Hospitality management accounting phần 8 ppt

The statement of changes to working capital views only the effects of actions that will change total current assets and/or total current liabilities.. This figure must agree with thechan

This ratio is a more realistic one than the ratio for the number of times

in-terest earned because inin-terest has to be paid with cash, not with net income.

This ratio can provide a more obvious warning that an inability to pay interestmay be on the horizon than does the traditional interest coverage ratio Thehigher this ratio is, the more comfortable the creditors will be

C A S H F L O W F R O M O P E R AT I N G A C T I V I T I E S M A R G I N

The cash flow from operating activities margin ratio is a profitability

ratio and is calculated as follows:

In our case, given the cash flow amount of $290,900 and Exhibit 10.1, thecalculation is

ᎏ

$

$ 7

2 ,2

9 6

0 2

,9 ,4

0 0

0 0

ᎏ ⴝ 0.04, or 4

ᎏᎏ%ᎏThe ratio compares the amount of cash generated per dollar of sales Al-though this ratio is similar to the profit margin ratio discussed earlier, it is againconsidered more realistic since it compares sales revenues with cash rather thannet income

In our case, because the cash flow of $290,900 is higher than the net come of $141,100, we know the cash flow from operating activities margin ra-tio will be higher than the profit margin ratio because both ratios use the samedenominator

in-A N in-A L Y S I S O F C H in-A N G E S

T O W O R K I N G C A P I T A L

The SCF provides additional information needed for effective cash agement and budget planning Working capital analysis is closely related to theSCF and provides another view of information in support of effective manage-ment of cash

man-Working capital is defined as the excess of current assets compared to

current liabilities, and indicates the amount of excess current assets relative tocurrent liabilities available to conduct revenue-generating operations Total cur-

rent asset minus total current liabilities is the value of working capital (CA⫺

CL) These terms are defined as follows:

Cash flow from operating activities

ᎏᎏᎏᎏ

Sales revenue

Current assets consist of cash, marketable securities, notes receivable,

credit card receivables, accounts receivable, inventories (for resale), plies, and prepaid expenses Current assets are resources that will be con-sumed in the production of sales revenue in the next operating period

sup-Current liabilities consist of accounts payable, accrued expenses (e.g.,

wages and salaries payable, interest payable, taxes payable), and notespayable Current liabilities represent operating costs that were incurred

on credit and will be paid in the next operating period

The preparation of a statement of changes in working capital is

simi-lar in many ways to the preparation of an SCF However, the analysis of

work-ing capital differs in a number of ways from the cash flow analysis, and serves

Income from operations In general terms, accrued income is sales

rev-enue less all expenses incurred (including income tax) in producing thesales revenue inflow Sales revenue is generated by cash sales or on creditthrough receivables that eventually become cash Expenses are incurred

by immediate payment of cash or on credit through payables Thepayables, accounts payable, and accrued payables will eventually be paid

Net income is expected to increase the organization’s cash accounts andincrease working capital

Accrual net income This is determined after deducting noncash expenses.

Such noncash expenses adjust the book or carrying value of long-termassets through depreciation and/or by recognizing amortization expense

To convert net income to the increase in working capital, all capitalized

A N A L Y S I S O F C H A N G E S T O W O R K I N G C A P I T A L 429

expenses must be added back to net income This uses the same dure followed in the operating activities section of the SCF Other itemsthat are handled in the same way as depreciation and amortization ex-penses may consist of prepaid franchise fees or the amortization of otherintangible assets such as goodwill.

proce-Sale of long-term or other noncurrent assets These include land,

build-ing, furniture, equipment, or an investment Their sale is treated as an flow, which increases working capital The sale will create an increase

in-in a current asset, cash, or a current receivable with no correspondin-ing fect to a current liability

ef-Increase in a long-term liability Creating or increasing a loan, mortgage,

debenture, or bond achieves this, and is an inflow that increases ing capital Borrowing additional long-term debt will create an increase

work-in a current asset, cash, or a current receivable with no correspondwork-ing fect to a current liability

ef-The issuance of stock Equity financing creates an inflow that increases

working capital In a proprietorship or partnership (an unincorporatedcompany), stock is not issued; however, any investment by the owner(s)increases their equity capital accounts The sale of equity or receipt of

an owner’s investment will create an increase in a current asset, cash, or

a current receivable with no corresponding effect on a current liability

O U T F L O W S — U S E S O F W O R K I N G C A P I TA L

The following are the major outflows or uses that will decrease working capital:

Loss from operations Just as accrual net income is an increase in

work-ing capital, an accrual net loss is a decrease in workwork-ing capital When aloss occurs, operating expenses have exceeded sales revenue, which de-creases working capital Just as net income has to be adjusted for non-cash expenditures (depreciation, franchise, goodwill, write-downs, oramortization), the net loss is similarly adjusted The net loss may be re-duced by any noncash expense shown on the income statement

Purchase of a long-term or other noncurrent asset This would include

land, building, furniture, equipment, or other investment that is an flow that decreases working capital The cost of another noncurrent as-set, such as the prepayment of a long-term franchise fee, is also an outflowthat decreases working capital

out-Payment of long-term liabilities Any payment reducing the principal

amount owed on a long-term (noncurrent) liability is an outflow that creases working capital

de-Redemption of stock Any previously issued stock repurchased by the issuing company is called treasury stock, an outflow that decreases work-

ing capital

Payment of cash dividends Previously declared, these are payable

obli-gations, payment of which is an outflow that decreases working capital

In a nonincorporated company, a partnership, or proprietorship, any cash

or other current asset withdrawals made by the owner(s) are reductions

of their capital investment and are treated as an outflow, decrease of ing capital

work-The major activities that create sources that increase working capital (WC) and

uses that will decrease working capital are summarized in the following:

A N A L Y S I S O F C H A N G E S T O W O R K I N G C A P I T A L 431

Increase WC ⫽ Borrowed Long-term Liabilities➞ Payment ⫽ Decrease WCIncrease WC ⫽ Sold equity Ownership Equity➞ Buy back ⫽ Decrease WC

➞

➞

S TAT E M E N T U S E S

A statement of changes to working capital is discussed first, followed by a

state-ment of changes to individual working capital accounts Let us consider the

fol-lowing three situations presented in Exhibits 10.8, 10.9, and 10.10, concerning

three different restaurants Each restaurant began the operating year with $88,000

of working capital and ended the year with $100,000 of working capital; each

restaurant increased working capital by $12,000 Each restaurant wants to

bor-row $15,000 for three years with interest from the same bank Information is

readily available from their balance sheets, but it does not clearly identify the

causes of the increase to working capital without a statement of working

capi-tal inflow sources and outflow uses The statement, when completed, will clearly

identify each source inflow and use outflow of working capital We will assume

the banker compiled the same information

R e s t a u ra n t A : E x h i b i t 10 8

The information regarding Restaurant A shows it generated sufficient ing capital from operations to pay out $8,000 in dividends If you assume that

work-the restaurant’s business will stay relatively work-the same over work-the next three years,

it appears there is a low risk to the bank that is lending the restaurant money

The restaurant should be able to pay the interest and repay $5,000 a year to

re-tire the loan

R e s t a u ra n t B : E x h i b i t 10 9

Based on this information, the banker would consider the restaurant to be

a moderate to high risk While this restaurant also paid out cash dividends of

$8,000, it already has a loan outstanding that requires a payment of $5,000 peryear plus interest If a new loan were granted, it might be questionable whetherthe restaurant could make and sustain yearly payments of $10,000 per year plusinterest A modest decline in net income over the next few years would decreasethe working capital and potentially create difficulties for the restaurant in meet-ing its debt obligations and paying dividends If this should occur, the risk in-volved would grow in proportion to the reduction of net income Thus, there ishigh risk to the lender

R e s t a u ra n t C : E x h i b i t 10 10

In this last situation, it would be an extremely high risk for the bank to loanthis restaurant $15,000 A net income of $4,000 was apparently adequate to meetthe current debt payment of $4,000, but not the interest Payment of the divi-dend in this situation is in itself questionable If net income remains at this level,the restaurant will not meet its current debt obligation, let alone pay dividends.Although the Restaurant C illustration is somewhat extreme, it does pointout the way in which information provided by the statement of changes to work-ing capital can be of value in decision making

Inflows of Working Capital

Loan payable (repayable over 4 years with interest)

ᎏ2ᎏ0ᎏ,ᎏ0ᎏ0ᎏ0ᎏ $40,000

Outflows of Working Capital

Cash Dividends paid

ᎏᎏ8ᎏ,ᎏ0ᎏ0ᎏ0ᎏ (ᎏ2ᎏ8ᎏ,ᎏ0ᎏ0ᎏ0ᎏ)

ᎏᎏ1ᎏᎏ2ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

EXHIBIT 10.9

Restaurant B Statement of Changes,Working Capital for the Year Ended December 31, 0006

Inflows of Working Capital

Outflows of Working Capital

Cash dividends declared and paid to stockholders (ᎏᎏ8ᎏ,ᎏ0ᎏ0ᎏ0ᎏ)

ᎏᎏ1ᎏᎏ2ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

EXHIBIT 10.8

Restaurant A Statement of Changes,Working Capital for the Year Ended December 31, 0006

T R A N S A C T I O N S A F F E C T I N G O N LY C U R R E N T A C C O U N T S

Note that all the items discussed and listed earlier under inflows or outflows of

working capital affected a current asset or current liability account and a

non-current account Transactions causing inflows and/or outflows of working

cap-ital identify the cause of such changes in net working capcap-ital However, it does

not show specific details of changes in individual current asset or current

lia-bility accounts Transactions affecting only current asset or current lialia-bility

ac-counts will not appear on the statement of changes to working capital For

example, consider the following partial balance sheet information:

Current Assets Current Liabilities

Inventories (for resale)

ᎏᎏ2ᎏᎏ2ᎏᎏ,ᎏᎏ8ᎏᎏ0ᎏᎏ0ᎏᎏ $ᎏᎏ1ᎏᎏ5ᎏᎏ,ᎏᎏ8ᎏᎏ0ᎏᎏ0ᎏᎏ

The working capital, CA ⫺ CL ⫽ $22,800 ⫺ $15,800 ⫽ $7,000 If $4,500

cash were paid on accounts payable, only two current accounts would be

af-fected A new partial balance sheet would be:

Current Assets Current Liabilities

Inventories (for resale)

ᎏᎏ1ᎏᎏ8ᎏᎏ,ᎏᎏ3ᎏᎏ0ᎏᎏ0ᎏᎏ $ᎏᎏ1ᎏᎏ1ᎏᎏ,ᎏᎏ3ᎏᎏ0ᎏᎏ0ᎏᎏ

A N A L Y S I S O F C H A N G E S T O W O R K I N G C A P I T A L 433

Inflows of Working Capital

Loans payable (investor, repayable over 4 years with interest)

ᎏ1ᎏ6ᎏ,ᎏ0ᎏ0ᎏ0ᎏ $20,000

Outflows of Working Capital

ᎏᎏ1ᎏᎏ2ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

EXHIBIT 10.10

Restaurant C Statement of Changes,Working Capital for the Year Ended December 31, 0006

Since the example transaction affected only two current accounts, currentassets and current liabilities, working capital will not change It is still $7,000($18,300⫺ $11,300) This type of simple transaction affects only two currentaccounts; both accounts are changed by the same amount If cash is received

in payment of a receivable, a transaction is created that causes an exchange

of one current asset for another current asset; no change to total current assetsoccurs

The purchase of a current asset on credit affects only two current accountsfor the same dollar amount As a result of these examples, we will not be concerned with changes between individual current asset and current liabilityaccounts

The statement of changes to working capital views only the effects of actions that will change total current assets and/or total current liabilities Tocomplete a statement of changes to working capital, we require the followinginformation:

trans-A balance sheet at the close of the previous accounting period

A balance sheet at the close of the current accounting period

An income statement for the current period

A statement of retained earnings at the close of the current period or tailed information about retained earnings on the balance sheet at theclose of the current period

de-Any other information not fully disclosed (e.g., information about thepurchase or sale of individual long-term assets or details about long-termliabilities or share transactions)

C O M P L E T I O N O F A S T A T E M E N T O F

C H A N G E S T O W O R K I N G C A P I T A L

To illustrate how a statement of changes to working capital can be oped, we will refer to the comparative balance sheets in Exhibit 10.11, includ-ing some information regarding retained earnings As we move through thediscussion, we will also reference Exhibit 10.12, a condensed income statementand, finally, look at Exhibit 10.13, a statement of retained earnings

devel-The use of working papers to gather the necessary information defining thechanges to working capital is the most accurate proof of working capital eval-uation, although working papers are not an absolute requirement The easiestmethod is to evaluate the comparative balance sheets, the income statement, andthe statement of retained earnings to identify relevant items as an inflow (in-crease) or an outflow (decrease) of working capital

C U R R E N T A C C O U N T I N F O R M AT I O N ,

C O M PA R AT I V E B A L A N C E S H E E T S

From Exhibit 10.11, the first step is to find the change in working capital from

the previous balance sheet ending date to the current balance sheet ending date

ᎏᎏ3ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏWorking capital 0007 ⫺ Working capital 0006 ⫽ Net change to working capital

ᎏᎏ4ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏᎏᎏIᎏᎏnᎏᎏcᎏᎏrᎏᎏeᎏᎏaᎏᎏsᎏᎏeᎏᎏWorking capital has an increase of $4,000 This figure must agree with thechange in working capital that appears as the difference between inflow increases

and outflow decreases on the statement of changes to working capital

Having identified the change in working capital, the current asset and currentliability sections of our comparative balance sheets can be ignored Only infor-

mation from noncurrent sections of the comparative balance sheets in Exhibit 10.11,

the income statement in Exhibit 10.12, and the statement of retained earnings in

Exhibit 10.13 will be required to complete the changes in working capital

N O N C U R R E N T B A L A N C E S H E E T I N F O R M AT I O N

As already stated, we do not need to consider the current balance sheet accounts

The second step is to evaluate the noncurrent assets and noncurrent liabilities

N o n c u r re n t A s s e t s

The land account remained unchanged at $30,000 and the building accountremained unchanged at $250,000 between year 0006 and year 0007 The furni-

ture account increased by $1,000, and the equipment account increased $4,000

between year 0006 and year 0007 Since additional furniture and equipment

were acquired during the year 0007 operating period, the total $5,000 increase

to two noncurrent asset accounts resulted from the use of cash

Use, Outflow, decrease to working capital:

purchase of furniture, $1,000, and equipment, $4,000

Total decrease to working capital ⴝ $

ᎏᎏ5ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ.

Less: Accum deprecation (ᎏᎏ1ᎏ5ᎏ,ᎏ0ᎏ0ᎏ0ᎏ) (ᎏᎏ2ᎏ7ᎏ,ᎏ0ᎏ0ᎏ0ᎏ)

Total Fixed Assets

In addition, the contra asset account, accumulated depreciation, increased

by $12,000 during the 0007 operating year, because of a noncash depreciation

expense transaction The effect of increasing accumulated depreciation is the

re-duction of the book value (carrying value) of related long-lived capital assets,

which does not affect working capital and is ignored

N o n c u r re n t L i a b i l i t i e s

The long-term liability, mortgage payable, decreased during year 0007 by

$10,000 The reduction of the long-term liability was caused by an outflow of

current assets, specifically cash

Use, Outflow, decrease to working capital:

mortgage payable reduction ⴝ $

ᎏᎏ1ᎏᎏ0ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

S t o c k h o l d e r s ’ E q u i t y

In the final step, the capital stock account increased during year 0007 from

$100,000 to $105,000 The increase to the capital stock account shows that

$5,000 of additional capital stock was issued for cash, which is an inflow of a

current asset Always assume stock is issued for cash unless specifically noted

in the accounting records or as a footnote to the balance sheet

Source, Inflow, increase, to working capital:

capital stock issued (sold) ⴝ $

Add: Net income for year

ᎏᎏ6ᎏ,ᎏ0ᎏ0ᎏ0ᎏ

ᎏᎏ2ᎏᎏ0ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

EXHIBIT 10.13

Statement of Retained Earnings for the Year Ended December 31, 0007

recognized under the accrual method and did not require a cash expenditure Asdiscussed earlier, depreciation is a noncash expense and is treated as an inflow,increase to working capital.

Source, Inflow, increase to working capital: Net income ⴝ $

ᎏᎏ6ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

Source, Inflow, increase to working capital:

Depreciation expense ⴝ $

ᎏᎏ1ᎏᎏ2ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏThe statement of retained earnings identifies the final item remaining to beevaluated from the statement of retained earnings, Exhibit 10.13 Two of theitems appearing in the statement of retained earnings have already been evalu-ated The first item was net income, which was treated as an inflow, increase toworking capital of $6,000 The second item was a noncash expense deprecia-tion, which was treated as an inflow, increase to working capital The only re-maining retained earnings item is cash dividends of $4,000, which is treated as

an outflow, decrease to working capital

Use, Outflow, decrease, to working capital, cash dividends ⴝ $

ᎏᎏ4ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏSince no other information is given, we have all the data required for com-piling our statement of source and use of working capital:

Use, outflow, decreases to working capital: Purchase furniture $ 1,000Use, outflow, decreases to working capital: Purchase equipment $ 4,000Use, outflow, decreases to working capital: Reduction of mortgage payable $10,000Source, inflow, increases to working capital: Additional capital stock issued $ 5,000Source, inflows, increases to working capital: Net income and depreciation $18,000Use, outflow, decreases to working capital: Payment of cash dividends $ 4,000

This information can now be arranged in an orderly fashion in the form of

a statement of changes to working capital as shown in Exhibit 10.14 Note thatthe net change in working capital shown on this statement, an increase of $4,000,agrees with the amount of the change in working capital previously determinedfrom the years 0006 to 0007 from Exhibit 10.11

To clarify specific transactions used in the completion of the statement ofchanges in working capital, additional information than that shown in the fi-nancial statements and statement footnotes is often required For example, thefurniture account shown in Exhibit 10.14 shows that it increased by $1,000, andthe equipment account increased by $4,000, for a total of $5,000 from year 0006

to year 0007 It was stated earlier that we can assume furniture and equipmenthad been purchased for a total of $5,000; however, in practice, it is necessary

to refer to the actual ledger accounts in the general ledger, and the related voices The following situation could have occurred with an item not being

in-shown To this effect, we will assume that a receipt was located showing old

furniture being sold during year 0007 for $42,000

Use, outflow, decrease furniture purchased during year 0007 3,000

Source, inflow, increase old furniture sold during year 0007 (ᎏ2ᎏ,ᎏ0ᎏ0ᎏ0ᎏ)

ᎏᎏ8ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏThe sale of old furniture for $2,000 showing a decrease in the account hasoccurred but not noted This means that $2,000 of cash received from the sale

of the old furniture and $1,000 of cash was paid for new furniture These two

transactions should be recorded separately on the statement of source and use

of working capital

Source, inflow, increase to working capital:

furniture sold $2,000

Use, outflow, decreases to working capital:

new furniture purchased $1,000

Any other noncurrent accounts where similar working capital inflow andoutflow transactions occurred during the operating period would have to be an-

alyzed in detail This procedure can ensure the changes to the working capital

statement will provide complete disclosure of such working capital changes

dur-ing the period

The statement of changes to working capital shows only the net change

in total working capital from an outflow decrease and inflow increase basis

Payment cash dividends

ᎏᎏ4ᎏ,ᎏ0ᎏ0ᎏ0ᎏ

ᎏᎏᎏᎏ4ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

EXHIBIT 10.14

Statement of Changes to Working Capital for the Year Ended December 31, 0007

occurring from noncurrent account transactions in one complete operating timeperiod It does not show how the individual accounts that are part of workingcapital have changed If this information is wanted, or required, it is shown separately in a statement of changes to individual working capital accounts If

we use the current asset and current liability sections of the balance sheet in Exhibit 10.11, we could summarize the changes in individual working capitalaccounts, as in Exhibit 10.15

An analysis of individual account changes can be made as a result of ing a statement of changes in working capital Questions could then be asked.For example, assume the cash account has increased by $2,000, or 20 percent($2,000 divided by $10,000); do we need extra cash on hand, or should the ex-tra cash be used to pay off some of a bank loan and save interest expense? Byreducing interest expense, net income may increase The receivables have gone

prepar-up by $3,000, or 60 percent; has our total revenue increased 60 percent, or have

we changed our credit policies, or are we not following up effectively on thecollection of accounts? The information in the statement of changes in workingcapital accounts raises these and other questions

The problem of cash management and the control of individual workingcapital accounts, such as inventory, accounts receivable, and accounts payable,will be discussed in Chapter 11

As a point of review, the effects of changes to current assets and current abilities and their effect on working capital can be summarized using a simplebase data set, as follows:

Bank loan payable

ᎏ1ᎏ1ᎏ,ᎏ0ᎏ0ᎏ0ᎏ ᎏᎏ8ᎏ,ᎏ0ᎏ0ᎏ0ᎏ ᎏ3ᎏ,ᎏ0ᎏ0ᎏ0ᎏTotal Current Liabilities $

ᎏᎏ1ᎏᎏ5ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ $ᎏᎏ1ᎏᎏ7ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

ᎏᎏᎏᎏ3ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ $ᎏᎏᎏᎏ7ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ ᎏᎏᎏᎏᎏᎏ$9,000 ᎏᎏᎏᎏᎏᎏ$5,000Net Change, Working Capital

D E T E R M I N I N G R E Q U I R E D W O R K I N G C A P I TA L

How much working capital does a hotel, motel, restaurant, or bar need during

an operating period? This question cannot be answered in general terms that

identify an absolute dollar amount For example, suppose it were a rule of thumb

that an operation should have working capital of $5,000 available A small

res-taurant that maintains small amounts of cash, inventories for resale, credit card

and accounts receivables, and other items that are current assets, might find

it-self with the following working capital:

C O M P L E T I O N O F A S T A T E M E N T O F C H A N G E S T O W O R K I N G C A P I T A L 441

Effects of change in WC shown in a symbol format:

앖⫽ Increased 앗⫽ Decreased NC⫽ No change

CA⫽ Current assets CL⫽ Current liabilities WC⫽ Working capital

are current assets It would also be expected to have larger amounts in its

vari-ous current liability accounts Its working capital could look like this:

The smaller restaurant is in much better financial shape than the larger one

The former has $1.50 of current assets for each $1.00 of current liabilities, a

comfortable cushion The latter has $1.05 of current assets for each dollar of

current liabilities, a not-so-comfortable cushion

As a general rule, a business would prefer to have a 2⬊1 current ratio, or atleast $2.00 of current assets for each $1.00 of current liabilities This would

mean that its working capital (current assets, $2.00, minus $1.00) is equivalent

to its current liabilities However, this rule is primarily for companies that need

to carry large inventories that do not turn over very rapidly Inventories of food

and beverages are, in part, perishable, and they are easily and frequently placed Thus, a hospitality business can operate with a current ratio of less than 2⬊1.

re-Hotels and motels have an inventory that is primarily made up of roomsthat appear under fixed, long-lived assets Relatively speaking, this allows ho-tels and motels to frequently operate with a very low ratio of current assets tocurrent liabilities, often as low as 1⬊1 In other words, for each $1.00 of currentassets, there is $1.00 of current liabilities This means that the hotel or motel infact has no working capital

At certain times of the year, seasonal hospitality operations may work in anegative working capital position, where current liabilities are greater than cur-rent assets During its peak operationg period, such an operation would havecurrent assets in excess of current liabilities The reverse situation will prevail

in the off-season During the preopening period of a hospitality operation, a ative working capital will normally exist

neg-C O M P U T E R A P P L I neg-C A T I O N S

Specific hospitality software programs and spreadsheet applications can beused to accomplish the evaluation of cash flows and the statements involved inworking capital analysis

S U M M A R Y

Two of the most useful documents to support financial statements are the SCFand a statement of changes in working capital These two statements are relatedbecause they both analyze current assets and current liabilities

The SCF determines the changes that have occurred in the cash accountover a specified operating period The statement is used to convert accrual netincome (or net loss) to a cash basis The conversion process identifies sourcesand uses of cash, and is commonly used to evaluate the liquidity and solvency(or net worth) of a business entity

In general, the statement is broken into three separate areas of business tivities in which net cash flows are shown as an increase or decrease The firstsection analyzes net cash flows from operations Sources of cash include net in-come and decreases in current asset operating accounts (except cash) An oper-ating net loss and increases in current asset accounts are treated as cash out-flows The operating activities section also recognizes noncash expenses such

ac-as depreciation and amortization by adding back such noncac-ash expenses to the

reported accrual income or loss In addition, reported losses on the disposal of

long-term assets are added back and gains of the disposal of such items are

de-ducted from the reported accrual income or loss

The final proof of the correctness of an SCF is to verify that final net cashflow (positive or negative) is, in fact, the same amount that occurred This amount

is shown in the change in the cash account over the operating period

The general rule to describe the effects of changes in the current accountsthat cause increases or decreases in the conversion of the reported net income

(or net loss) to the cash basis:

Symbols Identification

Current Asset⫽ CA Current Liability⫽ CL

Change in account⫽ Increase ⫽앖 Decrease⫽앗

Deduct⫽ (⫺) Add⫽ (⫹)Effects of changes to the balances of current accounts

CA앖⫽ (⫺) CL 앖⫽ (⫹)

CA앗⫽ (⫹) CL 앗⫽ (⫺)

As we have seen, current assets and current liabilities are also the major counts viewed during an analysis of working capital This analysis shows where

ac-cash is coming from and where it is going From that aspect, the SCF also helps

measure the effectiveness of cash management

The second section of the SCF reviews investing activities, such as the quisition or sale of long-lived assets and the acquisition or sale of long-lived in-

ac-vestments The acquisitions of such items are treated as cash use outflows, and

the sale of such items are treated as cash source inflows.

The third section of the SCF views cash inflows and outflows by ing the two primary methods used to acquire capital—the sale of ownership eq-

review-uity and the assumption of long-term debt If ownership eqreview-uity (stock) is sold

or long-term debt is borrowed, the proceeds are treated as cash inflow source

On the other hand, if ownership equity is repurchased (treasury stock) by the

business entity or long-term debt is repaid, they are treated as cash use outflows

If a cash dividend is paid during the operating period, the dividend is a cash use

operat-management how effectively working capital is being managed This statement,

along with a SCF, will provide creditors with insight into the use of credit by

the business operation

The major source inflows of working capital are

Income for operations, with noncash expense items of depreciation andamortization added back

Sales of long-term or other assetsThe borrowing of additional long-term debtThe sale of stock equity

The major uses of working capital are

Net loss from operationsPurchase of long-term or other assetsPayments on the principal of long-term debtRepurchase by the business of its own outstanding stock (treasury stock)Payment of cash dividends

A transaction that affects only two current asset accounts will not affectworking capital For example, if payment of $100 is received on a receivable,the cash account will increase by $100 and the current receivable will decrease

by the same amount; no overall change to current assets has occurred, the $100

of a current receivable has simply been reclassified If a single current asset count changes, and in the same transaction a single current liability accountchanges, no change in working capital will exist The exchange of a current as-set for a current asset or the creation of a current asset and a current liability inthe same amount in a transaction would not appear on a statement of source in-flows and use outflows

ac-To prepare a statement of source inflows and use outflows of working ital, the following are required:

cap-Balance sheets for the two latest consecutive periods of operations

An income statement for the operating period just ended

A statement of retained earnings and necessary supporting informationfor the operating period just ended

Other necessary supporting information regarding changes in propertyplant and equipment (fixed assets) and long-term liability accounts, andother assets not available in the balance sheets

The statement of source (inflows) and use (outflows) of working capitalidentifies only the change and the cause of the changes that determined net work-ing capital This statement will not identify changes to individual current assetand current liability working capital accounts This detail is shown in the SCF,indirect method that was discussed in this chapter

E X E R C I S E S 445

D I S C U S S I O N Q U E S T I O N S

1 What is the purpose of the SCF?

2 What are the major operating accounts by category analyzed in the SCF,

indirect method?

3 If a current asset account increases, how is the increase treated in the

state-ment of cash flows?

4 What is the typical noncash item, by name, that is automatically added back

in the operating activities section of the SCF?

5 The financing section of an SCF can analyze three different items by

cate-gory What are they?

6 What are the primary items by category analyzed in the SCF, investing

section?

7 What is working capital?

8 Of what use is the statement of source inflows and use outflows of

work-ing capital?

9 List the three major common source inflows and the three major common

use outflows of working capital

10 Explain why depreciation expense is treated as a source inflow of working

capital

11 What is a statement of source inflows and use outflows of working capital?

12 If a business operation has a current ratio of 1.25⬊1, what does this mean

relative to working capital?

E T H I C S S I T U A T I O N

A motel owner needs to borrow money from the bank The bank manager has

asked for statements of cash flows for the past three years to support the loan

application In preparing these statements, the motel owner omits to show that

dividends of $10,000 a year were paid out in each of the last three years

Dis-cuss the ethics of this situation

E X E R C I S E S

E10.1 The following lists current asset and current liability accounts Identify

each account as a current asset (CA) or a current liability (CL) account.

After classifying each account, determine how the change in the count balance is treated in the conversion of accrual net income to the

ac-cash basis, indirect method If ac-cash increases, use the word source; if cash decreases, use the word use.

Account Title CA or CL Increase or Decrease

Credit card receivables

E10.2 A monthly income statement reported net income of $80,000

Inven-tory for resale increased by $14,000 Accounts payable increased by

$16,000 Using only these three items, determine the net cash flow fromoperations, indirect method

E10.3 Net income is $260,000; Depreciation expense is $42,000; Accounts

receivable increased $2,500; Credit card receivables decreased $4,600;Prepaid insurance increased $2,400; Inventory increased by $4,500; Accounts payable decreased $3,000; and Accrued payroll payable in-creased $3,600 Complete net cash flow from operations activities, indirect method

E10.4 Identify how each of the following items would be treated in an

anal-ysis of changes to working capital Answer with the word Inflow to show an increase or Outflow to show a decrease in working capital.

Net income Sale of equity stock Net loss Purchase of equipment Depreciation Repayment of long-term debt Cash dividends Increasing long-term debt Sale of equipment Redemption of stock

E10.5 A hotel provided the following information for year 2006: The cash

flow from operating activities was $143,200, average current liabilitieswere $68,300, average total liabilities were $823,300, and total revenuefor the year was $2,406,800 Interest was $68,000 Calculate the fol-lowing ratios:

a The cash flow from operating activities to current liabilities ratio

b The cash flow for operating activities to total liabilities ratio

c The cash flow from operating activities margin ratio

d The cash flow from operating activities to interest ratio

E X E R C I S E S 447

E10.6 Given the following information regarding investing and financing

ac-tivities of an SCF, evaluate each of the given transactions and identify

to which section, investing (invest) or financing (finance), the tion belongs In addition, identify how the amount is handled Use In-crease for positive or Decrease for negative for the cash flow adjustmentconversion in the SCF

transac-Invest Increase ( ⴙ) or

or Finance Decrease ( ⴚ)

Purchased equipment

Sold shares of equity stock

Sold office furniture

Purchased a long-term investment

Declared and paid a cash dividend

Repurchased equity stock

Increased long-term debt

E10.7 Assume working capital was $44,000 for a given year During this year,

accounts receivable decreased by $1,400, inventory increased by $8,000,and accounts payable decreased by $2,000 Determine the amount ofcash from operations

E10.8 Assume the book value of an item of equipment shows $50,000 in year

one and $44,000 in year two Would the $6,000 difference be treated

as an inflow source, outflow use, or not shown at all with regard to itseffect on working capital?

E10.9 A review of a balance sheet indicated the beginning and ending totals of

current assets and current liabilities for a one-year operating period termine the working capital at the beginning and the end of the year Cal-culate the change in current assets, current liabilities, and working capital

De-Current Current Working Assets Liabilities Capital

December 31, 2004

ᎏ1ᎏ2ᎏ2ᎏ,ᎏ4ᎏ0ᎏ0ᎏ ᎏ7ᎏ6ᎏ,ᎏ5ᎏ0ᎏ0ᎏ ᎏᎏᎏᎏᎏᎏᎏChange, current assets $

E10.10 Assume a business enterprise reports its total current assets as $24,000

and its total current liabilities as $16,000 Answer the following:

a What is the amount of working capital?

b What is the current ratio (also called the working capital ratio)?

P R O B L E M S

P10.1 The following is provided to complete the operating activities section of

a statement of cash flows, indirect method

a Net income for the year is $20,000.

b Accounts receivable increased by $12,000.

c Inventory decreased by $4,000.

d Depreciation expense for the year is $8,000.

e Accounts payable decreased by $6,000.

f Other current liabilities increased by $2,000.

P10.2 Balance sheet information for a resort hotel reflects the changes to

cur-rent accounts that occurred over the annual operating period ended cember 31, 2005 Cash account balance at December 31, 2004, was

De-$14,000 and the ending cash balance at December 31, 2005, is $27,600

Current Asset Accounts Change Amount

c Will the working capital or its ratio change if a transaction collects

$2,800 in cash from its credit card receivables?

E10.11 A restaurant purchased new kitchen equipment for $35,000 Old kitchen

equipment was sold for $800 A long-term investment was sold for

$50,000 Equity stock was bought back (repurchased) for $12,000, and

a cash dividend was paid in the amount of $40,000 The company creased its long-term debt by $70,000

in-a Determine the net cash flow from investing activities.

b Determine the net cash flow from financing activities.

E10.12 The following are operating transactions that occurred during the

cur-rent year Analyze each transaction and explain if the transaction willincrease, decrease, or have no effect on working capital

a Purchased inventory on account, $5,400; terms 2/5, n/30.

b Borrowed $40,000 on a long-term note.

c Sold old equipment with a book value of $1,000 for $650.

d Sold marketable securities at a gain of $2,400.

e Paid $1,200 for insurance covering one year from the date of purchase.

Current Asset Accounts Change Amount

Current Liability Accounts

Additional information applying to the current year ending December 31,2005:

a Net income for the year 2005 was $113,400.

b Depreciation expense for the year 2005 was $121,500.

c Furnishings with a book value of $1,400 were sold for $5,400.

d Equipment with a book value of $2,200 was sold for $1,800.

e New furnishings were purchased for $14,800.

f New equipment was purchased for $22,200.

g A total of $55,600 was paid to reduce long-term debt.

h Cash dividends of $128,300 were declared and paid.

Using the information provided, complete an SCF, in good form usingthe indirect method

P10.3 You have the following comparative balance sheets for a restaurant for

the years ending December 31, 2004, and December 31, 2005 late the change in working capital and prepare the restaurant’s statement

Calcu-of sources and uses Calcu-of working capital for the year ending December 31,2005

ASSETS

Accumulated depreciation (ᎏᎏ3ᎏ,ᎏ5ᎏ0ᎏ0ᎏ) (ᎏᎏ4ᎏ,ᎏ5ᎏ0ᎏ0ᎏ)

ᎏᎏ4ᎏᎏ3ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ $ᎏᎏ4ᎏᎏ8ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏLIABILITIES & STOCKHOLDERS’ EQUITY

a Net income for year $7,000 Annual depreciation of $1,000 was

in-cluded as an expense to arrive at net income

b New equipment costing $4,000 was purchased.

c Dividends of $6,000 were paid out.

d New shares (100 at $10 each) were issued.

e The long-term loan was increased by $2,000.

P10.4 Refer to information provided in the preceding P10.3 and complete in

good form an SCF using the indirect method

P10.5 A motel has the following comparative balance sheets for two years:

Accum Depreciation, building ( 41,900) ( 50,200)

Accum Depreciation, furniture & equipment (ᎏᎏ1ᎏ5ᎏ,ᎏ4ᎏ0ᎏ0ᎏ) (ᎏᎏ1ᎏ9ᎏ,ᎏ1ᎏ0ᎏ0ᎏ)

Current portion of mortgage payable

P10.6 With the balance sheet information from Problem 10.5, and the

addi-tional information from the income statement and statement of retainedearnings, prepare the motel’s statement of changes to working capital forthe year ending December 31, 2005

Income Statement for Year Ended December 31, 2005

Income before depreciation and interest and tax 31,100

Depreciation, furniture and equipment (ᎏᎏᎏ3ᎏ,ᎏ7ᎏ0ᎏ0ᎏ)

ᎏᎏᎏᎏ2ᎏᎏ6ᎏᎏ,ᎏᎏ4ᎏᎏ0ᎏᎏ0ᎏᎏ

P10.7 Referring to the preceding Problems 10.5 and 10.6 that presented a

com-parative balance sheet, income statement, and a statement of retainedearnings, complete a statement of cash flows in good form using the in-direct method

P R O B L E M S 451

P10.8 A catering company reported the following additional financial

state-ments and information for two successive years:

Additional financial information:

1 In Year 2005, the building that was previously rented was purchased

for $150,000 The company paid $10,000 cash and assumed a term mortgage for $140,000 Depreciation on the building is $7,500for Year 2005 At the end of year 2005, $7,100 of the mortgage payablewas reclassified as a current liability payable in Year 2006

long-2 New stock was issued for cash, 200 shares at $50.00 each.

Statement of Retained Earnings For the Year Ended December 31, 2005

Retained earnings December 31, 2004 $29,900Operating loss for Year 2005 (ᎏᎏ8ᎏ,ᎏ1ᎏ0ᎏ0ᎏ)

ᎏᎏ2ᎏᎏ1ᎏᎏ,ᎏᎏ8ᎏᎏ0ᎏᎏ0ᎏᎏThe equipment account, and its accumulated depreciation account, isshown below:

Accum Equipment Depr.

Disposed of fully depreciated old equipment ( 4,100) ( 4,100)Depreciation expense year 2005

Noncurrent, Fixed Assets

Current portion of mortgage payable ᎏᎏᎏ-ᎏ0ᎏ-ᎏᎏᎏ ᎏᎏᎏ7ᎏ,ᎏ1ᎏ0ᎏ0ᎏ

ᎏᎏ6ᎏᎏ1ᎏᎏ,ᎏᎏ6ᎏᎏ0ᎏᎏ0ᎏᎏ $ᎏᎏ2ᎏᎏ0ᎏᎏ9ᎏᎏ,ᎏᎏ0ᎏᎏ0ᎏᎏ0ᎏᎏ

Calculate the changes in working capital and prepare the company’sstatement of sources (inflows) and uses (outflows) for the year endedDecember 31, 2005

P10.9 A motel has the following balance sheets at the end of each of its most

recent two years of operation

The income statements provide the following information:

The statement of retained earnings for year 2005 shows:

Retained earnings December 31, 2004 $60,000Net income for Year 2005

a net income of $16,800 after tax from year 2005 but has no money in thebank Give the owner any explanations you can using this information

C A S E 1 0

Given the budgeted balance sheet for 4C Company shown on p 455 and ence and information in Case 2, prepare a budgeted statement of cash flows foryear 2005

refer-4C Company Pro Forma Balance Sheet as of December 31, 2005 Assets

Current portion, bank loan

C A S H M A N A G E M E N T

I N T R O D U C T I O N

C H A P T E R 1 1

This chapter continues the discussion

of cash flows It illustrates the fact

that net income shown on an income

statement does not imply that there is

an equivalent amount of cash in the

bank

This chapter also demonstratesthe method of compiling a cash bud-

get from cash receipts and cash

dis-bursements Negative cash flow may

result at times Various other

nonre-curring transactions that could affect

the preparation of a cash budget are

also discussed

The subject of cash conservation

and working capital management iscovered Included are such items ascash on hand and in the bank, use ofbank float, concentration banking,use of two bank accounts, accountsreceivable, use of lockboxes, aging ofaccounts, marketable securities, in-ventories, and accounts payable

Finally, we tackle the topic oflong-range cash flow (as opposed toshort-term cash budgeting), includingthe use of CVP analysis (taking in-come tax into consideration) to con-vert required cash flow to a salesrevenue figure

C H A P T E R O B J E C T I V E S

After studying this chapter, the reader should be able to

1 Explain why cash planning is necessary, and state the two main purposes

of cash budgeting

2 Explain why net income on an income statement is not necessarily

in-dicative of the amount of cash on hand

3 List items that would appear under cash receipts and cash disbursements

on a cash budget, and with appropriate information prepare a cash budget

4 Define bank float and discuss the concept of concentration banking.

5 Explain some of the procedures that can be used to minimize outstanding

accounts receivable at any given time, including the use of a lockbox

6 Prepare a schedule of aging of accounts receivable.

7 Discuss the importance of marketable securities with reference to surplus

cash funds

8 Explain long-term cash flow budgeting, and use CVP to calculate the

rev-enue required to provide a desired cash flow amount

C A S H M A N A G E M E N T

Simply stated, cash management is the management of money so that billsand debts are paid when they are due Money does not always come into a busi-ness at the same rate as it goes out At times there will be excess cash on hand;

at other times there will be shortages of cash Both these events must be ipated so that surpluses can be used to advantage and shortages can be covered

antic-In this way, the cash balance will be kept at its optimum level

Although the statement of cash flows discussed in Chapter 10 allows ananalysis of inflows and outflows of cash on an annual basis, this chapter mainlydiscusses inflows and outflows of cash on a monthly basis

T H E C Y C L E O F C A S H F L O W

The cycle of cash flow through an enterprise is illustrated in Exhibit 11.1.This shows that cash management is not just a problem of making sure that thebalance of cash in the bank is correct and that the cashiers have the right amount

of money on hand Rather, it is management of all working capital accounts—cash, inventories, accounts receivable, plus the management of accounts payableand loan payments—and of discretionary spending items, such as purchase ofnew capital assets and payment of dividends if cash is available

Control over these various items of cash receipts and cash disbursements can

be managed by preparing cash budgets The importance of cash planning, or

cash budgets, can best be explained by showing that the net income that a pany has on its income statement (the excess of sales revenue over expenditure)

com-is not necessarily indicative of the amount of cash the company has on hand