CHAPTER 5

Long-Term Financial Forecasting

Chapter 4 provided an introductory overview of financial statement analysis. The focus of Chapter 4 was historical—meaning that financial statements were used to analyze how profitable, solvent, and liquid a company had been in the past. The focus of this chapter is forward-looking—meaning that it examines how accounting information is used to forecast a company’s potential financial performance in the future.

Financial forecasting can cover both short-term time horizons (such as months or quarters) and long-term time horizons that span multiple years. Short-term forecasting (often called operational budgeting) is primarily a managerial activity performed by internal users of financial information. Short-term forecasting is illustrated in Chapter 6.

Both internal and external users of financial information engage in long-term forecasting. Throughout this chapter long-term forecasting is examined from a managerial perspective. The material builds upon financial statement integration discussed in Chapter 2, timing differences addressed in Chapter 3, and applications profitability and liquidity measures introduced in Chapter 4.

Long-Term Financial Forecasting: An Overview

The goal of long-term financial forecasting is to create projected financial statements (and other important information) that will enable internal and external decision makers to better assess the timing, the amounts, and the uncertainties associated with an entity’s future earnings, its ongoing changes in financial position, and its potential to generate long-term cash flow.

Managers and other internal decision makers rely heavily upon long-term forecasts. Long-term projections are instrumental when planning investing activities, such as those related to fixed asset growth, equipment replacements, and capital leasing arrangements. They enable managers to budget for changes in technology, plan for product line diversification, and orchestrate mergers with—or acquisitions of—other companies. Long-term financial forecasts also assist managers as they grapple with complex workforce decisions, including pension fund structuring, early retirement incentives, downsizing, and the possibility of offshore manufacturing. Moreover, they are used to plan for, and to analyze, a variety of long-term financing decisions, such as the timing of an initial public offering, the issuance of bonds, or the refinancing of a mortgage.

External stakeholders also engage in long-term financial forecasting. Investors are keenly interested in the timing, amounts, and uncertainties about a corporation’s future dividend activity. Long-term dividend projections—in conjunction with various other forecasted data—are used to discern whether the current price of a company’s stock is realistic and to make informed predictions about its future growth potential. Creditors also engage in long-term financial forecasting to predict anticipated changes in a company’s capital structure, assess a borrower’s debt servicing potential, analyze probabilities of default, and negotiate troubled debt restructuring arrangements.

Long-term financial forecasts typically do not focus upon detailed operating activities such as accounts receivable collection schedules, raw materials acquisition plans, weekly production level targets, or other issues related to working capital management. These are short-term forecasting concerns that will be addressed in Chapter 6. Long-term financial forecasting has a much broader focus, much of which is related to macroeconomic variables. As such, it requires an understanding of monetary policy and how it relates to inflation and interest rate variability; fiscal policy and how it is tied to possible changes in the tax law legislation and tax rates; and foreign policies that affect global competition, the strength of the U.S. dollar, and the political stability of governments in other countries.

The creation and use of long-term financial forecasts will be illustrated with a short case throughout the remainder of this chapter. The case illustrates how managers of a hardware business use long-term forecasts to address and hopefully quell solvency concerns voiced by its major creditor.

The Case of Hometown Hardware

Hometown Hardware is a closely held corporation owned by McNamer Enterprises (a small group of investors). A loyal team of employees manages the business, and under its leadership, sales have steadily increased over the past several years. Although the company is profitable, its cash flow from operating activities is consistently negative, and it continually struggles with liquidity problems.

The shareholders of McNamer Enterprises believe in Hometown’s potential, yet they are frustrated that they have not received dividends for several years. To keep Hometown from depleting all of its cash reserves, McNamer Enterprises recently invested an additional $50,000 in exchange for shares of common stock, with a stipulation that a dividend of $125,000 must be distributed within 2 years. Even with this liquidity infusion, Hometown’s cash balance has fallen during the current year from $24,500 in early January, to $3,000 at the end of the year.

Hometown’s balance sheet shows a relatively strong financial position with total assets of $1,500,000 and shareholders’ equity claims of $1,000,000. Moreover, its current and quick ratios of 4.93-to-1 and 2.82-to-1 are well above industry averages. The seemingly strong liquidity position reflected in the balance sheet is confusing to management, given the company’s cash flow problems.

Hometown extends credit to numerous commercial customers, most of whom are construction contractors. The company’s accounts receivable turnover rate of 5 times (72 days) is well below the industry average of 8 times (45 days), and its inventory turnover rate of 4 times (90 days) is significantly below the industry average of 9 times (40 days). Its trade payable turnover rate is 6 times (60 days), compared to an industry average of 12 times (30 days).

Hometown’s balance sheet reports a $400,000 long-term note payable owed to a local bank. The annual debt service cost on this note is $48,000, of which $10,000 will be allocated to interest expense for the upcoming year, and $8,000 will be allocated to interest expense the following year.¹ The company has fallen into a pattern of being late in making its debt service payments. As such, the bank’s loan officers are extremely uncomfortable and worry about the company’s ability to service the $400,000 obligation. They met with the Hometown’s management near the end of the current year and demanded that they develop a financial plan to resolve the company’s cash flow problems. As part of the plan, they requested a complete set of financial statement forecasts for the next 2 years (Year-2 and Year-3). The forecasts are due the first week of the upcoming year (Year-2).

To improve cash flow, Hometown intends to implement tighter credit policies and offer credit customers financial incentives for paying on time. Management is confident that Year-2 accounts receivable turnover can be increased to 6 times (60 days), and that the industry average of 8 times (45 days) will be achieved by the end of Year-3.

The company’s computer system is antiquated and frequently crashes. Management believes that investing in a new system costing $120,000 will drastically improve the monitoring of accounts receivable, inventory, and trade payables. To that end, the company will invest in a new system during the first quarter of Year-2. Once operational, management predicts that Year-2 inventory turnover will improve to 5 times (72 days), and that the industry average of 9 times (40 days) will be achieved by the end of Year-3. In addition, management is hopeful that the new system will enable Hometown to increase Year-2 trade payables turnover to 8 times (45 days), and achieve the industry average of 12 times (30 days) by the end of Year-3. The new system is will increase the company’s annual depreciation expense by $15,000 in Year-2 and Year-3.

To raise additional cash, management intends to sell a parcel of land to a developer in Year-2. Hometown purchased the land 10 years ago for $40,000 with the intention of using it as a site for a warehouse facility; however, that plan has been abandoned. Unfortunately, due to a depressed real estate market, the developer is willing to pay only $25,000, which will result in a $15,000 loss on the sale.²

Management expects sales to increase by 10 percent in Year-2, and increase an additional 12 percent in Year-3. Cost of goods sold as a percentage of sales is expected to remain constant at 60 percent for the next 2 years—meaning gross profit will remain at 40 percent of sales. Selling, general, and administrative (SG&A) expenses are projected to increase by 2 percent in Year-2, and by an additional 3 percent in Year-3. The company’s accountant believes that the average income tax rate will hold steady for the next 2 years at 30 percent.

Figure 5.1 provides a summary of the input variables necessary to prepare 2 years of financial forecasts (Year-2 and Year-3). It also includes actual data from its current year of operations.

Figure 5.1 Summary of forecasting variables: year-2 and year-3

From the input data summarized in Figure 5.1, projected income statements, balance sheets, and statements of cash flows were created for Year-2 and Year-3. The statement of retained earnings is embedded in the shareholders’ equity section of each balance sheet.

Forecasted Income Statements

Long-term financial forecasts begin with the preparation of forecasted income statements. Hometown’s actual income statement for the current year and its projected income statements for Year-2 and Year-3 appear in Figure 5.2.

Figure 5.2 Projected income statements: year-2 and year-3

All of the revenue and expense amounts appearing in Figure 5.2 came directly from the input data in Figure 5.1. Projected sales of $1,540,000 in Year-2 represent a 10 percent increase over the current year’s actual sales of $1,400,000, whereas sales of $1,724,800 in Year-3 represent a 12 percent increase over Year-2 sales. The cost of goods sold reported in Year-2 and Year-3 is simply 60 percent of each year’s anticipated sales.

Projected SG&A expenses of $510,000 in Year-2 represent a 2 percent increase over the current year’s actual SG&A expenses of $500,000. The $525,300 SG&A figure in Year-3 represents a 3 percent increase over the SG&A amount in Year-2. All of Hometown’s SG&A expenses are paid in cash as they are incurred.

The projected $15,000 loss on the sale land in Year-2 is the land’s $40,000 original cost less the anticipated sales proceeds of $25,000. Projected interest expenses of $12,000 in Year-2 and $10,000 in Year-3 reflect the amount of Hometown’s annual $48,000 debt service cost allocated to interest in those 2 years. Projected income tax expenses of $7,200 in Year-2 and $29,886 in Year-3 equal 30 percent of each year’s projected income before taxes.

Forecasted Balance Sheets

Hometown’s forecasted balance sheets are presented in Figure 5.3. At first glance, it appears that the company’s cash position is expected to improve significantly in Year-2 and Year-3. Before discussing this improvement, it is important to understand how each of the other balance sheet items was derived.

Figure 5.3 Projected year-end balance sheets: year-2 and year-3

Accounts Receivable

Accounts receivable for Year-2 and Year-3 was projected by dividing each year’s sales in the Figure 5.2 income statements by the corresponding accounts receivable turnover targets summarized in Figure 5.1:

Sales ÷ Accounts Receivable Turnover = Projected Accounts Receivable

Using this approach, the projected accounts receivable amounts reported in the Figure 5.3 balance sheets are:

• Year-2: $1,540,000 ÷ 6 times = $256,667 projected accounts receivable
• Year-3: $1,724,800 ÷ 8 times = $215,600 projected accounts receivable.

Inventory

Inventory in Year-2 and Year-3 was projected by dividing each year’s cost of goods sold in the Figure 5.2 income statements by the corresponding inventory turnover targets summarized in Figure 5.1:

Cost of Goods Sold ÷ Inventory Turnover = Projected Inventory

Thus, the projected inventory amounts reported in the Figure 5.3 balance sheets are:

• Year-2: $924,000 ÷ 5 times = $184,800 projected inventory
• Year-3: $1,034,880 ÷ 9 times = $114,987 projected inventory.

Land

Year-2 and Year-3 land amounts were projected by adjusting each year’s beginning figure by anticipated acquisition and sales activities summarized in Figure 5.1:

Beginning Land + Land Purchased – Land Sold = Projected Land

Accordingly, the projected land figures reported in the Figure 5.3 balance sheets are³:

• Year-2: $165,000 + $0 − $40,000 = $125,000 projected land
• Year-3: $125,000 + $0 − $0 = $125,000 projected land.

Depreciable Fixed Assets

Hometown’s buildings, fixtures, and equipment (BFE) are the company’s depreciable fixed assets. As discussed previously, these assets are reported in the balance sheet at historical cost net of accumulated depreciation from prior years.⁴ The projected BFE amounts in Year-2 and Year-3 were projected by adjusting BFE at the beginning of each year by the events summarized in Figure 5.2 that are anticipated to occur during the year:

Beginning BFE + BFE Purchased – BFE Sold – Depreciation Expense = Projected BFE

Using this approach, the projected BFE amounts reported in the Figure 5.3 balance sheets are⁵:

• Year-2: $842,000 + $120,000 − $0 − $55,000 = $907,000 projected BFE
• Year-3: $907,000 + $0 − $0 − $55,000 = $852,000 projected BFE.

Trade Payables

Trade payables are current liabilities owed for inventory purchased on credit. To forecast trade payables, future inventory purchases must be determined first.⁶ Inventory purchases can be projected as follows:

Cost of Goods Sold + Ending Inventory – Beginning Inventory = Projected Inventory Purchases

Projected cost of goods sold in Year-2 and Year-3 is reported in the Figure 5.2 income statements. The inventory figures for Year-2 and Year-3 are reported in the Figure 5.3 balance sheets. The beginning Year-2 inventory is the actual ending inventory figure reported in the current-year balance sheet. The beginning inventory for Year-3 is the projected ending inventory for Year-2. Thus, projected inventory purchases for Year-2 and Year-3 are computed as follows:

• Year-2: $924,000 + $184,800 − $210,000 = $898,800 projected inventory purchases
• Year-3: $1,034,880 + $114,987 − $184,800 = $965,067 projected inventory purchases.

Using projected inventory purchases and dividing by the corresponding trade payable turnover targets from Figure 5.1, projected trade payable amounts are computed as follows:

Inventory Purchases ÷ Trade Payables Turnover = Projected Trade Payables

Thus, the trade payable projections reported in the Figure 5.3 balance sheets are:

• Year-2: $898,800 ÷ 8 times = $112,350 projected trade payables
• Year-3: $965,067 ÷ 12 times = $80,422 projected trade payables.

Long-Term Notes Payable

The long-term notes payable projections in Year-2 and Year-3 were derived in the following manner:

Beginning Notes Payable + New Borrowing – Principal Payments = Projected Notes Payable

Hometown does not anticipate any new borrowing in Year-2 or Year 3, so the only adjustment to the beginning balance each year is the annual principal payment shown in Figure 5.1. Thus, the long-term note payable projections reported in the Year-2 and Year-3 balance sheets are:

• Year-2: $400,000 + $0 − $36,000 = $364,000 projected long-term note payable
• Year-3: $364,000 + $0 − $38,000 = $326,000 projected long-term note payable.

Common Stock

Common stock at the end of Year-2 and Year-3 was projected by increasing the beginning amounts by the anticipated issuances of new stock to investors each year:

Beginning Common Stock + New Stock Issued = Projected Common Stock

Hometown does not anticipate any new stock issues, so the actual amount reported in its current-year balance sheet is carried forward to the Year-2 and Year-3 balance sheets, as follows:

• Year-2: $800,000 + $0 = $800,000 projected common stock
• Year-3: $800,000 + $0 = $800,000 projected common stock.

Retained Earnings

Changes to retained earnings in Year-2 and Year-3 are embedded in the shareholders’ equity section of the Figure 5.3 balance sheets. The projections follow the same format as a statement of retained earnings:

Beginning Retained Earnings + Income − Dividends = Projected Retained Earnings

Thus, the projected retained earnings amounts reported in the Figure 5.3 balance sheets are⁷:

• Year-2: $200,000 + $1,493,150 − $0 = $216,800 projected retained earnings
• Year-3: $216,800 + $60,734 − $125,000 = $161,534 projected retained earnings.

Cash

Thus far, the computation of every balance sheet forecast has been explained except cash. The cash projections in the Year-2 and Year-3 balance sheets could easily have been derived as plug figures required to balance the accounting equation (A = L + E). By rearranging this equation slightly, cash could have been computed as follows:

Liabilities + Shareholders’ Equity – All Noncash Assets = Projected Cash

Using this approach, the projected cash amounts reported in the Figure 5.3 balance sheets are⁸:

• Year-2: $476,350 + $1,016,800 − $1,473,467 = $19,683 projected cash
• Year-3: $406,422 + $961,534 − $1,307,586 = $60,370 projected cash.

This approach to forecasting cash is not advised. The reason? It does not provide any detailed information about the anticipated sources and uses of cash from operating activities, investing activities, and financing activities. To achieve this level of detail, forecasted statements of cash flow are required.

Forecasted Statements of Cash Flow

Before examining Hometown’s forecasted statements of cash flow for Year-2 and Year-3, a discussion of cash flow from operating activities is warranted. Cash flow from operating activities can be presented using one of two approaches—the direct method or the indirect method.⁹

The direct method has been illustrated in previous chapters due to its ease of interpretation. It conveys directly all sources and uses of operating cash flow in a straightforward manner, similar to the following format:

Cash Collected from Customers

– Cash Paid for Inventory

– Cash Paid for Selling, General, & Administrative Expenses

– Cash Paid for Interest Expense

= Net Cash Flow Provided by Operating Activities.

The indirect method is confusing to many users due to its somewhat convoluted format. It is called the indirect method because it derives operating cash flow indirectly by making a series of adjustments to the net income figure reported in a company’s income statement. The general format of the indirect method is as follows¹⁰:

Net Income

+ Depreciation Expense

+ Losses on Fixed Asset Disposals (or minus Gains)

+ Decreases in Accounts Receivable (or minus Increases)

+ Decreases in Inventory (or minus Increases)

+ Decreases in All Other Noncash Current Assets (or minus Increases)

+ Increases in Trade Payables (or minus Decreases)

+ Increases in All Other Current Liabilities (or minus Decreases)

= Net Cash Flow from Operating Activities.

The best way to explain why these adjustments to net income result in net cash flow from operating activities is to examine Hometown’s forecasted statements of cash flow illustrated in Figure 5.4.

Figure 5.4 Projected statements of cash flows: year-2 and year-3

Cash Flow from Operating Activities

Starting with Year-2 net income of $16,800, the first adjustment requires adding back the company’s Year-2 depreciation expense of $55,000. Depreciation is added to net income because it will not require any future payment of cash. Depreciation is referred to as a noncash expense, which means that it reduces net income without reducing cash. Thus, to convert net income to operating cash flow, depreciation expense must be added back. The same treatment of depreciation expense is repeated in Year-3.

Hometown projects a $15,000 loss on the sale of land in its Year-2 income statement. The loss—in similar fashion to depreciation expense—is added back to net income because it will not result in any form of cash payment. In fact, the company actually expects to receive $25,000 by selling land in Year-2, the entire amount of which is reported in the investing activities section of Figure 5.4. The $15,000 loss in the company’s projected income statement is simply the amount by which the land’s $40,000 original cost exceeds its projected $25,000 selling price. The loss will reduce net income without reducing cash, so it needs to be added back to convert net income to operating cash flow.¹¹

Hometown’s Year-2 projected accounts receivable of $256,667 in the Figure 5.3 balance sheet is $23,333 less than the actual $280,000 amount at the end of the current year. The anticipated $23,333 decrease is added to net income in Figure 5.4. A decrease in accounts receivable means that cash collections from credit customers during the year exceed credit sales reported in the income statement. These collections increase operating cash flow without increasing net income, so to convert net income to operating cash flow the decrease must be added back. Likewise, the company’s $215,600 accounts receivable projection in Year-3 is $41,067 less than the $256,666 amount forecasted in Year-2. This decrease must also be added back.¹²

Hometown’s Year-2 projected inventory of $184,800 in the Figure 5.3 balance sheet is $25,200 less than the actual $210,000 amount at the end of the current year. The $25,200 decrease is added to net income in Figure 5.4. A decrease in inventory means that cost of goods sold reported in the income statement exceeds inventory purchases for the year. The $25,200 amount by which cost of goods sold is expected to exceed inventory purchases will decrease net income without decreasing operating cash flow. Thus, to determine operating cash flow the $25,200 decrease must be added to net income. Likewise, the $114,987 inventory forecast in Year-3 is $69,813 less than the $184,800 Year-2 forecast. Thus, it must be added back, as well.¹³

Finally, Hometown’s Year-2 projected trade payables of $112,350 in the Figure 5.3 balance sheet is $12,350 more than the actual $100,000 amount at the end of the current year. The $12,350 increase is added to net income in Figure 5.4. An increase in trade payables means that inventory purchases during the year exceed cash payments to inventory vendors. The $12,350 amount by which inventory purchases are expected to exceed cash paid to vendors is not reflected in net income, so the increase must be added back.

Conversely, the projected $80,422 trade payables balance in Year-3 is $31,928 less than the $112,350 Year-2 amount. A decrease in trade payables means that cash payments to inventory vendors during the year exceed inventory purchases. The $12,350 amount by which cash payments to vendors are expected to exceed inventory purchases is not reflected in net income, so the decrease must be subtracted.¹⁴

Cash Flow from Investing Activities

In most cases, investing cash flows result from buying or selling investments in noncurrent fixed assets.¹⁵ Figure 5.4 reveals two investing cash flow projections, both of which are anticipated in Year-2. The first is a $25,000 cash inflow from the sale of land. This transaction is expected to result in the $15,000 loss that was added back to net income in determining of cash flow from operating activities. The second is a $120,000 cash outflow for the purchase of a new computer system. Taken together, the company’s projected net cash flow from investing activities in Year-2 is $95,000.

Cash Flow from Financing Activities

Financing cash flows result from long-term debt and equity transactions. Figure 5.4 reveals a single financing cash outflow in Year-2, and two financing cash outflows in Year-3. The anticipated cash outflow in Year-2 pertains to the $36,000 principal payment on Hometown’s $400,000 long-term note payable. A similar payment of $38,000 is forecasted in Year-3.

The company’s total debt service cost of $48,000 per year is allocated between the payment of principal and the payment of interest expense. The interest expense portion is considered an operating cash flow. The $12,000 allocated to interest expense in Year-2, and the $10,000 allocated to interest expense in Year-3, are both included in the projected net income figures used to forecast operating cash flows under the indirect method.

The second financing cash outflow in Year-3 is a projected $125,000 dividend to shareholders. Recall that the shareholders of McNamer Enterprises negotiated this dividend in exchange for purchasing $50,000 of additional stock in the current year. That transaction is shown in Figure 5.4 in the current year as a financing cash inflow.

Assessment of the Forecasts

Based on an assessment of Hometown’s forecasts, it appears that the company’s financial position, results of operations, and cash flow prospects may improve significantly over the next 2 years. Figure 5.5 provides a summary of several key assessment measures.

Figure 5.5 Forecast summary: year-2 and year-3

Hometown’s total assets are expected to decrease from $1,500,000 at the end of the current year, to $1,367,956 by the end of Year-3. This is not necessarily a bad sign, given the company’s goal to reduce its accounts receivable, inventory, and trade payables by bringing related turnover statistics up to industry averages by the end of Year-3.

If Hometown can achieve its goals, total liabilities also should decline from $500,000 at the end of the current year to $406,422 by the end of Year-3, causing a decrease in its debt-to-assets percentage from 33.33 percent in the current year, to 29.71 percent by the end of Year-3. Moreover, Hometown’s total shareholders’ equity is forecasted to decline by only $38,466—from $1,000,000 at the end of the current year to $961,534 by the end of Year-3—even though it intends to distribute a $125,000 dividend in Year-3.

The company’s net income is projected to grow from $3,000 in the current year to $60,370 by Year-3, and its net income as a percentage of sales is expected to grow from a current level of 0.25 percent to 4.04 percent over a two-year period. Hometown’s bankers should be comforted that operating cash flows are expected to improve from a negative $28,500 in the current year to an impressive $203,686 in Year-3. They also should find it encouraging that the company’s current ratio is expected to hold steady, whereas its quick ratio is expected to improve significantly.

Of course, impressive forecasting outcomes must always be viewed with cautious optimism. Indeed, financial forecasts are based entirely on assumptions about an uncertain future, so actual outcomes can differ significantly from expectations if key assumptions (such as anticipated sales growth, turnover estimates, or tax rates) prove invalid. Hometown’s bankers have good reason to be skeptical about these extremely optimistic forecasts. As such, they will certainly require that Hometown’s management provide forecasts based on a range of input assumptions in order to critically evaluate best-case, worst-case, and most likely outcomes. Indeed, forecasting models should always be designed to enable comparative analyses in response to changes in key input variables.

Summary

This chapter was devoted entirely to long-term financial forecasting. It marked a shift in focus from measuring historical performance to predicting future performance. Both internal and external users of financial information routinely engage in long-term forecasting. In addition to being well versed in economic trends and industry norms, both user groups need a solid understanding of financial statement integration, accrual and deferral timing differences, and various measures of liquidity and profitability.

Chapter 6 is devoted entirely to short-term financial forecasting. Short-term financial forecasting or operational budgeting is exclusively a managerial activity. Nevertheless, the process requires the same skill set and a similar understanding of important financial statement relationships as long-term forecasting. Regardless of its time horizon, financial forecasting is an interactive and dynamic process. As such, all of the long-term forecasts illustrated throughout this chapter were prepared using Excel. A basic level of spreadsheet proficiency is a mandatory skill for all serious users of financial information.

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¹The annual debt service cost of $48,000 is a fixed payment that is allocated between interest expense and the payback of the note’s outstanding principal. As the principal of the note declines over time, the amount of the $48,000 that is allocated to interest expense declines, as well.

²The $15,000 loss on the sale is computed by subtracting the $25,000 selling price from the original purchase price of $40,000.

³Land at the beginning of Year-2 is the $165,000 actual amount reported in the balance sheet at the end of the current year. Likewise, land at the beginning of Year-3 is the $125,000 projected amount reported at the end of Year-2. The $40,000 historical cost of the land that was sold in Year-2 is subtracted from the amount of land at the beginning of Year-2, not its $25,000 selling price. No land was purchased in either year.

⁴As explained in Chapter 2, land is not considered a depreciable fixed asset because its useful life is unlimited.

⁵BFE at the beginning of Year-2 is the $842,000 actual amount reported in the balance sheet at the end of the current year. Likewise, BFE at the beginning of Year-3 is the $907,000 projected amount reported at the end of Year-2. No BFE sales are anticipated in either year.

⁶Some analysis forecast trade payables based on cost of goods sold rather than inventory purchases. This practice is not recommended unless inventory amounts are relatively constant from year to year.

⁷Retained earnings at the beginning of Year-2 is the $200,000 actual amount reported in the balance sheet at the end of the current year. Likewise, retained earnings at the beginning of Year-3 is the $216,800 projected amount reported at the end of Year-2. The $125,000 dividend in Year-3 is from the input summary data presented in Figure 5.1.

⁸Noncash assets refer to the sum total of all assets other than cash.

⁹The direct method is more straightforward and easier to interpret than the indirect method. Nevertheless, the nearly all corporations use the indirect method in the financial statements they issue to external users. There are two reasons why. First, the indirect method is easier to prepare than the direct method. Second, even if companies choose to use the direct method, they are required to provide a supplemental schedule of operating cash flows prepared using the indirect method. If they elect to use the indirect method, they are not required to provide a supplemental schedule of operating cash flows using the direct method.

¹⁰Adjustments to net income using the indirect method are often far more complex than what is presented here; however, the general concepts underlying the conversion of net income into operating cash flow are the same.

¹¹Had Hometown expected to sell the $40,000 parcel of land for $55,000, a $15,000 gain would be reported in its forecasted Year-2 income statement, and $55,000 of cash proceeds from the sale would be reported in the investing activities section of the statement of cash flows. A $15,000 gain would increase net income, but it would not increase operating cash flow. As such, it would be subtracted from net income in the determination of cash flow from operating activities.

¹²Increases in accounts receivable occur when credit sales during the year exceed cash collections from credit customers. Credit sales increase net income without increasing operating cash flow. So to convert net income to operating cash flow, increases in accounts receivable are subtracted.

¹³Increases in inventory occur when inventory purchases during the year exceed cost of goods sold in the income statement. These purchases potentially decrease operating cash flow without decreasing net income. So to convert net income to operating cash flow, increases in inventory need to be subtracted.

¹⁴Changes in inventory and trade payables are not mutually exclusive occurrences—both are related to inventory purchases. The indirect method automatically takes this into account.

¹⁵As mentioned in Chapter 2, investing cash flows also can result from buying or selling financial investments, such as stock and bonds.