BUSADMIN A610 Module 11

Cash Flows

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

Quiz 4 Information

A610 Quiz 4 Information

(New!) 30 Multiple Choice Questions (15 for Module 8 and 15 for Module 11).
(New!) Solutions available in Avenue on Sunday, Nov. 17 @ 9AM

Attempt Allowed: 1 Attempt Allowed

Time Limit: 2 hours (120 Minutes)
Attempt grades published immediately upon completion.

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

Introduction: Preview

Learning Objectives Required: LO.1-6; Skip LO.7

Practice Questions in Textbook (updated):
Before-class: Review 11-1, 11-2, 11-3, 11-4, 11-5, 11-6, 11-7(1-3); MC 11-1,
11-3, 11-4, 11-6, 11-8, 11-9, 11-10; M 11-22, 11-23, 11-24, 11-28, 11-29
After-class: E11-31, 11-33, 11-38, 11-39, 11-40; P11-41, 11-48
Solutions available in Avenue.

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 1 Framework for Statement of Cash Flows

The statement of cash flows summarizes information about the flow of cash
into and out of a company. It informs the managers, creditors, investors
whether the company can
generate positive future net cash flows
need external financing
meet its debt obligations
pay its dividends

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LO. 1 Framework for Statement of Cash Flows

statement of cash flows vs. balance sheet

The balance sheet reports cash at a point in time (at the end of each period).
The statement of cash flows reports the change in cash from one balance
sheet date to the next.

statement of cash flows vs. income statement

The income statement reveals the results of the company’s operating activities
for the period, and these operating activities are a major contributor to the
changes in cash as reported in the statement of cash flows.

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LO. 1 Framework for Statement of Cash Flows

A statement of cash flows highlights three primary activities of the company.

1 operating activities
2 investing activities
3 financing activities

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LO. 1 Framework for Statement of Cash Flows

Statement of Cash Flows Preparation Overview

The three types of cash flows roughly correspond with the operating,
investing, and financing sections of the balance sheet.

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LO. 1 Statement of Cash Flows - Operating

Operating Cash Flows

Operating activities (Module #1)
hire and train employees
manufacture products or deliver services
market and sell products
manage after-sell customer support
Operating activity costs are reflected in changes in
current assets (e.g., cash, accounts receivable, and inventory), and
current liabilities (e.g., accounts payable, accrued liabilities, and unearned
revenue)
Operating cash flows reflect business success as they derive from core business
activities.

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 1 Statement of Cash Flows - Operating

Operating Cash Flows

Cash inflows and outflows relating to operating activities

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LO. 1 Statement of Cash Flows - Operating

Operating Cash Flows - Example

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LO. 1 Statement of Cash Flows - Operating

Operating Cash Flows - Preparation

The statement starts with net income and then makes two adjustments.
net income 6= cash
1 Noncash items adjustments
2 Operating working capital adjustments

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LO. 1 Statement of Cash Flows - Investing

Statement of Cash Flows: Investing Activities

1 the acquisition and disposal of PPE assets and intangible assets,
2 the purchase and sale of stocks, bonds, and other securities (that are not cash
equivalents), and
3 the lending and subsequent collection of money

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 1 Statement of Cash Flows - Investing

Statement of Cash Flows: Investing Activities

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LO. 1 Statement of Cash Flows - Financing

Statement of Cash Flows: Financing Activities

the borrowing and repayment debt, leases, and all other interest-bearing
obligations,
the sales and repurchases of the company’s stock, and
the payment of dividends

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LO. 1 Statement of Cash Flows - Financing

Statement of Cash Flows: Financing Activities

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LO. 2 Cash Flows from Operating Activities

Indirect method vs. Direct method

Net cash flows from investing and financing activities are prepared in the same
way under both methods; only the cash flow from operating activities differs.
Both report the same amount of net cash flow from operating activities.
More than 98% of companies use the indirect method (easy, less expensive).

Indirect method
starts with net income
applies a series of adjustments to net income
adjustments
net income −−−−−−→ net cash flow from operating activities

Data required for adjustments

income statement
comparative balance sheet
additional data

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Cash Flows from Operating Activities

Indirect method vs. Direct method

Net cash flows from investing and financing activities are prepared in the same
way under both methods; only the cash flow from operating activities differs.
Both report the same amount of net cash flow from operating activities.
More than 98% of companies use the indirect method (easy, less expensive).

Indirect method
starts with net income
applies a series of adjustments to net income
adjustments
net income −−−−−−→ net cash flow from operating activities

Data required for adjustments

income statement
comparative balance sheet
additional data

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Cash Flows from Operating Activities - 4 Steps

1 Begin with net income.

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LO. 2 Cash Flows from Operating Activities - 4 Steps

2 Adjust for noncash revenue, expenses, gains, and losses.

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LO. 2 Cash Flows from Operating Activities - 4 Steps

3 Adjust for changes in current operating assets and liabilities.

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Cash Flows from Operating Activities - 4 Steps

4 Sum from steps 1-3 to calculate net cash flows from operating activities.

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LO. 2 Cash Flows from Operating Activities

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LO. 2 Cash Flows from Operating Activities

Java House Illustration - In-class Practice

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Cash Flows from Operating Activities - 4 Steps

Java House Illustration

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LO. 2 Java House Illustration - 4 Steps

1 Begin with net income.

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LO. 2 Java House Illustration - Step 1

Converting Net Income to Net Cash Flow from Operating Activities

Step 1. Begin with Net Income

Net Income $32,000

Step 2. Noncash Revenues, Expenses, Gains, and Losses

Add Depreciation 10,000
Add Stock-based Compensation 2,000
Subtract Gain on Sale of Land (8,000)

Step 3.1. Changes in Current Operating Assets

Increase in Accounts Receivable (5,000)
Decrease in Inventory 6,000
Increase in Prepaid Insurance (13,000)

Step 3.2. Changes in Current Operating Liabilities

Decrease in Accounts Payable (9,000)
Increase in Tax Payable 2,000

Step 4. Sum the Amounts from Step 1-3 $17,000

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LO. 2 Java House Illustration - 4 Steps

2 Adjust for noncash revenue, expenses, gains, and losses.

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LO. 2 Java House Illustration - Step 2

Converting Net Income to Net Cash Flow from Operating Activities

Step 1. Begin with Net Income

Net Income $32,000

Step 2. Noncash Revenues, Expenses, Gains, and Losses

Add Depreciation 10,000
Add Stock-based Compensation 2,000
Subtract Gain on Sale of Land (8,000)

Step 3.1. Changes in Current Operating Assets

Increase in Accounts Receivable (5,000)
Decrease in Inventory 6,000
Increase in Prepaid Insurance (13,000)

Step 3.2. Changes in Current Operating Liabilities

Decrease in Accounts Payable (9,000)
Increase in Tax Payable 2,000

Step 4. Sum the Amounts from Step 1-3 $17,000

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Java House Illustration - 4 Steps

3 Adjust for changes in current operating assets and liabilities.

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Java House Illustration - Step 3

Converting Net Income to Net Cash Flow from Operating Activities

Step 1. Begin with Net Income

Net Income $32,000

Step 2. Noncash Revenues, Expenses, Gains, and Losses

Add Depreciation 10,000
Add Stock-based Compensation 2,000
Subtract Gain on Sale of Land (8,000)

Step 3.1. Changes in Current Operating Assets

Increase in Accounts Receivable (5,000)
Decrease in Inventory 6,000
Increase in Prepaid Insurance (13,000)

Step 3.2. Changes in Current Operating Liabilities

Decrease in Accounts Payable (9,000)
Increase in Tax Payable 2,000

Step 4. Sum the Amounts from Step 1-3 $17,000

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Java House Illustration - Step 3

Converting Net Income to Net Cash Flow from Operating Activities

Step 1. Begin with Net Income

Net Income $32,000

Step 2. Noncash Revenues, Expenses, Gains, and Losses

Add Depreciation 10,000
Add Stock-based Compensation 2,000
Subtract Gain on Sale of Land (8,000)

Step 3.1. Changes in Current Operating Assets

Increase in Accounts Receivable (5,000)
Decrease in Inventory 6,000
Increase in Prepaid Insurance (13,000)

Step 3.2. Changes in Current Operating Liabilities

Decrease in Accounts Payable (9,000)
Increase in Tax Payable 2,000

Step 4. Sum the Amounts from Step 1-3 $17,000

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 2 Java House Illustration - Step 4

Converting Net Income to Net Cash Flow from Operating Activities

Step 1. Begin with Net Income

Net Income $32,000

Step 2. Noncash Revenues, Expenses, Gains, and Losses

Add Depreciation 10,000
Add Stock-based Compensation 2,000
Subtract Gain on Sale of Land (8,000)

Step 3.1. Changes in Current Operating Assets

Increase in Accounts Receivable (5,000)
Decrease in Inventory 6,000
Increase in Prepaid Insurance (13,000)

Step 3.2. Changes in Current Operating Liabilities

Decrease in Accounts Payable (9,000)
Increase in Tax Payable 2,000

Step 4. Sum the Amounts from Step 1-3 $17,000

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 3 Cash Flow from Investing Activities

Change in investments, PP&E, Accumulated Depreciation, Patent

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LO. 3 Java House Illustration

Cash flows from investing activities

Purchase of investments ($15,000)

Purchase of equipment (5,000)
Sale of land 28,000

Net cash provided by investing activities $8,000

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 3 Java House Illustration

Cash flows from investing activities

Purchase of investments ($15,000)

Purchase of equipment (5,000)
Sale of land 28,000

Net cash provided by investing activities $8,000

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 3 Java House Illustration

Cash flows from investing activities

Purchase of investments ($15,000)

Purchase of equipment (5,000)
Sale of land 28,000

Net cash provided by investing activities $8,000

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LO. 3 Cash Flow from Investing Activities

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LO. 4 Cash Flow from Financing Activities

Analyzing Remaining Liabilities and Equity

Financing activities cause changes in liability and stockholders’ equity
accounts.
The accounts affected are usually noncurrent accounts.
bonds payable
common stock
We analyze changes in all liability and stockholders’ equity accounts that are
not used in computing net cash flow from operating activities.

Decision Rule:

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LO. 4 Cash Flow from Financing Activities

Changes in Common Stock, Debt, Retained Earnings.

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LO. 4 Java House Illustration

Cash flows from financing activities

Issuance of common stock $14,000

Repayment of long-term debt (12,000)
Payment of dividends (13,000)

Net cash provided by financing activities $(11,000)

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 3 Java House Illustration

Cash flows from financing activities

Issuance of common stock $14,000

Repayment of long-term debt (12,000)
Payment of dividends (13,000)

Net cash provided by financing activities $(11,000)

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Intro LO. 1 LO. 2 LO. 3 LO. 4 LO. 5 LO. 6

LO. 3 Java House Illustration

Cash flows from financing activities

Issuance of common stock $14,000

Repayment of long-term debt (12,000)
Payment of dividends (13,000)

Net cash provided by investing activities $(11,000)

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LO. 4 Cash Flow from Financing Activities

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LO. 4 Statement of Cash Flows

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LO. 5 Interpreting and Analyzing Cash Flows

Cash flow items as a percentage of revenues, S&P 500 in 2022

The median operating cash flow is 14.1% of total revenue.
Net income 10.9%
Depreciation and amortization 2.5%
Stock-based compensation 0.7%
Working capital = ? (neglible)

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LO. 5 Interpreting and Analyzing Cash Flows

Cash flow items as a percentage of revenues, S&P 500 in 2022

Investing activities represent an cash outflow of 5.0% (of revenue), out of
which 68% is CAPEX.
Financing activities represent an cash outflow of 9.4%.

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LO. 5 Interpreting and Analyzing Cash Flows

Cash Flow Patterns: a product life-cycle framework

Introduction - limited revenue (low income and operating cash flows); cash
outflows for investing and inflow for financing.
Growth - revenue, income, and operating cash flows all increase; investing and
financing cash flows increase or level out.
Maturity - peaks (or some decline) of revenues, income and operating cash
flows.
Decline - large decreases in revenue, income, and operating cash flows;
distribute cash flows for financing sources (repay debt, buy back stock, pay
dividends); realize some incoming investing cash flows as assets are sold off.
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LO. 6 Ratio Analyses of Cash Flows

1 Operating cash flow to current liability ratio

Liquidity measure: a company’s ability to liquidate current liabilities
Cash flow from operating activities is from statement of cash flows.
Avg. current liabilities is the avg. of the beginning and ending current liabilities.
The higher this ratio, more likely to settle current liabilities as they come due.

The median for S&P 500 companies was 0.46 in 2022.

Microsoft reports the following for FY 2023.
Operating cash to current liabilities =
$87, 582/[($95, 082 + $104, 149)/2] = 0.88

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LO. 6 Ratio Analyses of Cash Flows

2 Operating cash flow to capital expenditure ratio

a firm’s ability to replace and expand PPE from internally generated cash flow
Cash flow from operating activities is from statement of cash flows.
Capital expenditure is from investing section of the statement of cash flows (or
notes to the financial statements, supplementary information, and MD&A).
If ratio > 1, current operating activities are providing cash in excess of the
amount needed to provide the desired level of plant capacity (i.e., financial
strength, also indicating solvency).

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LO. 6 Ratio Analyses of Cash Flows

3 Free cash flow

Net operating profit after tax (NOPAT)
Change in net operating assets (NOA)
Free cash flow = NOPAT - NOA
How to increase firm value (or increase free cash flow)?
1 Increase NOPAT
2 Control NOA growth
Alternative definitions
A1 = operating cash flows - capital expenditure
A1 adjusted by removing interest expenses and interest revenue
Microsoft, 2018-2023

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