978-1285190907 Chapter 3 Part 4

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Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

3-31

in whole or in part.

Case 3.2: Prime Contractors

I. Case Objectives

A. Illustrate how the analyst can use information in the statement of cash flows

to observe a shift in business strategy.

B. Understand why net income and cash flows can move in opposite directions

over time.

C. Understand reasons for changes in the direction of deferred income taxes.

D. Examine the effects of dispositions of fixed assets on the statement of cash

flows.

E. Illustrate how a shift in business strategy can cause a financing strategy to

shift as well.

II. Responses to Case Questions.

a. The refuse business is fixed-asset-intensive, whereas the animal care business is

labor-intensive. The statement of cash flows shows that Prime significantly de-

creased its investments in new fixed assets beginning in Year 8. The statement

shows proceeds from selling fixed assets beginning in Year 9. Prime likely sold

some of the equipment it no longer needed in the refuse business. A related clue

for the strategic shift is the decline in the amount of depreciation added back to

net income to compute cash flow from operations. The depreciation charge de-

clined when Prime sold depreciable assets. Another clue is the shift in financ-

ing. Prime increased long-term debt in Year 6 and Year 7 to finance the

acquisition of fixed assets, but paid off the financing in Year 8, Year 9, and

Year 10 as it sold these assets. (See the response to Part f for elaboration on this

point.)

b. There are three principal explanations for the increased cash flow from opera-

tions coupled with decreased net income. First, the addback to net income for

depreciation increased. Although depreciation does not provide cash, it reduces

net income. The addback of depreciation zeroes it out. Second, despite increases

in revenues, accounts receivable decreased. Prime must have collected its recei-

vables more quickly over time, enhancing cash flow from operations. Third,

Prime stretched payments to providers of various goods and services as reflect-

ed in the Other Current Liabilities account. Although the case does not provide

an income statement, one might surmise that the decreased net income results

from the additional depreciation expense and the costs incurred to launch into

the animal care business.

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

3-32

in whole or in part.

c. There are three principal explanations for the decreased cash flow from opera-

tions coupled with the increased net income. First, the addback for depreciation

declined. Again, although the depreciation does not affect cash flows, the de-

creased depreciation could have had a positive effect on net income. Second,

deferred income became a subtraction from instead of an addition to net income.

Prime apparently had to pay income taxes that it had deferred in earlier years.

(See the response to Part d for elaboration on this point.) Third, net income in-

cludes gains on sales of fixed assets that do not affect cash flow from opera-

tions. Proceeds from such sales appear as investing activities. (See the response

to Part e for elaboration on this point.) The increased net income between Year

8 and Year 10 likely results from the successful launching of the animal care

business and the inclusion of gains on sales of fixed assets in earnings.

d. The largest temporary difference between income for financial reporting and

taxable income is likely the depreciation of fixed assets. Prime probably uses

straight-line depreciation for financial reporting and accelerated depreciation for

tax reporting. The large amount of fixed assets acquired in Year 6 and Year 7

resulted in more depreciation for tax reporting than for financial reporting and a

deferral of taxes to be paid. The addition to net income for deferred taxes in

Year 6, Year 7, and Year 8 indicates that the cash payment for taxes was less

than income tax expense, consistent with growing fixed assets. Prime not only

decreased significantly the acquisition of new fixed assets beginning in Year 8,

but also sold off some of its existing fixed assets in Year 9 and Year 10. Taxes

previously deferred became due because depreciation for financial reporting ex-

ceeded depreciation for tax reporting. The latter occurs in part because more as-

sets are in the later years of their lives when depreciation for financial reporting

exceeds depreciation for tax reporting. The latter also occurs because fixed

assets sold have been depreciated more for tax reporting than for financial re-

porting, giving rise to a reversal of deferred taxes.

e. Net income includes the gains on sales of fixed assets. GAAP requires firms to

classify the cash proceeds of sales of fixed assets as an investing activity, not an

operating activity. Sales of fixed assets are peripheral activities in support of the

firm’s primary operating activity. Firms cannot rely on irregular sales of fixed

assets as the primary source of operating cash flow. Classifying the cash

proceeds as an investing activity keeps it out of cash flow from operations. If

firms did not subtract gains on sales of fixed assets in the operating section, the

firms would double-count the portion of cash proceeds equal to the gain: once in

the operating section in an amount equal to the gain and once in the investing

section as part of the cash proceeds from the sale. The subtraction of the gain

zeroes out its effect on cash flow from operations. The addback of a loss on sale

likewise zeroes out its effect on cash flow from operations. Note that the gain on

sale in Year 9 exceeds the cash proceeds. The explanation is that the firm sold

equipment in part for receiving cash and in part by accepting notes from the

buyers to be paid later.

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

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in whole or in part.

f. As indicated in the response to Part a, Prime financed its acquisition of fixed as-

sets in Year 6 and Year 7 with long-term borrowing. There are several reasons

for using long-term borrowing instead of equity financing. First, the equipment

serves as collateral for the borrowing. Collateralizing the borrowing reduces the

risk of the lender and, therefore, reduces the interest rate charged on the loan.

Second, Prime has multi-year contracts in place with the U.S. government,

which provide reasonably assured cash flows to repay the debt. The contracts

likewise reduce the risk of the lender and lower the borrowing cost to Prime.

Third, perhaps the owners do not want to invest additional equity capital in the

firm.

Prime began repaying the long-term debt in Year 8 and continued doing so

in Year 9 and Year 10. Borrowing agreements on which the fixed assets served

as collateral probably required repayment when Prime sold the fixed assets.

Prime also had the cash flow from operations in excess of expenditures on fixed

assets with which to repay the loans. Prime also might have purposively decided

to reduce the amount of debt in the capital structure as it moved more and more

into a labor-intensive business.

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

3-34

in whole or in part.

Case 3.3: W. T. Grant Company

I. Case Objectives

A. Demonstrate the importance of analyzing cash flow from operations in as-

sessing the impact of operations on liquidity.

B. Demonstrate the impact of changes in accounting principles and misstate-

ments of accounting data on the analysis and interpretation of financial

statements.

C. Demonstrate how inadequate financial controls can get a decentralized organ-

ization into trouble.

II. Class Discussion

Begin by placing the following chart on the board:

1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976

MAJOR

EVENTS

Bank- Liquidation

Bank ruptcy

Support

CHANGES IN Consolidation Income

ACCOUNTING of Finance Recognition

PRINCIPLES Subsidiary on Installment

Sales

Spend a few minutes discussing the two accounting changes and their general

impact on the financial statements. The purpose of this discussion is merely to fami-

liarize students with these accounting changes. Also spend a few minutes address-

ing this question: Should the analysis be based on the amounts originally reported

for each year (Exhibits 3.36 and 3.37) or the amounts retroactively restated for

changes in accounting principles (Exhibits 3.38–3.40)? Although arguments can be

made for using each data set, most of the analysis is based on the amounts as

retroactively revised for each year.

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

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in whole or in part.

Then distribute Exhibit 3.A (see page 3-39) from this teaching note. Also place

this exhibit on an overhead transparency. Ask this question: When did the stock

market perceive Grant to have problems? The first panel in Exhibit 3.A suggests

that this occurred sometime during 1971. The actual date was in July 1971. Place

this event on the time line on the board.

Ask students this question next: If you were analyzing the financial statements

each year as Grant issued them, when would you have begun worrying about the

company? Place a plain sheet of paper over the last four panels on the transparency

for Exhibit 3.A. Slowly move the plain sheet of paper to the right. Most students

agree that the major deterioration in the ratios occurred in the fiscal year ending

January 31, 1970, or January 31, 1971. Write these dates on the time line on the

board, noting that the financial statements signaled Grant’s problems approximately

one year before the stock market reaction.

Next, place the following two column headings on the board:

“Major Contributing Factors” and “Questionable Policies”

Ask the class to identify the major factors that contributed to Grant’s collapse.

As students identify each factor, try to discuss it fully before moving on to the next

factor. Ask the student who offered each factor how he or she would identify the

problem using financial statement ratios. Following are the major factors and re-

lated issues that you should try to elicit from the discussion.

A. Credit Extension and Collection Policies—Grant operated with a decentra-

lized organizational philosophy. Each store manager had authority to extend

credit. There was no minimum on the amount that customers could charge.

There were extremely liberal policies with respect to the amount and timing of

repayment. The manager’s compensation, based on a percentage of sales, in-

duced store managers to extend credit at will. With appropriate centralized fi-

nancial controls, a decentralized organizational structure can have positive

motivational effects on employees. The absence of such controls, however,

can hurt the organization as a whole. The problems with the credit system be-

gan showing up in a decreasing accounts receivable turnover in the late sixties

and early seventies.

At this point, bring up three items affecting the accounts receivable data.

First, ask what impact consolidation of the finance subsidiary in 1970 had on

the accounts receivable turnover ratio. Consolidation did not affect sales in the

numerator, but it substantially increased accounts receivable in the deno-

minator. Thus, the receivables turnover ratio decreased as a result of consoli-

dation. Ask students this question: Can you see any reason for Grant to select

the year ending January 31, 1970, as the time to switch? One hypothesis is

that Grant saw its receivables turnover decreasing because of its poor credit

policies and figured it might confuse the market by changing its consolidation

policy at the same time. In this way, it would not be clear how much of the

decrease was due to consolidation and how much was due to the credit

problems.

Next, ask what impact the front-end loading of interest on installment

receivables had on the accounts receivable turnover ratio. A comparison of

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

3-36

in whole or in part.

Exhibits 3.36 and 3.38 in the case suggests that Grant netted interest revenue

against selling, general, and administrative expenses. Thus, the front-end load-

ing increased the denominator of the accounts receivable turnover ratio and

decreased the overall turnover ratio. The practice of front-end loading was

likely done primarily to prop up earnings.

Finally, ask about the adequacy of Grant’s provision for expected uncol-

lectibles. As judged ex post, the provisions were clearly inadequate. The large

provision in 1975 (see the change in the Allowance for Uncollectible

Accounts from 18,067 in 1974 to 79,510 in 1975 shown in Exhibit 3.36) indi-

cates understatements of the provision in earlier years. Grant should have rec-

ognized the inadequacy earlier, however. Note from Exhibit 3.36 that

customer installment receivables increased fivefold between 1966 and 1974,

yet the allowance for uncollectible accounts increased half that much. Stu-

dents often question how the independent auditor could have missed such a

material inadequacy.

Summarize this discussion of receivables by pointing out that firms can

play games with accounting data to make the situation appear better (or

worse) than is actually the case. The analyst must be alert to such games con-

tinually when using and interpreting financial statement data.

B. Inventory Policies—Students generally bring up inventory policies as a

second major contributing factor to Grant’s collapse. They point out that the

move to furniture and major appliances was inappropriate given Grant’s im-

age as an urban discount store. They also point out that Grant had no expe-

rience in servicing major appliances, a critical factor in consumers’ buying

decisions. Then ask why students think Grant made this move.

The reason is that Grant wanted to move into a segment of the market that

Sears left when Sears started pushing its Sears Best line. The thinking was that

Sears was no longer adequately serving the lower middle-income market;

therefore, an opportunity existed for Grant. Ask students where problems with

these inventory policies will show up. They can look at inventory turnover

and gross margin percentages for some clues. The inventory turnover was rel-

atively flat between 1967 and 1970, but began a decline in 1971. The gross

margin percentage was relatively flat at around 30%. The problem in the early

years was not with selling the merchandise. The problem came from an inabil-

ity to collect the cash from customers. (See discussion above.) Whether

the slowdown in inventory turnover beginning in 1971 was due to slower

furniture and appliances sales or to a buildup of inventories is difficult to

determine.

Grant had a poorly designed inventory information and control system.

When a store ran out of a particular item, it had no way of determining

whether a nearby Grant store had the item. This problem is another example

of the effect of poor financial and operating controls in this decentralized

organization.

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Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

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in whole or in part.

C. Store Expansion—The number of Grant stores grew rapidly during the late

sixties and early seventies. The impact of weak financial controls in such a

growth environment was discussed previously. A related problem is that Grant

tended to locate its new stores in second-quality shopping centers. The pre-

ferred store locations went to Sears or JCPenney. Grant’s sales per square foot

and profit per square foot were relatively stable through the early 1970s. Thus,

sales did not appear to be Grant’s major problem.

D. Financing—Most of the long-term financing for the growth in number of

stores came from long-term leases. Firms were not required to capitalize these

leases until 1976. Grant had two long-term debt issues (1972 and 1974) and

no significant new equity issues. Apparently, long-term financing was not a

major problem. Short-term financing came from supplier financing for inven-

tories and commercial paper financing for receivables (through the finance

sub). As the line for short-term debt on the balance sheet indicates, the amount

of short-term financing expanded as accounts receivable expanded. The poor

collection experience necessitated even greater short-term financing. When

Grant’s access to supplier financing and the commercial paper market dissi-

pated in 1974, the company had to rely on bank financing. This occurred at a

time when short-term interest rates increased significantly.

At this point in the discussion, ask whether Grant’s major problems involved work-

ing capital or were more long-term in nature. It is clear that the problems were

working-capital-oriented, although the viability of Grant’s long-term marketing

strategy was also suspect. Point out that the statement of cash flows provides in-

formation about the net amount of cash generated or used for operating, investing,

and financing activities and that this statement should provide clues about Grant’s

problems.

The statement of cash flows in Exhibit 3.40 shows that for seven of the nine

years preceding its bankruptcy, Grant was unable to generate positive cash flow

from operations. Its inventories increased more rapidly than accounts payable. Its

accounts receivable also increased significantly over this period. Grant financed

these asset buildups largely with short-term bank and commercial paper borrowing.

Grant’s continual reliance on external, not internal, financing eventually placed its

future survival under the control of the banks.

Close discussion of the case by asking the class to list questionable policies,

given Grant’s problems. Their list usually includes the following:

• Continued payment of dividends (to give the impression of “business as usual”

to shareholders)

• Continued purchase of treasury shares (to prop up stock market price; to minim-

ize dilution arising from exercise of stock options)

• Continued intercorporate investments (investment was in a Canadian subsidiary

that was thought to have excellent growth prospects)

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

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in whole or in part.

If time permits, spend a few minutes discussing the rationale for each of these ac-

tions.

Additional References

James A. Largay III and Clyde P. Stickney, “Cash Flows, Ratio Analysis and the W.T.

Grant Company Bankruptcy,” Financial Analysts Journal (July–August 1980), pp. 51–

54.

“How Grant Lost $175 Million Last Year,” Business Week (February 24, 1975), pp. 74–

76.

“W.T. Grant: Ripples from a Collapsing Grant,” Business Week (October 20, 1975), pp.

98–100.

“Investigating the Collapse of W.T. Grant,” Business Week (July 19, 1976), pp. 60–62.

Chapter 3

Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

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in whole or in part.

Exhibit 3.A W.T. Grant Company Stock Prices and Selected Ratios

for the Fiscal Years Ending January 31, 1966 to 1975

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Income Flows versus Cash Flows:

Understanding the Statement of Cash Flows

3-40

in whole or in part.

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