764 Part Nine Financial Planning and Working Capital Management
bre44380_ch29_759-786.indd 764 10/06/15 09:53 AM
- It increased its accounts payable, in effect borrowing an additional $25 million from its
suppliers (operating activity). - It issued $30 million of long-term debt (financing activity).
Dynamic’s cash flow statement shows that it used cash for the following purposes: - It allowed accounts receivable to expand by $25 million (operating activity). In effect, it
lent this additional amount to its customers. - It invested $30 million (investing activity). This shows up as the increase in gross fixed
assets in Table 29.2. - It paid a $30 million dividend (financing activity). (Note: The $30 million increase
in Dynamic’s equity in Table 29.2 is due to retained earnings: $60 million of equity
income, less the $30 million dividend.) - It purchased $25 million of marketable securities (financing activity).
- It repaid $25 million of short-term bank debt (financing activity).^6
Look again at Table 29.3. Notice that to calculate cash flows from operating activities, we
start with net income and then make two adjustments. First, since depreciation is not a cash
outlay, we must add it back to net income.^7 Second, we need to recognize the fact that the
income statement shows sales and expenditures when they are made, rather than when cash
changes hands. For example, think of what happens when Dynamic sells goods on credit. The
company records a profit at the time of sale, but there is no cash inflow until the bills are paid.
Since there is no cash inflow, there is no change in the company’s cash balance, although
there is an increase in working capital in the form of an increase in accounts receivable. No
net addition to cash would be shown in a cash flow statement like Table 29.3. The increase
in cash from operations would be offset by an increase in accounts receivable. Later, when
the bills are paid, there is an increase in the cash balance. However, there is no further profit
at this point and no increase in working capital. The increase in the cash balance is exactly
matched by a decrease in accounts receivable.
Table 29.3 adjusts the cash flow from operating activities downward by $25 million to
reflect the additional credit that Dynamic has extended to its customers. On the other hand, in
2015 Dynamic reduced its inventories and increased the amount that is owed to its suppliers.
The cash flow from operating activities is adjusted upward to reflect these changes.
If you draw up a balance sheet at the beginning of the process, you see cash. If you delay a little,
you find the cash replaced by inventories of raw materials and, still later, by inventories of finished
goods. When the goods are sold, the inventories give way to accounts receivable, and, finally, when
the customers pay their bills, the firm draws out its profit and replenishes the cash balance.
There is only one constant in this process, namely, working capital. That is one reason
why (net) working capital is a useful summary measure of current assets and liabilities. The
strength of the working-capital measure is that it is unaffected by seasonal or other temporary
movements between different current assets or liabilities. But the strength is also its weak-
ness, for the working-capital figure hides a lot of interesting information. In our example, cash
was transformed into inventory, then into receivables, and back into cash again. But these
(^7) There is a potential complication here, for the depreciation figure shown in the company’s report to shareholders is rarely the same as the
depreciation figure used to calculate tax. The reason is that firms can minimize their current tax payments by using accelerated deprecia-
tion when computing their taxable income. As a result, the shareholder books (which generally use straight-line depreciation) overstate
the firm’s current tax liability. Accelerated depreciation does not eliminate taxes; it only delays them. Since the ultimate liability has to
be recognized, the additional taxes that will need to be paid are shown on the balance sheet as a deferred tax liability. In the statement
of cash flows any increase in deferred taxes is treated as a source of funds. In the Dynamic Mattress example we ignore deferred taxes.
(^6) This is principal repayment, not interest. Sometimes interest payments are explicitly recognized as a use of funds. If so, cash flow
from operations would be defined before interest, that is, as net income plus interest plus depreciation.