Activity 1: Cash Flows from Day-to-Day Business Operations

To convert the company's income statement from an accrual basis to a cash basis:
- Step 1: by adding back depreciation to net profits, since depreciation is not a cash expense.
- Step 2: subtracting any uncollected sales (increase in accounts receivable) and payments for inventory (increases in inventory less increases in accounts payable).

The changes in accounts receivable, inventory and accounts payable may be less intuitive, 2 reasons for adding and subtracting:
- A firm's sales are either cash sales or credit sales. If accounts receivable increase, that means customers did not pay for everything they purchase. So need, to be subtracted from total sales to determine the cash that has been collected from customers.
- The other activity occurring in the daily course of business is purchasing inventory. An increase in inventory shows that inventory was purchased, but if accounts payable (credit extended by a supplier) increase, then we may conclude that the firm did not pay for the inventory purchased. The net payment for inventory is increase in inventory minus what has not yet been paid (increase in accounts payable)

Activity 2: Investing in Fixed Assets

Occurs when a company purchases or sells fixed assets such as equipment or buildings.
an increase in gross fixed assets (not net fixed assets) in the balance sheet.
An increase means the company spent cash buying fixed assets, while a decrease means it received cash from selling fixed assets.

Activity 3: Financing the Business

Cash flows associated with financing a business are as follows:

A cash inflow when a company borrows more money (increases short term and/or long term debt)
A cash outflow when a firm repays debt (a decrease in short term and/or long term debt)
A cash inflow when the owners invest in the business to increase their equity
A cash outflow when the owners withdraw money from the business. In sole proprietorships and partnerships, the owner(s) would simply write a check on the firm's bank account to take the money out. In a corporation, the company would either pay a dividend to the owners or repurchase the owners' stock.

Discussion Questions

Describe the three major components of a cash flow statement.
What questions do financial ratios help answer about a firm's financial performance?

Case Analysis

The Donahoo Western Furnishings Company was formed on December 31, 2010, with $1,000,000 in equity plus $500,000 in long term debt. On January 1, 2011, all of the firm's capital was held in cash. The following transactions occurred during January 2011.

January 2: Donahoo purchased $1,000,000 worth of furniture for resale. It paid $500,000 in cash and financed the balance using trade credit that required payment in 60 days.

January 3: Donahoo sold $250,000 worth of furniture that it had paid $200,000 to acquire. The entire sale was on credit terms of net 90 days.

January 15: Donahoo purchased more furniture for $200,000. This time, it used trade credit for the entire amount of the purchase, with credit terms of net 60 days.

January 31: Donahoo sold $500,000 worth of furniture, for which it had paid $400,000. The furniture was sold for 10 percent cash down, with the remainder payable in 90 days. In addition, the firm paid a cash dividend of $100,000 to its stockholders and paid off $250,000 of its long-term debt.

Questions:

What did Donahoo's balance sheet look like at the outset of the firm's life?
What did the firm's balance sheet look like after each transaction?
Ignoring taxes, determine how much income Donahoo earned during January. Prepare an income statement for the month. Recognize an interest expense of 1 percent for the month (12 percent annually) on the $500,000 long term debt, which has not been paid but is owed.