<<

. 7
( 100 .)



>>

CHAPTER 1 Cash Flow: A Mathematical Derivation 13
Activity Symbol Description

Operating NI Net income
GAIN Gains ( losses) on the sale of property, plant, and equipment
DEPR Depreciation and other noncash charges
RWC Increases ( decreases) in required working capital




When deriving the cash ¬‚ows from operating activities, we subtract
the gain (or add the loss) on the sale of property, plant, and equipment
for several reasons. First, these gains and losses simply are not the result
of ˜˜operating™™ activities. They are the result of ˜˜investing™™ activities.
These gains and losses arise when property, plant, and equipment are
sold for more or less than their net book value. Furthermore, the full
amount received for such sales (SALESFA) is included as part of the cash
¬‚ows from investing activities. To show these gains or losses again as part
of cash ¬‚ows from operating activities would erroneously double count
their impact.
Depreciation and other noncash expenses do reduce net income, but
they do not involve any payments during the current period. Therefore,
when the indirect method is used and net income is the starting point for
arriving at a ¬rm™s net cash ¬‚ow, these noncash expenses must be added
back.
The rationale for subtracting required increases (or adding decreases)
in working capital will be discussed at some length in the next section
after introducing the components of the other current assets ( OCA) and
the current liabilities ( CL).
To complete the summary of equations (1-17), (1-18), and (1-20), the
second and third lines consist of 14


Activity Symbol Description

Investing CAPEXP Capital expenditures
SALESFA Selling price of property, plant, and equipment disposed of or retired
Financing LTD Increases ( decreases) in long-term debt
SALSTK Proceeds received from the sale of stock
TRSTK Payments for treasury stock
DIV Dividends
AET Additional equity transactions




Considering the Components of Required Working Capital
Before discussing required working capital further, it will be helpful to
break down changes in ( OCA) other current assets and ( CL) current
liabilities into some typical component parts. Table 1-6 is a restatement
of Table 1-1 with this additional detail provided in the boxed sections.



14. The second line of both equations (1-17) and (1-20) is: CAPEXP + SALESFA
The third line of both equations (1-17) and (1-20) is: LTD + SALSTK TRSTK DIV +
AET


PART 1 Forecasting Cash Flows
14
T A B L E 1-6




Feathers R Us
BALANCE SHEETS
For Calendar Years

Increase
Symbols ASSETS: 1999 2000 (Decrease)

C Cash 1,125,000 1,500,000 375,000
Accounts receivable 100,000 150,000 50,000
Inventory 750,000 600,000 (150,000)
Additional current assets 25,000 40,000 15,000
Total current assets 2,000,000 2,290,000 290,000
GPPE Gross property, plant, & equipment 830,000 900,000 70,000
AD Accumulated depreciation 30,000 40,000 10,000
NPPE Net property, plant, & equipment 800,000 860,000 60,000
A Total assets 2,800,000 3,150,000 350,000

LIABILITIES

Accounts payable 200,000 225,000 25,000
Short-term notes payable 50,000 35,000 (15,000)
Accrued expenses 75,000 100,000 25,000
CL Current liabilities 325,000 360,000 35,000
LTD Long-term debt 750,000 725,000 (25,000)
L Total liabilities 1,075,000 1,085,000 10,000

STOCKHOLDERS™ EQUITY

Capital stock 100,000 150,000 50,000
Additional paid in capital 200,000 500,000 300,000
Retained earnings 1,425,000 1,465,000 40,000
Treasury stock 0 50,000 50,000
CAP Total stockholders™ equity 1,725,000 2,065,000 340,000
Total liabilities & equity 2,800,000 3,150,000 350,000




Here, other current assets consist of accounts receivable, inventory,
and additional current assets. Current liabilities include accounts payable,
short-term notes payable, and accrued expenses.
Accounts receivable, inventory, and additional current assets should
all be treated in the same way that other current assets was treated. When
using the indirect method, increases (decreases) in these component ac-
counts should be subtracted from (added to) net income to arrive at net
cash provided by operating activities.
Likewise, accounts payable, short-term notes payable, and accrued
expenses should all be treated in the same way that current liabilities was
treated. When using the indirect method, increases (decreases) in these
component accounts should be added to (subtracted from) net income to
arrive at net cash provided by operating activities.
Applying the procedures outlined in the two preceding paragraphs
results in the Statement of Cash Flows shown in Table 1-7 which is simply
a restatement of Table 1-5 with the boxed detail added.

CHAPTER 1 Cash Flow: A Mathematical Derivation 15
T A B L E 1-7




Feathers R Us
STATEMENT OF CASH
FLOWS
Symbols For Calendar Year 2000

Cash ¬‚ows from operating activities
NI Net Income 90,000
Adjustments to reconcile net income to net
cash provided by operating activities:
GAIN Gain on sale of property, plant, & (30,000)
equipment
DEPR Depreciation expense 30,000
Increase in accounts receivable (50,000)
Decrease in inventory 150,000
Increase in additional current assets (15,000)

Increase in accounts payable 25,000
Decrease in short-term notes payable (15,000)
Increase in accrued expenses 25,000 120,000
Net cash provided by operating activities 210,000
Cash ¬‚ows from investing activities
CAPEXP Purchase of property, plant, & equipment (175,000)
SALESFA Sale of property, plant, & equipment 115,000
Net cash used by investing activities (60,000)
Cash ¬‚ows from ¬nancing activities
LTD Decrease in long term debt (25,000)
SALSTK Sale of stock 350,000
TRSTK Purchase of treasury stock (50,000)
DIV Payment of dividends (50,000)
Net cash provided by ¬nancing activities 225,000
Net increase in cash 375,000
Cash, January 1, 2000 1,125,000
Cash, December 31, 2000 1,500,000




In many cases it is quite apparent why increases in current assets
should be subtracted from net income to arrive at net cash provided by
operating activities. Increases in inventories and other current assets (such
as supplies) do require the use of cash.
However, accounts receivable can be troublesome to think through.
Why should an increase in accounts receivable be subtracted from net
income to arrive at net cash provided by operating activities? Before an-
swering this question, it is helpful to consider why accounts receivable
increase in the ¬rst place. They increase because the company has failed
to collect cash. Its collections have been less than its reported revenues.
When applying the indirect method, the ¬rst source of cash from
operating activities is net income. This implies that each of the components
of net income represents a cash ¬‚ow. The full amount of reported sales, for
example, is implicitly being treated as a cash in¬‚ow. When net accounts
receivable have increased over the period, collections must have been less
than reported revenues. Therefore, it is necessary to subtract the increase
in accounts receivable from net income to arrive at the true ¬gure for cash
provided from operations.

PART 1 Forecasting Cash Flows
16
Also, it is usually apparent why increases in current liabilities should
be added to net income to arrive at net cash provided by operating ac-
tivities. Increases (decreases) in short-term notes payable do provide (use)
cash.
To understand the treatment of accounts payable, again it is helpful
to begin by considering why accounts payable increase. They increase
because the company has not paid these bills yet. Its disbursements have
been less than its reported expenses.
Again, under the indirect method, the full amount of a reported ex-
pense is implicitly being treated as a cash out¬‚ow. When accounts pay-
able has increased over the period, payments must have been less than
that reported expense. Therefore, it is necessary to add the increase in
accounts payable back to net income when trying to arrive at the true
¬gure for cash provided from operations.
Likewise, when accrued expenses increase, it means the company has
disbursed less cash than indicated by one of its reported expenses. Again
it is necessary to add the increase in accrued expenses back to net income
when trying to arrive at the true ¬gure for cash provided from operations.
This discussion of the treatment of the components of working cap-
ital calls to mind a major difference between the income statement and
the statement of cash ¬‚ows. Both do serve as a reconciling link between
the beginning and ending balance sheets. However, the income statement
in an accrual-based partial reconciliation between the beginning and end-
ing balances in retained earnings. (The complete reconciliation requires
consideration of dividends, and occasionally certain other items.) The
statement of cash ¬‚ows is a cash-based reconciliation between the begin-
ning and ending cash balances. Much of the immediate discussion has
simply been a recital of the differences between accrual and cash account-
ing.
Recall that cash ¬‚ows from operating activities are the cash equiva-
lent of the accrual-based income statement. Again, to complete the rec-
onciliation between the beginning and ending cash balances, the state-
ment of cash ¬‚ows (as illustrated above) must also include cash from
investing or ¬nancing activities.

Adjusting for Required Cash
For valuation purposes, it is important to recognize that all ¬rms require
a certain amount of cash be kept on hand; otherwise checks would con-
stantly bounce. Therefore, the amount of required cash (CReq) will not be
available for dividend payments.
In equation (1-19), the required change in working capital was de-
¬ned simply as the change in current assets other than cash, less the
change in current liabilities. We will now modify that de¬nition, as shown
in equation (1-21) below, to include the changes in the cash balance the
¬rm will be required to keep on hand ($20,000 in this illustration).15
RWC OCA CL CReq
(1-21)
(100,000) (85,000) 35,000 20,000


15. Typically appraisers forecast required cash as a percentage of sales. Required cash increases
(decreases) by that percentage multiplied by the increase (decrease) in sales.


CHAPTER 1 Cash Flow: A Mathematical Derivation 17
Previously (in equation [1-19]), the $85,000 decrease in other current
assets and the $35,000 increase in current liabilities gave rise to a reduc-
tion in required working capital of $120,000. After taking into consider-
ation the $20,000 additional cash which will be required, the reduction in
required working capital falls to $100,000, i.e., the net addition to cash
¬‚ow from the reduction in required net working capital is $20,000 less.
Using this modi¬ed de¬nition for RWC lowers the resulting cash
¬‚ow to $355,000 (from the $375,000 originally shown in equation [1-20]).16
NI GAIN DEPR
C* RWC
CAPEXP SALESFA
LTD SALSTK TRSTK DIV AET (1-20a)
90,000 30,000 30,000
355,000 (100,000)
175,000 115,000
(25,000) 350,000 50,000 50,000 0
This $355,000 amount represents the net cash ¬‚ow available for dividend
payments in excess of the dividends already considered ($50,000).
Alternatively, DIV could be added to both sides of equation (1-20a)
to show the total amount of net cash ¬‚ow available for distribution to stock-
holders. That amount is $405,000, as shown in equation (1-20b).
C* NI GAIN DEPR RWC
DIV
CAPEXP SALESFA
LTD SALSTK TRSTK AET (1-20b)
90,000 30,000 30,000 (100,000)
405,000
175,000 115,000
(25,000) 350,000 50,000 0

<<

. 7
( 100 .)



>>