Bad5shah

When calculating cash flow from operations (CFO) using the indirect method which of the following is most accurate?

A) The indirect method requires an additional schedule to reconcile net income to cash flow.

B) In using the indirect method, each item on the income statement is converted to its cash equivalent.

C) When recognizing a gain on the sale of fixed assets, the amount is a deduction to operating cash flows.

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When recognizing a gain on the sale of fixed assets, the amount is a deduction to operating cash flows. This is because the gain would be double counted in the investing section and in net income. Therefore, the gain must be removed from net income. The direct method of cash flow calculation converts the income statement items to their cash equivalents, not the indirect method. Also, depreciation is added to net income in order to calculate CFO using the indirect method.

Bad5shah

A company has the following changes in its balance sheet accounts:

Net Sales	$500
An increase in accounts receivable	20
A decrease in accounts payable	40
An increase in inventory	30
Sale of common stock	100
Repayment of debt	10
Depreciation	2
Net Income	100
Interest expense on debt	5

The company’s cash flow from financing is:

A) $100.

B) $90.

C) -$10.

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Sale of common stock	$100
Repayment of debt	(10)
Financing cash flows	$ 90

Bad5shah

Which of the following statements about accounting procedures and their impact on the statement of cash flows is least valid? All else equal:

A) A nonprofitable company that uses LIFO to account for inventory will have higher total cash flow than a nonprofitable company that uses FIFO during a period of rising prices.

B) Cash flow from financing (CFF) is higher over the life of a bond if a firm issues the bond at a premium, compared to issuing the bond at par.

C) A company that finances through common stock issues may have the same cash flow from financing (CFF) as a firm that issues debt.

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Because of the impact of income taxes, a profitable company that accounts for inventory using LIFO will have higher total cash flow than a profitable company that uses FIFO. The company that uses LIFO will have higher cost of goods sold, resulting in lower net income and thus lower taxes. The other statements are accurate:

• A company that issues common stock is not required to pay dividends (which would reduce cash flow from financing). Thus, it may have the same CFF as a firm that issues debt since interest paid on debt is a component of CFO.
• When a company issues bonds at a premium, the proceeds raised at issuance (CFF inflow) are greater than the par value repaid at maturity (CFF outflow). For bonds issued at par, the CFF inflow at issuance is equal to the CFF outflow at maturity.

Bad5shah

The net income for Miller Bat Company was $3 million for the year ended December 31, 2004. Additional information is as follows:

• Depreciation on fixed assets $1,500,000

• Gain from cash sales of land 200,000

• Increase in accounts payable 300,000

• Dividends paid on preferred stock 400,000

The net cash provided by operating activities in the statement of cash flows for the year ended December 31, 2004 is:

A) $4,800,000.

B) $4,600,000.

C) $4,200,000.

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$3,000,000 + $1,500,000 − $200,000 + $300,000 = $4,600,000.

Bad5shah

Galaxy, Inc.’s U.S. GAAP balance sheet as of December 31, 2004 included the following information (in $):

	12-31-03	12-31-04
Accounts Payable	300,000	500,000
Dividends Payable	200,000	300,000
Common Stock	1,000,000	1,000,000
Retained Earnings	700,000	1,000,000

Galaxy’s net income in 2004 was $800,000. What was Galaxy’s cash flow from financing (CFF) in 2004?

A) -$300,000.

B) -$500,000.

C) -$400,000.

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Dividends declared in 2004 are net income less the increase in retained earnings ($800,000 - $300,000 = $500,000). Dividends declared less the increase in dividends payable is dividends paid ($500,000 – ($300,000 - $200,000) = $400,000). This is a cash outflow so it is a negative number. Dividends paid are always cash flow from financing under U.S. GAAP. Note that accounts payable changes are included in cash flow from operations (CFO).

Bad5shah

Determine the cash flow from investing given the following table:

Item	Amount
Cash payment of dividends	$30
Sale of equipment	$25
Net income	$25
Purchase of land	$15
Increase in accounts payable	$20
Sale of preferred stock	$25
Increase in deferred taxes	$5

A) -$5.

B) -$10.

C) $10.

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Item		Amount
Cash payment of dividends	CFF	-$30
Sale of equipment	CFI	+$25
Net income	CFO	+$25
Purchase of land	CFI	-$15
Increase in accounts payable	CFO	+$20
Sale of preferred stock	CFF	+$25
Increase in deferred taxes	CFO	+$5

CFI = Sale of Equipment (+25) + Purchase of Land (–15) = $10.

Bad5shah

Which of the following statements regarding depreciation expense in the cash flow statements is CORRECT? Depreciation is added back to net income when determining CFO using:

A) either the direct or indirect methods.

B) the indirect method.

C) the direct method.

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Depreciation is a non-cash expense. Only in the indirect method is depreciation added back to net income when determining CFO because net income is only used in the indirect method and not the direct method. The direct method instead starts with cash sales and works down the income statement.

Bad5shah

Juniper Corp. has the following transactions in 2005.

• Juniper’s equipment with a book value of $55,000 was sold for $85,000 cash.
• 
  A parcel of land was purchased for $100,000 worth of Juniper common stock.
• 
  ABC company paid Juniper preferred dividends of $40,000.
• 
  Juniper declared and paid a $100,000 cash dividend.

Using the indirect method, what is cash flow from financing (CFF) for Juniper for 2005?

A) -$60,000.

B) -$100,000.

C) -$15,000.

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The only item involving cash flow from financing (CFF) was the payment of a cash dividend by Juniper. The sale of equipment affects cash flow from investing (CFI), the purchase of land has no effect on cash, and the preferred dividends received are cash flow from operations.

Bad5shah

Selected information from Rockway, Inc.’s U.S. GAAP financial statements for the year ended December 31, included the following (in $):

	2004	2005
Sales	17,000,000	21,000,000
Cost of Goods Sold	11,000,000	15,000,000
Interest Paid	800,000	1,000,000
Current Income Taxes Paid	700,000	1,000,000
Accounts Receivable	3,000,000	2,500,000
Inventory	2,400,000	3,000,000
Property, Plant & Equip.	2,000,000	16,000,000
Accounts Payable	1,000,000	1,400,000
Long-term Debt	8,000,000	9,000,000
Common Stock	4,000,000	5,000,000

Using the direct method, cash provided or used by operating activities(CFO) in the year 2005 was:

A) $6,300,000.

B) $4,300,000.

C) $5,300,000.

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Cash provided or used by operating activities under the direct method is computed by adding cash inflows and subtracting cash inputs and cash outflows. Operating Cash inflows for Rockway Inc. for 2005 came from sales ($21,000,000) and decrease in accounts receivable ($3,000,000 − $2,500,000 = $500,000) for net cash inflows of ($21,000,000 + $500,000 =) $21,500,000. Operating cash inputs were cost of goods sold ($15,000,000), plus the increase in inventory ($3,000,000 − $2,400,000 = $600,000) less the increase in accounts payable, (which is a source of funds) ($1,000,000 − $1,400,000 = -$400,000) for net cash inputs of ($15,000,000 + $600,000 - $400,000 =) $15,200,000. Other operating cash outflows were interest paid ($1,000,000) and current income taxes paid ($1,000,000) totaling ($2,000,000). Cash provided by operations was ($21,500,000 − $15,200,000 − $2,000,000 =) $4,300,000. Changes in property, plant and equipment, long-term debt and common stock do not affect cash from operations.

Bad5shah

John Stone, CFA, is an investment advisor specializing in the preparation of company and industry reports for high net worth customers at Learmon Brothers. Currently, Stone is preparing a report on Soft Corporation, a rapidly growing software company. The explosive growth of this company was financed primarily by an initial public offering in which 3,000,000 shares were issued at a price of $20 per share on June 27, 2004. Soft Corporation received additional capital when employee stock options for 1,000,000 shares at a price of $10 were exercised on January 1, 2005. Stone realizes the importance of cash flow on a company's financial health and would like to include a projected statement of cash flows for 2005. Soft Corporation financial statements are presented in Tables 1 and 2. Included are the actual statements for the year ending December 31, 2004.

Table 1
Soft Corporation Balance Sheets
as of December 31
(in millions)
		Actual 2004	Projected 2005
Cash		$24.0	$26.0
Accounts Receivable		17.0	24.0
Inventory		100.0	150.0
PP&E		100.0	125.0
Accumulated depreciation		(30.0)	(35.0)
	Total Assets	$211.0	$290.0
Accounts payable		$91.0	$101.0
Long-term debt		20.0	40.0
Common stock		80.0	90.0
Retained earnings		20.0	59.0
	Total liabilities and equity	$211.0	$290.0

Table 2
Soft Corporation Income Statement
for Years Ended December 31
(in millions except per share data)
		Actual 2004	Projected 2005
Sales		$80.0	$198.0
COGS		(38.0)	(90.0)
	Gross profit	$42.0	$108.0
SG&A		(13.0)	(30.0)
Depreciation		(3.0)	(5.0)
	Operating expenses	$(16.0)	$(35.0)
Interest expense		$(4.0)	$(5.0)
Pretax Income		22.0	68.0
Income tax expense		(7.0)	(25.0)
Net income		$15.0	$43.0
EPS		$2.0	$4.3
Average shares outstanding (millions)		7.5	10.0
Dividends per share		$0.1	$0.4

Under the indirect method, what will Stone find Soft Corporation's projected net change in cash to be for the year ending December 31, 2005?

A) $2,000,000.

B) $9,000,000.

C) $4,000,000.

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Using the easiest method of all, the difference in the cash account at the end of 2004 and the cash balance projected for the end of 2005 is $26.0 million - $24.0 million = $2.0 million. If the cash balances were not available, the change in cash could be calculated using the indirect method. Starting with cash flow from operations (CFO) in $ millions projected for 2005:

Net Income	43
Add: Noncash Expenses or Losses
Depreciation	5
Add: Changes in Current Assets and Liabilities
Less: Increase in Accounts Receivable	-7
Less: Increase in Inventory	-50
Plus: Increase in Accounts Payable	10
Net Cash Flow from Operations (CFO)	1
Increase in Property Plant & Equipment	-25
Net Cash Flow from Investing (CFI)	-25
Increase in Long-Term Debt	20
Increase in Common Stock	10
Less: Dividends Paid (10 million × $0.40)	- 4
Net Cash Flow from Financing (CFF)	26

Net Cash Flow = CFO + CFI + CFF = 1 – 25 + 26 = $2 million.