Accounting Cash Flows Essay

Question 2.2 – Accounting and Cash Flows: Why is it that the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during a period?  Financial Statements are prepared according to accrual rule of , according to which cost and revenue are recorded as they occur and not when they are actually received or paid. This is why cash flows during the year may be different from revenue and costs in income statements. Different companies use different policies to pay the costs and collect revenues in current and subsequent years. In other words, the income statement assumes that once a good is sold, it is also paid for at that exact same time. Typically collection of revenue does not happen at the same time of delivery. See more: Examples of satire in adventures of huckfinn essay As I reflect on managerial accounting, I recall that some companies only collect twenty-five percent the same month of the sale. Then, they collect the other fifty percent the month after and the final twenty-five percent two months after the sale. Question 2. 3 – Book Values versus Market Values: In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value? When comparing book value to market value it is simply what the firm paid for the item versus what the firm could sell the items on the market. Book values are used because they have a historical perspective associated with them. I understand from my readings that the book values are the â€Å"minimum† or worst case scenarios of what these items are worth. Question 2. 4 – Operating Cash Flow: In comparing accounting net income and operation cash flow, what two items do you find in net income that are not in operating cash flow? Explain what each is and why it is excluded in operating cash flow. Operating cash flow is revenues minus the costs, except for depreciation and financing interest, because neither of these is paid in cash. Cash flows are important because the cash flow reflects, basically, whether a company’s outflows of cash can meet their inflows of cash. Net income does include financing interest and depreciation, because all liabilities need to be accounted for. Question 3. 4 – Financial Ratios: Fully explain the kind of information the following financial ratios provide about the firm. Many companies use financial ratios to avoid problems with comparing companies of different sizes. A â€Å"quick ratio† is also known as â€Å"acid-test† and is an indicator of a company’s short-term liquidity. Furthermore, the quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio’s the better the position of the company. A quick ratio is calculated as follows: Quick Ratio = Current Assets – Inventory – Inventories / Current Liabilities As notes in our text, the using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. The idea is that inventory is relatively illiquid compared to cash. (Ross, Westerfield, Jordan, p. 57) A â€Å"cash ratio† equals cash divided by current liabilities. The ratio of a company’s total cash and cash equals it’s current liabilities. The cash ratio is most commonly used as a measure of company liquidity. It can determine if, and/or how quickly the company can repay its short-term debt. A strong cash ratio is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party. (Investopedia. om) Furthermore, the cash ratio is generally a more conservative look at a company’s ability to cover its liabilities than many other liquidity ratios. Mainly, due to the fact that inventory and accounts receivable are left out of the equation. Since these two accounts are a large part of many companies, this ratio should not be used in determining company value, but simply as one factor in determining liquidity. Final ly, the â€Å"capital intensity ratio† is a ratio measures the ability of a company to effectively use its assets. Simply put, capital intensity shows how much of an investment in fixed assets was required during a given period to produce $1 of sales revenue. The actual ratio formula to measure capital intensity is total assets divided by sales revenue for a specified period. One of the major problems with ratios is that different organizations and different sources often don’t compute them exactly the same way, which lead to confusion and false results. The definitions are vague and when comparing to other’s equations, you may find significant results depending on the way they are computed. Accounting: Cash Flows Essay John Stacey, a sales engineer for Aldhus Corporation, was worried. A flight delay had caused him to miss last week’s accounting class in the evening MBA program in which he had enrolled at the suggestion of the personnel director at Aldhus, a growing manufacturer of computer peripherals. The class he had missed had been devoted to a lecture and discussion of the statement of cash flows, and he was sure the material he had missed would be covered in the weekly quiz that was part of each class session. A classmate had faxed Stacey some notes distributed by their instructor, but they were too cryptic to be understood by anyone who had missed the class. In desperation, John called Lucille Barnes, the assistant controller at Aldhus, to ask if she could take a few minutes to point him in the right direction toward understanding the statement of cash flows. She seemed delighted by the request, and they agreed to meet that afternoon. op The Meeting At 2:00 P. M. John Stacey went to the office of Lucille Barnes with his notes and questions. After they had exchanged greetings, Lucille handed John three cash flow statements from the annual reports of other high-technology companies (Exhibits 1, 2, and 3). John was worried that Lucille would ask him to explain them, and that she would see how confused he still was about some aspects of accounting; instead, Lucille began explaining. Lucille Barnes (Assistant Controller): The statement of cash flows is really a very useful part of the set of three statements companies are required to prepare. In some cases, it tells more about what is actually happening in a business than either the balance sheet or income statement. The statements of cash flows that I have given you are very revealing. Let me give you a brief overview of the structure and content of cash flow statements, and then you take some time to study these statements. I have prepared some questions to guide your study. Then, we can meet again tomorrow to discuss what you have learned and to answer any questions that remain. I do not think you have to worry about your next quiz because if you understand how balance sheets and income statements are prepared, much about the statement of cash flows will seem pretty obvious. John Stacey: I hope you are right. I really like the accounting course, and I want to do well in it and to really learn the material. That’s why I panicked when I could not understand the notes our instructor passed out last week. Professors Julie H. Hertenstein and William J. Bruns prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright  © 1993 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www. hbsp. harvard. edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. Copying or posting is an infringement of copyright. Permissions@hbsp. harvard. edu or 617-783-7860. Statements of Cash Flows: Three Examples Lucille Barnes: Forget those notes for a while and just concentrate on studying the statements I have given you. Notice that the statement of cash flows is divided into three sections: operating activities, investing activities, and financing activities. Each section shows the cash inflows and the cash outflows associated with that type of activity. Operating activities shows the inflows and outflows related to the fundamental operations of the basic line or lines of business that the company is in. For example, it would include cash receipts from the sale of goods or services and the cash outflows for purchasing inventory, and paying wages, taxes and rent. Investing activities shows cash flows for the purchase and sale of assets not generally held for resale and for the making and collecting of loans. (Maybe it should more appropriately be called the investing and disinvesting activities section. ) Here is where you would see if the company sold a building, purchased equipment, made a loan to a subsidiary, or purchased a piece of equity in its supplier. Finally, financing activities shows the cash flows associated with increasing or decreasing the firm’s financing, for example, issuing or repurchasing stock and borrowing or repaying loans. It also includes dividends, which are cash flows associated with equity. However, ironically, it does not include interest payments; these are included in operating activities. John Stacey: That seems strange to me. Since loans are the reason interest payments are made, why are they not included in the financing activities section? You know, interest is to loans as dividends are to equity? Lucille Barnes: Actually in some other countries such as the United Kingdom interest is included in the financing activities section! But in the United States the Financial Accounting Standards Board voted that interest payments should be in the operating activities section instead. This is one of these situations where you might have to do some adjusting if you were trying to compare a U. K. company like British Petroleum to a U. S. company like Exxon. John Stacey: That is interesting! How can I use each section of the statement? Lucille Barnes: The operating activity section is the cash-flow engine of the company. When this engine is working effectively, it provides the cash flows to cover the cash needs of operations. In a healthy, growing company, we would expect growth in operating working capital accounts such as inventory and accounts receivable (uses of cash) as well as in accounts payable and other operating payables (sources of cash). Obviously there can be quite a bit of variability in working capital accounts from period to period, but on average inventories, receivables, and accounts payable usually grow in growing companies. In addition, this operating cash-flow engine provides cash for needed investments, to repay debt, and to pay dividends. There are exceptions, of course. Start-up companies, for example, usually have negative cash flows from operations because they have not gotten their cash-flow engines up to speed. Companies in cyclical industries may have negative operating cash flow in a â€Å"down† year; a company that has experienced an extensive strike could also be expected to have negative cash flow from operations. Although an occasional year of negative operating cash flow does not spell disaster, nonetheless, we should expect operating cash flow, on average, to be positive. Investing activities are a different story. Whereas we expect positive operating cash flow, we also expect a healthy company to continually invest in more plant, equipment, land, and other fixed assets to replace the assets that have been used up or have become technologically obsolete, as well as to expand and grow. Although companies often sell assets that are no longer of use to them, we would normally expect them to purchase more capital assets than they sell. As a result, in general, we expect negative cash flows from investing activities. Like operating activities, exceptions occur, especially if the firm divests a business or subsidiary. Copying or posting is an infringement of copyright. Permissions@hbsp. harvard. edu or 617-783-7860. Statements of Cash Flows: Three Examples Cash flows from financing activities could as easily be positive as negative in a healthy company, and they are likely to change back and forth. If the company’s need for cash to invest exceeds the cash flow generated by operating activities, this will require extra financing by debt or equity, therefore a positive financing cash flow. On the other hand, if cash flow from operating activities exceeds the investing needs, the firm will have excess cash to repay debt or pay more dividends, producing negative cash flows from financing.