Topic 4: Statement of Cash Flows

Sections:

I. Overview
II. Analysis of the Statement of Cash Flows
III. Development of the Statement of Cash Flows

I. Overview

The statement of cash flows explains changes in cash over an accounting period. This
statement classifies cash inflows and outflows into three categories: operating, investing,
and financing. That is, there are four elements in this statement: (1) cash, (2) operating
activities, (3) investing activities, and (4) financing activities.

The following balance sheet is retrieved from Intel’s 2005 10-K.

Intel Corporation
Consolidated Balance Sheet
December 25, 2004 and December 27, 2003 2004 2003
(In Millions—Except Par Value)

Assets
Current assets:
Cash and cash equivalents $ 8,407 $ 7,971
Short-term investments 5,654 5,568
Trading assets 3,111 2,625
Accounts receivable, net of allowance for doubtful accounts of $43 ($55 in 2003) 2,999 2,960
Inventories 2,621 2,519
Deferred tax assets 979 969
Other current assets 287 270

Total current assets 24,058 22,882

Property, plant and equipment, net 15,768 16,661

Marketable strategic equity securities 656 514
Other long-term investments 2,563 1,866
Goodwill 3,719 3,705
Other assets 1,379 1,515

Total assets $ 48,143 $ 47,143

Liabilities and stockholders’ equity

Current liabilities:
Short-term debt $ 201 $ 224
Accounts payable 1,943 1,660
Accrued compensation and benefits 1,858 1,559
Accrued advertising 894 716
Deferred income on shipments to distributors 592 633
Other accrued liabilities 1,355 1,302
Income taxes payable 1,163 785

Total current liabilities 8,006 6,879

Long-term debt 703 936

Deferred tax liabilities 855 1,482
Commitments and contingencies (Notes 17 and 18)
Stockholders’ equity:
Preferred stock, $0.001 par value, 50 shares authorized; none issued — —
 Common stock, $0.001 par value, 10,000 shares authorized; 6,253 issued and outstanding
(6,487 in 2003) and capital in excess of par value 6,143 6,754
Acquisition-related unearned stock compensation (4) (20)
Accumulated other comprehensive income 152 96
Retained earnings 32,288 31,016

Total stockholders’ equity 38,579 37,846

Total liabilities and stockholders’ equity $ 48,143 $ 47,143

The following statement of cash flows is also retrieved from Intel’s 2005 10-K.

Intel Corporation
Consolidated Statement of Cash Flows
Three Years Ended December 25, 2004 2004 2003 2002
(In Millions)

Cash and cash equivalents, beginning of year $ 7,971 $ 7,404 $ 7,970

Cash flows provided by (used for) operating activities:

Net income 7,516 5,641 3,117
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 4,590 4,651 4,676
Impairment of goodwill — 617 —
Amortization and impairment of intangibles and other acquisition-related costs 299 419 668
Purchased in-process research and development — 5 20
Losses on equity securities, net 2 283 372
Net loss on retirements and impairments of property, plant and equipment 91 217 301
Deferred taxes (207) 391 110
Tax benefit from employee equity incentive plans 344 216 270
Changes in assets and liabilities:
Trading assets (468) (698) (465)
Accounts receivable (39) (430) 30
Inventories (101) (245) (26)
Accounts payable 283 116 (226)
Accrued compensation and benefits 295 276 107
Income taxes payable 378 (361) 175
Other assets and liabilities 136 417 —

Total adjustments 5,603 5,874 6,012

Net cash provided by operating activities 13,119 11,515 9,129

Cash flows provided by (used for) investing activities:

Additions to property, plant and equipment (3,843) (3,656) (4,703)
Acquisitions, net of cash acquired (53) (61) (57)
Purchases of available-for-sale investments (16,618) (11,662) (6,309)
Maturities and sales of available-for-sale investments 15,633 8,488 5,634
Other investing activities (151) (199) (330)

Net cash used for investing activities (5,032) (7,090) (5,765)

Cash flows provided by (used for) financing activities:

Increase (decrease) in short-term debt, net 24 (152) (101)
Additions to long-term debt — — 55
Repayments and retirement of debt (31) (137) (18)
Proceeds from sales of shares through employee equity incentive plans 894 967 681
Repurchase and retirement of common stock (7,516) (4,012) (4,014)
Payment of dividends to stockholders (1,022) (524) (533)

Net cash used for financing activities (7,651) (3,858) (3,930)

Net increase (decrease) in cash and cash equivalents 436 567 (566)

Cash and cash equivalents, end of year $ 8,407 $ 7,971 $ 7,404

Supplemental disclosures of cash flow information:

Cash paid during the year for:
Interest $ 52 $ 59 $ 66
Income taxes, net of refunds $ 2,392 $ 1,567 $ 475

From the above, you can see that the statement of cash flows is developed to explain
changes in cash. For instance, the balance sheet shows that Intel’s cash amounts at the
end of 2003 and 2004 are $7,971 million and $8,407 million. The increase of $436
million is an aggregation of $13,119 million inflow from operation, $5,032 million
outflow from investments, and $7,651 million outflow from financing (13119 – 5032 –
7651 = 436).

Cash means cash and short-term, liquid marketable securities; cash does not include
short-term investments.

Why cash? A firm uses “cash,” not earnings on the book, to pay for raw materials,
interest expense, and dividends. It is possible for a firm to be highly profitable, i.e., good
earnings, and to go bankrupt.

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Homework:

Handout: W.T. Grant case.

Task: Read the case.

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Among operating, investing, and financing activities, analysts pay particular attention to
operating activities. The reason for this is that temporary shortfalls of cash (say, due to
expansion) can be satisfied by borrowing, but eventually the firm needs to be able to
generate cash from its operations (operating cash flow, OCF). Otherwise, the more the
firm borrows, the higher the interest rate, and the more difficult for the firm to turn the
whole thing around.

II. Analysis of the Statement of Cash Flows

There are several essential questions that need to be answered when one analyzes the
statement of cash flows:

1. What is the firm’s ability in generating cash flows from its operations? Does the firm
seem to be able to improve its ability in doing so in the future?
2. Does the firm seem to have the capacity to meet obligations for cash?
3. Does the firm manage its investments successfully and productively?
4. What is the firm’s future external financing needed (EFN)? EFN is also called
additional financing needed (AFN).

This section focuses on historical performance and current conditions. Looking forward
requires forecasting and estimation; this part will be discussed in Topic 6: Pro Forma
Financial Statements.

For the first question, Intel looks pretty good. Intel’s OCFs are $9,129 million, $11,515
million, and $13,119 million during the 2002-2004 period.

It is argued that OCF per share is a better indicator of a firm’s ability to pay dividends in
the short run. This formula is:

(OCF – preferred dividends)/diluted weighted average common shares outstanding

Intel’s OCFs per share are $1.35, $1.74, and $2.02 during the 2002-2004 period. This
increasing trend is good news for equity investors.

For the second question, one may want to focus on the OCF/total debt ratio:

OCF/total debt

Intel’s OCF/total debt ratios are 1.04, 1.24, and 1.37. These values are very high and
increasing. Creditors should have a minimum level of concern about Intel’s ability to
honor its debt.

For the third question, some firms sometimes have temporarily negative or low OCFs due
to expansions that are typically associated with substantial increases in inventories,
accounts receivable, etc. If so, one needs to carefully examine the quality of inventories
and accounts receivable. If these firms are able to turn these increased assets into good
OCF numbers in the subsequent accounting periods, the expansions look good. If not,
then one needs to be careful.

III. Development of the Statement of Cash Flows

The procedures for the development of the statement of cash flows can be found in
Finance 340 textbook, pp.120-124.

Example: AZwinery’s balance sheets for year T and T+1 are as follows:

T T+1
Cash 100 200
Marketable Securities 0 100
Receivables 100 100
Inventories 400 300
Gross Fixed Assets 1000 1200
Cumulative Depreciation (100) (200)
Total Assets 1500 1700

Accounts Payable 100 50

Notes Payable 100 150
Accruals 100 200
Long-Term Debt 200 100
Common Stock 800 900
Retained Earnings 200 300
Total Liabilities and Equity 1500 1700

AZwinery’s income statement for year T+1 is as follows:

Sales 1000
COGS (500)
Depreciation (100)
Other Operating Expenses (80)
Interest Expense (20)
Taxes (100)
Net Incomes 200
Dividends (100)
Addition to Retained Earnings 100

The following account balance changes indicate cash inflows:

(1) Decreases in assets (e.g., the sale of land for cash),

(2) Increases in liabilities (e.g., raising long-term debt), and
(3) Increases in shareholders’ equity (e.g., the sale of common stock).

The following account balance changes indicate cash outflows:

(1) Increases in assets (e.g., the purchase of a building),

(2) Decreases in liabilities (e.g., retirement of long-term debt), and
(3) Decreases in shareholders’ equity (e.g., the payment of a cash dividend).

We fist need to calculate the differences in balance sheet accounts:

T T+1 Difference Category

Cash 100 200 100 Cash
Marketable 0 100 100 Cash
Securities
Receivables 100 100 0 Operating
Inventories 400 300 (100) Operating
Gross Fixed Assets 1000 1200 200 Investing
Cumulative (100) (200) (100) Operating
Depreciation
Total Assets 1500 1700

Accounts Payable 100 50 (50) Operating

Notes Payable 100 150 50 Financing
Accruals 100 200 100 Operating
Long-Term Debt 200 100 (100) Financing
Common Stock 800 900 100 Financing
Retained Earnings 200 300 100
Total Liabilities 1500 1700
and Equity

Note that the amount of Retained Earnings is a function of net income and dividends.
There are classified as operating and financing, respectively.

In this class, we use the indirect method to calculate the net cash flows from operating
activities based on net income:

Net income (loss)

Noncash flow items:
Add expenses
(Deduct revenues)
Changes in balance sheet accounts (usually current asset and current liability accounts)
related to operations:
Add decreases in assets and increases in liabilities
(Deduct increases in assets and decreases in liabilities)
Gains and losses on the income statement that are not related to operations:
Add losses
(Deduct gains)
= Net cash provided by operating activities

Therefore, we have the following statement of cash flows:

Net Income 200

Depreciation 100
Decrease in inventories 100
Decrease in A/P (50)
Increase in accruals 100
Net cash provided by 450
operating activities
Increase in fixed assets (200)
Net cash provided by (200)
investing activities
Dividends (100)
Increase in notes payable 50
Decrease in long-term debt (100)
Increase in common stock 100
Net cash provided by (50)
financing activities

Net increase in cash 200

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Minicase 4-1:

Amazon.com is one of the leading online shopping companies. Amazon.com was found
in 1995 and became a publicly traded company in 1997. The company’s income
statements show that it operated at a loss through 2002. Nevertheless, Amazon.com’s
revenue has been growing at a rapid rate, and the company’s annual revenue was close to
$7 billion in 2004.

Tasks:

1. Analyze the statement of cash flows for Amazon.com for the period of 1998-2004.
Please pay particular attention to OCFs.
2. What have you found in the statement of cash flows that is not readily available in the
income statement or balance sheet?
3. Did the stock market react to your findings?
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