anthonyIM_11

CHAPTER 11 THE STATEMENT OF CASH FLOWS Changes from Eleventh Edition Updated from the Eleventh Edition. Approach This is a topic that has always been difficult for students. The indirect method of developing the amount of cash flow from operating activities is particularly difficult. The hearings prior to FASB 95 indicated that the investment analyst community would press companies to continue using the indirect (reconciliation) method; the primary supporters of the direct method were bankers. Thus, it appears that students will not be well served in this subject area unless they gain an understanding of the indirect method. Since students were introduced to the difference between cash flows and accrual accounting’s revenues and expenses way back in Chapter 3, this should be reinforcement at this point, but it usually seems to be a new revelation to at least a subset of the class. For those who never succeed in fully understanding the rationale for the adjustments, Illustration 11-4 now gives them a rote approach to which they can revert. Cases Medieval Adventures Company is an armchair case intended to dramatize the difference between operating cash flow and income. Amerbran Company (A) illustrates preparation of the cash flow statement from the other two statements and supplemental information. Great Valu Variety Stores illustrates the potential drawback of defining funds as working capital, and the importance of considering cash flows in conjunction with income statements. The origins of the case, the W.T. Grant bankruptcy apparently influenced the FASB in changing the required definition of funds from working capital to cash. Problems Problem 11-1

2003 sales........................................................................................................................................................................... $8,743,000 Less: Change in accounts receivable.................................................................................................................................. (70,000) Cash generated from sales during 2003.............................................................................................................................. $8,673,000 Problem 11-2 a. Issuance of a 12-month note in return for $2 million cash is a financing source of cash. Use of $2 million cash to purchase equipment is an investment use of cash. b. Cash proceeds from the issuance of common stock is a financing source of cash. The use of cash to retire mortgage bonds is a financing use of cash. c. No cash effect. d. No cash effect. e. Cash proceeds from the sale of machinery is an investment source of cash. The above responses assume the direct method is used to present its cash flow of statement.

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Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Problem 11-3

Kids’n Caboodle Statement of Cash Flows

Cash received from customers.......................................................................................................................... $155,000 Cash used in operations.................................................................................................................................... (146,900) Cash from operations.................................................................................................................................... $8,100

Equipment........................................................................................................................................................ (10,500) Cash used for investments............................................................................................................................. (10,500)

Loan................................................................................................................................................................. 21,000 Cash from financing...................................................................................................................................... 21,000

Increase in cash............................................................................................................................................. $ 18,600 Problem 11-4

Net loss............................................................................................................................................................... $(11,000) Depreciation....................................................................................................................................................... 26,400 15,400 Accounts receivable (reduced)............................................................................................................................ 17,600 Accounts payable (increased)............................................................................................................................. 8,800 Accrued salaries (increased)............................................................................................................................... 3,300 Other accruals (increased).................................................................................................................................. 2,200

Cash flow from operations.................................................................................................................................. 47,300

Investments......................................................................................................................................................... 0

Long-term debt (reduced)................................................................................................................................... (29,700)

Change in cash................................................................................................................................................ 17,600 Beginning cash................................................................................................................................................ 4,400 Ending cash..................................................................................................................................................... $22,000 Problem 11-5

Operating Activities Cash received from customers......................................................................................................................... $62,100 Interest received.............................................................................................................................................. 345 Operating cash payments................................................................................................................................. (54,165) Interest payment.............................................................................................................................................. (1,035) Net cash provided by operations..................................................................................................................... 7,245

Investing Activities Sale of old machine......................................................................................................................................... 3,105 Down payment on new truck........................................................................................................................... (3,450)

Net cash used in investing activities................................................................................................................ (345)

Financing Activities Payment of debt............................................................................................................................................... (3,450)

Net cash used in financing activities............................................................................................................... (3,450)

Increase in cash............................................................................................................................................... 3,450 Beginning cash................................................................................................................................................ 3,450

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©2007 McGraw-Hill/Irwin

Chapter 11

Ending cash........................................................................................................................................ $ 6,900

Cases Case 11-1 Medieval Adventures Company* Note: This case is the same version that was in the Eleventh Edition. Approach This (obviously) is an armchair case, intended to show dramatically the difference between profit and cash flow from operations. The case has mechanistic patterns built into it to help students see what is going on: relatively rapid growth is causing cash to be tied up in receivables and inventories faster than it is regenerated from collections. Although the case may seem trivial (at least after the calculations have been made) because of these mechanistic patterns, in fact many businesses have had severe (sometimes fatal) financial crises because management did not anticipate the basic phenomenon that this case develops. The graph included herein can be used in class to help illustrate this phenomenon.

Medieval Adventures Company 600,000 500,000 Sales

400,000

Net Income Net Operating Cash Flow

300,000

Cash Balance w /o Loan Accounts Receivable

200,000 100,000 0 -100,000 Jan

Feb

March

April

May

June

July

Aug

Sep

Oct

Question 1 The required monthly statements are shown on the following pages. The peak need comes by the end of July, when a $40,000 loan would be needed to maintain a zero cash balance. In August, cash generated by operations finally turns positive, enabling partial repayments of the loan. October’s $27,500 cash generated by operations enables making the final $15,000 loan repayment and ending the month with a $12,500 cash balance. *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Question 2 This question is the key one in terms of student insight from this case. The company has been paying its costs currently, but allowing customers two months to pay. This, coupled with constant growth, causes large net operating outflows for several months, which collectively eat up the firm’s initial capital. It is important for students to understand why it is that this situation eventually turns around: the unit margin is $20 and the monthly nonproduction costs are fixed at $10,000; thus, the continued unit sales growth eventually (in August) causes the current inflows (from sales two months ago) to exceed the current outflows (production costs for next month’s sales plus $10,000). In other words, as the income statement shows, the firm is profitable, and eventually those profits get realized in cash. This need could have been avoided by projecting the cash flow figures that the students have developed after the fact. Then the company could have arranged the necessary line of credit. Banks are happy to provide such funds for companies that anticipate the need because that anticipation reflects good financial management. On the other hand, banks are hesitant to lend to a firm that has been taken by surprise by a cash shortage. Of course, a no-cost method to avoid the problem was also probably feasible. The company could have arranged credit with vendors to help finance the inventory, and could have been more aggressive in collecting from its customers in accord with the stated 30-day terms. If the company delayed its payments by 30 days and accelerated receivable collections from 60 to 30 days (thus shortening its “cash cycle” by 60 days), the operating cash flow would have turned positive in March and no cash crisis would have occurred. Question 3 The purpose of this question is to give students practice in deriving a cash flow statement from the income statement and balance sheets. Because of the work done in question 1, where cash flows were dealt with directly, students can gain some confidence in these derivation procedures before they apply the procedures in more complex and realistic cases. The statements are as follows (in somewhat simplified format, befitting this introductory problem):

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March May July Net income................................................................................................................................................................................................................... $30,000 $50,000 $70,000 Increase in accounts receivable.................................................................................................................................................................................... (55,000) (55,000) (55,000) Increase in inventory.................................................................................................................................................................................................... (17,500) (17,500) (17,500) Cash from operations................................................................................................................................................................................................... (42,500) (22,500) (2,500) Proceeds of debt........................................................................................................................................................................................................... -022,500 2,500 Cash increase (decrease).............................................................................................................................................................................................. (42,500) 0 0 Beginning of month cash balance................................................................................................................................................................................ 72,500 0 0 End of month cash balance........................................................................................................................................................................................... $30,000 $0 $0 OPERATING BUDGET Jan. Feb. Mar. Apr. May June July Aug. Sept. Sales............................................................................................................................................................................................................................. $55,000 $82,500 $110,000 $137,500 $165,000 $192,500 $220,000 $247,500 $275,000 Cost of Sales................................................................................................................................................................................................................. 35,000 52,500 70,000 87,500 105,000 122,500 140,000 157,500 175,000 Gross Margin................................................................................................................................................................................................................ 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 100,000 Other Expenses............................................................................................................................................................................................................. 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Net Income................................................................................................................................................................................................................... 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 CASH BUDGET Cash lnflows: Cash forwarded............................................................................................................................................................................................................ $146,250 $111,250 $ 72,500 $ 30,000 $-0$-0$-0$-0$-0Collections.................................................................................................................................................................................................................... 27,500 41,250 55,000 82,500 110,000 137,500 165,000 192,500 220,000 Loan from bank......................................................................................................................................................................................................... ------2,500 22,500 12,500 2,500 ----Total....................................................................................................................................................................................................................... $173,750 $152,500 $127,500 $115,000 $132,500 $150,000 $167,500 $192,500 $220,000 Cash Outflows: Costs & expenses......................................................................................................................................................................................................... $ 62,500 $ 80,000 $ 97,500 $115,000 $132,500 $150,000 $167,500 $185,000 $202,500 Loan payback............................................................................................................................................................................................................ --------------7,500 17,500 Cash balance......................................................................................................................................................................................................... $111,250 $ 72,500 $ 30,000 $0 $0 $0 $0 $0 $0 Memo: Net operating cash flow................................................................................................................................................................................................ $(35,000) $(38,750) $(42,500) $(32,500) $(22,500) $(12,500) $(2,500) $ 7,500 $ 17,500 Cash balance w/o loan.................................................................................................................................................................................................. $111,250 $ 72,500 $ 30,000 $ (2,500) $(25,000) $(37,500) $(40,000) $(32,500) $(15,000)

Oct. $302,500 192,500 110,000 10,000 100,000

$-0247,500 --$247,500 $220,000 15,000 $ 12,500 $ 27,500 $ 12,500

Accounting: Text and Cases 12e – Instructor’s Manual

Dec. 31st

Jan. 31st

Anthony/Hawkins/Merchant

Feb. 28th

BALANCE SHEET Mar Apr. 31st 30th

May 31st

June 30th

July 31st

Aug. 31st

Sept. 30th

0ct. 31st

Assets: Cash........................................................................................................................................................................................................................... $146,250 $111,250 $ 72,500 $ 30,000 $0 $0 $0 $0 $0 Accounts Receivable................................................................................................................................................................................................. 68,750 96,250 137,500 192,500 247,500 302,500 357,500 412,500 467,500 Inventory................................................................................................................................................................................................................... 35,000 52,500 70,000 87,500 105,000 122,500 140,000 157,500 175,000 Total....................................................................................................................................................................................................................... $250,000 $260,000 $280,000 $310,000 $352,500 $425,000 $497,500 $570,000 $642,500

$0 522,500 192,500 $715,000

$ 12,500 577,500 210,000 $800,000

Liabilities and Equity: Note Payable............................................................................................................................................................................................................. $ --$ --$ --$ --$ 2,500 $ 25,000 $ 37,500 $ 40,000 $ 32,500 Common Stock.......................................................................................................................................................................................................... 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 Retained Earnings..................................................................................................................................................................................................... _______ 10,000 30,000 60,000 100,000 150,000 210,000 280,000 360,000 Total........................................................................................................................................................................................................................... $250,000 $260,000 $280,000 $310,000 $352,500 $425,000 $497,500 $570,000 $642,500

$ 15,000 250,000 450,000 $715,000

$ --250,000 550,000 $800,000

©2007 McGraw-Hill/Irwin

Chapter 11

Case 11-2 Amerbran Company (A)* Note: This case is unchanged from the Eleventh Edition. Approach This case is based on actual financial statements of American Brands, Inc. Although the numbers have been changed from those reported, the magnitudes and relationships have been preserved. This case provides additional practice in preparing a statement of cash flows. Since specific information is not given on cash collections and operating disbursements, it is expected that students will use the indirect approach in developing the cash generated by operations amount. The statements in Exhibit I also provide the raw data for the (B) case, which is a ratio analysis case that appears in Chapter 13. Answer to Question The required cash flow statement appears below. The explanatory notes to the statement are as follows: Note 1 This is the net of the following components:

Increase in accounts receivable ....................................................................................................................... $(68,827) Increase in inventories ..................................................................................................................................... (19,510) Decrease in prepaid expenses .......................................................................................................................... 1,027 Increase in accounts payable ........................................................................................................................... 33,075 Increase in accrued expenses payable ............................................................................................................. 194,728 $ 140,493 Note 2. The two components of this acquisition, as given in the case, could be shown separately. Note 3. The decrease in long-term debt is less than the decrease in long-term liabilities because the latter also includes deferred taxes. Note 4. Lacking specific information to the contrary, it is assumed that reissuance of treasury stock for bonuses generated no cash. The stock dividend was, in effect, a 2-for-1 stock split. The only difference is that if it were a stock split, the total shown for common stock at par would have remained $161,417 rather than doubling to $322,834. Note 5. The three major categories of cash flows generated a net of $11,785 of cash. Since the increase to be explained is only $4,960, “miscellaneous activities” must have used $6,825 of cash. Some students may include this line in operating activities, rather than as a fourth category; if they do, the net cash flow from operations becomes $567,303.

AMERBRAN COMPANY Statement of Cash Flows For the year ended December 31, 20x1 (in thousands) Net cash flow from operating activities: Net income...................................................................................................................................................................... $328,773 Noncash items included in income: Depreciation and amortization..................................................................................................................................... 115,974 Deferred taxes.............................................................................................................................................................. (17,548) *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Net change in receivables, inventories, and payables (Note 1)................................................................................................ 140,493 Write-off of obsolete equipment............................................................................................................................................... 66,046 Income from subsidiary............................................................................................................................................................ (59,610) Net cash flow from operating activities....................................................................................................................................... (574,128) Cash flows from investing activities: Acquisitions of property, plant, and equipment........................................................................................................................... (260,075) Proceeds from disposals............................................................................................................................................................... 33,162 Acquisition of Company X (Note 2)............................................................................................................................................ (133,721) Net cash used by investing activities........................................................................................................................................ (360,634) Cash flows from financing activities: Increase in short-term debt........................................................................................................................................................... 79,664 Decrease in long-term debt (Note 3)............................................................................................................................................ (34,606) Dividends paid............................................................................................................................................................................. (216,158) Purchase of treasury stock (Note 4)............................................................................................................................................. (30,609) Net cash used by financing activities........................................................................................................................................ (201,709) Cash flows from miscellaneous activities (Note 5)......................................................................................................................... (6,825) Net increase in cash......................................................................................................................................................................... 4,960 Cash at beginning of year................................................................................................................................................................ 23,952 Cash at end of year.......................................................................................................................................................................... $ 28,912

Case 11-3: Great Value Variety Stores* Note: A new case for the Twelfth Edition. Approach The premise motivative to case is that traditional ratio analysis and the definition of funds as working capital used in many finance classes may not reveal a company’s liquidity crisis as early as would a careful analysis of the firm’s cash flows. This case requires two class sessions. Trying to use it for only one session is likely to result in student confusion and frustration unless the instructor provides handouts before class with all of the ratio analysis and conversion of working capital flow to cash flow calculations done for the students. My two-day approach involves six steps: (l) Calculate the ratios for just one year, being sure the students understand what each ratio indicates (a few ratios have not yet been formally presented in the text, but students seem to catch on to them quickly). (2) Use a transparency spreadsheet with all of the ratios for all of the years, and discuss trends. (3) Discuss the working capital concepts of funds and how it differs from the cash concept. (4) Do the conversion from working capital to cash for at least one year. (5) Use a transparency to compare net income, working capital, and cash flow generated by operations, as well as financing and investing activities, for the 10-year period. (6) Give a brief “post mortem” along the lines mentioned below. Note the year 2007 is included in these handouts, the instructor may not want to show 2007 letting the students predict what 2007 may look like.

*

This teaching note was prepared by James S. Reece. Copyright © James S. Reece.

Question 1

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©2007 McGraw-Hill/Irwin

Chapter 11

Ratios are shown in Exhibit A. Graphs of groups of related ratios are also shown below. Although the case calls for calculation for days’ receivables, in the accompanying graph of turnover ratios that ratio has been converted to receivables turnover, so it could readily be graphed using the same scale as for inventory and asset turnover. (Receivables turnover is simply 365 divided by days’ receivables.) It should be noted that profitability ratios were gradually declining through FY2005, but the “big fall” did not start until 1963. Similarly, turnover ratios were gradually deteriorating (the improvement in 2007 is deceptive primarily the result of crisis management). Liquidity declined over the decade and solvency ratios also began to deteriorate in 2001. Question 2. The primary cause of student problems in answering Question 2 is that the changes in working capital components at the bottom of the statement of changes in financial position have the opposite signs from those needed for question 2. For example, an increase in inventory causes an increase in working capital, and thus is shown as a positive amount in the bottom section of the SCFP; but an inventory increase is a use of cash that must be subtracted in making the adjustments called for in question 2. I warn the students of this complication on the assignment sheet. This is, of course, an ideal case for use of a spreadsheet; the instructor may wish to make the data in Exhibits 1 and 2 available to the student as spreadsheet files to facilitate all of their calculations. The results of these calculations are graphed below, along with net income and working capital generated by operations. This graph vividly demonstrates the premise: a cash flow analysis would have revealed Big Value’s developing problem two or three years sooner than either net income or working capital generated by operations signaled it. Indeed, over the decade, Big Value had positive operating cash flow in only three years. The $100 million borrowings in 2004 and 2006 were needed to compensate for the lack of cash generated by operations, as receivables and inventories ballooned. Post Mortem This is a disguised case based on the W.T. Giant bankruptcy. The above analysis shows that net income was relatively flat through FY2005, yet sales doubled over the period. Nevertheless, the year-end FY2005 stock price was double that of year-end FY1998. Until 2006, Big Value’s p/e ratio (20) exceeded that of similar variety chains. The company was showing increased sales and had paid dividends since 1906; apparently this overwhelmed the fact that the growth was profitless. Big Value filed for Chapter XI bankruptcy on October shortly after the case and was liquidated soon thereafter.

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EXHIBIT A Big Value Variety Stores 1998 1999 2000 2001 2002 2003 2004 2005 2006 Selected Ratios Profit Margin........................................................................................................................................................................................ 0.038 0.034 0.034 0.035 0.035 0.029 0.023 0.021 0.006 Return on equity................................................................................................................................................................................... 0.164 0.149 0.137 0.136 0.144 0.131 0.106 0.116 0.037 Return on assets................................................................................................................................................................................... 0.078 0.062 0.060 0.061 0.059 0.049 0.036 0.034 0.009 Days’ receivables................................................................................................................................................................................. 75.2 91.3 101.5 104.2 111.0 104.3 108.4 104.0 106.7 Inventory turnover................................................................................................................................................................................ 3.82 3.62 3.65 3.55 3.68 3.24 3.12 2.82 2.85 Asset turnover...................................................................................................................................................................................... 2.07 1.80 1.78 1.76 1.71 1.68 1.57 1.59 1.55 Current ratio......................................................................................................................................................................................... 2.61 2.05 2.06 1.93 1.71 1.56 1.75 1.53 1.58 Quick ratio........................................................................................................................................................................................... 1.47 1.23 1.26 1.19 1.09 0.93 1.05 0.85 0.89 Total Liability Equity........................................................................................................................................................................... 1.113 1.415 1.292 1.221 1.431 1.695 1.947 2.423 3.054 Debt Capitalization............................................................................................................................................................................... 0.267 0.248 0.206 0.134 0.109 0.104 0.302 0.295 0.428

2007 -0.101 -1.557 -0.164 89.3 3.20 1.63 1.23 0.68 8.502 0.655

EXHIBIT B Big Value Variety Stores 1990 1999 2000 2001 2002 2003 2004 2005 2006 Cash Flow From Operations Working capital from operations.......................................................................................................................................................... 38.8 39.2 40.3 45.4 49.2 43.6 40.4 45.3 23.1 Accounts receivable decrease (increase).............................................................................................................................................. (53.7) (57.3) (42.1) (40.3) (55.5) 9.9 (49.9) (60.3) (72.2) Inventory decrease (increase)............................................................................................................................................................... (10.6) (23.2) (9.1) (24.9) (13.5) (38.4) (38.2) (100.8) (51.1) Other current assets decrease(increase)................................................................................................................................................ 0.0 (4.2) 0.2 (0.4) (0.6) (0.3) 0.0 (1.4) (0.6) Accounts payable increase (decrease).................................................................................................................................................. (2.5) (1.4) 6.2 15.6 7.5 9.8 14.0 (15.9) (2.8) Other current liabilities increase (decrease).......................................................................................................................................... 17.6 26.3 9.4 15.4 9.9 (17.8) 6.9 18.8 l0.4 Cash flow from operations................................................................................................................................................................... (10.4) (20.6) 4.9 10.8 (3.0) 6.8 (26.8) (114.3) (93.2) Note: 2007 figures are not in the case.

2007 (179.7) 109.6 43.2 0.7 (8.1) (51.0) (85.3)

©2007 McGraw-Hill/Irwin

Chapter 11

Profitability Ratios 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1 -1.1 -1.2 -1.3 -1.4 -1.5 -1.6 1998

1999

2000

2001

2002

Profit Margin

2003

2004

2005

ROE

2006

2007

ROA

Turnover Ratios 5 4.8 4.6 4.4 4.2 4 3.8 3.6 3.4 3.2 3 2.8 2.6 2.4 2.2 2 1.8 1.6 1.4 1998

1999

2000

2001

2002

Rcvbis

2003 Invent

11

2004

2005

2006 Assets

2007

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Liquidity Ratios 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 0.7 0.6 1998

1999

2000

2001

2002

2003

2004

2005

Current Ratio

2006

2007

2006

2007

Quick Ratio

Solvency Ratios 9 8 7 6 5 4 3 2 1 0 1998

1999

2000

2001

2002

Liab/Equity

2003

2004

2005

Debt/Capital

12

©2007 McGraw-Hill/Irwin

Chapter 11

Income and Funds Flows 60 40 20 0 -20 -40 -60 -80 -100 -120 -140 -160 -180 1998

1999

2000

Net Income

2001

2002

2003

Opns Wkg Cap

13

2004

2005

2006

Opns Cash

2007