)
(325,000)
20,000
Financing
Issue of long-term debt
Issue of common shares
Dividends
Cash flow from financing
150,000
100,000
(50,000)
Net Change in cash
Cash position beginning of year
Cash position end of year
(330,000)
200,000
12,000
188,000
$ 200,000
20
5.26
a)
Pharmex Pharmaceutical Company
Statement of Income and Retained Earnings
Year ended December 31, 20x3
Sales
Gain on sale of property, plant, and equipment
Less: Cost of goods sold
Amortization expense
Interest expense
Rent expense
Total expenses
Net income (Loss)
Retained eEarnings December 31, 20x2
Dividends
Retained Earnings December 31, 20x3
$1,052,000
15,000
1,067,000
878,000
75,000
60,000
85,000
1,098,000
(31,000)
386,000
(20,000)
$335,000
b)
Pharmex Pharmaceutical Company
Cash Flow Statement
Year ended December 31, 20x3
Operations:
Net income (Loss)
($31,000)
Add: Amortization
75,000
Increase in accounts receivable
(50,000)
Increase in inventories
(29,000)
Decrease in accounts payable
(15,000)
Gain on sale of property, plant,
And equipment
(15,000)
Cash flow from Operations
Investing Activities:
Purchase of machinery
(135,000)
Sale of machinery
115,000
Cash flow from Investing
Financing Activities
Bonds Issued
25,000
Shares Issued
50,000
Dividends
(20,000)
Cash flow from Financing
Net change in cash
Beginning cash balance
Ending cash balance
(65,000)
(20,000)
55,000
(30,000)
80,000
$50,000
21
22
T-Account Worksheet
A-Cash
Operations:
Amortization

80,000
(2)
75,000
Investing:
Proceeds from sale
of machinery
(3)
115,000
Financing:
Proceeds from:
Issuance of bonds (8)
Issuance of stocks (9)
25,000
50,000

50,000
31,000
15,000
(1)
(3)
50,000
29,000
15,000
(4)
(5)
(7)
135,000
(6)
20,000 (10)
Net Loss.
Gain on sale
of PP&E
Inc. in A/R
Inc. in Inv.
Dec. in A/P
Acquisition of
machinery
Dividends paid

(5)
A-Inventory
296,000
29,000
A-Accounts Receivable

185,000
(4) 50,000

325,000


(6)
A-Machinery
545,000
135,000
125,000

555,000
(7)
(3)
235,000
XA-Accumulated Amortization
122,500

(3)
25,000
75,000
(2)
172,500
L-Accounts Payable
97,500
15,000
82,500


L-Bonds Payable
150,000
25,000
175,000


(8)

23
SE-Common Shares
350,000
50,000

(9)
400,000

SE-Retained Earnings
386,000

(1)
31,000
(2)
20,000
335,000

5.27
a) $680,300 ($673,400 + $85,500 - $78,600) Lazard Company collected last
year’s accounts receivable plus a portion of this year’s sales; its current
year sales of $673,400 plus amounts owed from the prior years’ sales that
are reflected in the decrease in accounts receivable of $6,900.
b) $490,400 (Lazard company paid to suppliers the cost of its purchases for
the current year of $501,600 ($490,000 - $121,000 [ending inventory] +
$132,600 [ending inventory]) less the increase in accounts payable of
$11,200 ($54,900 - $43,700). Note that the purchases can be computed
from the beginning inventory, ending inventory, and cost of goods sold
amounts.
24
5.28 a)
Cash generated from operations:
Net income
Adjustments:
Amortization expense
Amortization of patent
Gain on sale of equipment
Increase in accounts receivable
Decrease in inventory
Increase in accounts payable
Decrease in wages payable
Increase in income taxes payable
Cash generated from operations
$388,900
67,000
3,800
(5,000)
(13,000)
7,000
3,500
(1,300)
3,100
$454,000
Supporting calculations:
Amortization of patent: $3800 = $31,200 - $27,400
Gain on sale of equipment: $5,000 = $22,000 - $17,000
b)
Cash flow from investing activities:
Purchase of patent
Purchase of equipment
Sale of equipment
Cash used in investing
$(31,200)
(516,000)
22,000
$(525,200)
Supporting calculations:
Purchase of equipment: $516,000 = $465,000 + $51,000
c)
Cash flow from financing activities:
Cash dividends paid
Purchase of common shares
Proceeds from sale of bonds
Cash generated by financing
$(52,000)
(44,000)
100,000
$ 4,000
25
d)
Downsview Company
Cash Flow Statement
Year ended December 31, 2000
Operations
Net Income
Add: amortization
Amortization of patent
Gain on sale of equipment
Increase in taxes payable
Increase in accounts receivable
Decrease in inventories
Increase in accounts payable
Decrease in wages payable
Cash Flow from operations
$388,900
67,000
3,800
(5,000)
3,100
(13,000)
7,000
3,500
(1,300)
$454,000
Investing
Purchase of patent
Purchase of plant and equipment
Sale of equipment
Cash flow from investing
(31,200)
(516,000)
22,000
Financing
Issue of bonds
Redemption of common shares
Dividends
Cash flow from financing
100,000
(44,000)
(52,000)
Net Change in cash
Beginning cash balance
Ending cash balance
(525,200)
4,000
(67,200)
261,800
$194,600
26
5.29
a) The two items that seem to be continuing needs for cash are the
acquisition of property, plant, and equipment and dividends. Both of these
items have increased over the last three years and are likely to require even
larger expenditures in the future. While cash from operations has also
grown over the last three year, this growth has not kept pace with the
growth in expenditures for property, plant, and equipment and dividends. In
20x1 cash from operations was just barely sufficient to meet both of these
needs. By 20x3 the cash from operation is significantly below the level of
these two needs. More sporadically cash has been used over the last three
years to retire long-term debt and to repurchase shares. During 20x1 and
20x2 these non-continuing uses of cash were financed by the issuance of longterm debt. In 20x3 the shortfall was covered through the issuance of shares.
In terms of the future it would seem that the cash from operations is not
keeping pace with the needs of the company and something will have to be
done to solve this problem. The issuance of shares in 20x3 also means that
in future years there could be a further increase in the amount of dividends
paid out, which is not a good sign. Of course the company has the option not
to pay dividends, but this may not be its policy.
b) The changes in the inventories and accounts payable shown in the
operating section do not seem significant and, therefore, do not seem to
indicate a problem. The rather large increases in accounts receivable over
the last two years are of some concern. These increases may indicate that
the company is having a hard time managing the collection of its receivables.
Part of the increase could be explained by the growth in income which
suggests an increase in the level of sales. However, the increases seem out of
line when compared to changes in the inventories and accounts payable
which you would also expect to increase in a period of increased volume of
activity.
c) Since cash from operations was not sufficient to meet the needs of
Sherman Brothers in 20x3 it issued shares.
Management Perspective Problems
5.30
The bank loan officer is very interested in determining the ability of the
company to pay back its loan. If the loan is short-term then the bank must
look for repayment of the loan from operating cash flows and secondarily
from other sources of cash that the company might have. This information is
best provided by the cash flow statement. The information on the income
statement represents the company’s best estimate of the net cash proceeds
that will ultimately result from the sale of goods and services during the
current accounting period. However, there are many leads and lags in these
numbers that prevent net income from being a short-run predictor of cash. If
the loan being evaluated is a long-term one then the income statement
becomes much more important to the banker since the repayment of the loan
will take place over a much longer period of time.
27
5.31
The stock analyst attempts to assess and value the productive capabilities of
a company. Those productive capabilities are played out over long periods of
time and hence the income statement is likely to be a better source of
information in trying to predict future results. The analyst cannot, however,
ignore the cash flow statement as it provides useful information about the
ability of the company to meet is cash flow and liquidity needs. If the
company is unsuccessful in managing its cash position in the short run it
may not make it to the long run to capture the value that is represented in
its forecasted earnings. Yet, if you had to decide which statement would
likely be more useful, you would conclude that the income statement is more
useful to the analyst.
5.32
Management compensation plans are typically used to motivate mangers to
think about the long run health of the company. Therefore, the income
statement would likely be a better performance measure to use than the cash
flow from operations since it focuses on the longer run net effect on the
wealth of the shareholder rather than the immediate cash picture. On the
other hand, if cash flow management were a particular problem for your
company you might be tempted to put in measures of both net income and
cash flow to focus mangers on both the long-term picture as well as the
shorter run cash flow issue.
5.33
In general, lenders should be quite satisfied with the classification of cash
flows into the three categories of operating activities, investing activities,
and financing activities. These activities represent the sources (financing)
and uses (investing) of cash, in addition to the cash generated as a result of
investment in business activities (operating). However, the classification of
interest as an operating activity is inappropriate in the sense that interest
represents a return paid to lenders, and is thus related to financing rather
than to the revenue-generating activities of the business.
5.34
a) Accumulating large amounts of cash and other current assets is not
necessarily a sign of good management. Cash and those securities which are
readily convertible into cash usually earn no return or a very low return. In
addition, increases in accounts receivable and inventory may be beneficial.
However these assets, although classified as current, are not as liquid as
cash. We do not know the type of activities in which Titalussa Company is
involved. The primary source of profit for many companies is through
investment in production facilities and the production and sale of goods or
through providing services to others. While holding sufficient cash to meet
the company’s cash flow needs is necessary, having larger balances is not
good utilization of the company’s resources.
b) There is little wrong with having modest amounts of debt if the company
is in a mature or declining industry and has limited investment alternatives.
If, however, there are opportunities for expansion into new product lines,
new territories, or further refinement of existing products, an unwillingness
to incur debt in order to take advantage of the opportunities may mean the
28
company is headed for difficult times in the not distant future. At present,
the company is earning an 18 percent return on equity. That appears to be a
relatively good return. Management obviously is doing some things right.
c) We do not know all the details of operating costs and revenues which
may have an impact on the amount of cash flows during the period.
However, we are told that revenues are increasing by 10 percent and
receivables and inventories are increasing at 20 percent annually. A buildup
in accounts receivable and inventory reduces cash available. When the
accumulation of inventories exceeds the increase in sales for a period of time,
the possibilities of holding obsolete or unsalable inventory increases. The
company should carefully evaluate its current inventory levels to be sure
they do not have unrecognized inventory losses. Accounts receivables also
are increasing faster than sales. The immediate question is whether all of
the receivables will be collected. Has an adequate allowances for
uncollectibles been made? Has the company loosened its credit standards in
order to increase sales and, as a result, had more slow paying customers or
ones which will not pay at all? A careful analysis of all accounts receivable
appears to be in order as well.
d) Titalussa is earning 18 percent on equity. We do not know what the
company is earning on the excess cash which it has on hand. Perhaps if it
distributed nearly all of the cash to the shareholders, the same amount of
total income would still be earned and the shareholders would get an
additional return by investing the funds received. If Titalussa is able to earn
a return on theses funds that is greater than that which the shareholders
can earn, it should invest the funds. On the other hand, if the investors can
earn a 20 percent return on their own and Titalussa is earning only at 18
percent return, the shareholders would be better off receiving the funds and
investing them.
29
5.35
a)
Sources of cash flow for Green Company:
Operating activities
Sales of operating assets
Issuance of common
shares
Total
b)
Dollar Amount
$ 720,000
$ 400,000
$1,000,000
$2,120,000
% of Total
33.96%
18.87%
47.17%
100.00%
Uses of cash flow for Green Company:
Purchase of operating
assets
Retirement of bonds
Dividends paid
Total
Dollar Amount
$1,200,000
$1,300,000
$ 250,000
$2,750,000
% of Total
43.64%
47.27%
9.09%
100.00%
c)
One of the reconciling items between net income and cash
provided by operations is a deduction of $120,000 for the change in
current assets other than cash. Because the amount is deducted it
means that current assets increased. An increase in current assets
would be consistent with an increase in sales. As sales increase, so
would accounts receivable (if sales are made on credit) and inventory
levels.
Green company appears to have reduced its financial risk during 2000.
A total of $1,300,000 of bonds were retired and $1,000,000 of
additional shares were issued.
d) The case does not provide information on the total asset base so we
do not know how large an investment in capital assets already exists;
however, $1,200,000 of new operating assets were purchased and
$400,000 was sold, resulting in a net investment of $800,000. This net
investment is substantially more than the $230,000 of amortization
expense charged on existing assets in 2000. By examining total
investment in capital assets, and accumulated amortization, a clearer
picture of the rate of expansion that occurred in 2000 can be obtained.
It would also be appropriate to examine the footnotes to see if some
portion of the assets acquired had previously been leased. If the assets
previously had been leased, a cost savings may be realized through
ownership, but there may have been no change in total productive
capacity.
30
Green reduced its net financing by $300,000, and experienced an
overall decrease in cash of $630,000. This indicates that additional
financing is required if Green expects to continue expanding and to
continue dividend payments of $250,000.
5.36
a) Accounts receivable have increased by $160,000 this year.
b) A total of $5,000 was added to net income for prepaid expenses in
computing cash provided by operations. When this occurs, the total for
prepaid expenses at the end of the period is less than the balance at
the start of the period. Thus, Johann has reduced the level of prepaid
expenses. The cash position is lowered when the prepayments are
made and a cash savings occurs in subsequent periods as the benefits
are received from the prepayments.
c) Inventory has increased $20,000 during 2000. An increase in
inventory must be paid for with cash or by increasing accounts
payable.
d) Accounts payable have increased by $95,000. While we do not
know the amount of the total purchases from suppliers for the year, it
is probable that this represents a substantial increase in the reliance
on credit financing.
e) There does not appear to be sufficient information to know whether
amortization expense has increased or decreased from the prior year.
The cash flow statement indicates only the current year amortization
expense.
f) Johann has an increase in accounts receivable of $160,000 and an
increase in accounts payable of $95,000. A creditor would want to
know the total dollar amounts of receivables and payables and the
proportion of receivables that Johann is likely to collect. Suppliers
have a greater likelihood of being paid if the increase in receivables
was due to an increase in sales rather than to problems in collecting
accounts receivable.
g) The cash balance at December 31, 2000 is close to $1,000,000 and
Johann generated $824,000 from operations in 2000. If it generates a
similar amount in 2001, it might come close to being able to make a
payment of $2,000,000 on January 12, 2002. However, it is unlikely
that all of the cash can be used for the payment of bonds. Johann has
other current liabilities to pay and perhaps the need to invest in other
assets. Johann very likely will have to borrow at least some portion of
the $2,000,000 or find additional cash through other means.
31
Reading and Interpreting Published Financial Statements
5.37
a)
Sources of cash
Issuance of shares
Loans receivable
Net obligations incurred
for capital leases
Long term debt
Disposition of property,
plant and equipment
b)
Dollar Amount
$1,111,570
20,000
% of Total
19.6
.3
23,907
4,465,107
.4
78.7
54,076
$5,674,660
1.0
100.0
Dollar Amount
$1,969,370
47,455
% of Total
26.0
.6
5,558,331
$7,575,156
73.4
100.0
Uses of cash
Operations
Payment to Liard Resources
Purchase of property,
plant and equipment
c) Accounts receivable decreased $1,231,649; prepaid expenses,
deposits and inventories increased $44,643; accounts payable and
accrued liabilities decreased $5,099,780; corporate taxes payable
increased $57,121.
d) The cash position of Purcell Energy Ltd. decreased dramatically in
1998. This is the result of several factors: a net loss of $2,545,249; a
decrease in accounts payable and accrued liabilities of $5,099,780 (the
company completely reversed its activity from 1997 where its accounts
payable increased by $5,538,039); and an investment in property,
plant, and equipment (this investment is less than half the size of the
previous year’s investment in property, plant, and equipment). These
uses of cash were financed by debt, $4,465,107, and the issuance of
shares, $1,111,570.
32
5.38
a)
Sources of cash
Operations
Proceeds from long term
debt
Issuance of shares
Proceeds from disposition
of capital assets
Translation adjustment
Change in non cash investment
working capital
b)
Dollar Amount
$104,987
% of Total
22.4
162,194
61,076
34.5
13,0
15,436
1,442
3.3
.3
124,392
$469,527
26.5
100.0
Dollar Amount
$ 2,131
10,259
85,468
154,005
12,906
$264,769
% of Total
.8
3.9
32.3
58.1
4.9
100.0
Uses of cash
Retirement of debt
Payment of dividend
Purchase of capital assets
Business acquisition
Other investments
c) The cash position of CCL increased by $204,758. This is largely the
result of operations, $104,987, proceeds from debt, $162,194, and
changes in non cash investment working capital, $124,392. The major
uses of cash during the year were to purchase capital assets, $85,468,
and to purchase an investment in another company, $154,005.
The major changes from the previous year were an increase in
financing from issuing shares ($23,927 to $61,076); a decrease in the
amount spent to acquire other companies ($306,252 to $154,005); a
decrease in the proceeds earned from disposals ($111,579 to $15,436);
and an increase in cash from non cash investment working capital (a
negative $106,694 in 1997 to a positive $124,392 in 1998).
33
5.39
a) Bema Gold has been operating at a loss in each of the three years
with 1998 representing the largest loss of $46,127 thousand. Although
the company operated at a loss, it generated a positive cash flow from
operations in two of the three years. Several of the items that
contributed to the losses did not affect cash. The largest of these items
in 1998 was the write-down of properties of $32,738 thousand.
There were dramatic changes in its accounts receivable, inventories
and accounts payable in 1998. The accounts receivable decreased
$1,685 thousand generating more cash for the company. The
inventories decreased $446 thousand when in the previous two years
they had been increasing. The company is either managing its
inventories more efficiently or its sales are stabilizing. The accounts
payable decreased $7,423 thousand which means the company used
cash to pay off more of its accounts payable.
In each of the three years, Bema Gold has been generating extra cash
by issuing shares rather than debt. Its repayment of debt has
exceeded its generation of cash through the issuance of new debt.
In each of the three years, Bema Gold has been using cash to invest in
other companies and to explore and development new mines. Both of
these activities are essential to its long term profitability.
b) The additional information you would want would be the following:
the current and expected future state of the mining industry; when the
company expects to make a profit; how many shares have been issued;
and the current level of debt. Other answers are possible.
5.40
a) Over the last two years, Algoma Central Corporation has generated
approximately $32 million in cash annually. In 1997, this was
sufficient to cover its cash needs for the year. In 1998, the company
used approximately $90 million to buy new capital assets. The amount
generated from operations was not sufficient to cover this. The large
expenditure for capital assets does appear to be continuing. In 1997,
the company purchased $32 million in capital assets and sold capital
assets for $61 million.
You would need more information before you could determine whether
an expenditure of $90 million or $32 million was typical of this
company.
b) The items that would require more investigation or further
explanation would be: the decline in net income; the changes in the
34
non-cash operating working capital; the company’s future needs for
capital assets; the company’s current debt load; the company’s ratio of
debt to equity; why the company chooses to issue new debt rather
than issue shares. Other answers are possible.
c) In 1998, the net income declined to $15,963 thousand from the
previous year’s $75,950 thousand. However the cash from operations
remained virtually the same, $31,155 thousand in 1998 and $33,091
thousand in 1997. The reasons for this are the following: first, the
amortization increased approximately $10,000 thousand from the
previous year. This is a non-cash expense and the reason for the
increase is probably due to the additional capital assets that were
acquired. Second, in 1997 there was a gain on the sale of forest lands,
$61,299 thousand, that was deducted from the net income amount.
The cash proceeds, including the gain, were included under the
investing activities. There was no gain in 1998. Third, the change in
the non-cash operating working capital in 1998 resulted in an
additional deduction of approximately $14,500 thousand larger than
the previous year. These major items were the main contributors to
the even cash flow from operations in the two years.
5.41
a) In 1997, AT Plastics had a shortfall of cash for the year of $14,815
thousand. In 1998, there was a slight increase in cash of $3,881
thousand. In 1997, the company generated a positive cash flow from
operations of $23,638 thousand. However, in the same year, it spent
almost $100,000 thousand in new assets. It met its cash needs for the
year by increasing its net debt position by approximately $63,000
thousand dollars and by using an additional $14,815 thousand from its
cash balance.
In 1998, the company generated $39,129 thousand from operations. In
this year, the company purchased approximately $150,000 thousand in
new assets. Besides operations, additional cash was generated from
issuing $25,000 thousand in new shares and taking on an additional
$100,000 thousand in new debt. The combination of these three items
enabled the company to end the year with an increase in cash of $3,881
thousand.
b) The items that would require more investigation or further
explanation would be: the change in the non-cash working capital and
other liabilities that changed from a negative $3,412 thousand in 1997
to a positive $11,145 thousand in 1998; the company’s future needs for
capital assets; the company’s current debt load; and the company’s
ratio of debt to equity. Other answers are possible.
35
c) Although the net incomes in 1997 and 1998 are very similar, the
final cash position was different: in 1997 the cash decreased $14,815
thousand and in 1998 , it increased $3,881 thousand. The reason for
the decline in cash in 1997 was that the company purchased
approximately $100,000 thousand in new assets and only borrowed an
additional $70,000 thousand to help cover the cash outlay for assets.
The company used approximately $6,000 thousand to repay debt
during the year. The combination of the cash from operations and
new borrowing and the use of cash for new assets and debt repayment
resulted in a decrease in cash of $14,815 thousand.
5.42
The main differences in this cash flow statement appear to be in the
financing and investing sections. Financing activities includes
increase (decrease) in customer deposits. These customer deposits
would be long-term liabilities that result from customers paying money
to Mackenzie to manage for them (similar to bank deposits). The
investing section includes payment of selling commissions. As
Mackenzie is involved in investment and fund management, these
selling commissions appear to be long-term liabilities that Mackenzie
owes to brokers and other agents who sell Mackenzie products. Also
under investing there is a decrease (increase) in loans. On the cash
flow statements illustrated in the chapter, loans would normally be
included under financing activities. The loans referred to here are not
loans that Mackenzie owes to outside lenders. Rather these are loans
that customers owe to them. They are assets and therefore are
classified correctly as investing activities.
5.43
a) The company is able to meet its need for cash over the last three years
through positive cash flows from operations. This cash has been used
to invest in property, plant, and equipment, to buy share investments
and to pay dividends. In addition, Volvo obtained cash through
increasing long-term loans in the amount of 3,404 krona in 1997.
Non-continuing items include the redemption of shares in the amount
of $5,807 that occurred in 1997.
b) To understand the financial health of Volvo Group Inc., further
explanation or explanation should be obtained for the nature of the
share investments that Volvo has made in each of the last three years,
and the reason for the increase in debt financing and decrease in
equity financing that occurred during 1997.
c) The ability of Volvo to generate cash from operations over the last
three years is evident from the positive operating cash flows that
occurred each year. These cash inflows resulted mainly from stable
net income for each of the three years. Except for 1996, the cash from
operations exceeded the original net income amount.
36
d) The main differences between this cash flow statement from
Sweden and a typical cash flow statement from Canada include the
term liquid funds rather than cash or cash position, the fact that each
amount on the statement is denoted as being positive or negative, and
the use of multiple columns in the presentation of each year. The type
of items appearing under each of the three categories, operating,
financing and investing, are similar.
37
Beyond the Book
5.44
Answers to this question will depend on the company selected.
CASE
5.45
Atlantic Service Company
Although Atlantic’s net income increased from 2000 to 2001, it is in a very
poor cash position, with accounts receivable, inventory and accounts payable
increasing and a very large negative cash position. The cash problem
appears to come from two areas, the increase in current assets (accounts
receivable and inventories) and the very large purchases of equipment.
To overcome this cash difficulty, Atlantic can attempt to increase its cash
flow by trying to collect the accounts receivable and reducing the level of
inventories. It might also consider discontinuing dividend payment and
reassessing the need for such large investments in equipment. However, it is
likely that Atlantic should increase its long-term financing by issuing more
shares or by arranging for a long-term loan, perhaps secured by a mortgage
on its equipment.
In general, the cash generated by operations is not that unhealthy. It would
have been sufficient to put Atlantic into a positive cash flow if it had not
purchased equipment. A recommendation would be to finance large
purchases of equipment by long-term debt.
Critical Thinking
5.46
Many countries have issued standards requiring cash flow statements and
the IASC has issued a standard requiring a cash flow statement very similar
to the one required in Canada. The authors’ major argument is that the
definitions provided in these standards tend to conflict, as do the objectives
of the related statements of cash flows. Among the dimensions on which the
definitions differ include (see Table 1 in the paper): treatment of cash and
cash equivalents, treatment of equity securities as cash equivalents, specific
guidelines on maturity periods for cash equivalents, and cash flow statement
disclosures (presentations of items). For example, the definition of cash in
both the U.S. and Canada excludes an investment that matures in more than
three months from the time of purchase even though it will mature in less
than three months from the balance sheet date. In addition, the definition of
cash tends to be a function of the intended users of financial statements. In
the U.S., primary financial statements users are investors and creditors,
thus the definition of cash tends to be more simplistic than in countries such
as Canada, which define cash as cash and certain equivalents that are
managed as cash. Whereas short-term borrowings would not be included in
the former definition, the later “treasure’s” perspective would subtract such
borrowings to arrive at a net cash position.
38