Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-11
in whole or in part.
Montgomery Ward shifted its financing to longer-term sources during Year 10 in
Year 10, a strong signal of problems.
Sales declined significantly during Year 11, and a large net loss occurred.
Montgomery Ward reduced its inventories and repaid its suppliers, perhaps neces-
sary to continue receiving new inventories. It also paid deferred taxes. Cash flow
from operations was significantly negative. The firm also reduced its capital ex-
firm’s bankruptcy. It is likely that Montgomery Ward was unable to obtain long-
term debt or equity financing to remain afloat. It is surprising that the firm was able
to obtain short-term financing!
almost two-thirds of its valuation.
Overall, the company had positive operating cash flows, negative investing, and
negative financing cash flows. This is consistent with a company in the mature
stage of its life cycle. However, the trends in both net income and operating cash
net income. The decreasing bad debt expense is consistent with under-recognition
of bad debt expense (perhaps to prop up earnings) or a legitimate decline in the esti-
mate of bad debts. Elsewhere in the financial reports, The Apollo Group explains
that receivables decreased substantially at the University of Phoenix, driven by de-
University of Phoenix by regulators during 2012.
Cash flows for investing activities also declined during 2012, which is consis-
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-12
in whole or in part.
for sale-leaseback proceeds and a collateralization of a letter of credit. Both trans–
company will embark on a repurchase program of the lower-priced shares. Investors
sometimes view the repurchases as a signal that the company’s management be-
lieves the shares are undervalued, which moderates or reverses the recent share
price declines.
clines in enrollment will continue or not. If so, then it is important to understand
whether the company has a restructuring strategy that can deploy the company’s
skills into growing and profitable businesses.
a. Despite Year 1 reporting a profit and Year 2 reporting a loss, Aer Lingus’ total
cash flows were negative in Year 1 and positive in Year 2. This is partially at-
tributable to large borrowings in Year 2 of €186 million, which offset negative
cash flows for operations and investing activities.
cash); perhaps vendors became weary of extending credit during the recessio-
nary economic environment.
Net cash from investing activities were positive in Year 1 but negative in
Year 2. This reflects two primary differences. First, in Year 1, the airline re-
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-13
in whole or in part.
below). Second, the airline curtailed its purchases of property, plant, and
which reflects borrowings of €186 million, offset slightly by repayments of €39
million. This contrasts with net repayments in Year 1 of approximately €59 mil-
lion. Also note that the borrowings in excess of negative cash flows from opera-
tions and investing activities resulted in an increase in the cash position of the
end of Year 1.
b. The operating section of Aer Lingus’ statement of cash flows ends up being a
direct method because of the simplification of the presentation by relegating the
complexities of non-working capital and working capital adjustments to a foot-
note. Footnote 27 includes these adjustments in the more common indirect for-
mat.
mation in the other statements discussed in the text. For example, cash paid to
suppliers for inventory can be computed as purchases of inventory – Δ accounts
payable, where purchases of inventory = cost of goods sold + Δ inventory. Nev-
ertheless, under either presentation, net cash flows provided by (or used in) op-
erating activities will be the same.
must invest heavily in property, plant, and equipment to create their products. Of
the first three firms, Firm 1 has the highest excess of cash flow from operations
over capital expenditures. It has used the excess cash flow to reduce long-term debt,
repurchase capital stock, and pay dividends. Thus, it has decreased its size over the
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-14
in whole or in part.
overcapacity in the electric utility industry, these characteristics are descriptive of
Pacific Gas & Electric.
for Firm 2 and should have a higher excess of cash flow from operations over capi-
tal expenditures.) The greater cyclicality of Inland Steel leads it to lower its debt le-
vels in years when it has positive cash flows. Its lower dividend payout results from
efforts to conserve cash and a policy of not wanting to cut dividends during down
periods in the business cycle.
These characteristics describe Biogen, a biotechnology company. Biotechnology
firms currently spend large sums for R&D (research and development). The imme-
diate expensing of R&D expenditures drives down net income. Biotechnology firms
require expensive equipment to create biotechnology products and use capital-
not pay dividends.
Firm 5 also grew rapidly during the three-year period and is modestly capital-
intensive. It generated positive free cash flow, which it used to repurchase capital
stock. Note that the firm does not pay dividends. These characteristics are descrip-
tive of Sun Microsystems, the computer manufacturer. The assembly strategy of
suance of additional capital stock during the three-year period. Many firms repur-
chased their capital stock in recent years. Sun might have repurchased its shares as a
defensive move against an unfriendly takeover.
Firm 6 has a significant excess of cash flow from operations over capital ex-
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-15
in whole or in part.
not have much in the way of inventory (essentially cleaning supplies in this case).
without fixed assets to serve as collateral, would minimize the use of long-term
debt. Servicemaster used the debt to help finance acquisitions. The predictable cash
flows from maintenance contracts permit Servicemaster to obtain long-term debt fi-
nancing. However, the change in long-term debt over the three-year period is rela-
tively small.
acquisitions), so one would expect a high dividend payout ratio. The high percen-
tage for “other investing transactions” relates to Heinz’ acquisition of other branded
foods companies in recent years. The assumption of long-term debt to finance ac-
quisitions results from the predictable cash flows of most branded food products.
leverage (discussed in Chapter 4).
Firm 8 is growing rapidly, as evidenced by sales growth, the changes in working
capital accounts, and the excess of capital expenditures over cash flow from opera-
tions. Changes in inventory are the largest of any firm, suggestive of a retailer. Firm
8 is Home Depot. The firm relied on a combination of debt and equity financing to
3.25 Preparing a Statement of Cash Flows from Balance Sheets and Income State-
ments.
a. Worksheets for the preparation of statements of cash flows for fiscal Year 2,
b. A comparative statement of cash flows for fiscal Year 2, Year 3, and Year 4 ap-
pears on the following pages.
c. Year 2: Net income was negative but cash flow from operations was positive,
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-16
in whole or in part.
idend. Stretching short-term creditors to repay long-term debt and a dividend is
ment for financial reporting.
Year 3: The net loss increased between fiscal Year 2 and fiscal Year 3, and
cash flow from operations turned negative. In addition to the net loss, the prin-
cipal reason for the negative cash flow from operations is decreased accounts
a dividend despite its operating and cash flow problems.
Year 4: The net loss increased still further in fiscal Year 4, but cash flow from
operations turned positive. The principal reason is an increase in the addback for
ment securities, to pay dividends, and to repurchase shares of its common stock.
Summary: One wonders about the wisdom of continuing to pay dividends and
repurchasing common stock in light of the mounting net losses from operations.
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-17
in whole or in part.
a. Worksheet for Statement of Cash Flows for Nojiri Pharmaceutical
Year 2
(amounts in millions)
(Problem 3.25)
Balance Sheet
Changes Operations Investing Financing
(Increase) Decrease in Assets
Accounts and Notes Receivable … ¥ (246) ¥ (246)
Inventories……………………………… (99) (99)
Deferred Income Taxes ……………. (124) (124)b
Prepayments …………………………… (6) (6)
Investments in Securities …………. 1,793 ¥ 1,793a
Increase (Decrease) in Liabilities
and Shareholders’ Equities
Accounts Payable ……………………. 47 47
Notes Payable to Banks …………… (244) ¥ (244)
Current Portion of Long-Term
Debt ………………………………….. —
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-18
in whole or in part.
Worksheet for Statement of Cash Flows for Nojiri Pharmaceutical
Year 3
(amounts in millions)
(Problem 3.25)
Balance Sheet
Changes Operations Investing Financing
(Increase) Decrease in Assets
Accounts and Notes Receivable … ¥ 1,875 ¥ 1,875
Inventories……………………………… 758 758
Deferred Income Taxes ……………. (244) (244)b
Prepayments …………………………… 315 315
Increase (Decrease) in Liabilities
and Shareholders’ Equities
Accounts Payable ……………………. (1,222) (1,222)
Notes Payable to Banks …………… 549 ¥ 549
Current Portion of Long-Term
Debt ………………………………….. 200 200c
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-19
in whole or in part.
Worksheet for Statement of Cash Flows for Nojiri Pharmaceutical
Year 4
(amounts in millions)
(Problem 3.25)
Balance Sheet
Changes Operations Investing Financing
(Increase) Decrease in Assets
Accounts and Notes Receivable … ¥ (1,175) ¥ (1,175)
Inventories……………………………… 255 255
Deferred Income Taxes ……………. (163) (163)b
Increase (Decrease) in Liabilities
and Shareholders’ Equities
Accounts Payable ……………………. 458 458
Notes Payable to Banks …………… 32 ¥ 32
Current Portion of Long-Term
Debt ………………………………….. (100) (100)c
Chapter 3
Income Flows versus Cash Flows:
Understanding the Statement of Cash Flows
3-20
in whole or in part.
b. Nojiri Pharmaceuticals
Statement of Cash Flows
(amounts in millions)
(Problem 3.25)
Year Ended March 31:
Year 2 Year 3 Year 4
Operations
Net Income (Loss) ……………………………. ¥ (357) ¥ (1,088) ¥ (1,872)
Depreciation…………………………………….. 1,057 2,058 1,777
Deferred Income Taxes …………………….. (1,111) (371) 4,570
Investing
Acquisition of Property, Plant, and
Equipment ……………………………………. ¥ (308) ¥ (184) ¥ (282)
(Acquisition) Sale of Investments in
Securities ……………………………………… 1,134 1,017 (805)
Financing
Increase (Decrease) in Short-Term Debt ¥ (244) ¥ 549 ¥ 32
Increase (Decrease) in Long-Term Debt (1,660) 1,602 151
Dividends ………………………………………… (960) (771) (787)
Reacquisition of Treasury Stock…………. (12) (73) (839)
Other Financing Transactions …………….. (16) (26) 1