CP

344 CHAPTER 9 Financial Statements, Cash Flow, and Taxes

Note that “Retained earnings” represents a claim against assets,not assets per se.

Moreover, firms retain earnings primarily to expand the business, and this means in-

vesting in plant and equipment, in inventories, and so on, notpiling up cash in a bank

account. Changes in retained earnings occur because common stockholders allow the

firm to reinvest funds that otherwise could be distributed as dividends. Thus, retained

earnings as reported on the balance sheet do not represent cash and are not “available” for the

payment of dividends or anything else.^4

What is the statement of retained earnings, and what information does it provide?

Why do changes in retained earnings occur?

Explain why the following statement is true: “Retained earnings as reported on

the balance sheet do not represent cash and are not ‘available’ for the payment

of dividends or anything else.”

Net Cash Flow

Many financial analysts focus on net cash flow.A business’s net cash flowgenerally dif-

fers from its accounting profitbecause some of the revenues and expenses listed on

the income statement were not paid in cash during the year. The relationship between

net cash flow and net income can be expressed as follows:

. (9-1)
The primary examples of noncash charges are depreciation and amortization. These
items reduce net income but are not paid out in cash, so we add them back to net income
when calculating net cash flow. Another example of a noncash charge is deferred taxes.
In some instances, companies are allowed to defer tax payments to a later date even
though the tax payment is reported as an expense on the income statement. Therefore,
deferred tax payments would be added to net income when calculating net cash flow.^5 At

Net cash flowNet income
Noncash revenuesNoncash charges

TABLE 9-3 MicroDrive Inc.: Statement of Retained Earnings for Year

Ending December 31, 2002 (Millions of Dollars)

Balance of retained earnings, December 31, 2001 $710.0

Add: Net income, 2002 113.5

Less: Dividends to common stockholders (57.5)a

Balance of retained earnings, December 31, 2002 $766.0

aHere, and throughout the book, parentheses are used to denote negative numbers.

See Ch 09 Tool Kit.xls

for details.

(^4) The amount reported in the retained earnings account is notan indication of the amount of cash the firm
has. Cash (as of the balance sheet date) is found in the cash account, an asset account. A positive number in
the retained earnings account indicates only that in the past the firm has earned some income, but its divi-
dends have been less than its earnings. Even though a company reports record earnings and shows an in-
crease in the retained earnings account, it still may be short of cash.
The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes, and an
expensive stereo, hence have a high net worth, but if you had only 23 cents in your pocket plus $5 in your
checking account, you would still be short of cash.
(^5) Deferred taxes may arise, for example, if a company uses accelerated depreciation for tax purposes but
straight-line depreciation for reporting its financial statements to investors.

340 Financial Statements, Cash Flow, and Taxes