3-1
in whole or in part.
CHAPTER 3
INCOME FLOWS VERSUS CASH FLOWS:
UNDERSTANDING THE STATEMENT OF CASH FLOWS
3.1 Need for a Statement of Cash Flows. The amount of revenue recognized equals
the amount of cash the firm expects to collect from customers. However, the firm
does not necessarily recognize the revenue at the time it receives the cash. It typi-
cally recognizes revenue at the time of sale even though it has not yet collected cash
from customers. Likewise, the amount of expense recognized equals the cash dis-
bursement made for equipment, materials, labor, and so on. However, the firm
recognizes the expense when it consumes the services of these factor inputs, not
when it makes the cash expenditure. Thus, accrual accounting ignores the timing of
cash flows related to revenues and expenses, creating the need for a financial state-
ment that reports how revenues and expenses affect cash flows. Furthermore, the
income statement typically reports only a portion of the effects of investing and
financing each period. Depreciation expense is the portion of the cost of depreciable
assets allocated to the period. Interest expense is the portion of the cost of debt fi-
nancing allocated to the period. Reported amounts of depreciation for any particular
period usually do not equal the cash flows associated with acquisitions and sales of
depreciable assets during the period. Likewise, reported amounts of interest for any
period do not equal the cash flows associated with increases and decreases in debt
financing. Thus, the need arises for a separate financial statement that reports how
investing and financing activities affect cash flows beyond any affect on accrual-
based net income.
3.2 Articulation of the Statement of Cash Flows with Other Financial Statements.
The statement of cash flows begins with net income (for firms using the indirect
method, which includes most firms), and net income is the summary bottom-line
performance measure from the income statement. The statement of cash flows cul-
minates with computed net change in cash and cash equivalents, which reconciles
with the beginning and ending balances of cash and cash equivalents on the balance
sheet. The balance sheet and income statement are linked through retained earnings,
which increases with net income (from the income statement).
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-2
in whole or in part.
3.3 Classification of Interest Expense. For many users, the explanation for why inter-
est expense is classified as an operating activity under U.S. GAAP is hard to under-
stand because it is clearly a cost of financing. In fact, of the seven members of the
FASB, three dissented to the requirement to include interest expense in operating
activities, arguing that costs of financing are a financing activity. Nevertheless, the
classification in the statement of cash flows parallels that in the income statement,
where interest on debt is an expense but payments on the principal amount of the
debt are not an expense, but a reduction in a liability. The overarching rule seems to
be that “if it’s in the income statement, it is operating.” The FASB considered the
classification of interest expense as a financing activity, but ultimately concluded
that “This Statement does, however, require that the amount of interest paid during
a period (net of amounts capitalized) be disclosed, which will permit users of finan-
cial statements who wish to consider interest paid as a financing cash outflow to do
so” (para. 90 of SFAS No. 95). Note that IFRS permits companies to classify inter-
est expense as an operating or financing activity so long as the treatment is consis-
tently followed.
3.4 Classification of Cash Flows Related to the Cost of Financing. As in Question
3.3, many users disagree with the classification of interest expense as an operating
activity under U.S. GAAP. Nevertheless, the classification in the statement of cash
flows parallels that in the income statement, where interest on debt is an expense
but dividends are a distribution of earnings, not an expense. The overarching rule in
U.S. GAAP seems to be that “if it’s in the income statement, it is operating.” How-
ever, IFRS permits companies to classify costs of financing as operating or financ-
ing so long as the treatment is consistently followed.
3.5 Classification of Changes in Short-Term Financing. Firms generally use ac-
counts payable directly in financing purchases of inventory and other operating
costs. One can view accounts payable as financing obtained from vendors. Indeed,
terms are often stipulated in vendor transactions such as “2/10, net 45,” which indi-
cates that the buyer may deduct 2% if the bill is paid within 10 days, but the full
amount is due within 45 days. The 2% discount, if not taken, is equivalent to an in-
terest charge on the amount financed by the vendor. However, the argument for
treating accounts payable and short-term financing separately is as follows: Firms
might use short-term bank financing indirectly in financing accounts receivable, in-
ventories, or operating costs or use it to finance acquisitions of noncurrent assets or
reductions in long-term financing. Thus, the link between short-term bank financing
and operations is less direct than vendor-provided financing and may not even re-
late to operating activities. To achieve consistency in classification, the FASB stipu-
lates that changes in short-term bank loans are financing activities. Of course, an
analyst can easily prepare pro forma statements of cash flow, where amounts are
reclassified.
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-3
in whole or in part.
taxable income. Second, this cash inflow, in the form of cash taxes avoided, needs
to show within operating cash flows. This is effectively accomplished when the de-
ferred tax asset associated with stock options declines. Third, a special exception
requires that excess tax benefits (i.e., the amount of the deduction minus the amount
3.7 Treatment of Non-Cash Exchanges. This is an investing and financing transaction
whose disclosure helps the statement user understand why property, plant, and
equipment and long-term debt changed during the period. This transaction also as-
sists the user in understanding how cash management interacts with asset purchases.
3.8 Computing Cash Collections from Customers. (amounts in millions)
Sales and Interest Revenues for Year 1 …………………………………………… $ 51,324
Plus Receivables at Beginning of Year 1 …………………………………………. 15,752
3.9 Computing Cash Payments to Suppliers. (amounts in millions)
Cost of Goods Sold for Year 1 ……………………………………………………….. $ 31,729
Plus Inventory at End of Year 1 ……………………………………………………… 7,611
Less Inventory at Beginning of Year 1 ……………………………………………. (8,209)
Equals Purchases during Year 1 …………………………………………………….. $ 31,131
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-4
in whole or in part.
Note that the deferred portion of income taxes expense relates to various deferred
income tax accounts, not to Income Tax Payable. Also note that computations such
as this one are approximations (due to acquisitions, divestitures, and other miscella-
neous events that affect the ability to reconcile balance sheet changes with informa-
“Supplemental Disclosure of Cash Flow Information,” which shows $1,172 million
for “Income taxes paid, net of refunds,” which differs from the amount approx-
imated with the above calculation by $31 million.
ment results in an addback for depreciation. The addback of depreciation coupled
with slow growth in operating working capital results in cash flow from operations
exceeding net income.
larger for Accenture than for Southwest Airlines. In fact, Southwest Airlines typi-
cally collects cash from customers before it provides airline services. Thus, cash
flow from operations should exceed net income for Southwest Airlines by a greater
multiple than the excess for Accenture.
tal-intensive. Kellogg has processing plants for its food products, but these are not
as capital-intensive as the fixed assets of FedEx. Thus, FedEx will have a larger
addback for depreciation expense. FedEx is in its high growth phase relative to the
more mature Kellogg. However, FedEx has few receivables or inventories, so oper-
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-5
in whole or in part.
fixed assets are substantial, consistent with the much larger cash outflow for in-
vesting activities relative to Kellogg. FedEx relies in part on external financing for
its growth. Kellogg, on the other hand, has a net cash outflow for financing activi-
ties typical of a firm repaying debt, paying a dividend, and repurchasing its com-
mon stock.
generates more than sufficient cash flow from operations to finance investing activi-
ties. It uses the excess for reducing debt and for equity financing.
3.15 Interpreting the Statement of Cash Flows. Coca-Cola, like PepsiCo, is a mature
tuates across years, but represents a large addback during Year 3. The change in
operating working capital is aggregated in a single line item, “Net change in oper-
ating assets and liabilities.” This adjustment is close to zero in Year 2 but negative
Cash flow from operations was more than sufficient in all five years to finance
acquisitions of fixed assets and acquisitions of bottlers, a characteristic of a mature
company. For example, in Year 3, cash provided by operating activities was $7,571
million relative to purchases of property, plant, and equipment of $1,968 million.
3.16 Interpreting the Statement of Cash Flows. The wide variation in sales indicates
the cyclical nature of demand for semiconductors. Net income tends to follow the
changes in sales, but with wider swings. The capital-intensive nature of semicon-
ductor manufacturing means that the relatively fixed costs do not increase or de-
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-6
in whole or in part.
crease in net income). Note that the pattern of changes in operating working capital
accounts is what you would expect with variations in growth. When sales increase,
accounts receivable and inventories increase; current liabilities tend to increase as
well (Year 2, Year 3, and Year 4). When sales decrease (Year 1), accounts receiva-
cycles tend not to rely on debt financing. Texas Instruments used the cash flow
from operations in excess of fixed asset acquisitions and debt retirements, particu-
larly in Year 2, Year 3, and Year 4, to pay dividends and repurchase its common
stock.
nancing activities were positive and large, ranging from $338 million in 2010 to
$446 million in 2011, and falling slightly back to $420 million in 2012. Overall,
these patterns suggest a firm in a growth phase. Significant cash flows are provided
by financing activities, which are both invested and consumed in operations. Be-
flows is from financing activities.
Examining the operating section, we see that Tesla has the typical addback for
non-cash depreciation, but it is explains only approximately $28 million of the $130
million difference between the 2012 net loss and negative operating cash flows.
Stock-based compensation of $50 million is added back, consistent with the use of
attributable to non-cash, non-working capital adjustments.
Within working capital adjustments, there are two very large adjustments that
nearly offset each other. First, there is a –$194 million adjustment for inventories
and operating lease vehicles. Tesla apparently increased its inventory levels signifi-
cantly during 2012, which is consistent with either a buildup in anticipation of de-
Tesla slowing down payments to vendors.
There are several other adjustments to typical working capital accounts, but the
only one that is large is a $47 million positive adjustment for reservation payments.
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-7
in whole or in part.
As Tesla explains, “Reservation payments consist of payments that allow potential
customers to hold a reservation for the future purchase of a Model S, Model X or
Tesla Roadster. These amounts are recorded as current liabilities until the vehicle is
delivered. For Model S and Model X, we require an initially fully refundable reser-
mon stock each year. Additionally, Tesla also obtains debt financing, which was
$189 million in 2012. Repayments of long-term debt are relatively small, totaling
only $13 million in 2012. Other cash is received as holders of stock options exercise
those options (and remit the strike price to the company). The company holds ap-
and maturities of marketable securities.
Thus, either operating cash flows must reverse trend in 2013 and capital ex-
penditures must decline, or Tesla will again seek external financing.
3.18 Interpreting the Statement of Cash Flows. The best place to start with interpret-
again in Year 4.
Cash flow from operations exceeded net income in Year 0 primarily because of
the addback of depreciation. Gap increased its accounts payable to finance part of
the increase in inventories. These patterns are typical of a growing firm. Cash flow
from operations was not sufficient to finance the growth in fixed assets. Gap used
to suppliers and other current liabilities, resulting in larger cash flow from opera-
tions in Year 1 than in Year 0. Gap reduced its expenditures on fixed assets consi-
derably between Year 0 and Year 1 in light of the decline in the rate of sales growth
and the weak operating results. The firm increased its long-term borrowing and re-
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-8
in whole or in part.
expenditures. Gap increased its long-term borrowing in Year 2. One wonders about
the new debt issued, given the excess cash flow. Gap invested some of the cash
flow in marketable securities and some simply in cash.
Sales and net income increased still further in Year 3. Gap must have instituted
commensurate small increase in net income. Cash flow from operations was more
than sufficient to finance acquisitions of fixed assets. Gap used the excess to reduce
long-term debt still further and reacquire outstanding common stock.
However, the investing section does show an inflow of $819.5 million, representing
cash acquired via the stock-for-stock merger. The company has been investing
between $65 million and $131 million in fixed assets each year, which is being
financed by long-term borrowings and a large opening cash balance (presumably
vices. For example, in 2006, 2007, and 2008, the company shows an adjustment for
deferred revenue of $181 million, $170 million, and $56 million, respectively.
These amounts reflect prepayments by subscribers for satellite radio service, which
results in a positive adjustment to net income to compute operating cash flows. The
3.20 Interpreting the Statement of Cash Flows.
a. The sales decline is a primary indicator of an operating problem. During a pe-
riod of decreased sales, accounts receivable and inventories usually decrease.
These accounts increased during Year 5, perhaps suggesting a problem with
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-9
in whole or in part.
improve the quality of its products and stimulate sales. Sunbeam sold some
businesses and acquired others, suggesting that it recognized the need to change
the mix of businesses in which it was involved. Cash flow from operations was
insufficient to finance its investing needs. The firm engaged in short-term bor-
stock to employees, so it repurchased approximately the same number of shares
that it issued to employees.
b. Net income turned negative during Year 6, primarily as a result of the provision
creased significantly due to the poor operating results. Despite a reduction in
capital expenditures, cash flow from operations was insufficient to finance ac-
quisitions of property, plant, and equipment. Sunbeam used a mixture of short-
and long-term financing to make up the shortfall. Again, the use of short-term
c. Net income increased significantly in Year 7, as one would expect from an
inventories. Although one would expect an increase in these accounts when
sales increase, the issue is whether the increase is too large. The analyst would
want to measure the average number of days that receivables are outstanding
ventories would result in a similar increase in accounts payable to suppliers.
Accounts payable actually declined during Year 7, perhaps indicating an unwil-
lingness on the part of suppliers to extend credit. Sunbeam reduced its capital
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-10
in whole or in part.
expenditures still further during Year 7 and sold off businesses to generate cash.
It continued to engage in short-term borrowing.
3.21 Interpreting the Statement of Cash Flows. Montgomery Ward’s march toward
tern over time.
During Year 7, sales grew slowly. Net income was positive. Cash flow from op-
erations exceeded net income because of the addback for depreciation. Cash flow
from operations was reduced, however, because Montgomery Ward repaid suppliers
and other providers of goods and services. Cash flow from operations was just suf-
creased its inventories significantly, perhaps anticipating faster growth in sales dur-
ing Year 9 (which did occur). The firm used suppliers to finance the buildup in
inventories. Cash flow from operations was insufficient to finance capital expendi-
tures, so Montgomery Ward increased its long-term borrowing.
borrowing in Year 9. To finance these cash outflows, the firm increased short- and
long-term borrowing, issued capital stock, and reduced the balance in its cash ac-
count. Lechmere has a combination of short-term (inventories) and long-term assets
(retail stores), so a combination of short-term and long-term financing makes sense
tive as Montgomery Ward paid deferred taxes and increased accounts receivable
and inventories in excess of the increase in current operating liabilities. The in-
crease in accounts receivable, in light of the slight sales decline, might indicate the
offering of easier credit terms to stimulate sales. The buildup of inventories, in light