FINANCIAL ACCOUNTING Prepared by L. de Grace C.A. a user perspective Sixth Canadian Edition John...

FINANCIAL ACCOUNTING

Prepared by L. de Grace C.A.

a user perspectiveSixth Canadian Edition

John Wiley & Sons Canada, Ltd. ©2011

Chapter 5The Statement of Cash Flows

Cash Flows versus Accrual Accounting

Accrual accounting measures performance at a point in the cycle

Ignores timing differences between revenues and expenses and the related cash flows

Not useful in tracking cash flows

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Discussion Question

The income statement measures performance; therefore, the accrual method provides the best information to the user. Why then do we prepare a cash flow statement?

Why AnotherFlow Statement?

3


User Relevance

Operating Activities:• The reason the company exists – regular

operations should generate positive cash flows Investing Activities:

• Users can evaluate the company’s decisions to buy and sell long-term assets, as well as any long-term investments in other companies.

Financing Activities:• Enables users to evaluate the company’s

financial strength and strategy, and to estimate its reliance on debt versus equity financing in the future.


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Ajax Company

Ajax Co. was established in December 2010 with an investment of $150,000. Its only activities in December were to spend $132,000 on capital assets and $4,000 on inventory, so as to be ready to commence sales in January 2011. The capital assets will be depreciated at a rate of $2,000 per month, starting in January 2011.

Product line• Ajax Co sells circuit board components• The components cost Ajax $4 each however Ajax

has no supplier credit – all inventory must be paid for in cash when it is ordered

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Ajax Company

Sales/Customer credit Ajax is a new company and is expecting rapid

growth in sales. The company expects its sales

to continue to grow at the rate of 1,000 units per month for at least the next year.• Ajax sells the components for $7 each• Ajax allows customers up to 30 days to

pay• For simplicity assume that customers

pay 30 days after a sale

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Ajax Company

Inventory policy• Ajax must maintain sufficient inventory

for meeting customer requirements• Components take four weeks to arrive

from overseas• Therefore Ajax must purchase the units

one month in advance for the following month’s sales.

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Ajax Company

Sales & Inventory Data

(in units)January Februar

yMarch

Units in beginning inventory 1,000 2,000 3,000

New inventory purchases 2,000 3,000 4,000

Units available for sale 3,000 5,000 7,000

Units sold 1,000 2,000 3,000

Units in ending inventory 2,000 3,000 4,000

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Ajax Company

Statement of Earnings January February March

Revenues $7,000 $14,000 $21,000

Cost of goods sold (4,000) (8,000) (12,000)

Depreciation expense (2,000) (2,000) (2,000)

Net income $1,000 $4,000 $7,000

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Ajax Company

Net income is growing Increased level of sales is

shown in:• Accounts receivable• Inventory

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Ajax Company

Partial Balance Sheet

Dec.31 Jan.31 Feb.28

Mar.31

Cash $14,000 $6,000 $1,000 $(1,000)

Accounts receivable 0 7,000 14,000 21,000

Inventory 4,000 8,000 12,200 16,000

Cash is declining while accounts receivable and inventory are increasing.

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Cash-to-Cash Cycle

Inventory Purchase

(cash outflow)

Sale of Inventory

Collection (cash inflow)

Cash

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Cash-to-Cash Cycle

Lead/lag relationship at Ajax Co.• Cash paid out to buy inventory 30 days in

advance of the month of sale, and• Cash coming in from collections of accounts

receivable takes another 30 days• The total lag between cash outflow and

cash inflow is two months• Companies can directly influence the

lead/lag relationship

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Ajax CompanyCash Flow

StatementDecem

berJanuary Februar

yMarch

Operating Activities:

Receipts (collections) 0 0 7,000 14,000

Payments (Inventory costs)

(4,000) (8,000) (12,000

)

(16,000)

(4,000) (8,000) (5,000) (2,000)

Financing Activities:

Cash received from owners

150,000 0 0 0

Investing Activities:

Purchase of capital assets (132,000)

0 0 0

Net cash flow 14,000 (8,000) (5,00

0)

(2,000)

Cash balance, beg. of month

0 14,000 6,000 1,000

Cash balance, end of month

$ 14,0

00

$ 6,000 $ 1,000 $(1,000)

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Ajax Company

Cash flow will be negative at the end of March – March 31 cash balance: ($1,000)

Will the company run out of cash? What will it do to continue doing

business ? The first step is to prepare a forecast.

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Ajax Company

Net Income Forecast

April May June

Revenues $28,000 $35,000 $42,000

Cost of goods sold (16,000) (20,000) (24,000)

Depreciation expense (2,000) (2,000) (2,000)

Net earnings $10,000 $13,000 $16,000

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Ajax Company

Cash Flow Forecast April May June

Operating Activities:

Receipts (collections) (21,000) (28,000) (35,000)

Payments (Inventory costs) (20,000) (24,000) (28,000)

$1,000 $4,000 $7,000

Financing Activities:

Cash received from owners 0 0 0

Investing Activities:

Purchase of capital assets 0 0 0

Net cash flow $1,000 $4,000 $7,000

Cash balance, beg. of month (1,000) 0 4,000

Cash balance, end of month 0 4,000 11,000

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Ajax Company

Net cash flow will be positive at the end of May and healthy at the end of June

The lead/lag relationship was responsible for the temporary cash shortage at Ajax.

Should the company take out a loan or establish a line of credit with the bank?

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Solutions to Cash Flow Problems

Three fundamental causes for cash flow shortage in new companies:

1. High growth rates in sales2. Significant lead/lag relationships3. Undercapitalization

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Solutions to Cash Flow Problems Under-capitalization

• Capitalization is the amount of cash the company starts with;

• Start-up companies tend to be under-capitalized;

• Companies can increase their capitalization through:• Equity financing (issue more shares) – this option

results in lower returns to the original owners;• Debt financing – this option results in interest

expense, which would then have to be factored into a revised cash flow forecast.

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Cash Flow Solutions

Reduce the high rate of growth:• Reducing the growth rate at Ajax from

1,000 units per month to 750 units per month eliminates the cash flow problem.

• This option reduces net earnings;• can be detrimental in the long run by

diverting customers to competitors

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Cash Flow Solutions

Lead/lag relationships

• Change the relationships between cash inflows and outflows• Make more sales for cash• Reduce the credit terms for credit sales• Hire a credit manager• Reduce levels of inventory• Increase the number of days to pay

suppliers (this option has limits)

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Cash Flow Statement

Cash and Cash Equivalents

• Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash

• The maximum time frame suggested is 90 days.

• Examples – Canada Savings Bonds, treasury bonds, short term GIC’s

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Cash Flow Statement

Components of cash flows:

• Operating Activities• Financing Activities• Investing Activities

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Cash Flow Statement

Operating activities• Sale of goods and services to customers• Changes to current assets and current

liabilities• All other transactions not covered by

financing or investing activities

LINDT & SPRÜNGLICASH FLOW STMT.

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Cash Flow Statement

Financing activities• Obtaining and repaying resources from

shareholders and lenders• Examples: shares, bonds, mortgages, notes,

dividends

Investing activities• Investment, sale, or disposal of long-term

assets• Examples: property, plant, equipment, long-

term marketable securities

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Cash Flow Statement - Presentation May differ only in format and content of the

Operating Activities section• Direct approach

• Theoretically informative• Rarely used

• Indirect approach• Normally used in published statements

Investing Activities and Financing Activities sections are the same

PREPARE A STATEMENTOF CASH FLOWS

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Interpretation of Cash Flow Information

Which cash flows are likely to continue? Is there sufficient cash from continuing

operations to pay for continuing investing and financing activities?

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NON-RECURRINGCASH FLOWS


Different users require different information:• Bank loan officer

• Ability to pay interest and repay loan• Stock analyst

• Ability to generate long-term cash flows for investors

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The use of equity and debt to generate cash is limited

Operating cash flows must be sufficient to support investing and financing activities over the long term• Purchase of property, plant and equipment• Repayment of debt and interest• Payment of dividends to shareholders

Key is to identify continuing cash sources and needs

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Discussion Question

Comment on the change in cash position and sources and uses of cash during the period for Le Chateau stores.

What can you infer about Le Chateau’s performance from the cash flow statement?

If nonrecurring items are excluded, what would be the company’s sustainable cash flows?

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LE CHATEAUSTATEMENT OF CASH FLOWS

Copyright © 2011 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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