23: Understanding the statement of cash flows CFA level 1

Under IFRS

interest and dividends received can be either operating or investing dividends and interest paid to company may be classified as either operating or financing n

Sale of land would be classified as:

investing cash flow.

cash flow per share

is a variation of basic EPS measured by using CFO instead of net income = (CFO - preferred dividends)/ Weighted av. # of common shares

dividend payment ratio

measures firms ability to make dividend payments from operating cash flow =CFO/dividends paid

cash to income ratio

measures the ability to generate cash from firm operations = CFO/ operating income

Cash flow to revenue ratio

measures the amount of operating cash flow generated for each dollar of revenue = CFO/ Net Revenue

debt payment ratio

measures the firm's ability to satisfy long-term debt with operating cash flow. = CFO / cash long-term debt repayment

interest coverage ratio

measures the firms ability to meet its interest obligations = CFO + interest paid + taxes paid/ interest paid

cash return on assets ratio

measures the return of operating cash flow attributed to all providers of capital = CFO/ average total assets

income from investments (interest and dividends received) reported as interest paid

operating activity

Under U.S. GAAP, dividends received from investments would be classified as:

operating cash flow.

Under U.S. GAAP, interest paid would be classified as:

operating cash flow.

CFO cash flow from operating activities.

"operating cash flow" consists of the inflows and outflows of cash resulting from transactions that affect a firms net income

Continental Corporation reported sales revenue of $150,000 for the current year. If accounts receivable decreased $10,000 during the year and accounts payable increased $4,000 during the year, cash collections were:

$150,000 sales + $10,000 decrease in accounts receivable = $160,000 cash collections. The change in accounts payable does not affect cash collections. Accounts payable result from a firm's purchases from its suppliers. (Module 25.3, LOS 23.f, 23.g)

Net income for Monique, Inc. for the year ended December 31, 20X7 was $78,000. Its accounts receivable balance at December 31, 20X7 was $121,000, and this balance was $69,000 at December 31, 20X6. The accounts payable balance at December 31, 20X7 was $72,000 and was $43,000 at December 31, 20X6. Depreciation for 20X7 was $12,000, and there was an unrealized gain of $15,000 included in 20X7 income from the change in value of trading securities. Which of the following amounts represents Monique's cash flow from operations for 20X7?

$52,000.

Direct and indirect methods know:

- CFO is calculated differentlt but the result is the same under both methods - calculation of CFI and CFF is identical under both methods - there is an inverse relationship between changes in assets and changes in cash flows. an inc. in liability account is a source of cash and a decrease in a liability is a use of cash - sources of cash are positive #'s (cash inflows) and uses of cash are negative numbers (cash outflows)

Free cash flow to the firm (FCFF)

- Cash available to all investors, both equity owners and debt holders - can be calculated by starting with either net income or operating cash flow = NI + NCC + [Int x (1- tax rate)] - FCInv - WCInv NCC = noncash charges (depreciation & Amoritization) Int = cash interest paid FCInv= fixed capital investment. (net capital expenditures) WCInv = working capital investment

Free Cash Flow

- a measure of cash that is available for discretionary purposes - cash flow available once the firm has covered its capital expenditures - fundamental and often used for valuation - several measures of FCF - 2 of the common measures: 1) FCF to the firm and 2) FCF to equity

General principal for converting

- adjust each income statement item for its corresponding balance sheet accounts and to eliminate non cash and non operating transactions

CFO under direct method

- can be computed using a combination of the income statement and a statement of cash flows prepared under the indirect method - 2 major sections: cash inflows (recipts) and cash outflows (payments)

Positive operating cash flow

- can be generated by a firms earnings related activities - can be generated by decreasing non cash working capital, such as liquidating inventory and receivables or increasing payables (decreasing non cash working cap is not sustainable, since inventories and receivables cannot fall below zero and creditors will not extend credit indefinitely unless payments are made when due)

Common components of cash flow that appear on a statement of cash flow under DIRECT METHOD

- cash collected from customers, main component of CFO - cash used in production of goods/services (cash inputs) - cash operating expense - cash paid for interest - cash paid for taxes

CFF: Cash flow from financing

- consists of the inflows and outflows of cash resulting from transactions affecting a firms capital structure

Main advantage of indirect method is

- focuses on the difference between net income and operating cash flow - provides useful link to income statement when forecasting future operating cash flow

Sources and use of cash flow from investing

- increasing capital expenditures (a use of cash) usually means growth - firm could reduce capex or sell capital assets in order to save or generate cash (higher cash outflows in the future as older assets are replaced or growth resumes)

Cash flow ratios

- performance ratios and coverage ratios

Primary advantage of direct method is

- that it presents the firms operating cash receipts and payments while the indirect method only presents the net result of these recipts and payments so direct provides more info than indirect

Performance ratios

1. Cash flow to revenue ratio 2. cash return on assets ratio 3. cash return on equity ratio 4. cash to income ratio 5. cash flow per share

2 methods of presenting the cash flow statement

1. Direct method 2. Indirect method Both permitted under U.S. GAAP and IFRS The use of direct method is encouraged by both standard setters ...but most firms use indirect method the difference between the two methods relates to the presentation of cash flow from operating activities

Coverage ratios

1. debt coverage ratio 2. interest coverage ratio 3. reinvestment ratio 4. debt payment ratio 5. dividend payment ratio 6. investing and financing ratio

Items on the cash flow statement come from two sources:

1. income statement 2. changes in balance sheet accounts

Steps for calculating CFO under the indirect method:

1: Begin with net income 2. Add or subtract changes to balance sheet operating accounts as follows: - inc in the operating asset accounts (uses of cash) are subtracted, while decreases (sources of cash) are added - inc in operating liability accounts (sources of cash) are added, while decreases (use of cash) are subtracted 3. Add back all non cash charges to income (depreciation and amoritization) and subtract all noncash components of revenue 4. Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land)

Which of the following is least likely a change in cash flow from operations under U.S. GAAP?

A decrease in notes payable. This is a financing activity

cash from asset sold

= book value of the asset + gain( or - loss) on sale

Net cash flows from creditors

= new borrowings - principal amounts repaid

net cash flows from shareholders

= new equity issued - share repurchases - cash dividends paid

Total cash flow

= sum of CFO, CFI and CFF total cash flow will equal the change in cash from one balance sheet to the next

Which of the following would be least likely to cause a change in investing cash flow?

An increase in depreciation expense Depreciation does not represent a cash flow. To the extent that it affects the firm's taxes, an increase in depreciation changes operating cash flows, but not investing cash flows. (LOS 23.a)

FYI

Because of the impact of income taxes, a profitable company that accounts for inventory using LIFO will have higher total cash flow than a profitable company that uses FIFO. The company that uses LIFO will have higher cost of goods sold, resulting in lower net income and thus lower taxes. The other statements are accurate: - A company that issues common stock is not required to pay dividends (which would reduce cash flow from financing). Thus, it may have the same CFF as a firm that issues debt since interest paid on debt is a component of CFO. -When a company issues bonds at a premium, the proceeds raised at issuance (CFF inflow) are greater than the par value repaid at maturity (CFF outflow). For bonds issued at par, the CFF inflow at issuance is equal to the CFF outflow at maturity. (Study Session 7, Module 23.2, LOS 23.f)

The only difference between indirect and direct method is in

CFO Cash flow from operations

Free Cash Flow to Equity (FCFE)

Cash flow that would be available for distribution to common shareholders = CFO- FCInv + net borrowing net borrowing = debt issued - debt repaid if net borrowing is negative we would not subtract net borrowing in calculating FCFE

FYI

Changes in property, plant and equipment, long-term debt and common stock do not affect cash from operations. (Study Session 7, Module 23.2, LOS 23.f)

FCFF can also be calculated from operating cash flow as

FCFF = CFO + [Int x (1- tax rate)] - FCInv goal is to calculate cash flow available to shareholders and debt holders

In converting a statement of cash flows from the indirect to the direct method, which of the following adjustments should be made for a decrease in unearned revenue when calculating cash collected from customers, and for an inventory writedown (when market value is less than cost) when calculating cash payments to suppliers?

In converting a statement of cash flows from the indirect to the direct method, which of the following adjustments should be made for a decrease in unearned revenue when calculating cash collected from customers, and for an inventory writedown (when market value is less than cost) when calculating cash payments to suppliers?

Noncurrent assets on the balance sheet are most closely linked to which part of the cash flow statement?

Investing cash flows are most closely linked with a firm's noncurrent assets. For example, purchases and sales of property, plant, and equipment are classified as investing cash flows. (Study Session 7, Module 23.1, LOS 23.e)

Which balance sheet items are most likely to be linked to cash flows from financing?

Long-term liabilities and equity. Financing cash flows are linked primarily to changes in long-term liabilities and equity. Changes in current assets and liabilities tend to be linked to operating cash flows. Changes in long-lived assets are typically linked to investing cash flows. (LOS 23.e)

debt coverage ratio

Measures financial risk and leverage = CFO/total debt

reinvestment ratio

Measures the firm's ability to acquire long term assets with operating cash flow = CFO/Cash Paid for Long-Term Assets

Investing and financing ratio

Measures the firms ability to purchase assets, satisfy debts and pay dividends = CFO/Investing and Financing Cash Outflows

cash return on equity ratio

Measures the return of operating cash flow attributed to shareholders = CFO / Average Total Equity

Indirect method

Net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions adjustments include: eliminating non cash expense (depreciation and amortization), non operating items (gains and losses) and changes in balance sheet accounts resulting from accrual accounting events the starting point is net income, the "bottom line" of the income statement

Formula

Operating cash flow + investing cash flow + financing cash flow = change in cash balance + beginning cash balance = ending cash balance

Cash flow statement

Provides info to assess the firms liquidity, solvency, and financial flexibility analyst can use this to determine: - regular operations generate enough cash to sustain the business - enough cash is generated to pay off existing debts as they mature - firm is likely to need additional financing - unexpected obligations can be met - the firm can take advantage of new business opportunities as they arise

Martin, Inc. had the following transactions during 20X7: Purchased new fixed assets for $75,000. Converted $70,000 worth of preferred shares to common shares. Received cash dividends of $12,000. Paid cash dividends of $21,000. Repaid mortgage principal of $17,000. Assuming Martin follows U.S. GAAP, which of the following amounts represents Martin's cash flows from investing and cash flows from financing in 20X7, respectively?

Purchased new fixed assets for $75,000 - cash outflow from investing Converted $70,000 of preferred shares to common shares - noncash transaction Received dividends of $12,000 - cash inflow from operations Paid dividends of $21,000 - cash outflow from financing Mortgage repayment of $17,000 - cash outflow from financing CFI = -75,000 CFF = -21,000 - 17,000 = -$38,000 (LOS 23.a, 23.f)

The correct set of cash flow treatments as they relate to interest paid according to U.S. generally accepted accounting principles (GAAP) and International Accounting Standards (IAS) GAAP is:

U.S. GAAP treats interest paid as CFO whereas IAS GAAP treats interest paid as either CFO or CFF. (Study Session 7, Module 23.1, LOS 23.c)

Where are dividends paid to shareholders reported in the cash flow statement under U.S. GAAP and IFRS?

Under U.S. GAAP, dividends paid are reported as financing activities. Under IFRS, dividends paid can be reported as either operating or financing activities. (LOS 23.c)

Pacific, Inc.'s cash flow from operations (CFO) in millions was:

Using the indirect method, cash flow from operations is net income less increase in accounts receivable, plus increase in accounts payable, less increase in inventory, plus loss on sale of equipment, less gain on sale of real estate.

Which balance sheet accounts are most closely related to the operating activities on a firm's cash flow statement?

Working capital. Typically, operating activities on the cash flow statement are most closely related to the working capital accounts (current assets and current liabilities) on the balance sheet. Investing activities are typically related to non-current assets. Financing activities are typically related to non-current liabilities for transactions with creditors, or equity for transactions with shareholders. (Study Session 7, Module 23.1, LOS 23.e)

The reinvestment ratio measures a firm's ability to use its operating cash flow to:

acquire long-lived assets. The reinvestment ratio is CFO / cash paid for long-term assets. (Module 25.4, LOS 23.i)

The payment of interest on debt is

an operating cash flow under U.S. GAAP. (LOS 23.a)

Non-cash Investing and Financing Activities

are not reported in the cash flow statement since they do not result in inflows or outflows

Acquisition of debt and equity investments and loans are reported

as investing activities

Cash flow relating to operating activities includes

ash paid to suppliers, cash received from customers, interest received, and wages paid.

accounts receivable formula

beginning accounts receivable + sales - cash collections = ending accounts receivables

If Jackson Ski Company issues common stock, and uses the proceeds to purchase fixed assets such as equipment:

cash flow from financing would increase and cash flow from investing would decrease. Cash flow from financing increases when stock is issued, while cash flow from investing decreases when spending for purchases of fixed assets. (Study Session 7, Module 23.1, LOS 23.a)

Fixed Capital Investment

cash spent on fixed assets - cash received from selling fixed assets Not the same as CFI

CFI cash flow from investing activities

consists of the inflows and outflows of cash resulting from the acquisition or disposal of long term assets and certain investments

U.S. GAAP

dividends received= operating cash flow dividends paid= financing cash flow

Direct Method

each line item of the accrual- based income statement is converted into cash receipts or cash payments revenue and expense recognition occur when cash is received or paid this method converts an accrual basis income statement into a cash basis income statement

Under IFRS, interest expense would be classified as:

either operating cash flow or financing cash flow.

ex of non cash transaction:

exchange of debt for equity..since no cash is involved in the transaction, it is not reported as an investing or financing activity in the cash flow statement noncash transactions must be disclosed in either footnotes or supplemental schedule to the cash flow statement

Principal amounts borrowed from others, reported as dividends paid to the firms shareholders

financing activities

Issuing bonds would be classified as:

financing cash flow.

To calculate free cash flow to the firm based on operating cash flow, an analyst should add interest expense net of tax and subtract:

fixed capital investment. FCFF can be calculated from CFO by adding interest expense net of tax and subtracting fixed capital investment. (Module 25.4, LOS 23.i)

Cash flow statement

provides information beyond that available from the income statement, which is based on accrual method, rather than cash, accounting. Provides: - info about companys cash receipts and cash payments during an accounting period - info about a companys operating, investing, and financing activities - understanding of the impact of accrual accounting events on cash flows

common-size cash flow statement

shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows.

From an analyst's perspective, an advantage of the indirect method for presenting operating cash flow is that the indirect method:

shows the difference between net income and operating cash flow.

Which of the following statements regarding depreciation expense in the cash flow statements is CORRECT? Depreciation is added back to net income when determining CFO using:

the indirect method. Depreciation is a non-cash expense. Only in the indirect method is depreciation added back to net income when determining CFO because net income is only used in the indirect method and not the direct method. The direct method instead starts with cash sales and works down the income statement. (Study Session 7, Module 23.2, LOS 23.f)

In preparing a common-size cash flow statement, each cash flow is expressed as a percentage of:

total revenues. The cash flow statement can be converted to common-size format by expressing each line item as a percentage of revenue. (Module 25.3, LOS 23.h)