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120 Part II: Figuring Out Financial Statements know that its cash decreases when a business pays down its debt, returns some of the capital that its owners had previously invested in the business, and invests in new fixed assets (buildings, machines, equipment, vehicles, and so on). Most people also know there is another important source of cash: making profit. However, things get a little tricky regarding this source of cash. One problem is this: Instead of saying that a business “earns profit,” people say that a business “makes money.” Therefore, many people assume that the bottom-line profit for the year increases cash exactly the same amount — no more, and no less. Not true: The actual amount of cash flow from making profit is invariably different than the amount of profit earned for the period. Earning profit and generating cash flow from the profit are two different things. You’re talking about apples and oranges when you’re talking about profit and cash flow from profit. Here’s a very brief explanation of why profit and cash flow from profit are different amounts. When a business makes sales on credit, sales revenue is recorded before cash is collected from customers. Cash inflow from credit sales takes place after recording the sales revenue. Also, many expenses are recorded before cash is paid for the liabilities incurred by the expenses. So, cash outflow for the expenses takes place after recording the expenses. Furthermore, the recording of depreciation expense does not require a cash outlay in the period. You could simply add back depreciation expense to bottom-line profit to get a rough (and I mean rough) measure of cash flow from making profit. But this shortcut ignores the other factors that affect cash flow from profit, and I don’t recommend it. Note: Because I use the same business example in this chapter that I use in Chapters 4 and 5, you may want to take a moment to review its 2009 income statement in Figure 4-1. And you may want to review Figure 5-1, which summarizes how the three types of activities changed its assets, liabilities, and owners’ equity accounts during the year 2009. (Go ahead, I’ll wait.) Suppose the president of the business asks me, the chief accountant (controller), for an executive summary of the company’s sources and uses of cash during the year ended December 31, 2009. The president does not want a formal, detailed financial statement with all the bells and whistles. He wants a very brief summary that speaks to him as the very busy chief executive of the business. Here’s what I would prepare for him: Chapter 6: Reporting Cash Flows Executive Summary for Company’s President Sources and Uses of Cash During the Year 2009 Cash flow from making profit Cash distributions from profit to shareowners $1,515,000 ($750,000) $765,000 Cash flow from increasing debt $250,000 Cash flow from capital invested by owners $150,000 Cash available for general business purposes Capital expenditures during year Cash decrease during year $1,165,000 ($1, 265,000) ($110,000) The president would do a critical review of the strategic decisions that were made during the year. For example, was it prudent to take on more debt? Why did the shareowners invest an additional $150,000 in the business, and will they invest additional capital during the coming year? Should the business have distributed about half of the cash flow from profit to its owners? I return to these issues in the last section of the chapter, “Being an Active Reader.” You may be wondering how I got the information to prepare the executive summary of cash flows for the president. I extracted the relevant information from the company’s asset, liability, and owners’ equity accounts. I examined the increases and decreases entered in the accounts during the year to determine the amounts you see in the executive summary. This is no problem; I’m an accountant, you know. Accountants prepare detailed spreadsheets in which changes in the asset, liability, and owners’ equity accounts are analyzed and classified in order to prepare a statement of cash flows, or an executive summary such as the one I show here. Computer software programs can be used for this purpose. The president of the business can request any particular accounting report or summary that he wants. The president is not limited or restricted to the format and content of the three financial statements that are prepared for external reporting. If the president wants an executive summary of cash flows, as opposed to a formal statement of cash flows as it is presented in the external financial report of the business, then as controller I prepare the executive summary. I know which side my bread is buttered on. There are no restrictions regarding how to report cash flows internally (inside the business to its managers). If the president doesn’t like or doesn’t understand the information I give him in the executive summary of cash flows, he will let me know in no uncertain terms. 121 122 Part II: Figuring Out Financial Statements You may be wondering in particular how I got the $1,515,000 amount for cash flow from making profit (see the executive summary). And, you may be wondering why this cash flow amount is different than the $1.69 million bottomline profit number reported in the company’s income statement for the year (see Figure 4-1 in Chapter 4). One purpose of the statement of cash flows is to report the cash flow from making profit and to explain the difference between the cash flow number and the bottom-line profit number in the income statement. The cash flow number is based on actual cash inflows and outflows; the profit number is based on accounting for sales revenue and expenses. Remember the following points:  If a business makes credit sales, the total cash inflow from customers is different than the total sales revenue recorded in the year (unless the business collects all its credit sales before the end of the year).  The total cash outlay for expenses during the year is different than the total amount of expenses recorded in the year. The statement of cash flows begins with the cash flow from making profit, or cash flow from operating activities as accountants call it. Operating activities is the technical term that accountants have adopted for sales and expenses, which are the “operations” that a business carries out to earn profit. I don’t think it’s the best term in the world, but we are stuck with it; it’s part of the official language of accounting. Meeting the Statement of Cash Flows I hate to start out like this, but I have to tell you that a business has its choice between two quite different methods of reporting cash flow from operating activities in its statement of cash flows. Financial reporting standards permit either approach. I first show you the preferred method, and then the alternative. Figure 6-1 presents the statement of cash flows for our business example dressed to the nines, in formal attire. This is not a condensed version; it’s the real thing, not an executive summary. One main difference, as compared with the executive summary of cash flows I prepared for the president, is seen in the first section, Cash Flows from Operating Activities. What you see in the first section of the statement of cash flows is called the direct method for reporting cash flow from operating activities. I think the term “direct” is meant to refer to the cash flows connected with sales and expenses. For example, the business collects $25.55 million from customers during the year, which is the direct result of making sales. Chapter 6: Reporting Cash Flows Typical Business, Inc. Statement of Cash Flows for Year Ended December 31, 2009 (Dollar amounts in thousands) Cash Flows from Operating Activities $25,550 Collections from sales Payments for products Payments for selling, general, and administrative costs ($15,025) ($7,750) Payments for interest on debt ($375) Payments on income tax ($885) Cash flow from operating activities ($24,035) $1,515 Cash Flows from Investing Activities ($1,275) Expenditures on property, plant, and equipment Figure 6-1: The statement of cash flows — using the direct method for presenting cash flow from operating activities. Cash Flows from Financing Activities Short-term debt increase $100 Long-term debt increase $150 Capital stock issue $150 Dividends paid stockholders ($750) Decrease in cash during year ($350) ($110) Beginning cash balance $2,275 Ending cash balance $2,165 Note in Figure 6-1 that cash flow from operating activities for the year is $1,515,000, which is $175,000 less than the company’s $1,690,000 net income for the year (refer to Figure 4-1). When issuing the financial reporting standard for the statement of cash flows, the Financial Accounting Standards Board (FASB) thought that financial report readers would compare cash flow from operating activities with net income, and they would want some sort of explanation for the difference between these two important financial numbers. Therefore, the FASB decreed that the statement of cash flows should also include a reconciliation schedule to explain the difference between cash flow from operating activities and net income. Or, a business can use the alternative method for reporting cash flow from operating activities. The alternative 123 124 Part II: Figuring Out Financial Statements method starts with net income, and then makes adjustments in order to reconcile cash flow from operating activities with net income. This alternative method is called the indirect method, which I show in Figure 6-2. Typical Business, Inc. Statement of Cash Flows for Year Ended December 31, 2009 (Dollar amounts in thousands) Cash Flows from Operating Activities $1,690 Net income Adjustments to net income for determining cash flow: Accounts receivable increase ($450) Inventory increase ($725) Prepaid expenses increase ($75) Depreciation expense $775 Accounts payable increase $125 Accrued expenses increase $150 Income tax payable increase $25 ($175) $1,515 Cash flow from operating activities Cash Flows from Investing Activities Expenditures on property, plant, and equipment Figure 6-2: The statement of cash flows — using the indirect method for presenting cash flow from operating activities. ($1,275) Cash Flows from Financing Activities Short-term debt increase $100 Long-term debt increase $150 Capital stock issue $150 Dividends paid stockholders ($750) Decrease in cash during year ($350) ($110) Beginning cash balance $2,275 Ending cash balance $2,165 Chapter 6: Reporting Cash Flows The indirect method for reporting cash flow from operating activities focuses on the changes during the year in the assets and liabilities that are connected with sales and expenses. I explain these connections in Chapter 4. (You can also trace these changes back to Figure 5-1, which includes the start-of-year and end-of-year balances of the balance sheet accounts for the business example.) While there are obvious differences in the first section of the statement of cash flows between the two methods for reporting cash flow from operating activities, the other two sections of the statement — cash flow from investing activities and cash flow from financing activities — are the same. The level of detail disclosed in these two sections varies from business to business. For example, some companies report one aggregate amount for all capital expenditures (investments in new long-term operating assets), whereas others give a more detailed breakdown. Dissecting the Difference Between Cash Flow and Net Income A positive cash flow from operating activities is the amount of cash generated by a business’s profit-making operations during the year, exclusive of its other sources of cash during the year. Cash flow from operating activities indicates a business’s ability to turn profit into available cash — cash in the bank that can be used for the needs of business. As you see in Figure 6-1 or Figure 6-2 (take your pick), the business in our example generated $1,515,000 cash from its profit-making activities in the year. As they say in New York, “That isn’t chopped liver.” The business in our example experienced a strong growth year. Its accounts receivable and inventory increased by relatively large amounts. In fact, all its assets and liabilities intimately connected with sales and expenses increased; their ending balances are larger than their beginning balances (which are the amounts carried forward from the end of the preceding year). Of course, this may not always be the case in a growth situation; one or more assets and liabilities could decrease during the year. For flat, no-growth situations, it’s likely that there will be a mix of modest-sized increases and decreases. The following sections explain how the asset and liability changes affect cash flow from operating activities. As a business manager, you should keep a close watch on the changes in each of your assets and liabilities and understand the cash flow effects caused by these changes. Investors should focus on the business’s ability to generate a healthy cash flow from operating activities, so investors should be equally concerned about these changes. In some situations these changes can signal serious problems! 125 126 Part II: Figuring Out Financial Statements I realize that you may not be too interested in the details that I discuss in the following sections. With this in mind, at the start of each section I present the punch line. If you wish, you can just read this and move on. But the details are fascinating (well, at least to accountants). Note: Instead of using the full phrase “cash flow from operating activities” every time, I use the shorter term “cash flow” in the following sections. All data for assets and liabilities are found in the two-year balance sheet of the business (see Figure 5-2). Accounts receivable change Punch Line: An increase in accounts receivable hurts cash flow; a decrease helps cash flow. The accounts receivable asset shows how much money customers who bought products on credit still owe the business; this asset is a promise of cash that the business will receive. Basically, accounts receivable is the amount of uncollected sales revenue at the end of the period. Cash does not increase until the business collects money from its customers. The business started the year with $2.15 million and ended the year with $2.6 million in accounts receivable. The beginning balance was collected during the year, but the ending balance had not been collected at the end of the year. Thus the net effect is a shortfall in cash inflow of $450,000. The key point is that you need to keep an eye on the increase or decrease in accounts receivable from the beginning of the period to the end of the period. Here’s what to look for:  If the amount of credit sales you made during the period is greater than what you collected from customers during the period, your accounts receivable increased over the period, and you need to subtract from net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, an increase in accounts receivable hurts cash flow by the amount of the increase.  If the amount you collected from customers during the period is greater than the credit sales you made during the period, your accounts receivable decreased over the period, and you need to add to net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, a decrease in accounts receivable helps cash flow by the amount of the decrease. Chapter 6: Reporting Cash Flows In our business example, accounts receivable increased $450,000. Cash collections from sales were $450,000 less than sales revenue. Ouch! The business increased its sales substantially over the last period, so you shouldn’t be surprised that its accounts receivable increased. The higher sales revenue was good for profit but bad for cash flow. The “lagging behind” effect of cash flow is the price of growth — managers and investors need to understand this point. Increasing sales without increasing accounts receivable is a happy situation for cash flow, but in the real world you usually can’t have one increase without the other. Inventory change Punch Line: An increase in inventory hurts cash flow; a decrease helps cash flow. Inventory is usually the largest short-term, or current, asset of businesses that sell products. If the inventory account is greater at the end of the period than at the start of the period — because unit costs increased or because the quantity of products increased — the amount the business actually paid out in cash for inventory purchases (or for manufacturing products) is more than what the business recorded in the cost of goods sold expense for the period. In our business example, inventory increased $725,000 from start-of-year to end-of-year. In other words, to support its higher sales levels in 2009, this business replaced the products that it sold during the year and increased its inventory by $725,000. The business had to come up with the cash to pay for this inventory increase. Basically, the business wrote checks amounting to $725,000 more than its cost of goods sold expense for the period. This stepup in its inventory level was necessary to support the higher sales level, which increased profit even though cash flow took a hit. Prepaid expenses change Punch Line: An increase in prepaid expenses (an asset account) hurts cash flow; a decrease helps cash flow. A change in the prepaid expenses asset account works the same way as a change in inventory and accounts receivable, although changes in prepaid expenses are usually much smaller than changes in those other two asset accounts. 127 128 Part II: Figuring Out Financial Statements The beginning balance of prepaid expenses is charged to expense this year, but the cash for this amount was actually paid out last year. This period (the year 2009 in our example), the business pays cash for next period’s prepaid expenses, which affects this period’s cash flow but doesn’t affect net income until next period. In short, the $75,000 increase in prepaid expenses in this business example has a negative cash flow effect. As it grows, a business needs to increase its prepaid expenses for such things as fire insurance (premiums have to be paid in advance of the insurance coverage) and its stocks of office and data processing supplies. Increases in accounts receivable, inventory, and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets. The depreciation factor Punch Line: Recording depreciation expense decreases the book value of long-term operating (fixed) assets. There is no cash outlay when recording depreciation expense. Each year the business converts part of the total cost invested in its fixed assets into cash. It recovers this amount through cash collections from sales. Thus, depreciation is a positive cash flow factor. The amount of depreciation expense recorded in the period is a portion of the original cost of the business’s fixed assets, most of which were bought and paid for years ago. (Chapters 4 and 5 explain more about depreciation.) Because the depreciation expense is not a cash outlay this period, the amount is added to net income to determine cash flow from operating activities (see Figure 6-2). For measuring profit, depreciation is definitely an expense — no doubt about it. Buildings, machinery, equipment, tools, vehicles, computers, and office furniture are all on an irreversible journey to the junk heap (although buildings usually take a long time to get there). Fixed assets (except for land) have a limited, finite life of usefulness to a business; depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue. In our example, the business recorded $775,000 depreciation expense for the year. Instead of looking at depreciation as only an expense, consider the investment-recovery cycle of fixed assets. A business invests money in its fixed assets that are then used for several or many years. Over the life of a fixed asset, a business has to recover through sales revenue the cost invested in the fixed asset (ignoring any salvage value at the end of its useful life). In a real sense, a business “sells” some of its fixed assets each period to its customers — it factors the cost of fixed assets into the sales prices that it charges its customers. Chapter 6: Reporting Cash Flows For example, when you go to a supermarket, a very small slice of the price you pay for that quart of milk goes toward the cost of the building, the shelves, the refrigeration equipment, and so on. (No wonder they charge so much!) Each period, a business recoups part of the cost invested in its fixed assets. In the example, $775,000 of sales revenue went toward reimbursing the business for the use of its fixed assets during the year. In short, depreciation is a positive cash flow factor. The depreciation amount is imbedded in sales revenue, and sales revenue generates cash flow. The business in our example does not own any intangible assets and, thus, does not record any amortization expense. (See Chapter 5 for an explanation of intangible assets and amortization.) If a business does own intangible assets, the amortization expense on these assets for the year is treated the same as depreciation is treated in the statement of cash flows. In other words, the recording of amortization expense does not require cash outlay in the year being charged with the expense. The cash outlay occurred in prior periods when the business invested in intangible assets. Changes in operating liabilities Punch Line: An increase in a short-term operating liability helps cash flow; a decrease hurts cash flow. The business in our example, like almost all businesses, has three basic liabilities inextricably intertwined with its expenses:  Accounts payable  Accrued expenses payable  Income tax payable When the beginning balance of one of these liability accounts is the same as its ending balance (not too likely, of course), the business breaks even on cash flow for that account. When the end-of-period balance is higher than the start-of-period balance, the business did not pay out as much money as was recorded as an expense in the year. In our business example, the business disbursed $640,000 to pay off last year’s accounts payable balance. (This $640,000 was the accounts payable balance at December 31, 2008, the end of the previous fiscal year.) Its cash this year decreased $640,000 because of these payments. But this year’s ending balance sheet (at December 31, 2009) shows accounts payable of $765,000 that the business will not pay until the following year. This $765,000 amount was recorded to expense in the year 2009. So, the amount of expense was $125,000 129