Topic 4_statement Of Cash Flows

Topic 4: Statement of Cash Flows Sections: I. Overview II. Analysis of the Statement of Cash Flows III. Development of the Statement of Cash Flows I. Overview The statement of cash flows explains changes in cash over an accounting period. This statement classifies cash inflows and outflows into three categories: operating, investing, and financing. That is, there are four elements in this statement: (1) cash, (2) operating activities, (3) investing activities, and (4) financing activities. The following balance sheet is retrieved from Intel’s 2005 10-K. Intel Corporation Consolidated Balance Sheet 2004

December 25, 2004 and December 27, 2003 (In Millions—Except Par Value)

Assets Current assets: Cash and cash equivalents Short-term investments Trading assets Accounts receivable, net of allowance for doubtful accounts of $43 ($55 in 2003) Inventories Deferred tax assets Other current assets

$

2003

8,407 5,654 3,111 2,999 2,621 979 287

$

7,971 5,568 2,625 2,960 2,519 969 270

Total current assets

24,058

22,882

Property, plant and equipment, net Marketable strategic equity securities Other long-term investments Goodwill Other assets

15,768 656 2,563 3,719 1,379

16,661 514 1,866 3,705 1,515

Total assets Liabilities and stockholders’ equity Current liabilities: Short-term debt Accounts payable Accrued compensation and benefits Accrued advertising Deferred income on shipments to distributors Other accrued liabilities Income taxes payable Total current liabilities Long-term debt Deferred tax liabilities Commitments and contingencies (Notes 17 and 18) Stockholders’ equity: Preferred stock, $0.001 par value, 50 shares authorized; none issued

$

48,143

$

47,143

$

201 1,943 1,858 894 592 1,355 1,163

$

224 1,660 1,559 716 633 1,302 785

8,006

6,879

703 855

936 1,482

—

—

Common stock, $0.001 par value, 10,000 shares authorized; 6,253 issued and outstanding (6,487 in 2003) and capital in excess of par value Acquisition-related unearned stock compensation Accumulated other comprehensive income Retained earnings

6,143 (4) 152 32,288

6,754 (20) 96 31,016

Total stockholders’ equity

38,579

37,846

Total liabilities and stockholders’ equity

$

48,143

$

47,143

The following statement of cash flows is also retrieved from Intel’s 2005 10-K. Intel Corporation Consolidated Statement of Cash Flows 2004

Three Years Ended December 25, 2004 (In Millions)

Cash and cash equivalents, beginning of year

$

Cash flows provided by (used for) operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Impairment of goodwill Amortization and impairment of intangibles and other acquisition-related costs Purchased in-process research and development Losses on equity securities, net Net loss on retirements and impairments of property, plant and equipment Deferred taxes Tax benefit from employee equity incentive plans Changes in assets and liabilities: Trading assets Accounts receivable Inventories Accounts payable Accrued compensation and benefits Income taxes payable Other assets and liabilities

7,971

2003

$

7,404

$ 7,970

7,516

5,641

3,117

4,590 — 299 — 2 91 (207) 344

4,651 617 419 5 283 217 391 216

4,676 — 668 20 372 301 110 270

(468) (39) (101) 283 295 378 136

Total adjustments

2002

(698) (430) (245) 116 276 (361) 417

(465) 30 (26) (226) 107 175 —

5,603

5,874

6,012

13,119

11,515

9,129

(3,843) (53) (16,618) 15,633 (151)

(3,656) (61) (11,662) 8,488 (199)

(4,703) (57) (6,309) 5,634 (330)

Net cash used for investing activities

(5,032)

(7,090)

(5,765)

Cash flows provided by (used for) financing activities: Increase (decrease) in short-term debt, net Additions to long-term debt Repayments and retirement of debt Proceeds from sales of shares through employee equity incentive plans Repurchase and retirement of common stock Payment of dividends to stockholders

24 — (31) 894 (7,516) (1,022)

(152) — (137) 967 (4,012) (524)

(101) 55 (18) 681 (4,014) (533)

Net cash used for financing activities

(7,651)

(3,858)

(3,930)

Net cash provided by operating activities Cash flows provided by (used for) investing activities: Additions to property, plant and equipment Acquisitions, net of cash acquired Purchases of available-for-sale investments Maturities and sales of available-for-sale investments Other investing activities

Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, end of year Supplemental disclosures of cash flow information:

436 $

8,407

567 $

7,971

(566) $ 7,404

Cash paid during the year for: Interest Income taxes, net of refunds

$ $

52 2,392

$ $

59 1,567

$ $

From the above, you can see that the statement of cash flows is developed to explain changes in cash. For instance, the balance sheet shows that Intel’s cash amounts at the end of 2003 and 2004 are $7,971 million and $8,407 million. The increase of $436 million is an aggregation of $13,119 million inflow from operation, $5,032 million outflow from investments, and $7,651 million outflow from financing (13119 – 5032 – 7651 = 436).

66 475

Cash means cash and short-term, liquid marketable securities; cash does not include short-term investments. Why cash? A firm uses “cash,” not earnings on the book, to pay for raw materials, interest expense, and dividends. It is possible for a firm to be highly profitable, i.e., good earnings, and to go bankrupt. ----------------------------------------------------------------------------------------------------------Homework: Handout: W.T. Grant case. Task: Read the case. ----------------------------------------------------------------------------------------------------------Among operating, investing, and financing activities, analysts pay particular attention to operating activities. The reason for this is that temporary shortfalls of cash (say, due to expansion) can be satisfied by borrowing, but eventually the firm needs to be able to generate cash from its operations (operating cash flow, OCF). Otherwise, the more the firm borrows, the higher the interest rate, and the more difficult for the firm to turn the whole thing around. II. Analysis of the Statement of Cash Flows There are several essential questions that need to be answered when one analyzes the statement of cash flows: 1. What is the firm’s ability in generating cash flows from its operations? Does the firm seem to be able to improve its ability in doing so in the future? 2. Does the firm seem to have the capacity to meet obligations for cash? 3. Does the firm manage its investments successfully and productively?

4. What is the firm’s future external financing needed (EFN)? EFN is also called additional financing needed (AFN). This section focuses on historical performance and current conditions. Looking forward requires forecasting and estimation; this part will be discussed in Topic 6: Pro Forma Financial Statements. For the first question, Intel looks pretty good. Intel’s OCFs are $9,129 million, $11,515 million, and $13,119 million during the 2002-2004 period. It is argued that OCF per share is a better indicator of a firm’s ability to pay dividends in the short run. This formula is: (OCF – preferred dividends)/diluted weighted average common shares outstanding Intel’s OCFs per share are $1.35, $1.74, and $2.02 during the 2002-2004 period. This increasing trend is good news for equity investors. For the second question, one may want to focus on the OCF/total debt ratio: OCF/total debt Intel’s OCF/total debt ratios are 1.04, 1.24, and 1.37. These values are very high and increasing. Creditors should have a minimum level of concern about Intel’s ability to honor its debt. For the third question, some firms sometimes have temporarily negative or low OCFs due to expansions that are typically associated with substantial increases in inventories, accounts receivable, etc. If so, one needs to carefully examine the quality of inventories and accounts receivable. If these firms are able to turn these increased assets into good OCF numbers in the subsequent accounting periods, the expansions look good. If not, then one needs to be careful. III. Development of the Statement of Cash Flows The procedures for the development of the statement of cash flows can be found in Finance 340 textbook, pp.120-124. Example: AZwinery’s balance sheets for year T and T+1 are as follows: Cash Marketable Securities Receivables Inventories Gross Fixed Assets

T 100 0 100 400 1000

T+1 200 100 100 300 1200

Cumulative Depreciation Total Assets

(100) 1500

(200) 1700

Accounts Payable Notes Payable Accruals Long-Term Debt Common Stock Retained Earnings Total Liabilities and Equity

100 100 100 200 800 200 1500

50 150 200 100 900 300 1700

AZwinery’s income statement for year T+1 is as follows: Sales COGS Depreciation Other Operating Expenses Interest Expense Taxes Net Incomes Dividends Addition to Retained Earnings

1000 (500) (100) (80) (20) (100) 200 (100) 100

The following account balance changes indicate cash inflows: (1) Decreases in assets (e.g., the sale of land for cash), (2) Increases in liabilities (e.g., raising long-term debt), and (3) Increases in shareholders’ equity (e.g., the sale of common stock). The following account balance changes indicate cash outflows: (1) Increases in assets (e.g., the purchase of a building), (2) Decreases in liabilities (e.g., retirement of long-term debt), and (3) Decreases in shareholders’ equity (e.g., the payment of a cash dividend). We fist need to calculate the differences in balance sheet accounts: Cash Marketable Securities Receivables Inventories Gross Fixed Assets Cumulative Depreciation

T 100 0

T+1 200 100

Difference 100 100

Category Cash Cash

100 400 1000 (100)

100 300 1200 (200)

0 (100) 200 (100)

Operating Operating Investing Operating

Total Assets

1500

1700

Accounts Payable Notes Payable Accruals Long-Term Debt Common Stock Retained Earnings Total Liabilities and Equity

100 100 100 200 800 200 1500

50 150 200 100 900 300 1700

(50) 50 100 (100) 100 100

Operating Financing Operating Financing Financing

Note that the amount of Retained Earnings is a function of net income and dividends. There are classified as operating and financing, respectively. In this class, we use the indirect method to calculate the net cash flows from operating activities based on net income: Net income (loss) Noncash flow items: Add expenses (Deduct revenues) Changes in balance sheet accounts (usually current asset and current liability accounts) related to operations: Add decreases in assets and increases in liabilities (Deduct increases in assets and decreases in liabilities) Gains and losses on the income statement that are not related to operations: Add losses (Deduct gains) = Net cash provided by operating activities Therefore, we have the following statement of cash flows: Net Income Depreciation Decrease in inventories Decrease in A/P Increase in accruals Net cash provided by operating activities Increase in fixed assets Net cash provided by investing activities Dividends Increase in notes payable Decrease in long-term debt Increase in common stock

200 100 100 (50) 100 450 (200) (200) (100) 50 (100) 100

Net cash provided by financing activities

(50)

Net increase in cash

200

----------------------------------------------------------------------------------------------------------Minicase 4-1: Amazon.com is one of the leading online shopping companies. Amazon.com was found in 1995 and became a publicly traded company in 1997. The company’s income statements show that it operated at a loss through 2002. Nevertheless, Amazon.com’s revenue has been growing at a rapid rate, and the company’s annual revenue was close to $7 billion in 2004. Tasks: 1. Analyze the statement of cash flows for Amazon.com for the period of 1998-2004. Please pay particular attention to OCFs. 2. What have you found in the statement of cash flows that is not readily available in the income statement or balance sheet? 3. Did the stock market react to your findings? -----------------------------------------------------------------------------------------------------------