Cash Flow Analysis
Statement of Cash Flows
The purpose of the statement of cash flows is to
provide information on cash inflows and outflows for
a period.
It also distinguishes among the sources and uses of
cash flows by separating them into operating,
investing, and financing activities.
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Statement of Cash Flows
X The comparative balance sheet reports financial position:
X shows whether cash increased or decreased;
X does not show why cash changed;
X covers a specific moment in time.
X The statement of cash flows reports cash flows:
X shows where cash came from (receipts) and how cash was
spent (payments);
X reports why cash increased or decreased during the period;
X covers a span of time and is dated the same as the income
statement (e.g. ´<HDU Ended December 31, 2016µ
X The communicating link between income statement and
balance sheet.
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Statement of Cash Flows
Why cash is so relevant?
Cash is the most liquid of assets.
² Offers both liquidity and flexibility.
² Both the beginning and the end of a FRPSDQ\·V
operating cycle.
Contrast: Accrual accounting and Cash basis
accounting.
² Net cash flow as the end measure of
profitability.
² Cash flow analysis helps in assessing liquidity,
solvency, and financial flexibility.
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Statement of Cash Flows
How do people use cash flow information?
The statement of cash flows helps to:
1. predict future cash flows. Past cash receipts and
payments help predict future cash flows.
2. evaluate management decisions. Wise investment
decisions help the business prosper, while unwise
decisions cause the business to have problems.
Investors and creditors use cash flow information
to evaluate PDQDJHUV· decisions.
3. predict ability to pay debts and dividends. Lenders
want to know whether they will collect on their
loans. Stockholders want dividends on their
investments. The statement of cash flows helps
make these predictions. 109
Statement of Cash Flows
It helps address questions such as:
DHow much cash is generated from or used in operations?
DWhat expenditures are made with cash from operations?
DHow are dividends paid when confronting an operating
loss?
DWhat is the source of cash for debt payments?
DHow is the increase in investments financed?
DWhat is the source of cash for new plant assets?
DWhy is cash lower when income increased?
DWhat is the use of cash received from new financing?
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Cash Equivalents
X Highly liquid short-term investments:
X Readily convertible into cash (three months or less)
X So near maturity they have minimal risk of price changes due to interest rate
movements.
X So close to cash it is considered as equals.
X Examples:
X Money-market accounts
X Investments in the government securities
X Commercial paper
X Short-term treasury bills
X Cash equivalents often serve as temporary repositories of excess cash.
¶&DVK equivalents are short-term, highly liquid investments
which are readily convertible into known amounts of cash
and which are subject to an insignificant risk of change in
value.· 111
IAS 7 definition
Cash Equivalents
112
Basic Types of Cash Flow Activities
Day-to-day
Operating operations
Investing Long-term assets
Equity & Long-
Financing term liabilities
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Operating Activities
X Most important category
X Reflects the day-to-day operations
X Determines the future of an organization
X Generate revenues, expenses, gains, and losses
X Affect net income on the income statement
X Affect current assets and current liabilities on the
balance sheet.
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Investing Activities
X Increase and decrease long-term assets
X Computers, software, land, buildings, and equipment
X Include purchases and sales of these assets
X Include long-term loans receivable from others (non-
trade) and collections of those loans
X Include purchases and sales of long-term investments
115
Financing Activities
X Increase and decrease long-term liabilities and equity
X Include issuing stocks, paying dividends, and buying
and selling treasury stocks
X Include borrowing money and paying off loans
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Basic Types of Cash Flow Activities
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Operating, Investing and Financing
Activities and the Balance Sheet
Current
Current assets
liabilities
Long-term
Long-term liabilities
assets 2ZQHUV¶
equity
118
Two Formats for Operating Activities
X Indirect method
X Startswith net income; adjusts it to net cash
provided by operating activities
X Used by most companies
X Direct method
X Restates income statement in terms of cash
X Shows cash receipts and payments from operating
activities
X Use different computations, but same operating cash
flows
X No effect on investing and financial cash flows
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Prepare the statement of cash flows
by the indirect method
Step 1: Lay out the statement format
Step 2: Compute the change in cash from the
comparative balance sheet
Step 3: Take the figures³Net Income,
depreciation, and any gains or losses³from the
income statement
Step 4: Complete the statement of cash flows
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Cash Flows from Operating
Activities: Indirect Method
121
Cash Flows from Operating
Activities: Indirect Method
122
Gather Income Statement
Items from the
income statement not
affecting cash
123
Comparative Balance Sheet
124
Changes in Current Assets (other than
cash) and Current Liabilities
If an If a
Effect on cash
increase decrease
Current assets
Current liabilities
125
Cash Flows from Operating Activities
Refer to the balance sheet for changes in the accounts
Operations provided net cash flow of $70,000.
This amount exceeds net income of $40,000. 126
Cash Flows from Investing Activities
X Sales and acquisitions of long-term assets
X Plant assets and investments
X Analyze accounts to determine activity
X Use of T-account is helpful
X If gain or loss appears on the income statement,
a long-term asset has been sold
127
Computing Acquisitions and Sales of
Plant Assets
X Combine all the plant assets into a single Plant assets account
X Find the cost of the sold assets
X The missing value in our net T-account
128
Cash from Selling Plant Assets
X Solve cash received using the T-account and journal entry
X Adding the cost of the sold asset to the gain yields cash received
129
Computing Cash Flows from Investing
Activities Summary
130
Cash Flows from Financing Activities
X Issuances of and payments on long-term notes payable
X Issuances of stock and purchases of treasury stock
X Payments of dividends
131
Long-Term Notes Payable
X Review balance sheet for differences
X Note increase in Long-term notes payable
X If new issuances or payments are known, the other can be calculated
X If unknown, review account for debits and credits
X With knowledge of a new note, note payments can be calculated
132
Issuances of Stock and Purchases of
Treasury Stock
X Review balance sheet for differences
X Note change in Common stock of $120,000
X If either new issuances or purchases are known, the
other can be calculated
X If unknown, review account for debits and credits
133
Issuances of Stock and Purchases of
Treasury Stock
X Review balance sheet for differences
X Note change in Treasury stock of $20,000
X If either new issuances or purchases are known, the
other can be calculated
X If unknown, review account for debits and credits
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Computing Dividend Payments
X Review balance sheet for differences in Retained
earnings
X Note change in Retained earnings
X Retained earnings is changed by net income, net
losses and dividends
X Net income of $40,000 is indicated on the
income statement
X Cannot have both income and loss
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Net Change in Cash and Cash
Balances
136
Example: computing cash flows from operating activities³
indirect method
One Way Cellular accountants have assembled the following
data for the year ended September 30, 2012:
Payment of dividends $6,100 Net income $ 55,000
Depreciation expense 20,000 Purchase of equipment 39,000
Cash receipt Decrease in current
from sale of land 34,000 liabilities 19,000
Cash receipt from Increase in current
issuance of common stk. 30,000 assets other than cash 14,000
Prepare the operating activities section using the indirect
method for One Way &HOOXODU·V statement of cash flows for
the year ended September 30, 2012.
137
Example: computing cash flows from operating activities³
indirect method
One Way Cellular
Statement of Cash²Partial
Year Ended September 30, 2012
Cash flows from operating activities
Net income: $55,000
Adjustments to reconcile net income to
net
cash provided by operating activities
Depreciation $20,000
Increase in current assets other than
cash (14,000)
Decrease in current liabilities (19,000) (13,000)
138
Net cash provided by operating activities $42,000
Noncash Investing and Financing
X Investing and financing activities that do not affect cash
X Some examples are:
X Acquired building by issuing stock
X Acquired land by issuing note payable
X Paid note payable by issuing common stock
X Reported in separate schedule or in a note
X Key³Cash not listed in entry to record transaction
139
Exercise ² Gould Corporation
1.The company purchased a truck
during the year at a cost of $30,000
that was financed in full by the
manufacturer.
2. A truck with a cost of $10,000 and a
net book value of $2,000 was sold
during the year for $7,000. There
were no other sales of depreciable
assets.
3. Dividends paid
140 during Year 2 are
$51,000
Exercise ² Gould Corporation
(1) Start with Net Income
(2) Adjust Net Income for non-cash expenses and gains
(3) Recognize cash inflows (outflows) from changes in current
assets and liabilities
(4) Sum to yield net cash flows from operations
(5) Changes in long-term assets yield net cash flows from investing
activities
(6) Changes in long-term liabilities and equity accounts yield net
cash flows from financing activities
(7) Sum cash flows from operations, investing, and financing
activities to yield net change in cash
(8) Add net change in cash to the beginning cash balance to yield
ending cash 141
Exercise ²
1
Gould
2
Corporation
3
6
7
8
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Statement of Cash Flows
Special Topics
Equity Method Investments
± The investor records as income its percentage interest in the
income of the investee company and records dividends
received as a reduction of the investment balance.
± The portion of undistributed earnings is noncash income and
should be eliminated from the SCF.
Acquisitions of Companies with Stock
± Such acquisitions are non-cash.
± Changes in balance sheet accounts reflecting the acquired
company will not equal cash inflows (outflows) reported in the
SCF.
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Statement of Cash Flows
Special Topics
Postretirement Benefit Costs
± The excess of net postretirement benefit expense over cash
benefits paid must be added to net income in computing net
cash flows from operations
Securitization of Accounts Receivable
± Companies account for the reduction in receivables as an
increase in cash flow from operations since that relates to a
current asset.
± Analysts should question whether they represent true
improvement in operating performance or a disguised
borrowing.
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Statement of Cash Flows
Direct Method
The direct (or inflow-outflow) method reports gross
cash receipts and cash disbursements related to
operations²essentially adjusting each income
statement item from accrual to cash basis
± Reports total amounts of cash flowing in and out of a company
from operating activities
± Preferred by analysts and creditors
± Implementation costs
± When companies report using the direct method, they must
disclose a reconciliation of net income to cash flows from
operations (the indirect method) in a separate schedule
145
The Direct Method
X Preferred by FASB
X Provides clearer information about cash receipts and payments
X Normally not used by private companies
X Takes more computations and implementation costs
X Only operating activities presentation changes
X Net cash flow from operating activities has the same amount of cash
X Investing and Financing sections not changed
X It reports gross cash receipts and cash disbursements
related to operations
X When companies report using the direct method, they must
disclose a reconciliation of net income to cash flows from
operations (the indirect method) in a separate schedule.
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Direct Method Format
X Net cash provided is the same as indirect method
147
Direct Method Cash Flow Steps
X STEP 1: Lay out the operating section by the
direct method
X STEP 2: Use the comparative balance sheet to
determine the increase or decrease in cash
X STEP 3: Use the available data to prepare the
statement of cash flows
X Reports only transactions with cash effects
X Essentially a cash-basis income statement
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Converting Income Statement
Amounts
X First item on income statement
X Sales
X Total of all sales, whether for cash or on account
X Yields cash collected from customers
X Formula Sales revenue
± Increase in Accounts receivable
Cash collections from customers
or
Sales revenue
+ Decrease in Accounts receivable
Cash collections from customers 149
Cash Collections from Interest
X Second item on income statement
X Interestrevenue
X Related account is Interest receivable
X Receivable account indicates some not received
X Formula
Interest revenue
± Increase in Interest receivable
Cash collections from interest
or
Interest revenue
+ Decrease in Interest receivable
Cash collections from interest
150
Cash Collections from Dividends
X Third item on income statement
X Dividend revenue
X Related account is Dividend receivable
X Receivable account indicates some not received
X Formula Dividend revenue
± Increase in Dividend receivable
Cash collections from dividends
or
Dividend revenue
+ Decrease in Dividend receivable
Cash collections from dividends
151
Cash Paid for Inventory
X Payments to suppliers include all payments for inventory and operating
expenses
X Formula
Cost of goods sold
± Decrease in Inventory
± Increase in Accounts payable
= Cash paid for Inventory
Cost of goods sold
+ Increase in Inventory
+ Decrease in Accounts payable
= Cash paid for Inventory
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Cash Paid for Operating Expenses
X Payments to suppliers include all payments for inventory and operating
expenses
X Formula
Other operating expenses
+ Decrease in Accrued liabilities
= Cash paid for operating expenses
Other operating expenses
± Increase in Accrued liabilities
= Cash paid for operating expenses
153
Payments to Suppliers
X Payments to suppliers include all payments for inventory and operating
expenses
X Formula
Cash paid for Inventory
+ Cash paid for operating expenses
= Cash paid to suppliers
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Payments to Employees
X Payments to employees includes salaries, wages, other employee
compensation
X Formula
Salary expense or Wages expense
+ Decrease in Accrued salaries
= Cash paid to employees
Salary expense or Wages expense
± Increase in Accrued salaries
= Cash paid to employees
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Payments for Interest Expense
X Payments for interest include all payments of interest on notes and bonds
X Formula
Interest expense
+ Decrease in Accrued interest
= Cash paid for interest
Interest expense
± Increase in Accrued interest
= Cash paid for interest
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Payments for Income Taxes
X Payments for income taxes for all payments of taxes on income
X Formula
Income tax expense
+ Decrease in Income tax payable
= Cash paid for income tax
Income tax expense
± Increase in Income tax payable
= Cash paid for income tax
157
Net Cash Provided by Operating Activities
X Add them all together
158
Converting from Indirect to Direct Method
159
Limitations in Cash Flow Reporting
Practice does not require separate disclosure of cash
flows pertaining to either extraordinary items or
discontinued operations.
Interest and dividends received and interest paid are
classified as operating cash flows.
Income taxes are classified as operating cash flows.
Removal of pretax (rather than after-tax) gains or losses
on sale of plant or investments from operating activities
distorts our analysis of both operating and investing
activities.
160
Interpreting Cash Flows and Net Income
161
Interpreting Cash Flows and Net Income
162
Interpreting Cash Flows and Net Income
An income statement records revenues when earned
and expenses when incurred.
It does not show the timing of cash inflows and outflows, nor
the effect of operations on liquidity and solvency.
This information is available in the Statement of Cash Flows.
Cash flows from operations (CFO) is a broader view of
operating activities than is net income.
It is not a measure of profitability.
A net measure, be it net income or cash flows from
operations, is of limited usefulness. The key is
information about components of these net measures.
163
Interpreting Cash Flows and Net Income
Accounting accruals determining net income rely on
estimates, deferrals, allocations, and valuations Æ
Subjectivity
CFO effectively serve as a check on net income, but
not a substitute for net income.
CFO include a financing element Æ useful for
evaluating and projecting short-term liquidity and
longer-term solvency.
CFO exclude elements of revenues and expenses not
currently affecting cash.
Our analysis of operations and profitability should not
proceed without considering these elements.
164
Analysis of Cash Flows
In evaluating sources and uses of cash, the analyst
should focus on questions like:
DAre asset replacements financed from internal or
external funds?
DWhat are the financing sources of expansion and
business acquisitions?
DIs the company dependent on external financing?
DWhat are the FRPSDQ\·V investing demands and
opportunities?
DWhat are the requirements and types of financing?
DAre managerial policies (such as dividends) highly
sensitive to cash flows?
165
Insights from Analysis of Cash Flows
Where management committed its resources
Where it reduced investments
Where additional cash was derived from
Where claims against the company were reduced
Disposition of earnings and the investment of
discretionary cash flows
The size, composition, pattern, and stability of
operating cash flows
166
Good or bad news?
1. Increase in operating cash flow deriving from the
securitization of accounts receivable
2. Increase in operating cash flow resulting from the
reduction of inventories.
3. Increase in operating cash flow coming from
increases in current liabilities.
4. «
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Company and Economic Conditions
,W¶V important to separate operating performance and
profitability from those of investing and financing
activities.
While both successful and unsuccessful companies
can experience problems with cash flows from
operations, the reasons are markedly different.
We must interpret changes in operating working
capital items in light of economic circumstances.
Inflationary conditions add to the financial burdens of
companies and challenges for analysis.
168
Cash Flow as Validators
SCF provides us with important clues on:
9Feasibility of financing capital expenditures.
9Cash sources in financing expansion.
9Dependence on external financing.
9Future dividend policies.
9Ability in meeting debt service requirements.
9Financial flexibility to unanticipated needs/opportunities.
9Financial practices of management.
9Quality of earnings.
169
Measuring Cash Adequacy: Free Cash Flow
X Cash available from operations after:
X Paying for planned investments in long-term assets
X Paying dividends to shareholders
X Used to manage operations
X If investment opportunity is available, cash is free to invest
Another definition that is widely used:
FCF = NOPAT - Change in NOA
(net operating profits after tax (NOPAT) less the increase in net operating assets (NOA))
170
EBITDA as Cash Flow Measure
EBITDA (earnings before interest, taxes, depreciation,
and amortization)
The using up of long-term depreciable assets is a real expense
that must not be ignored.
The add-back of depreciation expense does not generate cash.
It merely zeros out the noncash expense from net income as
discussed above. Cash is provided by operating and financing
activities, not by depreciation.
Net income plus depreciation ignores changes in working
capital accounts that comprise the remainder of net cash flows
from operating activities. Yet changes in working capital
accounts often comprise a large portion of cash flows from
operating activities.
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Specialized Cash Flow Ratios
Cash Flow Adequacy Ratio ± Measure of a FRPSDQ\¶V ability to generate
sufficient cash from operations to cover capital expenditures, investments in
inventories, and cash dividends:
Three-year sum of cash from operations
Three-year sum of expenditures, inventory additions, and cash dividends
Cash Reinvestment Ratio ± Measure of the percentage of investment in
assets representing operating cash retained and reinvested in the company for
both replacing assets and growth in operations:
Operating cash flow ± Dividends
Gross plant + Investment + Other assets + Working capital
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Case Analysis of Cash Flows of Campbell Soup
173
Guidelines
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