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Chapter

10 Statement of Cash Flows

Considering the importance of cash, it is not surprising that the statement of cashflows has become one of the primary financial statements. The statement of cashflows gives managers, equity analysts, commercial lenders, and investment bankers a thorough explanation of the changes that occurred in the firm’s cash balances.

The statement of cash flows provides an explanation of the changes that occurred in the firm’s cash balances for a specific period. Cash is considered to be the lifeblood of the firm. Understanding the flow of cash is critical to having a handle on the pulse of the firm.

Quote the Banker, “Watch Cash Flow”

Once upon a midnight dreary as I pondered weak and weary Over many a quaint and curious volume of accounting lore, Seeking gimmicks (without scruple) to squeeze through some new tax loophole, Suddenly I heard a knock upon my door, Only this, and nothing more.

Then I felt a queasy tingling and I heard the cash a-jingling As a fearsome banker entered whom I’d often seen before. His face was money-green and in his eyes there could be seen Dollar-signs that seemed to glitter as he reckoned up the score. “Cash flow,” the banker said, and nothing more.

I had always thought it fine to show a jet black bottom line, But the banker sounded a resounding, “No, Your receivables are high, mounting upward toward the sky; Write-offs loom. What matters is cash flow.” He repeated, “Watch cash flow.”

Then I tried to tell the story of our lovely inventory Which, though large, is full of most delightful stuff. But the banker saw its growth, and with a mighty oath

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He waved his arms and shouted, “Stop! Enough! Pay the interest, and don’t give me any guff!”

Next I looked for non-cash items which could add ad infinitum To replace the ever-outward flow of cash, But to keep my statement black I’d held depreciation back, And my banker said that I’d done something rash. He quivered, and his teeth began to gnash.

When I asked him for a loan, he responded, with a groan, That the interest rate would be just prime plus eight, And to guarantee my purity he’d insist on some security— All my assets plus the scalp upon my pate. Only this, a standard rate.

Though my bottom line is black, I am flat upon my back. My cash flows out and customers pay slow. The growth of my receivables is almost unbelievable; The result is certain—unremitting woe! And I hear the banker utter an ominous low mutter, “Watch cash flow.”

—HERBERT S. BAILEY Reprinted with permission.

Basic Elements of the Statement of Cash Flows The statement of cash flows is prepared using a concept of cash that includes not only cash itself but also short-term, highly liquid investments. This is referred to as the “cash and cash equivalent” focus. The category cash and cash equivalents includes cash on hand, cash on deposit, and investments in short-term, highly liquid investments. The cash flow statement analysis explains the change in these focus accounts by examining all the accounts on the balance sheet other than the focus accounts.

Management may use the statement of cash flows to determine dividend policy, cash generated by operations, and investing and financing policy. Outsiders, such as creditors or investors, may use it to determine such things as the firm’s ability to increase dividends, its ability to pay debt with cash from operations, and the percentage of cash from operations in relation to the cash from financing.

The statement of cash flows must report all transactions affecting cash flow. A company will occasionally have investing and/or financing activities that have no direct effect on cash flow. For example, a company may acquire land in exchange for common stock. This is an investing transaction (acquiring the land) and a financing transaction (issuing the common stock). The conversion of long-term bonds into common stock involves two financing activ- ities with no effect on cash flow. Since transactions such as these will have future effects on cash flows, these transactions are to be disclosed in a separate schedule presented with the statement of cash flows.

The statement of cash flows classifies cash receipts and cash payments into operating, investing, and financing activities.1 In brief, operating activities involve income statement items. Investing activities generally result from changes in long-term asset items. Financing activities generally relate to long-term liability and stockholders’ equity items. A description of these activities and typical cash flows are as follows:

1. OPERATING ACTIVITIES. Operating activities include all transactions and other events that are not investing or financing activities. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. Typical cash inflows: From sale of goods or services From return on loans (interest) From return on equity securities (dividends)

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Typical cash outflows: Payments for acquisitions of inventory Payments to employees Payments to governments (taxes) Payments of interest expense Payments to suppliers for other expenses

2. INVESTING ACTIVITIES. Investing activities include lending money and collecting on those loans and acquiring and selling investments and productive long-term assets. Typical cash inflows: From receipts from loans collected From sales of debt or equity securities of other corporations From sale of property, plant, and equipment

Typical cash outflows: Loans to other entities Purchase of debt or equity securities of other entities Purchase of property, plant, and equipment

3. FINANCING ACTIVITIES. Financing activities include cash flows relating to liability and owners’ equity. Typical cash inflows: From sale of equity securities From sale of bonds, mortgages, notes, and other short- or long-term borrowings

Typical cash outflows: Payment of dividends Reacquisition of the firm’s capital stock Payment of amounts borrowed

The statement of cash flows presents cash flows from operating activities first, followed by investing activities and then financing activities. The individual inflows and outflows from investing and financing activities are presented separately. The operating activities sec- tion can be presented using the direct method or the indirect method. (The indirect method is sometimes referred to as the reconciliation method.) The direct method essentially presents the income statement on a cash basis, instead of an accrual basis. The indirect method adjusts net income for items that affected net income but did not affect cash.

SFAS No. 95 encourages enterprises to use the direct method to present cash flows from operating activities. However, if a company uses the direct method, the standard requires a reconciliation of net income to net cash provided by operating activities in a separate sched- ule. If a firm uses the indirect method, it must make a separate disclosure of interest paid and income taxes paid during the period. Exhibit 10-1 presents skeleton formats of a state- ment of cash flows using the direct method and the indirect method.

EXHIBIT 10-1 Jones Company Example

Statement of Cash Flows—Comparison of Presentation of Direct Method and Indirect Method (Operating Activities) For Year Ended December 31, 20XX

Direct Method

Cash flows from operating activities: Cash received from customers $ 370,000 Cash paid to suppliers and employees (310,000) Interest received 10,000 Interest paid (net of amount capitalized) (4,000) Income taxes paid (15,000)

Net cash provided by operations 51,000

(continued)

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Direct Method

Cash flows from investing activities: Capital expenditures $ (30,000) Proceeds from property, plant, and equipment disposals 6,000

Net cash used in investing activities (24,000) Cash flows from financing activities: Net proceeds from repayment of commercial paper (4,000) Proceeds from issuance of long-term debt 6,000 Dividends paid (5,000)

Net cash used in financing activities (3,000) Net increase in cash and cash equivalents 24,000 Cash and cash equivalents at beginning of period 8,000 Cash and cash equivalents at end of period $ 32,000 Reconciliation of net earnings to cash provided by operating activities: Net earnings $ 40,000 Provision for depreciation 6,000 Provision for allowance for doubtful accounts 1,000 Deferred income taxes 1,000 Loss on property, plant, and equipment disposals 2,000

Changes in operating assets and liabilities: Receivables increase (2,000) Inventories increase (4,000) Accounts payable increase 5,000 Accrued income taxes increase 2,000

Net cash provided by operating activities $ 51,000 Supplemental schedule of noncash investing and financing activities: Land acquired (investing) by issuing bonds (financing) $ 10,000

Indirect Method

Operating activities: Net earnings $ 40,000 Provision for depreciation 6,000 Provision for allowance for doubtful accounts 1,000 Deferred income taxes 1,000 Loss on property, plant, and equipment disposals 2,000 Changes in operating assets and liabilities:

Receivables increase (2,000) Inventories increase (4,000) Accounts payable increase 5,000 Accrued income taxes increase 2,000

Net cash provided by operating activities $ 51,000 Cash flows from investing activities: Capital expenditures (30,000) Proceeds from property, plant, and equipment disposals 6,000

Supplemental disclosure of cash flow information: Interest paid $ 500 Income taxes paid 10,000

Supplemental schedule of noncash investing and financing activities: Land acquired (investing) and issuing bonds (financing) $ 10,000

EXHIBIT 10-1 Jones Company Example (continued)

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The 1986 SFAS Exposure Draft, “Statement of Cash Flows,” indicates that: The principal advantage of the direct method is that it shows the operating cash receipts and payments. Knowledge of where operating cash flows came from and how cash was used in past periods may be useful in estimating future cash flows. The indirect method of reporting has the advantage of focusing on the differences between income and cash flow from operating activities.2

Source: U.S. Securities and Exchange

The statement of cash flows has now been a required financial statement for over 20 years. The financial community is in agreement as to the importance of this statement. Unfortunately, the statement of cash flows has not proven as useful as many expected. A major reason for this is the failure to require the direct method of presenting operating activities. Many ratios relating to the cash flow have been developed by companies, financial services, articles, and books. There is little agreement on what ratios to compute and how to compute these ratios. Also, the direct method allows for analysis that cannot be done with the indirect method.

Exhibit 10-2 presents the 2011 Nike consolidated statement of cash flows. This state- ment presents cash from operations using the indirect method. The statement closely follows the standard format.

In addition to reviewing the flow of funds on a yearly basis, reviewing the flow of funds for a three-year period may be helpful. This can be accomplished by adding a total column to the statement that represents the total of each item for the three-year period. This has been done for Nike in Exhibit 10-2.

EXHIBIT 10-2 Nike, Inc.

Consolidated Statements of Cash Flows, with Three-Year Total (Total Column Added)

NIKE, INC. CONSOLIDATED STATEMENT OF CASH FLOWS

Year Ended May 31,

Total 2011 2010 2009

(In millions) Cash provided by operations: Net income $ 5,527 $ 2,133 $ 1,907 $ 1,487 Income charges (credits) not affecting cash: Depreciation 994 335 324 335 Deferred income taxes (362) (76) 8 (294) Stock-based compensation (Note 11) 435 105 159 171 Impairment of goodwill, intangibles and other assets (Note 4) 401 — — 401 Amortization and other 143 23 72 48

Changes in certain working capital components and other assets and liabilities excluding the impact of acquisition and divestitures:

(Increase) decrease in accounts receivable (329) (273) 182 (238) (Increase) decrease in inventories (234) (551) 285 32 (Increase) decrease in prepaid expenses and other current assets (91) (35) (70) 14 (Increase) decrease in accounts payable, accrued liabilities and

income taxes payable 228 151 297 (220) Cash provided by operations 6,712 1,812 3,164 1,736

Cash used by investing activities: Purchase of short-term investments (14,249) (7,616) (3,724) (2,909) Maturities of short-term investments 7,927 4,313 2,334 1,280 Sales of short-term investments 4,329 2,766 453 1,110 Additions to property, plant and equipment (1,223) (432) (335) (456) Disposals of property, plant and equipment 94 1 10 33 Increase in other assets, net of other liabilities (88) (30) (11) (47) Settlement of net investment hedges 173 (23) 5 191

Cash used by investing activities (3,087) (1,021) (1,268) (798)

Source: Nike, Inc. 2010 10-K (continued)

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Some observations on the 2011 Nike statement of cash flows, considering the three-year period ended May 31, 2011, follow:

1. Cash provided by operations was the major source of cash. This operating cash flow approximately offsets the cash outflow for investing activities and the outflow for financing activities.

2. Cash flow from operations related to net income and depreciation represented substantially all of the cash flow from operations.

3. Cash used for additions to property, plant, and equipment represented the major use of cash used by investing activities (except for purchases, maturities and sales of short-term investment).

4. Cash used for repurchase of common stock represented the major use of cash for financing activities. Possibly some of the repurchase of stock was related to the proceeds from exercise of stock options and other stock issuances. One of the reasons for expensing stock options is that typically a company will repurchase stock and then issue stock with the exercise of options.

Exhibit 10-3 presents the 2011 cash flow statement of Tech Data Corporation, with a total column for the three-year period. This firm presented the cash flows from operating activities using the direct method. Note the following with regard to the direct method in Ex- hibit 10-3.

1. Net cash provided by operations represented the major source of cash. 2. Acquisition of business, net of cash acquired represented the major outflow of funds

under investing activities. 3. Cash paid for purchase of treasury stock represented the major outflow of funds under

financing activities. 4. Capital contributions and net borrowings from joint venture parties represented the

major inflow of funds under financing activities.

Year Ended May 31,

Total 2011 2010 2009

(In millions) Cash used by financing activities: Reductions in long-term debt, including current portion $ (47) $ (8) $ (32) $ (7) Increase (decrease) in notes payable 13 41 (205) 177 Proceeds from exercise of stock options and other stock

issuances 896 345 364 187 Excess tax benefits from share-based payment arrangements 147 64 58 25 Repurchase of common stock (3,249) (1,859) (741) (649) Dividends – common and preferred (1,327) (555) (505) (467)

Cash used by financing activities (3,767) (1,972) (1,061) (734) Effect of exchange rate changes (37) 57 (47) (47)

Net (decrease) increase in cash and equivalents (179) (1,124) 788 157 Cash and equivalents, beginning of year 2,134 3,079 2,291 2,134 Cash and equivalents, end of year $ 1,955 $ 1,955 $ 3,079 $ 2,291 Supplemental disclosure of cash flow information: Cash paid during the year for: Interest, net of capitalized interest $ 127 $ 32 $ 48 $ 47 Income taxes 2,038 736 537 765

Dividends declared and not paid 397 145 131 121

EXHIBIT 10-2 Nike, Inc. (continued)

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EXHIBIT 10-3 Tech Data Corporation*

TECH DATA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands) (Total column added)

Year ended January 31,

Three-Year Total 2011 2010 2009

Cash flows from operating activities: Cash received from customers $ 70,175,744 $ 24,258,805 $ 21,927,372 $ 23,989,567 Cash paid to vendors and employees (69,022,849) (24,065,824) (21,320,637) (23,636,388) Interest paid, net (50,324) (15,927) (14,015) (20,382) Income taxes paid (124,988) (73,211) (48,790) (52,987)

Net cash provided by operating activities 927,583 103,843 543,930 279,810 Cash flows from investing activities: Acquisition of business, net of cash acquired (227,557) (141,138) (8,153) (78,266) Proceeds from sale of property and equipment 5,491 0 5,491 0 Expenditures for property and equipment (50,372) (18,614) (14,486) (17,272) Software and software development costs (42,942) (13,288) (14,379) (15,275)

Net cash used in investing activities (315,380) (173,040) (31,527) (110,813) Cash flows from financing activities: Proceeds from the issuance of treasury stock 44,494 5,005 37,959 1,530 Cash paid for purchase of treasury stock (300,000) (200,000) 0 (100,000) Capital contributions and net borrowings from joint

venture partner 68,574 34,556 23,208 10,810 Net (repayments) borrowings on revolving credit loans (22,927) (46,645) (19,116) 42,834 Principal payments on long-term debt (7,894) (454) (5,654) (1,786) Excess tax benefit from stock-based compensation (2,143) 1,180 963 0

Net cash (used in) provided by financing activities (215,610) (206,358) 37,360 (46,612) Effect of exchange rate changes on cash and cash equivalents (3,999) (1,090) 38,793 (41,702)

Net (decrease) increase in cash and cash equivalents 392,594 (276,645) 588,556 80,683 Cash and cash equivalents at beginning of year 447,340 1,116,579 528,023 447,340 Cash and cash equivalents at end of year $ 839,934 $ 839,934 $ 1,116,579 $ 528,023

Reconciliation of net income to net cash provided by operating activities:

Net income attributable to shareholders of Tech Data Corporation $ 511,676 $ 214,243 $ 180,155 $ 117,278

Net income (loss) attributable to noncontrolling interest: 3,843 4,620 1,045 (1,822) Consolidated net income 515,519 218,863 181,200 115,456 Adjustments to reconcile net income to net cash provided by

(used in) operating activities: Depreciation and amortization 144,473 47,285 45,594 51,234 Provision for losses on accounts receivable 37,470 11,517 10,953 15,000 Stock-based compensation expense 33,102 9,887 11,225 11,990 Accretion of debt discount on convertible senior debentures 30,834 10,278 10,278 10,278 Deferred income taxes 22,652 6,972 (2,541) 18,221 Excess tax benefit from stock-based compensation (2,143) (1,180) (963) — Changes in operating assets and liabilities, net of

acquisitions: Accounts receivable (367,878) (113,303) (168,152) (86,423) Inventories (494,860) (349,429) 116,543 (261,974) Prepaid expenses and other assets (32,072) (34,601) 21,290 (18,761) Accounts payable 989,639 278,356 336,587 374,696 Accrued expenses and other liabilities 50,847 19,198 (18,444) 50,093

Total adjustments 412,064 (115,020) 362,730 164,354 Net cash provided by operating activities $ 927,583 $ 103,843 $ 543,930 $ 279,810

*“Tech Data Corporation … is the world’s second largest wholesale distributor of technology products.” 10-K Source: Tech Data Corporation and Subsidiaries 2010 10-K

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Note the following with regard to the indirect method in Exhibit 10-3. (The indirect method represents “Reconciliation of net income to net cash provided by operating activities.”)

1. Net income plus depreciation and amortization make up most of the cash flow (remember that net income does not represent cash flow and that depreciation and amortization are not cash flow items).

2. Notice how changes in operating assets and liabilities make up approximately 44% of net cash provided by operating activities.

3. Acquisition of business, net of cash acquired represented the major outflow of funds in investing activities.

Exhibit 10-4 restates the 2011 cash flows for Tech Data Corporation, viewing inflows and outflows separately. Some observations regarding Exhibit 10-4 follow:

1. Approximately 100% of the total inflows came from operations. 2. Approximately 98% of total cash outflows related to operations. 3. The only significant inflow or outflow for investing activities was an outflow for

acquisition of business, net of cash acquired. 4. The only significant inflow or outflow for financing activities was an outflow for

purchase of treasury stock.

EXHIBIT 10-4 Tech Data Corporation*

Viewing Inflows and Outflows Separately Year Ended January 31, 2011

Percent

(In thousands) Inflows Outflows Inflow Outflow

Cash flows from operating activities: Cash received from customers $24,258,805 99.83 Cash paid to vendors and employees $24,065,824 97.92 Interest paid, net 15,927 .06 Income taxes paid 73,211 .30 Net cash provided by operating activities 24,258,805 24,154,962 99.83 98.29 Cash flows from investing activities: Acquisition of businesses, net of cash acquired 141,138 .57 Proceeds from sale of property and equipment 0 Expenditures for property and equipment 18,614 .08 Software and software development costs 13,288 .05 Net cash used in investing activities 0 173,040 0 .70 Cash flows from financing activities: Proceeds from the reissuance of treasury stock 5,005 .02 Cash paid for purchase of treasury stock 200,000 .81 Capital contributions and net borrowings from joint venture

partner 34,556 0.14 Net (repayments) borrowings on revaluing credit loans 46,645 .19 Principal payments on long-term debt 454 .00 Excess tax benefit from stock-based compensation 1,180 .00 Net cash (used in) provided by financing activities 40,741 247,099 .17 1.01 Effect of exchange rate changes on cash and cash equivalents 1,090 .00 Changes in cash (inflows and outflows): 24,299,546 24,576,191 100.00 100.00 Total cash inflows 24,299,546 Net decrease in cash $ 276,645

*“Tech Data Corporation (“Tech Data,” “we,” “our,” “us,” or the “Company”), is the world’s second largest wholesale distributor of technology products.” 10-K Source: Tech Data Corporation and Subsidiaries 2010 10-K

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Financial Ratios and the Statement of Cash Flows Financial ratios that relate to the statement of cash flows were slow in being developed. This was related to several factors. For one thing, most financial ratios traditionally related an income statement item(s) to a balance sheet item(s). This became the normal way of approach- ing financial analysis, and the statement of cash flows did not become a required statement until 1987. Thus, it took a while for analysts to become familiar with the statement.

Ratios have now been developed that relate to the cash flow statement. Some of these ratios are as follows:

1. Operating cash flow/current maturities of long-term debt and current notes payable 2. Operating cash flow/total debt 3. Operating cash flow per share 4. Operating cash flow/cash dividends

Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable The operating cash flow/current maturities of long-term debt and current notes payable is a ratio that indicates a firm’s ability to meet its current maturities of debt. The higher this ra- tio, the better the firm’s ability to meet its current maturities of debt. The higher this ratio, the better the firm’s liquidity. This ratio relates to the liquidity ratios discussed in Chapter 6.

The formula for operating cash flow/current maturities of long-term debt and current notes payable follows:

Operating Cash Flow Current Maturities of Long-Term Debt and Current Notes Payable

It is computed for Nike for 2011 and 2010 in Exhibit 10-5. For Nike, this ratio substan- tially declined in 2011. Both years represent material coverage.

Operating Cash Flow/Total Debt The operating cash flow/total debt indicates a firm’s ability to cover total debt with the yearly operating cash flow. The higher the ratio, the better the firm’s ability to carry its total debt. From a debt standpoint, this is considered to be important. It relates to the debt ratios presented in Chapter 7. It is a type of income view of debt, except that operating cash flow is the perspective instead of an income figure.

The operating cash flow is the same cash flow amount that is used for the operating cash flow/current maturities of long-term debt and current notes payable. The total debt figure is the same total debt amount that was computed in Chapter 7 for the debt ratio and the debt/equity ratio. For the primary computation of the operating cash flow/total debt ratio, all possible

EXHIBIT 10-5 Nike, Inc.

Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable

Years Ended May 31, 2011 and 2010

(In millions) 2011 2010

Operating cash flow [A] $1,812.0 $3,164.0 Current maturities of long-term debt and current notes

payable [B] $ 387.0 $ 146.0 Operating cash flow/current maturities of long-term debt

and current notes payable [A ÷ B] 4.68 times 21.67 times

Source: Nike, Inc. 2010 10-K

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balance sheet debt items are included, as was done for the debt ratio and the debt/equity ratio. This is the more conservative approach to computing the ratio. In practice, many firms are more selective about what is included in debt. Some include only short-term liabilities and long- term items, such as bonds payable. The formula for operating cash flow/total debt is as follows:

Operating Cash Flow Total Debt

The operating cash flow/total debt ratio is computed in Exhibit 10-6 for Nike for the years ended May 31, 2011 and 2010. It indicates that cash flow is significant in relation to total debt in both years, but the coverage materially declined in 2011.

Operating Cash Flow per Share Operating cash flow per share indicates the funds flow per common share outstanding. It is usually substantially higher than earnings per share because depreciation has not been deducted.

In the short run, operating cash flow per share is a better indication of a firm’s ability to make capital expenditure decisions and pay dividends than is earnings per share. This ratio should not be viewed as a substitute for earnings per share in terms of a firm’s profitability. For this reason, firms are prohibited from reporting cash flow per share on the face of the statement of cash flows or elsewhere in their financials. However, it is a complementary ratio that relates to the ratios of relevance to investors (discussed in Chapter 9).

The operating cash flow per share formula is as follows:

Operating Cash Flow� Preferred Dividends Diluted Weighted Average Common Shares Outstanding

The operating cash flow amount is the same figure that was used in the two previous cash flow formulas in this chapter. For common shares outstanding, use the shares that were used for the purpose of computing earnings per share on the most diluted basis. This figure is available when doing internal analysis. It is also in a firm’s 10-K annual report. Some com- panies disclose these shares in the annual report. This share number cannot be computed from information in the annual report, except for very simple situations.

EXHIBIT 10-6 Nike, Inc.

Operating Cash Flow/Total Debt

Years Ended May 31, 2011 and 2010

(In millions) 2011 2010

Operating cash flow [A] $ 1,812.0 $ 3,164.0 Total debt [B] $ 5,155.0 $ 4,665.0 Operating cash flow/total debt [A ÷ B] 35.15% 67.82%

Source: Nike, Inc. 2010 10-K

EXHIBIT 10-7 Nike, Inc.

Operating Cash Flow per Share

Years Ended May 31, 2011 and 2010

(In millions) 2011 2010

Operating cash flow $1,812.00 $3,164.00 Less: Redeemable preferred dividends 0.03 0.03 Operating cash flow after preferred dividends [A] $1,811.97 $3,163.97 Diluted weighted average common shares outstanding [B] 485.70 493.90 Operating cash flow per share [A ÷ B] $ 3.73 $ 6.41

Source: Nike, Inc. 2010 10-K

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When these share amounts are not available, use the outstanding shares of common stock. This will result in an approximation of the operating cash flow per share. The advant- age of using the number of shares used for earnings per share is that this results in an amount that can be compared with earnings per share, and it avoids distortions.

Operating cash flow per share is computed for Nike for 2011 and 2010 in Exhibit 10-7. Operating cash flow per share was materially more than earnings per share in 2010 and materially less than earnings per share in 2011.

Operating Cash Flow/Cash Dividends The operating cash flow/cash dividends indicates a firm’s ability to cover cash dividends with the yearly operating cash flow. The higher the ratio, the better the firm’s ability to cover cash dividends. This ratio relates to the investor ratios discussed in Chapter 9.

The operating cash flow/cash dividends formula is as follows:

Operating Cash Flow Cash Dividends

The operating cash flow amount is the same figure that was used in the three previous formulas in this chapter. Operating cash flow/cash dividends is computed for Nike for 2011 and 2010 in Exhibit 10-8. It indicates material coverage of cash dividends in both 2011 and 2010, although there was a material decline in 2011.

Alternative Cash Flow There is no standard definition of cash flow in the financial literature. Often, cash flow is used to mean net income plus depreciation expense. This definition of cash flow could be used to compute the cash flow amount for the formulas introduced in this chapter. However, this is a narrow definition of cash flow, and it is considered less useful than the net cash flow from operating activities.

Procedures for Development of the Statement of Cash Flows Cash inflows and outflows are determined by analyzing all balance sheet accounts other than the cash and cash equivalent accounts. The following account balance changes indicate cash inflows:

1. Decreases in assets (e.g., the sale of land for cash) 2. Increases in liabilities (e.g., the issuance of long-term bonds) 3. Increases in stockholders’ equity (e.g., the sale of common stock)

Cash outflows are indicated by the following account balance changes:

1. Increases in assets (e.g., the purchase of a building for cash)

EXHIBIT 10-8 Nike, Inc.

Operating Cash Flow/Cash Dividends

Years Ended May 31, 2011 and 2010

(In millions) 2011 2010

Operating cash flow [A] $1,812.0 $3,164.0 Cash dividends [B] $ 555.0 $ 505.0 Operating cash flow/cash dividends [A ÷ B] 3.26 times per year 6.27 times per year

Source: Nike, Inc. 2010 10-K

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2. Decreases in liabilities (e.g., retirement of long-term debt) 3. Decreases in stockholders’ equity (e.g., the payment of a cash dividend)

Transactions within any individual account may result in both a source and a use of cash. For example, the land account may have increased, but analysis may indicate that there was both an acquisition and a disposal of land.

Exhibit 10-9 contains the data needed for preparing a statement of cash flows for ABC Company for the year ended December 31, 2011. These data will be used to illustrate the preparation of the statement of cash flows.

Three techniques may be used to prepare the statement of cash flows: (1) the visual method, (2) the T-account method, and (3) the worksheet method. The visual method can be used only when the financial information is not complicated. When the financial information is complicated, either the T-account method or the worksheet method must be used. This book illustrates only the visual method because of the emphasis on using financial account- ing information, not on preparing financial statements. For an explanation of the T-account method and the worksheet method, consult an intermediate accounting textbook.

EXHIBIT 10-9 ABC Company

Financial Information for Statement of Cash Flows

Balance Sheet Information

Balances

Accounts December 31,

2010 December 31,

2011 Category

Assets: Cash $ 2,400 $ 3,000 Cash Accounts receivable, net 4,000 3,900 Operating Inventories 5,000 6,000 Operating

Total current assets 11,400 12,900 Land 10,000 19,500 Investing Equipment 72,000 73,000 Investing Accumulated depreciation (9,500) (14,000) Operating

Total assets $83,900 91,400 Liabilities: Accounts payable $ 4,000 $ 2,900 Operating Taxes payable 1,600 2,000 Operating

Total current liabilities 5,600 4,900 Bonds payable 35,000 40,000 Financing

Stockholders’ Equity: Common stock, $10 par 36,000 39,000 Financing Retained earnings 7,300 7,500 *

Total liabilities and stockholders’ equity $83,900 $ 91,400

Income Statement Information For the Year Ended December 31, 2011

Category

Sales $22,000 Operating Operating expenses 17,500 Operating Operating income 4,500 Gain on sale of land 1,000 Investing Income before tax expense 5,500 Tax expense 2,000 Operating Net income $ 3,500 *

*Retained earnings is decreased by cash dividends, $3,300 (financing), and increased by net income, $3,500. Net income can be a combination of operating, investing, and financing activities. In this exhibit, all of the net income relates to operating activities, except for the gain on sale of land (investing). Source: ABC Company 2010 10-K

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Following the steps in developing the statement of cash flows, first compute the change in cash and cash equivalents. For ABC Company, this is the increase of $600 in the cash account—the net increase in cash.

For the second step, compute the net change in each balance sheet account other than the cash account. The changes in the balance sheet accounts for ABC Company follow:

Assets: Accounts receivable decrease $ 100 Operating Inventories increase 1,000 Operating Land increase 9,500 Investing Equipment increase 1,000 Investing Accumulated depreciation increase 4,500 Operating (contra-asset—a change would be similar to a change in liabilities)

Liabilities: Accounts payable decrease 1,100 Operating Taxes payable increase 400 Operating Bonds payable increase 5,000 Financing

Stockholders’ equity: Common stock increase 3,000 Financing Retained earnings increase 200 *

*This is a combination of operating, financing, and investing activities.

For the third step, consider the changes in the balance sheet accounts along with the income statement for the current period and the supplementary information. The cash flows are segregated into cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Noncash investing and/or financing activities should be shown in a separate schedule with the statement of cash flows.

To illustrate the direct and indirect methods of presenting operating activities, the ABC Company income statement is used, along with the relevant supplemental informa- tion and balance sheet accounts. For the direct approach, the income statement is adjusted to present the revenue and expense accounts on a cash basis. Exhibit 10-10 illustrates the accrual basis income statement adjusted to a cash basis. Exhibit 10-11 shows the statement of cash flows for ABC Company, using the direct approach for presenting cash flows from operations.

When the cash provided by operations is presented using the direct approach, the income statement accounts are usually described in terms of receipts or payments. For exam- ple, “sales” on the accrual basis income statement is usually described as “receipts from cus- tomers” when presented on a cash basis.

Supplemental Information Category

(a) Dividends declared and paid are $3,300. Financing (b) Land was sold for $1,500. Investing (c) Equipment was purchased for $1,000. Investing (d) Bonds payable were retired for $5,000. Financing (e) Common stock was sold for $3,000. Financing (f) Operating expenses include depreciation expense of $4,500. Operating (g) The land account and the bonds payable account increased

by $10,000 because of a noncash exchange. Investing and Financing

EXHIBIT 10-9 ABC Company (continued)

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EXHIBIT 10-11 ABC Company*

Direct Approach for Presenting Cash Flows from Operations

Statement of Cash Flows For the Year Ended December 31, 2011

Cash flows from operating activities: Receipts from customers $ 22,100 Payments to suppliers (15,100) Income taxes paid (1,600)

Net cash provided by operating activities $ 5,400 Cash flows from investing activities: Proceeds from sale of land 1,500 Purchase of equipment (1,000)

Net cash provided by investing activities 500 Cash flows from financing activities: Dividends declared and paid (3,300) Retirement of bonds payable (5,000) Proceeds from common stock 3,000

Net cash used for financing activities (5,300) Net increase in cash $ 600

EXHIBIT 10-10 ABC Company

Schedule of Change from Accrual Basis to Cash Basis Income Statement

Accrual Basis Adjustments*

Add (Subtract)

Cash Basis

Sales $22,000 Decrease in receivables 100 $22,100 Operating expenses 17,500 Depreciation expense (4,500)

Increase in inventories 1,000 Decrease in accounts payable 1,100 15,100

Operating income 4,500 7,000 Gain on sale of land 1,000 This gain is related to investing

activities. (1,000) — Income before tax expense 5,500 7,000 Tax expense 2,000 Increase in taxes payable (400) 1,600 Net income $ 3,500 $ 5,400

*Adjustments are for noncash flow items in the income statement, changes in balance sheet accounts related to cash flow from operations, and the removal of gains and losses on the income statement that are related to investing or financing activities.

The noncash flow items in the income statement are removed from the account. For example, depreciation expense may be in the cost of goods sold, and this expense would be removed from the cost of goods sold.

Changes in balance sheet accounts related to cash flow from operations are adjusted to the related income statement account as follows:

Revenue accounts $ XXX Add decreases in asset accounts and increases in liability accounts +XXX Deduct increases in asset accounts and decreases in liability accounts −XXX Cash inflow $ XXX

Expense accounts Add increases in asset accounts and decreases in liability accounts +XXX Deduct decreases in asset accounts and increases in liability accounts −XXX Cash outflow $ XXX

Source: ABC Company 2010 10-K

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Exhibit 10-12 shows the statement of cash flows for ABC Company using the indirect approach. To compute cash flows from operations, we start with net income and add back or deduct adjustments necessary to change the income on an accrual basis to income on a cash basis, after eliminating gains or losses that relate to investing or financing activities. Notice on the ABC Company schedule of change from accrual basis to cash basis income statement (Exhibit 10-10) that the adjustments include noncash flow items on the income statement, changes in balance sheet accounts related to operations, and gains and losses on the income statement related to investing or financing activities.

EXHIBIT 10-12 ABC Company

Indirect Approach for Presenting Cash Flows from Operations

Statement of Cash Flows For the Year Ended December 31, 2011

Cash flows from operating activities: Net income $ 3,500 Add (deduct) items not affecting operating activities:

Depreciation expense 4,500 Decrease in accounts receivable 100 Increase in inventories (1,000) Decrease in accounts payable (1,100) Increase in taxes payable 400 Gain on sale of land (1,000)

Net cash provided by operating activities $ 5,400 Cash flows from investing activities: Proceeds from sale of land 1,500 Purchase of equipment (1,000)

Net cash provided by investing activities 500 Cash flows from financing activities: Dividends declared and paid (3,300) Retirement of bonds payable (5,000) Proceeds from common stock 3,000

Net cash used for financing activities (5,300) Net increase in cash $ 600 Supplemental disclosure of cash flow information: Cash paid during the year for: Interest net of amount capitalized $ 0 Income taxes 1,600

Supplemental schedule of noncash investing and financing activities: Land acquired by issuing bonds $10,000

Source: ABC Company 2010 10-K

Reconciliation of net income to net cash provided by operating activities: Net income $ 3,500 Adjustments to reconcile net income to net cash provided by operating activities: Decrease in accounts receivable 100 Depreciation expense 4,500 Increase in inventories (1,000) Decrease in accounts payable (1,100) Gain on sale of land (1,000) Increase in taxes payable 400

Net cash provided by operating activities $ 5,400 Supplemental schedule of noncash investing and financing activities: Land acquired by issuing bonds $10,000

EXHIBIT 10-11 ABC Company (continued)

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For the indirect approach, follow these directions when adjusting the net income (or loss) to net cash flows from operating activities:

Net income (loss) $XXX Noncash flow items:

Add expense +XXX Deduct revenues −XXX

Changes in balance sheet accounts related to operations:* Add decreases in assets and increases in liabilities +XXX Deduct increases in assets and decreases in liabilities −XXX

Gains and losses on the income statement that are related to investing or financing activities: Add losses +XXX Deduct gains −XXX

Net cash provided by operating activities $XXX

*These are usually the current asset and current liability accounts.

The remaining changes in balance sheet accounts (other than those used to compute cash provided by operating activities) and the remaining supplemental information are used to determine the cash flows from investing activities and cash flows from financing activities. These accounts are also used to determine noncash investing and/or financing.

Some observations on the ABC Company statement of cash flows follow:

1. Net cash provided by operating activities $5,400 2. Net cash provided by investing activities $ 500 3. Net cash used for financing activities $5,300 4. Net increase in cash $ 600

As previously indicated, when the operations section has been presented using the direct method, additional observations can be determined by preparing the statement of cash flows to present inflows and outflows separately. This has been done in Exhibit 10-13. Some observations from the summary of cash flows in Exhibit 10-13 follow:

EXHIBIT 10-13 ABC Company

Statement of Cash Flows For the Year Ended December 31, 2011 (Inflows and Outflows, by Activity—Inflows Presented on Direct Basis)

Inflows Outflows Inflow Percent

Outflow Percent

Operating activities: Receipts from customers $22,100 83.1% Payments to suppliers $15,100 58.1% Income taxes paid — 1,600 — 6.2

Cash flow from operating activities 22,100 16,700 83.1 64.3 Investing activities: Proceeds from sale of land 1,500 5.6 Purchase of equipment — 1,000 — 3.8

Cash flow from investing activities 1,500 1,000 5.6 3.8 Financing activities: Dividends declared and paid 3,300 12.7 Retirement of bonds payable 5,000 19.2 Proceeds from common stock 3,000 — 11.3 —

Cash flow from financing activities 3,000 8,300 11.3 31.9 Total cash inflows/outflows 26,600 $26,000 100.0% 100.0% Total cash outflows 26,000 Net increase in cash $ 600

Source: ABC Company 2010 10-K

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Inflows:

1. Receipts from customers represent approximately 83% of total cash inflow. 2. Proceeds from common stock sales approximate 11% of total cash inflow. 3. Proceeds from sales of land approximate 6% of total cash inflow.

Outflows:

1. Payments to suppliers represent approximately 58% of total cash outflow. 2. Retirement of bonds payable approximates 19% of total cash outflow. 3. Dividends paid approximate 13% of total cash outflow.

Summary The statement of cash flows provides cash flow information that is critical for users to make informed decisions. The state- ment of cash flows should be reviewed for several time periods in order to determine the major sources of cash and the major uses of cash.

The ratios related to the statement of cash flows are the following: The formula for operating cash flow/current maturities of long-term debt and current notes payable is:

Operating Cash Flow Current Maturities of Long-Term Debt and Current Notes Payable

The formula for operating cash flow/total debt is:

Operating Cash Flow Total Debt

The formula for operating cash flow per share is:

Operating Cash Flow� Preferred Dividends Diluted Weighted Average Common Shares Outstanding

The formula for operating cash flow/cash dividends is:

Operating Cash Flow Cash Dividends

Questions Q 10-1 If a firm presents an income statement and a bal- ance sheet, why is it necessary that a statement of cash flows also be presented?

Q 10-2 Into what three categories are cash flows segre- gated on the statement of cash flows?

Q 10-3 Using the descriptions of assets, liabilities, and stockholders’ equity, summarize the changes to these accounts for cash inflows and changes for cash outflows.

Q 10-4 The land account may be used only to explain a use of cash, but not a source of cash. Comment.

Q 10-5 Indicate the three techniques that may be used to complete the steps in developing the statement of cash flows.

Q 10-6 There are two principal methods of presenting cash flow from operating activities—the direct method and the indirect method. Describe these two methods.

Q 10-7 Depreciation expense, amortization of patents, and amortization of bond discount are examples of items

that are added to net income when using the indirect method of presenting cash flows from operating activities. Amortization of premium on bonds and a reduction in deferred taxes are examples of items that are deducted from net income when using the indirect method of pre- senting cash flows from operating activities. Explain why these adjustments to net income are made to compute cash flows from operating activities.

Q 10-8 What is the meaning of the term cash in the state- ment of cash flows?

Q 10-9 What is the purpose of the statement of cash flows?

Q 10-10 Why is it important to disclose certain noncash investing and financing transactions, such as exchanging common stock for land?

Q 10-11 Would a write-off of uncollectible accounts against allowance for doubtful accounts be disclosed on a cash flow statement? Explain.

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Q 10-12 Fully depreciated equipment costing $60,000 was discarded, with no salvage value. What effect would this have on the statement of cash flows?

Q 10-13 For the current year, a firm reported net income from operations of $20,000 on its income statement and an increase of $30,000 in cash from operations on the state- ment of cash flows. Explain some likely reasons for the greater increase in cash from operations than net income from operations.

Q 10-14 A firm owed accounts payable of $150,000 at the beginning of the year and $250,000 at the end of the year. What influence will the $100,000 increase have on cash from operations?

Q 10-15 A member of the board of directors is puzzled by the fact that the firm has had a very profitable year but does not have enough cash to pay its bills on time. Explain to the director how a firm can be profitable, yet not have enough cash to pay its bills and dividends.

Q 10-16 Depreciation is often considered a major source of funds. Do you agree? Explain.

Q 10-17 Pickerton started the year with $50,000 in accounts receivable. The firm ended the year with $20,000 in accounts receivable. How did this decrease influence cash from operations?

Q 10-18 Aerco Company acquired equipment in exchange for $50,000 in common stock. Should this transaction be on the statement of cash flows?

Q 10-19 Operating cash flow per share is a better indica- tor of profitability than is earnings per share. Do you agree? Explain.

Q 10-20 Hornet Company had operating cash flow of $60,000 during a year in which it paid dividends of $11,000. What does this indicate about Hornet’s dividend-paying ability?

Q 10-21 The Mason Company, a retail business had $100,000 in cash sales and $450,000 in credit sales for 2012. The accounts receivable balances were $50,000 and $60,000 on December 31, 2011 and 2012, respectively. What was the cash receipts from sales in 2012?

Problems P 10-1 The following material relates to Darrow Company:

Cash Flows Classification Effect on Cash

Noncash

Data Operating Activity

Investing Activity

Financing Activity Increase Decrease

Trans- actions

a. Net loss _________ _________ _________ _________ _________ _________ b. Increase in inventory _________ _________ _________ _________ _________ _________ c. Decrease in receivables _________ _________ _________ _________ _________ _________ d. Increase in prepaid insurance _________ _________ _________ _________ _________ _________ e. Issuance of common stock _________ _________ _________ _________ _________ _________ f. Acquisition of land, using

notes payable _________ _________ _________ _________ _________ _________ g. Purchase of land, using cash _________ _________ _________ _________ _________ _________ h. Paid cash dividend _________ _________ _________ _________ _________ _________ i. Payment of income taxes _________ _________ _________ _________ _________ _________ j. Retirement of bonds, using

cash _________ _________ _________ _________ _________ _________ k. Sale of equipment for cash _________ _________ _________ _________ _________ _________

Required Place an X in the appropriate columns for each of the situations.

P 10-2

Cash Flows Classification Effect on Cash

Noncash

Data Operating Activity

Investing Activity

Financing Activity Increase Decrease

Trans- actions

a. Net income _________ _________ _________ _________ _________ _________ b. Paid cash dividend _________ _________ _________ _________ _________ _________ c. Increase in receivables _________ _________ _________ _________ _________ _________ d. Retirement of debt—paying

cash _________ _________ _________ _________ _________ _________ e. Purchase of treasury stock _________ _________ _________ _________ _________ _________ f. Purchase of equipment _________ _________ _________ _________ _________ _________

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Cash Flows Classification Effect on Cash

Noncash

Data Operating Activity

Investing Activity

Financing Activity Increase Decrease

Trans- actions

g. Sale of equipment _________ _________ _________ _________ _________ _________ h. Decrease in inventory _________ _________ _________ _________ _________ _________ i. Acquisition of land, using

common stock _________ _________ _________ _________ _________ _________ j. Retired bonds, using

common stock _________ _________ _________ _________ _________ _________ k. Decrease in accounts payable _________ _________ _________ _________ _________ _________

Required Place an X in the appropriate columns for each of the situations.

P 10-3 BBB Company’s balance sheet and income statement follow:

BBB COMPANY Balance Sheet

December 31, 2011 and 2010

December 31,

2011 2010

Assets Cash $ 4,500 $ 4,000 Marketable securities 2,500 2,000 Accounts receivable 6,800 7,200 Inventories 7,500 8,000

Total current assets 21,300 21,200 Land 11,000 12,000 Equipment 24,000 20,500 Accumulated depreciation—equipment (3,800) (3,000) Building 70,000 70,000 Accumulated depreciation—building (14,000) (12,000)

Total assets $108,500 $108,700 Liabilities and Stockholders’ Equity Accounts payable $ 7,800 $ 7,000 Wages payable 1,050 1,000 Taxes payable 500 1,500

Total current liabilities 9,350 9,500 Bonds payable 30,000 30,000 Common stock, $10 par 32,000 30,000 Additional paid-in capital 21,000 19,200 Retained earnings 16,150 20,000

Total liabilities and stockholders’ equity $108,500 $108,700

BBB COMPANY Income Statement

For Year Ended December 31, 2011

Sales $38,000 Operating expenses:

Depreciation expense $ 2,800 Other operating expenses 35,000 37,800

Operating income 200 Gain on sale of land 800 Income before tax expense 1,000 Tax expense 500 Net income $ 500

(continued)

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Supplemental information: Dividends declared and paid $ 4,350 Land sold for cash 1,800 Equipment purchased for cash 3,500 Common stock sold for cash 3,800

Required a. Prepare a statement of cash flows for the year ended December 31, 2011. (Present the

cash flows from operations using the indirect method.) b. Comment on the statement of cash flows.

P 10-4 The income statement and other selected data for Frish Company follow:

FRISH COMPANY Income Statement

For Year Ended December 31, 2011

Net sales $640,000 Expenses:

Cost of goods sold 360,000 Selling and administrative expense 43,000 Other expense 2,000

Total expenses 405,000 Income before income tax 235,000 Income tax 92,000 Net income $143,000

Other data: a. Cost of goods sold, including depreciation expense of $15,000 b. Selling and administrative expense, including depreciation expense of $5,000 c. Other expense, representing amortization of patent, $3,000, and amortization of

bond premium, $1,000 d. Increase in accounts receivable $ 27,000 e. Increase in accounts payable 15,000 f. Increase in inventories 35,000 g. Decrease in prepaid expenses 1,000 h. Increase in accrued liabilities 3,000 i. Decrease in income taxes payable 10,000

Required a. Prepare a schedule of change from accrual basis to cash basis income statement. b. Using the schedule of change from accrual basis to cash basis income statement

computed in (a), present the cash provided by operations, using (1) the direct approach and (2) the indirect approach.

P 10-5 The income statement and other selected data for Boyer Company follow:

BOYER COMPANY Income Statement

For Year Ended December 31, 2011

Sales $19,000 Operating expenses:

Depreciation expense $ 2,300 Other operating expenses 12,000 14,300

Operating income 4,700 Loss on sale of land 1,500 Income before tax expense 3,200 Tax expense 1,000 Net income $ 2,200

(P 10-3 CONTINUED)

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Supplemental information: a. Dividends declared and paid $ 800 b. Land purchased 3,000 c. Land sold 500 d. Equipment purchased 2,000 e. Bonds payable retired 2,000 f. Common stock sold 1,400 g. Land acquired in exchange for common stock 3,000 h. Increase in accounts receivable 400 i. Increase in inventories 800 j. Increase in accounts payable 500 k. Decrease in income taxes payable 400

Required a. Prepare a schedule of change from an accrual basis to a cash basis income statement. b. Using the schedule of change from accrual basis to cash basis income statement

computed in (a), present the cash provided by operations, using (1) the direct approach and (2) the indirect approach.

P 10-6 Sampson Company’s balance sheets for December 31, 2011 and 2010, as well as the income statement for the year ended December 31, 2011, are shown next.

SAMPSON COMPANY Balance Sheet

December 31, 2011 and 2010

2011 2010

Assets Cash $ 38,000 $ 60,000 Net receivables 72,000 65,000 Inventory 98,000 85,000 Plant assets 195,000 180,000 Accumulated depreciation (45,000) (35,000) Total assets $358,000 $355,000

Liabilities and Stockholders’ Equity Accounts payable $ 85,000 $ 80,000 Accrued liabilities (related to cost of sales) 44,000 61,000 Mortgage payable 11,000 — Common stock 180,000 174,000 Retained earnings 38,000 40,000 Total liabilities and stockholders’ equity $358,000 $355,000

SAMPSON COMPANY Income Statement

For Year Ended December 31, 2011

Net sales $145,000 Cost of sales 108,000 Gross profit 37,000 Other expenses 6,000 Profit before taxes 31,000 Tax expense 12,000 Net income $ 19,000

Other data:

1. Dividends paid in cash during 2011 were $21,000. 2. Depreciation is included in the cost of sales. 3. The change in the accumulated depreciation account is the depreciation expense for the

year.

(continued)

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Required a. Prepare the statement of cash flows for the year ended December 31, 2011, using the

indirect method for net cash flow from operating activities. b. Prepare the statement of cash flows for the year ended December 31, 2011, using the

direct method for net cash flow from operating activities. c. Comment on significant items disclosed in the statement of cash flows.

P 10-7 Arrowbell Company is a growing company. Two years ago, it decided to expand in order to increase its production capacity. The company anticipates that the expansion program can be completed in another two years. Financial information for Arrowbell is as follows.

ARROWBELL COMPANY Sales and Net Income

Year Sales Net Income

2007 $2,568,660 $145,800 2008 2,660,455 101,600 2009 2,550,180 52,650 2010 2,625,280 86,800 2011 3,680,650 151,490

ARROWBELL COMPANY Balance Sheet

December 31, 2011 and 2010

2011 2010

Assets Current assets:

Cash $ 250,480 $ 260,155 Accounts receivable (net) 760,950 690,550 Inventories at lower-of-cost-or-market 725,318 628,238 Prepaid expenses 18,555 20,250 Total current assets 1,755,303 1,599,193

Plant and equipment: Land, buildings, machinery, and equipment 3,150,165 2,646,070 Less: Accumulated depreciation 650,180 525,650 Net plant and equipment 2,499,985 2,120,420

Other assets: Cash surrender value of life insurance 20,650 18,180 Other 40,660 38,918 Total other assets 61,310 57,098 Total assets $4,316,598 $3,776,711

Liabilities and Stockholders’ Equity Current liabilities:

Notes and mortgages payable, current portion $ 915,180 $ 550,155 Accounts payable and accrued liabilities 1,160,111 851,080 Total current liabilities 2,075,291 1,401,235

Long-term notes and mortgages payable, less current portion above 550,000 775,659 Total liabilities 2,625,291 2,176,894

Stockholders’ equity: Capital stock, par value $1.00; authorized, 800,000; issued

and outstanding, 600,000 (2011 and 2010) 600,000 600,000 Paid in excess of par 890,000 890,000 Retained earnings 201,307 109,817 Total stockholders’ equity 1,691,307 1,599,817

Total liabilities and stockholders’ equity $4,316,598 $3,776,711

(P 10-6 CONTINUED)

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ARROWBELL COMPANY Statement of Cash Flows

For Years Ended December 31, 2011 and 2010

2011 2010

Cash flows from operating activities: Net income $ 151,490 $ 86,800 Noncash expenses, revenues, losses, and gains included in

income: Depreciation 134,755 102,180 Increase in accounts receivable (70,400) (10,180) Increase in inventories (97,080) (15,349) Decrease in prepaid expenses in 2011, increase in 2010 1,695 (1,058) Increase in accounts payable and accrued liabilities 309,031 15,265

Net cash provided by operating activities 429,491 177,658 Cash flows from investing activities:

Proceeds from retirement of property, plant, and equipment 10,115 3,865 Purchases of property, plant, and equipment (524,435) (218,650) Increase in cash surrender value of life insurance (2,470) (1,848) Other (1,742) (1,630)

Net cash used for investing activities (518,532) (218,263) Cash flows from financing activities:

Retirement of long-term debt (225,659) (50,000) Increase in notes and mortgages payable 365,025 159,155 Cash dividends (60,000) (60,000)

Net cash provided by financing activities 79,366 49,155 Net increase (decrease) in cash $ (9,675) $ 8,550

Required a. Comment on the short-term debt position, including computations of current ratio,

acid-test ratio, cash ratio, and operating cash flow/current maturities of long-term debt and current notes payable.

b. If you were a supplier to this company, what would you be concerned about? c. Comment on the long-term debt position, including computations of the debt ratio,

debt/equity, debt to tangible net worth, and operating cash flow/total debt. Review the statement of operating cash flows.

d. If you were a banker, what would you be concerned about if this company approached you for a long-term loan to continue its expansion program?

e. What should management consider doing at this point with regard to the company’s expansion program?

P 10-8 The balance sheet for December 31, 2011, income statement for the year ended De- cember 31, 2011, and the statement of cash flows for the year ended December 31, 2011, of Bernett Company are shown in the following balance sheet.

The president of Bernett Company cannot understand why Bernett is having trouble paying current obligations. He notes that business has been very good, as sales have more than doubled, and the company achieved a profit of $69,000 in 2011.

BERNETT COMPANY Balance Sheet

December 31, 2011 and 2010

2011 2010

Assets Cash $ 5,000 $ 28,000 Accounts receivable, net 92,000 70,000 Inventory 130,000 85,000 Prepaid expenses 4,000 6,000 Land 30,000 10,000

(continued)

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2011 2010

Assets Building $170,000 $ 30,000 Accumulated depreciation (20,000) (10,000) Total assets $411,000 $219,000 Liabilities and Stockholders’ Equity Accounts payable $ 49,000 $ 44,000 Income taxes payable 5,000 4,000 Accrued liabilities 6,000 5,000 Bonds payable (current $10,000 at 12/31/11) 175,000 20,000 Common stock 106,000 96,000 Retained earnings 70,000 50,000 Total liabilities and stockholders’ equity $411,000 $219,000

BERNETT COMPANY Income Statement

For Year Ended December 31, 2011

Sales $500,000 Less expenses:

Cost of goods sold (includes depreciation of $4,000) 310,000 Selling and administrative expenses (includes depreciation of $6,000) 80,000 Interest expense 11,000 Total expenses 401,000

Income before taxes 99,000 Income tax expense 30,000 Net income $ 69,000

BERNETT COMPANY Statement of Cash Flows

For Year Ended December 31, 2011

Net cash flow from operating activities: Net income $ 69,000 Noncash expenses, revenues, losses, and gains included in income:

Depreciation 10,000 Increase in receivables (22,000) Increase in inventory (45,000) Decrease in prepaid expenses 2,000 Increase in accounts payable 5,000 Increase in income taxes payable 1,000 Increase in accrued liabilities 1,000

Net cash flow from operating activities $ 21,000 Cash flows from investing activities:

Increase in land $ (20,000) Increase in buildings (140,000)

Net cash used by investing activities (160,000) Cash flows from financing activities:

Bond payable increase $ 155,000 Common stock increase 10,000 Cash dividends paid (49,000)

Net cash provided by financing activities 116,000 Net decrease in cash $ (23,000)

Required a. Comment on the statement of cash flows. b. Compute the following liquidity ratios for 2011:

1. Current ratio 2. Acid-test ratio 3. Operating cash flow/current maturities of long-term debt and current notes payable 4. Cash ratio

(P 10-8 CONTINUED)

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c. Compute the following debt ratios for 2011:

1. Times interest earned 2. Debt ratio 3. Operating cash flow/total debt

d. Compute the following profitability ratios for 2011:

1. Return on assets (using average assets) 2. Return on common equity (using average common equity)

e. Compute the following investor ratio for 2011: Operating cash flow/cash dividends. f. Give your opinion as to the liquidity of Bernett. g. Give your opinion as to the debt position of Bernett. h. Give your opinion as to the profitability of Bernett. i. Give your opinion as to the investor ratio. j. Give your opinion of the alternatives Bernett has in order to ensure that it can pay bills

as they come due.

P 10-9 Zaro Company’s balance sheets for December 31, 2011 and 2010, income state- ment for the year ended December 31, 2011, and the statement of cash flows for the year ended December 31, 2011, follow:

ZARO COMPANY Balance Sheet

December 31, 2011 and 2010

2011 2010

Assets Cash $ 30,000 $ 15,000 Accounts receivable, net 75,000 87,000 Inventory 90,000 105,000 Prepaid expenses 3,000 2,000 Land 25,000 25,000 Building and equipment 122,000 120,000 Accumulated depreciation (92,000) (80,000) Total assets $253,000 $274,000

Liabilities and Stockholders’ Equity Accounts payable $ 25,500 $ 32,000 Income taxes payable 2,500 3,000 Accrued liabilities 5,000 5,000 Bonds payable (current $20,000 at 12/31/11) 90,000 95,000 Common stock 85,000 85,000 Retained earnings 45,000 54,000 Total liabilities and stockholders’ equity $253,000 $274,000

ZARO COMPANY Income Statement

For Year Ended December 31, 2011

Sales $400,000 Less expense:

Cost of goods sold (includes depreciation of $5,000) $280,000 Selling and administrative expenses (includes depreciation expenses of $7,000) 78,000 Interest expense 8,000 Total expenses $366,000

Income before taxes 34,000 Income tax expense 14,000 Net income $ 20,000

(continued)

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ZARO COMPANY Statement of Cash Flows

For Year Ended December 31, 2011

Net cash flow from operating activities: Net income $ 20,000 Noncash expenses, revenues, losses, and gains included in income:

Depreciation 12,000 Decrease in accounts receivable 12,000 Decrease in inventory 15,000 Increase in prepaid expenses (1,000) Decrease in accounts payable (6,500) Decrease in income taxes payable (500)

Net cash flow from operating activities $ 51,000 Cash flows from investing activities:

Increase in buildings and equipment $ (2,000) Net cash used by investing activities (2,000) Cash flows from financing activities:

Decrease in bonds payable $ (5,000) Cash dividends paid (29,000)

Net cash used for financing activities (34,000) Net increase in cash $ 15,000

The president of Zaro Company cannot understand how the company was able to pay cash dividends that were greater than net income and at the same time increase the cash bal- ance. He notes that business was down slightly in 2011. Required a. Comment on the statement of cash flows. b. Compute the following liquidity ratios for 2011:

1. Current ratio 2. Acid-test ratio 3. Operating cash flow/current maturities of long-term debt and current notes payable 4. Cash ratio

c. Compute the following debt ratios for 2011:

1. Times interest earned 2. Debt ratio

d. Compute the following profitability ratios for 2011:

1. Return on assets (using average assets) 2. Return on common equity (using average common equity)

e. Give your opinion as to the liquidity of Zaro. f. Give your opinion as to the debt position of Zaro. g. Give your opinion as to the profitability of Zaro. h. Explain to the president how Zaro was able to pay cash dividends that were greater

than net income and at the same time increase the cash balance.

P 10-10 The Ladies Store presented the following statement of cash flows for the year ended December 31, 2011:

THE LADIES STORE Statement of Cash Flows

For Year Ended December 31, 2011

Cash received: From sales to customers $150,000 From sales of bonds 100,000 From issuance of notes payable 40,000 From interest on bonds 5,000

Total cash received 295,000

(P 10-9 CONTINUED)

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Cash payments: For merchandise purchases $110,000 For purchase of truck 20,000 For purchase of investment 80,000 For purchase of equipment 45,000 For interest 2,000 For income taxes 15,000

Total cash payments 272,000 Net increase in cash $ 23,000

Note: Depreciation expense was $15,000.

Required a. Prepare a statement of cash flows in proper form. b. Comment on the major flows of cash.

P 10-11 Answer the following multiple-choice questions:

a. Which of the following could lead to cash flow problems?

1. Tightening of credit by suppliers. 2. Easing of credit by suppliers. 3. Reduction of inventory. 4. Improved quality of accounts receivable. 5. Selling of bonds.

b. Which of the following would not contribute to bankruptcy of a profitable firm?

1. Substantial increase in inventory. 2. Substantial increase in receivables. 3. Substantial decrease in accounts payable. 4. Substantial decrease in notes payable. 5. Substantial decrease in receivables.

c. Which of the following current asset or current liability accounts is not included in the computation of cash flows from operating activities?

1. Change in accounts receivable. 2. Change in inventory. 3. Change in accounts payable. 4. Change in accrued wages. 5. Change in notes payable to banks.

d. Which of the following items is not included in the adjustment of net income to cash flows from operating activities?

1. Increase in deferred taxes. 2. Amortization of goodwill. 3. Depreciation expense for the period. 4. Amortization of premium on bonds payable. 5. Proceeds from selling land.

e. Which of the following represents an internal source of cash?

1. Cash inflows from financing activities. 2. Cash inflows from investing activities. 3. Cash inflows from selling land. 4. Cash inflows from operating activities. 5. Cash inflows from issuing stock.

f. How would revenue from services be classified?

1. Investing inflow 2. Investing outflow

(continued)

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3. Operating inflow 4. Operating outflow 5. Financing outflow

g. What type of account is inventory?

1. Investing 2. Financing 3. Operating 4. Noncash 5. Sometimes operating and sometimes investing.

h. How would short-term investments in marketable securities be classified?

1. Operating activities 2. Financing activities 3. Investing activities 4. Noncash activities 5. Cash and cash equivalents

i. Which of the following is not a typical cash flow under operating activities?

1. Cash inflows from sale of goods or services. 2. Cash inflows from interest. 3. Cash outflows to employees. 4. Cash outflows to suppliers. 5. Cash inflows from sale of property, plant, and equipment.

j. A transaction that will increase working capital is

1. Purchase of marketable securities. 2. Payment of accounts payable. 3. Collection of accounts receivable. 4. Sale of common stock. 5. None of the above.

k. Working capital is defined as

1. Current assets less current liabilities. 2. Cash equivalent accounts less current liabilities. 3. Current assets less notes payable. 4. Total assets less current liabilities. 5. Current assets less cash equivalent accounts.

l. Management should use the statement of cash flows for which of the following purposes?

1. Determine the financial position. 2. Determine cash flow from investing activities. 3. Determine the balance in accounts payable. 4. Determine the balance in accounts receivable. 5. None of the above.

m. The purchase of land by the issuance of bonds payable should be presented in a statement of cash flows in which of the following sections?

1. Cash flows from operating activities. 2. Supplemental schedule of noncash investing and financing activities. 3. Cash flows from investing activities.

(P 10-11 CONTINUED)

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4. Cash flows from financing activities. 5. None of the above.

P 10-12 Szabo Company presented the following data with its 2011 financial statements:

DONNA SZABO COMPANY Statements of Cash Flows

For Years Ended December 31, 2011, 2010, and 2009

2011 2010 2009

Increase (decrease) in cash: Cash flows from operating activities:

Cash received from customers $ 173,233 $ 176,446 $ 158,702 Cash paid to suppliers and employees (150,668) (157,073) (144,060) Interest received 132 105 89 Interest paid (191) (389) (777) Income taxes paid (6,626) (4,754) (845)

Net cash provided by operations 15,880 14,335 13,109 Cash flows from investing activities:

Capital expenditures (8,988) (5,387) (6,781) Proceeds from property, plant, and equipment disposals 1,215 114 123

Net cash used in investing activities (7,773) (5,273) (6,658) Cash flows from financing activities:

Net increase (decrease) in short-term debt — 5,100 7,200 Increase in long-term debt 4,100 3,700 5,200 Dividends paid (6,050) (8,200) (8,000) Purchase of common stock (8,233) (3,109) (70)

Net cash used in financing activities (10,183) (2,509) 4,330 Net increase (decrease) in cash and cash equivalents (2,076) 6,553 10,781 Cash and cash equivalents at beginning of year 24,885 18,332 7,551 Cash and cash equivalents at end of year $ 22,809 $ 24,885 $ 18,332

Reconciliation of Net Income to Net Cash Provided by Operating Activities

2011 2010 2009

Net income $ 7,610 $ 3,242 $ 506 Provision for depreciation and amortization 12,000 9,700 9,000 Provision for losses on accounts receivable 170 163 140 Gain on property, plant, and equipment

disposals (2,000) (1,120) (1,500) Changes in operating assets and liabilities:

Accounts receivable (2,000) (1,750) (1,600) Inventories (3,100) (2,700) (2,300) Other assets — — (57) Accounts payable — 5,100 7,200 Accrued income taxes 1,200 — — Deferred income taxes 2,000 1,700 1,720

Net cash provided by operating activities $15,880 $14,335 $13,109

Required a. Prepare a statement of cash flows with a three-year total column for 2009–2011. b. Comment on significant trends you detect in the statement prepared in (a). c. Prepare a statement of cash flows, with inflow/outflow for the year ended December

31, 2011. d. Comment on significant trends you detect in the statement prepared in (c).

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P 10-13 Consider the following data for three different companies:

($000 Omitted)

Owens Arrow Alpha

Net cash provided (used) by: Operating activities $(2,000) $2,700 $(3,000) Investing activities (6,000) (600) (400) Financing activities 9,000 (400) (2,600)

Net increase (decrease) in cash $ 1,000 $1,700 $(6,000)

The patterns of cash flows for these firms differ. One firm is a growth firm that is expanding rapidly, another firm is in danger of bankruptcy, while another firm is an older firm that is expanding slowly.

Required Select the growth firm, the firm in danger of bankruptcy, and the firm that is the older firm expanding slowly. Explain your selection.

P 10-14 The following information was taken from the 2011 financial statements of Jones Corporation:

Accounts receivable, January 1, 2011 $ 30,000 Accounts receivable, December 31, 2011 40,000 Sales (all credit sales) 480,000

Note: No accounts receivable were written off or recovered during the year.

Required a. Determine the cash collected from customers by Jones Corporation in 2011. b. Comment on why cash collected from customers differed from sales.

P 10-15 Webster Corporation’s statement of cash flows for the year ended December 31, 2011, was prepared using the indirect method, and it included the following items:

Net income $100,000 Noncash adjustments:

Depreciation expense 20,000 Decrease in accounts receivable 8,000 Decrease in inventory 25,000 Increase in accounts payable 10,000

Net cash flows from operating activities $163,000

Note: Webster Corporation reported revenues from customers of $150,000 in its 2011 income statement.

Required a. What amount of cash did Webster receive from customers during the year ended

December 31, 2011? b. Did depreciation expense provide cash inflow? Comment.

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Cases CASE 10-1 TRAVEL COMPANY

The data in this case come from the financial reports of Priceline.com.*

Priceline.com Incorporated Selected Consolidated Balance Sheet Items

(In thousands, except per share data)

December 31,

2010 2009

Total current assets $1,957,464 $1,022,941 Total assets 2,905,953 1,834,224 Total current liabilities 471,168 408,765 Total liabilities 1,046,828 476,610 Accumulated earnings (deficit) 69,110 (454,673) Stockholders’ Equity 1,813,336 1,321,629

Priceline.com Incorporated Selected Consolidated Statements of Operations

(In thousands, except per share data)

December 31,

2010 2009 2008

Total revenues $3,084,905 $2,338,212 $1,884,806 Gross profit 1,908,991 1,260,763 955,971 Operating income 786,797 470,835 289,474 Net income 528,142 489,472 185,624 Per diluted common share $ 10.35 $ 9.88 $ 3.74

Priceline.com Incorporated Selected Consolidated Statements of Cash Flows

(In thousands)

2010 2009 2008

Net cash provided by operating activities $ 777,297 $ 509,665 $ 315,553 Net cash (used in) provided by investing activities (841,098) (501,460) (151,905) Net cash (used in) provided by financing activities 212,957 (168,960) (168,848) Cash and cash equivalents, end of period 358,967 202,141 364,550

Required a. 1. Compute the current ratio for 2010 and 2009. Comment.

2. Compute the debt ratio for 2010 and 2009. Comment. 3. Total revenues – Prepare a horizontal common-size – use 2008 as the base. Comment. 4. Gross profit – Prepare a horizontal common-size – use 2008 as the base. Comment. 5. Net income – Prepare a horizontal common-size – use 2008 as the base. Comment. 6. Per diluted common share – Prepare a horizontal common-size – use 2008 as the

base. Comment. 7. Net cash provided by operating activities – Prepare a horizontal common-size – use

2008 as the base. Comment. b. Give an overall comment.

*“Priceline.com Incorporated is a leading online travel company that offers our customers hotel room reservations at over 150,000 hotels worldwide through the Booking.com, priceline.com and Agoda brands.” 10-K Source: Priceline.com 2010 10-K

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CASE 10-2 CASH FLOW – THE DIRECT METHOD

ARDEN GROUP, INC. AND CONSOLIDATED SUBSIDIARIES* CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

Fifty-Two Weeks Ended January 1,

2011

Fifty-Two Weeks Ended January 2,

2010

Fifty-Three Weeks Ended January 3,

2009

Cash flows from operating activities: Cash received from customers $ 417,580 $ 431,108 $ 479,578 Cash paid to suppliers and employees (384,624) (391,957) (437,970) Interest and dividends received 1,580 565 2,513 Interest paid (94) (87) (109) Income taxes paid (11,354) (13,895) (15,545)

Net cash provided by operating activities 23,088 25,734 28,467 Cash flows from investing activities: Capital expenditures (2,597) (2,890) (5,159) Purchases of investments (29,861) (30,164) (25,130) Sales of investments 51,926 13,127 35,556 Proceeds from the sale of property, plant and

equipment 16 48 21 Net cash provided by (used) in investing activities 19,484 (19,879) 5,288

Cash flows from financing activities: Cash dividends paid (3,161) (3,161) (82,188)

Net cash used in financing activities (3,161) (3,161) (82,188) Net increase (decrease) in cash and cash equivalents 39,411 2,694 (48,433) Cash and cash equivalents at beginning of year 13,180 10,486 58,919 Cash and cash equivalents at end of year $ 52,591 $ 13,180 $ 10,486 Reconciliation of Net Income to Net Cash Provided by

Operating Activities: Net income $ 18,085 $ 21,624 $ 24,667 Adjustments to reconcile net income to net cash

provided by operating activities: Depreciation and amortization 5,307 5,599 6,110 Provision for losses on accounts receivable 44 94 169 Deferred income taxes 1,129 108 1,923 Net loss from the disposal of property, plant and

equipment 8 54 89 Realized loss on investments, net 66 0 907 Amortization of premium on investments 960 472 259 Stock appreciation rights compensation expense

(income) (394) (273) 1,823 Changes in assets and liabilities net of effects from

noncash investing and financing activities: (Increase) decrease in assets: Accounts and notes receivable 799 (246) 527 Inventories (1,302) 972 3,712 Other current assets 95 204 (281) Other assets 27 16 (69)

Increase (decrease) in liabilities: Accounts payable, trade and other current liabilities: (1,090) (2,402) (9,148) Federal and state income taxes payable (237) 668 (608) Deferred rent (61) 99 154 Other liabilities (348) (1,255) (1,767)

Net cash provided by operating activities $ 23,088 $ 25,734 $ 28,467

*“The Registrant, Arden Group, Inc. (Company or Arden), is a holding company which conducts operations through its wholly- owned subsidiary, Arden-Mayfair, Inc. (Arden-Mayfair) and Arden-Mayfair’s wholly-owned subsidiary, Gelson’s Markets (Gelson’s), which operates supermarkets in Southern California. The Company also owns certain real estate properties through a subsidiary, Mayfair Realty, Inc. (Mayfair Realty) which is wholly-owned by the Company and Arden-Mayfair. The Company is a Delaware Corporation organized in 1988.” 10-K

Source: ARDEN GROUP, INC. AND CONSOLIDATED SUBSIDIARIES, 2010 10-K

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Required a. Prepare the statement of cash flows with a total column for the three-year period.

(Do not include reconciliation of net income to net cash provided by operating activities).

b. Comment on significant cash flow items in the statement prepared in (a). c. Prepare the statement of cash flows for the 52 weeks ended January 1, 2011, with

inflows separated from outflows. Present the data in dollars and percentages. Do not include reconciliation of net income to net cash provided by operating activities.

d. Comment on significant cash flow items on the statement prepared in (c).

CASE 10-3 WEB SITE

Google, Inc.* CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions)

Year Ended December 31,

2008 2009 2010

Operating activities Net income $ 4,227 $ 6,520 $ 8,505 Adjustments:

Depreciation and amortization of property and equipment 1,212 1,240 1,067 Amortization of intangibles and other assets 288 284 329 Stock-based compensation 1,120 1,164 1,376 Excess tax benefits from stock-based award activity (159) (90) (94) Deferred income taxes (225) (268) 9 Impairment of equity investments 1,095 0 0 Other (32) (20) (12) Changes in assets and liabilities, net of effects of

acquisitions and divestiture: Accounts receivable (334) (504) (1,129) Income taxes, net 626 217 102 Prepaid revenue share, expenses and other assets (147) 262 (414) Accounts payable (212) 34 272 Accrued expenses and other liabilities 339 243 745 Accrued revenue share 14 158 214 Deferred revenue 41 76 111

Net cash provided by operating activities 7,853 9,316 11,081 Investing activities Purchases of property and equipment (2,359) (810) (4,018) Purchases of marketable securities (15,356) (29,139) (43,985) Maturities and sales of marketable securities 15,763 22,103 37,099 Investments in non-marketable equity securities (47) (65) (320) Cash collateral received from securities lending 0 0 2,361 Investments in reverse repurchase agreements 0 0 (750) Acquisitions, net of cash acquired and proceeds received from

divestiture, and purchases of intangible and other assets (3,320) (108) (1,067) Net cash used in investing activities (5,319) (8,019) (10,680) Financing activities Net proceeds (payments) from stock-based award activities (72) 143 294 Excess tax benefits from stock-based award activities 159 90 94 Repurchase of common stock in connection with acquisitions 0 0 (801) Proceeds from issuance of short-term debt 0 0 5,246 Repayment of short-term debt 0 0 (1,783) Net cash provided by financing activities 87 233 3,050

*“Google is a global technology leader focused on improving the ways people connect with information. We aspire to build products that improve the lives of billions of people globally.” 10-K Source: Google, Inc., 2010 10-K

(continued)

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