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Objectives for the Day1. Explain purposes of CFS2. Look at how to Construct a CFS3. Learn more about info in CFS and other F/S4. Evaluate a CFS

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Relatively RecentSome consider as important as EarningsExplains sources and uses of Cash and VERY LIQUID equivalents

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Purposes of Cash Flow Statement

Provide info on co.’s-ability to generate future cash flows-ability to meet its obligations-reasons for the difference between income cash- effect of investing & financing

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Cash Flow Statement…….

How do we construct aCFS?

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Let’s go back in timeto the simple accountingsystem of oursheepherders and look at their financials again…...

Let’s go back to countingsheep……

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Direct Method of CFS

Show Receipts andDisbursements in 3Categories….OperatingInvestingFinancing….

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DIRECT CFS - Isobel

Sheep REBirths 138 138Coat Sales 10Paid Dad (60)Bought Land (40)Food expense (18) (18) 20 130

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Indirect Method of CFS

Start with Net IncomeShow adjustments to CA and CL - OperatingChanges in NC Assets - InvestingChanges in NC Liabilities and Equities - Financing….

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Indirect Cash Flow - Isobel OperationsNet Income 130

Sales not in cash (10) Cash from Ops 120Investing - Land (40)

Financing - Debt (60)

Net change in Cash 20

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Direct CFS - Deyonne

Sheep REBirths 90 90Paid Tyronne ( 3)Death of Ox ( 5)Food expense ( 7) ( 7) 80 78

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Indirect Cash Flow - Deyonne

OperationsNet Income 78 Cash from Ops 83Investing -

Financing - Debt ( 3)

Net change in Cash 80

Loss not using Sheep 5

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Cash Flow Statement - Operations

1. Start with NET INCOME2. Adjust for transactions that affect income but NOT cash

a) Look at current assets b) Look at current liabilities

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Cash Flow -- Operations…..

c. Depreciationd. Goodwill amortization (now not so critical)e. Gains/losses on sales f. Other

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Cash Flow - Operations……..

3. Look for items that affectcash but NOT income….Other assets are substitutes for cash…as they increase cash goesdown.

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Cash Flow - Operations……..

This applies in various ways..For Receivables…We have satisfied the conditionsfor recording revenue, butnot received cash, so ourcash is adjusted DOWN.

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Cash Flow - Operations….

Some people memorize the rule that you addbeginning balance and subtractending balance for all Current Assets.

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Cash Flow - Operations…..

.A mnemonic -- IF we Owe morecash we OWN more cash.If we OWE less, we OWNless cash.

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How about Gains and Losses ondisposal? They affect incomeand Cash unequally. Remove gain or loss from Operating and show actual CASH paid or received inInvesting section of CFS.

Cash Flow - Operations…..

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Cash Flow - Operations

Depreciation and Amortizationare added back to Net Incomebecause while they reduce net income they do not reduce cash.

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Cash Flow - Investing

Here is where we show purchases and sales of long-termassets, e.g. P & E. Show the ENTIRE proceeds from sales or Show entire amount of CASH used to purchase….

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Cash Flow - Financing

Cash used to1) pay off debts2) pay dividends3) buy treasury stock

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Cash Flow - Financing

Cash received from1. Borrowing2. Selling capital stock

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Cash Flow Statement…….

Next we will look at how to evaluate it…..

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Cash Flow Statement -How to Read and Evaluate

Look at Ratios

Look at “Puzzle”

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CFS -- Ratios…….

1. Net Income/Cash from Ops

Usually .25 to 1, but rapid growth could lead to higher ratios.

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CFS - Ratios….

2. Investment

Capital Expenditures/Deprec. + Sales of Capital..

Is capital base expanding orshrinking? Ratios generally s/bgreater than 1.

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CFS - Ratios…..

3. Cash Flow AdequacyCash from Ops/LT Purchase + Divs + LT Debt PaidDoes the co. generate sufficient cash to pay debts, shareholders, and to buy new capital?

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CFS - Ratios…..

4. Cash Sources -- Common Size Statement…

Use all cash sources as 100% andthen get each source as a % of that. Look for trends.

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CFS - Ratios….

5. Dividend Payout RatioCash Dividends Paid/Cash from OpsLike most things…rewardingowners is good, but only if company does not incur large opportunity costs.

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It’s Greek to me…..

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CFS - “Puzzle” - Step One

Scanning the Big Picture

a) consider company life-cycleb) company’s resultsc) net incomed) unusual items on I/S?

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CFS - “Puzzle” Step Two

Cash Flow Enginea) Cash from Ops + or --?b) Growing or shrinking?c) Age of company?d) Are c.a. and c. l. both +?e) Covers depreciation?f) Covers dividends?g) Keeps company whole?

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CFS - “Puzzle” Step Three….

Pinpoint Good and the Bada) Look at Investing section… is co. replacing its old assets? S/b greater than depreciation at least. Is growth steady?

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CFS - “Puzzle”…..Step Threeb) Look at Financing section Look at borrowing and

repayment and look for trends. Iscompany near itsdebt limit?

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CFS - “Puzzle”…..Step Threeb) Look at Financing sectionLook at stock activity -- any buyback?Is company able to pay dividends consistently?

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CFS - “Puzzle” Step Four

Pull it all together

1. Any unusual items you saw?2.Combine the results of first three steps….

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CASH FLOWPUZZLE

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The Four “Greats”Look at carefully…...

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CFS - Other uses

Given primacy of cash flow asa determinant of success, companies create Pro Forma cash statements. If you want to justify an investment, you will be asked to predict cash flows…...

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CFS - Other uses

Some analysts consider cash flowper share as important as EPS.Cash Flow is used a great deal in valuing firms and in finance. Ultimately, most decisions hinge on long-term cash returns……..

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Cash is Royalty!!!!

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For next week…..

1.Read chapter 72. Do homework3. For problem 5.13 prepare common size financials4. Be sure to do Cumulative Return problem.5. Have Project #1 drafted.