Financial Accounting – Sessions 6 & 7

The Statement of Cash Flows

by Shiwon Song
Course Outline
The Financial Earnings Investing &
Operating
Reporting vs. Financing
Activities
Process Cash Flows Activities

5 Return on 10 Revenue
1 Overview
Invested Capital Recognition & 13 Financial
Accounts Liabilities &
6 Statement of Receivable
2 Balance Sheet CashFlows
Cash Flows Equity

7 Cash Flow 11 Inventory &

3 Income Analysis
Analysis Tangible Assets
Statement
8 Earnings-Based
Anomalies 12 Intangible
14 Investments
Assets &
4 Intro to
9 Earnings Operating
Financial Ratios
Management Liabilities
Sessions 6 & 7 Learning Objectives

1. The difference between accounting earnings and cash flows

2. Analyzing the sources and uses of cash through a cash flow profile

3. The steps involved in preparing a statement of cash flows

What do Investors Want?
Investors Want Cash Back
But there is NO guarantee that investors will be paid back

???
Communicating Information
What kind of information would investors want?
Existing & Potential
• About the Company’s business
•
Earnings
Summarized in Numbers & Categories
• OR
Organized & Standardized
(governed by rules & principles)
• Cash
Reported Flows?
on a regular basis
Accounting Earnings vs. Cash Flows
Cumulative stock return responses to earnings vs. cash flows

Source: Nichols and Wahlen (2004)

Accounting Earnings vs. Cash Flows

Source: Dechow (1994)

The Cash Flow Statement Δstock = Flow

The Company
Cash Flows over a specific period

Cash Flows from Cash Flows from Cash Flows from

Operating Activities Financing & Investing Activities
Operating Activities Investing Activities Financing Activities
The Cash Flow Statement
The Statement of Cash Flows (SCF)

1. Reconciles the starting & ending balance of the cash account by

summarizing all transactions that produced or consumed cash during
the period (i.e., cash inflows & outflows)

2. Transactions are classified into 3 categories:

Operating Activities Investing Activities Financing Activities
Day-to-day activities that Activities that alter Activities to obtain/repay funds
generate revenue infrastructure or investments used for operating & investing
(e.g., paying suppliers/employees) (e.g., capital expenditures) (e.g., bank loans, dividends)

BB Operating Cash Investing Cash Financing Cash EB

Cash
± Flows (CFFO)
± Flows (CFFI)
± Flows (CFFF)
= Cash

Change in Cash
Direct vs. Indirect Method SCF for CFFO
Either method is acceptable under U.S.GAAP and IFRS.

Direct Method Indirect Method

• Directly reports cash flows Cash Flows

from
used in, and generated by, Net Income (NI) ± De-Accrualizing = Operating
each individual transaction Adjustments Activities
from core operations (CFFO)

• Still requires reconciliation

of net income to cash flows • Indirectly arrives at CFFO by starting with NI
from operating activities • Adjustments necessary to “de-accrualize ”
accounting income
• Used by only 2-3% of US
firms, more popular
internationally
Net Income vs. Operating Cash Flows*
Net Income = Revenues − Expenses

? ① Revenues and Expenses from Non-Operating Activities

Operating Income = Operating Revenues − Operating Expenses

Assets↑ or Liabilities↓ Assets↓ or Liabilities↑
from operating activities from operating activities
Revenue Recognition Matching

? ② Always Non-Cash Expenses (e.g., depreciation, amortization, impairment)

③ Change in Non-Cash Operating Current Assets Change in
④ Change in Operating Current Liabilities Net Working Capital

Operating Operating
Operating Cash Flows = Cash Inflows − Cash Outflows
Cash Assets↑ Cash Assets↓
from operating activities from operating activities
The SCF Connects with the I/S & the B/S

Revenues Expenses
I/S Net Income = (revenue recognition) (matching)

∆ Equity ∆ Non-Cash
SCF (Net Income) + ∆ Liabilities Assets = ∆ Cash

Net Income = Accruals + ∆ Cash

• Facilitates revenue recognition & matching

• Provides incremental information over
cash flows about profitability
The SCF Connects with the I/S & the B/S

Revenues Expenses
I/S Net Income = (revenue recognition) (matching)

∆ Equity + ∆ Liabilities = ∆ Assets

∆ B/S
∆ Equity ∆ Non-Cash
(Net Income) + ∆ Liabilities = Assets + ∆ Cash

∆ Non-Cash
SCF Net Income + ∆ Liabilities Assets = ∆ Cash

↑ ↑ ↓ ↑
Changes in cash will be reflected by a change in a non-cash B/S item!
Case: Beterbed
The income statement
2012 2011
Revenue 397,288 397,035
Cost of sales (173,445) (172,625)
Gross profit 223,843 224,410

Wage and salary costs (91,126) (87,757)

Depreciation and impairment of fixed assets (14,424) (8,510)
Other operating expenses (94,574) (89,855)
Operating profit (ebit) 23,719 38,288

Financial income 175 394

Financial expenses (577) (828)
Profit before taxation 23,317 37,854

Income tax expense (8,899) (9,829)

Net profit 14,418 28,025

 Case: Beterbed
The balance sheet

2012 2011 2012 2011

Total tangible fixed assets 30,936 32,466 Total equity 55,832 62,015

Total intangible assets 2,855 5,331 Deferred tax liabilities 2,400 2,000
Credit institutions 1,000 3,000
Deferred tax assets 451 1,316 Total long-term liabilities 3,400 5,000
Long-term accounts receivable 527 614
Total financial fixed assets 978 1,930 Credit institutions 11,327 5,314
Trade creditors 8,923 12,879
Stocks 60,712 59,461 Profit tax payable 4,354 2,992
Accounts receivables 10,150 8,308 Taxes and social security contributions 9,217 9,082
Cash and cash equivalents 5,224 7,075 Other liabilities 17,802 17,289
Total current assets 76,086 74,844 Total current liabilities 51,623 47,556

Total assets 110,855 114,571 Total liabilities and equity 110,855 114,571
Operating Cash Flows in the SCF: DIRECT
− ∆ Accounts Receivable Cash Flows from
+ Revenues + ∆ Unearned Revenue = Revenues

− ∆ Inventory Cash Flows from

− COGS + ∆ Accounts Payable = COGS

− Operating − ∆ Prepaid Expenses + depreciation

+amortization Cash Flows from
Expenses + ∆ Other Payables +impairment = Operating Expenses

± Financing − ∆ Interest Receivable Cash Flows from

Financing
Income & Expenses + ∆ Interest Payable = Income & Expenses

± Investing − gain on sale

Income & Expenses + loss on sale =
− Income Tax Cash Flows from
Expense + ∆ Tax Payable = Income Tax Expense

Operating
Net Income
Cash Flows
Operating Cash Flows in the SCF: INDIRECT
− ∆ Accounts Receivable
+ ∆ Unearned Revenue
− ∆ Inventory
+ ∆ Accounts Payable
− ∆ Prepaid Expenses + depreciation
+amortization
+ ∆ Other Payables +impairment
− ∆ Interest Receivable Operating
Net Income + ∆ Interest Payable =
Cash Flows
− gain on sale
+ loss on sale

+ ∆ Tax Payable
Net Working Capital
Cash necessary to make the operating cycle turn

Inventory period Receivables period

period

Takes time to reap cash

Manufacturing period Sales period inflows from operations

Material Products Products Cash collected

acquired completed sold from customers

Cash injected in the operating cycle Cash injected in the operating cycle
funded by the company funded by outsiders
Accounts Receivable Accounts Payable
+ +
Inventory – Other Payables = Net Working Capital
+ +
Prepaid Expenses Unearned Revenue
SCF Categories*
I/S The Company’s Statement of Cash Flows
Fiscal Year (Quarter) Period
Net Income
+ Non-Cash Expenses B/S
+ (-) Non-Operating Losses (Gains)
+ (-) decreases (increases) in Non-Cash Current Operating Assets
changes in WC
+ (-) increases (decreases) in Current Operating Liabilities
Cash Flows from Operating Activities (CFFO) day-to-day activities to
generate revenues
Cash Flows from Investing Activities (CFFI)
periodic activities that
Cash Flows from Financing Activities (CFFF) alter infrastructure or
investments
Net Cash Flows
+ Beginning Cash activities to
obtain/repay funds
Ending Cash used for operating &
Goodwill investing
LT Investments B/S
Changes in Long-Lived Assets
How are they reflected in the SCF?

Beginning Tangible & Intangible Fixed Assets

+ Capital Expenditures Investing Cash Outflow

− Disposals Investing Cash Inflow

− Depreciation & Amortization

Non-Cash Expenses
− Impairments
add to net income to determine
Operating Cash Flows using
Ending Tangible & Intangible Fixed Assets the indirect method
Some Differences in Standards
Cash includes cash on hand, demand deposits, cash equivalents
IFRS U.S.GAAP
Overdrafts are included in the change in the
Overdrafts are NOT included in the change
net cash flow if considered an integral part
in the net cash flow.
of the company’s cash management strategy.

Managerial Discretion
Financial Income & Expense
IFRS U.S.GAAP
Management chooses whether to
classify as operating, investing, or financing Always operating.
(but consistency is required).
Case: Blockbuster
The SCF is not immune to manipulation

• Classified film library as long-term assets

• Reported Net Loss of over $1 bn while CFFO of $1 bn (in 2004)

• What happened next?

① restatement of long-term assets to current assets
② restatement of CFFI outflows to CFFO outflows ($836.3 mn)
Case: Netflix
Why does Netflix get away with this?

Netflix’s disclosures regarding film library:

The Company acquires DVD content for the purpose of renting such content to
its subscribers and earning subscription rental revenues, and, as such, the
Company considers its direct purchase DVD library to be a productive asset.
Accordingly, the Company classifies its DVD library in “Non-current content
library” on the Consolidated Balance Sheets.

The acquisition of DVD content library, net of changes in related liabilities, is

classified in the line item “Acquisition of DVD content library” within cash used
in investing activities in the Consolidated Statements of Cash Flows because the
DVD content library is considered a productive asset. Other companies in the
in-home entertainment video industry classify these cash flows as
operating activities.
Preparing a Cash Flow Profile

1. Determine the major sources and uses of cash.

2. Define the relationship between CFFO and net income.

3. Is the free cash flow positive or negative?

4. Identify significant trends.

 Exhibit 2
Wal-Mart
Statement of Cash Flows

Growth Case: Walmart (amounts in millions)

1984 1985 1986 1987 1988

Operations
1. Sources of cash
Net Income ...................................................$ 271 $ 327 $ 450 $ 628 $ 837
Depreciation ................................................. 67 90 124 166 214
Other Addbacks............................................ 9 18 7 0 1
Other Subtractions........................................ 0 0 0 -1 0
Working Capital Provided by Operations ....$
(Inc.) Decr. in Receivables ...........................
347
-6
$ 435
-12
$ 581
-33
$ 793
-6
$ 1,052
-31
Uses of cash
(Inc.) Decr. in Inventories ............................ -368 -284 -643 -575 -700
(Inc.) Decr. in Other Current Assets............. -77 -12 -8 -0 -6
Inc. (Decr.) in Accounts Payable-Trade ....... 161 287 229 127 290
Inc. (Decr.) in Other Current Liabilities ....... 22 16 139 120 129
Cash Flow from Operations .................$ 79 $ 430 $ 265 $ 459 $ 734

Investing
2. CFFO>NI or CFFO<NI
Fixed Assets Acquired .................................$ -322 $ -513 $ -675 $ -757 $ -797
Other Investing Transactions ....................... 148 -160 -4 -51 9
Cash Flow from Investing ...................$ -174 $ -673 $ -679 $ -808 $ -788

Financing

Incr. Short-Term Borrowing ........................$

Incr. Long-Term Borrowing......................... 129
0 $ 0
298
$ 0
460
$ 104
194
$ 0
248 3. FCF>0 or FCF<0
Issue of Capital Stock................................... 6 5 6 7 4
Decr. Short-Term Borrowing ....................... 0 0 0 0 -85
Decr. Long-Term Borrowing ....................... -16 -12 -13 -42 -21
Acquisition of Capital Stock ........................ -1 -1 0 0 0
Dividends .................................................... -30 -40 -48 -68 -91
Cash Flow from Financing ..................$ 88 $ 250 $ 405 $ 195 $ 55

Change in Cash ............................................$ -7 $ 7 $ -9 $ -154 $ 1 4. Significant trends

Sales (in millions of $) 6,401 8,451 11,909 15,959 20,649
 Exhibit 1
Sun Microsystems

Start-Up Case: Sun Microsystems Statement of Cash Flows

(amounts in millions)

1984 1985 1986 1987 1988

Operations 1. Sources of cash

Net Income ...................................................$ 3 $ 9 $ 12 $ 36 $ 66
Depreciation ................................................. 1 4 6 25 51
Working Capital Provided by Operations ....$ 4 $ 13 $ 18 $ 61 $ 117
(Inc.) Decr. In Receivables...........................
(Inc.) Decr. In Inventories ............................
-9
-8
-5
-8
-24
-21
-58
-32
-117
-77 Uses of cash
(Inc.) Decr. In Other Current Assets ............ -1 -1 -18 -31 -30
Inc. (Decr.) in Accounts Payable-Trade ....... 4 4 21 33 58
Inc. (Decr.) in Other Current Liabilities ....... 2 9 6 35 52
Cash Flow from Operations .................$ -8 $ 12 $ -18 $ 8 $ 3

Investing

Fixed Assets Acquired .................................$ -5 $ -15 $ -36 $ -76 $ -117 2. CFFO>NI or CFFO<NI
Other Investing Transactions ....................... 0 -2 -2 -23 -32
Cash Flow from Investing ...................$ -5 $ -17 $ -38 $ -99 $ -149

Financing

Incr. Short-Term Borrowing ........................$ 1 $ 3 $ 11 $ 21 $ 0

3. FCF>0 or FCF<0
Incr. Long-Term Borrowing......................... 3 5 1 121 0
Issue of Capital Stock................................... 11 21 47 96 63
Decr. Short-Term Borrowing ....................... 0 0 0 0 -6
Decr. Long-Term Borrowing ....................... 0 -1 -2 0 0
Other Financing Transactions ...................... 0 3 3 0 0
Cash Flow from Financing ..................$ 15 $ 31 $ 60 $ 238 $ 57

Change in Cash ............................................$ 2 $ 26 $ 4 $ 147 $ -89

Sales (in millions of $) ................................. NA 115 210 538 1,052

4. Significant trends
NA = not available
 Exhibit 3
Merck and Company
Statement of Cash Flows

Early-Maturity Case: Merck & Co. (amounts in millions)

1984 1985 1986 1987 1988

Operations

Net Income ...................................................$ 493 $ 540 $ 676 $ 906 $ 1,207

1. Sources of cash
Depreciation and Amort. .............................. 162 182 194 210 205
Other Addbacks............................................ 130 86 37 0 0
Other Subtractions........................................ 0 0 0 -66 -245
Working Capital Provided by Operations ....$
(Inc.) Decr. in Receivables ...........................
785
-102
$ 808
-53
$ 907
-42
$ 1,050
-170
$ 1,167
-106 Uses of cash
(Inc.) Decr. in Inventories ............................ 0 22 -35 -80 -14
(Inc.) Decr. in Other Cash ............................ 29 -1 0 0 0
Inc. (Decr.) Accounts Payable-Trade ........... 78 81 98 144 -77
Inc. (Decr.) in Other Current Liabilities....... -49 152 166 379 417
Cash Flow from Operations .................$ 741 $ 1,009 $ 1,094 $ 1,322 $ 1,387

Investing
2. CFFO>NI or CFFO<NI
Fixed Assets Sold .........................................$ 0 $ 92 $ 0 $ 0 $ 0
Fixed Assets Acquired ................................. -274 -238 -211 -254 -373
Other Investing Transactions ....................... 119 -278 -126 -206 262
Cash Flow from Investing ...................$ -155 $ -424 $ -337 $ -460 $ -111

Financing

Incr. Short-Term Borrowing ........................$

Incr. Long-Term Borrowing.........................
38
0
$ 0
0
$ 43
0
$ 478
0
$ 0
1,997
3. FCF>0 or FCF<0
Issue of Capital Stock................................... 2 18 25 21 30
Decr. Short-Term Borrowing ....................... 0 -79 0 0 -392
Decr. Long-Term Borrowing ....................... -206 -8 -3 0 -1,991
Acquisition of Capital Stock ........................ -164 -242 -500 -1,000 0
Dividends .................................................... -224 -235 -278 -335 -505
Other Financing Trans.................................. 0 0 0 0 31
Cash Flow from Financing ..................$ -554 $ -546 $ -713 $ -836 $ -830
4. Significant trends
Change in Cash ............................................$ 32 $ 39 $ 44 $ 27 $ 446

Sales (in millions of $) 3,560 3,548 4,128 5,061 5,940

Case: Inditex (Industria de Diseño Textil, S.A.)
Company Description

• Spanish multinational clothing company headquartered in Arteixo, Galicia.

• The largest fashion group in the world (over 7,000 stores in 91 countries).

• Zara, Zara Home, Massimo Dutti, Bershka, Oysho, Pull and Bear, Stradivarius and Uterqüe.

• The majority of its stores are corporate-owned, while franchises are mainly
conceded in countries where corporate properties can not be foreign-owned.

• Unique business model:

• No commitment of a large percentage of production each fashion season
• Weekly replenishment of new product by committing a small amount
→ uses customer feedback and an efficient production network
→ as little as 15 days to go from design and production to store shelves
Inditex: Statement of Cash Flows
Questions 1-3: SCF – Basic questions
Inditex: Changes in WC
Question 4: SCF – Changes in Assets and Liabilities
Inditex: Market Strategy
Is the company in expansion mode (MD&A)?

Is the company in expansion mode (SCF)?

Inditex: Dividend Strategy
Question 6: SCF and MD&A – dividend expansion
Inditex: WC Management Strategy
“The operating working capital position remains
negative, a consequence of the business model”
Sessions 6 & 7 Summary
1. The difference between accounting earnings & cash flows
Revenues _ Expenses
Net Income (Loss) = by Revenue Recognition by Matching

Net Income (Loss) = ∆ Cash + ∆ Non-Cash

Assets ‒ ∆ Liabilities

Net Income (Loss) = Cash Flows + Accruals

• Accounting profit is more informative than cash profit about value generated
• Accrual accounting requires non-cash assets & liabilities on the B/S

2. Analyzing the statement of cash flows using a cash flow profile

• Source and uses of cash?
• CFFO > NI or CFFO < NI?
• FCF > 0 or FCF <0?
• Significant trends?
Sessions 6 & 7 Summary
3. The steps involved in preparing a statement of cash flows

• Investing & Financing Cash Flows: only use the ‘direct’ method
• Operating Cash Flows: both ‘direct’ and ‘indirect’ method is allowed
However, reconciliation of profit to operating cash flows is always required.

Direct: CFFO = σ(𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐟𝐫𝐨𝐦 𝐞𝐚𝐜𝐡 𝐭𝐲𝐩𝐞 𝐨𝐟 𝐭𝐫𝐚𝐧𝐬𝐚𝐜𝐭𝐢𝐨𝐧)

Net Non-Cash & Non- Changes in Non-Cash Operating

Indirect: CFFO = Income ± Operating Items ± Current Assets & Liabilities
① ② ③

① + non-cash expenses (−) Revenues & Gains

② − (+) non-operating gains (losses) (+) Expenses & Losses
③ − (+) increases (decreases) in non-cash operating current assets Assets: opposite sign
+ (−) increases (decreases) in operating current liabilities Liabilities: same sign