BUS103: Introduction to Financial Accounting

Net cash provided by operations increased 13 percent to USD 1,101.0 in 2010 compared with USD 972.3 in 2009 and USD 995.3 in 2008. The increase in cash generated by operating activities in 2010 reflects the Company's improved profitability and working capital management. Cash generated from operations was used to fund capital spending, reduce debt levels and increase dividends.

During 2010, long-term debt decreased from USD 3,634.8 to USD 3,476.6. The Company continued to focus on enhancing its debt portfolio, resulting in the refinancing of a substantial portion of commercial paper and other short-term borrowings to longer term instruments. In 2010, the Company entered into a USD 595.6 loan agreement and obtained a USD 487.2 term loan with foreign commercial banks.

As of 2010 December 31, USD 410.3 of domestic and foreign commercial paper was outstanding. These borrowings carry a Standard & Poor's rating of A1. The commercial paper as well as other short-term borrowings are classified as long-term debt at 2010 December 31, as it is the Company's intent and ability to refinance such obligations on a long-term basis. The Company has additional sources of liquidity available in the form of lines of credit maintained with various banks. At 2010 December 31, such unused lines of credit amounted to USD 2,142.8.

The ratio of net debt to total capitalization (defined as the ratio of the book values of debt less cash and marketable securities ["net debt"] to net debt plus equity) decreased to 58 percent during 2010 from 64 percent in 2009. The decrease is primarily the result of higher Company earnings in 2010 as well as effective working capital management and lower acquisitions than in prior years. The ratio of market debt to market capitalization (defined as above using fair market values) decreased to 17 percent during 2010 from 23 percent in 2009. The Company primarily uses market value analyses to evaluate its optimal capitalization.

Capital expenditures were 5.2 percent of net sales in both 2010 and 2009 and were 5.3 percent of net sales in 2008. Capital spending continues to be focused primarily on projects that yield high aftertax returns, thereby reducing the Company's cost structure. Capital expenditures for 2008 are expected to continue at the current rate of approximately 5 percent of net sales.

Other investing activities in 2010, 2009, and 2008 included strategic acquisitions and equity investments worldwide. The aggregate purchase price of all 2010, 2009, and 2008 acquisitions was USD 46.2, USD 1,586.3, and USD 179.8, respectively.

Exhibit 55: Consolidated statements of cash flows for Synotech, Inc. - Indirect method

Dividend payments were USD 355.5 in 2010, up from USD 331.8 in 2009 and USD 296.3 in 2008.

Internally generated cash flows appear to be adequate to support currently planned business operations, acquisitions, and capital expenditures. Significant acquisitions would require external financing.

The Company is a party to various superfund and other environmental matters and is contingently liable with respect to lawsuits, taxes, and other matters arising out of the normal course of business. Management proactively reviews and manages its exposure to, and the impact of, environmental matters. While it is possible that the Company's cash flows and results of operations in particular quarterly or annual periods could be affected by the one-time impacts of the resolution of such contingencies, it is the opinion of management that the ultimate disposition of these matters, to the extent not previously provided for, will not have a material impact on the Company's financial condition or ongoing cash flows and results of operations.

Refer to Exhibit 55. First we will discuss the items in the operating activities section of the statement of cash flows, then we will discuss investing activities and financing activities.

Operating activities The company used the indirect method of calculating net cash provided by operations. Various adjustments were made to convert accrual based net income to cash basis net income.

The "restructured operations, net" item resulted from the fact that many companies restructured their operations by closing plants and significantly reducing their work forces. Some companies recognized a net loss from restructuring and others recognized a net gain. Apparently, the company recognized a net gain in 2010 because it deducted the item from net income on the statement of cash flows. The actual cash flows from restructuring will occur in a later period.

"Depreciation and amortization" includes depreciation on plant assets and amortization of intangible assets. Depreciation and amortization are noncash charges against revenues and must be added back to net income.

The "deferred income taxes and other, net" item deduction from net income results primarily from the fact that income tax expense on the income statement was lower than the actual income taxes paid in 2010. This phenomenon occurs because of using a different method for tax and accounting purposes for such items as depreciation.

Receivables and inventories increased (causing cash to decrease), while other current assets remained about the same. Payables and accruals increased (causing cash to increase). These changes are net of any amounts related to acquisitions, dispositions, or amounts that are included elsewhere, such as in "restructured operations, net". The changes described may differ from the amounts derived from only analyzing the balance sheets for the last two years because of certain technical "adjustments" that are beyond the scope of this text.

Investing activities "Capital expenditures" include the purchase of plant assets, such as new machinery and equipment, to modernize production facilities. Companies normally select those capital expenditures with the highest rate of return. For instance, if funds are limited (and they normally are) and two capital investments (a machine and a mainframe computer) are being considered, one yielding a 20 percent return and the other yielding a 25 percent return, the company will normally select the one with the 25 percent return.

"Payment for acquisitions, net of cash acquired" shows the amount spent in acquiring other companies and segments of other companies, net of the amount of cash held by those companies and obtained as a part of the acquisition.

The company sold "marketable securities and other investments". These securities normally consist of stocks, bonds, and other instruments of other companies. For fiscal years beginning after 1993 December 15, marketable securities must be identified as trading securities, available-for-sale securities, or held-to-maturity securities. Trading securities and available-for-sale securities were discussed in some detail in Chapter 14. Held-to-maturity securities were mentioned briefly in Chapter 15. These held-to-maturity securities are debt securities (such as bonds of other companies) that the company has purchased and has both the intent and ability to hold to maturity. As mentioned earlier, the proceeds from sales and purchases of trading securities must be shown as cash flows from operating activities, and the proceeds from sales and purchases of available-for-sale and held-to-maturity securities must be shown as cash flows from investing activities.

Financing activities The company paid off some old debt (USD 1,397.5 million) and incurred new debt (USD 1,292.9 million). Recently many companies are substituting new debt with a low interest rate for old debt with a high interest rate, just as homeowners refinance their homes to lower their interest rate.

The "proceeds from outside investors" resulted from the other participants in the formation of certain businesses in which the company holds more than a 50 percent share.

"Dividends paid" is an item that should be familiar to you. Dividends paid increased each year for the period 2008 through 2010.

The company bought back some of its own stock (treasury stock). Companies often buy back their own shares because they (1) need the shares to issue to employees or officers under stock option plans, (2) want to bolster the market price of the stock, or (3) hope to later sell the stock at a substantially higher price.

"Proceeds from exercise of stock options and other, net" represents the proceeds received from employees and officers who exercised their stock options. Stock options are usually granted to employees to encourage them to work efficiently to increase profitability, which should increase the market price of the stock. Stock options made available to officers are for the same purpose or to attract or retain a talented executive. Normally, an option gives the recipient the right to buy a certain number of shares at a stated price within a given time frame. For instance, the president of a company may be granted an option to buy 10,000 shares at USD 40 per share any time after two years from that date and before six years from that date. Assume that the current market price is USD 38. If the market price of the stock rises to USD 80 at some time during the option period, the president could buy the shares at USD 40 and then hold them or sell them at the higher market price. Executives of companies have become multimillionaires by exercising their stock options. The employees and executives of Synotech, Inc., paid the company between USD 22.2 million and USD 36.8 million per year to exercise their stock options during the three-year period. The company re-issued some of its treasury stock as a result of the exercise of the stock options.

We will discuss some examples of the ways that the information in the statement of cash flows can be used by management, stockholders, and creditors to make decisions. Each of these parties would use more than the statement of cash flows to perform an analysis of the company's performance, but we will restrict ourselves to the statement of cash flows. The next chapter shows a more complete analysis of the company's performance.

Management Management is the first to see the information contained in the statement of cash flows. You have already read portions of "Management's Discussion and Analysis" concerning the information contained in that statement. Management concluded that the amount of internally generated cash flows (net cash provided by operations) appears adequate to support currently planned business operations, acquisitions, and capital expenditures. Thus, unless the company engages in a significant acquisition it will not have to sell more stock or borrow more funds in the foreseeable future. Also, the company apparently replaced some of its high interest rate debt (USD 1,397.5 million) with lower interest rate debt (USD 1,292.9 million). Many companies are doing this same thing recently to take advantage of the low interest rates available.

Stockholders Stockholders can see that dividend payments (USD 355.5 million) are comfortably covered by net cash provided by operations (USD 1,101.0 million). Stockholders are undoubtedly pleased that the per share dividend rate has increased each year during 2008 through 2010. The company continues to invest in its future by making capital expenditures (USD 550.8 million) to modernize its productive facilities. The repurchase of its own stock (USD 32.9 million) decreases the number of shares outstanding, although some of the stock will undoubtedly be reissued in the future as employees and executives exercise their stock options. Any net reduction in the number of shares outstanding will tend to increase earnings per share and help to increase the market price per share in the future. Also, the company may decide to increase dividends per share in the future. These favorable factors might induce present stockholders to retain their stock or even increase their holdings. Potential stockholders might also be attracted to the stock.

A broader perspective:

Johnson & Johnson

Creditors An encouraging factor is the increasing amount of net cash provided by operations in 2010. Also comforting to creditors is the information in Management's Discussion and Analysis that the company has access to USD 2,142.8 million in lines of credit.

The preceding discussions are merely examples of how the information contained in the statement of cash flows might be analyzed to make decisions. The next section describes three ratios that can provide further analyses of cash flows.