Question

The Fried Company has assembled the accompanying balance sheets and income statement and reconciliation of retained earnings for 2018. Fried Co. Balance Sheets as of December 31 (in millions) 2018 2017

	2018	2017
Assets:
Cash	10	25
Accounts-receivable	40	28
Inventory	70	50
Prepaid-general-expenses	4	3
Plant-assets,net	202	150
	326	256
Liabilities-and-Shareholders’-Equity:
Accounts-payable-for-merchandise	74	60
Accrued-tax-payable	3	2
Long-term-debt	50	--
Capital-stock	100	100
Retained-earnings	99	94
	326	256
Sales		250
Less-cost-of-goods-sold:
Inventory,December-31,2017	50
Purchases	160
Cost-of-goods-available-for-sale	210
Inventory,December-31,2018	70	140
Gross-profit		110
Less-other-expenses:
General-expense	51
Depreciation	40
Taxes	10	101
Net-income		9
Dividends		4
Net-income-of-the-period-retained		5
Retained-earnings,December-31,2017		94
Retained-earnings,December-31,2018		99

On December 30, 2018, Fried paid $98 million in cash to acquire a new plant to expand operations. This was partly financed by an issue of long-term debt for $50 million. Some plant assets were sold for their book value of $6 million during 2018. Because net income was $9 million, the highest in the company’s history, Naftali Fried, the chief executive officer, was distressed by the company’s extremely low cash balance.

Required: a. Prepare a statement of cash flows using the direct method for reporting cash flows from operating activities. Do not forget to prepare a schedule that reconciles net income to net cash provided by operating activities. b. What is revealed by the statement of cash flows? Does it help you reduce Mr. Fried’s distress? Why? Briefly explain to Mr. Fried why cash has decreased even though net income was $9 million.

Answer 1

a.

Fried Company Statement of Cash Flows ( Direct Method) For the year ended December 31, 2018
	$	$
Cash Flows from Operating Activities
Cash received from customers	238
Cash paid to suppliers of inventory	(146)
Cash paid for general expenses	(52)
Cash paid for income taxes	(9)
Net cash provided by Operating Activities		31
Cash Flows from Investing Activities
Cash from sale of plant assets	6
Cash paid for new plant assets	(98)
Net Cash used in Investing Activities		(92)
Cash Flows from Financing Activities
Cash from issuance of long-term debt	50
Cash dividends paid	(4)
Net cash provided by Financing Activities		46
Net decrease in cash		(15)
Beginning cash balance		25
Ending cash balance		10

Reconciliation of net income to net cash provided by operating activities:

Net Income		$ 9
Adjustments to reconcile net income with net operating cash flows
Depreciation expense	40
Increase in accounts receivable	(12)
Increase in Inventory	(20)
Increase in prepaid general expenses	(1)
Increase in accounts payable for merchandise	14
Increase in accrued tax payable	1	22
Net cash provided by Operating Activities		$ 31

b. Net cash provided by operations of $ 31 million greatly exceeds net income of $ 9 million. The reason for decrease in cash during the year is not due to poor working capital management, it is due to large expansion activities undertaken by the firm. An expansion of $ 98 million has been partly met by issuance of long-term debt of $ 50 million, and sale of assets amounting to $ 6 million. The remaining $42 million towards CAPEX was met out of operating cash flows.

Yes, Mr. Fried's distress should be greatly reduced due to the following reasons:

• As net operating cash flows far exceed net income, earnings quality of the company is very good, and working capital management is excellent.
• Nearly 43 % ( 42 / 98) of the capital expenditures could be met from internal general of funds.
• In spite of going for a major expansion drive, the firm paid dividends to its shareholders at 44.44 %.