chapter 6: understanding cash flow statements

CHAPTER 6UNDERSTANDING CASH FLOW STATEMENTS

Presenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

OVERVIEW

• Statement of Cash Flows: Overview• Format of Statement of Cash Flows• Preparing a Statement of Cash Flows• Additional Analytical Considerations


APPLE, Inc.

CLASSIFICATION OF ACTIVITIES ON THE STATEMENT OF CASH FLOWS

Operating activities: Deliver or produce goods for sale and provide services. Examples:

• Receive cash from customers • Pay cash to suppliers • Pay cash for operating expenses.

Investing activities: Buy or sell long-term assets and other investments. Examples:

• Property, plant, and equipment (PP&E)• Other companies’ securities (that are not cash equivalents)

Financing activities: Obtain or repay capital. Examples:• Borrow from creditors and repay the principal• Issue or repurchase stock• Pay dividends



COLGATE: CASH FLOWS CLASSIFIED BY ACTIVITY

2011 2010 2009

Net cash provided by operations 2,896 3,211 3,277

Net cash used in investing activities (1,213) (658) (841)

Net cash used in financing activities (1,242) (2,624) (2,270)Effect of exchange rate changes (53) (39) (121)Net (decrease) increase in cash and cash equivalents 388 (110) 45 Cash and cash equivalents at beginning of year 490 600 555 Cash and cash equivalents at end of year $878 $490 $600


COLGATE’S OPERATING CASH FLOWS


COLGATE’S INVESTING CASH FLOWS


COLGATE’S FINANCING CASH FLOWS


COMMON-SIZE STATEMENT OF CASH FLOW FOR COLGATE (ABBREVIATED)

2011 2010 2009 Operating ActivitiesNet income including noncontrolling interests 15.3% 14.9% 15.6% Net cash provided by operations 17.3% 20.6% 21.4% Net cash used in investing activities –7.2% –4.2% –5.5% Net cash used in financing activities –7.4% –16.9% –14.8%

Each line item is presented as a percentage of net revenue.


COLGATE’S CASH FLOWS: SUMMARY• Overall, $323 million net increase in cash over three years, from $555

million at the beginning of 2009 to $878 million at the end of 2011. • Colgate consistently obtains its cash inflow from operating activities

and uses cash in investing and financing activities—a typical profile for a mature company.

• Colgate’s operating cash flow exceeded net income in every year—a desirable profile for a mature company.

• In every year, Colgate’s cash from operations was more than enough to cover its capital expenditures.

• The amount of dividends paid has steadily increased over the past three years.

• Amount of operating cash after paying for capital expenditures was more than enough to cover the dividend payments.

• In summary, Colgate’s cash flows represent a positive profile.


COLGATE’S OPERATING CASH FLOWS:INDIRECT METHOD


INDIRECT VS. DIRECT METHOD FOR PRESENTING OPERATING CASH FLOWS

Indirect method• Begins with net income and

adjusts to operating cash flows.• Arguments for:

- Clearly shows the reasons for differences between net income and operating cash flows.

- Mirrors forecasting approach that begins with forecast of income, then derives cash flows.

Direct method• Shows each cash inflow and

outflow related to receipts and disbursements.

• Arguments for:- Provides information on the

specific sources of operating cash receipts and payments.

- Does not net.


INDIRECT VS. DIRECT METHOD FOR PRESENTING OPERATING CASH FLOWS

Indirect method• IFRS permit.• U.S. GAAP permit.• Used by the majority of

companies, whether reporting under IFRS or U.S. GAAP.

Direct method•IFRS encourage.

•U.S. GAAP encourage, but requires a reconciliation of net income to cash flow from operating activities.


TECH DATA’S OPERATING CASH FLOWS:EXAMPLE OF DIRECT METHOD


CLASSIFICATION OF CASH FLOWS UNDER IFRS VS. U.S. GAAP

Item IFRS U.S. GAAP Interest received Interest paid Dividends received Dividends paid

Operating or investingOperating or financingOperating or investingOperating or financing

OperatingOperatingOperatingFinancing

Bank overdrafts Considered part of cash equivalents

Not considered part of cash and cash equivalents; classified as financing.

Taxes paid Generally operating, but a portion can be allocated to investing or financing

Operating


PORTUGAL TELECOM’S OPERATING CASH FLOWS: ANOTHER EXAMPLE OF DIRECT METHOD


PORTUGAL TELECOM’S INVESTING CASH FLOWS


PORTUGAL TELECOM’S FINANCING CASH FLOWS


NONCASH INVESTING AND FINANCING ACTIVITIES

• Noncash transaction: Any transaction that does not involve an inflow or outflow of cash (e.g., exchange of one no-monetary asset for another).

• Not incorporated in the cash flow statement.• Must be disclosed.


Cash at beginning and end of year

links to the balance sheet.


Cash at beginning and end of year links to the balance sheet.

PREPARATION OF THE STATEMENT OF CASH FLOWS: STEPS

• Step 1. Determine the change in cash.• Step 2. Determine the net cash flow from operating activities.

Use both the current year's income statement and information on current assets and liabilities from the comparative balance sheets.

• Step 3. Determine net cash flows from investing and financing activities. Examine all other changes in the balance sheet accounts.

• Step 4. Include summary of net increase (decrease) in cash, cash at beginning, and cash at end.

• Step 5. Disclose any significant noncash transactions separately at the bottom of the statement.


EXAMPLE

A new company has the following transactions: • Sells stock for $100.• Buys a building for $50. Its primary line of business is selling

a service, so it has no COGS (cost of goods sold) and no inventory.

• Makes credit sales of $100, and subsequently collects $90. • Accrues SG&A (selling, general, and administrative)

expense of $40, and subsequently pays cash of $25. • Records depreciation expense of $10.

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STEP 1. DETERMINE THE CHANGE IN CASH

Beginning balance

Ending balance Change

Cash 0 115 115 Accounts receivable 0 10 10 Building 0 50 50 Accumulated depreciation 0 (10) (10)Total assets 0 165 165 Accounts payable 0 15 15 Common stock 0 100 100 Retained earnings 0 50 50 Total liabilities and equity 0 165 165

This step is straightforward. The information is on the comparative balance sheets. Change was $115.


STEP 2. DETERMINE THE NET CASH FLOW FROM OPERATING ACTIVITIES, BEGINNING WITH NET

INCOME FOR THE INDIRECT METHOD

Income statementCredit sales $ 100SG&A expense –40Depreciation expense –10Net income $ 50

Net income $ 50+ Depreciation expense +10 Noncash expense– Change in receivables –10 Only collected $90 + Change in payables +15 Only paid $25Cash from operating activities $ 65


STEP 3. DETERMINE NET CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES

Beginning balance


Cash 0 115 115 In first stepAccounts receivable 0 10 10 In operatingBuilding 0 50 50 ?Accumulated depreciation 0 (10) (10)In operatingTotal assets 0 165 165 Accounts payable 0 15 15 In operatingCommon stock 0 100 100 ?Retained earnings 0 50 50 In operating*Total liabilities 0 165 165

Examine all other changes in the balance sheet accounts.

*There are no dividends in this example; all changes in retained earnings are from net income


INVESTING CASH FLOWS

• Determine investing cash flows by examining changes in long-term assets. In this example, we have only PP&E.

• Beginning PP&E + Purchases – Dispositions = Ending PP&E• Ending PP&E – Beginning PP&E = Purchases – Dispositions

(i.e., investing cash flows)

• PP&E increased by $50, indicating cash spent acquiring PP&E.

• We also know this from the transaction list at the beginning of the example.


FINANCING CASH FLOWS

• Determine financing cash flows by examining changes in debt and equity accounts. In this example, we have only common stock.

• Beginning stock + Issuances – Repurchases = Ending stock• Ending stock – Beginning stock = Issuances – Repurchases

• Stock account increased by $100, indicating cash was raised by issuing stock.

• We also know this from the transaction list at the beginning of the example.


STEP 3. DETERMINE NET CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES

Beginning balance


Cash 0 115 115 In first stepAccounts receivable 0 10 10 In operatingBuilding 0 50 50 In investingAccumulated depreciation 0 (10) (10)In operatingTotal assets 0 165 165 Accounts payable 0 15 15 In operatingCommon stock 0 100 100 In financingRetained earnings 0 50 50 In operating*Total liabilities 0 165 165

Examine all other changes in the balance sheet accounts.

*There are no dividends in this example, so all change was net income.


Company ABCCash Flow Statement for the period ended

Operating cash flow Net income 50Depreciation expense + 10Increase in accounts receivable – 10Increase in accrued liabilities + 15Total operating cash flow + 65 Investing cash flow Capital expenditure – 50 Financing cash flow Issue of stock + 100 Total change in cash + 115Beginning cash balance 0Ending cash balance 115

INDIRECT METHOD


ALTERNATIVE STEP 2. DETERMINE THE NET CASH FLOW FROM OPERATING ACTIVITIES, BEGINNING WITH EACH LINE ITEM FOR THE DIRECT METHOD

Income statementCredit sales $ 100SG&A expense –40Depreciation expense –10Net income $ 50

Cash from customers $ 90Credit sales ($100) minus

Change in receivables ($10)

Cash paid for expenses –25SG&A expenses ($40) minus

increase in payables ($15)Cash from operating activities $ 65


Company ABCCash Flow Statement for the period ended

Cash collected from customers + 90Cash paid to suppliers – 25Total operating cash flow + 65 Investing cash flow Capital expenditure – 50 Financing cash flow Issue of stock + 100 Total change in cash + 115Beginning cash balance 0

Ending cash balance 115

DIRECT METHOD


FREE CASH FLOW

Free Cash Flow to the Firm (FCFF): Cash flow available to the company’s suppliers of capital (debt and equity).- After all operating expenses (including taxes) have been paid.- After all operating investments have been made for fixed capital and

working capital. Free Cash Flow to Equity (FCFE): Cash flow available to the

company’s common stockholders. - After all operating expenses (including taxes) have been paid.- After borrowing costs (principal and interest) have been paid.- After all operating investments have been made for fixed capital and

working capital.


COMPUTE FCFF

Net Income+ Noncash charges– Working capital investment

+ Interest expense × (1 – Tax rate)– Fixed capital investments= FCFF

Interest, a cash flow available to one of the capital providers, which

has been deducted from

net income, so it must be added

back

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FCFF CAN ALSO BE COMPUTED FROM CASH FLOW FROM OPERATING ACTIVITIES

Net income+ Noncash charges– Working capital investment

= Cash from operating activities

+ Interest Expense × (1 – Tax rate)– Fixed capital investments= FCFF

CFO already has added noncash

items to net income and

deducted working capital

investment



COMPUTE FCFE

Net Income+ Noncash charges– Working capital investment

– Fixed capital investment+ Net new borrowing (or minus net debt repayments)= FCFE

Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt.


CASH FLOW PERFORMANCE RATIOS

Ratio Calculation What It MeasuresCash 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 of common shares outstanding

Operating cash flow on a per-share basis


CASH FLOW COVERAGE RATIOS

Ratio Calculation What It MeasuresDebt coverage CFO ÷ Total debt Financial risk and financial

leverageInterest coverage (CFO + Interest paid +

Taxes paid) ÷ Interest paidAbility to meet interest obligations

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 repayment

Ability to pay debts with operating cash flows

Dividend payment

CFO ÷ Dividends paid Ability to pay dividends with operating cash flows

Investing and financing

CFO ÷ Cash outflows for investing and financing activities

Ability to acquire assets, pay debts, and make distributions to owners


SUMMARY

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

• Cash flows are categorized as operating, investing, and financing.• Compared with U.S. GAAP, IFRS provide companies with more

choices in classifying some cash flow items as operating, investing, or financing activities.

• The operating activities section of the statement of cash flows can be presented using the direct method or the indirect method.

• Two approaches to developing common-size cash flow statements are the total cash inflows/total cash outflows method and the percentage of net revenues method.

• Cash flow ratios measure a company’s profitability, performance, and financial strength.

chapter 6: understanding cash flow statements

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