The Foundation
2.4 Statement of Cash Flows
Practical Financial Tip 2.2
The actual cash flows generated by a firm may differ from its net income during a given period due to accrual accounting practices, noncash revenues and expenses, and taxes.
• Accrual accounting: revenues are normally recorded on an income statement when the sale is made and not when the cash is actually collected from that sale, and the corresponding expense of producing an item is recorded when the rev- enue is recorded, not when the cash is actually paid out for that expense.
• Noncash revenues and expenses: the income statement usually includes noncash expenses such as depreciation and amortization.
• Taxes: firms in the US can use one depreciation method for determining taxable income for their financial statements for reporting purposes and another method for determining their taxable income reportable to the tax authority (IRS).
32 THEFOUNDATION
The Home Depot, Inc. and Subsidiaries
Amount in millions February 2, February 3,
2003 2002
Cash provided from operations
Net earnings $3,664 $3,044
Reconciliation of net earnings to net cash provided by operations
Depreciation and amortization 903 764
(Increase) decrease in receivables, net (38) (119)
Increase in merchandise inventories (1,592) (166)
Increase in accounts payable and accrued liabilities 1,394 1,878
Increase in deferred revenue 147 200
Increase in income taxes payable 83 272
Increase (decrease) in deferred income taxes 173 (6)
Other operating activities 68 96
Net cash provided by operations 4,802 5,963
Cash flows from investing activities
Capital expenditures (2,749) (3,393)
Payments for businesses acquired, net (235) (190)
Proceeds from sales of businesses, net 22 64
Proceeds from sales of property and equipment 105 126
Purchases of investments (583) (85)
Proceeds from maturities of investments 506 25
Advances secured by real estate, net (13)
Net cash used by investing activities (2,934) (3,466)
Cash flows from financing activities
Issuance (repayments) of commercial paper obligations, net – (754)
Proceeds from long-term debt 1 532
Repayments of long-term debt – –
Repurchase of common stock (2,000) –
Proceeds from sale of common stock, net 326 445
Cash dividends paid to stockholders (492) (396)
Net cash provided by financing activities (2,165) (173) Effect of exchange rate changes on cash and cash equivalents 8 (14) (Decrease) increase in cash and cash equivalents (289) 2310 Cash and cash equivalents at beginning of year 2,477 167
Cash and cash equivalents at end of year $2,188 $2,477
Supplemental disclosure of cash payments made for:
Interest, net of interest capitalized $50 $18
Income taxes $1,951 $1,685
Figure 2.4 Statement of Cash Flows
its cash equivalent by adding or subtracting the changes in the corresponding balance sheet accounts.
• Indirect method. The indirect method, also called the bottom-up approach, involves several steps. This approach begins with the firm’s net earnings (income) for the period, and then subtracts gains or adds losses that result from financing or investment cash flows. Next, the approach adds back any non-cash charges such as depreciation and amortization it subtracted to arrive at net income. Net income is further adjusted by accounting for any cash that the firm used to fund increases in current assets or decreases in current liabilities. As we will soon see, Home Depot uses the indirect method to calculate cash flow from operations.
Investing Cash Flows
Cash flow from investing (CFI) reports the cash used to acquire and dispose of non-cash assets. Firms acquire such assets with the expectation of generating income. Such items are found in the non-current portion of the asset section of the balance sheet. Investing activities often include purchases of property, plant, and equipment, investments in joint ventures and affiliates, payments for businesses acquired, proceeds from sales of assets, and investments in or sales of marketable securities.
Financing Cash Flows
Cash flows from financing (CFF) reports capital structure transactions. These items are located in the long-term capital section of the balance sheet and the statement of re- tained earnings and involve activities related to contributing, withdrawing, and servicing of funds to support the firm’s business activities. Financing activities include new debt issuances, debt repayments or retirements, stock sales and repurchases, and cash dividend payments.
Figure 2.4 shows the statement of cash flows for Home Depot for fiscal years 2001 and 2002. The first section provides details on the net cash provided from operations. To arrive at its net cash provided by operations, Home Depot adds back to its net income the de- preciation and amortization expense for fiscal year 2002. Remember that depreciation and amortization are non-cash expenses that Home Depot subtracted on the income statement to determine the net income. Thus, to convert net income to actual cash flow requires adding back these non-cash expenses.
Home Depot makes further adjustments to account for the accrual accounting process that causes net income to deviate from cash flows that we discussed previously. Specifically, increases (decreases) in current asset accounts such as receivables and inventories are sub- tracted from (added to) net income, and increases (decreases) in current liability accounts such as accounts payable and taxes payable are added to (subtracted from) net income.
The resulting cash flow provided for operations by Home Depot is $4,802 million for fiscal year 2002. Thus, the net income figure of $3,664 million underestimates the actual cash flow from the firm’s operations. The chief reason for the difference is the $903 million deprecia- tion expense. Analysts pay close attention to the operating cash flow section of the cash flow
34 THEFOUNDATION
2 By contrast, increased profits matched by decreasing cash flows from operations may be a warning signal.
That is, some of the profits may represent sales that may not be paid or where purchasers were granted less than reliable credit terms.
statement because large, positive cash flows provided by operations are an initial sign of good health and liquidity for a firm.2
The second section details Home Depot’s cash flow from investing activities. The dominant figure in this section is Home Depot’s sizable $2,749 million it spent on capital expenditures in fiscal year 2002. In the Management’s Discussion and Analysis of Results section of the Annual Report, Home Depot reports that it opened 203 new stores in fiscal year 2002 (the firm owns 195 and lease the remainder) and attributes these capital expenditures to the new store openings. Total net cash used for investing activities was $2,934 million.
The third section provides details about Home Depot’s financing activities. Home Depot repurchased $2,000 million of shares of common stock, paid $492 million cash dividends to common shareholders, and raised $326 million by issuing new shares of common stock and received $1 million by issuing new long-term debt in the fiscal year ending in February 2003.
The net cash outflow from financing activities was $2,165 million.
Finally, by comparing the results of these three sections for fiscal year 2002, we find that Home Depot was able to finance its sizable growth (capital expenditures and payments for business acquired) largely by the cash flow generated from operations. Specifically, the
$4,802 million net cash flow provided by operations for fiscal 2002 exceeds the $2,934 mil- lion used for capital expenditures and acquisitions. Thus, Home Depot did not need to seek external financing sources (debt or equity) to fund its recent aggressive growth.
Practical Financial Tip 2.3
The statement of cash flows summarizes the sources and uses of cash for a firm during the year. Cash flows are organized into operating, investing, and financing activities.
Activities in each area that bring in cash represent sources of cash while activities that involve spending cash are uses of cash. Positive cash flows from operations are a good indicator of financial health and liquidity for a firm.
Concept Check 2.4
1 What are the three major sections of a firm’s statement of cash flows?
2 If depreciation is a non-cash item, why is it included in a firm’s statement of cash flows?
3 Morgan Development Corp. (MDC) has reported negative net cash flow from operations and negative net cash flow from investing activities for each of the last 5 years. However, MDC’s cash balances have remained stable during the period because of a large positive net cash flow from financing activities. Under what conditions or situations would this cause concern for investors?
4 Why is having a positive cash flow from operations important to a firm?