chapter 4 solution outlines -

Financial Accounting: An Integrated Approach, Sixth Edith

Chapter 4 Measuring and Evaluating Cash Flow

Solution Outline for Problem 4.1

a. Investing activities is often the largest use (outflow) of cash especially in expanding businesses. The investing section of the cash flow statement offers insight into what the company is doing in this regard. Financing provide the reader with more readable information on the companies changes in debt and capital structure than does the balance sheet alone. Both new issues and retirements of debt and shares are disclosed here.

b. An increase in accounts receivable reduces the cash inflow from earnings from that indicated by net income.

c. There can be many reasons for this occurrence. Among them: Increases in current assets such as accounts receivable (cash from sales not collected),

Increases in inventory purchased and paid for but not sold, Increases in prepaid items such as rent use cash before expense is recognized, Decreases in current liabilities, the outlay of cash during the period with no expense recognized, The repayment of long-term debt, The retirement of shares and the payment of dividends, The acquisition of long-term assets which will be expensed in future periods.

d. This occurs because cash flows do not normally coincide with expense recognition as in c above. e. The declaration of a cash dividend has no effect on cash flow. A cash outflow occurs when the

dividend is paid whether this is the period in which the dividend is declared or a subsequent period. Solution Outline for Problem 4.2 In answering this, students should try to avoid jargon (which often conceals a lack of real understanding) and speak to the issues in clear English. Points could include the following: a. The income statement attempts to measure overall economic performance, which includes

estimates and assumptions about receipts and payments of cash that happened in previous years or have not yet happened. Management of the company's cash (buying things, paying bills, collecting from customers, borrowing and lending) is a different sort of problem than earning income, so the cash flow statement has been developed to show how the company performed in managing its cash.

b. There are various kinds of cash, such as cash on hand, cash in bank accounts and cash invested in

short-term investments that could be gotten back for paying bills if need be. There is even “negative cash”, such as bank overdrafts. Moving cash around among all these is a daily management task, but it is thought that investors are not really interested in such details so the cash flow statement lumps them all together as “cash and cash equivalents” and explains what happened to the total cash and equivalents during the year. (The bottom of the cash flow statement usually says what the company has included as cash and equivalents.)

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Instructor’s Solution Manual

c. Income and cash flow usually reflect good or poor management in the same sort of direction. A company making income should have a positive cash flow (more receipts than payments), and one making a loss should have a negative cash flow (more payments than receipts). Therefore, the cash flow statement starts off with the income figure and “corrects” that for items not involving cash receipts and payments during the year, arriving at a figure showing the net amount of cash inflow or outflow from day to day operations. This figure tells you how the company has done in generating (or using up) cash in its routine activities of buying and selling goods, manufacturing, administering and generally running its normal affairs.

d. The cash flow statement also tells you about cash received or paid out for four other less routine

kinds of activities, which are not represented in the income statement. The cash flow statement therefore gives a more complete picture of cash activities than the income statement could, even if the income statement were done on a receipts and payments basis. These four other activities are: i. Cash dividends paid to investors during the year; ii. Cash paid for, or received by selling, investments such as land, buildings, equipment and

long-term investments such as in other companies; iii. Cash received from, or paid out to repay, long-term debt financing such as mortgages or

bonds; iv. Cash received from, or paid out to redeem, equity financing such as new share issues.

(Amounts paid by one investor to another in stock market trades do not get to the company and so are not included in the cash flow statement or any of the financial statements.)

Solution Outline for Problem 4.3 1. The cash flow information covers at least the following:

a. It tells you what the cash income (cash from operations) is. b. It tells you why the cash income differs from the accrual net income. c. If done by the traditional indirect method, it reports whether the company’s noncash working

capital is rising or falling (supplementing the working capital and working capital ratio: if working capital is growing, that may not be good because receivables are not being collected or inventories are increasing, and if such is going on, the indirect method cash flow statement will point out the negative effect of this on cash).

d. It reports several cash activities that the income statement does not include and that can be determined from the balance sheet only if you know how to do it, such as expenditures on additional noncurrent assets, proceeds from the sale of such assets, and the raising and repayment of noncurrent liabilities and share capital.

e. It reports how much cash was used to pay dividends.

2. Net change in cash = $127,976 - $238,040 + $107,000 = -$3,064. Solution Outline for Problem 4.4 Some points that might be raised:

• analysts pay attention to income performance already - it is not ignored in favour of cash flow information, but rather that information adds to the understanding of performance;

• the strong interest in performance is what produces the interest in cash flow - it is not just idle interest;

• monitoring management's performance is an important activity, springing from a belief by investors and others that managers should not be just left to work on their own - the interest in cash is a natural part of this;

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• there's more to managing cash than just daily attention - such important but not usually frequent activities as making investments in long-term assets, raising long-term financing and issuing share capital are also involved;

• income performance and cash flow performance can be quite different, so it is not satisfactory to make presumptions about cash management based on income performance.

Solution Outline for Problem 4.5 Some points for discussion: Spending more money to produce cash flow statements?

• Cash flow statements are not costly to prepare. They are not based on the accounts in the way the income statement is; they are an analysis of the income statement, balance sheet, and retained earnings information.

• Users of financial information could reconstruct the cash flow statement using the balance sheet and income statement information. (Not in quite as much detail as that provided by management.)

Creating a dubious income measure and then uncreating it?

• Accrual accounting measures performance over time by measuring changes in wealth. • Changes in wealth are unequal to changes in cash. • The cash flow statement measures another aspect of performance, i.e. the managing of inflows and

outflows of cash, so that the entity has enough cash to pay its bills, finance its growth and keep borrowing under control.

• Cash situation of the entity can be obscured by accrual accounting. No need for cash flow statement?

• Cash flow statements report three main kinds of changes in cash, cash from operations, cash from investing activities and cash from financing activities.

• Cash from operations is basically a cash flow income statement. • The income statement does not give information about the financing and investing activities of the

entity. • The cash flow statement provides information about the solvency and liquidity of the entity. The

income statement does not provide this information.

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Cash Flow Statement for the Year X

Operating Activities: Cash receipts ($31,610 + $797,640) $ 829,250 Cash disbursements ($8,920 + $513,600 + $14,920 + $223,610) 761,050 Cash generated by operations $ 68,200Investing Activities: Noncurrent assets acquired ($81,000 + $49,000) $(130,000) Proceeds from disposal of noncurrent assets 7,000 Cash used in investing activities $(123,000)Financing Activities: Bank loan obtained $ 60,000 Repayments on mortgage (80,500) Common shares issued 140,000 Paid to redeem preferred shares (25,000) Dividends paid (15,000) Cash obtained from financing activities $ 79,500Increase in cash for the year $ 24,700 Cash on hand at the beginning of the year 68,920Cash on hand at the end of the year $ 93,620


Ryley's Dog Treats Inc. Cash Flow Statement for the Year X (Direct Method)

Operations: Cash receipts (919,160 + 65,580) 984,740 Cash disbursements (468,380 + 365,730 +

32,400 + 32,490) (899,000) 85,740Investing: Noncurrent assets acquired (132,000 + 233,750) (365,750) Proceeds from disposal of noncurrent assets 29,700 (336,050)Financing: Bonds issued 90,000 Repayments on mortgage (73,700) Common shares issued 242,000 Paid to redeem preferred shares (44,000) Dividends paid (33,000) 181,300 Decrease in cash for the year (69,010) Cash on hand at the beginning of the year 108,270Cash on hand at the end of the year 39,260

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Hannibal's Fine Dining Ltd. Cash Flow Statement for the Year X (Direct Method)

Operations: Cash receipts (850,630 + 3,100) $853,730 Cash disbursements (168,580 + 229,850 + 149,240 +

63,170) (610,840) 242,890 Investing: Noncurrent assets acquired (40,000 + 30,000) (70,000) Proceeds from disposal of noncurrent assets 6,500 (63,500) Financing: Withdrawls on line of credit 20,000 Repayments on mortgage (97,500) Common shares issued 30,000 Paid to redeem preferred shares (50,000) Dividends paid (80,000) (177,500) Change in cash 1,890 Cash on hand at the beginning of the year 146,800 Cash on hand at the end of the year $148,690 Solution Outline for Problem 4.9 Operations: Cash receipts (48,000 + 944,980) $992,980 Cash payments (832,630) 160,350Investing: Equipment purchased (580,340) Building sold 290,000 (290,340)Financing: Bonds issued 463,000 Shares issued 90,000 Bonds repaid (373,000) Dividends paid (100,000 – 20,000) (80,000) 100,000 Change in cash (29,990) Cash beginning (deduced) 55,680Cash end (43,220-17,530) $25,690

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The following items do not involve cash and are therefore irrelevant:

• Accounts receivable written off • Amortization expense • Inventory purchased on credit • Investment written down • Shares issued in exchange for land


Northern Star Theatre Company Cash Flow Statement

for the Period November 5, 2005, to August 26, 2006 Operations: Partnership income for the period $3,420 Add back amortization expense 132 Increase in interest receivable and inventory (100) Increase in accounts payable 940 Cash from operations $4,392 Investing activities: Costumes and props (660) Financing activities: Contributions by partners 1,450Cash provided during the period and on hand at its end $5,182

Solution Outline for Problem 4.11 1. Accrual Basis Cash Basis Sales $1,206 Sales 1,181 Cost of goods sold 700 Cost of goods sold 735 Gross profit $ 506 Gross profit $446 Operating expense Operating expense Amortization $38 Amortization $ Miscellaneous 146 Miscellaneous 145 Rent Rent 6 Wages ________ 184___ Wages _____ 151_____

___ Net income for the year

$ 322

Net income for the year

$295___

Accrual notes: Sales: 860 = 346 = 1,206 Cost of goods sold = 185+610+135-230 = 700 Miscellaneous 145+12-5-6 = 146 Wages and rent included in Miscellaneous Cash basis notes Cash sales + Acct. rec. collections: 860+85+346-110=311 Wages included in Miscellaneous.

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2. Micadam Inc

Statement of Cash Flows For the Year Ended December 31, 2006

Net income $ 322Amortization 38 360Increase in accounts receivable (25)Increase in inventory (45)Increase in accounts payable 10 Increase in wages payable 7Increase in prepaid rent (6) (59)Cash flow from operations $ 301 Solution Outline for Problem 4.12 Saint John Enterprises Inc. Cash Flow Statement For the Year 2003 Operations:

Net income $ 38,400 Add (subtract) non-cash items: Amortization expense 37,700 (2) Noncurrent asset write-off 112,000 Future income taxes 8,800 Gain on sale of truck (700) Change in working capital accounts: Current assets (40,600) Current liabilities 25,800 (1)

$ 181,400 Investing: Proceeds from sale of truck 8,400 Acquisition of noncurrent assets (191,000) (2) Cash used in investing activities $(182,600) Financing: Payment of noncurrent liabilities (9,300) (3) Increase in share capital 20,000 Dividends paid (8,500) (4) Cash from financing activities $ 2,200 Net increase in cash $ 1,000 (5) Cash beginning of the year 5,200 Cash end of the year $ 6,200

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Solution Outline for Problem 4.12 (Continued) (1) Change in current liabilities 27,300 Dividends payable (1,500) 25,800 (2) Reconciliation of noncurrent assets: Balance 2002 286,200 NBV of truck sold (7,700) Amortization expense (37,700) Acquisition of assets 191,000 Written-off (112,000) Balance 2003 319,800 Note: We see the NBV of truck sold in the cash flow statement as follows: Investing - proceeds of disposition 8,400 Operating - gain on sale (700) NBV of truck sold 7,700 (3) Change in noncurrent liabilities (500) Increase in future income tax liability (8,800) Payment of noncurrent liabilities (9,300) Note: We know that the total noncurrent liabilities changed by (500) and that + 8,800 was due to

future income tax, so by deduction, the company must have repaid 9,300 of some other noncurrent liabilities.

(4) Dividends declared 10,000 Dividends payable (1,500) Dividends paid 8,500 (5) Change in cash equivalent assets 3,100 Change in cash equivalent liabilities (2,100) Net increase in cash 1,000

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Gronsky’s Great Things Ltd. Cash Flow Statement

For the year Ended August 31, 2007 Operations Net income 35,050 Amortization 3,750 Non-cash working capital changes Accounts receivable (4,375) Income tax receivable (950) Inventory of clothing (37,775) Supplies inventory (11,250) Prepaid rent (2,500) Accounts payable 28,750 Credit note liability 550 (27,550) 11,250 Investing Purchase of furniture and fixtures (19,375) Purchase of investment (12,500) Incorporation costs (2,375) (34,250) Financing Loan 10,000 Dividends paid (4,000 – 2,000) (2,500) 7,500 Change in cash (15,500) Cash, beginning 18,750 Cash, ending 3,250 Solution Outline for Problem 4.14

Wriggle Corp.

Cash Flow Statement For the Year Ended December 31, 2007

Net income $ 21 Amortization 9 30 Increase in accounts receivable (12) Increase in inventory (6) Increase in accounts payable 6 Gain on disposal of fixed assets (3) Loss on disposal of investment 6 (9) Cash flow operations 21

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Investing activities: Disposal of investments $ 15 Disposal of fixed assets 12 Purchase of fixed assets (60) Net Cash outflow investing (33) Cash used by investing activities Financing activities: Issuance of long-term notes payable $12 Issuance of common shares 15 Dividends paid (9) Net cash flow financing 18 Net increase in cash $6

2.

• Wriggle had a positive cash flow for the year • Proportionately large outflow in investing (purchase of fixed assests) • Operations provided insufficient cash to make fixed asset purchases • Increased both long-term debt and share capital to pay for acquisitions • Company would appear to be expanding capacity in the expectation of increase sales

Solution Outline for Problem 4.15 There is enough information to prepare an indirect cash flow statement, so this is illustrated below. Net income: Collection of this year’s revenue 347,085 Uncollected revenue at the end of this year 28,116 375,201 Payment of this year’s expenses 267,269 Amortization 42,221 Unpaid expenses at the end of this year 26,417 (335,907) Proceeds on sale of equipment 2,160 Cost of equipment that was sold (14,400) Accumulated amort. on equipment that was sold 10,800 (1,440) 37,854 Cash receipts: Collection of this year’s revenue 347,085 Collection of last year’s revenue 20,516 Deposit on next year’s revenue 5,489 Noncurrent debt issued 67,500 Proceeds on sale of equipment 2,160 442,750 Cash disbursements: Payment of this year’s expenses 267,269 Payment of last year’s expenses 1,701 Advance payment on next year’s expenses 8,028 Repayment of noncurrent debt 27,000 Purchase of new equipment 164,178 468,176

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Ending cash: 63,419 + 442,750 - 468,176 = 37,993 If the direct method were used, cash from operations would be shown as: Cash received from customers: 347,085 + 20,516 + 5,489 = 373,090 Cash paid to suppliers: 267,269 + 1,701 + 8,028 = (276,998) 96,092

Chatal Inc. Cash Flow Statement for Year X

Operations Net income $42,060 Amortization 46,912 Loss on disposal 1,600 $90,572 Changes in non-cash working capital: Receivables (22,795 - 31,240) $(8,445) Prepaids ( 0 - 8,920) (8,920) Payables (1,890 - 29,352) 27,462 Deferred revenue (0 - 6,099) 6,099 16,196 $106,768 Investing Purchase of new equipment $(182,420) Proceeds from equipment sale 2,400 $(180,020) Financing Issue of long-term debt $ 75,000 Repayment of long term debt (30,000) $45,000 Decrease in cash for the year $(28,252) Cash at beginning of the year 63,419 Cash at end of the year $35,167 Solution Outline for Problem 4.19 1. If the garage had brought $40,000 instead of $25,000, cash used in investing activities would have gone

down $15,000 for the proceeds, to $212,414. In Operations, income would have been $15,000 higher because the garage disposal would have produced a $10,000 gain instead of the $5,000 loss shown in the Problem 4.30* solution. But this would cancel out in calculating cash from operations, because instead of a $5,000 loss being added back to income of $56,292, there would have been a $10,000 gain deducted from an income of $71,292. So no effect on cash from operations, and the lower Investing net outflow would carry down to the bottom cash change, which would be $15,000 higher, and ending cash would therefore be $15,000 higher at $31,064. This makes sense, as the company would have $15,000 more cash from the garbage disposal.

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2. Ignoring part 1, this would have changed the $5,000 loss on sales to a $7,000 gain ($25,000 proceeds minus $18,000 book value). But that change would mean that the amortization expense deduced in Problem 4.30* would have been $12,000 higher. So in Operations, the amortization add-back would be $12,000 higher and instead of a $5,000 loss add-back there would be a $7,000 gain deducted, for a change of $12,000 in the opposite direction. So no net effect on cash from operations or cash on hand. This makes sense, because a change in the garage’s accumulated amortization doesn’t involve cash at all, so cannot have any effect on the cash flow statement.

Solution Outline for Problem 4.16a. Cash from operations = $11,000 income + $5,000 amortization – $4,000 gain + $3,000 future tax

expense + $13,000 loss – $1,000 change in OCA + $2,000 change in OCL = $29,000. b. Cash from financing = $2,000 shares + $4,000 debt* – $6,000 dividend = $0. (*Debt change: NCL begin = $18,000 + $3,000 regular future tax – $8,000 future tax reduction on

special item = $13,000. Present NCL = $17,000, so it seems $4,000 more debt was incurred.) c. Cash for investing = $34,000 new spending** – $7,000 proceeds = $27,000 net outflow. (** New spending: NCA begin = $32,000 – $21,000 write-off – $3,000 book value of item sold –

$5,000 amortization = $3,000. Present NCA = $37,000, so it appears that $34,000 of new spending happened.)

d. From above, $29,000 + $0 – $27,000 = $2,000. Looking at the CEA and CEL categories, the net cash (CEA – CEL) was $(2,000) at the beginning and $0 at the end, an improvement of $2,000.


Aragon Ltd. Cash Flow Statement

for the Year X Operating activities Net income for the year $216,350 Add back: Amortization $ 218,890 Future income tax expense 21,210 240,100 Noncash working capital changes Increase in accounts receivable (223,120) Decrease in inventory 80,200 Decrease in accounts payable (91,970) Increase in current income tax payable 6,530 (228,360) Cash from operating activities $228,090 Investing activities Additions to noncurrent assets $(393,980) Proceeds from sales of noncurrent assets 11,260 Cash used by investing activities (382,720) Financing activities New noncurrent debt $ 250,500 Repayments of noncurrent debt (78,800) Share capital issued 120,000 Dividends paid (75,000) Cash from financing activities 216,700 Change in cash for the year $ 62,070 Beginning cash (13,730)1

Ending cash $ 48,340 1 -The beginning cash figure is deduced from the change in cash for the year and the ending cash balance, both of which are known from Fred’s draft statement.

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Solution Outline for Problem 4.18 Effects if the event had occurred during the year: a. Investing would show an expenditure of $38,950, which would reduce the cash inflow from Investing

activities. The net change in cash would be $38,950 lower. b. Investing would now show an expenditure of $18,950 ($38,950 – $20,000), which would reduce the

cash inflow from Investing activities. The net change in cash would be $18,950 lower. c. The change in accounts receivable would have been $6,000 higher in the direction of reducing cash

in the Operating activities section of the statement, because this revenue is reflected in income but hasn’t yet been collected. Cash from operating activities and the net change in cash would be $6,000 lower.

d. Dividends would show a cash outflow of $15,000, which would reduce the cash inflow from Financing activities. The net change in cash would be $15,000 lower.

e. The demand loan would increase the cash inflow from Financing by $25,000, and the change in cash would also be $25,000 higher.

f. No change. In Operating activities, net income would be $5,000 lower but then the amortization added back in the Operations section would be $5,000 higher, cancelling out the effect. Therefore, there is no effect on the net total change in cash. Amortization has no effect on cash or on total cash from operations.

Solution Outline for Problem 4.20 2004 a) Additions to properties (673.8 + 25.0) (698.8) Cash used in investing activities (666.1 + 25.0) (691.11) Increase (decrease) in net cash (218.3 - 25.0) 193.3 Net cash at end of year (353.0 - 25.0) $ 328.0 b) Issuance of Common Shares (2.5 + 14.0) 16.5 Cash provided by (used in) financing activities (98.4 + 14.0) 112.4 Increase (decrease) in net cash (218.3 + 14.0) 232.3 Net cash at end of year (353.0 + 14.0) $ 367.0 c) Net income (413.0 + 10.0) $ 423.0 Depreciation and amortization (407.1 - 10.0) 397.1 Cash provided by operating activities no change Increase (decrease) in net cash no change Net cash at end of year no change d) Repayment of long-term debt (16.1 + 130.0) (146.1) Cash provided by (used in) financing activities (98.4 - 130.0) 31.6 Increase (decrease) in net cash (218.3 – 130.0) 88.3 Net cash at end of year (353.0 –130.0) $ 223.0 e) Track dismantling (costs) net of proceeds from disposal of transportation properties (10.2 + 7.0) (17.2) Cash used in investing activities (666.1 + 7.0) (659.1) Increase (decrease) in net cash (218.3 – 7.0) 225.3 Net cash at end of year (353.0 – 7.0) $ 360.0

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f) Accounts receivable (Note 10) (39.0 - 5.0) $ 34.0 Change in non-cash working capital (Note 10) (33.2 + 5.0) 38.2 Change in non-cash working capital balances Cash provided by operating activities (786.0 + 5.0) 791.0 Increase (decrease) in net cash (218.3 + 5.0) 223.3 Net cash at end of year (353.0 + 5.0) $ 358.0 Solution Outline for Problem 4.21 1. Two figures in the cash flow statement are incorrect. The change in accounts.payable (in Operations)

includes the dividend payable, so the increase in that payable has the effect of increasing cash from operations, via an incorrect change in noncash working capital accounts. The dividend figure in the Financing section is also wrong, by the same amount, because so far, it will have been assumed that the whole dividend declared had been paid. The declared amount should have been reduced by the payable (unpaid) amount so that the Financing section showed only the cash paid for dividends. So cash from Financing is too low, and cash from Operations is too high, by the same amount. The two cancel out in their effect on the total change in cash.

2. a. Let x be the acquisitions during the year. Then x - $159,400 amortization expense - $790,000 cost

removed when building was sold + $610,000 accumulated amortization removed when building was sold = $382,500 net change. Solving, x = $721,900. Going the other way, $721,900 - $790,000 -$159,400 + $610,000 = $382,500,

b. The book value of the building was $790,000 - $610,000 = $180,000. The $190,000 proceeds - $180,000 book value = $10,000 gain on sale.

c. Add back amortization of $159,400; subtract gain on sale of $10,000. d. Investing would show $721,900 acquisitions minus $190,000 proceeds, for a net expenditure of

$531,900. Solution Outline for Problem 4.22 This problem is an example of “what if” or “change effects” analysis, an important skill to be emphasized in later chapters. 1. There would be no effect on the cash flow statement as long as the demand bank loan is considered

part of the total cash and cash equivalents explained by the cash flow statement. It's just a rearrangement within CCE: the CCE figures at the bottom would show cash going up by $250,000 and bank loan going up by the same. The two changes would cancel out in calculating total CCE change. (If there had been a long-term loan, CCE would have gone up by $250,000 due to the increased cash and that increase would be explained by a cash inflow under the cash flow statement's financing activities category.)

2. Cash generated from operations would go up because the change in accounts receivable would be reduced by $75,000, which would look the same as if the money had been collected from customers. Cash used by investing activities would also go up, as if the company had gone out and made a $75,000 long-term investment. The net effect on CCE would be zero: quite properly, as no cash actually was affected by the reclassification.

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3. Cash used by investing activities would go up by $710,000, as would cash received from financing activities. There would be no net effect on CCE as cash position is really unaffected by a 100% financed acquisition. (The cash flow statement “grosses up” the transaction as if the $710,000 was deposited from the borrowing and then expended purchasing the land. Indeed, this may well have happened, or instead a lawyer or trustee may have handled all the cash. No matter: the cash flow statement tells us about it anyway.) If the financing had been by equity instead of debt, there would be little effect: instead of the “debt” line under financing activities showing the $710,000 cash receipt, the “equity” line would.

4. Income would go down by $82,000 and the amortization added back to income at the top of the cash flow statement would go up by $82,000. There would therefore be no effect on cash from operations or any other part of the cash flow statement, including on the CCE figure. This is as it should be: there was no cash involved in the increase of depreciation expense.

5. CCE would go down by $50,000 when the cash was paid, and the reason would be shown under the dividends paid category of the cash flow statement. Until the dividend is paid, the cash flow statement would not reflect the dividend declaration because no cash has yet been paid out.

6. Income would go down by $35,000, as would CCE due to the disbursement of the cash. Thus the CCE figure would be $35,000 lower and would be explained by reduced cash generated from operations.

Solution Outline for Problem 4.23 • Cash began and ended negative in spite of much activity, but the change in cash was positive so the

situation improved. • Cash from opeartions was more than twice net income so that is good, but increased accounts

receivable (possible collection problems) and inventories (possible selling problems), combined with increased payables (possible problems keeping up with bills), suggest difficulty with managing the day-to-day cash and with working capital management.

• Investing activities were almost twice the cash from operations, and given the lack of cash on hand, the company had to get substantial financing to support the asset acquisitions. Not much cash was obtained by selling noncurrent assets, so management seems to be building up the company’s plant and equipment.

• Amortization expense was twice the income and almost equal to cash from operations, but only half the new long-term investment. This supports the idea that the company’s productive capacity is growing and being kept up to date.

• Financing activities seemed to be complicated by substantial debt repayments—another demand on cash (we don’t know if the debts had come due or if the company chose to repay them, perhaps to refinance and get lower interest rates); therefore, almost $550,000 of new financing was required. This was raised mostly through debt, but also additional shares were issued (perhaps to keep the debt-equity mix from becoming too much weighted to debt).

• The company chose to pay out almost 40% of net income as dividends. If that had not been done, there would have been almost no cash deficit at the end of the year.

Solution Outline for Problem 4.24 • Cash from operations was nearly five times as large as net income. • Accounts receivable increased while inventories decreased. This suggests that management has

allowed collections to slip a bit, however the increase in receivables may result from an increase in sales. The decrease in inventories may signal more effective management of stock on hand. Definitive analyses would require examination of both balance sheet movements and income statement amounts. Accounts payable has increased and this may signify difficulty with paying bills timely.

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• Investing activities were about 60% of cash from operations and approximately 20% amortization expense. Wemakem does not appear to be growing but simply maintaining its productive capacity.

• Wemakem made significant debt repayments. There was no need to issue additional debt, as more than enough cash was generated to support what little investing was done.

• Dividends in excess of net income were paid out to shareholders. This high dividend payout ratio, combined with minimal investing activity seems to suggest that Wemakem is a “cash cow”.

• There has been an overall decline in cash but that is not a bad thing if the money in the bank is not earning much in the way of interest and can be put to better use.


• Cash flow Provided by Operating Activities declined significantly, 58%,((877.4 – 368.5/877.4)) in 2003. This is mostly due to changes in operating assets and liabilities. Note 19 shows that the major changes were the increases in inventory and accounts receivable. The accounts receivable collection period rose from 99.9 days in 2002 (817.5/(2987.7/365)) to 136.6 days (1,120.7/(3061.7/365)) in 2003. This may have been the result of accounts receivable acquired with subsidiaries purchases or the collections may have slowed. Not 1 states that inventories are valued at the OEB approved price. Thus the increase in inventory value reported may have arisen from any combination of price increase and volume of gas in storage.

• The proceeds of disposition of non-current assets provided about three-quarters of the funds requires to support acquisitions, long-term investments and additions to property plant and equipment in 2002

• Investments in new long-term assets was so much lower in 2003 that the sale of other assets and collections of loans from affiliates generated surplus funds.

• 2004 showed a return to increased investment in long-term assets with investing activities using more funds than were generated from operating activities.

• Net debt reduction was significant in both 2002 and 2003. 2004 showed a return to net borrowings largely to finance the return to increased investment activities.

Solution Outline for Problem 4.261. The story of how there can be a profit but no cash on hand is clearly set out in the cash flow

statement: Cash income for 2007 was $12,000 The bank loan provided more cash 7,000 $19,000 There was cash on hand at the beginning 1,000 Total cash available $20,000 Bikes and shed were purchased 20,000 So no cash left $ 0

Natasha spent all the cash from the profit, and more, on the new bikes and the shed. 2. The loan from Natasha’s parents would increase 2007 cash by $5,000 and would be shown under

Financing in the cash flow statement, as the 2006 loan was. The bank loan is a little trickier: • If the extra bank loan were treated as the 2007 loan was then it would increase cash by $2,000

and would be shown under Financing just to keep the direct financing sources separate; • If the cash flow statement’s definition of cash were broadened to include cash and equivalents

(as in most cash flow statements), and if this loan were considered part of CCE because of its demand nature, then this loan would have no effect on the cash flow statement. Cash would go up by $2,000 but the loan (part of CCE) would go up the same, so there would be no net effect on CCE even though plain cash went up.

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3. If Natasha continues the business, she will not have to pay for a shed or bicycles next year. She should therefore have a great deal of extra cash. She could potentially borrow against the bicycles on a long-term loan as the bicycles should be able to generate revenues for many years.

Solution Outline for Problem 4.27 Operations: $100,000 + $200,000 – $150,000 – $25,000 = $125,000 cash generated Investing: $600,000 – $30,000 proceeds = $570,000 cash used Financing: $90,000 + $250,000 + $100,000 – $40,000 = $400,000 cash obtained Change in cash overall = $125,000 – $570,000 + $400,000 = negative $45,000 Comments: • Yes, the comfortable $50,000 cash on hand from last year end has been reduced to a marginal

$5,000 this year end. • Collection problems and increased inventory took a very large bite out of cash from operations. The

receivables increase alone is three times the year’s cash decline. • Cash from operations would have been almost enough to complete the company’s financing needs,

if dividends had not been paid. • It can be argued that dividends are the least necessary payment to make if cash is short: if they had

not been paid, there would have been only a small decline in cash, or else much less need for the bank loan.

• The company did not provide enough financing to pay for the new assets (given the collection problems): investing activities cost $570,000 but financing amounted to a net of only $400,000, and that included the $90,000 bank loan.

• The company spent three times as much on new assets as amortization expense, suggesting that the company is keeping assets up to date; indeed, the spending on new assets is so much above the cash from operations that the company appears to be growing rapidly. Cash strains often accompany growth.

Solution Outline for Problem 4.28 1. • The narrator was likely referring to the net income figure which has shown an increasing trend

with the exception of 2000 and 1994. 2. • Total net income ten years - $28.2 million. • Total cash flow from operation for ten years - $28.7 million. • Net income is very smooth and generally increasing. • Is there a possibility of net income manipulation given how variable the business is supposed to

be? • Cash from operations is not smooth at all (time variability?). • In recent years, cash from operation is not generally larger than net income, therefore the company

must be piling up accounts receivables and inventory minus accounts payable in the same amounts as depreciation.

• Assets have grown $21.3 million over ten years and bank loans have grown $10.2 million, so this is an example of the need to borrow, due to lack of internally generated funds.

• Bank loans used to be 34% of total assets, now they are 40% of total assets. • Not covered in text yet but NI/Assets = 8.6% in 1994 and 7.4% in 2003, so the company's relative

performance is slipping a bit (perhaps because of higher interest charges on its borrowing.)

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3. • Existing research has found only small market reactions to cash flow statement information, perhaps because net income and cash flow are quite highly correlated.

• Although in some years cash and income are very similar for this company, for other years they are quite dissimilar. May observe a price reaction in years in which results are quite dissimilar (e.g. 2003).

• Might also note that stock market reaction to earnings is quite strong, and this may outweigh the effects of added cash flow statement information.


Lambic Beverages Inc. Cash Flow Statement

for This Year Operating activities Net loss $ (210) Add back: Amortization expense $ 2,630 Future income tax expense 250 2,880 Noncash working capital changes: Accounts receivable $(1,150) Inventory 470 Accounts payable 1,020 Income tax payable (330) 10 Cash from operating activities $2,680 Investing activities Increase in noncurrent assets (1,850) Financing activities Repayment of bank loan $(1,100) Repayment of debt (540) Share capital issued 300 Dividends paid (50) Cash used by financing activities (1,390) Change in cash $ (560) Cash, beginning of year 1,120 Cash, ending of year $ 560

Comments on the statement: • Cash flow is quite positive in spite of negative income. • The increase in accounts receivable suggests that there may be a problem with collections. • The increase in accounts payable is inconsistent with the reduction in inventory. • Less has been spent on new assets than amortization, so the book value of noncurrent assets is

lower (are they being kept up to date?). • Financing had a negative net effect because debt repayments and the large repayment on the bank

loan exceeded proceeds from new share capital. • Overall, the company’s entire financing came from operating activities because all other cash flows

were negative. Cash remained positive, however, so reductions in the company’s bank loan and debt were probably sensible, saving interest and reducing risk.

This Year Last Year Working capital ratio 8,210 / 7,640 = 1.075 8,090 / 8,050 = 1.005 Debt-equity ratio (7,640 + 14,060) / 5,420 = 4.00 (8,050 + 14,350) / 5,380 = 4.16

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Comments on ratios: • The decline in cash is countered by a slight improvement in the working capital ratio, but the

current position is not strong because the working capital remains only slightly positive. • The debt-equity ratio has also improved: the company paid off debt and raised share capital greater

than the sum of the loss and dividends. Solution Outline for Problem 4.30

Tamarack Systems Inc. Cash Flow Statement

for the Year 2007 Operating activities Net income $ 56,292 Noncash expenses ($139,904 amortization* + $5,000 garage loss + $35,000 land write-off + $4,075 warranty provision** + $4,516 future tax expense) 188,495 Noncash working capital changes ( – $76,706 accounts receivable + $10,815 inventories + $5,317 prepaids + $35,987 accounts payable + $1,138 taxes payable) (23,449) Cash from operating activities $ 221,338 Investing activities Additions ($37,500 land*** + $279,914 building****) $(317,414) Proceeds from disposal (garage) 25,000 Cash used by investing activities $(292,414) Financing activities Bank loan obtained $ 21,700 Repayment of bonds ($22,000 – $2,000 current) (20,000) Warranty payments** (7,000) Shares issued ($50,000 – $5,000 non-cash exchange for land***) 45,000 Dividends paid ($24,000 declared + $6,000 from year before) (30,000) Cash from financing activities $ 9,700 Decrease in cash and short-term investments for the year $ (61,376) Cash and short-term investments on hand at the beginning of the year 77,440 Cash and short-term investments on hand at the end of the year $ 16,064 * Change in accumulated amortization = $69,904, but the garage’s $70,000 amortization would have been removed when it was sold, so there must have been an addition, due to expense, of $139,904. ** Warranty change = $2,925 down, but that was after paying out $7,000, so a further noncash expense provision of $4,075 must have been made. *** Land change = $7,500. This was after a $35,000 write-off, so there must have been additions to land of $42,500. But $5,000 of that was a noncash exchange for shares, so the cash spent on land was $37,500. **** Building cost change = $179,914, but the garage’s $100,000 cost would have been removed when it was sold, so the additions to building must have cost $279,914.

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Comments: • Tamarack generated about all the cash it needed to finance its investing from operations, so it

needed little noncurrent financing and still managed a small increase in cash. • Cash from operations was four times net income. This demonstrates that accrual income can be a

poor guide to cash flow. • Cash was maintained partly by cashing in the temporary investments on hand last year. So you

could say that near-cash resources actually went down this year: there are no temporary investments left to use if there are cash needs next year.

• The rise in accounts receivable was the only negative in the otherwise cash-increasing management of noncash working capital accounts. If the receivables had not risen so much, the company would not have had to liquidate its temporary investments.

Solution Outline for Problem 4.31 1. Cash and cash equivalents could be defined in various ways. Defining CCE as "cash plus 30-days

term deposits" produces the following cash flow statement:

Greenplace Restaurants Inc. Cash Flow Statement for 2006

Operations: Net income $ 61,140 Add back non-cash expenses (amortization) 47,110 $108,250 Changes in non-cash working capital: Receivables $ 24,489 Inventories (37,241) Prepaid expenses (8,778) Trade payables 37,970 Taxes payable (9,498) 6,942 Cash generated by operations $115,192 Investing activities: Cash used to acquire buildings and equipment (206,942) Financing activities: Cash obtained through mortgage $ 45,500 Cash obtained through bank loan 24,780 Cash obtained from shares issued 35,000 Dividends paid (21,000) 84,280 Decrease in cash and equivalents $(7,470) Reconciliation of change in cash and equivalents: Increase in cash $ 3,030 Decrease in term deposits (10,500) $(7,470)

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2. What the cash flow statement reveals about the company's 2006 cash management: • cash (CCE) declined during the year; • cash from operations was positive but was used up in investing activities; • most of the cash from operations arose from income - there were many changes in non-

cash working capital accounts, but they all netted out close to zero, so the company appeared to be keeping its working capital under control;

• dividends caused a fairly minor drain on cash; • acquisition of buildings and equipment caused a very large drain on cash, larger than cash

from operations and from financing put together - this indicates the company is keeping its operating assets up to date;

• cash from financing was divided between debt and equity, with twice as much coming from debt as from equity;

• all in all, cash management seems to have been all right, with most of the cash from income used to acquire operating assets and not much used to pay dividends or increase current assets - however, more information about the policies and actions behind the figures is needed to make a proper evaluation of the cash management.

Solution Outline for Problem 4.32 1. Fuzzy Wuzzy Wines Ltd.

Cash Flow Statement For the Year Ended August 31, 2006

Operations: Net income $ 235 Non-cash items: Amortization $210 Write-off on building 45 255 Changes in non-cash working capital: Receivables (went up, tied up cash) $(170) Inventories (went up, tied up cash (90) Payables (went up, saved cash) 225 (35) $455 Investing: Increased factory investment (used cash) $(655) Decreased term deposit (produced cash) 150 (505) Financing: Long-term loans reduced (used cash) $(175) Share capital issued (produced cash) 200 Bank loan received (produced cash) 40 Dividend paid: as given (used cash) (110) (45) Net decrease in cash for the year $(95)

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2. Degree of happiness with management's performance depends on the story behind what the cash flow statement reveals. There is one main good thing: substantial cash was generated by operations. However, that is clouded by large increases in receivables and inventories, tying up cash. Apparent difficulties in paying bills are shown by the large rise in payables. The company put a great deal of money into its factory: if this improved products or competitiveness, the company may be well fixed for the future, but it probably cannot stand another year with a cash decrease. Perhaps strangely, the company repaid a lot of long-term debt in the year it was acquiring new factory assets. As that was offset by new share capital issued, perhaps the company was trying to reduce its debt risk. (Even with the increases in payables and bank loan, the debt/equity ratio improved from 0.88 in 2005 [$700/$800] to 0.70 in 2006 [$790/$1,125].)

We can see that this cash flow statement tells us a lot about what happened to the company during the year. Some of the results are fairly clear, others (such as the factory expenditures and the financing changes) require more investigation or data.

Solution Outline for Problem 4.33 Prairie Products Inc. Balance Sheet as at November 30, 2007 (With 2006 Figures for Comparison) (in thousands of dollars)

ASSETS LIABILITIES AND EQUITY 2007 2006 Change 2007 2006 Change

Current assets: Current liabilities: Cash $ 31 $ 38 (7) Bank loan $ 25 $ 30 (5) Marketable sec. 100 200 (100) Accounts payable 195 284 (89) Accounts rec. 281 315 (34) Taxes payable 34 20 14 Inventories 321 239 82 Dividends payable 20 30 (10) Prepaid expenses 12 18 (6) $274 $364 (90) $745 $810 (65) Noncurrent assets: Noncurrent liabilities: Land cost $182 $ 70 112 Mortgage payable $240 $280 (40) Buildings cost 761 493 268 Bonds payable 200 0 200 Equipment cost 643 510 133 Future income tax 138 111 27 $1,586 $1,073 513 Warranty liability 126 118 8 $704 $509 195 Accum. amort. 631 569 (62) Shareholders' equity: $ 955 $ 504 451 Share capital 600 450 150 Investments, cost 365 438 (73) Retained earnings 487 429 58 $1,320 $ 942 378 $1,087 $ 879 208 TOTAL $2,065 $1,752 313 TOTAL $2,065 $1,752 313

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Prairie Products Inc. Cash Flow Statement For the Year Ended November 30, 2007 Operations: Net income $ 98 Add (subtract) items not affecting cash: Amortization expense 118 (1) Loss on sale of building 12 (1) Future income tax 27 Warranty expense 23 (4) Gain on sale of investments (29) (2) Change in working capital accounts: Accounts receivable 34 Inventories (82) Prepaid expenses 6 Accounts payable (89) Taxes payable 14 Cash flow from operations $ 132 Investing: Sale of marketable securities 100 Proceeds on sale of investment 102 (2) Acquisition of land (112) Proceeds on sale of building 42 (1) Acquisition of building (378) (1) Acquisition of equipment (133) Cash used in investing activities $(379) Financing: Payment of bank loan (5) Payment in warranty liability (15) (4) Payment of mortgage (40) Bond issue 200 Sale of shares 150 Dividends paid (50) (3) Cash flow from financing activities $ 240 Change in cash (7) Cash, beginning of the year 38 Cash, end of the year $ 31

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(1) Reconciliation of building account and accumulated amortization: Building: 2002 balance 493 Cost of building sold (110) 383 Acquisition of building (plug) 378 2003 balance 761 Accumulated amortization: 2002 balance 569 Accumulated amortization - building sold (56) Amortization expense 118 2003 balance 631 Loss on sale of building: Proceeds 42 NBV 110 - 56 (54) Loss (12) (2) Gain on sale of investment Proceeds 102 Cost (73) Gain 29 (3) Dividends paid Dividends declared 40 Change in dividend payable 10 Dividends paid 50 (4) Reconciliation of warranty liability: 2002 balance 118 Current year expense 23 Current year payment (15) 2003 balance 126 Some comments on cash management for 2007: • Not much change in cash. They company seems to be behind on accounts payable payments, but

accounts receivable collections seem okay. • Large use of cash for investing in capital assets, financed 1/3 by operations and 2/3 by debt and equity.

Capital assets are being kept up to date, acquisitions more than exceed amortization.

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Solution Outline for Problem 4.34 1. Cash receipts: 46,665 + 848,911 + 20,000 = 915,576 Cash payments: 78,640 + 649,925 + 14,610 = 743,175 Cash income: 915,676 – 743,175 = 172,401 2. Revenue: 848,911 + (73,007 – 53,116 + 46,665) = 915,467 Expense: 649,925 + (115,304 – 78,640 + 78,640) = (765,229) Gain on land (135,000 – 80,000) = 55,000 Amortization = (114,618) Accrual net income 90,620 3. Net income + non-cash (90,620 – 55,000 + 114,618) = 150,238 Accounts receivable change (73,007 – 53,116) = (19,891) Accounts payable change (115,304 – 78,640) = 36,664 Customer deposits 20,000 Prepaid expenses (14,610) Cash from operating activities 172,401 4. Cash from operating activities: 915,576 – 743,175 (all in Part 1) = 172,401 Solution Outline for Problem 4.35 1. 784,000 – 645,000 – (12,750,000 – 6,000,000) – 4,800,000 - 495,000 + 3,310,000 = (8,596,000) 2. No change, still (442,000) 3. Not okay if new president just trying to look good. But okay if these were really economically

valid. Effects should be clean from income. Solution Outline for Problem 4.36 TGIF Industries Ltd. Balance Sheet as at December 31, 2007 (thousands of dollars) 2006 Change 2007 Current assets: Cash on hand 19 +6 25 Cash in bank 238 -17 221 Term deposits 0 +100 100 Accounts receivable 2,868 -1,134 1,734 Inventories 2,916 -647 2,269 Prepaid expenses 184 -37 147 6,225 4,496 Noncurrent assets: Land cost 416 -80 336 Automotive equipment cost 892 0 892 Building cost 2,411 -890+1,670 3,191 Equipment cost 1,020 +643 1,663 4,739 6,082 Accumulated amortization 863 +291 -4141 740 3,876 5,342 Investments cost 740 -560 180 4,616 5,522 Total 10,841 10,018

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1Calculation of accumulated amortization on building sold. Proceeds - gain on sale = NBV 514 - 38 = 476 Cost-accumulated depreciation = NBV 890 - x = 476 x = 890 - 476 x = 414 Accumulated amortization on building sold = 414 Liabilities and Equity 2006 Change 2007 Current liabilities: Demand bank loan 2,205 -1,137 1,068 Other bank indebtedness 840 -360 480 Accounts payable, accruals 1,948 -587 1,361 Income other taxes payable 213 -14 199 Dividends payable 0 +60 60 5,206 3,168 Noncurrent liabilities: Mortgage payable 516 -103 413 Loans from shareholders 600 +250 850 Debenture debt 0 +300 300 Other long-term loans 318 -74 244 Future income tax 248 +68 316 Estimated pension liability 163 +53 -43 173 1,845 2,296 Shareholders' equity: Share capital 1,000 +250 1,250 Retained earnings 2,790 +614 -100 3,304 3,790 4,554 Total 10,841 10,018 Comments on management strategy: • Investing activities indicate selling off of significant long-term assets, even at a loss. • Strong reduction of accounts receivable and inventory. Cash used partly to reduce accounts payable. • Increase in long-term borrowing and decrease in short-term borrowing. • Large reduction in demand loan and other bank indebtedness. • Contributions by shareholders (500 = ½ loan, ½ shares) Ratios 2006 2007 Working capital: Current assets 6,225 = 1.20 4,496 = 1.42 Current liabilities 5,206 3,168 Debt/Equity: Liabilities 7,051 = 1.86 5,464 = 1.20 Equity 3,790 4,554 All of this indicates that management's strategy has left the company in a much stronger position.

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Solution Outline for Problem 4.37 1. These statements should be fairly straightforward from the information given, but reasonable

assumptions leading to some differences may be made (e.g. about where to place service revenue). A full set of statements should also contain notes, but there is insufficient information in this problem to prepare notes.

For ease, we begin with the income statements. Grandin Ltd. Income Statement for the Year 2007 (With 2006 Figures for Comparison) 2007 2006 Product sales revenue $163,290 $116,250 Cost of goods sold 103,190 71,650 Gross profit from product sales $ 60,100 $ 44,600 Service revenue 73,700 32,600 Total gross profit $133,800 $ 77,200 General expenses: Administration $ 14,600 $ 11,900 Amortization 4,000 5,800 Interest 4,800 3,900 Packaging and shipping 8,100 7,500 Service wages 69,500 28,200 Utilities 9,200 6,200 Total general expenses $110,200 $ 63,500 Income before income tax $ 23,600 $ 13,700 Income tax expense: Current portion $ 5,200 $ 3,000 Future portion 250 500 Total income tax expense 5,450 3,500 Net income for the year $ 18,150 $ 10,200 Grandin Ltd. Statement of Retained Earnings for the Year 2007 (With 2006 Figures for Comparison) 2007 2006 Beginning balance $37,500 $33,300 Net income for the year 18,150 10,200 $55,650 $43,500 Dividends declared and paid 4,000 6,000 Ending balance $51,650 $37,500

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Grandin Ltd. Balance Sheet as at the End of 2007 (With 2006 Figures for Comparison)

2007 2006 2007 2006 Current assets: Current liabilities: Cash $ 4,700 $ 5,400 Bank loan $ 29,000 $ 19,000 Receivables 44,200 21,300 Payables 12,300 8,900 Inventory 42,500 37,000 Inc. tax pay. 2,200 1,000 Prepaids 2,100 800 Current liabilities $ 43,500 $ 28,900 Current assets $93,500 $ 64,500 Noncurrent liabilities: Noncurrent assets: Eq. financing $ 20,000 $ 24,000 Equipment $87,000 $ 87,000 Future inc. tax 4,350 4,100 Acc. amort. 36,000 32,000 Noncurrent liab. $ 24,350 $ 28,100 Noncurr.assets $51,000 $ 55,000 Shareholders' equity: Share capital $ 25,000 $ 25,000 Retained earnings 51,650 37,500 Equity $ 76,650 $ 62,500 TOTALS $144,500 $119,500 TOTALS $144,500 $119,500

2. Grandin Ltd. Cash Flow Statement For the Year 2007 Operations: Net income for the year $ 18,150 Add back expenses not involving cash (amortization $4,000 plus future income tax $250) 4,250 $ 22,400 Changes in non-cash working capital* (25,100) Cash used in operations $ (2,700) Investing activities 0 Financing activities Equip. financing paid (4,000) Bank loan 10,000 Dividends paid (4,000) 2,000 Decrease in cash for the year $(700) Cash, beginning 5,400 Cash, ending $ 4,700 * Receivables $(22,900) Inventory (5,500) Prepaids (1,300) Payables 3,400 Inc. tax payable 1,200 Net total changes $(25,100)

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Solution Outline for Problem 4.38 There are many ways cash flow can be manipulated. The following are three possibilities. 1. Operating Cash Flows • Defer inventory purchases, i.e. allow inventory levels to run down. • This increases cash flow from operations. • May be necessary because of cash shortages or decreases in demand. • On the other hand, if there is no cash shortage and demand has not decreased this can hurt the

company. The company may not be able to supply customers, thus alienating the customers and causing a decrease in sales.

• Unethical if the manager just does it to make himself look good. 2. Investing Cash Flows • Defer acquisition of new assets. • May be necessary because of cash flow problems. • May hurt the company if existing equipment is wearing out. • May hurt the company if there is an opportunity for expansion, thus increased sales, that the

manager is not taking advantage of. • Unethical if the manager does it just to make himself look good. 3. Financing Cash Flows • Defer redemption of bonds when interest rates are falling. • May be necessary because of cash flow problems. • May result in the company making higher interest payments in the long run than they otherwise

would have had to. • Unethical if cash is available for redemption and manager fails to redeem bonds in order to make

himself look good. Solution Outline for Case 4A This case is intended to be based on any set of financial statements the instructor or students select, so there is no particular set of solution points. Instead, a few observations are made below to assist in organizing the case discussion. 1. In discussing the usefulness of the cash flow statement, it might be helpful to work through its main

parts and prompt some discussion of any difficulties students have with each: a. The statement starts with net income and so requires reconciling items that would not appear if

the statement just started with cash income or with receipts and disbursements (direct method). b. The non-cash revenues and expenses reconciliation may seem counter-intuitive because non-

cash revenues are deducted and non-cash expenses are added (leading to some people thinking that amortization is a source of cash, for example).

c. The non-cash working capital reconciliation provides information about whether cash is tied up in or released via changes in receivables, payables, etc.

d. Cash from operations specifies the cash generated from day-to-day operations. e. Cash for investing relates to the cash used or obtained via non-current asset changes. f. Cash from financing relates to the cash obtained via or used in non-current liability or equity

changes (other than from income). g. The reconciliation of cash changes to the balance sheet demonstrates that the cash flow

statement’s summary is correct.

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2. Discussing these points might be done under such headings as: a. Ways in which the income and cash flow measures correlate, or support each other. b. Ways in which the two measures differ – and if these differences add information to the overall

set of statements or else indicate some problems with the two measures, as the case implies. c. Aspects of performance that might not be well measured by either income or cash flow.

3. This is a specific application of the points in part 2. 4. This is a specific application of the points in part 1. 5. This applies to the cash flow statement’s overall interpretation. The instructor might get some help

with this discussion from section 10.5 in addition to the material in Chapter 4. Solution Outline for Case 4B The points below are only guides to the discussion. They start with the 14 comments and end with some overall observations. 1. Depends how performance is defined. Cash performance does show a reduction. Other questions

indicate the company did not issue significant new shares during the year, so the per-share figures can be compared to the past year.

2. Cash flow should be higher than accrual income because of the presence of significant non-cash

expenses like depreciation and amortization. 3. It can easily be that both figures are correct. Other questions show some of the reasons. But the

concern may be valid – the two should not be in opposite directions for any length of time. This particular pattern is not a good one, prompting the worries about earnings quality that other questions express.

4. A rise in accounts receivable could indicate aggressive recording of revenues, as the questioner

worried. But it could also indicate lax collection efforts or a change in sales patterns to lower-quality or slower-paying customers (governments are slow to pay). A rise in inventories probably is not earnings management but rather indicates difficulty selling or poor purchasing policies in which inventories pile up.

5. Depreciation and amortization do not bring in cash. This is a common misunderstanding resulting

from the cash flow statement’s format. 6. Yes, it means the restructuring charge has not been paid yet, and probably is just an estimate of a

future cash flow. Note the presence of this charge indicates that the gap between accrual income and cash income should have been larger than last year, not smaller. It adds to the growing feeling that the company is not generating cash from operations as it should.

7. Good question. Since cash did not go up much in spite of borrowing, cash must have been used for

investments, dividends or other non-operating uses. 8. Yes, good point.

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9. This is a serious point. It appears both that the company is not replacing its property and plant as they wear out and that the increases in receivables and inventories were quite large. Neither of these conclusions indicates a healthy operation.

10. Yes. It seems that cash from operations was not very large. The per-share numbers for cash flow

and EPS might have led us to think both were solid, but the evidence is building up that both were not very healthy.

11. Also true. Good idea to link cash uses and sources according to short or long-term. Issuing more

share capital would have accomplished this linkage without the risk of the borrowing. 12. Yes, this is an indication of financial trouble. 13. Again yes. The stock market is usually sensitive to cash flow, and in a case like this with falling

cash flow and rising earnings, the stock price quite likely would reflect the cash decline rather than the earnings increase.

14. Good summary comment. The next year looks quite challenging, which also could have influenced

forward-looking investors and so share prices.

Overall, the questions give us a pretty good idea of the cash flow statement’s contents and the company’s financial situation. These are just some ideas:

• Earnings and operating cash flows are not strong; • Non-cash working capital (receivables and inventories) are getting too large, draining cash; • The company is not keeping up with its property and plant investments (perhaps due to lack of

cash); • The company is borrowing to finance investments because it is not generating enough cash

internally to do this; • The company’s cash situation, both as to generating it and as to how much is available, seems

to be deteriorating steadily.

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