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BUS650_Chapter_05.pdf
Learning Objectives
After studying this chapter, you should be able to:
• Describe the cash cycle of a typical firm.
• Explain the significance and use of different financial statements.
• Express why accounting profits and cash flows sometimes differ.
• Show how accounting profits can be transformed into cash flows.
• Explain how to construct pro forma financial statements.
• Express how growth impacts a company’s cash flows.
• Show how to estimate expected value of future cash flows.
Blend Images/Corbis5
Estimating Cash Flows
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CHAPTER 5Introduction
Introduction
Figure 5.0: Chapter 5 in focus
Cash used to purchase inputs
Cash from financing
The Financial Balance Sheet
Cash generated from operations
Employees Suppliers
The ongoing health of a business, and almost all financial valuation, is based on cash flows not accounting income. In Chapter 5, we take a closer look at the corporation’s cash cycle and how to estimate those important cash flows.
Cash—dollars and cents—is the lifeblood of every business. Companies distribute cash to shareholders in the form of dividends and use cash to pay employees and suppliers, to pay taxes, and to repay loans. For a business to stay healthy, it is cash, not accounting prof- its, that matters. This may sound like a contradiction, but many profitable, fast-growing small companies have gone out of business because they lacked sufficient cash to pay their bills. Regardless of its profitability, a firm without enough cash to pay its bills risks going bankrupt. Because cash is so important, we must understand how to estimate cash flow and how cash circulates through a company.
Profitability is not identical to cash flow. One of the key objectives of this chapter is explain- ing why accounting profits and cash flow can differ. This difference hinges on several of the rules included in the accounting profession’s generally accepted accounting principles (GAAP). We begin by describing the cash cycle of a typical company, then we relate this cash cycle to basic accounting concepts and the primary financial statements produced by a company.
Once we understand how accounting profits and cash flows differ, we describe two meth- ods for translating accounting profits into cash flows. We use these techniques to estimate the future cash flows for a brand-new project or investment. We extend this forecasting technique to the creation of pro forma (or projected) financial statements. Once you have mastered these techniques—translating accounting data into cash flows, estimating cash flows for a new investment, and creating projected financial statements for a company— you will have gained a sound introduction to tools that are used daily by business people in a variety of fields.
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CHAPTER 5Section 5.1 The Cash Cycle of a Typical Firm
Pre-Test
1. Accounts payable are excluded from the simple cash cycle. a. True b. False
2. The Retained Earnings account on the balance sheet shows the cash available to the company from the retention from historical profits.
a. True b. False
3. Cash flow is equivalent to net income. a. True b. False
4. A simple approximation of cash flow can be found by adding depreciation expense to net income.
a. True b. False
5. There are six steps involved in constructing pro forma income statements. a. True b. False
6. Growth is always sustainable. a. True b. False
7. An investment’s future payoff is best estimated using the expected value of the future cash flows.
a. True b. False
Answers 1. b. False. The answer can be found in Section 5.1. 2. b. False. The answer can be found in Section 5.2. 3. b. False. The answer can be found in Section 5.3. 4. a. True. The answer can be found in Section 5.4. 5. a. True. The answer can be found in Section 5.5. 6. b. False. The answer can be found in Section 5.6. 7. a. True. The answer can be found in Section 5.7.
5.1 The Cash Cycle of a Typical Firm
For managers of small businesses it is particularly important to understand and man-age the company’s cash cycle. In fact, the lack of a cash cushion is one of the primary reasons that small businesses fail. For some of the other reasons, see The New York Times article “Top 10 Reasons Small Businesses Fail,” in the Web Resources section.
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CHAPTER 5Section 5.1 The Cash Cycle of a Typical Firm
We begin this chapter by describing how cash travels through a typical business enter- prise. Understanding the cash cycle will help you see why the profits reported on a com- pany’s income statement s differ from the actual cash generated by the firm’s activities.
Simple Cash Cycle The operations of a typical firm follow:
1. Goods are produced or purchased for resale. 2. Sales are made. 3. Cash from the sales is collected.
Cash expenditures for materials, wages, advertising, and so on occur at stages 1 and 2, but only at stage 3 does cash flow into the firm, providing the cash for another cycle of pro- duction, sales, and collections. Typically, accounting revenues and expenses are recorded at stage 2. If not managed properly, these seemingly slight timing differences between the expenditures of cash, and the collection of cash, can cause serious problems and even bankruptcy. Figure 5.1 shows a simple cash cycle.
Figure 5.1: Simple cash cycle
Generate accounts payable
Recognize revenue Generate accounts receivable
1. Buy materials Manufacture goods
2. Make sale 3. Collect accounts receivable
Pay accounts payable Buy more materials
The business of purchasing materials and selling products creates a cycle of intertwined accounting entries and cash payments and collections.
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CHAPTER 5Section 5.1 The Cash Cycle of a Typical Firm
In Figure 5.1, the firm buys materials on credit and generates an account payable (A/P). Dur- ing the manufacturing process, the firm gener- ates additional costs. Production costs include employee wages and benefits, utility expenses, and rent. Another cost of production is the wear and tear on, or depreciation of, equipment, though this doesn’t include any actual cash outlay (we explain the noncash aspect of depreciation later in the chapter).
The firm eventually sells the finished products and recognizes revenues and—it hopes—prof- its. If a credit sale is made, the firm receives no cash at the time of the sale. Instead, the sale cre- ates an account receivable (A/R), and the firm must wait for the customer to pay the bill before any cash arrives. Profits may be recognized at stage 2, before any cash is actually collected. Thus, accounting profits (or net income) may not repre- sent cash flow.
Complete Cash Cycle Figure 5.2 shows a somewhat simplistic cash cycle. It ignores a number of important factors, such as taxes, dividends, cash infusions from the capital markets, maintenance of inventory to avoid stock-outs, and the purchase and sale of productive assets. These are added to the cash cycle diagram presented in Figure 5.2 to give a more complete picture of how cash moves into, out of, and through the firm. As Fig- ure 5.2 shows, taxes and dividends represent cash flowing out of the firm. The company acquires additional cash from the capital markets by selling shares of stock, issuing bonds, or borrowing from financial institutions. Because the company must pay its lenders inter- est and repay the amount borrowed, another cash outflow is debt service payments (inter- est and principal). Two arrows represent the sale and purchase of productive assets such as machinery, vehicles, and factories. To remain competitive, companies upgrade their manufacturing methods with new equipment, selling the machines that no longer fit their production processes.
When customers use credit cards to pay for products, firms wait for the bank that issued the card to pay for the merchandise on behalf of the customer.
Polka Dot/Thinkstock
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CHAPTER 5Section 5.2 A Review of Financial Statements
Figure 5.2: Complete cash cycle
Increase inventory
1. Buy materials Manufacture goods
2. Make sale Decrease inventory
Interest and principal Dividends Buy assets
Sell assets Issue bonds and stock
Financing/Investment
Taxes
3. Collect accounts receivable Pay accounts payable Buy more materials
Recognize revenue Generate accounts receivable
Generate accounts payable
A more complete depiction of the cash cycle includes tax payments, disbursements to claimants, and asset purchases.
5.2 A Review of Financial Statements
You may have already taken one (or more) accounting courses, but accounting is so important to managerial finance that we want to provide a short review. The review is from a finance perspective, so we will discuss why some accounting items are particularly important to financial managers.
Income Statement The income statement shows a company’s revenues and profits over a set time period, usually a year or a quarter. It is also called a P&L (profits and loss) statement. An income state- ment always begins with the revenues or sales for the period at the top and then shows the
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CHAPTER 5Section 5.2 A Review of Financial Statements
costs incurred to make these sales. The costs listed first are the direct costs associated with the sales, such as materials and manufacturing labor. These items are often combined into a single COGS (cost of goods sold) or cost of revenue expense line. Subtracting these direct expenses from revenues gives us the company’s gross margin. Next on the statement are indirect costs, which include SG&A (sales, general, and administrative) expenses, depre- ciation and amortization expenses, and R&D (research and development) expenses. All of these expenses are considered operating expenses. Subtracting these expenses produces the operating margin or EBIT (earnings before interest and taxes).
The most common non-operating expenses are interest expense and taxes. Subtracting these items from the operating margin gives us the company’s net income or net profit. This is the proverbial “bottom line” that people refer to, as in “What is the bottom line?” In fact, usually there are a few more lines that show per share information such as earnings per share and dividends per share. Figure 5.3 shows Nike’s income statement, using the basic structure we have just discussed.
Figure 5.3: Nike income statement, 2011
NIKE, INC. 2011(In millions, except per share data)
Revenues
Cost of sales
Gross margin
Demand creation expense
Operating overhead expense
Total selling and administrative expense
Interest expense (income), net (Notes 6, 7, and 8)
Other (income), net (Note 17)
Income before income taxes
Income taxes (Note 9)
Net income
Basic earnings per common share (Notes 1 and 12)
Diluted earnings per common share (Notes 1 and 12)
Dividends declared per common share
20,862
11,354
9,508
2,448
4,245
6,693
4
(33)
2,844
711
2,133
4.48
4.39
1.20
$
$
$
$
19,014
10,214
8,800
2,356
3,970
6,326
6
(49)
2,517
610
1,907
3.93
3.86
1.06
$
$
$
$
2010
Year Ended May 31,
The income statement shows revenues and expenses over the course of the year.
Data from Nike annual report to the Securities and Exchange Commission, 2011: http://www.sec.gov/Archives/edgar/ data/320187/000119312511194791/d10k.htm.
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CHAPTER 5Section 5.2 A Review of Financial Statements
Companies sometimes modify financial statements to better reflect how they do business. In Figure 5.4, we see that Nike Inc. has included an expense line titled “Demand Creation Expense.” The notes to the financial statements explain that this expense is for sponsoring athletic events and athletes. Apparently Nike sees these types of expenses as sufficiently different from standard marketing activities and has separated them out on their state- ment. Notice too that several items refer to Notes. The financial statements reported in a company’s Form 10-K (the annual report filed with the SEC) will have very detailed notes about many accounting items. The standard statement shown on corporate financial state- ments is: “The accompanying notes to consolidated financial statements are an integral part of this statement.”
Balance Sheet The balance sheet shows a company’s financial position at a point in time, for exam- ple as of December 31, 2013, or at the end of a business quarter. A balance sheet based on information from December 31st will differ from a balance sheet computed on December 1 or January 31. A balance sheet is a financial “snapshot” of a firm’s financial position at a point in time. Some balance sheet items are changing constantly. Contrast this to the income statement that covers a period of time. It is a record of the firm’s money- making activities over a period of time, such as a year or quarter.
The balance sheet is also called the statement of financial position. It shows what the com- pany owns and what it owes. It contains three categories of items: assets, liabilities, and equity. Assets are traditionally shown on the left-hand side of the balance sheet (or on the top) and liabilities and equity on the right-hand side (or below the assets). The liabilities and equity must equal the assets; the two sides have to balance. Assets are listed accord- ing to their liquidity, or how quickly they can be turned into cash. Cash and marketable securities are extremely liquid, whereas inventory is less so since it must be sold and receivables must be collected before they become cash.
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CHAPTER 5Section 5.2 A Review of Financial Statements
Figure 5.4: Nike consolidated balance sheets
NIKE, INC. 2011
1,955
2,583
3,138
2,715
312
594
11,297
2,115
487
205
894
14,998
200
187
1,469
1,985
117
3,958
276
921
3
3,944
95
5,801
9,843
14,998
$
$
$
$
3,079
2,067
2,650
2,041
249
873
10,959
1,932
1,907
467
873
14,419
7
139
1,255
1,904
59
3,364
446
855
3
3,441
215
6,095
9,754
14,419
$
$
$
$
2010
Year Ended May 31,
(In millions)
ASSETS
Current assets:
Cash and equivalents
Short-term investments (Note 6)
Accounts receivable, net (Note 1)
Inventories (Notes 1 and 2)
Deferred income taxes (Note 9)
Prepaid expense and other current assets
Total current assets
Property, plant and equipment, net (Note 3)
Identifiable intangible assets, net (Note 4)
Goodwill (Note 4)
Deferred income taxes and other assets (Notes 9 and 17)
TOTAL ASSETS
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt (Note 8)
Notes payable (Note 7)
Accounts payable (Note 7)
Accrued liabilities (Notes 5 and 17)
Income taxes payable (Note 9)
Total current liabilities
Long-term debt (Note 8)
Deferred income taxes and other liabilities (Notes 9 and 17)
Shareholders’ equity:
Common stock at stated value (Note 11):
Class A convertible—90 and 90 shares outstanding
Class B—378 and 394 shares outstanding
Capital in excess of stated value
Accumulated other comprehensive income (Note 14)
Retained earnings
Total shareholders’ equity
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
The accompanying notes to consolidated financial statements are an integral part of this statement.
The balance sheet is a snapshot of a firm’s assets, liabilities, and equity on a particular date.
Data from: Nike annual report to the Securities and Exchange Commission, 2011 http://www.sec.gov/Archives/edgar/ data/320187/000119312511194791/d10k.htm.
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CHAPTER 5Section 5.2 A Review of Financial Statements
Office equipment like computers are listed among long-term company assets included in the PP&E category. Can you think of other examples that would go into this category?
Ingram Publishing/Thinkstock
Usually the largest category of long-term assets is plant, property and equipment (PP&E). Plant, property and equipment includes all the long- lived assets that the company owns, such as fac- tories, machines, cars, trucks, and computers. It is reported as the total historical cost of purchas- ing those items. The next line on the balance sheet is accumulated depreciation. This is the sum of all depreciation expense associated with these assets since they were purchased. Subtracting accumu- lated depreciation from total PP&E gives us net PP&E. As items are disposed of, their cost and associated accumulated depreciation are sub- tracted from these accounting items. Nike’s con- solidated balance sheet (Figure 5.4) shows that net PP&E will sometimes be reported instead of separate lines for the total PP&E and accumu- lated depreciation. Net PP&E shows the book value remaining in a company’s assets; it is the undepreciated portion of the assets’ historic cost. Land is an exception to this depreciation treat- ment. Land is not depreciated and will appear on a company’s balance at its historic cost forever.
Liabilities are listed roughly according to when they must be paid. Current liabilities, such as accounts payable, wages payable, and taxes pay- able, are examples of liabilities due within a year. Some companies report “current portion of long-
term debt,” which is the principal repayment on loans or bonds due within one year. Long-term liabilities include multiyear bank loans, leases, bonds, and mortgages.
The equity component (often called shareholders’ equity) is the difference between assets (what is owned) and liabilities (what is owed). The book value of equity is also equal to the historical contributions of shareholders to the firm plus all profits that have been retained on behalf of shareholders. How we account for these contributions is reviewed in the following paragraphs.
The equity section is often separated into three line items:
1. Par value 2. Paid-in capital in excess of par 3. Retained earnings
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CHAPTER 5Section 5.2 A Review of Financial Statements
The first two items are the amounts that shareholders have invested into the company. For common stock the par value or face value is the lowest price that the company can sell a share of stock. Not all states require par values, so many issues of common stock do not have a par value. When stocks have a par value, it is usually set very low, for example 1¢ or 10¢ of $1.00. Paid-in capital in excess of par is the amount above the par value that the company collected when it sold stock to investors. If a company sells shares with a $1.00 par value to investors for $15.00 per share, the paid-in capital in excess of par is $14.00 per share.
The final component of the equity section of the balance sheet is retained earnings. This is the historical accumulation of profits retained in the firm and invested on behalf of shareholders. This is not an account which contains actual cash. It is very important that you understand that retained earnings has nothing to do with how much cash the company has available. All of the money that’s been retained has been used to either purchase assets or to repay liabilities. The only cash the company has is in its cash account on the asset side of the balance sheet. Remember, the right-hand side of the balance sheet informs us about the sources of the firm’s financing, whereas the left-hand side tells us what the firm has done with those funds.
For most profitable firms, retained earnings is positive. However, it is possible for a com- pany to have negative retained earnings if it has lost money (reported negative net income) over several years. For corporations, negative retained earnings or negative shareholders’ equity does not mean that shareholders owe the company money. These investors have limited liability and can only lose the amount they invested. For sole proprietorships this is not the case. The sole proprietor is personally responsible for the debts of the business, so negative equity is potentially serious since it puts the owner’s other assets at risk if legal claims are made against the company.
It is interesting to note that some young firms actually have negative equity accounts because they have accumulated negative retained earnings over time as they develop their products and markets. The fact that these young and not-yet-profitable corporations have positive share prices for their stock illustrates that market value depends on the expected future for the company and not on its past record. Here, then, we have an example of the difference between the financial balance sheet introduced in Chapter 1 and highlighted throughout the text, and the accounting balance sheet that we’re reviewing.
The income statement and balance sheet do not stand alone but rather are tied together by several accounts. For example, depreciation expense from the income statement accumu- lates in the Accumulated Depreciation account on the balance sheet. Also from the income statement, net income, less dividends, accumulates in the Retained Earnings account on the balance sheet.
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CHAPTER 5Section 5.2 A Review of Financial Statements
Cash Flow The cash flow statement breaks cash flow into three categories:
1. Cash flow from operating activities 2. Cash flow from financing activities 3. Cash flow from investing activities
The cash flow statement starts with net income for the period. It then adjusts for cash used in or provided by operating activities, such as depreciation (a noncash charge) and changes in working capital. Investing activities include buying or selling machinery or facilities, investing in marketable securities, and realizing returns from investments in securities. Financing activities involve paying dividends to shareholders, repurchasing or issuing stock, and borrowing (or repaying) loans. A company with foreign operations will usually have an additional item after the financing section that shows the effect of exchange rate fluctuations on cash flow. When the cash flow impact of all of these activities is summed, it will show the change in cash over the income statement period.
The general rule regarding cash flow is: Increasing an asset account uses cash, and increas- ing a liability is a source of cash. If a company buys a machine (increasing PP&E), it spends or uses cash. If the company takes out a loan, it receives cash (the loan is a source of cash but increases a liability account such as Bank Loans). Conversely, repaying a loan uses cash, and selling an asset is a source of cash.
In the Nike statement of cash flows (Figure 5.5), notice that the activities shown for 2011 reconcile the change in the company’s cash position from $3,079 million at the end of 2010 to $1,955 million at the end of 2011, exactly as shown on the balance sheet in Figure 5.4.
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CHAPTER 5Section 5.2 A Review of Financial Statements
Figure 5.5: Nike consolidated statements of cash flows
NIKE, INC. Year Ended May 31,
(In millions)
Cash provided by operations:
Net income
Income charges (credits) not affecting cash:
Depreciation
Deferred income taxes
Stock-based compensation (Note 11)
Impairment of goodwill, intangibles and other assets (Note 4)
Amortization and other
Changes in certain working capital components and other assets and liabilities excluding the impact of acquisition and divestures:
(Increase) decrease in accounts receivable
(Increase) decrease in inventories
(Increase) decrease in prepaid expenses and other current assets
Increase (decrease) in accounts payable, accrued liabilities and income taxes payable
Cash provided by operations
Cash used by investing activities:
Purchases of short-term investments
Maturities of short-term investments
Sales of short-term investments
Additions to property, plant and equipment
Disposals of property, plant and equipment
Increase in other assets, net of other liabilities
Settlement of net investment hedges
Cash used by investing activities
Cash used by financing activities:
Reductions in long-term debt, including current portion
Increase (decrease) in notes payable
Proceeds from exercise of stock options and other stock issuances
Excess tax benefits from share-based payement arrangements
Repurchase of common stock
Dividends — common and preferred
Cash used by financing activities
Effect of exchange rate changes
Net (decrease) increase in cash and equivalents
Cash and equivalents, beginning of year
CASH AND EQUIVALENTS, END OF YEAR
2011
2,133
335
(76)
105
—
23
(273)
(551)
(35)
151
1,812
(7,616)
4,313
2,766
(432)
1
(30)
(23)
(1,021)
(8)
41
345
64
(1,859)
(555)
(1,972)
57
(1,124)
3,079
1,955
$
$
2010
1,907
324
8
159
—
72
182
285
(70)
297
3,164
(3,724)
2,334
453
(335)
10
(11)
5
(1,268)
(32)
(205)
364
58
(741)
(505)
(1,061)
(47)
788
2,291
3,079
$
$
2009
1,487
335
(294)
171
401
48
(238)
32
14
(220)
1,736
(2,909)
1,280
1,110
(456)
33
(47)
191
(798)
(7)
177
187
25
(649)
(467)
(734)
(47)
157
2,134
2,291
$
$
The statements of cash flows consolidates the cash activities over the year and classifies the activities into operations, financing, and investing categories.
Data from Nike annual report to the Securities and Exchange Commission, 2011: http://www.sec.gov/Archives/edgar/ data/320187/000119312511194791/d10k.htm.
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CHAPTER 5Section 5.3 Why Accounting Profits and Cash Flows Differ
Everyone is familiar with cash accounting as it’s the same system we use to balance our checkbooks. Most corporations however use an accrual accounting system, which is much more complex.
Comstock Images/Getty Images
As we discuss in detail in Section 5.3, almost every income statement category can have a recorded amount that differs from the actual cash inflows or outflows for that cate- gory. You may ask why accountants don’t simply keep track of cash, instead of using the accrual accounting system. In fact, in response to a growing interest in cash flow informa- tion, accounting statements now include a statement of cash flows.
5.3 Why Accounting Profits and Cash Flows Differ
Generally Accepted Accounting Principles (GAAP) prescribe how accountants record business transactions and construct financial statements. These account-ing rules were designed to provide an objective portrayal of a company’s busi- ness activities and how those activities affect the company’s financial position. Three accounting principles are particularly important to under- standing why accounting profits often differ from cash flows. These principles deal with
1. The recognition of revenue 2. How expenses and revenues are matched 3. Rules regarding how the depreciation
(i.e., wear-and-tear) of long-lived equip- ment is shown on the income statement
These principles, especially the matching prin- ciple, mean that corporate financial accounting is an accrual accounting system, not a cash account- ing system. As we discuss these accounting prin- ciples, you will see how accrual accounting differs from cash accounting. Cash accounting is the sys- tem you use in your checkbook. At any moment in time (except for checks that have been written but haven’t yet been cashed), the balance shows the cash you have available. As we will see, this is very different from the accounting used in most businesses.
Revenue Recognition The rules of revenue recognition state that rev- enues are recorded when a transaction has occurred. There are several definitions of transac- tion. It may be when the title or ownership of an item changes from the seller to the buyer. It may be at the time of delivery or pickup. In some cases, a transaction might occur when an order is placed. The actual point at which a sale is considered to have been completed varies, depending on the nature of the contract or agreement between the buyer and the seller, the rights of the buyer to renege from the deal, and so on.
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CHAPTER 5Section 5.3 Why Accounting Profits and Cash Flows Differ
One thing to notice about the above definitions is that none define a transaction as occur- ring when money changes hands. There is a very good reason for this omission. Many sales are made on credit; that is, the buyer delays paying for several weeks or months, or spreads the payments out over time. If sales were only recorded as the cash arrived, the sales figure for a particular period would reflect the cash collected, not the actual sales activities during the period. The objective of the GAAP principles is to provide an accu- rate picture of a company’s activities, the primary one of which is selling products, not collecting cash. Therefore, the accounting rules are designed to focus more on sales and revenue generation than on cash collection.
Matching Principle The rules of accounting require that the expenses recorded on the income statement be those associated with the sales recognized during that period. This is referred to as the matching principle. Expenses refer to the cost of producing the items sold, not the actual cash outlays for labor, materials, and so on made during the period. For example, sup- pose a company manufactures 175 air conditioners during the month of April but sells 100 of those units in April. On an income statement for the month of April, the expenses would be the cost of producing the 100 units that the company actually sold, not the 175 that it manufactured. The cost of producing the 75 units that were manufactured but not sold in April will appear on future income statements when those units are sold. In the meantime, the cost of producing those 75 units is recorded as an increase in inventory. If the company paid cash to its employees and suppliers of raw materials for the 175 units produced, the expense shown on the income statement is less than the actual cash outlays the firm made in April. If the recorded expenses are too low, then net income—revenue minus expenses—overstates how much cash the firm has generated during the period.
The matching principle may also cause net income to understate cash flow. For example, suppose the firm sold 100 units in April but paid for the raw materials used to manu- facture those units in May. Thus, the cash for the materials was paid in May but was recorded as inventory, and the cost of goods sold expense for the units would appear in April’s income statement. In this case, the expense shown for raw materials on April’s income statement would be greater than the actual cash outlays made in April for materi- als, so April’s income would be lower than its actual cash flow—holding everything else constant.
The matching principle is designed to give users of financial statements an idea of the firm’s activities during a specific period of time. More specifically, the matching prin- ciple is designed to show a firm’s profitability. By focusing on revenues or sales and then matching expenses to that sales level, the income statement presents information on the profitability of the company’s operations.
Depreciation When business people use the term depreciation (or depletion or amortization, depend- ing on the asset being considered) they are referring to the allocation of the cost of a long- lived asset to several accounting periods. A machine, vehicle, computer, or building will usually last for more than one year. When a company invests in an asset that will be used for several years, for accounting purposes it allocates the cost of the asset over several periods as depreciation expense. The idea is to match the use (or the consumption or
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CHAPTER 5Section 5.3 Why Accounting Profits and Cash Flows Differ
wearing out) of the asset to the accounting period in which that use occurs. By reporting depreciation expense on the income statement as the asset is used, accountants attempt to show the total costs of doing business during that particular accounting period. It is important to understand that although the cost of the asset is spread over several years, the purchase was made and paid for when the asset was acquired.
In terms of estimating cash flows, the allocation of depreciation means that net income is different than the cash generated during the period. This is most easily shown with an example. Suppose Acme Metal Fabricating Company purchases a computer-aided lathe in January of 2012 for $100,000. The lathe is expected to last for five years, at which time the company plans on trading it in for a newer model. In 2012, Acme writes a check for $100,000. The entire cash outlay for the lathe is made in 2012. In the years 2013 through 2016, there are no cash outlays associated with purchasing the lathe, but the company uses the lathe extensively each of those years. To allocate the cost of the lathe over its estimated useful life, the company’s accountant adds a depreciation expense of $20,000 to the com- pany’s expenses for each of the five years from 2012 through 2016 ($20,000 5 $100,000/5).
When the company buys the lathe, it records an increase in fixed assets of $100,000. Each year when it records its depreciation expense, it reduces the value of the asset by the amount of the depreciation. In the years 2013 through 2016, the depreciation expense has no corresponding cash outlay. Because of this, depreciation is often called a noncash expense or noncash charge. The noncash expense lowers net income without affecting the firm’s cash position. Of course, in 2012, when the machine was purchased, there was a cash outlay of $100,000, but an expense for use of the machine of only $20,000 is reported. Therefore, in 2012 the net income overstates the cash flows of the firm, whereas in the fol- lowing four years it understates the cash flows.
In many cases, depreciation is the major factor that causes accounting profits and cash flows to differ. In Chapter 6, we return to the topic of depreciation and describe in more detail how to compute depreciation expense and how firms benefit from depreciation tax deductions.
Income Statements and GAAP Figure 5.6 shows an income statement for Acme Metal Fabricating Company, highlighting the company’s operating activities during the 2013 fiscal year. Arrows identify the income statement accounts that can cause net income and cash flow to differ. The sales (or rev- enue) account may not equal the cash collections for the accounting period because of rev- enue recognition rules. The matching principle implies that the actual cash flowing into or out of the firm may differ from the amount reported as cost of goods sold and GA&S expense for that period. GA&S expense reflects costs necessary to operate the business that are not directly tied to the production of products. Depreciation expense, as we just discussed, is a noncash charge that allocates the cost of long-lived assets to the accounting periods during which the asset is used. Therefore, the income statement amount does not reflect actual cash outlays during the accounting period.
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CHAPTER 5Section 5.4 Translating Accounting Profits Into Cash Flows
Figure 5.6: Acme’s income statement and GAAP
Acme Metal Fabricating Co. Income Statement for the year ended December 31, 2013 ($ in 000s)
Sales, net of discounts COGS
Gross Margin GA&S Expense Depreciation
Earnings before taxes
Taxes
Net profit or net income
Revenue recognition
Matching principle
Cost allocation
$257,000 176,545
80,455 22,158 34,780
23,517
7,525
15,992
Generally Accepted Accounting Principles (GAAP) are rules that can cause accounting profit to differ from cash flow.
Deferred Taxes Although a detailed discussion is beyond the scope of this text, the amount of taxes reported on company income statements often differs from the actual cash payment made to the Internal Revenue Service and/or state taxing agencies. This results in a deferred taxes liability (it can also be an asset, but this is less common). One of the most common examples of this occurs when a company uses accelerated depreciation for tax purposes but a nonaccelerated method of depreciation, such as straight-line, for its reporting. This creates a timing difference between when taxes are paid and when they are reported in financial statements. Eventually the difference reverses itself as accelerated depreciation for the asset falls below the amount reported using straight-line.
5.4 Translating Accounting Profits Into Cash Flows
One of the most important tools you will learn in this class is computing the net present value (NPV) of a proposed investment using discount cash flow analysis. As the name suggests NPV relies on cash flows. We will describe two methods for transforming data from a company’s income statement into an estimate of cash flow: a quick-and-dirty method and a more accurate, but somewhat longer, method.
Simple Method The quick method, which provides a rough estimate of the cash that the company gener- ated from operations during the accounting period, requires just one step: Add the depre- ciation expense for the period to net income!
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CHAPTER 5Section 5.4 Translating Accounting Profits Into Cash Flows
Why does this simple computation change net income into cash flow? For many firms, depreciation is the main reason that cash flow differs from accounting profit or net income. If, for items other than depreciation, there is only a small difference between recorded expenses and cash outlays, then correcting for depreciation gets us very close to cash flow.
This formula (Cash flow from operations 5 Net income 1 Depreciation) recognizes that depreciation is a noncash charge. We know that in the year that a company buys an asset there can be a large cash outlay to pay for the purchase. Notice, though, that the formula is for “cash flow from operations.” The formula tries to give investors an idea of cash flow generated by a company’s day-to-day or month-to-month operating activities. As later chapters will show, these are the cash flows that investors are most interested in. Thus, ignoring the cash flows associated with an infrequent event is often not a serious problem if we are most interested in a firm’s operating activities.
Now, let’s apply what you just learned about the simple method of estimating cash flows using an example.
Suppose your company is thinking about replacing a truck with a more efficient model. The new truck will do exactly the same job the older truck did, but it will use less fuel and have lower maintenance costs. These savings are estimated to be $3,000 per year, which will increase earnings before taxes by $3,000. The new truck will generate addi- tional depreciation expense of $4,000 per year, which, when combined with the savings, implies that earnings before taxes will actually decrease by $1,000 per year. At a 30% tax rate, net income will decrease by $700! We usually don’t make changes that reduce profits, but we need to look at the cash flow implications of the change. Figure 5.7 shows the bot- tom section of an income statement that shows these changes.
Figure 5.7: Change and cash flow
Category Earnings before truck expenses Truck operating expenses Truck depreciation Earnings before taxes Taxes (30%) Net income Add back depreciation Cash flow
Old Truck 40,000 8,000 3,000
29,000 8,700
20,300 3,000
23,300
New Truck 40,000 5,000 7,000
28,000 8,400
19,600 7,000
26,600
Change
(3,000) 4,000
(1,000) (300) (700) 4,000 3,300
A careful examination of how the replacement truck will affect earnings and expenses is crucial to maximizing cash flows. Here, that impact is illustrated in the bottom section of the income statement.
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CHAPTER 5Section 5.4 Translating Accounting Profits Into Cash Flows
Despite net income falling a bit, cash flow increases by $3,300. This is because much of the decrease in net income was due to higher depreciation (a noncash charge). When we cor- rect for the added depreciation expense, we have an increase in cash flow. In this example, cash flow increased. In the next chapter, we will learn methods to determine if this increase in cash flow justifies spending money on the new truck.
Complete Method If we need an estimate of a com- pany’s overall cash flow, then, in addition to operating activi- ties, we must consider a firm’s investing activities (e.g., its purchase and sale of assets or increases and decreases in asset accounts) and its financ- ing activities (e.g., changes in its borrowing, stock sales, and dividend decisions). This more precise measure considers changes in all asset and liability accounts. Examples of such balance sheet effects include increased accounts receivable from more credit sales, changes in accounts payable from the delayed (or early) payment for supplies, changes in debt and equity accounts caused by new funds the firm obtained from (or repaid to) banks or investors, and changes to the PP&E account caused by expenditures for (or proceeds from the sale of) long-lived assets. Table 5.1 summarizes the effect on cash flows due to changes in assets and liabilities.
Table 5.1: Effect on cash flows due to changes in assets and liabilities
Cash increases when . . . Cash decreases when . . .
Assets decrease Liabilities or equity decrease
Liabilities or equity increase Assets increase
This is a good time to take a minute to test your understanding of cash flow and its rela- tionship with common business activities. Answer the questions in the Applying Finance: Cash Flow feature to assess your understanding.
Purchasing new equipment such as a fuel-efficient truck, despite increased depreciation and lower net income, can actually increase cash flow. Do you think purchasing the truck would be beneficial?
Associated Press
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CHAPTER 5Section 5.4 Translating Accounting Profits Into Cash Flows
The concept of a reservoir is helpful in illustrating cash flow and analogizing how companies decide to divert some of their cash flow money into another account, or “reservoir.”
age fotostock/SuperStock
The item in the Applying Finance: Cash Flow feature that might have confused you is 7—”Increas- ing the money in the Cash & Marketable Securities account?” We are measuring cash flow, the money moving between accounts within the company, or the money available to invest or pay bills. If we decide to increase our cash reserves we are tak- ing money from that available pool and setting it aside. The flow of usable cash has gotten smaller. Consider a river run- ning through a town. The water in the river is our cash flow. If the town decides to divert some of that water into a reservoir to use during a dry period, the flow in the river has been reduced. The
reservoir is analogous to the Cash & Marketable Security account. Having more money in that account is a valuable resource if the company faces a downturn in sales or wants to pursue a great growth opportunity, but building up that reserve (i.e., filling up the reser- voir) reduces cash flow (water flowing in the river).
Now, let’s look at an example where we need to consider changes in balance sheet items as well as depreciation to get a good estimate of cash flow.
Suppose a company is considering offering a new product. The product will increase earnings before depreciation and taxes, as shown in Figure 5.8. The additional sales must be supported by increased working capital investments. The sales will be mostly on credit so accounts receivable will increase (an increase in an asset account uses cash flow), more inventory will be required to avoid stock-outs (an increase in an asset account requires
Applying Finance: Cash Flow
Instructions: Does the described action increase (INC) or decrease (DEC) cash flow?
1. Selling a machine? 2. Repaying a bank loan? 3. Purchasing a fleet of delivery vehicles? 4. Making more sales on credit? 5. Accelerating the payments to suppliers to take advantage of a cash discount? 6. Building up inventory in preparation for high holiday sales? 7. Increasing the money in the Cash & Marketable Securities account?
See Appendix B for the answers.
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CHAPTER 5Section 5.5 Pro Forma Financial Statements
cash outflow), but there will also be some spontaneous financing from an increase in accounts payable (an increase in a liability account generates cash inflow). The company estimates that the new product will require a working capital investment equal to 25% of sales.
Figure 5.8: Cash flow estimation
Category Earnings before depreciation and taxes Depreciation expense Earnings before taxes Taxes (30%) Net income Add back depreciation Cash flow before additional working capital investment Working capital (25% of sales) Additional working capital investment Cash flow
Year 1 $50,000 $30,000 $20,000 $6,000
$14,000 $30,000 $44,000 $12,500 $12,500 $31,500
Year 2 $70,000 $30,000 $40,000 $12,000 $28,000 $30,000 $58,000 $17,500 $5,000
$53,000
Year 3 $80,000 $30,000 $50,000 $15,000 $35,000 $30,000 $65,000 $20,000 $2,500
$62,500
Year 4 $40,000 $30,000 $10,000 $3,000 $7,000
$30,000 $37,000 $10,000
−$10,000 $47,000
Being able to accurately estimate cash flows into the future is essential to the success of a corporation.
Considering the required investment in working capital changes the annual cash flow sig- nificantly. Notice that in Year 2 the working capital requirement is $17,500. Since $12,500 was invested in Year 1, an additional investment of only $5,000 is required in Year 2. Also note that in Year 4, as sales decline, working capital is released enhancing cash flow. The release of working capital occurs because as sales fall the company provides less credit to customers and needs less inventory to satisfy orders.
Had we ignored the working capital investment in this example, our estimates of cash flow would have been incorrect and could have led to a poor decision about whether or not to introduce this product.
5.5 Pro Forma Financial Statements
Pro forma (or projected) financial statements are powerful tools for the financial manager or analyst. They help the financial manager forecast how changes in poli-cies will affect the company’s financial situation. For example, how will changing a company’s credit policy change the size of its short-term bank loan? One of our students who became an investment banker doing leveraged buyouts of companies says that he used pro forma statements more than any other financial tool. In this section, we first show the mechanics of creating a pro forma income statement and balance sheet, then we discuss where an analyst would get the information required for these statements.
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CHAPTER 5Section 5.5 Pro Forma Financial Statements
The Pro Forma Income Statement A fairly standard method for constructing pro forma income statements is to use historical percent-of-sales for many categories, supplementing with additional information when it is available. The approach is as follows:
Step 1: Obtain sales estimates or estimated sales growth from the previous year.
Step 2: Compute cost of goods sold, as a percent of sales based on historical data. If infor- mation is available about possible changes in the cost structure, this can be used to modify the estimate.
Step 3: Compute gross margin (Sales – Cost of goods sold).
Step 4: Determine general, administrative, and sales expense, depreciation expense, and other expenses, based on historical patterns from previous years, or cost estimates from other departments.
Step 5: Compute taxable income by subtracting the expenses in Step 4 from the gross margin.
Step 6: Compute taxes using the company-wide rate or rates from tax tables; then subtract taxes from taxable income to arrive at net income.
Now we will demonstrate how to build a pro forma income statement using the steps listed above. We will use ACME Inc.’s income statements for 2011 and 2012 to construct a pro forma income statement for 2013 based on some assumptions about how the business will perform during 2013. Below we list the assumptions for 2013, while the historical income statements for the company appear in Figure 5.9.
Assumptions for 2013:
• Sales will increase by 10% in 2013 from 2012 levels. • COGS and SG&A will be the average percent of sales they were for the last two
years. • Depreciation expense will increase to $1,800. • Interest expense will be $840. • The tax rate is 25%. • Dividend payout will remain at $650.
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CHAPTER 5Section 5.5 Pro Forma Financial Statements
Figure 5.9: ACME Inc. historical income statements
Revenue COGS Gross margin SG&A expense Depreciation expense EBIT Interest expense Taxable income Taxes Net income Dividends To retained earnings
45,000 32,400 12,600 5,850 1,500 5,250
750 4,500 1,125 3,375
600 2,775
2011 48,000 34,560 13,440 6,240 1,600 5,600
800 4,800 1,200 3,600
650 2,950
2012
We will use ACME Inc.’s historical income statements to build a pro forma income statement.
Using this data, we can start solving for the information needed to create our pro forma income statement. According to our assumptions, sales will increase by 10% in 2013, so 1.10 3 $48,000 5 $52,800. In 2011 and 2012, COGS were 72% of sales. We assume that COGS remains 72% of sales in 2103. SG&A expense was 13% of sales in both 2011 and 2012, so we will use that percent of sales in 2013. With this information, we can begin building the pro forma income statement, as seen in Figure 5.10.
Figure 5.10: ACME Inc. pro forma income statement
Revenue COGS Gross margin SG&A expense Depreciation expense EBIT Interest expense Taxable income Taxes Net income Dividends To retained earnings
45,000 32,400 12,600 5,850 1,500 5,250
750 4,500 1,125 3,375
600 2,775
2011 (Actual)
48,000 34,560 13,440 6,240 1,600 5,600
800 4,800 1,200 3,600
650 2,950
2012 (Actual)
52,800 38,016 14,784 6,864 1,800 6,120
840 5,280 1,320 3,960
650 3,310
10% Growth 72% of sales
Subtraction 13% of sales
Given Subtraction
Given Subtraction
25% of taxable income Subtraction
Given Subtraction
2013 (Projected) Source
Using our assumptions for 2013, and the historical income statements, we were able to construct ACME Inc.’s pro forma income statement.
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CHAPTER 5Section 5.5 Pro Forma Financial Statements
Once a pro forma balance sheet is created, it is important for company managers to work together to discuss the implications of the balance sheet before making major financial decisions.
In Pictures/Corbis
Starting with sales, we enter the information we have and then subtract items to get gross margin, EBIT, and taxable income. We compute taxes at 40% and subtract them from tax- able income to get net income. We subtract dividends from net income to determine how much money will be reinvested in the firm by adding it to retained earnings on the bal- ance sheet.
The Pro Forma Balance Sheet Pro forma or projected bal- ance sheets are often necessary when analyzing the effect of corporate decisions on the com- pany’s financial condition. One of the most common uses for pro forma balance sheets is esti- mating future financial need, so a company can make arrange- ments for loans or lines of credit. Some loans require that the borrower maintain financial ratios at or above a certain level. Therefore, before managers of a company subject to such a loan arrangement initiate changes that could affect the company’s balance sheet, they would want to construct pro forma balance sheets to ensure that the loan restrictions are satisfied.
Constructing a simple pro forma balance sheet usually requires four steps. More complex balance sheets require more steps. The construction of the balance sheet depends on hav- ing already completed the appropriate pro forma income statement, so the pattern given here assumes the income statement is available.
Step 1: Fill in all of the values that don’t change, that are known, or that change in a defi- nite manner. These include items such as long-term debt and the common stock accounts.
Step 2: Fill in all values from income statement. These are depreciation and retained earnings.
Step 3: Fill in all values that are projected according to company policy or that represent target policy values. These include inventory, accounts receivable, accounts payable, and plant, property, and equipment. Some of these will change as a percent of sales. Often the Cash account is set at some minimum based on sales.
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CHAPTER 5Section 5.5 Pro Forma Financial Statements
Step 4: Add up the asset side of the balance sheet and transfer that total to the liabilities and equity side. Balance the assets and liabilities by adjusting a plug figure, usually bank loans or notes payable on the liabilities side of the balance sheet. If the bank loan is nega- tive, make it zero, add up the liabilities, move that total to total assets, and adjust the asset side with the Cash account taking up whatever slack is necessary to balance things.
We will demonstrate with an example that builds on the pro forma income statement we just completed for ACME Inc. The actual balance sheet for 2012 is shown in Figure 5.11. We will construct the pro forma balance sheet for 2013 using the following assumptions:
• The minimum cash balance is 3% of sales. • Working capital accounts (A/R, A/P, and Inventory) will be the same percent of
Sales in 2013 as they were in 2012. • $4,000 of new PP&E will be purchased in 2013. • Other current liabilities will remain at 2% of sales in 2013. • There will be no changes in the Common Stock or Long-term Debt accounts. • The plug figure is bank loan.
Figure 5.11: ACME Inc. balance sheet
ASSETS Cash Accounts receivable Inventory Total current assets Plant, Property & Equipment (PP&E) Accumulated depreciation Net PP&E TOTAL ASSETS
LIABILITIES AND EQUITY Accounts payable Bank loan (10%) Other CL Total current liabilities Long-term debt (12%) Common stock Retained earnings TOTAL LIABILITIES AND EQUITY
As of December 31, 2012 1,440 3,840 7,200
12,480 24,570
8,900 15,670 28,150
As of December 31, 2012 1,728 4,102
960 6,790 5,600 1,000
14,760 28,150
The accounting balance sheet is one of the most important sources of tracking business progress.
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CHAPTER 5Section 5.5 Pro Forma Financial Statements
Now we can complete our pro forma balance sheet. We add the items that we know for 2013, then fill in the asset side of the balance sheet. We work up from the bottom of the liabilities side of the balance sheet by first transferring total assets to total liabilities and equity. We work our way up the liabilities side until there is one item left. In our example, the last cell will be the Bank Loan account. The Bank Loan account must put the balance sheet in balance so the Bank Loan amount is our plug figure; it is the number that makes things balance. Figure 5.12 shows the completed pro forma balance sheet for ACME Inc.
Figure 5.12: ACME Inc. pro forma balance sheet
Assets Cash Accounts receivable Inventory Total current assets Plant, Property & Equipment (PP&E) Accumulated depreciation Net PP&E Total Assets
Liabilities and equity Accounts payable Bank loan (10%)
Other CL Total current liabilities
Long-term debt (12%) Common stock Retained earnings
Total liabilities and equity
Explanation 3% of sales 8% of sales 15% of sales Sum Plus $4,000 purchased in 2013 2012 value plus 2013 Depreciation expense Subtraction Current assets plus net PP&E
Explanation 5% of COGS Subtraction: Total current liabilities minus Other CL minus Accounts Payable 2% of sales Subtraction: TL&E minus LT debt minus Common stock minus Retained earnings No change No change 2012 value plus 2013 earnings retained from Income Statement From total assets
1,584 4,224 7,920
13,728 28,570
10,700
17,870 31,598
1,901 3,971
1,056 6,928
5,600 1,000
18,070
31,598
As of December 31, 2013 (pro forma)
As of December 31, 2013 (pro forma)
1,440 3,840 7,200
12,480 24,570
8,900
15,670 28,150
1,728 4,102
960 6,790
5,600 1,000
14,760
28,150
As of December 31, 2012
As of December 31, 2012
The pro forma accounting balance sheet will allow ACME Inc.’s management to project business activity into the future.
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CHAPTER 5Section 5.6 How Growth Affects Cash Flow
5.6 How Growth Affects Cash Flow
Many profitable small businesses fail because they grow too fast for the amount of cash they have. One of the authors watched a very profitable small company grow and fail because of the lack of cash. Government agencies hired the com- pany to duplicate and store records such as land titles, surveying plats, building permits, and other documents that governments generate that might be called on in the future if a dispute or question arises. The owner had enough money to purchase the equipment and have a small cash reserve. Business picked up quickly because local governments had a mandate to store these items, but had neither a system nor the labor to do so. The business was very profitable in an accounting sense, but it failed. The problem was that the govern- ment agencies were slow to pay their bills. The owner had to pay his expenses right away but had to wait 90 to 120 days to receive payments from the government agencies. Every time around the cash cycle, the business accrued a larger bill for expenses than it did cash from customers. The financing gap—the gap between having to disburse cash to suppli- ers and receiving cash from customers—continued to grow with each cash cycle. Figure 5.13 shows a stylized version of the company’s financial situation.
Figure 5.13: The company’s financial situation
Sales Costs
Inflow Outflow Net cash flow Cumulative net cash flow
Month 1 20,000 16,000
0 16,000
−16,000
−16,000
Month 2 30,000 24,000
0 24,000
−24,000
−40,000
Month 3 45,000 36,000
0 36,000
−36,000
−76,000
Month 4 65,000 52,000
20,000 52,000
−32,000
−108,000
Month 5 90,000 72,000
30,000 72,000
−42,000
−150,000
Month 6 126,000 100,800
45,000 100,800 −55,800
−205,800
A company’s financial situation sometimes becomes evident over a period of time. Sometimes, a company cannot financially sustain rapid growth.
You can see from the figure that as the company continued to grow the cash outlays also grew. The inflows lagged the outlays by three months, so as long as the company kept growing, the net cash flow (inflows-outflows) grew. If the cash reserve was only $100,000 or $150,000, you can see that the company could only remain in business for four or five months. Unless the company slowed its growth, the inflows could not catch up with the outflows. This is known as negative cash flow. Later in the text, we will discuss how to estimate a sustainable growth rate.
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CHAPTER 5Section 5.7 Computing Expected Cash Flows
As small businesses grow, they must watch their cash inflow to make sure they do not grow so fast that they have no money to pay their expenses.
Erich Schlegel/Corbis
This particular story had a sad end. The owner of the business couldn’t get a very large bank loan and decided to make up the funds by not paying the taxes that he had withheld from employees paychecks (This is illegal!). Even- tually the tax authorities caught him, and the business was shut down.
The moral of the story is that it is better to turn away some busi- ness than fail. And, always pay your taxes.
5.7 Computing Expected Cash Flows
When we discuss cash flows from invest-ments, we are talking about future or expected cash flows. Investing today generates payoffs in the future. Therefore, when evaluating investment opportunities, we must try to estimate each investment’s expected cash flows. In finance, we say that investors form expectations about these future payoffs. The best estimate of an investment’s future payoff is called the expected value of future cash flows. The expected value is a weighted average, with the weights being probabilities. Suppose a security analyst (a person who analyzes stocks and then makes recommendations to clients on whether to buy, hold, or sell the stocks) believes that Chevron Corporation (Ticker: CVX), a leading oil producer, will pay a dividend next quarter of between $0.70 and $1.00. More precisely, the analyst thinks that there is a 10% chance the dividend will be $0.70, a 30% chance it will be $0.80, and a 40% it will be $0.90, and a 20% it will be $1.00. The expected value of Chevron’s next dividend is computed by multiplying each of the possible outcomes ($0.70, $0.80, $0.90, and $1.00) times its respective prob- ability and then adding up these products. Arith- metically, the expected dividend is
Securities analysts play an important role in computing expected cash flows and advising investors on investment opportunities.
Photographer’s Choice/Getty Images
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CHAPTER 5Conclusion
Expected dividend 5 10% 3 $0.70 1 30% 3 $0.80 1 40% 3 $0.90 1 20% 3 $1.00
5 $0.07 1 $0.24 1 $0.36 1 $0.20 5 $0.87
The expected value is slightly more than the middle of the value ($0.85) because the ana- lyst assigns a slightly higher probability to the $0.90 outcome. Notice that the analyst predicts that the dividend will be either $0.70, $0.80, $0.90, or $1.00. Nowhere does the analyst predict a dividend of $0.87. The actual outcome will not be the expected value of $0.87. Although we compute an expected value for a given point in time (next quarter’s dividend, next year’s sales, etc.), expected values are long-run averages. If this set of pos- sible outcomes and probabilities occurred many times, the average dividend from those many occurrences would be the expected value, $0.87.
As this example shows, the expected value is a probability weighted average. Each possi- ble outcome is weighted by the likelihood that it will occur; then these weighted outcomes are summed. Mathematically, the expected value is expressed as follows:
(5.1) Expected value 5 p1 CF1 1 p2 CF2 1 p3 CF3 1 . . . 1 pn CFn 5 ani 5 1 piCFi
Where CFi represents one of the possible cash flow levels (e.g., in the Chevron example, CF1 5 $0.70) and pi represents the probability of that cash flow level actually occurring (the probability associated with the $0.70 outcome in the Chevron example is 10%). The probabilities, p1 through pn , must sum to 1.0 or 100%. The sigma, S, is a summation sign, which means we add up all of the separate elements created as our counter i goes from 1 to n. The formula for expected value allows for an unlimited number of possible outcomes because n, the last outcome, can be as large as we want it to be.
Conclusion
This chapter discussed cash flow. Cash is the lifeblood of a business enterprise. Despite having accounting profits, a business without cash is doomed. Without cash the company cannot pay its employees, its suppliers, its tax bill, or its bankers. Our discussion of cash flow focused on understanding how cash flows into, out of, and through the company. The cash cycle is a valuable tool for thinking about the day-to-day operations of any business. After our accounting review, we explained why accounting profits differ from cash flow. The majority of the chapter discussed how to estimate cash flows from income statement and balance sheet information and how to estimate the cash flows for a new investment project using pro forma (or projected) income statements. If you have a good understanding of cash flow—its importance and how to estimate it—and have mastered some of the analytic tools introduced in this chapter, you have taken a sig- nificant first step in learning how to manage a financially healthy business.
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CHAPTER 5Post-Test
Post-Test
1. Accounts payable are excluded from the simple cash cycle. a. True b. False
2. The Retained Earnings account on the Balance Sheet shows the cash available to the company from the retention from historical profits.
a. True b. False
3. Cash flow is equivalent to net income. a. True b. False
4. A simple approximation of cash flow can be found by adding Depreciation Expense to Net Income.
a. True b. False
5. There are six steps involved in constructing pro forma income statements. a. True b. False
6. Growth is always sustainable. a. True b. False
7. An investment’s future payoff is best estimated using the expected value of the future cash flows.
a. True b. False
8. Which of the following is NOT part of the simple cash cycle? a. Manufacture of goods. b. Purchase of more materials. c. Collection of accounts receivable. d. Payment of taxes.
9. What is significant about Depreciation Expense? a. Depreciation is a negative cost. b. Depreciation is a noncash charge against income. c. Depreciation is imaginary so has no effect on cash flow or profits. d. Depreciation is simply an accounting issue so should be ignored.
10. As of 2012 several European Union countries, Spain and Greece, were in deep financial trouble. If a bank had loaned money to these governments and reported the interest from these loans as revenue, though actual interest payments were likely to be much less than originally agreed to, what issue will result?
a. This is a revenue recognition problem that would understate profits. b. This is a matching principle problem that would understate profits.
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CHAPTER 5Post-Test
c. This is a revenue recognition problem that would overstate profits. d. This is a matching principal problem that would overstate profits.
11. To arrive at a more accurate estimate of cash flow, we would add depreciation expense to net income and then
a. reduce our estimate by the increases in liabilities. b. reduce our estimate by the decreases in assets. c. increase our estimate by the increases in liabilities. d. do nothing more because we have an accurate estimate.
12. You are creating a pro forma income statement for Western State Transport for 2014. Managers expect revenues to increase by 8% from 2013 levels of $5,500,000. Because of anticipated increases in fuel prices, COGS is expected to increase to 64% of revenues. What will Western State Transport’s pro forma gross margin be in 2014?
a. Revenues will be $5,940,000, and gross margin will be $1,138,400. b. Revenues will be $5,940,000, and gross margin will be $2,138,400. c. Revenues will be $6,300,000, and gross margin will be $1,138,400. d. Revenues will be $6,420,000, and gross margin will be $2,138,400.
13. From a financing perspective, cash flow is more important than Net Income because
a. net income doesn’t measure profit. b. net income doesn’t include tax effects. c. a company cannot use net income to pay its bills. d. cash flow is a measure of profit.
14. Which of the following is NOT true of the expected value of a future cash flow? a. The formula allows for a limited number of possible outcomes. b. It is a probability weighted average. c. It is computed for a given point in time. d. It is the best estimate of an investment’s future payoff.
Answers 1. b. False. The answer can be found in Section 5.1. 2. b. False. The answer can be found in Section 5.2. 3. b. False. The answer can be found in Section 5.3. 4. a. True. The answer can be found in Section 5.4. 5. a. True. The answer can be found in Section 5.5. 6. b. False. The answer can be found in Section 5.6. 7. a. True. The answer can be found in Section 5.7. 8. d. Payment of taxes. The answer can be found in Section 5.1. 9. b. Depreciation is a non-cash charge against income. The answer can be found in Section 5.2. 10. c. This is a revenue recognition problem that would overstate profits. The answer can be found in
Section 5.3. 11. c. increase our estimate by the increases in liabilities. The answer can be found in Section 5.4. 12. b. Revenues will be $5,940,000, and gross margin will be $2,138,400. The answer can be found in Section
5.5. 13. c. A company cannot use net income to pay its bills. The answer can be found in Section 5.6. 14. a. The formula allows for a limited number of possible outcomes. The answer can be found in Section
5.7.
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CHAPTER 5Critical Thinking Questions
Key Ideas
• The simple cash cycle is made up of three steps: 1. The purchase of materials and manufacture of goods; 2. The sale of goods; 3. The collection of accounts receivable, payment of accounts payable, and pur-
chase of more material. • The complete cash cycle expands on the simple cash cycle. It includes additional
steps, such as payment of taxes, disbursements to claimants, and asset purchases. • The income statement is important because it shows revenues and expenses over
the course of the year. • The accounting balance sheet is one of the most important sources of tracking
business progress. • The statement of cash flows consolidates the cash activities over the year and
classifies the activities into operations, financing, and investing categories. • The simple method for translating accounting profits into cash flows is achieved
by adding the depreciation expense for an accounting period to net income. • The complete method for translating accounting profits into cash flows requires
the consideration of a firm’s operating, investing, and financing activities. • Pro forma financial statements help the financial manager forecast how changes
in policies will affect the company’s financial situation. • The effects of rapid company growth are not always sustainable. Outflows can-
not exceed inflows, otherwise the company will fail. • The expected value of future cash flows is the best estimate of an investment’s
future payoff.
Critical Thinking Questions
1. If a project analysis shows accounting losses (negative net income), does that ensure that the project should not be pursued? Imagine a project with large capi- tal investments and correspondingly large depreciation.
2. Suppose two new companies are identical in all ways except that one uses an accelerated depreciation method and the other uses the straight-line method. Initially, which company will have the higher profits? Which will have the higher cash flow? Explain your answers using a simple income statement.
3. In a company there are two divisions competing for investment funds. Manager A proposes a project that uses some idle capacity on existing machines. Manager B, her competitor, says that Manager A should include depreciation expense for that idle machinery in the cash flow estimates of Manager A’s pro- posal. Will including extra depreciation from existing machinery make the proj- ect look worse as Manager B hopes?
4. Some financial analysts use EBITDA (Earnings before Interest, Taxes, Deprecia- tion and Amortization) as a proxy for cash flow. Would this be a better metric of cash flow available to service debt or available to equityholders? It might be helpful to use an income statement to explain your answer.
5. We say, “An increase in an asset account is a use of cash.” But the Cash account is an asset account, so how can an increase in the Cash account be a use of cash?
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CHAPTER 5Key Terms
balance sheet Snapshot of a company’s financial position at a moment in time. The left-hand side lists assets and the right-hand side lists liabilities and owners’ equity.
cash cycle The sequence of activities associated with cash moving through the company.
cash flow The amount of money that passes through a corporation. Residual cash flow, for example, refers to the amount of money that stockholders have a claim on after all other claims have been paid.
depreciation An accounting expense designed to reflect the wear and tear or use of a long-lived asset.
expected cash flow The future cash flow from an investment computed by assign- ing probabilities to various outcomes.
expected value of future cash flows The probability weighted value of an invest- ment, computed by assigning a probability of occurrence to the various possible future values.
financing gap The days or dollars that a company must finance with reserves before cash from sales flow into the company.
generally accepted accounting principles (GAAP) The accounting rules that define how companies construct their financial reports. Designed to provide as accurate as possible a picture of a company’s opera- tional activities and financial position.
gross margin Represents the amount of revenue that is left after costs to cover operating expenses.
income statement A record for a period of a company’s operational activities. Sometimes referred to as a P/L or profit/ loss statement because the bottom line of the report provides profit or loss income information.
matching principle The accounting rule that matches expenses for a period to the number of units sold during the period. Designed to help users of financial state- ments determine whether a firm can earn profits.
negative cash flow Cash outflows exceed cash inflows. Even profitable companies may experience negative cash flow on occasion.
6. Section 5.1 introduced the cash cycle: purchasing materials to produce inventory, making a sale, and finally collecting the cash from the sale. One way to think about the cash cycle is in terms of days. Inventory days tells us how long it takes from buying materials (or items for resale) to selling an item. Receivable days tells us how long it takes to collect cash after a sale is made, and Payables days tells us how long we have to pay our suppliers for materials or merchandise. The cash cycle can be seen as Inventory days 1 Receivable Days – Payables days. If a company has a negative cash cycle that means that it collects cash from a sale before it must pay its suppliers. Is a negative cash cycle good or bad for a com- pany? Is it the same thing as negative cash flow?
Key Terms
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CHAPTER 5Web Resources
Key Formulas
Cash flow 5 Net income 1 Depreciation
Cash flow 5 Net income 1 Depreciation –(Change in assets) 1 (Change in liabilities and equity)
(5.1) Expected value 5 p1 CF1 1 p2 CF2 1 p3 CF3 1 . . . 1 pn CFn 1 ani 5 1 piCFi
Web Resources
To read The New York Times article “Top 10 Reasons Small Businesses Fail,” see: http://boss.blogs.nytimes.com/2011/01/05/top-10-reasons-small-businesses-fail/
To see Nike’s financial report and notes, visit: http://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/ docs/Nike_2011_10-K.pdf
Learn more about Ernst & Young’s U.S. GAAP vs. IFRS: The Basics here: http://www.ey.com/Publication/vwLUAssets/IFRS_vs_US_GAAP_Basics_ March_2010/$FILE/IFRS_vs_US_GAAP_Basics_March_2010.pdf
For more information on deferred taxes, see: http://www.centrec.com/resources/articles/finanalysisfarmranches/deferredtaxes.pdf
EBITDA is sometimes used as a measure of cash flow (see Critical Thinking Question 4). Here is an interesting application of EBITDA to company valuation: http://www.inc.com/guides/2010/10/how-to-understand-earnings-or-ebitda.html
operating expenses Expenses that arise during the ordinary course of running a business. These include salaries paid to employees, research and development costs, legal fees, accountant fees, bank charges, office supplies, electricity bills, business licenses, and more.
operating margin The total pre-tax profit a business generated from its operations.
pro forma (or projected) financial state- ments Financial statements for future periods constructed based on historic financial ratios and assumptions about how the firm will perform in the future. They are useful tools for analyzing many types of corporate decisions.
revenue recognition Accounting rules that explain when a company may rec- ognize a transaction as a sale. Companies with aggressive accounting strategies recognize revenue as early as possible, while more conservative companies delay until they are certain of the amount to be collected.
statement of cash flows An accounting statement that shows cash from operating, investing, and financing activities.
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