Topic 2

Accounting Statements and Cash Flow

Financial Management
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 Accounting & Finance
Financial statements (B/S, I/S)

§ The main source of information needed for various financial decisions.

§ Financial statements, however, do not directly provide the cash flow
numbers.

Accounting vs. Finance

§ Accounting deals with revenue, costs, and accounting profits such as NI

(net income).
§ Finance deals with cash flows, which are cashes actually come into/go
out of the business accounts.
§ Usually, accounting profit is not same as net cash flow.

Cash flows can be calculated from financial statements.

§ B/S & I/S [ cash flows [ financial decisions

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 Accounting & Finance
Example (accounting profit vs. cash flow)
: Lexington Furniture Company manufactures quality furniture. At the end
of the year the company sold 500 bedroom suites to Hilton Hotels for $2.5
million. It costs the company $1.4 million to manufacture the furniture. As
of the end of the year, Hilton has not paid for the bedroom suites. So from
an accounting view point, Lexington appears very profitable. The finance
view, however, focuses on cash flow and shows a much different story.

§ Income Statement (accounting view)

Sales : 2.5 million
– Cost : 1.4 million
Profit : 1.1 million

§ Statement of Cash Flow (finance view)

Cash Inflow :0
– Cash Outflow : 1.4 million
Net Cash Flow : – 1.4 million

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 Balance Sheet (B/S)

Balance sheet shows the firm’s accounting value on a

particular date (usually the end of fiscal year).

§ Accounting value is measured as historical acquisition

costs.
§ Accounting value (book value) ≠ market value

Common equity is a residual account.

§ Assets – liabilities – preferred stock = common equity

§ Common equity can be negative in B/S.

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 Balance Sheet (B/S)
Common equity has three components.

§ Common stock (par value)

§ Paid in capital (excess over par)
§ Retained earnings

§ The amounts of 1st and 2nd component are fixed at the time of
stock issue.

§ The amount of 3rd component, however, changes throughout

the time.
o NI (net income) not paid out as dividends goes to R/E
(retained earnings).

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 Income Statement (I/S or P/L)

Basic Structure of an Income Statement

Operating Revenue (or Sales)

– COGS
– Expenses
– Depreciation
EBIT
– Interests
EBT
– Taxes
NI

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 Income Statement (I/S or P/L)
Non-cash Item

§ The items on I/S that are expenses but not cash outflows.

§ The most common example is depreciation.

o Recorded as an expense in I/S
o No actual cash outflow

Tax savings effect (or tax shield effect) of non-cash item

§ Non-cash items such as depreciation decrease the amount of

taxes which are actual cash outflows.

§ The amount of tax savings is Depreciation × tax rate.

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 Net Working Capital (NWC)
Net working capital = current assets – current liabilities

Positive NWC means

current assets > current liabilities

_ the available cash is larger than the cash to be paid out (in near
future).

The idea is that current assets can be converted to cash quickly and easily.

§ Current assets are cash, account receivables, inventory etc.

Investments into NWC ≡ increases of NWC

§ Then what is the decrease of NWC?

§ Decrease of NWC ≡ recovery of invested money from NWC

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 Net Working Capital (NWC)

Calculation of NWC for ‘Star Corp’

§ Net working capital = current assets – current liabilities

§ 2017: 5,470 – 3,187 = 2,283
§ 2018: 5,728 – 3,354 = 2,374

§ ∆NWC (the change in NWC) = 2,374 – 2,283 = 91

o This is the amount of investments into NWC during

the year 2018.

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 Cash Flow
What we want is the summary of all of the cashes which flowed into/out
of the company during a specific period of time (usually a fiscal year).

§ (1),(2),(3), and (4) in the figure below.

debit B/S credit

(2) (1)
Investments H H Financing
debt
assets

(3) equity (4)

Money from business I I Money to investors

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 Cash Flow
Cash Flow Identity

§ Accounting identity states that

Assets = Debt (or Liabilities) + Equity

§ Similarly, we have

Cash flow from Cash flow to Cash flow to

= +
Assets Debt holders Equity holders

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 Cash Flow from Assets
Cash flow from assets (CFA) = OCF – NCS – ∆NWC

§ Operating cash flow (OCF)

= EBIT + Depreciation – Taxes

o Money made from the operation, but it’s not an accounting

number such as NI but a cash flow.
• Does not consider interest.
• Taxes are included because it’s actual CF.
• Depreciation is added back.

§ For ‘Star Corp’,

OCF = 903 + 325 – 141 = 1,087

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 Cash Flow from Assets

Net capital spending (NCS)

§ The change in (net) fixed assets (= ∆NFA)

§ (Net) Investments into fixed assets
§ NCS = ending (net) fixed assets – beginning (net) fixed
assets + depreciation

§ For ‘Star Corp’,

NCS = 4,986 – 5,134 + 325 = 177

∆NWC is calculated already as 91.

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 Cash Flow from Assets
Then, cash flow from assets (CFA) for ‘Star Corp’ is,

§ CFA = OCF – NCS – ∆NWC

= 1,087 – 177 – 91
= 819
debit B/S credit
(2) (1)
Investments H H Financing
debt
(4)
(3) assets
Money from business I equity I Money to investors
_ OCF
NCS CFC
∆NWC
CFS
CFA

Can the cash flow from assets be negative? If then, what’s the meaning?

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 Cash Flow to Creditors and Stockholders
Cash flow to creditors (CFC) = interests paid – net new long-term borrowing

§ Net new long-term borrowing is an increase in long-term debt

= ending long-term debt – beginning long-term debt

§ For ‘Star Corp’,

CFC = 553 – (4,745 – 4,917) = 725

Cash flow to stockholders (CFS) = dividends paid – net new equity

§ Net new equity is an increase in equity (excluding R/E)

§ For ‘Star Corp’,

CFS = 94 – 0 = 94

Thus, total cash flow to investors is CFC + CFS = 725 + 94 = 819

§ We can see cash flow identity holds.

CFA (819) = CFC (725) + CFS (94)

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Summary of Cash Flows

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 Extra Problems
1. Given a partial balance sheet and income statement for Jaaski, Inc.
Fill in the missing information for the balance sheet and income statement for Jaaski
Inc. and find the cash flow from assets.

Balance Sheet 2008 2009 Income Statement 2009

Stockholders Equity 197 246 Taxes (0.30) 55.2
Total Assets 439 546 EBIT 226
Current Liabilities 190 255 Interest Exp 42
Current Assets 228 148 COGS 405
Long-Term Liabilities 52 45 EBT 184
Total Liab/Stock Eq 439 546 Net Income 128.8
Fixed Assets 211 398 Depreciation 345
Revenue 976

§ OCF = 226+345 – 55.2 = 515.8

§ NCS = (398 – 211) + 345 = 532
§ ∆NWC = (148 – 255) – (228 – 190) = – 145

§ \ CFA = 515.8 – 532 – (– 145) = 128.8

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 Extra Problems
2. Stone Inc. reported current assets of $80 and fixed assets of $150 as of December 31.
The company, as of December 31, also reports current liabilities of $72 and long-term
liabilities of $149. Calculate Stone’s stockholder’s equity.

§ TA – TD = TE
_ (CA + FA) – (CL + LTD) = SE

§ \ (80 + 150) – (72 + 149) = 9

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 Extra Problems
3. Tomkovich Inc, a local accounting firm has just hired Megan, their newest addition to
their team, and is trying to get her accustomed to financial statements and cash flow
analysis. For some practice, they tell her that Company A has $6,575 in interest
expense, $10,020 in depreciation, and $43,000 in earnings before tax for the year ended
2005. The company is in the 32% tax bracket. What would Megan report as the cash
flow from operations?

§ OCF = EBIT + Dep. – Taxes

o EBIT = EBT + Interest = 43,000 + 6,575 = 49,575
o Taxes = EBT × 0.32 = 43,000 × 0.32 = 13,760

§ \ OCF = 49,575 + 10,020 – 13,760 = 45,835

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 Extra Problems
4. Kim’s, Inc. had net income of $106,000. The company had $20,000 in depreciation and
interest expenses are 10% of the firm’s total debt burden of $200,000. If the tax rate is
34%, what is the OCF of Kim’s, Inc.?

§ Interest = 200,000 × 0.1 = 20,000

§ EBT = NI/(1 – t) = 106,000/(1 – 0.34) = 160,606

o EBIT = EBT + Interest = 160,606 + 20,000 = 180,606

§ Taxes = EBT × 0.34 = 160,606 × 0.34 = 54,606

§ \ OCF = 180,606 + 20,000 – 54,606 = 146,000

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 Extra Problems
5. Spartan Graduation Supplies reported an operating cash flow of $100,000 in 2003
operations. Their net capital spending was $10,000, and 2003 net working capital was
$70,000 higher than 2002’s NWC. If their cash flow to Creditors and their interest
expense was $12,000, where did Spartan Graduation Supplies obtain the financing for
their 2003 dividend of $30,000? What was the amount of this financing?

§ CFC = 12,000 = 12,000 – x \ x = 0 (net new long-term borrowing)

§ CFA = OCF – NCS – ∆NWC = 100,000 – 10,000 – 70,000 = 20,000

§ \ CFS = CFA – CFC = 20,000 – 12,000 = 8,000

§ \ CFS = 8,000 = 30,000 – y \ y = 22,000 (net new equity)

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 Extra Problems
6. During 1999, Quale Potato Corp. had sales of $700,000. Cost of goods sold,
administrative and selling expenses, and depreciation expenses were $400,000,
$200,000, and $60,000, respectively. In addition, the company had an interest expense
of $55,000 and a tax rate of 35 percent. (Ignore any tax loss carry-back.)

a. What is Quale’s net income for 1999?

b. What is its operating cash flow?
c. Compare your results in (a) and (b) and explain.

§ Sales 700,000
– COGS – 400,000
– Expenses – 200,000
– Depreciation – 60,000
EBIT 40,000
– Interests – 55,000
EBT – 15,000
– Taxes –0
NI – 15,000

§ OCF = EBIT + Dep. – Taxes = 40,000 + 60,000 – 0 = 100,000

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