LOS FINES

The Importance of Cash

As the saying goes, “Cash is king.” Without the green a business cannot function. For example, let’s take a look at Leonard, Inc., who sold package-printing equipment to the food companies that sup-plied Bob’s Market. If Leonard, Inc., sold three printing presses to Kraft at $5 million each and earned $2 million on each, Leonard’s income statement would show $6 million in profits. However, Leonard manufactured the equipment during the summer and Kraft paid for it in the fall when it was delivered. The factory employees wouldn’t be too happy if their July paychecks bounced while the company waited for the cash in October.

Because the cash is critical for operations, and most important in order to stay out of bankruptcy, the FASB wrote rule No. 95, man-dating that all financial statements include the Statement of Cash Flows or Cash Flow Statement. Remember those FASB rules that I mentioned accountants make to address current business concerns?

Because knowing the “sources” and “uses” of cash is paramount for a business, the addition of the statement of cash flows has widely been seen as a great improvement by the financial community.

The inability to manage a company’s cash needs is often the pri-mary cause of the demise of many “profitable” enterprises. Many

companies that measured their success by their net income have had a rude awakening when confronted with cash shortages and angry creditors. This is just what happened to Chrysler in 1979 when it went hat in hand to the federal government for a bailout.

Investors myopically looking at the income statement for a mea-sure of health can be deceived. For example, Boeing’s McDonnell Douglas, the defense contractor, had healthy earnings in 1990 that masked an underlying corporate illness. Forbes reported it to its readers:

On the surface, things don’t look so bad for McDonnell Douglas.

It will probably report over $10 a share in earnings in 1990, versus

$5.72 last year. But even a cursory glance examination of the numbers shows that earnings are shaky, if not ephemeral. Start with cash flow. It was negative $35 million by the third quarter of 1991 . . . and the bleeding of cash could accelerate. . . .

The leveraged buyout (LBO) phenomenon of the 1980s used the principles of cash flow as its tool. A raider’s ability to repay the money borrowed to acquire a target company was based in large part on the cash-flow-generating ability of the acquisition. Much of that information lies in the statement of cash flows. In 1989, Kohlberg Kravis Roberts (KKR) bought RJR Nabisco in the largest leveraged buyout up to that time with $26.4 billion in debt financing based on the cash-generating ability of the company to pay off the debt.

The Cash Flow Statement’s Link to the Balance Sheet

The cash flow statement also follows the balancing-act principle of accounting. I will present the accounting math first so that you may understand the logic of what, at first glance, can be a confusing statement. With the math out of the way, the cash flow statement ex-ample can readily be understood. The equations that follow are not included to impress, merely to inform.

Using the golden fundamental accounting equation we have:

A = L + OE

Assets = Liabilities + Owners’ Equity

Because assets and liabilities are composed of both current (short-term) and noncurrent (long-term) items, the equation can be expanded:

CA + NCA = CL + NCL + OE

Current Assets + Noncurrent Assets = Current Liabilities + Noncurrent Liabilities + Owners’ Equity

To further break it down, the current asset class can be shown as its individual components:

Cash + Accounts Receivable (AR) + Inventory (INV) + NCA = CL + NCL + OE

Rearranging the equation algebraically, we can isolate cash:

Cash = CL + NCL + OE AR INV NCA

As revealed by the equation, an increase in a current liability (CL) on the right of the equals sign would mean an increase in cash on the left. Increasing your debts to suppliers frees up a business’s cash for other purposes. Conversely an increase in an asset such as inventory would mean a decrease in cash. It makes sense; buying in-ventory requires cash. Adding or subtracting on one side of the equals sign affects the total on the other side of the equation.

My study group at business school found cash flow statements to be the most confusing of the major topics in accounting. But if the former Peace Corps volunteer in my study group with no business training caught on, I have full confidence in your ability to pick it up also. With the preceding as foundation, I will illustrate the impor-tance of the cash flow statement and use Bob’s Market as an exam-ple to finish off the cash flow lesson.

The Uses for the Cash Flow Statement

The cash flow statement is a management tool to help avoid li-quidity problems. Both the income statement and the balance sheet are used to form the cash flow picture of a company. The statement answers the following important questions:

What is the relationship between cash flow and earnings?

How are dividends financed?

How are debts paid off?

How is the cash generated by operations used?

Are management’s stated financial policies reflected in the cash flow?

By using a statement of cash flows, managers can plan and manage their cash sources and needs from three types of business activities:

Operations Activities Investing Activities Financing Activities

These activities are shown clearly in the cash flow statements.

A Cash Flow Statement Example

Let’s look at Bob’s Market as a springboard from my theoreti-cal discussion and get into an actual cash flow statement, found on page 99.

It is easy to get too wrapped up in the numbers and not really grasp the logic behind the preparation of the statement. Therefore, let’s look at each entry separately and explain the logic behind it.

The MBA’s accounting education focuses on the logic behind the numbers, while undergraduate programs focus primarily on the ac-counting mechanics to turn out CPAs, not MBA managers.

Please refer to Bob’s cash flow statement during the following discussion.

Operating Activities

In the Operating Activities section, accountants calculate the cash generated from the day-to-day operating activities of a busi-ness. The income statement showed “accounting profit” of $30,000 for Bob, but it did not show how much cash was used or generated by his operations. As I explained earlier, most companies use accrual basis accounting, as Bob has, to determine his net income. The cash flow statement converts that accrual basis net income to a cash basis. To do that the net income has to be adjusted in two ways to get back to a cash basis.

Step 1. Adjust Net Income for Noncash Expenses. The first step to determine the flow of cash is to adjust the net income from the in-come statement. Operating items that did not use cash, but were de-ducted in the income statement as an expense, must be added back.

Depreciation, as explained in the income statement section, does not actually take the company’s cash “out the door.” Only when Bob purchased the carts, registers, and displays was cash used. But over the life of these assets, depreciation is only an “accounting cost” that matches the original cash expenditure for these assets with the sales they benefit. Therefore, depreciation must be added back. It is not a use of cash. The purchases of the assets themselves are included later in the Investing Activities section.

Step 2. Adjust Net Income for Changes in Working Capital. Net in-come must also be adjusted for the changes in current assets and cur-rent liabilities that operational activities affected during the year. By adjusting net income for working capital increases and decreases, we can determine the effect on cash by using the fundamental account-ing equation.

When Bob increased his current assets, such as his shelf inven-tory, he used cash because it took cash to buy groceries. This is shown as subtractions on the cash flow statement. When he ex-tended credit to his customers, it delayed his receipt of cash, thus

“using” cash that the store could have been using for other pur-poses. This is also shown as a subtraction on the statement.

Con-versely, reductions in inventory, i.e., sales, would have increased Bob’s cash. If receivables had declined, i.e., customers’ payments, cash would have been generated. Point of Learning: Increases in cur-rent assets use cash while decreases in curcur-rent assets produce cash.

Current liabilities changes have the opposite effect on cash. In Bob’s case his vendors advanced him $80,000. When Bob ran up a large debt with his vendors and employees, this meant that credit was extended to him, which in turn freed his cash for other pur-poses. In a sense, cash was created. If Bob had reduced his liabilities, that would have meant that he had made payments to reduce his debts, reducing cash. Point of Learning: Increases in current liabili-ties increase cash while decreases use up cash.

To calculate the net changes for the year, simply subtract the be-ginning of the period’s balances of current assets and liabilities from the ending balances items. Because it was Bob’s first year (and to make it simple), the beginning balances were all zero and the ending balances are equal to the account increases for the year. The in-creases in current assets are “uses” and the inin-creases in current lia-bilities are “sources” of cash.

Convince yourself that Bob’s cash flow statement is correct.

Refer to his cash flow statement. Look back at the income statement to verify the net income. Review the balance sheet to check that the changes in the working capital items (CA + CL) equal the changes shown on the cash flow statement. It all fits together!

Investing Activities

As the title explains, this area of the cash flow statement deals with cash use and generation by long-term “investments” by the company. Accordingly, the investment activities section reflects the cash effects of transactions in long-term (noncurrent) assets on the balance sheet. When a company buys or sells a long-term asset like a building or piece of equipment, the cash relating to the trans-action is reflected in the investing activities section of the cash flow statement. In Bob’s case, he invested $30,000 in store equipment as