cash flpw analysis

8/9/2019 cash flpw analysis

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Statement of Cash Flows Relevance of Cash Flows

Cash Defined -- refers to cash and cashequivalents.

Cash equivalents are short-term, highly liquidinvestments that are (1) readily convertible toknown amounts of cash, and (2) near maturity

(typically within 3 months) with limited risk of pricechanges due to interest rate shifts.


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Cash is the beginning and the end of a companys operating cycle.

Net cash flow is the end measure of profitability.

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 nearness to cash of assets and liabilities.Solvency is the ability to pay liabilities when they mature.Financial flexibility is the ability to react to opportunities and

adversities.


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Statement of cash flows (SCF) helps address questions suchas:

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?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?


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Statement of Cash Flows Cash Flow Relations

Illustration: Consider two consecutive years balance sheets divided into(1) cash, and (2) all other balance sheet accounts:

Accounts Year 1 Year 2

Cash and cash equivalents $3,000 $5,000Noncash accounts:

Noncash current assets $(9,000) $(11,000)Noncurrent assets (6,000) (8,000)Current liabilities 8,000 10,000Long-term liabilities 3,000 5,000

Equity accounts 7,000 9,000Net noncash balance $3,000 $5,000

Note:Change in cash from Year 1 to Year 2 (increase of $2,000) = Change in noncashbalance sheet accounts ($2,000 increase) from Year 1 to Year 2


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Interrelations between cash and noncash balance sheetaccounts can be generalized:

Net changes in cash are explained by net changes innoncash balance sheet accounts.

Changes within or among noncash balance sheetaccounts do not affect cash. Yet, there is disclosure of all

significant financing and investing activities in

a separate schedule of noncash investing and financingactivities.

Changes within the components of cashare not reported .

Statement of Cash Flows Cash Flow Relations


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Statement of Cash Flows Reporting by Activities

Statement of cash flows reports receipts and payments byoperating, financing, and investing activities

Operating activit ies are the earning related activitiesof a company.

Investing activit ies are means of acquiring anddisposing of noncash assets.

Financing activit ies are means of contributing,withdrawing, and servicing funds to support businessactivities.


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Statement of Cash Flows Net Cash Flows from Operations

Indirect Method-Net income is adjusted for non-cash income (expense) itemsand 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 formatdiffers.


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Statement of Cash FlowsIndirect 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


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Statement of Cash Flows Depreciation Add-Back

Sales- Expenses- Depreciation and amortization expense

Net Income+ Depreciation expense+/- Gains (losses) on sales of assets+/- Cash generated (used) by current assets

and liabilitiesNet cash flows from operating activities

Add Back


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

In period of collection no income is recorded.

Net Income 0Depreciation and amortization expense 0Gains (losses) on sale of assets 0

Change in accounts receivable 100Net Cash flow from operations 100


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Statement of Cash FlowsConstructing the Statement

Increase DecreaseAssets (Outflow) InflowLiabs/Equity Inflow (Outflow)


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Statement of Cash FlowsConstructing the Statement

CashReceivablesInventoryPrepaid expensesPlant assetsAccumlated depreciation

Intangibles

GoComparatiAs of De

1. The company purchased a truck during the year at a cost of $30,000 that was financed in full by the manufacturer.

2. A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year for $7,000. There were noother sales of depreciable assets.

3. Dividends paid during Year 2 are $51,000


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Statement of Cash FlowsSteps 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 assetsand 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


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Statement of Cash FlowsSteps in Constructing the Statement

Net incomeAdd (deduct):Depreciation & amortization expeGain on sale of assets

Accounts receivable

For t

Note: assets costing $30,000 were purchased during Year 2 and were financed in whole by the manufacturer.


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Statement of Cash FlowsSpecial Topics

Equity Method Investments Under equity method accounting,investor records its proportionate share of investee company profits. Theposition of reported earnings in excess of dividends received should beeliminated as it is non-cash earnings.

Acquisitions of Companies with Stock Acquisitions made withstock are non-cash. As a result, changes in balance sheet accounts reflectingthe acquired company will not equal cash inflows (outflows) reported in theStatement of Cash Flows.

Postretirement Benefit Costs The excess of net postretirement

benefit expense over cash benefits paid must be added to net income incomputing net cash flows from operations

Securitization of Accounts Receivable Reductions in receivablesas a result of securitization increases net cash flows from operations.Securitizations are a financing activity and should be interpreted as such.


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Deriving Operating Cash Flows from Income for Gould.

Amount Item (in thousands) Explanation

Net income, accrual basis $ 54 Starting point of conversion

Add (deduct) adjustment to cash basis:Depreciation 35 Depreciation has no cash outflow.Gain on sale of assets (5) Remove gain (because it is onoperating)cash

inflow is cash from investing activities.Increase in receivables (9) Cash flow from sales is less than accrual sales.Decrease in inventories 6 Cash outflow for inventory exceeds accrual

inventory cost included in cost of sales.Decrease in prepaids 3 Cash outflow occurred when prepaids were

purchased-current expense is non-cashDecrease in accounts payable (5) Cash outflows for purchases (included in cost of

goods sold) is less than accrual purchases cost.Increase in accrued expenses 4 Expense has been recognized but no cash paid

_____ yet.

Cash flows from operations (Exhibit 7.3) $113

Deriving Operating Cash Flows from Income for Gould.

Amount Item (in thousands) Explanation

Net income, accrual basis $ 54 Starting point of conversion

Add (deduct) adjustment to cash basis:Depreciation 35 Depreciation has no cash outflow.Gain on sale of assets (5) Remove gain (because it is onoperating)cash

inflow is cash from investing activities.Increase in receivables (9) Cash flow from sales is less than accrual sales.Decrease in inventories 6 Cash outflow for inventory exceeds accrual

inventory cost included in cost of sales.Decrease in prepaids 3 Cash outflow occurred when prepaids were

purchased-current expense is non-cashDecrease in accounts payable (5) Cash outflows for purchases (included in cost of

goods sold) is less than accrual purchases cost.Increase in accrued expenses 4 Expense has been recognized but no cash paid

_____ yet.

Cash flows from operations (Exhibit 7.3) $113

Cash From OperationsIndirect Method for CFO


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Cash From OperationsReporting Formats for CFO

Companies Reporting Cash Flows using Indirect or Direct Formats

Indirect Method97%

Direct Method3%


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Cash From OperationsInterpreting Accrual Income and Operating Cash Flow

Sales

G ain on S ale of asset

C


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Net income plus major noncash expenses (typically depreciation and amortization)

Net income plus major noncash expenses (typically depreciation and amortization)

Cash From OperationsAlternative Cash Flow Measure


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Assume two companies (A and B) each invest $50,000 in machinery yielding$45,000 per year cash flows before depreciation. Assuming a five year useful life and no salvage value for the machinery, results for the entire five-

year period are:

Five-Year Period Cash provided by operations ($45,000 x 5 years) $225,000Cost of the machine $ (50,000)

Income from operating machine $175,000Average yearly net income $ 35,000

Assume two companies (A and B) each invest $50,000 in machinery yielding$45,000 per year cash flows before depreciation. Assuming a five year useful life and no salvage value for the machinery, results for the entire five-

year period are:

Five-Year Period Cash provided by operations ($45,000 x 5 years) $225,000Cost of the machine $ (50,000)

Income from operating machine $175,000Average yearly net income $ 35,000

Cash From OperationsAlternative Cash Flow Measure - Illustration


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Company A: Company B:Straight-Line Sum-of-the-Years-Depreciation Digits Depreciation

Income

before Year Depreciation Depreciation Net Income Depreciation Net Income

1 $ 45,000 $10,000 $ 35,000 $16,667 $ 28,3332 45,000 10,000 35,000 13,334 31,6663 45,000 10,000 35,000 10,000 35,0004 45,000 10,000 35,000 6,667 38,3335 45,000 10,000 35,000 3,332 41,668Total $225,000 $50,000 $175,000 $50,000 $175,000

Income before depreciation for these two companies is identical--this faithfully reveals identicalearning power.

Income after depreciation is considerably different across the yearsthis does not reflectchanges in earning power.

Company A: Company B:Straight-Line Sum-of-the-Years-Depreciation Digits Depreciation

Income before

Year Depreciation Depreciation Net Income Depreciation Net Income

1 $ 45,000 $10,000 $ 35,000 $16,667 $ 28,3332 45,000 10,000 35,000 13,334 31,6663 45,000 10,000 35,000 10,000 35,0004 45,000 10,000 35,000 6,667 38,3335 45,000 10,000 35,000 3,332 41,668Total $225,000 $50,000 $175,000 $50,000 $175,000

Income before depreciation for these two companies is identical--this faithfully reveals identicalearning power.

Income after depreciation is considerably different across the yearsthis does not reflectchanges in earning power.

Cash From OperationsAlternative Cash Flow Measure - Illustration


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While both successful and unsuccessful companies canexperience problems with cash flows from operations,the reasons are markedly different.

We must interpret changes in operating working capitalitems in light of economic circumstances.

Inflationary conditions add to thefinancial burdens of companiesand challenges for analysis.

While both successful and unsuccessful companies canexperience problems with cash flows from operations,

the reasons are markedly different.

We must interpret changes in operating working capitalitems in light of economic circumstances.

Inflationary conditions add to thefinancial burdens of companiesand challenges for analysis.

Cash From OperationsBusiness Conditions and Cash Flows


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Cash flows from operations

Deduct: Net capital expenditures required tomaintain productive capacity

_______________________________ Equals Free cash flow (FCF)

Cash flows from operations

Deduct: Net capital expenditures required tomaintain productive capacity

_______________________________

Equals Free cash flow (FCF)

Cash From OperationsFree Cash Flow


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Positive free cash flow reflects the amount available for business activities after allowances for financing andinvesting requirements to maintain productive capacity atcurrent levels.

Growth and financial flexibility depend on adequate free cashflow.

Recognize that the amount of capital expendituresneeded to maintain productive capacity is generallynot disclosedinstead, most use total capitalexpenditures, which is disclosed, but can includeoutlays for expansion of productive capacity.

Positive free cash flow reflects the amount available for business activities after allowances for financing andinvesting requirements to maintain productive capacity atcurrent levels.

Growth and financial flexibility depend on adequate free cashflow.

Recognize that the amount of capital expendituresneeded to maintain productive capacity is generallynot disclosedinstead, most use total capitalexpenditures, which is disclosed, but can includeoutlays for expansion of productive capacity.

Cash From OperationsFree Cash Flow


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The statement of cash flows isuseful in identifying misleadingor erroneous operating results

or expectations.

The statement of cash flows isuseful in identifying misleadingor erroneous operating results

or expectations.

Cash From OperationsCash Flow as Validators


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Cash Flow Adequacy Ratio Measure of a companys ability togenerate 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 Flow Adequacy Ratio Measure of a companys ability togenerate 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 From OperationsSpecialized Cash Flow Ratios

cash flpw analysis

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