Skip to main content
Message Font: Serif | Sans-Serif
 
No. of Recommendations: 0
Hi Fools,

I need help with a couple of items. Please, and thanks in advance.

(1) In all of the literature that I have read(including TMF Investment Workbook), no one seems to place any real importance on the "Financing Activities" section of the Cash Flow Statement. It seems, based on the few that I have studied, these activities can make or break whether a company has a positive or negative cash flow and it would seem intuitive that these activities are a measure of how well management is using our money. Where am I wrong(and why)regarding my observations?

(2) I can flow pretty well from one financial statement to the other. However, "retained earnings" is eating my lunch. Considering the fact that earnings are not necessarily cash, then how does one retain an earning and what does a company do with these retained earnings? I ask only because it would seem all my expenses have been paid, I have used some of my earnings on capex, I have re-purchased stock, etc. In summary, I've gotten a little lost on the shareholders equity portion of the balance sheet and how that ties to the cash flow and income statement.

I sincerely apologize for the length of the post. Thanks for any response.

scarbdr
Print the post Back To Top
No. of Recommendations: 0
scarbdr,

Well, I don't know if I'm right or not, but here's my take on it.

(1) In all of the literature that I have read(including TMF Investment Workbook), no one seems to place any real importance on the "Financing Activities" section of the Cash Flow Statement. It seems, based on the few that I have studied, these activities can make or break whether a company has a positive or negative cash flow and it would seem intuitive that these activities are a measure of how well management is using our money. Where am I wrong(and why)regarding my observations?

First, I think that the "Financing Activities" section of the cash flow statement is very important. This section is important for the very reason you stated, that it is one of several measures of how well management is using our money. The part that I believe I see differently is that you seem to be saying that you don't like to see this section as a negative cash flow. I do. Why? Because if this section is showing a negative cash flow that tells me that management is using it's cash to pay off it's debts and/or to purchase new property, plant and equipment. I like to see cash used this way. If this section were showing a positive flow of cash that would tell me that they company was borrowing funds, oh no they are taking on debt. I don't like that.


(2) I can flow pretty well from one financial statement to the other. However, "retained earnings" is eating my lunch. Considering the fact that earnings are not necessarily cash, then how does one retain an earning and what does a company do with these retained earnings? I ask only because it would seem all my expenses have been paid, I have used some of my earnings on capex, I have re-purchased stock, etc. In summary, I've gotten a little lost on the shareholders equity portion of the balance sheet and how that ties to the cash flow and income statement.

I believe this problem is really a cash vs. accrual problem. Earnings does not equate to cash, just like you stated. The reason it doesn't equate to cash is due to items that are non-cash related (certain related party transactions, depreciation and amortization, etc.) and the change in accruals (accounts receivable, accounts payable, inventory, etc.). Simply put (maybe too simplistically) an increase in retained earnings can be directly related to an increase in accruals.

The income statement is prepared on the accrual method of accounting and therefore the net income from that statement flows directly to retained earnings (because the balance sheet is also on the accrual method of accounting).

The cash flow statement turns the accrual net income into a cash net income number. It takes the accruals out of the picture.

I hope I didn't make it more confusing. If you have more questions please post again and if I can't clear things up I'm sure someone else will.

e


Print the post Back To Top
No. of Recommendations: 0
Thanks e,

Yea, your right. We do want to see this section of the cash flow statement negative if stock is being re-purchased and it's nice to see someone else see the section as important. I guess it could also be negative for pay-off of debt,etc.

I'm feeling a little silly about the second part of my question though. First, it was poorly worded and I did not articulate my confusion very well. Second, I just re-looked at Best Buy's(BBY) 2000 annual report and I think I have seen some light. Retained earnings appear to be simply reported earnings for the period and this value is reconciled(simply added) to net income from previous periods and provided on the balance sheet in the equity section. It appears some of the components of the Additional Paid-In Capital(e.g. re-purchase of stock) also tie the balance sheet(via equity) to the cash flow statement. I think I now have a grasp of the mechanics but I definitely need to think through the why portion of the issue.

Isn't there a bit of a double dipping going on though? Specifically, Earnings are the result of the income statement and the cash flow statement uses these same earnings to arrive at a new cash and equivalents. These same cash and equivalents are reported as an asset on the balance sheet and the equity section of the balance sheet is the difference between total assets less total liabilities. Where I get left in the dust is when I remember that the equity section of the balance sheet can be separately developed by adding common stock(at par value) with paid in capital and retained earnings. Didn't we just go full circle?

Clear as mud, isn't it? Sincere thanks for the reply e,

scarbdr
Print the post Back To Top
No. of Recommendations: 1
scarbdr,

Oh yes, this is confusing and I'll see what I can do, but again with no guarantees:

Isn't there a bit of a double dipping going on though?

No, actually they are just reconciling one statement with the other (meaning reconciling the income statement with the balance sheet - and then reconciling the cash flow statement to the balance sheet - and then a third reconciliation of the balance sheet itself).

Specifically, Earnings are the result of the income statement

Correct. In simplistic form the retained earnings is just all the net income (from the income statement) from all prior periods added together and put on the balance sheet. So we just reconciled the "earnings" portion of the balance sheet.

and the cash flow statement uses these same earnings to arrive at a new cash and equivalents.

Correct again. The cash flow statement turns the income statement from accrual to cash. When the cash flow statement does this it reconciles cash from the beginning of the year to cash from the end of the year. We now know where all the cash went during the year. So we just reconciled the "cash" portion of the balance sheet.


These same cash and equivalents are reported as an asset on the balance sheet

Correct. The reconciled cash from the cash flow statement is reported on the balance sheet. Now we know that the cash number on the balance sheet is a "good" number. We know about all the cash that came in and all the cash that went out, thanks to the cash flow statement.

and the equity section of the balance sheet is the difference between total assets less total liabilities.


Yep. That's the formula for putting the balance sheet in balance.


Where I get left in the dust is when I remember that the equity section of the balance sheet can be separately developed by adding common stock(at par value) with paid in capital and retained earnings. Didn't we just go full circle?

Yes, we did go full circle and we want to. When we do we know we're in balance. Consider it another double check on the numbers.

Okay, I haven't looked at the financials that you're looking at, so bear with me here, but if there are any changes to anything other than retained earnings (and if there are any changes to retained earnings that don't come directly from this period's net income) there should be another statement called something like "Statement of Retained Earnings".

Each of the supporting statements (income statement, statement of cash flows and statement of retained earnings) have told us, based on the activity for the year what the ending balance should be in cash and retained earnings.

Now go to the balance sheet. The balance sheets tells us what the ending balances are. Does cash equal the amount from the cash flow statement. Yes. Great, I know that number has taken all activity for the year into account.

Now, does retained earnings agree with the net income from the income statement (or statement of retained earnings)? Yes, then great I know that number is correct as well.

Now look at the other components of the equity section. Did they stay the same? If so, and the balance sheet is in balance (assets minus liabilities equals equity) then they have told us everything that has gone on during the year.

Now what if the other components of equity do not stay the same? Then there is either another statement reconciling the difference or a footnote that reconciles the difference. The difference must be reported somewhere. Once you know what the difference is and that it has been reconciled for all activity that took place during the year, then they told us everything.

So, you see it is a full circle. We start with last years balance sheet (that's our beginning numbers for this year), then we record income on our income statement (the activity for the whole year), then we reconcile our cash with the cash flow statement (we tell us what our activity on a cash basis was for the whole year) and our earnings are reconciled from the income statement (the accrual based activity for the year). If we're still in balance on the balance sheet we have properly reported everything.

Okay, how was that?

e

Print the post Back To Top
No. of Recommendations: 0
Scarbdr-

I will use all my knowledge and schooling in accounting to try and clear up this confusion for you.

1) The equity section of the balance sheet represents the amount of ownership in a company by the owners. For instance, common stock and paid-in-capital represent the investments by the owners. Retained earnings represent all earnings since the foundation of the business that have not been distributed to the owners. This is reported in the equity section because, ultimately, the owners have the right to the profits of their company.

2) You wrote: "It appears some of the components of the Additional Paid-In Capital(e.g. re-purchase of stock) also tie the balance sheet(via equity) to the cash flow statement"

Actually, additional paid in capital results from the issuance of stock, not the repurchase. Most common stock has a legal par value (usually very low, like, around $1). Any price paid for stock above this par value is recorded as additional paid in capital. For instance, if a company issues 1 share of $1 par common stock for $50, it would show in the equity section of the balance sheet common stock for $1 and additional paid in captial for $49.

3) You wrote: "Isn't there a bit of a double dipping going on though? Specifically, Earnings are the result of the income statement and the cash flow statement uses these same earnings to arrive at a new cash and equivalents"

Yes, the income statement reports earnings. However, as was stated already, these earnings are not all cash. Therefore, in the cash flow statement, there must be a reconciliation from accrued earnings to cash income or outflow. The purpose of the cash flow statement is to show how the company is using its cash. One of the most important numbers in the entire financial statements is the cash flow from operations. If this number is negative, it means that the company is using more cash than it is bringing in through operations. This means that a company will eventually need to turn to outside financing unless that number becomes positive.

The reconciliation from beginning cash to ending cash at the bottom of the cash flow statement is just to prove that the company has accounted for all the use or receipt of cash during the period.

4) Finally, you wrote: "Where I get left in the dust is when I remember that the equity section of the balance sheet can be separately developed by adding common stock(at par value) with paid in capital and retained earnings" In accounting, there is a balance sheet equation, where assets=liabilities + equity. This is true because, if our hypothetical company is liquidated, it would sell its assets, then pay its liabilities. What is left would then be for the owners, so it is reported as equity. As I stated earlier, equity is made up of investments by owners (common stock and paid in capital), and the cumulative earnings (less distributions).

Hope I have helped out a little.

RG
Print the post Back To Top
No. of Recommendations: 0
Great job e. I think even my feeble mind now "gets it".

Sincere thanks,

scarbdr
Print the post Back To Top
No. of Recommendations: 0
Thanks very much for the reply e and RG, you both helped me understand a little better. I still have one bit of confusion and I ask for your collective patience(I am an engineer and not an accountant - we are a little slower than most).

I understand the math but I still am struggling with the meaning. I can rationalize the concept of the balance sheet by thinking of my home. My home is an asset so it's value would show up as as an asset on my personal balance sheet. It is also a liability if I have an outstanding mortgage balance. The difference between the two values represents my(the owner's) equity.

I think my only remaining confusion lies in the reported breakdown of shareholder's equity. Through your explanation, I now fully undertand the common stock(par value) and paid in capital math and concepts. Where I am specifically struggling is the inclusion of the retained earnings(net earnings less distributions)in this equity breakdown. The reason I have my mental block is that we started with net earnings(via the Income Statement) to develop Cash and Equivalents(via the Cash Flow Statement)which is reported on the asset side of the Balance Sheet. By review of the Cash Flow Statement, I can easily see how those net/retained earnings were used(e.g. capex, stock repurchase, etc.), not retained. Therefore, even though I certainly grasp the concept(i.e. need) for an equity value to balance the Assets-Liabilities equation(just like my home example), it doesn't seem intuitive that a portion of the equity is the result of summing reported earnings that(via the information on the cash flow statement)have obviously been spent to one degree or another. Put another way, if the cash flow statement shows a negative cash flow for the reporting period, how is it possible to have a "retained earning"?

Boy this was long winded(er, worded) and I again ask for and appreciate your patience. Am I the only novice Fool that struggles with this concept??

scarbdr
Print the post Back To Top
No. of Recommendations: 0
Scarbdr-

I understand your confusion. I think it is stemming from the use of net income in the cash flow statement. Now, stick with me, this may get a little long winded.

The purpose of the cash flow statement is not to show how earnings were spent, but how cash was spent. Lets say you own an engineering firm in your house. All you have is some cash (and your house to use as an office). Before you have any income, you can still spend the cash you had on hand to begin with. It is the same for a big corporation. Some of the cash spent during the period is not generated during the period, but was on hand at the beginning.

Now, there are two ways to prepare the cash flow statement, the direct method and the indirect method. Under the direct method, a company keeps track of every dollar in cash it takes in and sends out. AS you may imagine, this would require and extraordinary amount of excess bookkeeping. So, most organizations use the indirect method, which converts accrual basis earnings (net income on the income statement) to cash basis in or outflow (cash flow from operations). Basically, we're just using net income to figure out how much cash we generated. We are not saying how much of those earnings were spent.

As for retained earnings, let's go back to the engineering firm example. We'll say in the first year, you make $100,000 net income. You give yourself $50,000 of it to live on, but now what to do with the rest? That extra $50,000 goes nowhere, it is retained (not distributed) by the firm. However, as owner, you are still entitled to that amount, so it is reported in the equity section. This would be reported as retained earnings.

Also, the cash flow statement is not used to develop an ending cash balance for the balance sheet. The cash balances on the balance sheet are generated from actual cash balances per bank statements and such. The cash flow statement just shows what the organization has done with its cash which caused the balance to change.

Hope I have helped a little more.

RG
Print the post Back To Top
No. of Recommendations: 0
RG,

I think you found a way to help me resolve the issue. with your comment:

"Before you have any income, you can still spend the cash you had on hand to begin with. It is the same for a big corporation. Some of the cash spent during the period is not generated during the period, but was on hand at the beginning."

Thanks very much,

scarbdr
Print the post Back To Top