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Analyzing Cash Flow

For various reasons, you might want to determine how a company uses its cash assets. The choice to use cash to acquire an asset, to meet a liability, or to retire a debt is a process of investment and disinvestment, and a manager always has choices to make, some smart and some maladroit. It's important to keep track of how well a company's management is making these choices.

Furthermore, as useful as the accrual method of accounting is in matching revenues with expenses, it tends to obscure how cash flows through a firm. One of the purposes of cash flow analysis is to highlight differences between, say, net income and the actual acquisition of cash. For example, accounts receivable is one component of net income, but it will not show up as cash until the check clears. A company might have a healthy net income, but if its customers do not pay it on a timely basis, it might have difficulty meeting its obligations. Cash flow analysis can illuminate problems, even impending problems such as that one.

To illustrate this process, consider what might transpire in Marble Designs' financial structure over the period of a year.

As a benchmark against which the following analysis will be compared, Figure 5.10 shows the actual cash transactions that occurred as a result of Marble Designs' activities during the 12-month period.

Figure 5.10

Figure 5.10 Marble Designs' cash positions can be tracked by examining individual cash transactions.

Again, though, the information in Figure 5.10 is simply a benchmark used as a check on the cash flow analysis. You would almost never attempt to do a cash flow analysis using actual cash receipts and payments over any lengthy period of time: It would be too time consuming and is a less informative method of analysis.

Developing the Basic Information

Instead of beginning with a checkbook register, start with the standard financial reports: the income statement and balance sheet. Figure 5.11 shows the income statement for the period January 31, 2007, through January 31, 2008, for Marble Designs, as well as a comparative balance sheet showing assets, liabilities, and equity at the beginning and end of that period.

Figure 5.11

Figure 5.11 The income statement and balance sheet provide starting points for a cash flow analysis.

The income statement shows $1,500 worth of materials in inventory at the beginning of the period, an additional $25,000 purchased during the period, and $2,000 remaining at the end. Therefore, $24,500 in materials was used in the completion of $90,000 in sales for the period, resulting in a gross profit of $65,500.

Against that gross profit, various operating expenses were incurred: salaries, the cost of the office lease, and the telephone expense. The $1,833 in office supplies that remained at the end of January 31, 2007, were consumed: This was a prepaid expense because Marble purchased the entire stock of supplies at the beginning of January 2007. Another $2,000 were purchased during the period covered by the income statement.

The depreciation on the computers also appears in the income statement. However, this is a noncash expense. The formula used in cell C18 of Figure 5.11 is as follows

=SLN(1950,0,3)+SLN(2320,0,3)/2

This formula uses Excel's straight-line depreciation function, whose arguments are Cost, Salvage Value, and Life. The cost is simply the item's initial cost, its salvage value is the item's value at the end of its useful life (here, Marble estimates that the value will be zero), and its life is the number of periods that will expire before the item reaches its salvage value. The function returns the amount of depreciation that occurs during one period of the item's useful life. So this fragment returns $650, the amount of depreciation in the value of the first computer purchased, during one year of its assumed three-year life:

SLN(1950,0,3)

The second computer cost $2,320 and was purchased in July 2007, halfway through the period covered by the income statement. Therefore, the depreciation on that computer during the second half of the year, $386.67, is returned by this fragment:

SLN(2320,0,3)/2

Together, the $650 in depreciation over 12 months for the first computer and the $386.67 in depreciation over six months for the second computer result in a total equipment depreciation of $1,036.67.

It's important to keep in mind that this depreciation does not constitute a cash expense such as a salary check or the payment of a monthly telephone bill. As noted previously, no funds change hands when you record depreciation: It is merely a means of apportioning, or accruing, an earlier use of capital to a period in which the item contributes to the creation of revenue.

Finally, the $5,000 profit from the acquisition (for $30,000) and subsequent sale (for $35,000) of the office space is recorded and added to obtain the total net income. Note that this $5,000 is nonoperating income—that is, it is profit created from an activity, the purchase and sale of property that is not a part of Marble Designs' normal operations.

The balance sheet repeats from Figure 5.6, in column E, Marble Designs' assets, liabilities, and equity at the end of January 31, 2007. Column F also shows these figures as of January 31, 2008. The transactions that occurred during the 12-month period resulted in a healthy increase in cash and minor changes to the remaining asset and liability categories. These entries are taken from ledger accounts; the exception is the owner's equity figure of $27,295.50. The owner's equity in cell F17 of Figure 5.11 is calculated as follows:

=E17+C22

That is, this the prior equity figure of $13,783.17 in cell E17, plus the net income of $13,512.33 for the period in cell C22.

Summarizing the Sources and Uses of Working Capital

Figure 5.12 shows the changes in working capital that occurred during the year, determined by analyzing the effect of noncurrent accounts. Sources of working capital include operations, the nonoperating profit realized from the purchase and sale of the office space, and a new short-term note.

Figure 5.12

Figure 5.12 Analyzing the sources and uses of working capital is often a useful indicator of how well a business is managing its resources.

Note three points about this analysis of sources and uses of working capital:

  • You can calculate overall cash flow by determining the net change in the Cash account, but to analyze cash flow, you need to examine all the changes in the balance sheet accounts—including working capital. The details and the overall effect of changes in working capital usually differ from those of cash transactions. Both the working capital and the cash impacts are important in understanding of a company's financial position.
  • Changes in working capital are not the same as changes in cash. In this case, cash increases during the accounting period by $15,229, whereas working capital increases by $12,229.
  • The profit on the purchase and sale of the office space appears to have no effect on the increase in working capital. In fact, however, it does: The profit of $5,000 has already been included in net income. Figure 5.12 subtracts that profit from net income to provide a more accurate picture of operations as a source of working capital. Furthermore, the transaction is shown under both sources and uses, to show how capital has been generated and used, not simply to calculate the increase or the decrease over time.

Identifying Cash Flows Due to Operating Activities

The next step in analyzing cash flows is to focus on cash generated by and used in operations. Figure 5.13 shows this step.

Figure 5.13

Figure 5.13 Determining cash flows from operating activities.

Generally, three sources or uses of cash arise from operating activities:

  • Cash receipts from customers—You can easily determine this amount by combining the value for sales (net of any discounts that might have been provided to customers) with changes in accounts receivable. That is, add accounts receivable at the end of the period to the sales figure and then subtract accounts receivable at the beginning of the period. The logic is that if accounts receivable has declined during the period, you have collected more in cash than you have accrued in accounts receivable; if it has increased, you have accrued more in receivables than you have collected in cash.
  • Cash outlays for purchases—From the standpoint of operating activities, there is one use of cash for purchases: inventory. Therefore, to summarize cash flow for operating purchases, add to the cost of goods sold during the period of the ending inventory level, and subtract the beginning inventory level.

    Additionally, you might have purchased inventory with a note or account payable to the suppliers of your inventory materials. In this case, you add any decrease in these payables (because you used cash to decrease them) or subtract any increase in these payables (because you used credit, not cash, to acquire the materials).

  • Cash outlays for expenses—These are available from the operating expenses portion of the income statement. Combine the total operating expenses with any changes in prepayments and accrued liabilities, such as employee salaries earned but as yet unpaid, at the end of the period.

In the case of Marble Designs, applying these calculations as shown in Figure 5.13 indicates that sales, increased by a reduction of $2,500 in accounts receivable, results in cash receipts of $92,500. Cost of goods sold, increased by the $500 change in inventory level, results in $25,000 in cash purchases. Total operating expenses also were (a) reduced by $1,036.67 in depreciation, a noncash, long-term prepayment, and (b) increased by a change in the amount of notes payable, converted to cash and used to acquire office supplies.

Subtracting cash payments for purchases and for expenses from total receipts results in $12,549.00, the amount of cash provided by operations.

This completes the process of converting information contained in the income statement, receipts, and outlays represented as accruals into a cash basis, represented as actual cash receipts and outlays occurring during the period in question.

Combining Cash from Operations with Cash from Nonoperating Transactions

The final step in developing the cash flow analysis is to combine the cash amounts used for normal operations with the cash transactions that apply to nonoperating activities. Figure 5.14 provides this summary.

Figure 5.14

Figure 5.14 Marble Designs' cash flow statement, January 31, 2007, through January 31, 2008.

Cash receipts, in this case, consist of cash from operations and cash received from selling the office space. Cash outlays consist of the purchase of the new computer and the office space. The difference between the two, $15,229, represents the amount of cash Marble Designs generated during the 12-month period, and this figure should agree with the difference in the cash account between January 31, 2007, and January 31, 2008. Refer back to Figure 5.10: The difference between the ending balance of $17,783 and the beginning balance of $2,554 is $15,229, which agrees with the results of the cash flow analysis.

In reality, cash flow analysis is a much more complicated task than the relatively simple example provided here. It includes many more transactions than were included in this example: The effect of taxes must be taken into account, accrued liabilities complicate the process, and such transactions as the issuance of stock, dividends, and long-term bonds affect the identification and calculation of cash flows. However, the example illustrates the basic principles and overall process of converting balance sheets and income statements into information about how a company creates and uses its cash resources.

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