Notes

So far, we mainly focused on the balance sheet and income statement of Kellogg's. We also discussed the components of the statement of shareholders' equity (common stock, addition paid-in capital, treasury stock and dividends) and the statement of other comprehensive income (to account for unrealized gains and losses relative to available-for-sale securities).

Accounting standards require companies to make a statement of cash flows given the importance that cash has for firms' activities. Analysts often say that "Cash is the king" because the availability of cash implies that the firm has enough financial resources to keep their business operations (by buying supplies and paying employees), make new investments (by purchasing new tangible and intangible assets), fulfill their financial obligations (by paying interests and dividends as well as repaying principal amounts of bonds and loans). Yet, the availability of financial resources does not always overlap with firm's profitability in a given accounting period as not all revenues immediately generate cash and not all expenses lead to a reduction in cash. The divergence is a consequence of the revenue recognition and matching expense principles.

According to the revenue recognition principle, revenues are recognized when they are earned (namely when the goods and services are sold/delivered) regardless of the cash receipt. Thus, it might be the case that the firm earned revenues but did not receive cash from the clients yet (so that account receivables arise). Likewise, according to the matching expense principle, expenses should be recognized when they are incurred (namely when the associated revenues are earned) regardless of the cash payment. Hence, it might be the case that the company recognized an expense although it did not pay the suppliers yet (so that account payables arise).

As a consequence, a firm can be profitable reporting a positive net income in the income statement, but it might not have enough cash to keep their activities. This can happen if the firm was not able to collect cash from clients while it had to pay suppliers. On the other hand, a firm can report a loss in the income statement, but it can have enough cash to keep their activities. This can occur if the firm received cash from clients without recognizing revenues. Hence it is important to consider both aspects (i.e. profitability and availability of cash) at the moment of evaluating the firm.

Note that the cash flow statement is strictly related to the balance sheet as the cash reported at the end of the cash flow statement is the amount of cash reported in the balance sheet.

The cash flow statement has 3 distinct sections/areas reflecting the variation in cash for:

• Operating activities, (i.e. related to buying of supplies and selling of goods) -> an example of cash generated by the operating activities is the cash received from the clients for the sale of goods while an example of cash used by operating activities is the cash paid to suppliers for the use of raw materials;
• Investing activities, (i.e. related to the purchase and disposal of tangible and intangible assets) -> an example of cash generated by the investing activities is the cash obtained through the sale of PPE while an example of cash used by investing activities is the cash paid for the purchase of new equipment;
• Financing activities, (i.e. related to firms' transactions with capital providers like banks and shareholders) -> an example of cash generated by the financing activities is the cash received by banks, bondholders and equity holders while an example of cash used by the financing activities is the cash used to pay dividends or to pay back the principal amount of the bonds.

Each activity will generate a (net) cash flow which is the difference between the cash generated and the cash used by each activity. In order to determine the cash to report in the balance sheet, we add/subtract the variation in cash due to the three activities (i.e. the sum of the three cash flows) to the beginning value of cash. As we already discussed, the cash flow from operating activities represents the cash generated and/or used by the selling of goods and the purchase of raw materials. We have two methods to compute the cash flow from operating activities:

• Direct Method, we directly consider the cash received from clients for the selling of goods and the cash payments to suppliers and employees. Keeping track of all the receipts and payments related to the operating activities can be demanding so that most of firms prefer to use the indirect method.
• Indirect Method, we determine the net cash flow from operating activities by adjusting the net income reported in the income statement. Hence, we start from the net income reported in the income statement and we try to distinguish between the cash and non-cash component of revenues and expenses in order to determine the cash flow from operating activities.

Cash Flow from Operating Activities As the cash flow statement starts with the net income, our goal is to determine the cash generated by the operating activities so that we need to adjust the net income by the non-cash components of revenues and expenses.

Let's start with revenues. As we previously said, not all revenues result in an immediate increase in cash. Indeed the firm can grant a credit to clients. As a result, the firm will recognize the revenue but the cash will be received in the future. Given that, in order to determine the cash-component of cash, we consider the variation in accounts receivables. An increase in accounts receivables means that the company will receive cash in the future. In other words, the company recognized a revenue for which did not receive cash yet. Given that, in order to determine the cash generated by the operating activities, we need to subtract the increase in accounts receivables. Instead, a decrease in accounts receivables means that the company collected cash from clients. Given that, we need to add back the decrease in accounts receivables as we obtained cash thanks to the selling of finished goods.

Let's consider now the expenses that we subtract from revenues in order to determine the net income. As for the revenues, not all expenses lead to a variation in cash as firms not all always immediately suppliers. When suppliers allow firms to pay them later, the firm recognizes an expense (if the associated revenue is earned) and an accounts payable. Thus, from the point of view of the cash flows, an accounts payable represents cash that the firm did not use to pay suppliers and it is kept inside the firm. When we use the indirect method to compute the cash flow from operating activities, we need to account for the expenses that give rise to the accounts payable as they represent a reduction in revenues that are not associated with a decrease in cash. Hence, we consider the variation in accounts payable and, if an increase in accounts payable is observed, we add it back to the net income in order to determine the cash generated by the operating activities. Contrariwise, when a decrease in accounts payables is observed, it means that we used cash to pay suppliers so that we need to subtract it from the net income.

A similar logic applies for the other operating liabilities: an increase in operating liabilities should be added back to net income as they represent expenses for which there is no reduction in cash while a decrease should be subtracted as it suggests that cash is used to pay back suppliers.

Yet, accounting for variations in accounts receivables and liabilities is not the only adjustment that we need to do to determine the cash used by the generating activities. Another important adjustment is that relative to inventories.

Inventories represent materials purchased by the firm that have not been transformed into finished goods as well as finished goods that have not been sold yet. In both cases, they are associated with expenses that the firm incurs but for which it did not obtain economic and financial benefits yet. Noteworthy, they represent cash that the firm can generate in the future (through the selling of goods). In particular, an increase in inventories represent materials and/or goods that the firm purchased and/or realized during the accounting period but they will generate cash in the future. Given that, like the accounts receivables, an increase in inventories should be subtracted from the net income. At the same time, a decrease in inventories suggests that the firm sold finished goods that the firm realized in the past generating cash. Hence, a decrease in inventories should be added back.

Thus, if for the current liabilities (e.g. accounts payable; accrued income taxes; accrued interest expense), we add increases in liabilities and we subtract decreases in liabilities as they represent sources and uses of cash, respectively; in the case of current assets (e.g. accounts receivable and inventories), we subtract increases in assets and we add decreases in assets representing sources and uses of cash, respectively.

Note that these adjustments are in line with the definition of current assets as assets that will turn into cash within one accounting period. Hence, an increase in current assets represent potential increases in cash in the future but in the immediate they represent cash that has not been generated but for which the firm recognized revenues in the income statement (i.e. accounts receivable) or cash that has been used without recognizing an expense in the income statement (i.e. inventories).

Likewise, remember that current liabilities represent obligations that the firm will settle within the next accounting period. Thus, they represent potential uses of cash in the future while in the immediate they represent cash that is kept inside the firm although the firm recognized expenses in the income statement.

Adjustments for the variations in accounts payable, inventories and accounts receivable are called accrual adjustments and are necessary to identify the part of net income that generated/use cash from the part (i.e. accruals) that did not generate/use cash.

The last adjustment to consider is that relative to non-cash expenses.

So far, we focused on expenses for which we did not pay in cash in a given accounting period, but the cash payment would occur in the future. Yet, there are expenses that would not be associated with a decrease in cash now and in the future. An example is depreciation and amortization. Both represent allocations of cost over time for the use of long-lived assets for which the firm paid at the moment of the initial purchase. Given that, they do not represent expenses for which the firm would pay for cash in an accounting period.

Cash Flow from Investing Activities The section of the cash flow statement relative to the investing activities provides information about the cash used (outflow) and generated (inflow) by the investing activities of the company. Hence, it includes the cash payments relative to the purchase of assets (tangible, intangible assets and investments in other corporations) and receipts relative to their selling. The net cash flow from investing activities is positive when the cash receipts from the disposal of firm's assets exceed the cash payments for the purchase of new assets. Instead, it is negative when the cash payments for the purchase of new assets are greater than the cash received for the sale of existing assets.

Cash Flow from Financing Activities The financing activities section of the cash flow statement provides information about the cash generated and used by the financing activities of the company namely relative to the transactions that the company has with its equity holders and debtholders. In particular, we consider the inflows of cash relative to the issuance of new debt (both bank loans and bonds) and new equity (seasoned equity offerings, initial public offerings and private placements, exercise of stock option). At the same time, we consider outflows of cash relative to the repayment of debt principal and purchase of firm's shares (i.e. treasury stock). As we are focusing on US GAAP, we will also consider in the financing activities the decrease in cash due to the payment of cash dividends.

Notice that we did not consider the changes in cash due to the following transactions:

• Dividends received from the investment in other companies -> under the US GAAP, the inflows related to the dividends received are included in the operating activities section.
• Interests paid and received -> under the US GAAP, the outflows of cash relative to the interest payment and the inflows of cash relative to the receipt of interests from the investment in other companies are included in the operating activities section of the cash flow statement.

Notice that, as for the cash flow from investing activities, in order to determine the cash flow from financing activities, we did not distinguish between a direct and indirect method as in the case of cash flow from operating activities. Moreover, as in the case of the cash flow from investing activities, information included in the balance sheet are not always enough to compute the reductions and increases in cash due to the financing activities. Additional information are needed.