Analyzing Cash Flows

Statement of Cash Flows

Statement of Cash Flows
• 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 when confronting an
operating loss?
 What is the source of cash for debt payments?
 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 received from new financing?

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Internal Uses of CFS
 Along side with cash budget CFS is used:
 To assess liquidity
 Determine if short-term financing is necessary

 To determine dividend policy

 Decide to distribute; or increase or decrease

 To evaluate the investment and financing decisions

Preparing a Statement of Cash Flows
Prepared by
• calculating changes in all of the balance sheet
accounts, including cash
• listing the changes in all of the accounts except cash
as inflows or outflows
• categorizing the flows by operating, financing, or
investing activities
The inflows less the outflows balance to and explain
the change in cash.

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Four Parts of a Statement of Cash Flows
 Cash
 Operating activities
 Investing activities
 Financing activities

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Four Parts of a Statement of Cash Flows

Cash
• Cash and highly liquid short-term marketable securities
• Also called cash equivalents
• If a company separates marketable securities into two
accounts (cash and cash equivalents and short-term
investments), the short-term investments are classified as
investing activities.

4-6
 Classification of Cash Flows

Operations -- cash flows related to selling goods and services;

that is, the principle business of the firm.
Investing -- cash flows related to the acquisition or sale of
noncurrent assets.
Financing -- long term and short term cash flows related to
liabilities and owners’ equity; dividends are a financing cash
outflow.
Cash flow from operating activities

 Examples (IAS No.7):

 cash received from customers through sale of goods or
services performed;
 cash received from non-operating activities such as
dividends from investments, interest revenue,
commissions, and fees;
 cash payments to suppliers or employees;
 cash payments for taxes and other expenses;

In effect, the income statement is changed from

accrual basis to cash basis
Investing Activities
Examples of investing activities include:
 cash payments to acquire property, plant, and equipment (PPE),
other tangible or intangible assets, and other long-term assets; and
sale of such assets
 loans extended to other companies; and collection of such loans;
Financing Activities
Examples of financing activities are :
 cash received from issuing share capital;
 cash proceeds from issuing bonds, loans, notes, mortgages
and other short or long-term borrowings;
 cash repayment of loans and other borrowings; and
 cash payments to shareholders as dividends.
 Format of the Cash Flow Statement

Name of the Company

Cash Flow Statement
For the period …

Cash from operating activities A

Cash from investing activities B
Cash from financing activities C
Net Change in Cash D = (A+B+C) increase or (decrease)
+ Beginning Cash balance CB, from the beginning balance sheet
Ending Cash balance =CB + D should equal to ending cash
balance in the ending balance sheet
Non-cash Investing and Financing Activities
Determination of Cash Flows From
Operating Activities

Direct Method
Income Statement items are converted to cash flows
individually

Indirect Method
Net income or loss is adjusted for accruals such as
accounts receivable and payable, and for non-cash
expenses such as depreciation
reconciliation of the accrual based and cash based
accounting
 Comparison of Methods

 Direct method of presentation calculates cash flow from operations

by subtracting cash disbursements to supplies, employees, and
others from cash receipts from customers.
 The indirect method calculates cash flow from operations by
adjusting net income for non-cash revenues and expenses.
 Most firms present their cash flows using the indirect method.

Only operating activities section is different between the

methods, investing and financing sections are the same.
How to prepare cash flow statement
 Firms could prepare their own cash flow statement
directly from the cash account.
 however, we need two consecutive balance sheets and
the income statement that covers the period between
the two balance sheets
 Algebraic Formulation*

Assets = Liabilities + Shareholders’ Equity

or A = L + SHE
Assets are either cash (C) or not (Non-Cash)
Thus reorganizing
C + Non Cash Assets (NCA) = L + SE
 C +  NCA =  L +  SE
Where  means the change in the balance of the item from
the previous period.
Solving for change in cash:
 C =  L +  SE -  NCA

Based on Stickney and Weil, 10th ed. Financial Accounting Slides http://www.swlearning.com/accounting/stickney/tenth_edition/stickney.html
 Algebraic Formulation (Cont.)

 C =  L +  SE -  NCA

The change in cash,  C, is the increase or decrease in the

cash account.
This amount must equal changes in liabilities plus changes in
shareholders’ equity minus changes in assets other than
cash.
Thus, we can identify the causes in the change in the cash
account by studying the changes in non-cash accounts.
Indirect Method – cash flow from operations
Adjusting Net Income of the period (accrual) to cash basis income

INCREASE DECREASE
Increase in non-cash Decrease in non-cash
assets shows that cash assets shows that
Assets was spent, they provided cash
so cash outflow. so cash inflow.

Increase in liabilities
Liabilities Decrease in liabilities
cash savings;
and or SHE shows
increase in SHE cash
Shareholders’ received;
cash paid;
equity so cash outflow
so cash inflow
Indirect Method- operating activities-
Adjustments to net income

Net income
+ noncash expenses: depreciation, amortization,
uncollectible account expense,etc
+ loss on sale of asset
+ increases in current liabilities
+ decreases in current assets
- gain on sale of asset
- decrease in current liabilities
- increase in current assets
= Cashflow from operating activities
 Noncash Expenses

 Noncash expenses, such as depreciation expense, are

added back – because they were deducted to measure
net income but did not require any cash payment in the
current period
 They are not truly sources of cash, even though they are
associated with cash inflows but reversal of an accrued
expense
Portakal Company
Prepare Cash Flow Statement
increase
Accounts with Debit Balances 2008 2007 (decrease)
Cash 37.500 39.250 (1.750)
Notes Receivable (from loans to other companies) 69.000 50.000 19.000
Accounts Receivable 53.700 39.900 13.800
Merchandise Inventory 158.000 120.000 38.000
Prepaid Operating Expenses 2.100 1.800 300
Interest Receivable 1.400 600 800
Land 110.000 65.000 45.000
Property,Plant and Equipment-PPE-net 377.000 380.000 (3.000)
808.700 696.550 112.150

Accounts with Credit Balances

Accounts Payable 45.000 38.000 7.000
Accrued Wages Payable 3.000 2.400 600
Income Taxes Payable 6.000 4.500 1.500
Unearned Revenues 2.500 1.250 1.250
Bank Notes Payable - long term 215.000 200.000 15.000
Common Stock; TL 15 par value 405.000 375.000 30.000
Additional Paid in Capital 70.000 50.000 20.000
Retained Earnings 62.200 25.400 36.800
808.700 696.550 112.150
 Portakal Company 0
Income Statement 2008

Sales Revenue 750.000

Cost of Goods Sold (375.000)
Depreciation Expense (43.000)
Salary and Wages Expense (125.000)
Administrative Expenses (80.000)
Loss on Sale of Equipment (4.000)
Other Operating Expenses (5.000)
Interest Revenue 4.000
Interest Expense (20.000)
Income Tax Expense (28.000)
Net Income 74.000

The company paid TL 50.000 of Bank Notes and borrowed new bank loan.
The company declared and paid cash dividends.
The company sold equipment with a cost of TL 12000 and accumulated depreciation of TL
6000 for TL 2000 receving a note in return to be collected in 2009.
The company purchased equipment for TL 46.000; paid TL 44.000 in 2008 and gave a
note for Jan. 2009.
The company issued common stock during the year .
Portakal Company 2008
Cash Flow Statement

Cashflow from Operating Activities

Net Income 74000
Add back noncash:
Depreciation Expense 43.000
Loss on Sale of Equipment 4.000
121.000
adjustments that increase cash:
increase in Acct.Payable 7.000
Increase in Acc.Wages Payable 600
increase in Income Taxes payable 1.500
increase in unearned revenued 1.250
10.350
adjustments that decrease cash:
increase in Accts Rec. (13.800)
increase in Merch. Inv. (38.000)
Increase in Prepaid Expense (300)
increase in interest recev. (800)
(52.900)

Cashflow from operations 78.450

Cashflow from investing
Sale of PPE (note will be received in 2009)
Purchase of PPE (44.000)
Loans extended( to other companies) (19.000)
Purchase of land (45.000)
Cashflow from investing (108.000)
Cashflow from financing
Bank Notes Payable - long term 65.000
Common Stock; TL 15 par value 30.000
Additional Paid in Capital 20.000
Payment of Bank loan (50.000)
Payment of Dividends (37.200)
Cashflow from financing 27.800

Net Change in Cash (1.750)

 Effects of a Sale of
a Long-Term Assets on Cash Flows

 A few transactions complicate the derivation of a cash flow

statement from a comparative balance sheet, for example, the
sale of a long-term (or fixed) asset.
 Recall the journal entry for the sale of an asset:

Cash nnnn
Accumulated Depreciation nnnn
Asset nnnn
Gain (or loss) on sale nnnn
 Sale of an Asset

 Each of the four parts of the above journal entry require an

adjustment in the cash flow statement.
 The first line, cash, adds a line to the investing section.
 The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change in the
change in the accumulated depreciation account.
 The third line, a credit to the asset, increases the amount of
cash invested in long-lived assets above the change in the
fixed asset accounts.
 The fourth line, a gain or loss, is reversed out in the operating
sections since this is not a cash flow.
Steps to prepare CFS – indirect CFO
(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
 Comparison of Cash Flow to Net Income
 Net income is an accrual based concept and purports to show
the long-term.
 Cash flows purport to show the short term.
 Consider the outlook for both short-term and long-term and
consider that each is either good or poor.
 A strong growing firm would show both good long-term and
good short-term outlooks.
 A failing firm would show both poor long-term and poor short
term outlooks.
 What about a firm with good cash flows (short-term) but poor
net income (long-term)?
 What about a firm with poor cash flows (short-term) but good
net income (long-term)?
Analysis Implications of Cash Flows

Limitations in Cash Flow Reporting

• Some limitations of the current reporting of cash flow:
– 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.
Analysis Implications of Cash Flows
Analysis Implications of Cash Flows

Interpreting Cash Flows and Net Income

Analysis of Cash Flows

• In evaluating sources and uses of cash, the analyst should

focus on questions like:
 Are asset replacements financed from internal or external funds?
 What are the financing sources of expansion and business
acquisitions?
 Is the company dependent on external financing?
 What are the company’s investing demands and opportunities?
 What are the requirements and types of financing?
 Are managerial policies (such as dividends) highly sensitive to cash
flows?
Analysis of Cash Flows

Inferences from Analysis of Cash Flows

• Inferences from analysis of cash flows include:
– 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
Analysis of Cash Flows

Alternative Cash Flow Measures

• Net income plus depreciation and amortization
– EBITDA (earnings before interest, taxes, depreciation,
and amortization)
Analysis of Cash Flows

Issues with EBITDA

• 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.
Analysis of Cash Flows

Company and Economic Conditions

• 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.
Analysis of Cash Flows

Free Cash Flow

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))
Analysis of Cash Flows

Free Cash Flow

Positive free cash flow reflects the amount available for business
activities after allowances for financing and investing requirements
to maintain productive capacity at current levels.

Growth and financial flexibility depend on adequate free cash flow.

Recognize that the amount of capital expenditures

needed to maintain productive capacity is generally not
disclosed—instead, most use total capital
expenditures, which is disclosed, but can include
outlays for expansion of productive capacity.
Analysis of Cash Flows

Cash Flow as Validators

• The SCF is useful in identifying misleading or erroneous

operating results or expectations.

SCF provides us with important clues on:

Feasibility of financing capital expenditures.
Cash sources in financing expansion.
Dependence on external financing.
Future dividend policies.
Ability in meeting debt service requirements.
Financial flexibility to unanticipated needs/opportunities.
Financial practices of management.
Quality of earnings.
Specialized Cash Flow Ratios

Cash Flow Adequacy Ratio – Measure of a company’s 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