The Ten-Day MBA 4th Ed. Page 10

  During the year, running totals are accumulated for each revenue and expense to calculate the final net income figure for the entire year. At year’s end when the final tally is completed and net income is calculated, the running totals of revenues and expenses are set to zero for the new year, and the difference or net income or loss is recorded on the balance sheet as retained earnings. That accounting year, at times called a fiscal year, can begin in any month. It does not have to start in January.

  The journal entries look the same as those that you have seen used for the balance sheet. To track the income statement, revenues are recorded as credits (on the right side), and expenses are recorded as debits (on the left).

  Income statement entries are combined with balance sheet entries. A sale means that the business received something of value, an asset, in exchange for something else of value, an expense. At Bob’s grocery store, sales meant that an inflow of cash came in exchange for grocery inventory. Bob’s accountant made weekly entries to record his sales and their costs in the following way:

  INCOME STATEMENT JOURNAL ENTRY #1

  ACCOUNT TITLE: Cash

  (TYPE): (Asset)

  DEBIT: 100,000

  CREDIT:

  EFFECT: increase

  ACCOUNT TITLE: Sales Revenue

  (TYPE): (Income Statement)

  DEBIT:

  CREDIT: 100,000

  EFFECT: increase

  Similarly the accountant recorded the cost of those sales:

  INCOME STATEMENT JOURNAL ENTRY #2

  ACCOUNT TITLE: Cost of Goods Sold

  (TYPE): (Income Statement)

  DEBIT: 95,000

  CREDIT:

  EFFECT: decrease

  ACCOUNT TITLE: Inventory

  (TYPE): (Asset)

  DEBIT:

  CREDIT: 95,000

  EFFECT: decrease

  To illustrate a full year’s income statement entries, assume that those two entries were the only sales and costs for the entire year. The net income for the year would have been the net of the total sales revenues of $100,000 less the total COGS of $95,000, or $5,000. That net income figure also mimicked the change in net assets recorded by those same entries. Cash increased $100,000 and groceries decreased $95,000, a net of $5,000.

  At year’s end the net increase of assets of $5,000 equals the net income for the year. Bob would have recorded that net change on the balance sheet as an increase to retained earnings. He would also close out or set to zero all the revenue and expense accounts for the year in preparation for recording the next year’s activity in the following entry:

  INCOME STATEMENT YEAR END CLOSE OUT ENTRY

  ACCOUNT TITLE: Sales Revenue

  (TYPE): (Income Statement)

  DEBIT: 100,000

  CREDIT:

  EFFECT: reversal

  ACCOUNT TITLE: Cost of Goods Sold

  (TYPE): (Income Statement)

  DEBIT:

  CREDIT: 95,000

  EFFECT: reversal

  ACCOUNT TITLE: Retained Earnings

  (TYPE): (Owner’s Equity on the Balance Sheet)

  DEBIT:

  CREDIT: 5,000

  EFFECT: increase

  Notice that the journal entry balances. The income statement entries reversed themselves, leaving the net income addition to retained earnings on the balance sheet. Where sales of $100,000 were entered on the right during the year, they are cleared at year end with a $100,000 entry on the left. The balance sheet’s asset, liability, and owners’ equity balances are permanent running totals that are carried forward to the next accounting year. There you have it. In a page you’ve witnessed an abbreviated version of an entire year’s accounting cycle and hours of MBA classroom consternation.

  The Income Statement’s Link to the Balance Sheet

  From Bob’s actual income statement, the reader can see that the store had a marginally profitable year. He had a net income of $30,000. What is even more important than just the calculations of income is the understanding of how the income statement relates to the balance sheet. The income statement is the result of many activities during the year. Assets and liabilities are affected upward and downward during the year through many individual transactions. At year’s end, the net assets of the firm, as totaled by the balance sheet, had changed because of operating activities. The net income, as calculated by the income statement, tells the story of the year’s operations by showing how that change in net assets occurred. Because it was Bob’s first year, retained earnings equaled $30,000, the first year’s net income. In succeeding years it will be affected by the next year’s earnings and dividends.

  THE STATEMENT OF CASH FLOWS

  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 supplied 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, all financial statements include the Statement of Cash Flows or Cash Flow Statement. 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 primary 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.

  Investors myopically looking at the income statement for a measure of health can be deceived. For example, Boeing’s McDonnell Douglas, the defense contractor, had healthy earnings 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 . . . , 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 . . . 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 example 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 + Account
s 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 inventory 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 importance of the cash flow statement and use Bob’s Market as an example 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 liquidity 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 theoretical discussion and get into an actual cash flow statement, found below.

  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 accounting mechanics to turn out CPAs, not MBA managers.

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

  BOB’S MARKET STATEMENT OF CASH FLOWS FOR THE YEAR ENDING DECEMBER 31, 2012

  Operating Activities

  In the Operating Activities section, accountants calculate the cash generated from the day-to-day operating activities of a business. 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 income statement. Operating items that did not use cash, but were deducted 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 income must also be adjusted for the changes in current assets and current 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 accounting equation.

  When Bob increased his current assets, such as his shelf inventory, he used cash because it took cash to buy groceries. This is shown as subtractions on the cash flow statement. When he extended credit to his customers, it delayed his receipt of cash, thus “using” cash that the store could have been using for other purposes. This is also shown as a subtraction on the statement. Conversely, 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 current assets use cash while decreases in current 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 purposes. 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 liabilities increase cash while decreases use up cash.

  To calculate the net changes for the year, simply subtract the beginning 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 increases in current assets are “uses” and the increases in current liabilities 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 transaction is reflected in the investing activities section of the cash flow statement. In Bob’s case, he invested $30,000 in store equipment as shown on his statement. If he had sold the equipment, the cash received would have been reflected. Review the balance sheet to verify how the change in his long-term assets was reflected in the investing section of the cash flow statement.

  Financing Activities

  There are two ways a company can finance itself. Either managers borrow money or they raise money from investors. Borrowing would be reflected in changes in the long-term liabilities section of the balance sheet. The participation by investors would be reflected in changes in the owners’ equity accounts of the balance sheet.

  Bob borrowed $10,000 from the bank, which increased cash. On the balance sheet, “bank debt” increased from $0 to $10,000 and it was reflected as a source of cash. When the store repays the debt, it will be reflected as a use of cash in the financing activities section.

  Referring back to Bob’s Market’s balance sheet, the owners’ equity accounts are on the right side. The balance sheet shows that investors contributed $15,000 cash to start the business. That is shown on the balance sheet as “common stock” issued, and it is also reflected on the cash flow statement as a source of cash.

  As we have already learned, the other component of the owners’ equity section is retained earnings (RE). As explained, there will be changes in RE when net income is added during the year and if dividends are paid out to investors. Bob and his father elected to continue to “finance” the business by having the company “retain” it
s earnings. The financing section, accordingly, does not show any dividend payments. If the owners elected to pay a dividend, it would have been shown as a use.

  After a year of operations Bob had $5,000 more than when he started. With his cash flow statement he can understand how it happened!

  Once prepared, what does the cash flow statement mean?

  Take a step back, or else you can get lost in the mechanics. This cash flow statement shows the net change in cash for the year. It appears at the bottom of the statement. Take a look. It sounds simple, but some newly minted CPAs I worked with never really understood that fact as they labored to prepare the report’s details. You do. Where the changes in cash took place is of real importance to MBAs.

  Was the company a seemingly profitable company, but must borrow heavily just to stay alive?

  Did the company’s operations throw off cash, even though it may be just marginally profitable according to the income statement?

  Those are samples of the important questions that neither the balance sheet nor the income statement can tell a reader. That is why the cash flow statement exists.

  When a company is healthy, operating activities will generate cash. That message is delivered by the net income adjusted for changes in working capital. That is the operating activities section’s function.

  Does the company require a great investment in fixed assets such as new equipment or technology? Is the company selling off its assets to fill an insatiable cash drain from operations? That type of information lies in the investment activities section.