8. Cash Flow Complexities

Cash Flows: Additional Complexities

• Presented by S. Levkoff, PhD, CAP®, UC San Diego

• Focuses on complications related to cash flow statements and their interpretation.

Some Complications

• Balance Sheet vs Cash Flow Statement:

  • Change in balance sheet numbers may not match cash flow statement due to various factors.

• Reasons for Discrepancies:

  1. Noncash investing and financing activities.

  2. Acquisitions and divestitures of businesses.

  3. Foreign currency translation adjustments.

  4. Subsidiaries operating in different industries.

Noncash Investing & Financing Activity

• Operational Section of SCF: Noncash activities can alter working capital accounts.

• Examples:

  • Payment in land instead of cash for customer debt.

  • Service provided instead of cash payment to suppliers.

• Must be disclosed at the bottom of the SCF.

Working Capital

• Definition: Working Capital = Current Assets - Current Liabilities.

• Involves noncash elements such as:

  • Accounts Receivable.

  • Accounts Payable.

  • Inventory.

  • Prepaid Expenses.

• Represents assets and liabilities management is able to control aside from liquid cash.

Acquisition and Divestitures of Business Entities

• Investing Cash Flow: Cash paid is treated as an investing cash flow.

• Accounts receivable from acquisitions are on the balance sheet but not reflected in operating sections of the SCF to avoid double counting.

• Necessary adjustments are made for accurate reporting.

Foreign Currency Translation Adjustments

• Important for multinational companies with diverse currency operations.

• Exchange rate variations should be excluded from operating sections of the cash flow.

• Nominal economic effects must not affect real market activities.

Relationship to Macroeconomic Theory

• Variables Classification:

  • Real Variables: Physical quantities and relative prices.

  • Nominal Variables: Measured in monetary terms.

• Time Horizon:

  • Short run: Prices are sticky.

  • Long run: Prices can adjust freely.

• Classical Dichotomy: Distinction between short-term relevance of some variables versus long-term irrelevance.

The Classical Dichotomy

• Real Variables Examples:

  • Quantity of output, real wages, real interest rates.

• Nominal Variables Examples:

  • Nominal wage, nominal interest rates, price levels.

Classical Dichotomy and Accounting Treatment

• Nominal variables do not affect real variables long-term.

• Treatment of FOREX fluctuations reflects changes in nominal variables which shouldn’t impact real market activity.

Cross-Industry Subsidiaries

• Subsidiaries in varied industries may classify operating activities differently.

• Example:

  • Pharmaceutical purchases land classified as investing; real estate subsidiary treats as operating.

Disagreement Over FASB Classification - Interest

• Investors may prefer classifying interest payments as financing.

• Interest/dividends received can be seen as investing activities.

• Flexibility exists under IFRS but not GAAP.

• Disclosure of cash paid for interest allows easy adjustment by analysts.

Disagreement Over FASB Classification - Taxes

• All income tax effects are treated as operating activities.

• Taxes related to investing activities also show up in operating flows, leading to potential adjustments.

EBITDA, Earnings, and Cash Flows

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):

  • Proxy for operating cash flow, excluding interest and taxes, making it popular among investors.

• Limitations:

  • Changes in working capital and net income manipulations may distort true cash flow representation.

• Important adjustments may be needed to provide accurate EBITDA.

An Empirical Result

• Research indicates earnings predict future cash flows more reliably than current operational cash flows.

Predictors of Future Operating Cash Flows

• Importance of both earnings and cash flow data in forecasting future performance.

Free Cash Flows (FCF)

• Definition: Cash generated from operations after accounting for long-term investments.

• Various measurements exist, leading to discrepancies in disclosures and definitions.

Preparing the Statement of Cash Flows (SCF)

• Overview of SCF preparation processes for two operations, Red Inc. and Blue Corps.

• Focus on income statement from December 31st, 2017.

Understanding Restructuring Liabilities

• Restructuring involves costs related to layoffs and facility changes.

• Anticipated expenses must be recognized, even if not yet settled.

Statement of Cash Flows Example

• Calculations based on various components including depreciation, restructuring charges, and net income adjustments.

Further Example and Journal Entries

• Recording of PP&E sell-offs and their impact on cash flow and statements.

Summary of Cash Flows Scenario

• Detailed SCF including impacts of depreciation, restructuring, gains/losses, and capital expenditures.

Changes in Noncash Working Capital Accounts

• Exploration of adjustments in accounts receivable, inventory, and prepaid expenses over the year ending December 31, 2017.

EBITDA Adjustments

• Necessity of adjusting EBITDA to represent financial conditions more faithfully by accounting for noncash activities.