Exercise 1: Depreciation as a Source of Cash

An economics book has the following statement: “For the business firm there are typically, three major sources of funds. Two of these, depreciation reserves and retained earnings, are internal. The third is external, consisting of funds obtained either by borrowing, or by the sale of new equities.”

Required:(a) Is depreciation a source of cash?(b) If depreciation is not a source of cash, what might explain the belief by some

that depreciation is a source of cash?(c) If depreciation is a source of cash, explain the manner in which depreciation

provides cash to the business.

Answer:(a) Depreciation is neither a source nor a use of cash. Instead, depreciation is

an allocation of the cost of an asset over its useful life.(b) A major cause of the belief that depreciation is a source of cash is the "add

back" presentation in the SCF prepared using the indirect format. This presentation adds depreciation to net income and gives the erroneous impression that it increases cash from operations.

(c) There is one sense in which depreciation is a source of cash, and for this reason we must not overemphasize the idea that depreciation is not a source of cash. Namely, when selling prices are sufficient to recover the depreciation expense allocated to products sold, then revenues do provide management with a discretionary, even if temporary, inflow of cash (assuming no significant change in operating working capital). Normally, management will have to invest this cash in fixed assets replacements to continue in business on a long-term basis. However, in the event of a financial crisis or cash shortfall, management has the option of diverting such cash to uses that will avert a liquidity crisis. This is the one exception that may allow one to regard depreciation as a temporary “source of cash.”

Exercise 2: Linking Operating Cash Flows with Earnings Quality

In reviewing the financial statements of NanoTech Company, you discover that net income increased while operating cash flows decreased for the most recent two consecutive years.

Required:(a) Explain how net income could increase for NanoTech while its operating

cash flows decrease. Your answer should include three illustrative examples.

(b) Describe how operating cash flows can serve as one indicator of earnings quality.

Answer:(a) Revenues are, in certain instances, recognized before cash is received (that

is, when earned). Expenses are, in certain instances, recognized after cash is paid (that is, matched with revenues). As a result, net income can be positive when operating cash flows are negative. Consider some examples: (1) If accounts receivable increase substantially during the year, this implies that revenues outpaced cash collections. (2) If a company builds up its inventory levels substantially, then cash is paid out but no expense is recognized. (3) If the company reduces its accounts payable balances substantially during the year, then cash flows can be negative when net income is positive.

(b) Operating cash flows can serve as one indicator of earnings quality because over a number of years, cash flows should approximate earnings. If cash flows from operations are consistently lower than earnings, it is possible that the reported earnings are not of high quality. (As with any broad guideline, one must look for corroborating evidence.)

Managing Cash Flows: One of management’s most basic responsibilities is to ensure that the business has enough cash t meet its obligations as they come due.

Budgeting: The Primary Cash Management Tool

The primary tool used by management to anticipate and shape future cash flows is a cash budget. A cash budget is a forecast of future cash receipts and payments. Cash budget is not a financial statement and is not distributed to people outside of the organization.

In many ways, a cash budget is similar to a statement of cash flows. However, the cash budget shows the results expected in future periods, rather than those achieved in the past. Also, CB is more detailed, usually showing expected cash flows month-by-month and separately for every department within the organization.

Problem 3: Preparing a Cash Budget

Garden Depot is a retailer that is preparing its budget for the upcoming fiscal year. Management has prepared the following summary of its budgeted cash flows:

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Total cash receipts $180,000 330,000 210,000 230,000Total cash disbursements $260,000 230,000 220,000 240,000

The company’s beginning cash balance for the upcoming fiscal year will be $20,000. The company requires a minimum cash balance of $10,000 and may borrow any amount needed from a local bank at an annual interest rate of 12%. The company may borrow any amount at the beginning of any quarter and may repay its loans, or any part of its loans, at the end of any quarter. Interest payments are due on any principal at the time it is repaid.

Required: Prepare the company’s cash budget for the upcoming fiscal.

Answer:Garden Depot Cash Budget

1st Q 2nd Q 3rd Q 4th Q Bal. Beg. $20,000 $10,000 $35,800   25,800Cash Receipts   180,000   330,000   210,000   230,000  

Total cash available 200,000 340,000 245,800 255,800Less cash disb’ts 260,000   230,000   220,000   240,000   Excess (deficiency) (60,000)  110,000       25,800       15,800       Financing:Borrowings (beg) 70,000Repayment (at end) (70,000)Interest*                     (4,200 )                                                      Total financing 70,000 (74,200)                                                      Cash bal. End $10,000 $35,800 $25,800 $15,800

*Interest: $70,000 x 12% x 2/4 = $4,200

What Priority Should Managers Give to Increasing Net Cash Flows?

Creditors and investors look to a company’s cash flows to protect their investment and provide future returns. Trends in key cash flows (such as from operations and

free cash flows) affect a company’s credit rating, stock price, and access to additional investment capital. For these reasons, management is under constant pressure to improve the key measures of cash flow. Unfortunately, the pressure to report higher cash flows in the current period may conflict with manager’s long-run responsibilities.

Short-Term Results versus Long-Term Growth:

Often, short-term operating results can be improved at the expense of long-term growth. For example, reducing R&D expenditures for developing new products will increase earnings and net cash flows in the current period. But over time, this strategy may reduce the company’s competitiveness and long-term profitability.

One-Time Boosts to Cash Flows:

Some strategies can increase the net cash flows of the current period, but without having much effect on future cash flows. Two examples of such strategies include collecting accounts receivables more quickly and reducing size of inventory. Shortening the collection period from 60 to 30 days, for example, provided only a one-time boost in cash receipts. A similar one-time boost may be achieved by reducing the size of inventory. This reduces the need for purchasing merchandise, but only while inventory levels are falling.

Some Strategies for Permanent Improvements in Cash Flow

Several strategies may improve cash flows in both the short-term and long-term. These are deferring income taxes, peak pricing, and developing an effective product mix.

Deferring Income Taxes: Deferring income taxes means using accounting methods for income tax purposes that legally postpone the payment of income taxes. An example is using an Accelerated depreciation method for income tax purposes. The Modified Accelerated Cost Recovery System (MACRS) is an accelerated method widely used for income tax purposes.

Deferring taxes may benefit a growing business every year. The reason a growing business can benefit from deferred taxes every year is that each year it defers a greater amount than comes due from the past. Thus, it is an effective and popular cash management strategy.

Peak Pricing: Some businesses have more customers than they can handle—at least at certain times of the day or year. Examples include popular restaurants, resort hotels, telephone companies, and electricity supply companies.

Peak pricing is a strategy of using sales prices both to increase revenue and to ration goods and services when total demand exceeds supply (or capacity). A higher price

is charged during the peak periods of customer demand and a lower price during off-peak periods.

Peak pricing has two related goals. First, it increases the seller’s revenue during the periods of greatest demands. Second, it shifts some of the demand to off-peak periods, when the business is better able to service additional customers. Peak pricing may make goods and services available to customers who otherwise could not afford them. Peak pricing is not always appropriate: doctor/hospital to raise their prices during epidemics or natural disasters.

Develop an Effective Product Mix: Another tool for increasing revenue and cash receipts is the mix of products offered for sale. Dual purposes of an effective product-mix are to (1) increase total sales, and (2) increase gross margins.

Some products complement one another, meaning customer who buys one product often purchase the other. Examples include French fries at a hamburger restaurant, snacks at a movie theater, and a car wash connected to a gas station.

Ex. 7: Effects of Business Strategy

Indicate how you would expect the following strategies to affect the company’s net cash flows from operating activities (1) in the near future and (2) in later periods (after the strategy’s long-term effects have “taken hold”). Fully explain your reasoning.

a. A successful pharmaceutical company substantially reduces its expenditures for research and development (R&D).

b. A restaurant that previously sold only for cash adopts a policy of accepting bank credit cards, such as Visa and MasterCard.

c. A manufacturing company reduces by 50 percent the size of its inventories of raw materials (assume no change in inventory storage costs).

d. Through tax planning, a rapidly growing real estate developer is able to defer significant amounts of income taxes.

e. A rapidly growing software company announces that it will stop paying cash dividends for the foreseeable future and will instead distribute stock dividends.

Answer

a. (1) Expenditures for R&D are an operating activity. In the short term, reducing these expenditures will increase the net cash flow from operating activities.         

             (2) In the long run, reducing expenditures for R&D may reduce cash flows from

operations by reducing the number of new products the company brings to market.

                    b. Selling to customers using bank credit cards taps a new market of potential

customers. This should increase sales and cash receipts in both the short and long term.

            c. (1) Reducing inventory will lessen expenditures for inventory purchases during

the time that inventory levels decline. This will improve the net cash flow from operating activities in the near term.

                      (2) Once inventory has stabilized at the new and lower level, monthly

expenditures will become approximately equal to the inventory used. Thus, this strategy will not affect cash flows once inventory has stabilized.

                    d. (1) Deferring taxes can postpone taxes each year. For a growing business, this

can reduce annual cash outlays year after year. Thus, it can increase net cash flows over both the short and long terms.

                      (2) At some point in the future, the early deferrals will require payment, causing

the cash paid to stabilize, much like c. (2) above.         

FREE CASH FLOW:

Many analysts put a company’s cash flows into perspective by computing an amount called FREE CASH FLOW (FCF). FCF is intended to represent the cash flow available to management for discretionary purposes, after the company has met all of its basic obligations relating to business operations.

Different analysts compute this measure in different ways because there is no widespread agreement as to the basic obligations relating to business operations. For example, are all expenditures for plant assets “basic obligations,” or only those expenditures made to maintain the current level of productive capacity?

One common method of computing FCF is to deduct from the net cash flows from operating activities any net cash used (cash paid to acquire plant assets less proceeds from sale of plant assets) for investments in plant assets and any dividends paid. For example:

Net cash flows from operating activities $50,000Less: Net cash used for acquiring plant assets: 85,000(Cash paid to acquire plant assets 160,000 less Proceeds from sale of plant assets 75,000 = 85,000) Less: Dividends paid 40,000Free Cash Flow (75,000)

Ex. 6: Using a Statement of Cash Flow

Auto Supply Company’s 2007 statement of cash flows appears below. Study the statement and respond to the following questions:

 

a. What was the company’s “free” cash flow in 2007? b. What were the major sources and uses of cash from financing activities during

2007? Did the net effect of financing activities result in an increase or a decrease in cash during the year?

c. What happened to the total amount of cash and cash equivalents during the year? Assuming 2007 was a typical year, is the firm in a position to continue its dividend payments in the future? Explain.

d. Look at the reconciliation of net income to net cash provided by operating activities, and explain the following:

1. Net loss (gain) from the sale of marketable securities. 2. Increase in accounts receivable.

Answer:

Note: All dollar figures in the following calculations are in thousands.  

  a. Cash from operations ………………………………………………………………… $ 280      Expenditures for property and equipment …………………………………….. (30)     Dividends paid ………………………………………………………………………… (140)    Free cash flow …………………………………………………………………………. $ 110    b. The major sources and uses of cash from financing activities during 2001 were:        Source: …………………………………………………………………………… none  

    Use: Dividend paid ……………………………………………………………… $ 140  

    Use: Retirement of Debt …………………………………………………………… $ 150  

        290    Financing activities resulted in a decline in cash of $290 in 2007.    c. Cash and cash equivalents decreased by $5,000 during 2007, moving the cash balance from

$50,000 to $45,000. The company paid dividends of $140,000 in 2007, and appears to be in a relatively strong cash position should it decide to pay dividends in the future.

             d. (1) The gain on the sale of marketable securities represents a reclassification of this item from

the operating activities section of the statement of cash flows to the investing activities section of the statement of cash flows. If a gain is present, as in 2007, it is deducted to effectively remove the item from net income; if a loss has been present, it would have been added to effectively remove it from net income.

(2) The increase in accounts receivable represents credit sales which were not collectedin 2007. In the indirect method calculation, this item is a decrease in the amount ofcash provided by net income because the sale was recognized in determining netincome, but the cash was not received in 2007.

                         

FCF PROBLEM:

You are working for a stock market research firm and your boss focuses primarily on free cash flow and dividends in choosing stocks.

Your boss is interested in stocks where free cash flow equals at least 50% of cash flow from operations. He also wants dividends to be 25% or more of cash flow from operations. You are considering the following stocks: Home Depot Inc., Intel, Coca-Cola, Genentech, eBay, and Amazon. Your boss provides you with the following information (in millions $) and asks you to recommend which stocks are consistent with his investment criteria.

Company Cash Flow from Operations (CFO)

Net Capital Expenditures

Dividends

Home Depot 6,545 3,243 595Intel 9, 129 4,703 533Coca-Cola 5,456 725 2,166Genentech 1,237 322 ---eBay 252 54 ---Amazon 392 46 ---

He also tells you that a potential new client is going to be calling you this afternoon. This potential client is an elderly widow who is quite wealthy, and she is curious as to why the relative levels of free cash flow and dividends are important metrics. She also does not understand why all firms do not pay dividends. Your boss tells you to answer this prospective client’s questions.

Answer:

Based on the analysis below, none of these companies meet your boss's investment screens of free cash flow to cash flow from operations of 50% or more, and dividends to cash flow from operations of 25% or more. However, Coca-Cola is very close to meeting these two criteria. Coca-cola's free cash flow is 47% of its cash flow from operations and dividends of 40 % of cash flow from operations are paid.

In Millions $

Company

Cash Flow from

Operations (CFO)

Net CapitalExpenditures Dividends

Free Cash Flow (FCF)

FCF to CFO

%

Dividends to CFO

%

Home Depot $6,545 $3,243 $ 595 $2,707 0.41% 0.09%Intel 9,129 4,703 533 3,893 0.43 0.06

Coca-Cola 5,456 725 2,166 2,565 0.47 0.40Genentech 1,237 322 - 915 0.74 -

eBay 252 54 - 198 0.79 -Amazon 392 46 - 346 0.88 -

You tell the prospective client that the relative level of free cash flow (free cash flow to cash flow from operations) is an important metric because it provides a measure of a company's financial flexibility. A company with financial flexibility has the ability to quickly take advantage of business opportunities without having to tap outside financing (i.e., debt or issuing new equity). Unexpected opportunities include the opportunity to buy other companies, to expand into new markets, to introduce new products, and so on. A company with a high level of free cash flow to cash flow from operations also is better positioned to withstand an economic downturn.

The relative level of dividends is an important metric for two reasons. First, by paying a current period dividend, investors receive an immediate and tangible return on their investment in the company's stock. Over long periods of time, dividend payouts have been an important source of stock market returns. The recent reduction in the tax rate applicable to dividends (reduced to 15 percent) should make dividends increasingly attractive to investors. Second, companies that generate substantial cash flows from operations but that don't pay dividends can often put these excess cash flows to unproductive uses, particularly if the company operates in a slow-growth industry. Companies that generate substantial cash flows from operations and that don't pay dividends can waste shareholder funds through ill-conceived acquisitions of other businesses, by paying excess compensation to company employees, and by consuming excess perquisites (e.g., company airplanes, lavish Christmas parties, "trophy" office buildings). Paying dividends imposes a discipline on management, reducing the risk that cash flow will be spent unwisely.

Finally, you tell the prospective client that young, rapidly growing firms typically do not pay dividends (e.g., Genentech, eBay, and Amazon). These firms believe that cash flows from operations are best reinvested in the business to help fund future growth initiatives. The funding of future growth initiatives might involve building additional

productive capacity, investing in research and development activities, investing in marketing campaigns to build market share, investing in the company's infrastructure (e.g., computer systems, distribution systems), and building a cash cushion to help the company weather any economic downturns. In essence, companies that reinvest earnings believe that they can earn a higher return on the reinvested funds than stockholders could earn on the cash that they would have to reinvest if the company's earnings were returned to them in the form of dividends.

Ex. 4: Cash Flow Statement--Indirect Method

The following data are taken from the income statement and balance sheet of Keaner Machinery, Inc.:

Required: Using this information, prepare a partial statement of cash flows for the year ended December 31, 2007, showing the computation of net cash flows from operating activities by the indirect method.

Answer:

KEANER MACHINERY, INC.Partial Statement of Cash Flows

For the Year Ended December 31, 2007Cash flows from operating activities:  Net income………………………………………………………………….     $385,000   Add: Depreciation expense ……………………………………….. $125,000        Amortization of intangible assets ………………………………… 40,000        Nonoperating loss on sale of investments ……. 35,000        Decrease in accounts receivable …………………………………. 45,000        Decrease in inventory …………………………………………….. 72,000        Increase in accrued expenses payable …………………………….. 25,000   342,000   Subtotal ……………………………………………………………………..     727,000   Less: Nonoperating gain on sale of plant assets……………………….. $90,000        Increase in prepaid expenses ………………………………………. $12,000        Decrease in accounts payable …………………………………….. 31,000  

133,000   Net cash flow from operating activities ………………………………….     $ 594,000

Ex. 5: Using a Statement of Cash Flow

Wallace Company’s statement of cash flows for the current year is summarized as follows:

Required:a. Briefly explain what is included in each of the first three categories listed (i.e., the

cash from operating, investing, and financing activities categories). b. Based on the limited information presented above, describe the company’s change in

cash position during the year and your interpretation of the strength of the company’s current (end-of-year) cash position.

Answer:

a. The operating activities section generally includes the cash provided by and used for those transactions that are included in the determination of net income. The investing activities section includes cash provided by and used for the purchase and disposal of assets that are not held for resale, primarily investments, and plant and intangible assets. Financing activities generally include cash provided by and used for debt and equity financing transactions.

   

   

   

  b. Wallace Company's cash increased significantly in 2007, going from $75,000 to $243,000. Operations were strong, providing $200,000 of positive cash flow. Based on the limited information provided, interpreting the use of $120,000 for investing activities is difficult, but one possible positive interpretation is that the company is preparing for the future by acquiring additional plant and other assets that will be required. The increase in cash of $88,000 from financing activities indicates that the company is expanding its financing in some ways, probably some combination of selling bonds or other debt securities and selling common, preferred, or treasury stock. While the limited information presented makes substantive interpretation of the overall cash picture highly speculative, it is clear that the company has a much larger cash balance at the end than at the beginning of the year and that the increase is tied directly to its success in generating cash from its ongoing, normal operations.

   

   

   

   

Ex. 8: Cash Flow from Investing Activities

Wofford Company provides the following information related to its investing and financing activities for the current year:

1. Calculate the net amount of cash provided by or used for investing activities for the year.

2. What impact, if any, do the following facts have on your calculation? (1) Equipment was sold at a loss, and (2) land was sold at a gain.

3. Briefly explain your decision to exclude any of the items listed above if they were not included in your calculation in part a.

Answer:a. Cash provided by investing activities:

    Sale of equipment  $ 156,000   Sale of land   160,000

316,000   Less: Purchase of equipment     (178,000)

138,000 

  b. The amount of gain or loss is reflected in the cash receipts figure. For example, equipment that was sold for $156,000 at a $34,000 loss had a book value (cost, less accumulated depreciation) at the time of sale of $190,000:

                 Cost, less accumulated depreciation   $190,000        Cash received from sale   (156,000)       Loss on sale   $ 34,000      Similarly, land that was sold for $160,000 and which resulted in a $50,000 gain had a

cost of $110,000: 

      Cash received from sale   $ 160,000        Cost   (100,000)      Gain on sale   $50,000    Using the amount of cash received in the calculation of cash provided by investing

activities automatically incorporates the gain or loss on the sale. 

     c. The following items were excluded because they are financing activities, not

investing activities: 

         ● Cash receipts from sale of common stock            ● Cash payments to purchase treasury stock, retire debt, and pay dividends on

preferred and common stock 

       

Ex. 9: Cash Flow Provided by Financing Activities

Shepherd Industries had the following cash flows by major categories during the current year:

a. Calculate the net amount of cash provided by or used for financing activities for the year.

b. Briefly justify why you excluded any of the above items in your calculation in part a.

c. Briefly explain your treatment of interest expense in your calculation in part a.

Answer:a. Cash      

    Sale of bonds   $400,000  Sale of treasury stock   34,000  Dividends on common stock   (60,000)Purchase of treasury stock   (20,000)

    Net cash provided by financing activities     $354,000   b. The following items were excluded from the above calculations because they are

classified as indicated below in the statement of cash flows: 

         Classified as operating activities:          ● Cash received from customers            ● Cash received from interest & dividends received            ● Cash paid to employees            ● Cash paid to purchase inventory            ● Cash paid for interest expense            Classified as investing activities:          ● Cash received from sale of equipment          c. While an argument could be made that interest expense should be classified as a

financing activity in the statement of cash flows, the Financial Accounting Standards Board has ruled that interest expense should be in the operating activities category. The primary justification for this classification is that interest expense is an ordinary

 

cost of doing business and is included in the determination of net income.