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Analyzing Cash Flows Statement of Cash Flows

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Page 1: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analyzing Cash Flows

Statement of Cash Flows

Page 2: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

2

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?

Page 3: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Page 4: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

4

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.

Page 5: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Four Parts of a Statement of Cash Flows

4-5

Cash Operating activities Investing activities Financing activities

Page 6: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

4-6

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.

Page 7: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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.

Page 8: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Page 9: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Investing ActivitiesExamples 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;

Page 10: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Financing ActivitiesExamples 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.

Page 11: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Format of the Cash Flow Statement

Name of the CompanyCash Flow StatementFor the period …

Cash from operating activities ACash from investing activities BCash from financing activities CNet 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 sheetNon-cash Investing and Financing Activities

Page 12: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Determination of Cash Flows From Operating Activities

Direct MethodIncome 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

Page 13: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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.

Page 14: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Page 15: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Algebraic Formulation*

Assets = Liabilities + Shareholders’ Equityor A = L + SHE

Assets are either cash (C) or not (Non-Cash) Thus reorganizing

C + Non Cash Assets (NCA) = L + SE

C + NCA = L + SEWhere 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

Page 16: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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.

Page 17: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Indirect Method – cash flow from operations

Increase in non-cash assets shows that cash

was spent,so cash outflow.

Increase in non-cash assets shows that cash

was spent,so cash outflow.

Decrease in non-cash assets shows that

they provided cashso cash inflow.

Decrease in non-cash assets shows that

they provided cashso cash inflow.

Increase in liabilities cash savings;

increase in SHE cash received;

so cash inflow

Increase in liabilities cash savings;

increase in SHE cash received;

so cash inflow

Decrease in liabilities or SHE shows

cash paid; so cash outflow

Decrease in liabilities or SHE shows

cash paid; so cash outflow

Assets

Liabilitiesand Shareholders’equity

INCREASE DECREASE

Adjusting Net Income of the period (accrual) to cash basis income

Page 18: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Page 19: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Page 20: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Portakal Company Prepare Cash Flow Statement

Accounts with Debit Balances 2008 2007increase

(decrease)

Cash 37.500 39.250 (1.750)Notes Receivable (from loans to other companies) 69.000 50.000 19.000Accounts Receivable 53.700 39.900 13.800Merchandise Inventory 158.000 120.000 38.000Prepaid Operating Expenses 2.100 1.800 300Interest Receivable 1.400 600 800Land 110.000 65.000 45.000Property,Plant and Equipment-PPE-net 377.000 380.000 (3.000)

808.700 696.550 112.150

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

808.700 696.550 112.150

Page 21: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Portakal Company 0Income Statement 2008

Sales Revenue 750.000Cost 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 4.000Interest 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 issued common stock during the year .

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.

Page 22: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Portakal Company 2008Cash Flow Statement

Cashflow from Operating ActivitiesNet Income 74000Add back noncash:Depreciation Expense 43.000Loss on Sale of Equipment 4.000

121.000

Page 23: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

adjustments that increase cash:increase in Acct.Payable 7.000Increase in Acc.Wages Payable 600increase in Income Taxes payable 1.500increase in unearned revenued 1.250

10.350adjustments 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

Page 24: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Cashflow from investingSale 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 financingBank Notes Payable - long term 65.000Common Stock; TL 15 par value 30.000Additional Paid in Capital 20.000Payment of Bank loan (50.000)Payment of Dividends (37.200)Cashflow from financing 27.800

Net Change in Cash (1.750)

Page 25: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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 nnnnAccumulated Depreciation nnnn Asset nnnn Gain (or loss) on sale nnnn

Page 26: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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.

Page 27: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Page 28: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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)?

Page 29: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis Implications of Cash Flows

• 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.

Limitations in Cash Flow Reporting

Page 30: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis Implications of Cash Flows

Page 31: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis Implications of Cash Flows

Interpreting Cash Flows and Net Income

Page 32: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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?

Page 33: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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

Inferences from Analysis of Cash Flows

Page 34: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis of Cash Flows

• Net income plus depreciation and amortization– EBITDA (earnings before interest, taxes,

depreciation, and amortization)

Alternative Cash Flow Measures

Page 35: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis of Cash Flows

• 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.

Issues with EBITDA

Page 36: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis of Cash Flows

• 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.

Company and Economic Conditions

Page 37: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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))

Page 38: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis of Cash Flows

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.

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.

Page 39: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

Analysis of Cash Flows

• The SCF is useful in identifying misleading or erroneous operating results or expectations.

Cash Flow as Validators

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.

Page 40: Analyzing Cash Flows Statement of Cash Flows. helps address questions such as:  How much cash is generated from or used in operations?  What expenditures

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 operationsThree-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 – DividendsGross plant + Investment + Other assets + Working capital

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 operationsThree-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 – DividendsGross plant + Investment + Other assets + Working capital