Understanding Business Accounting For Dummies, 2nd Edition (55 page)

Note:
Typically, every year a business disposes of some of its fixed assets that have reached the end of their useful lives and will no longer be used. These fixed assets are sent to the junkyard, traded in on new fixed assets, or sold for relatively small amounts of money. The value of a fixed asset at the end of its useful life is called its
salvage value.
The disposal proceeds from selling fixed assets are reported as a source of cash in the investments section of the cash flow statement. Usually, these amounts are fairly small. In contrast, a business may sell off fixed assets because
it's downsizing or abandoning a major segment of its business. These cash proceeds can be fairly large.

Financing activities

Note that in the annual cash flow statement (refer to Figure 7-2) of the business example we've been using, the positive cash flow from profit is £1,100,000 and the negative cash flow from investing activities is £1,275,000. The result to this point, therefore, is a net cash outflow of £175,000 - which would have decreased the company's cash balance this much if the business did not go to outside sources of capital for additional money during the year. In fact, the business increased its short-term and long-term debt during the year, and its owners invested additional money in the business. The third section of the cash flow statement summarises these financing activities of the business over the period.

The term
financing
generally refers to a business raising capital from debt and equity sources - from borrowing money from banks and other sources willing to loan money to the business and from its owners putting additional money in the business. The term also includes the flip side; that is, making payments on debt and returning capital to owners. The term
financing
also includes cash distributions (if any) from profit by the business to its owners.

Most businesses borrow money for a short term (generally defined as less than one year), as well as for longer terms (generally defined as more than one year). In other words, a typical business has both short-term and long-term debt. (Chapter 6 explains that short-term debt is presented in the current liabilities section of the balance sheet.) The business in our example has both short-term and long-term debt. Although not a hard-and-fast rule, most cash flow statements report just the
net
increase or decrease in short-term debt, not the total amount borrowed and the total payments on short-term debt during the period. In contrast, both the total amount borrowed from and the total amount paid on long-term debt during the year are reported in the cash flow statement.

For the business we've been using as an example, no long-term debt was paid down during the year but short-term debt was paid off during the year and replaced with new short-term notes payable. However, only the net increase (£200,000) is reported in the cash flow statement. The business also increased its long-term debt by £300,000 (refer to Figure 7-2).

The financing section of the cash flow statement also reports on the flow of cash between the business and its owners (who are the stockholders of a corporation). Owners can be both a source of a business's cash (capital invested by owners) and a use of a business's cash (profit distributed to owners). This section of the cash flow statement reports capital raised from its owners, if any, as well as any capital returned to the owners. In the cash flow statement (Figure 7-2), note that the business did issue additional stock shares for £60,000 during the year, and it paid a total of £400,000 cash dividends (distributions) from profit to its owners.

Free Cash Flow: What on Earth Does That Mean?

A new term has emerged in the lexicon of accounting and finance -
free cash flow.
This piece of language is not - we repeat,
not
- an officially defined term by any authoritative accounting rule-making body. Furthermore, the term does
not
appear in the cash flow statements reported by businesses. Rather, free cash flow is street language, or slang, even though the term appears often in
The Financial Times
and
The Economist.
Securities brokers and investment analysts use the term freely (pun intended). Like most new words being tossed around for the first time, this one hasn't settled down into one universal meaning although the most common usage of the term pivots on cash flow from profit.

The term
free cash flow
is used to mean any of the following:

Net income plus depreciation (plus any other expense recorded during the period that does not involve the outlay of cash but rather the allocation of the cost of a long-term asset other than property, plant, and equipment - such as the intangible assets of a business).

Cash flow from operating activities (as reported in the cash flow statement).

Cash flow from operating activities minus some or all of the capital expenditures made during the year (such as purchases or construction of new, long-lived operating assets such as property, plant, and equipment).

Cash flow from operating activities plus interest, and depreciation, and income tax expenses, or, in other words, cash flow before these expenses are deducted.

In the strongest possible terms, we advise you to be very clear on which definition of
free cash flow
the speaker or writer is using. Unfortunately, you can't always determine what the term means in any given context. The reporter or investment professional should define the term.

One definition of free cash flow, in our view, is quite useful: cash flow from profit minus capital expenditures for the year. The idea is that a business needs to make capital expenditures in order to stay in business and thrive. And to make capital expenditures, the business needs cash. Only after paying for its capital expenditures does a business have ‘free' cash flow that it can use as it likes. In our example, the free cash flow is, in fact, negative - £1,100,000 cash flow from profit minus £1,275,000 capital expenditures for new fixed assets equals a
negative
£175,000.

This is a key point. In many cases, cash flow from profit falls short of the money needed for capital expenditures. So the business has to borrow more money, persuade its owners to invest more money in the business, or dip into its cash reserve. Should a business in this situation distribute some of its profit to owners? After all, it has a cash
deficit
after paying for capital expenditures. But many companies like the business in our example do, in fact, make cash distributions from profit to their owners.