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Statement of cash flow Q & A

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  • Chapter 5 Statement of Cash Flows 191

    CHAPTER 5 5-1 No. All public companies report it because the statement of cash

    flows is a required statement with a required format. 5-2 A cash flow statement shows the sources of changes in cash

    balances and:

    a) aids in predicting future cash flows and evaluating how management's decisions generate and use of cash;

    b) aids in determining a company's ability to pay dividends and interest and to pay debts when due;

    c) aids in understanding and identifying changes in the mix of productive assets.

    5-3 Cash equivalents are highly-liquid, short-term investments that

    can be converted easily to cash with little delay. Examples include money market funds and treasury bills.

    5-4 Operating activities, investing activities, and financing activities

    are the three major types of activities summarized in the statement of cash flows.

    5-5 Major operating activities include:

    Collections Payments from customers (for sales) to suppliers (for inventory) from investees (interest & dividends) to employees (for wages) to creditors (interest) to government (taxes)

  • 192

    5-6 Major investing activities include: a) sales and purchases of property, b) sales and purchases of securities that are long-term

    investments, c) making and collecting long-term loans . 5-7 Major financing activities include: a) borrowing from (nontrade) creditors, b) repaying (nontrade) creditors, c) issuing equity securities, d) repurchasing equity securities, and e) paying dividends. 5-8 Interest paid or received appears in the operating activities

    section. Some commentators favor showing interest paid elsewhere since it is associated with financing.

    5-9 Only increasing long-term debt increases cash. Both

    repurchasing common shares and paying dividends decrease cash.

    5-10 Selling fixed assets for cash and collecting a loan increase cash.

    Purchasing equipment decreases cash. Purchasing fixed assets by issuing debt does not affect cash, but it should be shown in a schedule of noncash investing and financing activities that is part of the statement of cash flows.

    5-11 When liabilities increase, the firm has either raised cash and

    promised to pay it back later or it has preserved cash rather than paying it out to reduce growing accounts payable. So more liabilities lead to more cash. Likewise, increases in noncash assets require cash. Either cash is spent to get the asset or an asset is recorded instead of receiving cash.

    5-12 Noncash investing and financing activities generally could have

    been accomplished identically in substance (though not in form)

  • Chapter 5 Statement of Cash Flows 193

    by cash transactions. For example, issuing debt to purchase an asset could have been accomplished by issuing debt for cash and then using the cash to purchase the asset. Companies should not be able to prevent disclosure of such a transaction to readers of the statement of cash flows simply by using a noncash form of transaction.

    5-13 This transaction should not be shown in the body of the

    statement of cash flows because it involves no cash flows. However, it should be reported in an accompanying schedule. Why? The transaction could have been accomplished by issuing stock for cash and then buying the fixed asset, whereby it would be in the statement of cash flows. Readers of statements of cash flows should be informed about such transactions.

    5-14 Yes. It is important to know of the periodic need to pay off and

    refinance debt. Companies with large short-term debt levels often find it an inexpensive way to borrow, but when interest rates rise or a company's financial condition worsens, refinancing may be both difficult and expensive.

    5-15 The direct method and the indirect method are the two major

    ways of computing net cash flow from operating activities. 5-16 The information for the direct-method cash flow statement

    comes directly from entries into a companys cash account. 5-17 The required adjustments are to add noncash expenses and

    losses, deduct noncash revenues and gains, add decreases in operating assets and increases in operating liabilities, and deduct increases in operating assets and decreases in operating liabilities.

  • 194

    5-18 Sales revenue is recognized on the accrual basis when it is earned and realized, not when cash is received. Therefore, cash collections from customers will not ordinarily equal sales revenue during any given period. Sometimes cash from customers arrives before it is earned (creating a liability to perform) or after it is earned (collection eliminates an account receivable).

    5-19 Changes in the inventory and accounts payable accounts

    explain the difference between cost of goods sold and cash payments to suppliers.

    5-20 Strictly speaking, net losses, by themselves, do not drain cash.

    A net loss is an excess of expenses over revenues; it is an income statement item rather than an item on a statement of cash flows. As an extreme example, equipment may be sold below its book value and cause a net loss, but cash proceeds resulting from the transaction would be an addition to cash, not a cash drain.

    5-21 Cash + Noncash assets = Liabilities + Paid-in capital + Retained earnings Cash = Liabilities + Paid-in capital + Retained earnings Noncash assets 5-22 The erroneous impression is that depreciation is a source of

    cash because it is added to net income to determine cash flow from operations. Depreciation is an allocation of an assets original cost to expense that does not entail a current cash outlay; that is, depreciation is a noncash expense. It is added to net income when using the indirect method only to offset its deduction in computing net income.

    5-23 The newsletter reinforces the widely held erroneous impression

    that depreciation provides cash. See the solution to 5-22.

  • Chapter 5 Statement of Cash Flows 195

    5-24 Under the indirect method of preparation, depreciation is very prominent in the calculation, although not directly a source of cash. Depreciation belongs in a supporting schedule when using the direct method. Depreciation is one of the items that reconciles net income to net cash flow from operating activities.

    5-25 Profitable companies often lack for cash because they are

    growing quickly and must acquire inventory for future sales while waiting to collect growing receivable balances. New firms in industries such as computers, electronics, and bio-tech might experience this.

    5-26 Large, non-cash expenses such as depreciation could cause

    this. The airline industry might be a good example.

    5-27 I would be concerned about this company. Negative cash flow from operations and new investing is not uncommon among new, high growth firms. However, at that stage in the growth pattern the financing is generally from equity and longer-term debt. The significant use of short-term debt with covenants that will restrict further debt issues and other actions of the firm suggests that the equity and long-term debt markets are not and will not be open to this client. Unless profitability and positive cash flow from operations are around the corner, this company could have serious problems raising additional capital. This may not be a good investment.

  • 196

    5-28 It is always hard to know what is in a managers mind. Microsoft experienced explosive growth. It is bought companies on a regular basis, but its available cash and liquid investments continued to grow. It does not make sense to continue to manage low yielding investments in government bonds and such. Microsoft chose to distribute this capital to investors as share buybacks and a very large one-time dividend, with a commitment to continue paying dividends. Prior to Microsofts decision to pay dividends, many analysts feared that Microsoft would choose to make even larger and perhaps ill-advised purchases of other companies.

    5-29 Until 2002 Amazon had negative cash flows from operations, and it used cash for investing activities. The positive cash flow from operations indicates that Amazon is maturing. In fact, having cash flow from operations exceeding investment needs (that is, positive free cash flow) is a sign that Amazon is entering a stage where growth may be slowing but profitability is increasing.

    5-30 This attitude would prevent anyone from ever investing in a brand new company with a great idea. Since these companies are often risky, this strategy might be quite appropriate for investors who were retired and relied on investments for living expenses. However, for a younger person with more ability to take risk, an appropriate exposure to young, dynamic growth companies might be quite appropriate. The characteristics referred to in the question identify the target investments as young growth companies for the most part but do not reveal much about other investment decision variables such as the industry, the age of the firm, the nature of the product, and so on.

  • Chapter 5 Statement of Cash Flows 197

    5-31 (10 min.)

    BREMERHAVN SHIPPING COMPANY Statement of Cash Flows from Financing Activities

    For the Year Ended December 31, 20X8 Cash flows from financing activities: Proceeds from issue of long-term debt 200,000 Payment to retire long-term debt (160,000) Payment to retire common stock (35,000) Dividends paid (11,000) Net cash used for financing activities (6,000) Notice especially that both proceeds from the new issue and the payment to retire long-term debt are listed. P