What does it mean when cash flow from operations on a company’s cash flow statement is negative? Is this bad news? Is it dangerous?
It means that the company’s operating activities consumed cash. A combination of two things can cause this: operating losses, and increases in accounts receivable and inventories. Operating losses can obviously be dangerous. Rising receivables and inventories need not be dangerous provided they are growing in step with sales, and provided the company is able to finance the cash shortfalls. Rising receivables and inventories relative to sales suggest slackening management control of important operating assets, a potential danger.
What does is mean when cash flow from investing activities on a company’s cash flow statements is negative? Is this bad news? Is it dangerous?
This means that the company’s investing activities consumed cash, that the company purchased more property, plant, equipment, or marketable securities than it disposed of during the year. For most growing, stable companies, cash flows from investing activities are negative as firms build production capacity and replace used equipment. Positive cash flows from investing activities can signal problems, suggesting the firm has no attractive investment opportunities or that it might be liquidating productive assets due to financial difficulties.
What does it mean when cash flow from financing activities on a company’s cash flow statement is negative? Is this bad news? Is it dangerous?
Negative cash flows from financing activities means that the firm is paying out more money to investors (in the form of debt principal repayment, interest payments, dividends and share repurchases) that it is raising from investors. Usually, negative cash flows from financing activities are associated with mature companies generating more than enough cash from operations to fund future activities. It is not necessarily bad news. Conversely, early-stage firms, rapidly growing firms, and those in financial distress typically have positive cash flows from financing activities.
Braintree Corporation has $5 billion in assets, $4 billion in equity, and earned a profit of $100 million last year as the economy boomed. Senior management proposes paying themselves a large cash bonus in recognition of their performance. As a member of Braintree’s board of directors, how would you respond to this proposal?
Management is either dumb or thinks its board is. Earning $100 million on a $3 billion equity investment is a return of less than 4 percent, a figure well below any reasonable cost of equity. As a board member, I would vote to cut management’s compensation, not raise it. I would also criticize them sharply for apparently attempting to deceive the board.
If a company gets into financial difficulty, it can use some of its shareholders’ equity to pay its bills for a time.
Shareholders’ equity is on the liabilities side of the balance sheet. It represents owners’ claims on company assets. Or said differently, the money contributed by owners and supplemented by retained profits has already been spent to acquire company assets.
It is impossible for a firm to have a negative book value of equity without the firm going into bankruptcy.
Book value of equity is simply the “plug” number that makes the book value of assets equal the sum of the book value of liabilities and the book value of equity. If the book value of liabilities is greater that the book value of assets, then (by definition) book value of equity must be negative. This does not automatically spell bankruptcy. Bankruptcy occurs when a firm cannot pay its bills in a timely manner and creditors force it to seek, or it voluntarily seeks court protection.
If a company increases its dividend, its net income will decrease.
Earnings are allocated to either dividends or retained earnings after net income is calculated. Increasing the dividend will reduce retained earnings, but will not affect net income.
You can construct a sources and uses statement for 2014 if you have a company’s balance sheet for year-end 2013 and 2014.
By comparing a balance sheet from the beginning of 2014 (year-end 2013) with a balance sheet from the end of 2014, it is possible to construct a sources and uses statement for 2014.
The “goodwill” account on the balance sheet is an attempt by accountants to measure the benefits that result from a company’s public relations efforts in the community.
Goodwill arises when one firm acquires another at a price above its book value. For example, if one firm acquires another for $10 million in cash but the target has a book value of only $8 million, the accountants record a $10 million reduction in the acquirer’s cash, and $8 million increase in assets, and a $2 million increase in goodwill to balance the accounts.
A reduction in an asset account is a use of cash, while a reduction in a liability account is a source of cash.
It’s just the reverse. As an asset account decreases, cash is made available for other uses. Thus, decreases in assets are sources of cash, In order to decrease a liability account, the firm must use cash to lower the liability. Thus, decreases in liability accounts are uses of cash.
Explain briefly how each of the following transaction would affect a company’s balance sheet. (Remember, assets must equal liabilities plus owners equity before and after the transaction.)
Sale of used equipment with a book value of $300,000 for $500,000 cash.
Cash rises $500,000; plant and equipment falls $300,000; equity rises $200,000.
Purchase of a new $80 million building, financed 40% with cash and 60% with a bank loan.
Net plant and equipment rises $80 million; Cash falls $32 million; Bank debt rises $48 million.
Purchase a new building for $60 million cash
Net plant and equipment rises $60 million; cash falls $60 million.
A $40,000 payment to trade creditors.
Cash falls $40,000; Accounts payable falls $40,000.
A firm’s repurchase of 10,000 shares of its own stock at a price of $24 per share.
Cash falls $240,000; Owner’s equity falls by $240,000 (via an increase in Treasury stock).
Sale of merchandise for $80,000 in cash.
Cash rises $80,000; Inventory falls; Accrued taxes, Owners’ equity, and possibly other cost categories rise such that the algebraic sum equals $80,000.
Sale of merchandise for $120 in credit
Accounts receivable rise $120,000. Other categories change as described in part f.
Dividend payment to shareholders of $50,000
Cash falls $50,000. Owner’s equity falls by $50,000 (via Retained Earnings).
Why do you suppose financial statement are constructed on an accrual basis rather than a cash basis when cash accounting is so much easier to understand?
Because the accountants primary goal is to measure earnings, not cash generated. She sees earnings as a fundamental indicator of viability, not cash generation. A more balanced perspective is that over the long run successful companies must be both profitable and have cash in the bank to pay their bills when due. This means that you should pay attention to both earnings and cash flows.
Table 3.1 in Chapter 3 presents financial statements over the period 2011-2014 for R&E Supplies, Inc.
Construct a sources and uses statement for the company over the period (one statement for all 3 years)
R&E Supplies, Inc. Sources and Uses Statement 2008 – 2011 ($000).
Sources of cash:
Decrease in cash and securities $259
Increase in accounts payable 2,205
Increase in current portion long-term debt 40
Increase in accrued wages 13
Increase in retained earnings 537
Uses of cash:
Increase in accounts receivable $1,543
Increase in inventories 1,148
Increase in prepaid expenses 4
Increase in net fixed assets 159
Decrease in long-term debt 200
What insights, if any, does the sources and uses statement five you about the financial position of R&E Supplies?
1. R&E is making extensive use of trade credit to finance a buildup in current assets. The increase in accounts payable equals almost three fourths of total sources of cash. Increasing accounts receivable and inventories account for almost 90 percent of the uses of cash.
2. External long-term debt financing is a use of cash for R&E, meaning that it is repaying its loans. A restructuring involving less reliance on accounts payable and more bank debt appears appropriate.
Your are responsible for labor relations in your company. During heated labor negotiations, the General Secretary of your largest union exclaims, “Look, this company has $15 billion is assets, $7.5 billion in equity, and made a profit last year of $300 million-due largely, I might add, to the effort of the union employees. So don’t tell me you can’t afford our wage demands.” How would you reply?
The General Secretary has confused accounting profits with economic profits. Earning $300 million on a $7.5 billion equity investment is a return of only 4%. This is poor performance and is too low for the company to continue attracting new investment necessary for growth. The company is certainly not covering its cost of equity.
You manage a real estate investment company. One year ago the company purchased a 10 parcels of land distributed throughout the community for $10 million each. A recent appraisal of the properties indicates that five of the parcels are now worth $8 million each, while the other five are worth $16 million each. Ignoring any income received form the properties and any taxes paid over the year, calculate the investment company’s accounting earning and its economic earning in each of the following cases.
The company sells all of the properties at their appraised values today.
Accounting income will be the value of the parcels sold, less their original purchase price. So if all parcels are sold, the income is 5x$16 million + 5x$8 million -$100 million = $20 million. Economic income will be the increase in the market value of the land, whether sold or not, over the period. At the end of the first year, this will be $20 million. Answers to each part of the question appear below.
Accounting Income Economic Income
$20 million $20 million
The company sells non the the properties.
Accounting Income Economic Income
0 $20 million
The company sells the properties that have fallen in value and keeps the others.
Accounting Income Economic Income
-$10 million $20 million
the company sells the properties that have risen in value and keeps the others.
Accounting Income Economic Income
$30 million $20 million
After returning from a property management seminar, and employee recommends that the company adopt and end-of-year policy of always selling properties that have risen in value since purchase and always retaining properties that have fallen in value. The employee explains that, with this policy, the company will never show a loss on its real estate investment activities. do you agree with the employee? Why, or why not?
Too many companies have tried this. If the market value of a piece of land falls, the owner loses whether he sells or not. The market price of the land fell because people thought the future income stream to the owners was worth less. Continuing to hold the property, forces the owner to accept the lower income. Whether the loss is recognized or not might affect accounting earnings, but has nothing to do with reality.
Please ignore taxes for this problem. During 2013, Acadia, Inc. earned net income of $500,000. The firm increased its accounts receivable during the year by $150,000. The book value of its assets declined by an amount equal to the year’s depreciation charge, or $130,000, and the market value of its assets increased by $25,000. Based only on this information, how much cash did Acadia generate during the year?
Acadia, Inc. generated $480,000 of cash during the year. The $500,000 net income ignores the fact accounts receivable rose $150,000, a use of cash. It also treats $130,000 depreciation as an expense, whereas its is a non-cash charge. The $25,000 increase in market value of assets adds to the market value of the business, but is not a cash flow. Here are the figures:
Accounting Income $500,000
Depreciation (a non-cash charge) +$130,000
Increase in accounts receivable -$150,000
Cash Generated $480,000
Jonathan currently is a brew master for Acme Brewery. He really enjoys his job, but is intrigues by the prospect of quitting and starting his own brewery. He currently makes $62,000 at Acme Brewery. Jonathan anticipates that his new brewery will have annual revenues of $230,000, and total annual expenses for operating the brewery, outside of any payments to Jonathan, will be $190,000. Jonathan come to you with his idea. He belives that he would be equally happy with either option, but that starting his own brewery is the right decision in light of its profitability. Ignoring what might happen beyond the first year, do you agree with him? Why or Why not?
The accounting profits from Jonathan’s brewery are expected to be $40,000. These accounting profits do not include the implicit cost of the entrepreneur’s time. Jonathan’s time is worth at least $62,000, the current income he will have to forego to manage the brewery. When these implicit opportunity costs are included net income falls to:
$230,000 – $190,000 – $62,000 = -$22,000
This new venture will reduce Jonathan’s income not increase it.
Selected information for Blake’s Restaurant Supply follows.
Net Sales 694 782
COGS 450 502
Depreciation 51 61
Net Income 130 142
Finished Goods Inv. 39 29
AR 57 87
AP 39 44
Net Fixed Assets 404 482
Year-end Cash Balance 86 135
During 2014 how much cash did Blake’s collect from sales?
In 2014, company sales were $782 million, but accounts receivable rose $30 million, meaning the company received only $752 million in cash. (This ignores possible changes in bad debt reserves.) Letting bop stand for beggining of period, and eop for end of period, the relevant equation is:
AR pop = AR eop
+Sales – Collections
Collections = Sales – Change in AR
$752 million = $782 million – $30 million
During 2014 what was the cost of goods sold produced by the company?
During 2014 the company sold $502 million of merchandise at cost, but finished goods inventory fell $10 million, indicating that the company produced only $492 million of merchandise. The equation is:
Inventory eop = Inventory bop + Production – Cost of Sales
Production = Cost of Sales + Change in Inventory
$492 Million = $502 million – $10 million
Assuming the company neither sold nor salvaged any assets during the year, what were the company’s capital expenditures during 2014?
Net fixed assets rose $78 million, depreciation reduced net fixed assets $61 million, so capital expenditures must have been $139 million (ignoring asset sales or write-offs).
Net fixed assets eop = Net fixed assets bop + Capital Exp
Capital Exp = Change in net fixed assets + Depreciation
$139 million = $78 million + $61 million
Assuming that there were no financing ash flows during 2014 and basing your answer solely on the information provided, what was Blake’s cash flow from operation in 2014?
There are two way to derive cash flow from operations. If there were no financing cash flows for the year, then changes in the year end cash balance must be due to cash flows from operations and investing activities. The capital expenditures of $139 million represent the investing cash flows of the firm. Thus, we can us ethe change in the cahs balance from 2013 to 2014 ($49 million) and the cash flows form investing ot obtain cash flow from operations.
Change in cash balance = CF from ops + CF from investing
+ CF from financing
$49 million = CF form ops + (-$139 million)+ 0
CF from ops = $49 + 139 = $188 million
CF from ops = Net income – increase in AR + decrease in
inventory + increase in AP + Depreciation
CF from ops = 142 – 30 + 10 + 5 + 61 = $188 million
Below are summary cash flow statements for three roughly equal sized companies.
A B C
Net CF from Ops (300) (300) 300
Net cash in Inv. (900) (30) (90)
Net cash from Fin. 1,200 210 (240)
Cash balance beginning 150 150 150
Calculate each company’s cash balance at the end of the year.
Company A B C
Year end cash $150 million $30 million $120 million
Explain what might cause company C’s net cash from financing activities to be negative.
It appears that company C retired more debt than it issued, repurchased more stock than it issued, or some combination of the two.
Looking at companies A and B, which company would you prefer to own? Why?
I’d prefer to own company A. A appears to be a growing company as evidenced by the sizable net cash used in investing activities, and its negative net cash flow from operations may well be due to increasing accounts receivable and inventories that naturally accompany sales growth. Company B appears not to be growing, so its negative net cash flows from operations are probably due to losses or to increasing receivables and inventories relative to sales, a trend denoting poor management of current assets.
Is company C’s cash flow statement cause for concern on the Part of C’s management or shareholders? Why or why not?
I don’t think there is necessarily any cause for concern. It appears company C is a mature, slow-growth company that is returning its unneeded operating cash flows to investors in the form of debt repayment, share repurchase, dividends, or some combination of these. This is a perfectly viable strategy in the absence of attractive investment opportunities.
Telluride Mining’s equity has a market value of $25 million with 800,000 share outstanding. The book value of its equity is $15 million.
What is Telluride’s stock price per share? What is its book value per share?
Stock price per share = $25 million/800,000 shares – $31.25 per share. Book value per share = $15 million/800,000 =$18.75 per share
If the company repurchases 20% of its shares in the stock market at their current price, how will this affect the book value of equity if all else remains the same?
Telluride Mining will pay $31.25 per share for the 160,000 shares it repurchases. This reduces the book value of equity by $5,000,000. Assuming all else remains the same, the new book value will be $10,000,000.
If there are no taxes or transaction costs, and investors do not change their perceptions of the firm, what should the market value of the firm be after the repurchase?
Since nothing else has changed, investors do not change their perceptions of the firms, and there are not taxes or transaction costs, the market value should fall by exactly the amount of the cash paid in the transaction. The new market value should be $20,000,000. Another way to think about he question is to note the repurchase of the share will reduce cash by $5,000,000 or increase liabilities by the same amount if they finance the repurchase with debt. Either way the firm is worth $5,000,000 less to owners after the repurchase,or $20,000,000. With 640,000 shares outstanding after the repurchase, the price per share remain $31.25 ($20,000,000/640,000).
Instead of a share repurchase, the company decides to raise money by selling an additional 10% of its shares on the market. If it can issue these additional share at the current market price, how ill this affect the book value of equity if all else remains the same?
Shares outstanding increase 10%. or 80,000 shares. At $31.25 per share, Telluride would raise $2,500,000. Assuming all else remains the same, the new book value of equity will be $17,500,000 ($15 million + $2,500,000).
If there are no taxes or transaction costs, and investors do not change their perception of the firm, what what should the market value of the firm be after this stock issuance? Its price per share?
Due to the same reasoning as in par (c), the market value should rise by $2,500,000. In essence the sale raises company cash by $2,500,000, increasing the value of the firm by just this amount. The new market value should be $27,500,000. The price per share should remain $31.25 ($27,500,000/880,000 shares).