Part 2
Adjusting Net Income to Cash Flow from Operating Activities
Items to Add Items to Subtract
a. Noncash expenses Noncash revenues
Teamwork in Action (Concluded)
Part 3
Explanation: Sales reflects what is earned during the period. If Accounts
b. Cash paid for inventory requires a two-step computation.
(1) Purchases = Cost of goods sold + Increase in inventory, or, –
Explanation for (1): If inventory increases, the entity bought more than
Explanation for (2): If Accounts Payable decreases, the entity paid for
c. Cash paid for wages and operating expenses = Wages and other
Explanation: If prepaid expenses increase, the entity paid for more than
was incurred, so we add it. If prepaid expenses decrease, the entity paid
Explanation: If the related payable decreases, the entity paid for more
Entrepreneurial Decision — BTN 16-7
1. It is common that small businesses must pay cash in advance for items
such as rent, advertising, supplies, and facilities expansion. Consequently,
2. As a privately owned company, it can potentially raise cash financing for
expansion by selling shares in the company or by borrowing money. The
Entrepreneurial Decision — BTN 16-8
Memorandum
To: Jenna and Matt Wilder
From: Your name
Subject: Performance evaluation of Mountain High
Date: Current Date
I have completed my evaluation of your company, Mountain High. My
conclusion is that Mountain High is performing well. This is in spite of its
reported net loss and its negative net cash flow, which I explain in this
memorandum.
First, with respect to the net loss, please note that it includes an $85,000
extraordinary loss. Absent this extraordinary loss, Mountain High would report
a $75,000 net income. Using year-end total assets, Mountain High’s return on
assets would be roughly 9.4% (computed as $75,000 divided by $800,000).
This return is reasonable for a company in its second year of operations.
Second, with respect to its net cash outflow of $(5,000), please note that this is
mainly due to Mountain High’s renovation and expansion activities. This is
reflected in its summarized statement of cash flows. Specifically, its cash
flows provided by operating activities are an impressive $295,000. Again,
using year-end total assets of $800,000, Mountain High’s operating cash flow
on total assets ratio is roughly 36.9%. This return is especially good for a
company’s second year of operations.
Consequently, my evaluation is positive. Operating cash flows are very good
and attention should be directed at maintaining or increasing these amounts.
Also, income from continuing operations is a reasonable $75,000. Still, given
the high operating cash flows relative to income from continuing operations,
special scrutiny should be directed at identifying and assessing differences
between cash flow and accrual amounts for important individual operating
activities.
Hitting the Road — BTN 16-9
1. The Motley Fool’s Website defines cash flow as earnings before
interest, taxes, depreciation, and amortization (EBITDA). The school’s
justification for this definition includes: “Interest income and expense, as
well as taxes, are all tossed aside because cash flow is designed to focus on the
2. Some analysts tend to focus on this particular earnings definition
(earnings before interest and taxes or EBIT) as it purportedly allows a
3. Answer depends on the links visited and chosen for the report.
Global Decision — BTN 16-10
1. Samsung’s cash flow on total assets ratio follows (in KRW millions):
Current Year = Operating cash flows / Average total assets
Prior Year = Operating cash flows / Average total assets
2. For the current and prior years, Samsung’s ratios (23.6% and 22.5%,
