Financial Reporting and Analysis

Understanding Cash Flow Statements

1
 Contents
1. Introduction

2. Components and Format of the Cash Flow Statement

3. The Cash Flow Statement: Linkages and Preparation

4. Cash Flow Statement Analysis

2
 1. Introduction
• The cash flow statement provides important information about a company’s
cash receipts and payments during an accounting period

• Cash flow statement is a vital information source that assists users to evaluate
a company’s liquidity, solvency and financial flexibility

• For an analyst, it is crucial to estimate future cash flows

3
 2. Components and Format of the Cash Flow Statement
Classifications of cash flows:

Operating activities are activities that are part of the day to day business operations of the company
1. Sales of goods and services (R)
2. Cost of providing good and services (X)
3. Short term assets and liabilities directly related to operating activities (A), (L)

Investing activities are activities associated with acquisition and disposal of long-term assets
1. Purchase or sale of property, plant and equipment (A)
2. Purchase or sale of other entities’ equity and debt securities (A)

Financing activities are activities related to obtaining or repaying capital

1. Issuance or repurchase of company’s own preferred or common stock (E)
2. Issuance or repayment of debt (L)
3. Dividend payments (E)

4
 Example
JFK Enterprises recorded the following for the year 2012:
Purchase of equipment $70,000
Gain from sale of van $8,000
Receipts from sale of van $18,000
Dividends paid on ordinary share capital $10,000
Interest and preference dividend paid $12,000
Salaries paid $40,000

What is the net cash flow from investing activities?

Outflow of $52,000.

5
 Summary of Differences between IFRS and U.S. GAAP

Cash flow IFRS U.S. GAAP

Interest received Operating or investing Operating

Interest paid Operating or financing Operating

Dividends received Operating or investing Operating

Dividends paid Operating or financing Financing

6
 Direct and Indirect Methods for Reporting Cash Flow from Operating Activities

Direct: Indirect:

Cash collection from Net income

customers Adjustments to reconcile net income to cash flow
provided by operating activities:
Cash paid to suppliers Depreciation and amortization
Deferred income tax
Cash paid for operating expenses Increase in account receivable
Increase in inventory
Cash paid for interest Decrease in prepaid expenses
Increase in accounts payable
Cash paid for taxes
Increase in accrued liabilities
Operating cash flow Operating cash flow

7
 Non-Cash Activities
• A non cash transaction is any transaction that does not involve an outflow or
inflow of cash
• It must be disclosed in either a footnote or supplemental schedule to the cash
flow statement
• An analyst should incorporate non cash transaction into analysis of past and
current performance and include their effects in estimating future cash flows

Example:
A conversion of a face value $1,000,000 convertible bond for $1,000,000 of
common stock

8
 3. The Cash Flow Statement: Linkages and Preparation

• Linkages of the Cash Flow Statement with the Income

Statement and Balance Sheet

• Steps in Preparing Cash Flow Statements

• Conversion of Cash Flows from Indirect to Direct Format

9
Linkages of the Cash Flow Statement with the Income Statement
and Balance Sheet

Beginning Balance Statement of Cash Flows for Year Ended 31 Ending Balance Sheet at
Sheet at 1 Jan 1010 December 2010 31 Dec 2010
Beginning Cash Plus Cash Receipts Less Cash Payments
100 50 40 110

Beginning Balance Income Statement Statement of Cash Ending Balance Sheet at

Sheet at 1 Jan 1010 Flows 31 Dec 2010
Beginning A/R Plus Revenue Less Cash Collected Ending A/R
From Customers
200 5,000 4,800 400

10
Steps in Preparing the Cash Flow Statement

Operating Activities: Direct Method

Investing Activities: Direct Method

Financing Activities: Direct Method

Overall Statement of Cash Flows: Direct Method

Overall Statement of Cash Flows: Indirect Method

11
 Operating Activities: Direct Method

Cash collection from customers

Cash paid to suppliers

Cash paid for operating expenses

Cash paid for interest

Cash paid for taxes

Operating cash flow

12
Short-Cut for Determining Operating Cash Flows
Determine whether cash flow is income (+) or an expense (-)

Increase in asset will have a negative impact on cash flow

Decrease in asset will have a positive impact on cash flow

Increase in liability will have a positive impact on cash flow

Decrease in liability will have a negative impact on cash flow

13
 Example
Amanda Mills Ltd. reported revenues of $10 million, expenses of $7.5 million, and
thus a profit of $2.5 million. Accounts receivable increased by $4 million. How much
cash did the company receive from its customers?

Answer: 6 million

14
 Example
An analyst collects the following information for a company:
Net revenue $200,000
Gross profit $50,000
Increase in inventory $8,000
Increase in accounts payable $12,000
How much cash did the company pay to its suppliers?

Answer: 146,000

15
 Investing Activities: Direct method
CFI is calculated by examining the change in the gross asset account that results from investing activities;
typically we are considering purchases or sale of equipment (long term assets)

To determine cash paid for new equipment, it is necessary to analyze whether old assets are sold or not

Ending Gross Beginning Gross

Cash Paid for New
Equipment = Equipment
Balance
+ Gross Cost of
Equipment Sold
- Equipment
Balance

BB Equipment
+Equip. Purchased
- EB Equipment

16
 Investing Activities: Direct method
To determine the cash inflow from the sale of equipment, the equipment, accumulated depreciation
account and gain or loss on the sale of equipment are analyzed

Historical Cost
Cash from Sale = of Equipment
Sold
- Depreciation on
Equipment Sold
+ Gain on Sale of
Equipment

BB Equipment BB Acc. Depreciation

+Equip. Purchased + Dep. Expense
- EB Equipment - EB Acc. Depreciation

17
 Example
The balance sheet extract for Jackal Labs Ltd shows the machinery and accumulated depreciation
balances for the years 2011 and 2012.

2011 2012
Machinery (Gross) $80 million $91 million

Accumulated depreciation $25 million $31 million

Further information provided is as follows:

Gain on sale of machinery $1.5 million
Depreciation expense for 2012 $7 million
Capital expenditure on machinery $14 million
How much did the company receive in cash from sale of machinery?

18
 Solution
2011 2012 Gain on sale of machinery $1.5 million
Machinery (Gross) $80 $91 Depreciation expense for 2012 $7 million
million million Capital expenditure on machinery $14 million
Accumulated depreciation $25 $31
million million

Cash from Sale =

3.5 =
Hist cost of
equip sold: 3
- Dep on equip
sold: 1
+ Gain on sale of
equip: 1.5

BB Equipment BB Acc. Depreciation

+Equip. Purchased + Dep. Expense
- EB Equipment - EB Acc. Depreciation
19
 Financing Activities: Direct Method
Cash flow between the firm and suppliers of capital

Net cash flow from creditors =

Bondholders
new borrowings – principle
Lenders
amount repaid

Firm
Net cash flow from shareholders =
Shareholders new equity issued – shares
repurchased – cash dividends paid

20
Overall Cash Flow Statement: Direct Method

Source: Financialeducation.com

21
 Operating Activities: Indirect Method
1. Begin with net income Net Income
2. Add back all non cash charges to
income and subtract all non cash + Depreciation expense
components of revenue
3. Subtract gain that resulted from
financing or investing cash flows - Gain on sale of equipment

4. Add or subtract changes to balance

sheet operating accounts
 Increases in the operating asset account - Increase in current (operating) assets
(use of cash) are subtracted, while
decrease (source of cash) are added
 Increase in the operating liability accounts + Increase in current (operating) liabilities
(sources of cash) are added, while
decrease (uses of cash) are subtracted
Net cash provided by operating activities
22
 Conversion of Cash Flows from Indirect to Direct Method
Total Revenue
– Total Expenses
= Net Income
1. Aggregate all revenue and all expenses
Total Revenue less non
cash revenue
2. Remove all noncash item from COGS
aggregated revenues and expenses and Salary and wages
Other op. expenses
break out remaining items into relevant Interest expense
cash flow items Tax expense

Total
3. Convert accrual amounts to cash flow Cash From Customers
amounts by adjusting for working
capital changes Cash to suppliers
Cash to employees
Cash for op. expenses
Cash paid for interest
Cash paid for tax
23
Total
 4. Cash Flow Statement Analysis
The analysis of a company’s cash flows can provide useful information for
understanding a company’s business and earnings and for predicting its future
cash flows.
1. Evaluate where the major sources and uses of cash flow are between
operating, investing and financing activities
 Will operating cash flow cover capital expenditures
2. Evaluate the primary determinants of operating cash flow
 Compare operating cash flow with net income
 Look at consistency of operating cash flow
3. Evaluate the primary determinants of investing cash flow
4. Evaluate the primary determinants of financing cash flow

24
Common-Size Analysis of the Statement of Cash Flows (Two Approaches)
Express each line item of cash inflow Express each line item as a percentage of revenue
(outflow) as a percentage of total inflows
(outflows)

Inflows Actual % of Total Inflows Actual % of Total

Inflow Revenue
Receipt from Receipt from
customers customers

Sale of Sale of
Equipment Equipment

Issue of Issue of
Shares Shares

Total Total

25
 Free Cash Flow to Firm and Free Cash Flow to Equity

Lenders
FCFF = NI + NCC + Int(1-Tax rate) – FCInv – WCInv
Firm
FCFF = CFO + Int(1-Tax rate) – FCInv
Generates
Cash
Shareholders

FCFE = CFO – FCInv + Net borrowing

FCFE = CFO – FCInv – Net debt repayment

26
 Cash Flow Ratios
Performance Ratios Calculation What It Measures
Cash flow to revenue CFO ÷ Net revenue Operating cash generated per dollar
of revenue

Cash return on assets CFO ÷ Average total assets Operating cash generated per dollar
of asset investment

Cash return on equity CFO ÷ Average shareholders’ equity Operating cash generated per dollar
of owner investment

Cash to income CFO ÷ Operating income Cash generating ability of operations

Cash flow per share (CFO – Preferred dividends) ÷ Number Operating cash flow on a per-share
of common shares outstanding basis

27
 Cash Flow Ratios
Coverage Ratios Calculation What It Measures
Debt coverage CFO ÷ Total debt Financial risk and financial leverage
Interest coverage (CFO + Interest paid + Taxes paid) ÷ Interest Ability to meet interest obligations
paid
Reinvestment CFO ÷ Cash paid for long-term assets Ability to acquire assets with
operating cash flows

Debt payment CFO ÷ Cash paid for long-term debt Ability to pay debts with operating
repayment cash flows
Dividend payment CFO ÷ Dividends paid Ability to pay dividends with
operating cash flows
Investing and CFO ÷ Cash outflows for investing and Ability to acquire assets, pay debts,
financing financing activities and make distributions to owners

28
 Summary
• Operating, Investing and Financing Activities
• Cash Flow Items under IFRS and U.S. GAAP
• Direct versus Indirect Cash Flow Statement
• Cash Flow Statement can be Derived from the Income
Statement and Balance Sheet
• Steps in Preparing Direct and Indirect Cash Flow Statements
• Cash Flow Analysis
• FCFF and FCFE

29
 Conclusion
• Read summary

• Review learning objectives

• Examples

• Practice problems: good but not enough

• Practice questions from other sources

30