Page 59 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 2. Performance Measurements and Standards 45

the income statement. A company will record a sale when it is delivered to a customer, but
since few customers pay cash at that precise moment, there is a time lag before a company
receives the cash. Additionally, the company may have investing and financing activities. The
cash flow statement is thus a report of the cash received and spent during the business year.
First, cash flow from operations is determined. There are two methods: direct and indi-
rect. The indirect method, shown in Table 2-2, begins with net income for the year
($9,658,800) increased by expenses that did not require the expenditure of cash such as
depreciation and amortization ($4,012,400), reduced by payment of deferred taxes
($1,703,800), and increased for the tax benefit of the stock plan ($9,165,400). Changes in
working capital (with the exception of marketable securities) are also reflected in this section
of the cash flow statement. This includes accounts payable ( $858,200), accrued—but not
paid—compensation ( $6,164,200), other accrued liabilities ( $5,643,000), other taxes
payable ( $3,389,700), inventories ( $1,907,200), prepaid expenses ( $1,374,800), and
accounts receivable ( $3,517,900). The net amount ($23,608,600) is net cash provided by
operating activities.
The next step in a cash flow analysis is to determine the amount of cash used in invest-
ment activities. This section reflects the acquisition or divestiture of assets used in the
production of the firm’s goods or services. Cash would be increased from the proceeds of
business sales ($42,398,500 in Table 2-2) and redemption (receipts) for short-term
($6,181,500) and long-term ($5,406,200) investments. Cash would be decreased for purchase
of short-term ($3,486,500) and long-term ($4,176,200) investments; property, plant, and
equipment ($18,649,300); licenses ($3,916,500); purchase of business ($37,183,700); and
other liability activities ($1,374,900). Subtracting the outflow from the inflow of cash would
result in net cash used in investment activities ($14,800,900).
The third category of a cash flow analysis is to determine the cash flow from financing
activities. This section deals with the debt and equity financing of the company. Cash would
be increased with sale of common stock ($23,719,600 in Table 2-2) and issuance of long-term
debt ($7,524,200). It would be decreased with the payments on short- and long-term debt
($654,300 and $15,704,900, respectively), purchase of common stock ($16,175,100), and cash
dividends paid ($6,953,600). The difference between increases and decreases results in the net
cash used in financing activities ($8,244,100).
Subtracting the net cash used in investing ($14,800,900) and financing ($8,244,100)
activities from the net cash provided by operating activities results in the increase or decrease
in cash/cash equivalents for the year. In Table 2-2, this is an increase of $563,600. Cash flow
statements also report the cash position at the beginning and end of the year ($6,197,600 and
$6,761,200, respectively).
When FASB issued Financial Accounting Standard FAS 123R requiring a charge to earn-
ings for stock options that previously had escaped expensing under APB 25, the action also
had an impact on the cash flow statement. It required shifting the tax benefits from operat-
ing activities to investment activities. The result is that operating activity cash flow goes
down by the same amount that financing activity increased. Thus, the overall impact is net-
ted out, but since operating activity income is usually considered the more important of the
two, companies with a significant amount of market value options have been significantly
affected. Furthermore, this action also reduces free cash flow, namely, operating activity cash
minus capital spending.
The other method of constructing a cash flow statement is the direct method. Rather than
beginning with net income (as done in the indirect method), the inflow and outflow of cash