Analysis of Cash Flows

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
 What expenditures are made with cash from
 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?
Internal Uses of CFS
Along side with cash budget CFS is used:
To assess liquidity
To determine dividend policy
Determine if short-term financing is necessary
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.
Four Parts of a Statement of Cash Flows
Operating activities
Investing activities
Financing activities
Four Parts of a Statement of Cash Flows
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.
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
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
Cash from investing activities
Cash from financing activities
Net Change in Cash
+ Beginning Cash balance
Ending Cash balance
D = (A+B+C) increase or (decrease)
CB, from the beginning balance sheet
=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
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
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
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
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 in non-cash Decrease in non-cash
assets shows that cash
assets shows that
was spent,
they provided cash
so cash outflow.
so cash inflow.
Increase in liabilities
cash savings;
increase in SHE cash
so cash inflow
Decrease in liabilities
or SHE shows
cash paid;
so cash outflow
Indirect Method- operating activitiesAdjustments 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
Portakal Company
Prepare Cash Flow Statement
Accounts with Debit Balances
Notes Receivable (from loans to other companies)
Accounts Receivable
Merchandise Inventory
Prepaid Operating Expenses
Interest Receivable
Property,Plant and Equipment-PPE-net
Accounts with Credit Balances
Accounts Payable
Accrued Wages Payable
Income Taxes Payable
Unearned Revenues
Bank Notes Payable - long term
Common Stock; TL 15 par value
Additional Paid in Capital
Retained Earnings
Portakal Company
Income Statement
Sales Revenue
Cost of Goods Sold
Depreciation Expense
Salary and Wages Expense
Administrative Expenses
Loss on Sale of Equipment
Other Operating Expenses
Interest Revenue
Interest Expense
Income Tax Expense
Net Income
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
Cash Flow Statement
Cashflow from Operating Activities
Net Income
Add back noncash:
Depreciation Expense
Loss on Sale of Equipment
adjustments that increase cash:
increase in Acct.Payable
Increase in Acc.Wages Payable
increase in Income Taxes payable
increase in unearned revenued
adjustments that decrease cash:
increase in Accts Rec.
increase in Merch. Inv.
Increase in Prepaid Expense
increase in interest recev.
Cashflow from operations
Cashflow from investing
Sale of PPE (note will be received in 2009)
Purchase of PPE
Loans extended( to other companies) (19.000)
Purchase of land
Cashflow from investing
Cashflow from financing
Bank Notes Payable - long term
Common Stock; TL 15 par value
Additional Paid in Capital
Payment of Bank loan
Payment of Dividends
Cashflow from financing
Net Change in Cash
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:
Accumulated Depreciation
Gain (or loss) on sale
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
(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
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
 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
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
– 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
• 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
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

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