WGU C214 Financial Managment Topic 3

Statement of Cash Flows (SCF)

Cash from Operation (CFO)

Cash from investing (CFI)

Cash from financing (CFF)

- cash flow reveals the true health of a company;

- explains cash in & cash out from operations (CFO), investing & financing for a given year.

CFO + CFI + CFF = change in cash= ending cash - beginning cash

-line items on the cash flow statement serve to show why & where the increase occurred & what type of activity (i.e., operating, investing, or financing) caused it.

Operational

- decisions on what to produce, how to produce it, whom to sell it to, whom to use for suppliers

- CFO measures the net cash impact of operating decisions

Investing

- decisions on purchasing & selling of long term assets such as conveyor belts or the construction of new production facilities

- CFI measures the net cash impact of investing decisions.

Financing

decision on issuance of debt & equity, repayment of debts, repurchasing stock & payment of dividends

- CFF measures the NET CASH IMPACT of financing decisions.

Core activities

- firm's core activities will impact the way cash flows are categorized

-

Cash flow management

- some managers will "manage" (increase/decrease) reporting of cash flows

- For instance, a manager whose bonus is impacted by CFO may be tempted to recategorize some items to make CFO appear larger.

Market pressure

- pressures to manipulate cash flow categorization in the market place

- For instance, a firm that is in the process of raising capital does NOT want to show a decrease in CFO. Hence, managers may be willing to use their discretion over accounting choices to increase the reported level of CFO.

Differences in CFO & Net Income

CFO includes all cash flows related to producing & selling the firm's product, such as cash coming in from customers, cash flowing out for raw materials & operating expenses, & cash flowing out for taxes.

1. revenue is not the same as cash collected from sales because of changes in accounts receivable (AR)

2. gains/losses are only seen in net income

3. depreciation is only seen in net income

Calculating CFO from balance sheet

Net income + non-cash expenses (depreciation) + decrease in operating asset accounts (other than cash) - increase in operating asset accounts (other than cash) + increase in operating liability accounts (other than notes payable) - decrease in operating liability accounts (other than notes payable)

CFO=

= NI + depreciation expense + changes in operating accounts

±

changes in operating assets (Note: add decreases and subtract increases)

±

changes in operating liability accounts (Note: add increases and subtract decrease)

A change in notes payable will impact CFO.

FALSE

* Solution: A change in notes payable will NOT impact CFO (Note: notes payable is a financing variable; hence, changes in notes payable impact CFF).

Operating asset accounts

* Increase = an outflow of cash

* Decrease = an inflow of cash

Operating liability accounts (e.g., accounts payable and accrued wages) are

*Increases = an inflow of cash

*Decreases = an outflow of cash

Increase in assets (A/R, inventory)

out flow of cash

Increase in liabilities (A/P, accrued wage)

increases cash

Calculating CFI

(CFI is Cash Flow from Investing)

* Change in Gross PP&E or

* change in Net PP&E + depreciation expense

* (Net PP & E is Net Property Plant and Equipment)

3.6 Question

Last year a firm recorded Net PP&E of $4,600 while this year the same firm recorded Net PP&E of $4,500. If the depreciation expense for last year and this year are $500 and $800 respectively, what is the CFI of the company? (assume no asset disposals)

Answer: $700

Solution: CFI = (Change in Net PP&E + Depreciation Exp) = (4500 - 4600 + 800) = $700

A firm recorded Gross PP&E of $5,000 in 20x1 and $6,300 in 20x2. Further, accumulated depreciation was $2,000 and $2,400 in 20x1 and 20x2, respectively. Assuming no asset disposals, CFI is closest to which of the following?

Answer: ($1,300)

Solution: CFI = (Change in Gross PP&E) = (6300 - 5000) = ($1,300).

Logan Enterprises Cash Flow

(20x2_ 20x1)

Gross PP&E $22,500 _

$?????

Less: Acc. Depr $7,100 _ $?????

Net PP&E $15,400_ $15,200

Using the data above and assuming no asset disposals, what is the firm's CFI for the year 20x2? Assume that the firm claims $1,600 in depreciation expense during the period.

Answer: $1,800

With the assumption of no asset disposals, CFI will be equal to 1) change in Gross PP& E, or 2) Change in Net PP&E plus depreciation expense. The change in Net PP&E of $200 plus $1,600 in depreciation expense equals CFI of $1800.

Change in RE (RE = retained earnings)

Net income - dividends

Dividends

= (Old RE + Net Income) - New RE

* represents a cash outflow.

Calculating CFF

(Cash Flow fr Financing)

change in equity + change in debt - new RE

* the net cash impact from financing and includes cash flows resulting from increased borrowing, debt repayment, stock issuance, stock repurchase, or dividend payment.

An increase in a financing account (e.g., debt, including notes payable, and equity)

signals a cash inflow

A decrease in a financing account indicates

a cash outflow associated with repaying lenders or repurchasing stock.

3.7 Question 1

Balken Inc. reports the following on their most recent financial statements:

- Change in accounts payable: $50

- Change in notes payable: $100

- Change in long-term debt: $200

- Change in retained earnings: -$120

- Dividends declared: $160

What is Balken's net income for the period?

Answer: $40

Change in RE = net income - dividends; -120 = net income - 160.

3.7 Question 2

U&I Inc. recorded retained earnings of $2,000 last year and $2,500 this year. Net income of U&I Inc. is $500 and $650 for last year and this year, respectively. This year, U&I Inc. must have paid dividends of:

Answer: $150

Solution: Change in RE = NI -dividends. Rearranging: Dividends = NI - Change in RE.

Therefore: Dividends = 650 - (2500 - 2000) = $150.

3.7 Question 3

Balken Inc. reports the following on their most recent financial statements:

- Change in accounts payable: $50

- Change in notes payable: $100

- Change in long-term debt: $200

- Change in retained earnings: -$120

- Net income: $170

What is Balken's CFF for the period?

Answer: $10

CFF = change in notes payable + change in long-term debt - dividends (assuming no other relevant changes); hence, CFF = 100 + 200 -Dividends. The change in RE = net income - dividends; so, -120 = 170 - dividends; thus, dividends = 290. Finally, CFF = 100 +200 - 290 = 10.

3.8 Question 1

Generally speaking, the operating accounts relevant to the calculation of CFO are located at the top of both the asset and financing side of the balance sheet.

True

3.8 Question 2

When calculating CFF, most of the data can be located at the bottom of the asset side of the balance sheet.

False

The bottom of the asset side of the balance sheet (long-term assets) is most closely associated with CFI. CFF comes from the liabilities and equity side of the balance sheet.

3.8 Question 3

Which of the following are current asset or current liability accounts that are not included in the calculation of CFO?

Cash and notes payable

Change in cash is not considered in the calculation of any of the three cash flow categorizations. We are reconciling to the change in cash. Notes payable is an important cash flow variable, but it is a financing variable and included in CFF.

3.9 Question 1

A firm with positive CFO should be considered healthy.

False

Positive CFO is usually a key component in firm health, but positive CFO by itself says little about a firm.

3.9 Question 2

The firm in an industry with the largest CFO is the industry's top performer.

False

Having the largest CFO might merely be a function of size. Best" is multi-dimensional. The firm reporting the largest CFO might be historically successful but now be struggling/shrinking because of a lack of innovation, market dynamics, etc.

Further, having the largest CFO in the buggy whip industry does not reveal much about performance.

Free Cash Flow (FCF)

distributable cash

Free Cash Flow Firm (FCFF)

is the cash distributable to all the providers of capital (i.e., to both debt and equity holders) and is most commonly used in financial analysis.

Net Operating Profit after taxes (NOPAT) + depreciation - capital expenditures on PP&E (CFI) - increases in Net working capital (current assets- current liability)

= EBIT(1- tax rate) + Depreciation - CAPEX - increase in NWC

Free Cash Flow Equity holders (FCFE)

Net income + depreciation - capital expenditures on PP&E (CFI) - increases in Net working capital (current assets- current liability) + increase in debt (new borrowings-repayment of old debt)

3.10 Question 1

Dividing CFO among the owners of a firm is a sustainable policy.

False

CFO doesn't allow for required reinvestment.

3.10 Question 3

Depreciation expense is added back when calculating Free Cash Flow (FCF) because depreciation expense:

Answer: Is a non-cash expense

Solution: Depreciation expense is added back since it is non-cash expense.

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Topic 3 review question 1

Which one of the following is NOT a part of the statement of cash flows?

Cash flows from liquidating activities

Solution: Cash flows from liquidating activities is not part of the cash flow statement (note: liquidation of assets held for use is reported as part of CFI).

Found in the following section(s) of the text: 3.2

Topic 3 question 2

The sum of CFO + CFI + CFF is equal to:

Answer: The change in cash during the period

CFO + CFI + CFF = change in cash during the period.

Found in the following section(s) of the text: 3.2

Topic 3 question 3

Which of the following is true with respect to CFO?

Answer: An increase in inventory indicates a reduction in CFO

An increase in an operating liability (like A/P) will increase CFO. An increase in notes payable will increase CFF. An increase in cash is the result of operations, investment, and financing.

Found in the following section(s) of the text:

3.2: The Statement of Cash

topic 3 question 4

Free Cash Flow (FCF) is different from Cash Flows from Operations (CFO) because FCF:

Answer: Represents cash flow after required investment

Solution: FCF allows for required reinvestment (i.e., FCF is after reinvestment cash). Conceptually, FCF is distributable cash.

Found in the following section(s) of the text: 3.10

Topic 3 Question 5

Balken, Inc. reports the following on their most recent financial statements:

Change in accounts payable: $50

Change in notes payable: $100

Change in long-term debt: $200

Change in retained earnings: -$120

Net income: $170

What is Balken's CFF for the period?

Answer: $10

CFF = change in notes payable + change in long-term debt - dividends (assuming no other relevant changes); hence, CFF = 100 + 200 -Dividends. The change in RE = net income - dividends; so, -120 = 170 - dividends; thus, dividends = 290. Finally, CFF = 100 +200 - 290 = 10.

Found in the following section(s) of the text: 3.7

Topic 3 question 6

The Statement of Cash Flows is not useful when assessing the financial health of a firm due to the impact of accrual accounting.

Answer: False

Solution: The answer is false. In order to understand the health of a company, you must understand how the firm generates and expends cash. The impacts of accrual accounting are seen most in relation to net income.

Topic 3 question 7

Which of the following will decrease CFO?

Answer: An increase in accounts receivable and a decrease in accounts payable

Increase in inventory or accounts receivable and decreases in accounts payable will decrease CFO. Notes payable is a financing item.

Found in the following section(s) of the text:

3.5:

Topic 3 question 8

Depreciation expense is a significant source of difference between net income and CFO because:

Answer: Depreciation expense is non-cash expense on the income statement associated with the acquisition of long-lived assets.

Solution: Depreciation is non-cash expense associated with the acquisition of long-lived assets. Suppose a firm spends $1000 for an asset that will last four years. Accrual accounting requires that the cost be allocated to the periods where benefit is received. The cash is expended when the asset is purchased, but the depreciation expense is recognized over the four years of use. Hence, depreciation is a non-cash expense. Note that depreciation creates a tax shield since it is subtracted before tax is calculated. Hence, depreciation is subtracted to calculate EBT and NI but must be added back to calculate CFO.

Found in the following section(s) of the text: 3.3:

Topic 3 Question 9

For visualizaiton purposes, it is correct to think of balance sheet accounts relevant to CFI as being on the bottom of the financing side.

Answer: False

CFI accounts are generally non-current assets (i.e., bottom of the asset side of the balance sheet).

Found in the following section(s) of the text: 3.8

Topic 3 question 10

Increases in operating assets and decreases in operating liabilities will decrease CFO.

Answer: True

Increases in assets consume cash as do decreases in operating liabilities.

Topic 3 question 11

While looking at XYZ Corp's two most recent balance sheets, you notice inventory decreased by $100,000. The firm has a tax rate of 40%. To calculate Cash Flow from Operations, you will:

Answer: Add $100,000 to CFO

Solution: A decrease in an operating asset represent a cash inflow associated with CFO. The tax rate does not impact the question.

Found in the following section(s) of the text: 3.5: CFO

Topic 3 question 12

Assuming no asset disposals, CFI is equal to the change in Net PP&E.

Answer: False

Solution: Assuming no asset disposals, CFI is the change in GrossPP&E. Equivalently, CFI is equal to the change in Net PP&E plus depreciation expense.

Found in the following section(s) of the text: 3.6

Topic 3 Question 13

A firm can sustain negative CFO indefinitely by borrowing, selling equity, and/or by selling assets.

Answer: False

Solution: The correct answer is False. Firms can sustain negative CFO in the short-run buy borrowing, etc. In the long run, the firm will run out of assets to sell and lenders will refuse to lend. A firm cannot sustain negative CFO forever.

Found in the following section(s) of the text: 3.9

Topic 3 question 14

A firm reports the following cash flow data:

o CFO = $1mm

o CFI = -$750k

o CFF = -$100k

Which of the following is most reasonable assessment given the data?

Answer: The firm is sustainable in its current state

With the given data we cannot accurately determine whether the firm is a top performer, under investing, or has bad management decision making.

The data show the firm is generating cash from operations. The negative CFI indicated investment in new assets (replacing old assets? Planning for future growth?). The negative CFF indicates that the firm is likely: 1) paying down debt or buying back stock, or 2) paying dividends. We need more detail to make a better assessment, but the most reasonable conclusion is that the firm is sustainable in its current state because its cash flow from operations is greater than its cash outflows for investing and financing.

Found in the following section(s) of the text:

3.9

Topic 3 question 15

Increases in operating balance sheet accounts will decrease CFO.

Answer: False

Increases in operating ASSET accounts will decrease CFO, but increases in operating LIABILITY accounts (i.e., A/P) will increase CFO.

Found in the following section(s) of the text: 3.2

Topic 3 question 16

When calculating CFO, which of the following is correct?

Answer: Add an increase in accrued wages

Solution: An increase in an operating liability such as accounts payable or accrued wages represent an inflow to the firm.

Found in the following section(s) of the text: 3.5:

Topic 3 question 17

Which one of the following items should NOT be included in the calculation of CFF?

Answer: Change in Retained Earnings

Solution: Change in retained earnings is accounted in CFO by adding net income and CFF by subtracting dividends paid.

Found in the following section(s) of the text: 3.7:

Topic 3 question 18

When calculating CFO, you generally include the changes in all current assets and current liabilities.

Answer: False

Solution: The answer is False. Most current asset and current liability accounts are operating accounts; hence, changes are included in the calculation of CFO. However, Operating assets do not include all current assets. Cash is the notable exception. Operating liabilities do not include notes payable (changes in notes payable are included in CFF). Note that there are other exceptions, but they are beyond the scope of this discussion.

Found in the following section(s) of the text: 3.4

Topic 3 Question 19

Assuming no asset disposals, depreciation expense is equal to:

Answer: The change in accumulated depreciation

Solution: The change in Accumulated Depreciation is equal to the Depreciation Expense (assuming no asset disposals).

Found in the following section(s) of the text: 3.4

Topic 3 question 20

FCFF can sustainably be distributed to the providers of capital.

Answer: True

This is the definition of FCFF.

Found in the following section(s) of the text: 3.10:

Topic 3 question 21

Given the following data, calculate CFF for 20x3

Retained earnings (20x2: 3400) (20x3: 3600)

Account payable (20x2: 2100) (20x3: 1900)

Notes payable (20x2: 1200) (20x3: 1300)

Common stock (20x2: 4200) (20x3: 4500)

Account receivable (20x2: 3200) (20x3: 3700)

Net Income: (20x2: 400) (20x3: 500)

Long term debt (20x2: 4500) (20x3: 4500)

Answer: $100

·

CFF = Change in N/P + Change in LTDebt + Change in CS - Dividends

o Change in LTDebt = 4500-4500 = 0

o Dividends = NI - change in retained earnings = 500 - [3600-3400] = 300

· Therefore CFF = 100 + 0 + 300 - 300 = $100

Found in the following section(s) of the text: 3.7

Topic 3 Question 22

The calculation of FCFF uses NOPAT instead of Net Income because FCFF is the cash available to both debt holders and equity holders.

Answer: True

Solution: The answer is true. NOPAT (i.e. EBIT x [1-tax rate]) is determined before cash is divided into cash to debt holders (i.e., interest payments) and cash to equity holders.

Found in the following section(s) of the text: 3.10