Cash Flow Analysis

7
CHAPTER
Statement of Cash Flows
Relevance of Cash Flows

Cash Defined -- refers to cash and cash

equivalents.

Cash equivalents are short-term, highly liquid

investments that are (1) readily convertible to
known amounts of cash, and (2) near maturity
(typically within 3 months) with limited risk of price
changes due to interest rate shifts.
 Statement of Cash Flows
Relevance of Cash Flows

Cash is the beginning and the end of a company’s operating cycle.

Cash repays loans, replaces equipment,

expands facilities, and pays dividends.

Analyzing cash inflows and outflows helps assess liquidity,

solvency, and financial flexibility.

Liquidity is the ability to meet short-term obligations.

Solvency is the ability to cover long-term obligations.
Financial flexibility is the ability to react to opportunities.
 Cash Flow Statement
 The cash flow statement is a report, like the income
statement and balance sheet, that firms use to explain
changes in their cash balances over a period of time
by identifying all of the sources and uses of cash for
the period spanned by the statement.

 The focus of the cash flow statement is the change in

the firm’s cash balance for the period of time covered
by the statement (i.e. one year or one quarter):

Change in cash = Ending cash – Beginning cash

balance balance balance

39
 Cash Flow Statement
The cash flow statement reports cash inflows and
cash outflows over a specific period of time, and
summarises these according to:
Cash flows from operating activities
– represent the company’s main business, including cash
received from sales and cash paid for expenses.
Cash flows from investing activities
– represent the cash flows that arise out of the purchase and
sale of long-term assets such as plant and equipment.
Cash flows from financing activities
– represent changes in the firm’s use of debt and equity such
as issue of new shares, the repurchase of outstanding
shares and the payment of dividends.

40
41
 Statement of Cash Flows
Relevance of Cash Flows
Statement of cash flows (SCF) helps address questions such as:
 How much cash is generated from or used in operations?
 What expenditures are made with cash from operations?
 How are dividends paid?
 What is the source of cash for debt payments?
 What is the source of cash for redeeming preferred stock?
 How is the increase in investments financed?
 What is the source of cash for new plant assets?
 Why is cash lower when income increased?
 What is the use of cash from new financing?
 Statement of Cash Flows
Net Cash Flows from Operations

Indirect Method
-Net income is adjusted for non-cash items and accruals to
yield cash flow from operations

Direct Method
-Each income item is adjusted for its related accruals

*Both methods yield identical results-only the presentation format

differs.
 Statement of Cash Flows
Indirect Method
Net Cash Flows from Operations

Net Income
+ Depreciation
+/- Gains (losses) on sales of assets
+/- Cash generated (used) by current assets & liabilities
Net cash flows from operating activities
 Statement of Cash Flows
Income vs. Cash Flows Example
Consider a $100 sale on account
(1) In period of sale, net income is increased by $100 but no
cash has been generated.

Net Income 100

Depreciation and amortization expense 0
Gains (losses) on sale of assets 0
Change in accounts receivable (100)
Net Cash flow from operations 0

 In period of collection no income is recorded.

Net Income 0
Depreciation and amortization expense 0
Gains (losses) on sale of assets 0
Change in accounts receivable 100
Net Cash flow from operations 100
 Statement of Cash Flows
Steps in Constructing the Statement
(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
 Cash From Operations
Indirect Method for CFO

Deriving
DerivingOperating
OperatingCash
CashFlows
Flowsfrom
fromIncome
Incomefor
forGould.
Gould.
Amount
Amount
Item
Item(in
(inthousands)
thousands) Explanation
Explanation
Net
Netincome,
income,accrual
accrualbasis
basis $$84
84 Starting
Startingpoint
pointofofconversion
conversion
Add
Add(deduct)
(deduct)adjustment
adjustmenttotocash
cashbasis:
basis:
Depreciation
Depreciation 35
35 Depreciation
Depreciationhas
hasno
nocash
cashoutflow.
outflow.
Gain
Gainon
onsale
saleofofassets
assets (5)
(5) Remove
Removegain
gain(because
(becauseititisisnonoperating)—
nonoperating)—
cash
cash
inflow
inflowisiscash
cashfrom
frominvesting
investingactivities.
activities.
Increase
Increaseininreceivables
receivables (9)
(9) Cash
Cashflow
flowfrom
fromsales
salesisisless
lessthan
thanaccrual
accrualsales.
sales.
Decrease
Decreaseinininventories
inventories 66 Cash
Cashoutflow
outflowfor
forinventory
inventoryexceeds
exceedsaccrual
accrual
inventory
inventory cost included in costofofsales.
cost included in cost sales.
Decrease
Decreaseininprepaid
prepaidexpenses
expenses 33 Cash
Cashoutflow
outflowoccurred
occurredwhenwhenprepaids
prepaidswere
were
purchased-current expense is non-cash
purchased-current expense is non-cash
Decrease
Decreaseininaccounts
accountspayable
payable (5)
(5) Cash
Cashoutflows
outflowsforforpurchases
purchases(included
(includedinincost
costofof
goods
goods sold) is less than accrual purchasescost.
sold) is less than accrual purchases cost.
Increase
Increaseininaccrued
accruedexpenses
expenses 44 Expense
Expensehashasbeen
beenrecognized
recognizedbutbutno
nocash
cashpaid
paid
_____
_____ yet.
yet.
 Cash From Operations
Converting Indirect to Direct
Gould
GouldCorporation
Corporation
Cash
CashFlows
Flowsfrom
fromOperations
Operations ($
($thousands)
thousands)
For
ForYear
YearEnded
EndedDecember
December31,31,Year
Year22
Cash
Cashflows
flowsfrom
fromoperating
operatingactivities:
activities:
Cash
Cashreceipts
receiptsfrom
fromcustomers
customers[a][a] $651,000
$651,000
Cash
Cashpaid
paidfor
forinventories
inventories[b]
[b] (362,000)
(362,000)
Cash
Cashpaid
paidgeneral,
general,selling,
selling,and
andadministrative
administrativeexpenses
expenses[c]
[c] (176,000)
(176,000)
________
________
Net
Netcash
cashflows
flowsfrom
fromoperations
operations $113,000
$113,000

Computations:
Computations:
[a]
[a] Sales
Salesofof$660,000
$660,000less
lessincrease
increaseininaccounts
accountsreceivables
receivablesofof$9,000.
$9,000.
[b]
[b] Cost
Cost of goods sold of $363,000 less decrease in inventoriesof
of goods sold of $363,000 less decrease in inventories of$6,000
$6,000plus
plusdecrease
decreaseinin
accounts
accountspayable
payableof of$5,000
$5,000
[c]
[c] General,
General,selling,
selling,and
andadministrative
administrativeexpenses
expensesofof$218,000
$218,000less
less(noncash)
(noncash)depreciation
depreciation
and
and amortization of $35,000, less decrease in prepaid expenses of 3,000, lessincrease
amortization of $35,000, less decrease in prepaid expenses of 3,000, less increase
ininaccrued
accruedexpenses
expensesof of4,000.
4,000.
Cash From Operations
Reporting Formats for CFO

Companies Reporting Cash Flows using Indirect or

Direct Formats

Direct Method
3%

Indirect Method
97%
 Cash flow analysis
An income statement measures company profitability for a
period. However, an income statement does not show us the
timing of cash inflows and outflows, nor the effect of
operations on liquidity and solvency.
The income statement uses accrual accounting in recognizing revenues
earned and expenses incurred.

Cash flow from operations focuses on the liquidity and solvency

aspects.
Cash flows from operations report revenues received in cash and
expenses paid.
We often relate cash flows from operations to net income in assessing its quality.
 Cash flow analysis

Establish major past sources of cash and their

uses
A common-size analysis of the statement of cash
flows aids in this assessment.
In estimating trends, it is useful to total the major
sources and uses of cash over a period of a few years.
Cash flow analysis

During this six-year period

the major sources of cash
are operations ($3,010
million), long-term debt
($854 million),
and short-term debt ($737
million)
Cash flow analysis

Major uses are plant

purchases, business
acquisitions, and cash
dividends.
 Cash From Operations
Business Conditions and Cash Flows

While
While both
both successful
successful and
and unsuccessful
unsuccessful companies
companies can
can
experience
experience problems
problems with
with cash
cash flows
flows from
from operations,
operations,
the
thereasons
reasonsare
aredifferent.
different.

We
We must
must interpret
interpret changes
changes in
in operating
operating working
working capital
capital
items
itemsin
inlight
lightof
ofeconomic
economiccircumstances.
circumstances.
https://siteeconomics.blogspot.com/2016/08/cash-flow-activities-and-firms-life.html
Cash From Operations
Cash Flow as Validators

The
The statement
statement of of cash
cash flows
flows is
is
useful
useful in
in identifying
identifying misleading
misleading
or
or erroneous
erroneous operating
operating results
results
or
or expectations.
expectations.
 Cash From Operations
Specialized Cash Flow Ratios

Cash
CashFlow
FlowAdequacy
AdequacyRatio
Ratio––Measure
Measureofofaacompany’s
company’sability
abilityto
togenerate
generate
sufficient
sufficientcash
cashfrom
fromoperations
operationsto
tocover
covercapital
capitalexpenditures,
expenditures,investments
investmentsinin
inventories,
inventories,and
andcash
cashdividends.
dividends.AAratio
ratioofof11indicates
indicatesthe
thecompany
companyexactly
exactly
covered these cash needs without a need for external financing.
covered these cash needs without a need for external financing.
Three-year
Three-yearsumsumofofcash
cashfrom fromoperations
operations
Three-year
Three-yearsumsumofofexpenditures,
expenditures,inventory
inventoryadditions,
additions,and
andcash
cashdividends
dividends

Cash
CashReinvestment
ReinvestmentRatio
Ratio––Measure
Measureofofthe
thepercentage
percentageofofinvestment
investmentinin
assets
assetsrepresenting
representingoperating
operatingcash
cashretained
retainedand
andreinvested
reinvestedininthe
thecompany
companyfor for
both
both replacing assets and growth in operations. A reinvestment ratio in the areaofof
replacing assets and growth in operations. A reinvestment ratio in the area
7%
7%toto11%
11%isisgenerally
generallyconsidered
consideredsatisfactory
satisfactory

Operating
Operatingcash
cashflow
flow––Dividends
Dividends
Gross
Grossplant
plant++Investment
Investment++Other
Otherassets
assets++Working
Workingcapital
capital
Cash From Operations
Alternative Cash Flow Measure

Net
Net income
income plus
plus major
major noncash
noncash expenses
expenses
(typically
(typicallydepreciation
depreciationand
andamortization)
amortization)
 Cash From Operations
Alternative Cash Flow Measure - Illustration

Assume
Assumetwo twocompanies
companies(A(Aand
andB)B)each
eachinvest
invest$50,000
$50,000in
inmachinery
machineryyielding
yielding
$45,000 per year cash flows before depreciation. Assuming a
$45,000 per year cash flows before depreciation. Assuming a five‑yearfive‑year
useful
usefullife
lifeand
andno
nosalvage
salvagevalue
valuefor
forthe
themachinery,
machinery,results
resultsfor
forthe
theentire
entirefive-
five-
year
yearperiod
periodare:
are:

Five-Year
Five-YearPeriod
Period
Cash
Cashprovided
providedbybyoperations
operations($45,000
($45,000xx55years)
years) $225,000
$225,000
Cost
Costof
ofthe
themachine
machine $$(50,000)
(50,000)
Income
Incomefrom
fromoperating
operatingmachine
machine $175,000
$175,000
Average
Averageyearly
yearlynet
netincome
income $$ 35,000
35,000
 Cash From Operations
Alternative Cash Flow Measure - Illustration

Company
CompanyA: A: Company
CompanyB: B:
Straight-Line
Straight-Line Sum-of-the-Years’-
Sum-of-the-Years’-
Depreciation
Depreciation Digits
DigitsDepreciation
Depreciation
Income
Income
before
before
Year
Year Depreciation
Depreciation Depreciation
Depreciation Net
NetIncome
Income Depreciation
Depreciation Net
NetIncome
Income
11 $$ 45,000
45,000 $10,000
$10,000 $$ 35,000
35,000 $16,667
$16,667 $$ 28,333
28,333
22 45,000
45,000 10,000
10,000 35,000
35,000 13,334
13,334 31,666
31,666
33 45,000
45,000 10,000
10,000 35,000
35,000 10,000
10,000 35,000
35,000
44 45,000
45,000 10,000
10,000 35,000
35,000 6,667
6,667 38,333
38,333
55 45,000
45,000 10,000
10,000 35,000
35,000 3,332
3,332 41,668
41,668
Total
Total $225,000
$225,000 $50,000
$50,000 $175,000
$175,000 $50,000
$50,000 $175,000
$175,000

Income
Incomebefore
beforedepreciation
depreciationfor
forthese
thesetwo
twocompanies
companiesisisidentical--this
identical--thisreveals
revealsidentical
identicalearning
earning
power.
power.
Income
Incomeafter
afterdepreciation
depreciationisisconsiderably
considerablydifferent
differentacross
acrossthe
theyears—this
years—thisdoes
doesnot
notreflect
reflect
changes in earning power.
changes in earning power.
 Cash From Operations
Free Cash Flow

Cash
Cashflows
flowsfrom
fromoperations
operations

Deduct:
Deduct: Net
Netcapital
capital expenditures
expendituresrequired
requiredto
to
maintain
maintainproductive
productivecapacity
capacity

Dividends
Dividendson
onpreferred
preferredstock
stockand
andcommon
common
stock
stock(assuming
(assumingaapayout
payoutpolicy)
policy)

Equals
Equals Free
Freecash
cashflow
flow (FCF)
(FCF)
 Cash From Operations
Free Cash Flow
Positive
Positive free
free cash
cash flow
flow reflects
reflects the
the amount
amount available
available for
for
business
business activities
activities after
after allowances
allowances forfor financing
financing andand
investing
investing requirements
requirements to to maintain
maintain productive
productive capacity
capacity atat
current
currentlevels.
levels.

Growth
Growth and
and financial
financial flexibility
flexibility depend
depend on
on adequate
adequate free
free cash
cash
flow.
flow.

Recognize
Recognizethat
thatthe
theamount
amountof ofcapital
capitalexpenditures
expenditures
needed
neededtotomaintain
maintainproductive
productivecapacity
capacityisisgenerally
generally
not
notdisclosed—instead,
disclosed—instead,most
mostuse
usetotal
totalcapital
capital
expenditures,
expenditures,which
whichisisdisclosed,
disclosed,but
butcan
caninclude
include
outlays
outlaysfor
forexpansion
expansionof ofproductive
productivecapacity.
capacity.