Understanding Cash Flow Statement

Distinguish between the direct and indirect methods of presenting cash flow from operating activities and describe arguments in favor of each method

Companies can use either the direct or the indirect method for reporting their operating cash flow. • The direct method discloses operating cash inflows by source and operating cash outflows by use • The indirect method reconciles net income to operating cash flow by adjusting net income for all non-cash items and net changes in the operating working capital accounts. The amount of operating cash flow is identical under both methods; only the presentation format of the operating cf section differs. IFRS and GAAP both encourage the use of the direct method but permit either method. Whenever the direct method is used, US GAAP require a disclosure note and a schedule that reconciles net income with the net cash flow from operating activities.

Contrast cash flow statements prepared under IFRS and US GAAP

Cash flow statements under IFRS and US GAAP are similar, however, IFRS Provide companies with more choices in classifying some cash flow items as operating, investing or financing activities.

Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

Free cash flow: the excess of operating cash flow over capital expenditures FCFF: cash flow available to the company's suppliers of debt and equity capital after all operating expenses (including income taxes) have been paid and necessary investments in working cpital and fixed capital have been made. FCFF= NI + NCC + Int(1-T) - FCInv - WCInv Where NI= net income NCC= non-cash charges (depreciation and amortization) Int = Interest Expense FCIn v= Capital Expenditures (fixed capital, such as equipment) WCInv = Working capital expenditures The reason for adding back interest is htat FCFF is the CF available to the suppliers of debt capital as well as equity capital. FCFF can also be calculated as = CFO + (1-T) - FCInv FCFE is the CF available to the company's common stockholders after all operating expenses and borrowing costs have been paid and necessary investments in working capital and fixed capital have been made. FCFE = CFO - FCInv + Net borrowing When net borrowing is negative, debt payments exceed receipts of borrow funds so: FCFE = CFO - FCInv - net debt repayment

Describe the steps in the preparation of direct cash flow statement, including how cash flows can be computed using income statement and the balance sheet

I. First step is to determine the total cash flows from operating activities: A. Direct Method 1. Determine how much cash is received from customers Revenue Less: increase in accounts receivable Cash received from customers 2. Determine how much cash was paid to suppliers COGS Plus Increase in inventory Equals purchases from suppliers Less: Increase in accounts payable Cash paid to suppliers 3. Determine how much cash was paid to employees Salary and wages expense Less: Increase in salary and wages payable Cash paid to employees 4. Determine how much cash was paid for other operating expenses interest and income taxes. Other operating expenses Less Decrease in prepaid expenses Less: increase in other accrued liabilities Cash paid for other operating expenses Interest expense Plus: Decrease in interest payable Cash paid for interest Income Tax Expense Less: Increase in income tax payable Cash paid for income taxes II. Second step is to determine cash flow from investing activities: Same under direct and indirect 5. Beginning balance equipment (from balance sheet) Plus equipment purchased (from informational note) Minus ending balance equipment (from balance sheet) Equals historical cost of equipment Historical cost of equipment sold Less Accumulated depreciation on equipment sold (beginning balance accumulated depreciation + depreciation expense - ending balance accumulated depreciation) Equals book value of equipment sold Plus gain on sale of equipment Equals cash received from sale of equipment III. Third step is to determine cash flow from financing activities: Same under direct and indirect methods 6. Cash paid to retire LT debt Cash paid to retire common stock Cash paid for dividends Net cash used for financing activities

Describe the steps in the preparation of indirect cash flow statements, including how cash flows can be computed using income statement and the balance sheet

I. First step is to determine the total cash flows from operating activities: B. Indirect Method Under this approach, we much reconcile the firm net income to its operating cash flow. To do this net income is adjusted for a) any non-operating activities b) any non-cash expenses and c) changes in operating working capital items. Exhibit 9 on page 299 includes all of these specific adjustments. II. Second step is to determine cash flow from investing activities: Same under direct and indirect 5. Beginning balance equipment (from balance sheet) Plus equipment purchased (from informational note) Minus ending balance equipment (from balance sheet) Equals historical cost of equipment Historical cost of equipment sold Less Accumulated depreciation on equipment sold (beginning balance accumulated depreciation + depreciation expense - ending balance accumulated depreciation) Equals book value of equipment sold Plus gain on sale of equipment Equals cash received from sale of equipment III. Third step is to determine cash flow from financing activities: Same under direct and indirect methods 6. Cash paid to retire LT debt Cash paid to retire common stock Cash paid for dividends Net cash used for financing activities

Describe how non-cash investing and financing activities are reported

Significant non-cash transaction activities (if present) are reported by using a supplemental disclosure note to the cash flow statement

Compare cash flows from operating, investing and financing activities and classify cash flow items as relating to one of those three categories given a description of the items

Operating Activities: include the company's day-to-day activities that create revenues, such as selling inventory and providing services, and other activities not classified as investing or financing. Also includes trading securities or dealing securities. US GAAP and IFRS classify all income tax expenses as an operating activity. Investing activities: include purchasing and selling long term assets and other investment. PPE, intangible assets, other LT assets. Financing activities: include obtaining and repaying capital, such as equity and LT debt. Two primary sources of capital are shareholders and creditors. Under US GAAP, discretion is not permitted in classifying interest and dividends (like it is in IFRS). Interest paid and received is reported as operating activities for all companies and dividends received are always reported as operating activities and dividends paid are reported as financing activities.

Analyze and interpret both reported and common-size cash flow statements

Step to analyze: 1. Evaluate where the major sources and uses of cash flow are between operating, investing and financing activities 2. Evaluate the primary determinants of operating cash flows 3. Evaluate the primary determinants investing cash flows 4. Evaluate the primary determinants investing financing cash flows Common size analysis of statement of cash flows: each income and expense line item is expressed as a percentage of net revenues (net sales). For the common-size cash flow statement, there are two alternative approaches. A. Express each line item of cash inflow (outflow) as a percentage of total inflows (outflows) of cash. B. Express each line item as a percentage of net revenue

Convert cash flows from the indirect to direct method

Steps: 1. Begin by disaggregating net income into total revenues and total expenses 2. Next, remove any non-operating and non-cash items. 3. Then, convert accrual amounts of revenues and expenses to cash flow amounts of receipts and payments by adjusting for changes in working capital accounts

Describe how the cash flow statement is linked to the income statement and the balance sheet

The cash flow statement is linked to a company's income statement and comparative balance sheets and to data on those statements. Cash is an asset. The statement of CF ultimately shows the change in cash during an accounting period. The beginning and ending balances of cash are show on the company's balance sheets for the previous and current years, and the bottom of the cash flow statement reconciles beginning cash with ending cash. Beginning Balance Sheet at 12/31/09: beginning cash Statement of CF for year ended 12/31/10: Plus cash receipts (from operating, investing and financing activities) Less cash payments (for operating, investing and financing activities) Ending Balance sheet at 12/31/10: ending cash Income statement relationship with CF statement: Beginning Balance Sheet at 12/31/09: beginning accounts receivable Income Statement for year ended 12/31/10: Plus Revenues Statement of CF for year ended 12/31/10: Minus: cash collected from customers Ending Balance sheet at 12/31/10: Equals: ending accounts receivables