Chapter 3 Income Statement

Question 1

Statement of Cash Flow

Answer 1

The purpose of the statement of cash flow is to provide a user of the financial statements with important information about how the company manages its cash

• Simplest level, merely tells the reader how much the company’s cash balance changed during the period
• Sophisticated Level - reveals just where a businesses cash came from and how it was used

Question 2

Three activity categories that summarize a firms inflows and outflows of cash

Answer 2

1) Cash Flow from Operating activities
2) Cash Flow from investing activities
3) Cash Flow from financing activities

Question 3

Cash Flow from Operating activities

CFFO

Answer 3

Represents the aggregate of the cash received from the sale of goods and services less the cash spent on operating expenses

Question 4

Cash Flow from investing activities

CFFI

Answer 4

Represents the aggregate of the cash received from the ale of investments, property and equipment and intangible assets less the cash spent to acquire these various types of assets

Question 5

Cash Flow from financing activities

CFFF

Answer 5

Represents the aggregate of the cash received from the sale of debt and equity securities less the cash paid to retire debt, repurchase equity securities or pay dividends to shareholders

Question 6

There are two formats available under the GAAP to present the Statement of cash flow

Answer 6

1) Direct Method

2) Indirect Method

Question 7

Direct Method

Answer 7

Cash flow from operations is computed directly from the company’s cash transactions

Question 8

Indirect Method

Answer 8

A company computes its cash flow from operations by making various adjustments to convert its accrual-based net income to its cash flow from operations
- The objective of tis approach is to provide the user of the statement with critical information about why the firms net income did or did not translate into cash generation

Question 9

Computing Cash Flow Under the Indirect Method

Answer 9

1) Assets (A) = Liabilities (L) + Shareholders Equity (SE)
2) Cash + Noncash Assets (NCA) = L + SE
3) ΔCash+ΔNCA = ΔL + ΔSE
4) ΔCash = ΔL - ΔNCA + ΔSE

Δ = Difference between two balance sheets

Question 10

Five Steps to Cash Flow

Indirect Method

Answer 10

1) Calculate the change in all balance sheets
2) Classify each account into one of the three cash flow categories
3) Prepare a preliminary statement of cash flow
4) Integrate the income statement data
5) Remove nonrecurring and/or nonoperating effects from net income

Question 11

1) Calculate the change in all balance sheets
Five Steps to Cash Flow
(Indirect Method)

Answer 11

Using just the beginning and ending balance sheets, calculate the change in each balance sheet account. To verify the accuracy of the step one calculation, simply compare the sum of changes in the assets account to the sum of the changes in the lability and shareholder equity account.

These totals must equal

Question 12

2) Classify each account into one of the three cash flow categories
Five Steps to Cash Flow
(Indirect Method)

Answer 12

This step involves identifying the appropriate cash-slow activity category (operating, investing or financing)

• AR, Inventory, AP and Tax Payable are operating
• Changes in the notes payable (current and non current) and common stock accounts are finance
• PPE are associated with capital investment

Question 13

3) Prepare a preliminary statement of cash flow
Five Steps to Cash Flow
(Indirect Method)

Answer 13

When preparing the indirect method, an increase in AR represents a subtraction from net income and a decline in intangible assets represents an addition to net income.

Step 3 is important to remember to reverse the sign of the change values for the asset accounts.

Question 14

4) Integrate the income statement data
Five Steps to Cash Flow
(Indirect Method)

Answer 14

Accomplish two important actions:

1) Replace the change in retained earnings from the balance sheet with the net income from the income statement
2) Adjust net income for any noncash expenses such as depreciation of PPE and the amortization of intangibles that were deducted in the process of calculating the firms accrual net income

Question 15

5) Remove nonrecurring and/or nonoperating effects from net income
Five Steps to Cash Flow
(Indirect Method)

Answer 15

Adjustments to remove any non-operating or nonrecurring gains and losses from the CFFO

Question 16

Analysis of the statement of cash flow

Performance

Answer 16

Performance is defined in terms of a company’s accrual net income, where earned revenues are matched against the expenses associated with generating that revenue whether or not associated with cash

Question 17

Operating Funds Ration

Cash Flow Ratios

Answer 17

• Indicates the portion of a company’s earnings supported by operating cash flow

Operating funds ratio = Cash Flow from Operations / Net Income

Question 18

Operating cash flow to current liabilities ratio = Cash Flow from Operations / Current Liabilities

Answer 18

This ratio provides insights about a firms liquidity, specifically the extent to which a company’s current obligations can be satisfied by operating cash flow

Operating cash flow to current liabilities ratio = Cash Flow from Operations / Current Liabilities

Question 19

Cash Conversion Ratio

Answer 19

Reveals the extent to which the sales re[orted on the income statement are converted into cash during the same accounting period

Cash Conversion Ratio = Cash from Sales / Net Sales

Question 20

Cash from Sales

Answer 20

Calculated as Net Sales minus the increase in accounts receivable plus the increase in unearned revenue

Question 21

EBITDA

Alternative Measures of Cash Flow

Answer 21

Earnings before interest, taxes, depreciation and amortization.

Thought to provide an easily calculated alternative to operating cash flow as both measures begin with net income and both measures adjust for the noncash operating expenses of depreciation and amortization

Question 22

Free Cash Flow

Alternative Measures of Cash Flow

Answer 22

Often used by analysts to evaluate a company’s cash-flow strength.

FCF is the amount of cash that could be “freely” distributed to the owners of the company or used for general corporate purposes without affecting the ongoing operations and required investments.

FCF = CFFO - CapEx

Question 23

Capital Expenditures

CapEx

Answer 23

The required reinvestment in the assets of a business necessary to enable the firm to maintain itself as a going concern.

Question 24

Discretionary Cash Flow
(DisCF)
(Alternative Measures of Cash Flow)

Answer 24

Addresses the question “How much internally generated operating cash flow is available to permit a company’s management to undertake a discretionary, value-creating action?”

DisCF = CFFO - Required debt payments - Dividend Payments

Question 25

Discretionary Cash Flow

Answer 25

Addresses the question “How much internally generated operating cash flow is available to permit a company’s management to undertake a discretionary, value-creating action?”

Question 26

Discretionary Cash Flow

DisCF

Answer 26

Addresses the question “How much internally generated operating cash flow is available to permit a company’s management to undertake a discretionary, value-creating action?”

Question 27

Earnings Persistence

Answer 27

USING HISTORICAL EARNINGS TO PREDICT FUTURE EARNINGS IS THE EXTENT TO WHICH EARNINGS RECUR OVER TIME

Question 28

Sustainable Earnings / Permanent Earnings

Answer 28

Persistence of operating earnings is closely linked to value

Question 29

Transitory Earnings

Answer 29

Include such single-period items as special items, restructuring charges, changes in accounting principle and discounted operations

Question 30

Intrinsic Value

Answer 30

Refers to the underlying economic value of a business as a going concern, that is, the value that a business could be sold for in an efficient market

Question 31

Special Item

Answer 31

Often include gains or lossses tgat are outside a firms normal operations

Question 32

Restructuring Charges

Answer 32

Associated with changing a business operations (right-sizing or down-sizing)

Question 33

Taking a bath

Answer 33

Lumping restructuring charges in years characterized by poor operating results to enhance the probability og improved performance in future years

Question 34

Change in accounting principal

Answer 34

Mandatory accounting changes occur when an accounting regulatory body, such as FASB or IASB, changes the generally accepted accounting practice

Question 35

Consistency Principle

Answer 35

Requires that a firm use the same accounting measurement principles from one fiscal period to the next

Question 36

Extraordinary Gains (Losses)

Answer 36

These were gains (losses) that were both unusual and infrequent in nature

Question 37

Discontinued Operations

Answer 37

When a company discontinues a separate business unit, it will generally incur costs to lay off employees, liquidate inventory and shutter facilities

Question 38

Basic Earnings Per Share

Answer 38

Net income (less preferred stock dividends) divided by the actual number of common shares outstanding.

Question 39

Pro Forma Earnings

Answer 39

Earnings before bad stuff

Question 40

Accrual basis income

Answer 40

It’s different from cash basis, because we make some adjustments to cash. Revenue is recognized when it’s earned