Chapter 3 - Solutions

Overview:
Problem Length Problem #s
{S} 1, 3
{M} 2, 7, 8, 12, 13
{L} ! ", # ! 11, 1, 1$
1.{S}a. Palomba Pizza Stores
Statement of Cash Flows
Year Ended December 31, !!!
Cash Flows from "peratin#
$cti%ities&
Cash Collections from Customers
Cash Payments to Suppliers
Cash Payments for Salaries
Cash Payments for Interest
Net Cash from Operating Activities
Cash Flows from 'n%estin#
$cti%ities&
Sales of Euipment
Purchase of Euipment
Purchase of !an"
Net Cash for Investing Activities
Cash Flows from Financin#
$cti%ities&
#etirement of Common Stoc$
Payment of %ivi"en"s
Net Cash for &inancing Activities
Net Increase in Cash
Cash at 'eginning of (ear
Cash at En" of (ear
) *+,-,,,
./+-,,,0
.1+-,,,0
.1,-,,,0
2/-,,,
.2,-,,,0
.11-,,,0
.*+-,,,0
.2+-,,,0
) 11,-,,,
.3-,,,0
.3,-,,,0
) 11-,,,
+,-,,,
) 41-,,,
5. Cash &lo6 from Operations .C&O0 measures the cash
generating a5ility of operations- in a""ition to
profita5ility. If use" as a measure of performance-
C&O is less su57ect to "istortion than net income.
Analysts use the C&O as a chec$ on the uality of
reporte" earnings- although it is not a su5stitute for
net income. Companies 6ith high net income an" lo6 C&O
may 5e using overly aggressive income recognition
techniues. 8he a5ility of a firm to generate cash
from operations on a consistent 5asis is one
in"ication of the financial health of the firm.
Analysts search for tren"s in C&O to in"icate future
291
cash con"itions an" potential liui"ity or solvency
pro5lems.
Cash &lo6 from Investing Activities .C&I0 reports ho6
the firm is investing its e:cess cash. 8he analyst
must consi"er the a5ility of the firm to continue to
gro6 an" C&I is a goo" in"ication of the attitu"e of
management in this area. 8his component of total cash
flo6 inclu"es the capital e:pen"itures ma"e 5y
management to maintain an" e:pan" pro"uctive capacity.
%ecreasing C&I may 5e a forecast of slo6er future
gro6th.
Cash &lo6 from &inancing .C&&0 in"icates the sources
of financing for the firm. &or firms that reuire
e:ternal sources of financing .either 5orro6ing or
euity financing0 it communicates management;s
preferences regar"ing financial leverage. %e5t
financing in"icates future cash reuirements for
principal an" interest payments. Euity financing 6ill
cause future earnings per share "ilution.
&or firms 6hose operating cash flo6 e:cee"s investment
nee"s- C&& in"icates 6hether that e:cess is use" to
repay "e5t- pay .or increase0 cash "ivi"en"s- or
repurchase outstan"ing shares.
c. Cash payments for interest shoul" 5e classifie" as C&&
for purposes of analysis. 8his classification
separates the effect of financial leverage "ecisions
from operating results. It also facilitates the
comparison of Palom5a 6ith other firms 6hose financial
leverage "iffers.
". 8he change in cash has no analytic significance. 8he
change in cash .an" hence- the cash 5alance at the en"
of the year0 is a pro"uct of management "ecisions
regar"ing financing. &or e:ample- the firm can sho6 a
large cash 5alance 5y "ra6ing on 5an$ lines 7ust prior
to year en".
e. an" f.
8here are a num5er of "efinitions of free cash flo6s.
In the te:t- free cash flo6 is "efine" as cash from
operations less the amount of capital e:pen"itures
reuire" to maintain the firm<s current pro"uctive
capacity. 8his "efinition reuires the e:clusion of
costs of gro6th an" acuisitions. =o6ever- fe6 firms
29*
provi"e separate "isclosures of e:pen"itures incurre"
to maintain pro"uctive capacity. Capital costs of
acuisitions may 5e o5taine" from pro:y statements an"
other "isclosures of acuisitions .See Chapter 110.
In the finance literature- free cash flo6s availa5le
to euity hol"ers are often measure" as cash from
operations less capital e:pen"itures. Interest pai" is
a "e"uction 6hen computing cash from operations as it
is pai" to cre"itors. Palom5a<s free cash flo6
availa5le to euity hol"ers is calculate" as follo6s>
Net cash flo6 from operating activities less net cash
for investing activities>
)11,-,,, 9 )3-,,, ? (1!),!!!

8he investment activities "isclose" in the pro5lem "o
not in"icate any acuisitions.
Another "efinition of free cash flo6s- 6hich focuses
on free cash flo6 availa5le to all provi"ers of
capital- 6oul" e:clu"e payments for interest .)1,-,,,
in this case0 an" "e5t. 8hus- Palom5a<s free cash flo6
availa5le to all provi"ers of capital 6oul" 5e
)111-,,,.
*.{@}a.
1##" 1##7 1##8 1### 2%%% 2%%1
Sales
'a" "e5t e:pense
Net receiva5les
Cash collections
1
) 999
999
2,
) 999
) 11,
A
1,
( 13
)1+,
A
+,
(133
)13+
/
3,
(1)*
)1A+
1,
A+
(1+!
)14+
1,
4+
(1,+
1
Sales 9 5a" "e5t e:pense 9 increase in net receiva5les
5.
1##7 1##8 1### 2%%% 2%%1
'a" "e5t e:penseBsales+.,C 1.AC 1.4C +.AC +.1C
Net receiva5lesBsales */.3 22.2 23.1 1*./ 1/.A
Cash collectionsBsales/A.4 //.A /4.1 /+.A /1.3
c. 8he 5a" "e5t provision "oes not seem to 5e a"euate.
&rom 144A 9 *,,1 sales increase" 5y appro:imately 1,C-
6hile net receiva5les more than "ou5le"- in"icating
that collections have 5een lagging. 8he ratios
292
calculate" in part 5 also in"icate the pro5lem. Dhile
5a" "e5t e:pense has remaine" fairly constant at +C of
sales over the + year perio"- net receiva5les as a
percentage of sales have increase" from *4C to 14CE
cash collections relative to sales have "ecline".
Other possi5le e:planations for these "ata are that
state" payment terms have lengthene" or that Stengel
has allo6e" customers to "elay payment for competitive
reasons.
291
2.{S}-ia#ara Compan.
Statement of Cash Flows !!1
Cash collections
Cash inputs
Cash e:penses
Cash interest pai"
Income ta:es pai"
Cash from Operations
Purchase of fi:e" assets
Cash Fse" for Investing
Increase in !8 "e5t
%ecrease in notes paya5le
%ivi"en"s pai"
Cash Fse" for &inancing
Net Change in Cash
Cash 'alance 1*B21B,,
Cash 'alance 1*B21B,1
) 4/,
.3A,0
.A+0
.1,0
.2,0
) 13+
.1+,0
.1+,0
+,
.*+0
.2,0
.+0
) 1,
+,
) 3,
GSales 9 Accounts #eceiva5leH
GCOIS J Inventory
GSelling K Ieneral E:pense 9 Accounts Paya5le
1
H
GInterest E:pense 9 Interest Paya5leH
GIncome 8a: E:pense 9 %eferre" 8a:H
G%epreciation E:pense J &i:e" Assets .net0H
GNet Income 9 #etaine" earningsH
1
Can also 5e use" to calculate cash inputs- "ecreasing that outflo6 to )31+ 6hile increasing cash e:penses
to )1,,.
29+
1.{!}a. / Compan.
'ncome Statement, !!! 0( thousands1
Sales
COIS J operating
e:penses
1
%epreciation
Interest
8a:es
Net income
) 2-/11
2-3+1
1+
11
1*
) 4*
Greceipts from customers J increase in
accounts receiva5leH
Gpayments 9 increase in inventory J
increase in accounts paya5leH
Gincrease in accumulate" "epreciationH
GpaymentsH
Gpayment J increase in ta: paya5leH
Gchec$ ? change in retaine" earnings as
there are no "ivi"en"sH
1
Note that these t6o items cannot 5e calculate" separately from the
information availa5le.
5. 2 Compan.
Cash 3eceipts and Disbursements, !!! 0( thousands1
Cash receipts from&
Customers
Issue of stoc$
Short9term "e5t
!ong9term "e5t
8otal
Cash disbursements&
COIS an" operating
e:penses
8a:es
Interest
%ivi"en"s

PPKE purchase
8otal
Chan#e in cash
) 1-/,A
2
3*
43
) 1-43/
) 1-/12
2
+1
**
22
) 1-4+*
) 13
GSales 9 increase in receiva5lesH
GIncrease in accountH
GIncrease in lia5ilityH
GIncrease in lia5ilityH
GCOIS J operating e:pense J
increase in inventory J "ecrease
in accounts paya5leH
GE:pense 9 increase in ta: paya5leH
GE:penseH
GIncome J "ecrease in retaine"
earningsH
GChange in PPKEH
&ote> 8his is not a true receipts an" "is5ursements sche"ule as
it sho6s certain amounts .e.g.- "e5t0 on a net 5asis rather
than gross. Such sche"ules .an" cash flo6 statements0 prepare"
from pu5lishe" "ata can only sho6 some amounts net- unless
supplementary "ata are availa5le.
293
c. 8he cash flo6 statements are presente" 6ith the income
statement for comparison purposes in ans6ering Part ".
2 Compan.& Statement of Cash Flows 0( thousands1
144, 144* 1445 1444 !!!
CF"&
&rom customers
6ess outla.s for&
COISBoper. e:p.
Interest
8a:es
CF'&
PPKE purchase
CFF&
Issue of stoc$
Short9term "e5t
!ong9term "e5t
%ivi"en"s
Stoc$ repurchase
!8 "e5t repai"
S8 "e5t repai"
Change in cash
)1-13+
1-12,
1+
*2
) .20
.110
+
31
99
.*,0
.**0
.*0
99
) *+
/
)1-*1,
1-1/A
14
14
) .1+0
.1A0
+
3+
99
.*10
.110
.*0
99
) 22
1
)1-2*A
1-2*3
13
4
) .*10
.2A0
/
99
1,,
.*10
99
.20
./0
) A3
1+
)1-+/A
1-3A*
*1
4
) .11+0
.2,0
2
1+2
99
.*10
.1,0
99
99
) 1*+
.*,0
)1-/,A
1-/12
+1
2
) .4,0
.220
2
3*
43
.**0
99
99
99
) 124
13
2 Compan.& 'ncome Statement 0( thousands1
144, 144* 1445 1444 !!!
Sales
COIS
Operating e:pense
%epreciation
Interest
8a:es
8otal
Net Income
) 1-**,
/1/
*4/
4
1+
2/
) 1-1A/
1*
) 1-*3+
/12
2*,
1,
14
22
) 1-**+
1,
) 1-2/1
421
232
11
13
*A
) 1-21/
23
) 1-3++
1-1*+
121
1*
*1
*3
) 1-/+*
2A
) 1-/31
1-*AA
+,1
11
+1
3
) 1-/+*
4
29A
/ Compan.& Statement of Cash Flows 0( thousands1
144, 144* 1445 1444 !!!
CF"&
&rom customers
Disbursements&
COISBOper. e:p.
Interest
8a:es

CF'&
PPKE purchase
CFF&
Issue of stoc$
Short9term "e5t
!ong9term "e5t

Change in cash
)1-11,
1-*11
11
12
) .1*/0
999
1,
/,
1,
) 12,
) *
)1-3+4
1-A,*
12
1+
) .A10
999
999
+*
*2
) A+
) 1
)*-132
1-A,*
*2
13
) .420
.*,0
+
41
*,
) 113
) 2
)*-/,4
*-/4+
*4
*4
) .1110
.1,0
1+
2
1*+
) 1A2
) 14
)2-3A4
2-AA/
11
2+
) .1A+0
999
2,
3,
+,
) 11,
) 2+
/ Compan.--'ncome Statement 0( thousands1
144, 144* 1445 1444 !!!
Sales
COIS
Operating e:pense
%epreciation
Interest
8a:es
8otal
Net income
) 1-224
1-,24
*12
1,
11
12
) 1-213
) *2
) 1-A21
1-221
21*
1,
12
*,
) 1-3/4
) 1*
) *-*31
1-A12
24/
1*
*2
*A
) *-*,2
) +/
) *-424
*-*3A
+*1
11
*4
21
) *-/3+
) A1
) 2-/11
} 999
}2-3+1
1+
11
1*
) 2-A14
) 4*
Note> *,,, COIS an" operating e:pense are com5ine" as there is
insufficient information to separate them.
29/
". 'oth companies are cre"it ris$s. Although 5oth are
profita5le- their C&O is increasingly negative. If
current tren"s continue they face possi5le insolvency.
=o6ever- 5efore re7ecting 5oth loans outright- it is
important to $no6 6hether C&O an" income "iffer
5ecause the companies are "oing poorly or 5ecause they
are gro6ing too fast.
'oth companies increase" sales over the + year perio"E
Company @ 5y +,C- Company I 5y more than 2,,C. Are
these sales real .6ill cash collections materialiLe0M
If they are Ngro6ing too fast-N it may 5e a"visa5le to
ma$e the loan 5ut also to force the company to curtail
its gro6th until C&O catches up. One 6ay to verify
6hether the gap is the result of sales to poor cre"it
ris$s is to chec$ if the gro6th in receiva5les is
NproportionalN to the sales gro6th. Similar chec$s can
5e ma"e for the gro6th in inventories an" paya5les. In
this case- the inventory of @ company has "ou5le" from
1443 to *,,, 6hile COIS increase" 5y only +3C. 8he
inventory increase 6oul" 5e one area to investigate
further.
8here is a significant "ifference in the investment
pattern of the t6o companies. Company @ has ma"e
purchases of PPE each year- 6hile Company I has ma"e
little net investment in PPE over the perio". (et
Company I has gro6n much faster. %oes this reflect the
nature of the 5usiness .Company I is much less capital
intensive0 or has Company I use" off 5alance sheet
financing techniuesM
8he cash from financing patterns of the t6o companies
also "iffer. 'oth triple" their total "e5t over the
perio" an" increase" the ratio of total "e5t to
euity. Iiven Company @;s slo6er gro6th .in sales an"
euity0- its "e5t 5ur"en has gro6n much more rapi"ly.
%espite this- Company @ has continue" to pay "ivi"en"s
an" repurchase stoc$. Company I has not pai" "ivi"en"s
an" has issue" ne6 euity. 8hese t6o factors account
for its larger increase in euity from 1443 to *,,,.
'ase" only on the financial "ata provi"e"- I loo$s
li$e the 5etter cre"it ris$. Its sales an" income are
gro6ing rapi"ly- 6hile @;s income is sta5le to
"eclining on mo"estly gro6ing sales. Fnless further
investigation changes the insights "iscusse" here- you
294
shoul" prefer to len" to Company I.
291,
+.{!}a. .i0
Statement of Cash Flows - 'ndirect 2ethod
Cash from operations&
Net income )1-,/,
A"" noncash e:pense> "epreciation 3,,
A""BSu5tract changes in 6or$ing capital>
Accounts receiva5le .1+,0
Inventory .*,,0
Accruals /,
Accounts paya5le 1*, .1+,0
)1,+3!
Cash from in%estin#&
Capital e:pen"itures 1,1+!
Cash from financin#&
Short term 5orro6ing ++,
!ong9term repayment .24/0
%ivi"en"s .12*0
(05!1
-et chan#e in cash ( 1!!
7or8sheet for 0'ndirect 2ethod1 Cash Flow Statement
'n(ome )*l*n(e Sheet +*sh
St*tement 12,31,%% 12,31,%1 +h*nge -..e(t
Net income )1-,/, )1-,/,
%epreciation 3,, 3,,
Accounts
receiva5le
)1-+,, )1-3+, )1+, .1+,0
Inventory *-,,, *-*,, *,, .*,,0
Accruals /,, //, /, /,
Accounts paya5le 1-*,, 1-2*, 1*, 1*,
%epreciation .3,,0 .3,,0
Net fi:e" assets 3-+,, A-,+, ++, .++,0
Capital expenditures $(1,150)
Note paya5le +-+,, 3-,+, ++, ++,
Short-term borrowing $ 550
!ong9term "e5t *-,,, 1-3,* .24/0 .24/0
Long-term debt repayment $ (!")
Net income .1-,/,0 .1-,/,0
#etaine" earnings +,, 1-11/ 31/ 31/
#i$idends paid $ (%&)
2911
OOOOOOOOO OOOOOO
, ) 1,,
8he 6or$sheet to create the cash flo6 statement is
presente" a5ove. Each 5alance sheet change .other than
cash0 is accounte" for an" matche" 6ith its correspon"ing
activity. As a last chec$- the net income an" the a""95ac$s
of non9cash items are 5alance" an" Pclose"Q to their
respective accounts .PPKE an" retaine" earnings0 provi"ing
the amounts of capital e:pen"itures an" "ivi"en"s.
a9 0ii1 Statement of Cash Flows - Direct 2ethod
Cash from "perations&
Cash collections )4-/+,
Cash payments for merchan"ise .3-,/,0
Cash pai" for SIKA .4*,0
Cash pai" for interest .3,,0
Cash pai" for ta:es .A*, 0
(1,+3!
Cash for 'n%estin# $cti%ities&
Capital e:pen"itures 01,1+!1
Cash for Financin# $cti%ities&
Short9term 5orro6ing ++,
!ong9term "e5t repayment . 24/0
%ivi"en"s . 12* 0
(0 5! 1
-et Chan#e in Cash ( 1!!
8he 6or$sheet to create the cash flo6 statement is
presente" 5elo6. Each 5alance sheet change .other than
cash0 is accounte" for an" matche" 6ith its correspon"ing
activity. &urthermore the operating account changes are
matche" to their correspon"ing income statement item. As a
last chec$- the net income is 5alance" an" Pclose"Q to
retaine" earnings provi"ing the amount of "ivi"en"s.
Note that there is no "ifference 5et6een the in"irect an"
"irect metho"s in the cash flo6 statement an" in the
6or$sheet for cash for investing an" financing activities-
291*
7or8sheet for 0Direct 2ethod1 Cash Flow Statement
'n(ome )*l*n(e Sheet +*sh
St*tement 12,31,%% 12,31,%1 +h*nge -..e(t
Sales )1,-,,, )1,-,,,
Accounts receiva5le ) 1-+,, ) 1-3+, ) 1+, .1+,0
Cash Colle'tions $ !,"50
COIS .3-,,,0 .3-,,,0
Inventory *-,,, *-*,, *,, .*,,0
Accounts paya5le 1-*,, 1-2*, 1*, 1*,
Cash (aid )or *er'handise $(+,0"0)
SIKA e:pense .1-,,,0 .1-,,,0
Accruals /,, //, /, /,
Cash (aid )or S,-. $ (!&0)
Interest e:pense .3,,0 .3,,0
Cash (aid )or /nterest $ (+00)
8a:es .A*,0 .A*,0
Cash (aid )or 0axes $ (1&0)
%epreciation .3,,0 .3,,0
Net fi:e" assets 3-+,, A-,+, ++, .++,0
Capital 2xpenditures $(1,150)
Note paya5le +-+,, 3-,+, ++, ++,
Short-term 3orrowing $ 550
!ong9term "e5t *-,,, 1-3,* .24/0 .24/0
Long-term #ebt 4epaid $ (!")
Net income .1-,/,0 .1-,/,0
#etaine" earnings +,, 1-11/ 31/ 31/
#i$idends $ (%&)
OOO OOO OOOOOOO
) , ) 1,,
2912
3.{!}a. E:hi5it 2P92 "oes not provi"e the .changes in the0
in"ivi"ual components that ma$e up the changes in
6or$ing capital. As such- to create the "irect metho"
cash flo6 statement- 6e must o5tain the information
"irectly from the 5alance sheet. 8his proce"ure "oes
not necessarily yiel" the same cash flo6 components
using the "irect metho" as those provi"e" 5y the
company in its in"irect metho" calculations.
%ifferences may arise 6hen
1. there are acuisitionsB"ivestments
*. there are foreign e:change a"7ustments
2. the firm aggregates or classifies investing
accruals together 6ith operating ones.
In this case- the "ifferences are minimal as in"icate" 5elo6.
.8he calculations reuire" for the "irect metho" cash flo6
statement are presente" in E:hi5it 2S91 along 6ith the
assumptions use" to generate the statement0
/ire(t Metho0 +*sh 1low St*tement
2-3hibit 3S!14
'n0ire(t
Metho0
2-3hibit
3P!34
/i..eren(e
Cash collections )21/-3*A
Cash for suppliers .*13-1,,0
Cash e:penses .41-A410
Interest pai" .+-2,20
8a: pai" .*-1*A0
CAS= &#O@ OPE#A8IONS ) 1-+3, )1-24/ ) 13*
CAS= &#O@ INRES8@EN8S .1-*+1
0
.1-,/40 .13*0
CAS= &#O@ &INANCINI *1+ *1+ 999
C=ANIE IN CAS= ) +*1 ) +*1 999
2911
E:hibit 3S-1& Direct 2ethod Statement of Cash Flows
'n(ome )*l*n(e )*l*n(e
St*tement Sheet Sheet
2%%1 12,31,%% ",3%,2%%1 +h*nge +*sh -..e(t
Sales )21*-*1+ ) 21*-*1+
Accounts receiva5le 41-323 /+-**1 .3-11*0 3-11*
Cash collections ( 3)5,,*
Cost of goo"s sol" .*2/-A440 .*2/-A440
Inventories 132-*,3 1+/-1+1 .1-A++0 1-A++
Accounts paya5le /1-A21 A*-3A/ .1*-,+30 .1*-,+30
Cash inputs (0),,1!!1
Operating e:penses .41-A4+0 .41-A4+0
Other current assets 1-1*3 1-/12 11A .11A0
Prepai" e:penses K
other assets ++-+33 +3-32, 1-,31 .1-,310
Accrue" e:pensesS 1A-3A4 13-*44 .1-2/,0 .1-2/,0
Postretirement
5enefit o5ligation *-*3+ *-12, .12+0 .12+0
Cash e:penses ( 04),*411
Interest e:pense .+-1*/0 .+-1*/0
Interest paya5leS 1A+ , .1A+0 .1A+0
'nterest paid ( 0+,3!31
8a: e:pense ./210 ./210
Income ta: receiva5le 1-113 *-//4 .1-**A0 1-**A
Income ta: paya5le 1-12, *-2/2 1-*+2 1-*+2
%eferre" income ta:es 1/-,43 1/-+A1 1A/ 1A/
;a: paid ( ,1*
C$S< F6"7 F3"2 "PE3$;'"-S ),+,!
%epreciation e:pense .1-A2*0 .1-A2*0
&i:e" assets 41-1,/ 4,-433 .11*0 11*
Investments in 7oint
ventures 4-A11 4-+41 .1*20 1*2
@inority interest 4A1 1-1/A *13 *13
C$S< F6"7 F3"2 '-=ES;2E-;S ( 0),+11
Current portion of
long9term "e5t 2-1*+ 2-1*+ 9 ,
!ong9term "e5t 131-12+ 13+-A44 1-331 1-331
%ivi"en"s pai"SS .1-1310
Other 9 change in stoc$hol"ers; euity 1*
C$S< F6"7 F3"2 F'-$-C'-/ ( 1+
Net Income .chec$0 42,
-et chan#e in cash ( +)
S Assume" change in interest paya5le to conform to interest pai".
SS &rom the in"irect metho"
291+
5.
1st "
Months
1##" 1##7 1##8 1### 2%%% 2%%1 5ot*ls
C&O )21-41+ ) +-13+ ).*2-+*/0 )A2-+4A ).1/-3,30 )1-+3, ) A3-1,2
C&I .2/-,,A0 .1*-4AA0 .13-A3A0 .12-+,,0 .4-,1A0 .1-*+10 .1+1-+140
).2-,4*0 ).2A-/1*0 ).A,-*4+0 )3,-,4A ).*A-3*20 ) 2,4 ).A/-1130
C&& 1-*2, 2/-A/* A,-1A1 .3,-1A20 *A-1*1 *1+ /,-2+*
As note" in 'o: 29*- from 1443 to *,,,- the company
generate" free cash flo6 .C&O less net capital
e:pen"itures0 of )1.+ million- "uring the first si:
months the A. @. Castle a""e" another )2,4 thousan".
=o6ever- 'o: 29* also sho6e" that over the five9year
perio"- Castle pai" nearly )+, million in "ivi"en"s
an" 5orro6e" nearly )12, million to finance its
investments an" acuisitions. 8his tren" continue" in
the first si: months of *,,1 "uring 6hich the firm
5orro6e" an a""itional )1.331 million to help pay its
"ivi"en"s an" meet capital e:pen"iture nee"s.
Cash generate" from operations from 1443 through the
en" of the first 3 months of *,,1 6as )A3 million 5ut
the company spent )1+1 million to replace pro"uctive
capacity an" for investments an" acuisitions. Dhen
free cash flo6s is calculate" on this 5asis .i.e. C&O
T C&I0 there is a shortfall of )A/ million. 8his
shortfall as 6ell as "ivi"en" payments 6ere finance"
5y 5orro6ing over the same perio".
8he ina5ility to meet its capital an" "ivi"en" nee"s
from operations clearly in"icate" that either the
"ivi"en" 6oul" have to 5e re"uce" or the company 6oul"
not 5e a5le to remain competitive an"Bor gro6 as
nee"e".
2913
A.{@}a.
8he S6e"ish IAAP cash flo6 statements .C&S0 5egin 6ith
preta: an" pre9financial items 6hereas the F.S. IAAP
C&S sho6 a"7ustments to net income.
8he net financial items aggregate interest costs an"
interest income from various sources .inclu"ing
"ivi"en"s an" interest from associate" companies an"
other interest income0 .
S6e"ish IAAP C&S aggregate all changes in 6or$ing
capitalE F.S. IAAP C&S provi"e "etaile" "isclosure of
the operating changes in components of 6or$ing
capitalE non9operating changes are reporte" as
components of investing activities.
S6e"ish IAAP com5ines cash an" cash euivalents-
financial receiva5les .primarily receiva5les from
associate" companies0 an" financial lia5ilities
.current an" long9term "e5t0 in a measure calle" net
financial assets or lia5ilities. S&AS 4+ sho6s the
change in cash an" cash euivalents 6ith changes in
financial receiva5les reporte" as components of C&O
an" C&I. Changes in current an" long9term "e5t are
reporte" in cash from financing activities.
5. 8he cash flo6 statement is sho6n on page 13.
c. %isa"vantages>
.10 Aggregation of all changes in operating or
6or$ing capital accounts com5ines cash
conseuences of operating an" investing
activities. As note" in the chapter- investing
activities ten" to "istort cash flo6 from
operations.
.*0 8he use of net financial items ten"s to o5scures
operating- investing- an" financing activities.
Although "isclosure is availa5le to facilitate
its calculation- no separate "isclosure of actual
cash outflo6 for interest .financing0 costs is
provi"e".
.20 8he inclusion of financial lia5ilities .5orro6ing
an" repayment0 an" financial receiva5les in
liui" fun"s "istorts cash flo6s from 5oth
investing an" financing activities. 8his approach
also hampers the analysis of free cash flo6s
"iscusse" in the chapter. It is also unclear 6hat
5asis 6as use" 5y the company to allocate a
portion of the financial receiva5les to operating
291A
activities an" the remain"er to the net financial
position category.
6P*rt ( is (ontin7e0 on 8*ge 179
291/
5. Amounts in millions of S6e"ish Uronor
Swe0ish :;;P <=S= :;;P
>e*rs -n0ing /e(ember 31 1### 1##8 1### 1##8
Operating profit *-31+ *-1A+ Net income *-*/A *-+41
Noncash items 1-++1 1-2// 1-++1 1-2//
Change in 6or$ing capital .20 134 .20 134
Net financial items .*,30 .12A0 .12A0
Pai" ta: .1**0 *+2 , *+2
Cash flow before capital e:penditure 3,53+ ),1)5 5perating a'ti$ities 3,53+ ),1)5
Capital e:pen"iture .1-4//0 .*-++A0 .1-4//0 .*-++A0
Change in financial receiva5les .2-24+0
Effects from "iveste" activities 2-*+/ , 2-*+/ ,
Cash flow before di%idend +,1!+ 1,+41 /n$esting a'ti$ities

0,1+1

0,++*1
Issue of 6arrants an" converti5le loan , 13 , 13
%ivi"en" pai"> Or"inary .//40 ./,,0 .//40 ./,,0
E:tra .2-11,0 , .2-11,0 ,
Change in financial lia5ilities *-+*1 ,
6inan'ing a'ti$ities 01,)*51 0*+)1
Currenc. effects 01*1 01111 2x'hange rate e))e'ts (11) (111)
Chan#e in net financial liabilit. 1,!54 *, Change in 'ash and
mar7etable se'urities &15 1&+
Closing liui" fun"s 1-1+3 1-*11
&inancial receiva5les 2-24+ ,
&inancial lia5ilities .3-4,+0 .1-2/10
Cash and mar7etable
se'urities8


Net financial lia5ility .*-,+10 .2-1120
Opening liui" fun"s 1-*11 1-323 3eginning o) period 1,&%1 1,++
Change in liui" fun"s *2+ .1320
Currency effects .*,0 3/
2914
Closing liui" fun"s 1-1+3 1-*11 2nd o) period 1,%5+ 1,&%1
29*,
A. c. .continue" from page 1+0
A"vantages>
.10 8he separate "isplay of pre9interest an" pre9ta:
cash flo6s permits a comparison across companies
6ith "ifferent capital structures an" ta: regimes.
.*0 %etaile" "isclosure of investment cash flo6s
.acuisition an" other0 may facilitate analysis
of free cash flo6s.
/.{@}a. %ifferences 5et6een F.S. an" IAS IAAP .see te:t page
4/0>
IAS IAAP is permissive regar"ing the
classification of interest an" "ivi"en"s
receive"- interest pai"- an" "ivi"en"s pai">
these cash flo6s may 5e reporte" either as
components of C&O or C&I .interest an" "ivi"en"s
receive"0 an" C&& .interest an" "ivi"en"s pai"0.
#oche classifies interest an" "ivi"en"s receive"
as C&I an" interest an" "ivi"en"s pai" as C&&.
'an$ over"rafts may 5e reporte" as components of
cash an" cash euivalents in IAS IAAPE the change
in 5an$ over"rafts 6oul" not 5e reporte" as part
of the statement of cash flo6s. F.S. IAAP
reuires their classification as lia5ilities an"
therefore- as components of financing cash flo6s.
#oche footnote *1 in"icates that over"rafts are
reporte" as short9term "e5t 5ut is unclear as to
ho6 changes are reporte" in the cash flo6
statement.
Companies using IAS IAAP an" the "irect metho"
are not reuire" to report the reconciliation
from net income to C&O.
5. Cash flo6 statement on page 1/.
Note that conversion to S&AS 4+ results in only a
small "ifference in C&O as the classification
"ifferences largely 5alance. =o6ever 5oth C&& an"
.especially0 C&I are uite "ifferent .5oth level an"
tren"0. 8he ma7or "ifference is that the large *,,,
investment in mar$eta5le securities is sho6n as a C&I
outflo6 un"er IAS A 5ut an increase in cash an"
mar$eta5le securities un"er S&AS 4+ assuming that the
mar$eta5le securities 6oul" 5e consi"ere" cash
euivalents un"er FS IAAP. #oche footnote 14 contains
29*1
general information a5out its mar$eta5le securities-
5ut not enough "etail to "etermine 6hich investments
6oul" 5e consi"ere" cash euivalents.
29**
5. #oche cash flo6 statement> IAS an" FS IAAP 1### 2%%%
;mo7nts in +?1 Millions ';S 7 S1;S #$ ';S 7 S1;S #$
Operating profitS 3-1*1 3-1*1 A-121 A-121
%epreciation an" amortiLation *-1+2 *-1+2 *-/1/ *-/1/
E'I8%A /-/A1 N.#. 4-4A4 N.#.
Ienentech transactions .1-++,0 .1-++,0 .2-A410 .2-A410
Other non9cash transactions 314 314 .4,0 .4,0
Other .2-+4/0 .2-+4/0 .*-+140 .*-+140
Interest pai" .3/30 .4,*0
Interest an" "ivi"en"s receive" 1+4 A12
Increase in 6or$ing capital .*-31/0 .*-31/0 23A 23A
Cash from operations 1,** 1,+!! 3,41, 3,*+*
&inancing transactions +11 +11 ./,10 ./,10
Interest an" "ivi"en"s pai" .1-1230 .1-A2A0
%ivi"en"s pai" 9 .A+,0 9 ./2+0
Cash from financin# acti%ities 054+1 0!41 0,+351 01,,3,1
Capital e:pen"itures- investments an" "ivestitures .4,30 .4,30 1-4*1 1-4*1
Interest an" "ivi"en"s receive" 1+4 9 A12
Change in mar$eta5le securities .1*,0 9 .2-1430 9
Cash from in%estin# acti%ities 05,*1 04!,1 0531 1,41
-et effect of currenc. translation on cash 1!3 1!3 03,1 03,1
'ncrease 0decrease1 in cash ,5 +1!
'ncrease 0decrease1 in cash and m8t9 secs9 )55 ),!!,
Note> #o6 hea"ings that are right 7ustifie" apply to S&AS 43 amounts.
SActually fun"s from operations
N.#. Not reuire" 5y FS IAAP- 5ut sometimes "isclose"
29*2
c. A"vantage> IAS recommen"s separate "isclosure of cash
outflo6s for maintenance e:pen"itures an" capital
e:pen"itures for gro6thE 6hen availa5le that can 5e a
significant 5enefit.
%isa"vantages>
.10 Availa5le alternatives for the treatment of
interest an" "ivi"en"s receive"- interest pai"-
an" "ivi"en"s pai" .see ans6er to part a0 may
"istort C&O- C&I- an" C&& an" hamper comparisons
6ith companies using FS IAAP or .for companies
using IAS IAAP0 choosing "ifferent alternatives.
.*0 &or companies using the "irect metho"- 6hen the
reconciliation from net income to C&O is not
reporte" it is impossi5le to "etermine" 6hether
changes in operating assets an" lia5ilities .e.g.
inventory0 are "ue to operating or other factors.
29*1
4.{!}8he cash flo6 statement sho6s a stea"y "eterioration in
C&OE al5eit C&O remains positive. Income .5efore
e:traor"inary items0 on the other han" increases stea"ily
at appro:imately /C91,C per year.
8o e:plain the "iscrepancy 5et6een the pattern of income
an" C&O- 6e first compute the "irect metho" cash flo6
statement an" then compare the cash flo6 components 6ith
their income statement counterparts.

8he .a55reviate"0 cash flo6 statement un"er the "irect
metho" is presente" 5elo6>
Years Ended December 31
1##2 1##3 1##
Cash from operating activities>
Collections from customers )*-114-+32 )*-1*,-431 ) *-A11-1+4
Payments for merchan"ise .1-+,*-1110 .1-A1*-1140 .*-,31-/1+0
Payments for SIKA .1+2-1140 .+*2-1A10 .3,1-+A+0
Interest pai" .2A-//20 .22-23A0 .22-41/0
8a:es pai" .1*-1110 .**-4/40 ./-1,/0
Other .plug0 .12-*320 .*1A0 .1-3140
) 1,,-11, ) 4/-A2+ ) 2,-A41
Cash for investing activities>
Capital e:pen"itures .1/-/A/0 .11,-+210 .4,-,,40
Acuisition of leasehol"s .2,-3,*0 .*1-/410 ./-,*+0
) ./+-1/,0 ) .12*-1*/0 ) .4/-,210
Cash for financing activities>
!ong9term 5orro6ings .2-*A30 .*2-/210 .14-12*0
#evolving cre"it 5orro6ings A,-*12
Procee"s from sale of stoc$-
options an" 6arrants
1-44+ +1-13, 1-,+,
) .1-*/10 ) 2,-3*4 ) +1-/31
Net change in cash ) 12-2A4 ) .2-,310 ) .1+-2A40
8he reuire" calculations for the operating items are
presente" in E:hi5it 2S9* on page *1. 8he last item PotherQ
is the plug amount use" to arrive at the C&O presente" in
the in"irect cash flo6 statement .E:hi5it 2P910.
29*+
E:hi5it 2S9*
Dor$sheet for Operating Items for %irect @etho" SoC&
1##2 1##3 1##
Sales ) *-1*A-3/1 *-111-1*1 ) *-A1/-321
Change in receiva5les ./-1*10 3-/2A .1-1A+0
Cash Collections ( ,114,+,3 ,)!,4,1 ( ,*)),1+4
COIS .1-+*A-A210 .1-A1*-*A30 .1-4A+-22*0
Change in inventory .*/-1,10 .3,-/420 ./*-/320
Change in accounts paya5le +2-A1/ 31-,*, .3-3*,0
Pa.ments to Suppliers (01,+!,)1)1 (01,*),1)41 (0,!,),51+1
SIKA e:pense .1+/-/,10 .+*,-3/+0 .3,+-+2/0
Change in prepai" e:penses 1-21A .*-12A0 .2-2+/0
Change in accrue" 6ages 1-,2/ .3+*0 A-2*1
Pa.ments for S/>$ ( 0)+3,))41 ( 0+3,)*)1 ( 0,!1,+*+1
Interest e:pense .24-4210 .21-4,10 .21-41/0
AmortiLation of "e5t
issuance costs
*-,+1 1-+2A 1-,,,
'nterest paid ( 03*,5531 ( 033,3,*1 ( 033,4)51
8a: e:pense .*+-+,A0 .*3-1+*0 .*A-+340
Change in ta:es paya5le 4-,,2 *-33* 1A-+3A
%eferre" ta:es 1-,4, +,1 1-+41
;a:es paid ( 01,)1)1 ( 0,4541 ( 05,)!51
29*3
8he comparison of the cash flo6 an" income statement
components is presente" 5elo6>
1##2 1##3 1## @(h*nge
1##2!#3
@(h*nge
1##3!#
@(h*nge
1##2!#
Sales *-1*A-3/1 *-111-1*1 *-A1/-321 12.+C 12.4C *4.*C
Cash collections
*-114-+32

*-1*,-431

*-A11-1+4 11.*C 12.2C *4.+C
Collections?Sales 449,1@ 1!!95@ 4495)@
COIS .1-+*A-A210 .1-A1*-*A30 .1-4A+-22*0 11.,C 12.1C *4.2C
Payments to
suppliers
.1-+,*-1110 .1-A1*-1140 .*-,31-/1+0
13.,C 1/.+C 2A.1C
Pa.ments?C"/S 4/.21C 44.44C 1,1.+2C
SIKA e:pense .1+/-/,10 .+*,-3/+0 .3,+-+2/0 12.+C 13.2C 2*.,C
Payments for SIKA .1+2-1140 .+*2-1A10 .3,1-+A+0 1+.1C 11.4C 2*.AC
Pa.ments?S/>$ 45953@ 1!!9+)@ 4493+@
Cre"it an" collections "o not seem to 5e responsi5le for
the "eterioration in C&O. A comparison of cash collections
6ith sales in"icates that collections increase" at a
slightly faster pace than sales. 8he collectionsBsales
ratio increase" from 44.31C in 144* to 44./1C in 1441.
Inventory- ho6ever- is another matter. Payments for
inventory increase" 5y 2AC 6hereas COIS increase" 5y only
*4C. 8his is in"icative of inventory 5eing 5ought an" pai"
for 5ut not 5eing sol". 8he proportion of payments to COIS
increase" accor"ingly from 4/.2C to 1,1.+C in t6o years.
8his 3C increase translates .5ase" on COIS of close to
)*-,,,-,,,0 to an increase" annual cash reuirement of
)1*,-,,,.
8hus- the first cause of #a"loc<s pro5lems seems to 5e
inventories. Its income may 5e overstate" as inventory may
have to 5e 6ritten "o6n if it cannot 5e sol". Even if
inventory is eventually sol" an" the purchases no6 5eing
ma"e no6 are a5le to satisfy future gro6th- the firm may
still face liui"ity pro5lems as it reuires cash to
purchase .an" carry0 the ne6 inventory.
=o6ever- as C&O is still positive the firm may still 5e a
goo" can"i"ate for cre"it.
29*A
&urther insights as to the impact of gro6th can 5e seen if
6e compare free cash flo6 .C&O 9 C&I0 6ith income an" C&O.
1##2 1##3 1##
Earnings 5efore e:traor"inary )2A-*3* )11-2A/ )11-2+4
C&O 1,,-11, 4/-A2+ 2,-A41
&ree Cash &lo6 11-33, .22-3420 .3A-*1,0
(100,000)
(50,000)
-
50,000
100,000
150,000
1992 1993 1994
Earnings bef ore
extraordinary items
CFO
Free Cas F!o"s
Although income rises- C&O an" free cash flo6 fall. C&O
e:cee"s income in 144* an" 1442 as the noncash "epreciation
a""5ac$ increases C&O relative to income. 'y 1441- ho6ever-
C&O- .although positive0 falls 5elo6 income. 8his in"icates
that the firm m*A have pro5lems in covering the replacement
of (7rrent pro"uctive capacity.
&ree cash flo6 is negative in 1442 an" 1441 an" P5arelyQ
positive in 144*. 8his in"icates that the firm<s gro6th .in
a""ition to inventory0 reuires cash that #a"loc cannot
supply internally.
Dhere "i" the cash come fromM
In 1442- it met its cash reuirements 5y issuing stoc$E in
1441 the firm<s short term "e5t increase" consi"era5ly as
it "re6 "o6n its revolving cre"it lines.
8hus- the loan shoul" not 5e grante" as the firm seems to
5e facing an increasing liui"ity crisis..
&ote> #a"loc is an anagram for Cal"or- a chain of "iscount
stores. 8he "ata in E:hi5it 2P91 6ere ta$en from Cal"or<s
pu5lishe" financial statements. Cal"or file" for Chapter 11
5an$ruptcy soon after the 1441 statements 6ere pu5lishe".
29*/
1,.{!}a. 8his part of the uestion reuires an un"erstan"ing of
S&AS 4+- 6hich governs the preparation of the
Statement of Cash &lo6s. S&AS 4+ permits use of either
the "irect or in"irect metho". As an initial step
un"er either metho"- the effect of the Uraft
acuisition must 5e remove" as follo6s>
Aalance Sheet Chan#es 0( in millionsB
;s
Be8orte0
1#87
;s
Be8orte0
1#88
Be8orte0
+h*nge
1#87!88
Less
Cr*.t
;0D7ste0
+h*nge
#eceiva5les
Inventory
PPE
Ioo"6ill
S8 "e5t
ABC paya5le
Accrue"
lia5ilities
!8 "e5t
) *-,3+
1-1+1
3-+/*
1-,+*
1-11,
A41
*-*AA
3-*42
) *-***
+-2/1
/-31/
1+-,A1
1-*+4
1-AAA
2-/1/
1A-1**
) 1+A
1-*2,
*-,33
11-,14
.1/10
4/3
1-+A1
1,-/*4
) A+/
1-*2*
1-A1,
1,-231
A,,
+A/
+2,
4,,
) .3,10
.*0
2*3
3+/
.//10
1,/
1-,11
4-4*4

8he transactional analysis 6or$sheet an" statement of
cash flo6s are sho6n on pages *+ an" *3 respectively.
5. 8he simplest calculation 6oul" 5e operating cash flo6
less capital e:pen"itures> )+-*,+ 9 )4/, ? )1-**+
million. 'ut many variations are possi5le.
8he more important part of the uestion is the
connection 5et6een free cash flo6 an" future earnings
an" financial con"ition. Possi5le uses of free cash
flo6 inclu"e>
10 #epayment of "e5t resulting in lo6er interest
cost an" higher earnings. 8his also re"uces "e5t
ratios an" improves interest coverage- possi5ly
lea"ing to higher "e5t ratings.
*0 #epurchase of euity may raise earnings per share
an" .if repurchase" 5elo6 state" 5oo$ value or
real value per share0 increase these.
20 Acuisitions .such as Uraft0 that may provi"e
future gro6th- 5etter "iversification- lo6er
ris$- etc.
10 E:pen"itures to fun" internal gro6th through
capital spen"ing- research an" "evelopment- ne6
29*4
pro"uct costs- etc.
292,
;ransactional $nal.sis 7or8sheet 0( 2illions1
#evenues
%ecrease in receiva5les
Cash collections
Cost of goo"s sol"
%ecrease in inventory
Increase in accounts paya5le
Cash inputs
Selling K a"min. e:pense
Increase in accrue" lia5ilities
Cash e:penses
Income ta: e:pense
Increase in income ta:es paya5le
%ecrease in "eferre" income ta:es
Income ta:es pai"
Interest e:pense
Cash flo699operating activities
%epreciation e:pense
Increase in net PPE
Cash investe" in PPE
Ioo"6ill amortiLation
Increase in goo"6ill
Ioo"6ill purchase"
%ecrease in investments
Acuisition of Uraft
Cash flo699investing activities
%ivi"en"s "eclare"
Increase in "ivi"en"s paya5le
%ivi"en"s pai"
%ecrease in stoc$hol"ers; euity
.repurchase0S
Net change in short9term "e5t
Net change in long9term "e5t
Cash flo699financing activities
Increase in cash an" euivalents
)21-A1*
3,1
.1*-1+30
*
1,/
.11-11,0
1-,11
.1-24,0
23*
.2*+0
) .3+10
.2*30

.1*+0
.3+/0
) .4110
1A
) 2*-212
.11-A130
.12-2340
.1-2+20
.3A,0
) +-*,+
) .4/,0
.A/20
1,+
.11-2/20
).1*-A110
) ./410
.+1,0
.//10
4-4*4
) A-311
) A/
S
8he net issuance or repurchase of euity is compute" 5y reconciling the
stoc$hol"ers; euity account>
#econciliation of Stoc$hol"ers; Euity
1*B21B/A 5alance ) 3-/*2
14// net income *-22A
%ivi"en"s "eclare" .411 0
8otal ) /-*14
1*B21B// 5alance .A-3A4 0
%ecrease in stoc$hol"ers; euity .repurchase0 ) +1,
2921
Philip 2orris Companies, 'nc9
7or8sheet for Statement of Cash Flows
'ndirect 2ethod
Year Ended December 31, 1455 0( 2illions1
Cash flows from operatin# acti%ities&
Net income
A"7ustments to cash 5asis&
%epreciation e:pense
AmortiLation of goo"6ill
%ecrease in accounts receiva5le
%ecrease in inventory
%ecrease in "eferre" ta:es
Increase in accounts paya5le
Increase in accrue" lia5ilities
Increase in income ta:es paya5le
Net cash flo6 from operating activities
Cash flows from in%estin# acti%ities&
Increase in PPE .5efore "epreciation0
Increase in goo"6ill .5efore amort.0
%ecrease in investments
Acuisition of Uraft
Net cash use" 5y investing activities
Cash flows from financin# acti%ities&
%ecrease in short9term "e5t
Increase in long9term "e5t
%ecrease in stoc$hol"ers; euity
.repurchase0
%ivi"en"s "eclare"
Increase in "ivi"en"s paya5le
Net cash provi"e" 5y financing
activities
Net increase in cash
Supplementar. disclosure of cash flow
information&
Interest pai" "uring year
Income ta:es pai" "uring year
Schedule of noncash in%estin# and
financin# acti%ities&
) *-22A
3+1
1*+
3,1
*
.2*+0
1,/
1-,11
23*
) .4/,0
.A/20
1,+
.11-2/20
) .//10
4-4*4
.+1,0
.4110
1A
) +-*,+
.1*-A110
A-311
) A/
3A,
1-2+2
)9999999
292*
c. If the acuire" inventories an" receiva5les are sol"
the procee"s 6ill 5e reporte" as cash flo6 from
operations .C&O0. As their acuisition 6as reporte" as
cash use" for investment- C&O 6ill 5e inflate". 8his
6ill occur if Uraft re"uces its reuire" level of
inventories an" receiva5les 5ecause of operating
changes .such as changes in pro"uct lines or cre"it
terms0 or the use of financing techniues that remove
these assets from the 5alance sheet.
11.{!}a. 8he first step is to match the items from the in"irect
cash flo6 statement 6ith their correspon"ing items on
the income statement as 5elo6.
1

'n0ire(t Metho0 St*tement 'n /ire(t Metho0 St*tement
o..set to: Net income ) 111
;0D7stments to in(ome
%epreciation */, %epreciation e:pense
%eferre" ta: 2* 8a: e:pense
#estructuring .see Note A0 A4 #estructuring e:pense
In COIS 1.A Cost of pro"ucts sol"
Pension cre"it .A40 Selling- research etcS
Asset sale gains .1/0 Other income
Currency .gains0 losses 2.3 Other income
Other 2./ Other income
EorFing (*8it*l (h*nges
#eceiva5les .11.10 Sales
Inventories *1.3 Cost of pro"ucts sol"
Prepai" e:penses etc. .1.10 Selling- research etc
Accounts paya5le *1./ Cost of pro"ucts sol"
Income ta: .4.A0 8a:es pai"
Cash from operations ) 111.3
S It is possi5le the pension cre"it may also 5e inclu"e" in
Pcost of pro"ucts sol".Q
1
As a result of this matching- "epreciation e:pense an" restructuring e:pense
offset an" are eliminate" from the "irect metho" cash flo6 statement.
2922
7est%aco Direct 2ethod Cash Flow Statement
Sales ) *-/,*
Change in accounts receiva5le .110
Cash collections ( ,*,1
Cost of pro"ucts sol" .1-4A,0
Change in inventories *+
Change in accounts paya5le an" other accrue" e:penses *+
Inventory 6rite "o6n .restructuring0 *
Cash paid for inputs (01,4151
Selling- research an" a"ministrative e:penses .*210
Change in prepai" e:penses .10
Pension cre"it .A40
A"7ustment for interest an" ta:esS .110
Cash e:penses ( 03+1
Interest e:pense .1*20
A"7ustment to interest pai" .Note =0S 11
'nterest paid ( 0111
8a: e:pense .2A0
%eferre" ta: 2*
Change in income ta: paya5le .1,0
A"7ustment to ta: pai" .Note =0S 2
'ncome ta:es paid ( 011
"therCC 15
Cash from operations ( )1
S In Note =- Destvaco provi"es .as reuire" 5y S&AS 4+0 the
amount of interest an" income ta: pai". Our calculations must 5e
a"7uste" to reconcile 6ith these amounts. De have applie" the
a"7ustment to cash e:penses- although it is possi5le that it
shoul" 5e applie" to cash pai" for inputs
SS Other income of )*4 from income statement less .from in"irect
cash flo6 statement0 gains on asset sales )1/- plus currency
losses of )2.3 an" PotherQ of )2./. G*4 T 1/ J 2.3 J 2./ ? 1/0
2921
5. 8here are limite" insights availa5le from a single
year<s "irect metho" cash flo6 statement. =o6ever- 6e
can compare some cash flo6 relationships 6ith their
income statement analogues>
COIS to sales A,.2
Cash inputs to cash collections 34.+C
Selling- research- an" a"min. e:pense to sales /.2C
Cash e:penses to cash collections 11./C
8he secon" set of ratios sho6s the more significant
"ifference. Destvaco<s cash e:penses as a C of cash
collections are much higher than the income statement
relationships. 8he e:planation .see chapter 1*0 is
that Destvaco ha" a large noncash pension cre"it-
6hich re"uce" net e:penses.
c. 8he company increase" C&O .from )241 million in 144A
to )+/2 million in *,,,0 an" su5stantially re"uce" its
capital e:pen"itures .see note =0 from )3*1 million in
144A to )**4 million in 1444- generating the free cash
flo6 nee"e" to ma$e acuisitions. A""itional "ata use"
in &igure 291 tells the same story>
1##7 1##8 1### 2%%%
C&O )241 )1,A )112 )+/2
&C&1 *,/ .40 *,A 234
&C&* *,* .40 1/2 ./4*0
&C&1 ? C&O T net capital e:pen"itures
&C&* ? C&O T C&I .6here C&I ? capital e:pen"itures plus cash
flo6s for acuisitions an" from "ivestitures0
8he company 5orro6e" fun"s in 144A 5ut re"uce" that
"e5t in 144/ an" 1444E outflo6s for "ivi"en"s are
lo6er 5ut not significantly so. 8hus- Destvaco use"
higher C&O an" 5orro6ing- com5ine" 6ith lo6er capital
e:pen"itures- to finance its *,,, acuisitions.
292+
1*.{@}a. <ertz Corp9 0( millions1
1#8# 1##% 1##1
#eporte" cash from operations
A"" 5ac$> purchases of euipment
Su5tract> sales of euipment
A"7uste" cash from operations
) .11A0
2-,,2
.*-2+10
) +2*
) 4*
1-,*1
.2-1210
) 3/*
) */3
1-,13
.2-A/10
) +1/
5. As reporte"- cash flo6 from operations sho6s stea"y
improvement over the perio" 14/4 9 1441- changing from
a negative to a positive amount. After a"7ustment- the
tren" is eliminate"E cash flo6 from operations is
lo6er in 1441 than in either 14/4 or 144,. 8he
improvement in reporte" cash flo6 from operations 6as
the result of re"ucing =ertL;s net investment in
rental euipment.
c.
1#8# 1##% 1##1
#eporte" cash flo6 for investing
Su5tract> purchases of euipment
A"" 5ac$> sales of euipment
A"7uste" cash flo6 for investing
) .1220
.2-,,20
*-2+1
) .A/*0
) .A40
.1-,*10
2-121
) .3340
) .A*0
.1-,130
2-A/1
) .2,10
". #eporte" cash flo6 for investing sho6s little change
over the three9year perio". After reclassification of
euipment purchases an" sales- cash flo6 for investing
"rops 5y more than half in 1441. After
reclassification it reflects the sharp "rop in net car
an" truc$ purchases in that year.
e. &ree cash flo6 can 5e "efine" as cash flo6 from
operations less investment reuire" to maintain
pro"uctive capacity. If 6e assume that =ertL;s
investments are solely to maintain e:isting capacity-
then free cash flo6 euals cash flo6 from operations
less cash flo6 for investing>
1#8# 1##% 1##1
#eporte" cash from operations
!ess> reporte" cash for investing
Euals> free cash flo6
) .11A0
.1220
) .*+,0
) 4*
.A40
) 12
) */3
.A*0
) *11
2923
292A
Note that reclassification of purchases an" sales of
revenue euipment has no effect on free cash flo6>
1#8# 1##% 1##1
A"7uste" cash from operations
!ess> a"7uste" cash for investing
Euals> free cash flo6
) +2*
.A/*0
) .*+,0
) 3/*
.3340
) 12
) +1/
.2,10
) *11
8hus 5y "efining free cash flo6 in a manner 6hich
su5tracts out all e:pen"itures reuire" to maintain
the operating capacity of the firm- 6hether
capitaliLe" or not an" regar"less of classification-
the effects of accounting an" reporting "ifferences
can 5e overcome. 8his solution reuires- of course-
the i"entification of the amounts of such items.
f. Dhen euipment is purchase"- the full amount is
reporte" as an operating cash outflo6. &or lease"
euipment- only the perio"ic lease payments are
reporte" as operating cash outflo6s. 8hus- for =ertL-
leasing increases reporte" cash flo6 from operations.
g. Dhen euipment purchases are classifie" as investing
cash flo6s- then leasing re"uces operating cash flo6s
relative to purchases. 8hat is 5ecause the outflo6
connecte" 6ith purchases .or any other capitaliLe"
e:pen"iture0 is never classifie" as an operating
outflo6. GSee Chapter 11 for a "etaile" analysis of
this issue.H
292/
12.{@}a.
#epsol S&AS 4+ Statement of Cash &lo6s
V @illions >e*rs en0e0 12,31
1##8 1###
O8er*ting *(tivities:
&un"s from operationsS *-1+, 2-1/*
Su5si"ies an" other revenues 4* A1
Net assets from consoli"ation .130 .+*,0
Change in 6or$ing capital /2, 1-414
Cash from operatin# acti%ities 3,!+, *,,5+
'nvesting *(tivities:
Investments in property .1-A*20 .*-32,0
Acuisitions .14A0 .11-*AA0
Other investments .*4A0 ./,10
%isposal of property 111 A3A
%isposal of investments 113 1+*
@inority interests 11 *+
Cash from in%estin# acti%ities 01,4*41 01,,*,*1
1in*n(ing *(tivities:
!oans receive" +11 1*-41*
Other long9term "e5t 11 *2
%ivi"en"s pai" .+1A0 .+3A0
Shares issue" +-33+
%e5t repai" or reclassifie" .1-1440 ./-*3A0
Cash from financin# acti%ities 01,1,11 4,*4,
-et chan#e 05)1 *1)
-et effect of currenc. chan#es 05)1 *1)
Assumptions>
1. Su5si"ies an" other revenues are sho6n as a component
of cash flo6s from operating activities 5ecause they
inclu"e revenues an" cash .su5si"ies0 presuma5ly
receive" from the government. De have assume" .an" it
appears so from "ata provi"e"0 that this item 6as not
inclu"e" in income .part of fun"s from operations0.
*. Net assets from consoli"ation are "efine" .else6here
in #epsol<s financial statements T not provi"e" in the
pro5lem0 as non9cash items resulting from accounting
"ifferences 6ithin the consoli"ate" group. 8hese are
sho6n as a component of cash from operating activities
to offset any items inclu"e" in income.
2924
Note that #epsol<s statement of sources an"
applications of fun"s "oes not sho6 the change in
cash. 8he net change in cash in the ta5le a5ove
reflects all changes e:cept the effect of currency
changes. If 6e separate out the actual change in cash
an" euivalents .3+ in 144/- *4A in 14440 6e can
pro"uce a statement that is similar to the FS IAAP
format>
V @illions 1##8 1###
Cash from operating activities 2-,+3 A-3/+
Plus> increase in cash an" euivalents 3+ *4A
$dDusted cash from operatin# acti%ities 3,11 *,45
Cash from in%estin# acti%ities 01,4*41 01,,*,*1
Cash from financin# acti%ities 01,1,11 4,*4,
-et effect of currenc. chan#es 5) 0*1)1
Chan#e in cash and eEui%alents ,+ 4*
5. A sources an" uses statement "oes not recogniLe
"ifferences among operating- investing- an" financing
activities. S&AS 4+ reuires grouping of similar
transactions in these three categories. Separate
"isclosure of the cash conseuences of operating
activities facilitates .10 an evaluation of the
earnings an" cash generating a5ility of the firm- .*0
the uality of revenue an" e:pense recognition
principles use" to prepare the financial statements-
an" .20 the computation of free cash flo6s.

Separate "isclosure of investing activities permits an
assessment of capital e:pen"itures- gro6th- an"
investments in other entities. Information a5out
financing activities sho6s ho6 the company finances
its capital nee"s an" "ivi"en" payments. Although the
sources an" uses format provi"es these "ata .an" in
gross form as reuire" 5y S&AS 4+0 for investing an"
financing activities- it "oes not provi"e the
"isclosure 5y categoryE In contrast- S&AS 4+
facilitates the analysis of free cash flo6s an" other
analytical measures.

c. Separate "isclosure of the components of .10 the change
in 6or$ing capital accounts- .*0 non9cash income an"
291,
e:pense- .20 net assets from consoli"ation- .10
6hether any restructuring charges are inclu"e" an"
6here they 6ere reporte"- an" .+0 "e5t repai" or
reclassifie" 6oul" 5e useful.
". 8he total source of fun"s .an" year9to9year changes in
that measure0 is useless as a measure of liui"ity.
Cash from operations- 6hich aggregates cash inflo6s
an" outflo6s 5y type of activity- is far more useful.
=o6ever- C&O .li$e any P5ottom lineQ0 cannot 5e use"
6ithout un"erstan"ing the source of its changes. 8he
follo6ing ta5le sho6s the components of C&O>
#epsol Cash from Operations .V @illions0
>e*rs en0e0 12,31 1##8 1### /i..eren(e
O8er*ting *(tivities:
&un"s from operationsS *-1+, 2-1/* 1-,2*
Su5si"ies an" other revenues 4* A1 .1/0
Net assets from consoli"ation .130 .+*,0 .+,10
Change in 6or$ing capital /2, 1-414 1-114
Cash from operations 2-,+3 A-3/+ 1-3*4
At first glance- the 1444 increase in C&O suggests an
improvement in liui"ity. 8he increase is primarily
"ue to the change in 6or$ing capital .1-114 of the
total change of 1-3*40 an" secon"arily the increase in
fun"s from operations .1-,2* of the total change of
1-3*40. De nee" to $no6 6hether the change is the
continuation of a tren" or a reversal. It 6oul" help
to have the components of fun"s from operations an"
the changes in 6or$ing capital to evaluate the
sustaina5ility of the increases. &or e:ample- "i" the
company securitiLe receiva5les- accelerating cash
collectionsM =as the company "elaye" payments to
suppliersM =as it re"uce" pro"uction- "ecreasing
outflo6s for pro"uction costsM
e. .i0 In its Statement of the Source an" Application of
&un"s- #epsol reports the net effect of currency
changes as a use .application0 of fun"s. S&AS 4+
reuires separate .i.e.- not as a component of
operating- investing- an" financing cash flo6s0
reporting of these effects.
.ii0 8he net effect of currency changes reflects the
aggregate impact of translating the assets an"
lia5ilities of foreign operations. 'ecause it is
2911
represents e:change rate changes rather than
actual cash conseuences- the S&AS 4+ treatment
is 5etter an" in general- the amount shoul" not
influence valuation an" investment "ecisions.
=o6ever- see Chapter 1+ for a""itional "iscussion
of this issue.
291*
11.{!}a. *,,1 %irect @etho" Statement of Cash &lo6s
Sales ) /-,,,
Change in accounts receiva5le .1+,0
Cash collections ( *,5+!
Cost of goo"s sol" .+-,,,0
Change in inventories .13+0
Change in accounts paya5le *1+
Cash inputs (0),4+!1
SIKA .*-,,,0
Change in prepai" e:penses .*+0
Severance payments .*+0
Cash e:penses (0,!+!1
'nterest e:pense F paid 01+!1
Cash flow from operations ( *!!
5. 8he a"7uste" income statements are presente" 5elo6.
After a"7ustment- .recurring0 net income sho6s a
"ecline" in *,,1 in contrast to the reporte" increase
in the financial statements.
'n(ome St*tement 2%%% 2%%1
Sales )A-1,, )/-,,,
COIS .1-*,,0 .+-,,,0
SIKA .1-3A+0 .*-,,,0
%epreciation .*+,0 .*+,0
Interest e:pense .1+,0 .1+,0
-et income ( 5+ ( ,!!
&ote> 8he year *,,, income statement e:clu"es the
restructuring charge of )1*+ .)1,, has 5een a""e" to
COIS for the inventory 6rite9"o6n an" )*+ to SIKA for
the severance payment0. 8he *,,1 gain on sale of a
"ivision has 5een eliminate" from the computation of
net income.
2912
c. Comparison of *,,, to *,,1 change in accrual95ase"
items to the change in their cash analogs .after
removal of nonrecurring items0>
2%%% 2%%1 @ (h*nge
Sales )A-1,, )/-,,, 1*.3/C
Cash collections A-,,, A-/+, 1*.11C
Cash collectionsBsales ,.4/3 ,.4/1
Cost of goo"s sol" .1-*,,0 .+-,,,0 14.,+C
Cash inputs .1-1,,0 .1-4+,0 *,.A2C
Cash inputsBCOIS ,.4A3 ,.44,
SIKA .1-3A+0 .*-,,,0 14.1,C
Cash e:penses .1-A+,0 .*-,*+0 1+.A1C
Cash e:pensesBSIKA 1.,1+ 1.,12
8he changes in sales e:cee" their cash analog- cash
collections- 5ut only marginally.
Cash inputs are higher than amounts recor"e" as
e:pense T li$ely "ue to "elaye" recognition of
e:penses an"Bor accumulation of inventories "ue to
"eclining uality of or "eman" for pro"ucts. Again-
ho6ever the "ifference in the changes is not
significant- SIKA e:pense is higher on an accrual9
5asisE li$ely "ue to payment in *,,, of prior accruals
or prepayment of *,,1 e:penses.
". 8he "ecline in C&O can 5e a function of
1. changes in the timing of cash collections
."is5ursements0 relative to the income .e:pense0
components
*. lo6er income .after a"7usting for the
nonrecurring nonoperating events0
De uantify 5oth effects 5elo6.
2))e't o) 'hanges in the timing o) 'ash 'olle'tions
(disbursements) relati$e to in'ome (expense)
'omponents
Effect of change in cash collectionsBsales
.,.4/19,.4/30 : )/-,,, ? ).1,0
Effect of change in cash inputsBCOIS
.,.44,9,.4A30 : ).+-,,,0 ? .A,0
2911
Effect of change in cash e:pensesBSIKA
.1.,1291.,1+0 : ).*-,,,0 ? 31
-et effect (0),1
As note" in part c. the "ifferences 5et6een the income
an" cash flo6 counterparts are relatively small. 8hus
these "ifferences "i" not contri5ute significantly to
the "rop in C&O- contri5uting only )13 out of the )2,,
"ecline.
8he remaining "ecline 6as "ue to the "rop in income
an" can 5e calculate" as
2))e't o) 'hanges in re$enue and expense on C65
Change in sales>,.4/3 : G)/-,,, 9 )A-1,,H ? ) //A
Change in COIS> ,.4A3 : G.+-,,,0 T .1-*,,0H ? .A/10
Change in SIKA> 1.,1+ : G.*-,,,0 T .1-3A+0H ? .21,0
-et effect (03)1
8he "ecline in C&O 6as )2,,. @ost of the effect .)*210
6as cause" 5y a "rop in income. In spite of the fact
that revenues increase"- e:penses gre6 at a faster
rate. .#evenue gre6 at a rate of 1*.AC 6hereas
e:penses gre6 at a rate of almost *,C0.
*

e. Nonrecurring charges 6ill not contri5ute to future
earnings an" cash generating a5ility- that is- they "o
not contri5ute to value an" shoul" 5e e:clu"e" for
valuation purposes.
*
8he C&O "ecline of )2,, can 5e reconcile" as follo6s>
Effect of changes in timing ). 130
Income effect .*210
Nonrecurring severance payment .*+0
).2,+0
8he "ifference of )+ is "ue to roun"ing errors. If the calculations 6ere "one
6ith the cashBincome ratios ta$en to four or five "ecimal places then the
timing effect 6oul" 5e .1*0 an" the income effect 6oul" 5e .*220.
291+
1+.{!}a. !!1 Direct 2ethod Cash Flow Statement
Sales )A-1,2
Change in accounts receiva5le .12/0
Cash collections (,,4,+
Cost of goo"s sol" .1-*4+0
Inventories .1110
Accounts paya5le 1+
#estructuring charge 1,2
Cash inputs 0(),411
SIKASS ).1-A1*0
Prepai" e:penses .1A0
#estructuring charge **
Cash e:penses (01,*3*1
'nterest e:pense F paid 01),1
Cash flow from operations (*41
5. 8he a"7uste" income statements are presente" 5elo6.
After a"7ustment- .recurring0 net income sho6s a
"ecline" in *,,1 in contrast to the reporte" increase
in the financial statements.
'n(ome St*tements 2%%% 2%%1
Sales )A-1,2 )A-,1A
COIS .1-14*0 .1-1**0
SIKA .1-34,0 .1-A*10
%epreciation .*2+0 .*3,0
Interest e:pense .113 0 .1140
-et income ( 5)! ( *4
2913
c. Comparison of *,,, to *,,1 change in accrual95ase"
items to the change in their cash analogs .after
removal of nonrecurring items0>
2%%% 2%%1 @ (h*nge
Sales )A-1,2 )A-,1A 9,.A4C
Cash collections 3-43+ A-1/* 2.1*C
Cash collectionsBsales ,.4/1 1.,14
Cost of goo"s sol" ).1-14*0).1-1**0 91.3AC
Cash inputs .1-*410 .1-,4A0 91.+*C
Cash inputsBCOIS 1.,*1 ,.441
SIKAS ).1-34,0).1-A*10 *.,1C
Cash e:penses .1-A2A0 .1-3210 9+.42C
Cash e:pensesBSIKA 1.,*/ ,.41/
8he changes in sales are lo6er than their cash analog-
cash collections- 5ecause of higher collections- i.e.-
a "ecrease in receiva5les T in"icating more
conservative revenue recognition relative to cash
receipts an"Bor more efficient collection proce"ures
in *,,1.
Cash inputs "ecline" more than compara5le amounts
recor"e" as e:pense T li$ely "ue to "elaye"
recognition of e:penses an"Bor prior accumulation of
inventories "ue to "eclining uality of or "eman" for
pro"ucts in *,,,.
Similarly cash SIKA e:pense fell in *,,1 "espite an
increase in SIKA itselfE possi5ly 5ecause of a "ecline
in prepai" e:penses or an increase in accruals.
8he improvements in efficiency of cash relative to
income is reflecte" in the cashBincome ratios as each
one improve" .i.e. increase" for cashBrevenue an"
"ecline" in cashBe:penses T see part ".0
". As income "ecline" .after a"7usting for the
nonrecurring nonoperating events0 the increase in C&O
must 5e a function solely of changes in the timing of
cash collections ."is5ursements0 relative to the
income .e:pense0 components
291A
2))e't o) 'hanges in the timing o) 'ash 'olle'tions
(disbursements) relati$e to in'ome (expense)
'omponents
Effect of change in cash collectionsBsales
.1.,149,.4/10 : )A-,1A ? *3/
Effect of change in cash inputsBCOIS
.,.44191.,*10 : ).1-1**0 ? 1*1
Effect of change in cash e:pensesBSIKA
.,.41/91.,*/0 : ).1-A*10 ? 12/
-et effect +3!
8he overall increase in C&O 6as .1-*/,9A41?0 )1/4. 8he
increase 6as solely "ue to more effective cash
management techniues 6ith improve" collections
accounting for more than half of the improvement.
2
A""itionally- the company 6as a5le to control its cash
payments for inventory an" SIKA. Although reporte"
income increase"- income 6as not a contri5uting factor
to the increase" C&O. If anything income has a
negative impact on C&O as after removing nonrecurring
an" nonoperating events income "ecline".
e. Nonrecurring charges 6ill not contri5ute to future
earnings an" cash generating a5ility- that is- they "o
not contri5ute to value an" shoul" 5e e:clu"e" for
valuation purposes.
2
Of the )11 "ifference 5et6een )+2, an" )1/4- )** is "ue to severance pay an"
)1/ is "ue to "eclining income. 8he )1/ amount can 5e calculate" 5y follo6ing
the proce"ure use" in pro5lem 2911 part ".
291/
13.{S}a. %irect @etho" Statement of Cash &lo6s for (ear *
Sales )1*-,,,
Change in accounts receiva5le .*1,0
Cash collections (11,*,!
Cost of goo"s sol" .A-1,,0
Change in Inventories .*,,0
Change in Accounts paya5le .*1,0
Cash inputs 0(*,+)!1
SIKA .2-A,,0
%epreciation 1-,,,
Accrue" lia5ilities .*+0
Cash e:penses 0(,*+1
'nterest e:pense F paid 0(3!!1
Cash flow from operations (1,14+
5. 8he comparison of the income statement components 6ith
their cash flo6 counterparts is presente" 5elo6.
>e*r 1 >e*r 2 @ (h*nge
Sales )1,-,,, )1*-,,, *,.,C
Cash collections )4-/,, )11-A3, *,.,C
Cash collectionsBsales ,.4/ ,.4/
Cost of goo"s sol" .3-,,,0 .A-1,,0 1/.2C
Cash inputs .+-/,,0 .A-+1,0 2,.,C
Cash inputsBCOIS ,.4A 1.,3
SIKAS .*-,,,0 .*-A,,0 2+.,C
Cash e:penses .*-,,,0 .*-A*+0 23.2C
Cash e:pensesBSIKA 1.,, 1.,1
Interest e:pense .2,,0 .2,,0 ,.,C
Interest pai" .*A+0 .2,,0 4.1C
Interest pai"BInterest e:pense ,.4* 1.,,
S A"7uste" for "epreciation e:pense an" assuming "epreciation is
euivalent in 5oth years.
&rom the "ata it is apparent that payments for inventory
ha" the 5iggest impact on C&O. Although COIS only increase"
5y 1/.2C- payments for inventory increase" 2,C. 8he cash
inputsBCOIS ratio increase" 5y .,4 .from ,.4A to 1.,30.
8his increase of 4C translates .5ase" on COIS of )A-1,,0 to
an increase" cash outflo6 of )324 accounting for the
"ecrease in C&O
1
as the effects of the cashBincome
1
8he actual "ecrease in C&O 6as only )+2, as the )324 outflo6
6as offset 5y increases in C&O resulting from higher income.
2914
relationships of the other income statement components is
small.
29+,