Reading Financial Reports for Dummies (22 page)

The investing-activities and financing-activities sections for both the direct and indirect methods look something like Figure 8-3 and Figure 8-4, both of which show the basic line items. Read on to find out what’s included in each of these line items. If you’re interested in finding out about line items that make their way onto the statement only in special circumstances, see

“Recognizing the Special Line Items,” later in the chapter.

Figure 8-3:

Cash flows from investing activities

The

Additions (sale) of property, plant, and equipment

investing-

Investments and acquisitions

Sales of investments

activities

Other

section.

Net cash utilized for investing activities

Cash flows from financing activities

Proceeds from borrowing

Figure 8-4:

Net proceeds from repayments

The

Purchase or sale of common stock

Stock option transactions

financing-

Dividends paid

activities

Net cash provided (utilized) by financing activities

section.

Cash and short-term investments at beginning of the year Cash and short-term investments at end of the year

Chapter 8: The Statement of Cash Flows
111

Checking Out Operating Activities

The operating-activities section is where you find a summary of how much cash flowed into and out of the company during the day-to-day operations of the business.

Operating activities is the most important section of the statement of cash flows. If a company isn’t generating enough cash from its operations, it isn’t going to be in business long. Although new companies often don’t generate a lot of cash in their early years, they can’t survive that way for long before going bust.

The primary purpose of the operating-activities section is to adjust the net income by adding or subtracting entries that were made in order to abide by the rules of accrual accounting that don’t actually require the use of cash.

In this section, I describe several of the accounts in the operating-activities section of the statement and explain how they’re impacted by the changes required to revert accrual accounting entries to actual cash flow.

Depreciation

A company that buys a lot of new equipment or builds new facilities has high depreciation expenses that lower its net income. This is particularly true for many high-tech businesses that must always upgrade their equipment and facilities to keep up with their competitors.

Finding out the importance of cash the hard way

Dot.com babies certainly discovered the impor-

cash dried up in 2000 because they didn’t gen-

tance of cash on hand the hard way. Many erate enough money from their operations. In newly minted dot.com companies raised mil-fact, more than 850 dot.com companies bit the

lions of dollars in cash in the late 1990s and

dust between January 2000 and January 2002.

were able to stay in business for two or three

If you want to find out more about the dot.com

years. But after these companies could no business fiascos, you can read the business longer raise money from investors or borrow

plans of many of the failed companies at www.

funds, the dot.com babies went bankrupt. Most

businessplanarchive.org.

dot.com companies died when the investor

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The bottom line may not look good, but all those depreciation expenses don’t represent the use of cash. In reality, no cash changes hands to pay depreciation expenses. These expenses are actually added back into the equation when you look at whether the company is generating enough cash from its operations because the company didn’t actually lay out cash to pay for these expenses.

For example, if the company’s net income is $200,000 for the year and its depreciation expenses are $50,000, the $50,000 is added back in to find the net cash from operations, which totals $250,000. Essentially, the firm is in better shape than it looked to be before the depreciation expenses because of this noncash transaction.

Inventory

Another adjustment shown on the statement of cash flows that usually adds cash to the mix is a decrease in inventory. If a company’s inventory on hand is less in the current year than in the previous year, some of the inventory sold was actually bought with cash in the previous year.

On the other hand, if the company’s inventory increases from the previous year, it spent more money on inventory in the current year and it subtracts the difference from the net income to find its current cash holdings. For example, if inventory decreases by $10,000, the company adds that amount to net income on the statement of cash flows.

Accounts receivable

Accounts receivable
is the summary of accounts of customers who buy their goods or services on credit provided directly by the company. Customers who buy their goods by using credit cards from banks or other financial institutions aren’t included in accounts receivable. Payments by outside credit sources are instead counted as cash because the company receives cash from the bank or financial institution. The bank or financial institution collects from those customers, so the company that sells the good or service doesn’t have to worry about collecting the cash.

When accounts receivable increase during the year, the company sells more products or services on credit than it collects in actual cash from customers. In this case, an increase in accounts receivable means a decrease in cash available.

Chapter 8: The Statement of Cash Flows
113

The opposite is true if accounts receivable are lower during the current year than the previous year. In this case, the company collects more cash than it adds credit to customers’ credit accounts. In this situation, a decrease in accounts receivable results in more cash received, which adds to the net income.

Accounts payable

Accounts payable
is the summary of accounts of bills due that haven’t yet been paid, which means cash must still be laid out in a future accounting period to pay those bills.

When accounts payable increase, a company uses less cash to pay bills in the current year than it did in the previous one, so more cash is on hand. This has a positive effect on the cash situation. Expenses incurred are shown on the income statement, which means net income is lower. But in reality, the cash hasn’t yet been laid out to pay those expenses, so an increase is added to net income to find out how much cash is actually on hand.

Conversely, if accounts payable decrease, the company pays out more cash for this liability. A decrease in accounts payable means the company has less cash on hand, and it subtracts this number from net income.

Summing up the cash-flow-

from-activities section

To give you a taste of what all these line items look like in the statement of cash flows, see Table 8-1, where I roll together the information from the previous sections to show you how it all comes together.

Table 8-1

Cash Flows from Operating Activities

Line Item

Cash Received or Spent

Net income

$200,000

Depreciation

50,000

Increase in accounts receivable

(20,000)

Decrease in inventories

10,000

Decrease in accounts payable

(10,000)

Net cash provided by (used in) operating

$230,000

activities

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In Table 8-1, the company has $30,000 more in cash from operations than it reported on the income statement, so the company actually generated more cash than you may have thought if you just looked at net income.

If you compare the statements for the toy companies Mattel and Hasbro in 2007 (you can download them at www.mattel.com and www.hasbro.com), you can see that Mattel’s net cash flow totaled $560.5 million after adjustments on $600 million net income, whereas Hasbro’s net cash was $601.8

million on $333 million of net income. For Hasbro, depreciation and amortization adjustments added $156.5 million to the company’s net cash position.

Mattel added $171.9 million to its net cash with depreciation and amortization.

Mattel used a large chunk of its cash to decrease accounts payable, accrued liabilities, and income taxes by $311.9 million. Hasbro increased its cash with increases in deferred income taxes, prepaid taxes, and accounts payable.

Investigating Investing Activities

The investment-activities section of the statement of cash flows, which looks at the purchase or sale of major new assets, is usually a drainer of cash.

Consider what’s typically listed in this section:

✓

Purchases of new buildings, land, and major equipment

✓

Mergers or acquisitions

✓

Major improvements to existing buildings

✓

Major upgrades to existing factories and equipment

✓

Purchases of new marketable securities, such as bonds or stock The sale of buildings, land, major equipment, and marketable securities is also shown in the investment-activities section. When any of these major assets are sold, they’re shown as cash generators rather than as cash drainers.

The primary reason to check out the investments section is to see how the company is managing its
capital expenditures
(money spent to buy or upgrade assets) and how much cash it’s using for these expenditures. If the company shows large investments in this area, be sure to look for explanations in the management’s discussion and analysis and the notes to the financial statements (see Chapter 9) to get more details about the reasons for the expenditures.

If you believe that the firm is making the right choices to grow the business and improve profits, investing in its stock may be worthwhile. If the company is making most of its capital expenditures to keep old factories operating as long as possible, that may be a sign that it isn’t keeping up with new technology.

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115

Compare companies in the same industry to see what type of expenditures each lists in investment activities and the explanations for those expenditures in the notes to the financial statements. Comparing a company with one of its peers helps you determine whether the company is budgeting its capital expenditures wisely.

In comparing the statements of Hasbro and Mattel, you can see that Mattel spent more on purchases of tools, dies, molds, property, plant, and equipment. Mattel’s spending totaled more than $146.6 million, whereas Hasbro spent about $91.5 million.

Understanding Financing Activities

Companies can’t always raise all the cash they need from their day-to-day operations. Financing activities are another means of generating cash. Any cash raised through activities that don’t include day-to-day operations can be found in the financing section of the statement of cash flows.

Issuing stock

When a company first sells its shares of stock, it shows the money it raises in the financing section of the statement of cash flows. The first time a company sells shares of stock to the general public, this sale is called an
initial public
offering
(IPO; see Chapter 3 for more information). Whenever a company decides to sell additional shares to raise capital, all additional sales of stock are called
secondary public offerings.

Usually, when companies decide to do a secondary public offering, they do so to raise cash for a specific project or group of projects that they can’t fund by ongoing operations. The financial department must determine whether it wants to raise funds for these new projects by borrowing money (new debt) or by issuing stock (new equity). If the company already has a great deal of debt and finds that borrowing more is difficult, it may try to sell additional shares to cover the shortfall. I talk more about debt versus equity in Chapter 12.

Buying back stock

Sometimes you see a line item in the financing section indicating that a company has bought back its stock. Most often, companies that announce a stock buyback are trying to accomplish one of two things:

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✓

Increase the market price of their stock. (If companies buy back their stock, fewer shares remain on the market, thus raising the value of shares still available for purchase.)

✓

Meet internal obligations regarding employee stock options, which guarantee employees the opportunity to buy shares of stock at a price that’s usually below the price outsiders must pay for the stock.

Sometimes a company buys back stock with the intention of going private (see Chapter 3). In this case, company executives and the board of directors decide that they no longer want to operate under the watchful eyes of investors and the government. Instead, they prefer to operate under a veil of privacy and not to have to worry about satisfying so many company outsiders. I discuss the advantages and disadvantages of staying private in Chapter 3.

For many firms, an announcement that they’re buying back stock is an indication that they’re doing well financially and that the executives believe in their company’s growth prospects for the future. Because buybacks reduce the number of outstanding shares, a company can make its per-share numbers look better even though a fundamental change hasn’t occurred in the business’s operations.

If you see a big jump in earnings per share, look for an indication of stock buyback in the financing-activities section of the statement of cash flows.

Paying dividends

Whenever a company pays dividends, it shows the amount paid to shareholders in the financing-activities section. Companies aren’t required to pay dividends each year, but they rarely stop paying dividends after the shareholders have gotten used to their dividend checks.