Traditional financial ratio analysis can be a useful tool to an analyst trying to evaluate a firm’s performance. However, many of the key performance measures, such as return on sales, assets, and equity, rely on accounting income concepts. Accounting income is not the relevant source of value in a firm cash flow is. Only cash can be spent. Accounting income, in contrast, does not reflect the actual cash inflows and outflows in a firm. Consequently, in this section we illustrate and define further the cash flow concept you encountered in, and introduce the statement of cash flows.
The Cash Flow Concept
The income statement can be modified to provide a quick measure of the after -tax cash flow (ATCF) that is available from current operations to make capital expenditures, pay dividends, and repay debt. Accordingly, the ATCF is generally a more important number than the net income or earnings after taxes (EAT) figure. One shortcoming of the ATCF is that it does not consider additional cash tied up in (or released from) net working capital. ATCF is found by adding back noncash charges to EAT:ATCF = EAT + Noncash charges
Noncash charges consist of such items as depreciation and deferred taxes. Hence:ATCF = EAT + Depreciation + Deferred Taxes
An Overview of the Corporate Planning Process
Depreciation is defined as the systematic allocation of the cost of an asset over more than one year. The annual depreciation expense recorded for a particular asset is an allocation of its original cost and does not represent a cash outlay. As a result, a company’s annual depreciation expense is added to earnings after taxes in calculating after -tax cash flow. For example, in 2003, General Electric Company had earnings after taxes of $15.0 billion. Its 2003 depreciation expense of $7.0 billion must be added to the earnings after taxes amount in calculating General Electric’s 2003 ATCF.1
After-tax cash flow also differs from earnings after taxes by the amount of a company’s deferred taxes. In accordance with generally accepted accounting principles and specifically in accordance with Statement of Financial Accounting Standards No.96, a company usually reports a different income tax expense amount to its stockholders than it actually pays in cash during that year.
Frequently, the income tax amount shown on the company’s income statement is larger than the income tax amount paid. The difference between the tax amount reported to stockholders and the cash amount actually paid is referred to as a deferred tax because it is due to be paid by the company sometime in the future. For example, during 2002, PepsiCo reported the following earnings amounts to its stockholders:
In calculating PepsiCo’s 2002 after -tax cash flow, the deferred tax amount, $288 million, is added to the earnings after tax, because the deferred taxes were subtracted as an expense in determining earnings but did not constitute a cash payment by PepsiCo in 2002. Deferred taxes generally occur because of temporary differences in the stated amounts of assets and liabilities for financial reporting purposes and for tax purposes.
Specifically, even though deferred taxes can occur for a variety of reasons, some of the more common reasons include differences between financial reporting and tax methods regarding accounting for depreciation, inventories, and pensions. Many companies use the straightline depreciation method to calculate the income they report to their stockholders and an ccelerated depreciation method to calculate taxable income. This practice usually results in the taxes currently owed being less than they would be if the company used straight -line depreciation methods for tax purposes.
A company effectively can continue to defer payment of these taxes as long as it continues to purchase a sufficient amount of new fixed assets.When it ceases purchasing such assets or purchases fewer of them, it will have to pay the deferred taxes.
The effect of depreciation and deferred income taxes on the after -tax cash flows of the Ellwood Applicance Company is illustrated. Using straight-line depreciation for financial reporting purposes results in reported income taxes of $8.0 million and EAT of $12.0 million. Using accelerated depreciation (MACRS)3 for tax purposes results in a current income tax payment of $7.2 million, with the balance of $0.8 million (i.e., $8.0 million $7.2 million) being deferred.
If the tax records for Ellwood are available, the ATCF of $22.8 million can be calculated by adding the depreciation amount of $12.0 million to the earnings after taxes amount of $10.8 million. If the tax records are not available, the ATCF can be calculated using Equation, as follows:
Ellwood Appliance Company:After-Tax Cash Flow (ATCF) Calculation
ATCF = $12.0 + $10.0 + $0.8 = $22.8 (million)
The Statement of Cash Flows
The statement of cash flows, together with the balance sheet and the income statement, constitute a major portion of a company’s financial statements. The statement of cash flows shows the effects of a company’s operating, investing, and financing activities on its cash balance. The principal purpose of the statement of cash flows is to provide relevant information about a company’s cash receipts and cash payments during a particular accounting period.
The statement of cash flows provides a more complete indication of the sources (and the uses) of a firm’s cash resources over time.
The procedures for preparing the statement of cash flows are presented in Statement of Financial Accounting Standards No. 95, issued by the Financial Accounting Standards Board (FASB) in November 1987.
It requires companies to include a statement of cash flows when issuing a complete set of financial statements for annual periods ending after July 15, 1988. The FASB encourages companies to prepare their statement of cash flows using the direct method of presenting cash flows from operating activities.
Statement of Cash Flows: Direct Method
We shows an example of a statement of cash flows using the direct method for the Summit Furniture Company, a retail chain of furniture stores. During 2005, Summit’s “cash flows from operating activities” totaled $14,600,000 ($142,000,000 cash received from customers, plus $600,000 of interest received, less $120,000,000 paid to suppliers and employees, less $2,000,000 interest paid, less $6,000,000 of income taxes paid).
Summit’s investing activities used net cash of $18,000,000. The company spent $19,000,000 on capital expenditures and received $1,000,000 in proceeds from the sale of an asset. During the year the net cash provided by financing activities equaled $3,600,000. The $3,600,000 is calculated as the difference between financing activities that require cash outflows and those that result in cash inflows.
Summit had financing cash outflows totaling $3,100,000 ($2,600,000 repayment of longterm debt and $500,000 of dividends paid out) and financing cash inflows totaling $6,700,000 (bank borrowing of $1,000,000 plus proceeds from the issuance of long-term debt of $4,000,000 plus proceeds from the issuance of common stock of $1,700,000). The overall change in cash is calculated as follows:
Summit Furniture Company Statement of Cash Flows for the Year Ended December 31,2005
The statement of cash flows presented in Table provides Summit’s management, investors, and creditors with a summary of its cash flows for the year. In particular, Summit’s operations provided net cash of $14,600,000; however, the company used a total of $18,000,000 in its investing activities. As a result, if Summit wanted to keep its cash balance at about $5,000,000, the company’s financing activities would have to provide $3,400,000 of net cash ($18,000,000 $14,600,000). In fact, Summit’s financing activities actually did provide $3,600,000, causing the ending cash balance to be $5,200,000, or $200,000 above the beginning $5,000,000.
Statement of Cash Flows: Indirect Method A sampling of recent annual reports shows that very few companies present their statement of cash flows using the direct method. Instead, most companies use the indirect, or reconciliation, method to report the net cash flow from operating activities. The indirect method involves adjusting net income to reconcile it to net cash flow from operating activities. Table shows the statements of cash flows using the indirect method for PepsiCo, Inc.
PepsiCo had 2002 net income (EAT) of $3,313 million. Converting this net income to cash flow requires adding back noncash expenses, including depreciation and deferred taxes. Then PepsiCo adjusted net income from the accrual method (required by GAAP) to the cash amount by showing increases and decreases in its various current asset and liability accounts. After these adjustments, PepsiCo had net cash from operations of $4,627 million. In 2002 PepsiCo used $527 million in investing activities, primarily for capital expenditures and acquisitions. Financing activities used $3,179 million.
The net effect of PepsiCo’s 2002 activities was an increase in cash and cash equivalents of $955 million. The PepsiCo statement of cash flows gives a good feel for the effect PepsiCo’s operating, investing, and financing activities had on its cash position.
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