Reading 25: Understanding Cash Flow Statements

"Gross"

"gross" simply means an amount that is presented on the balance sheet before deducting any accumulated depreciation or amortization.

Two Methods of Presenting the Cash Flow Statement

1. Direct Method 2. Indirect Method Use of the direct method, however, is encouraged by both standard setters. -most firms use the indirect method. The difference between the two methods relates to the presentation of cash flow from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods

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

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

Converting Cash collections from customers`

1.Begin with net sales from the income statement. 2. Subtract (add) any increase (decrease) in the accounts receivable balance as reported in the indirect method. If the company has sold more on credit than has been collected from customers, accounts receivable will increase and cash collections will be less than net sales. 3. Add (subtract) an increase (decrease) in unearned revenue. Unearned revenue includes cash advances from customers. Cash received from customers when the goods or services have yet to be delivered is not included in net sales, so the advances must be added to net sales in order to calculate cash collections.

Adjustments for Changes in Accounts Payable

A change in accounts payable indicates a difference between purchases and the amount paid to suppliers. An increase in accounts payable, for example, results when purchases are greater than cash paid to suppliers. -Since purchases were subtracted in calculating net income, we need to add any increase in accounts payable to net income so that CFO reflects the actual cash disbursements for purchases (rather than total purchases).

Advantage of Direct Method

Advantage of the direct method is that it presents the firm's operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. Therefore, the direct method provides more information than the indirect method. -This knowledge of past receipts and payments is useful in estimating future operating cash flows

Major Sources and Uses of Cash

Cash flow analysis begins with an evaluation of the firm's sources and uses of cash from operating, investing, and financing activities. Sources and uses of cash change as the firm moves through its life cycle. For example, when a firm is in the early stages of growth, it may experience negative operating cash flow as it uses cash to finance increases in inventory and receivables. -This negative operating cash flow is usually financed externally by issuing debt or equity securities. -These sources of financing are not sustainable. Eventually, the firm must begin generating positive operating cash flow or the sources of external capital may no longer be available. Over the long term, successful firms must be able to generate operating cash flows that exceed capital expenditures and provide a return to debt and equity holders.

Indirect Method for presenting cash flow statement

Cash flow from operations is presented differently under the indirect method, but the amount of CFO is the same under either method. Cash flow from financing and cash flow from investing are presented in the same way on cash flow statements prepared under both the direct and indirect methods of presenting the statement of cash flows.

Free Cash Flow to Equity (FCFE)

Cash flow that would be available for distribution to common shareholders. FCFE can be calculated as follows: FCFE = CFO - FCInv + net borrowing where: CFO = cash flow from operations FCInv = fixed capital investment (net capital expenditures) net borrowing = debt issued - debt repaid If net borrowing is negative (debt repaid exceeds debt issued), we would subtract net borrowing in calculating FCFE. If firms that follow IFRS have subtracted dividends paid in calculating CFO, dividends must be added back when calculating FCFE.

Cash Flow from Investing Activities (CFI)

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

Cash Flow from Financing Activities (CFF)

Consists of the inflows and outflows of cash resulting from transactions affecting a firm's capital structure. Dividends paid to the firm's shareholders are financing activities.

Dividends paid vs. Dividends received

Don't confuse dividends received and dividends paid. Under U.S. GAAP, dividends received are operating cash flows and dividends paid are financing cash flows.

Fixed Capital Investment

Fixed capital investment is cash spent on fixed assets minus cash received from selling fixed assets. -It is not the same as CFI, which includes cash flows from fixed investments, investments in securities, and repaid principal from loans made.

Investing Cash Flows under the Direct Method

Investing cash flows (CFI) are calculated by examining the change in the gross asset accounts that result from investing activities, such as property, plant, and equipment, intangible assets, and investment securities. Related accumulated depreciation or amortization accounts are ignored since they do not represent cash expenses

Cash Flow Statement Item Sources

Items on the cash flow statement come from two sources: (1) income statement items and (2) changes in balance sheet accounts

Debt Coverage Ratio

Measures financial risk and leverage. debt coverage=CFO/total debt

Dividend Payment Ratio

Measures the firm's ability to make dividend payments from operating cash flow. dividend payment=CFO/dividends paid

Debt Payment Ratio

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

Other Conversions from Direct Method

Other items in a direct method cash flow statement follow the same principles. -Cash taxes paid, for example, can be derived by starting with income tax expense on the income statement. Adjustment must be made for changes in related balance sheet accounts (deferred tax assets and liabilities, and income taxes payable). Cash operating expense is equal to selling, general, and administrative expense (SG&A) from the income statement, increased (decreased) for any increase (decrease) in prepaid expenses. Any increase in prepaid expenses is a cash outflow that is not included in SG&A for the current period.

Cash Flows from Loans

Principal amounts borrowed from others are reported as financing activities The interest paid is reported as an operating activity

Direct Method of Presenting a Cash Flow Statement

Shows only cash payments and cash receipts over the period. The sum of these inflows and outflows is the company's CFO. The direct method gives the analyst more information than the indirect method. -The analyst can see the actual amounts that went to each use of cash and that were received from each source of cash. -This information can help the analyst to better understand the firm's performance over time and to forecast future cash flows.

Cash Flow from Operating Activities (CFO)

Sometimes referred to as "cash flow from operations" or "operating cash flow" Consists of the inflows and outflows of cash resulting from transactions that affect a firm's net income.

Steps in calculating CFO under the indirect method

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

Cash Flow Statement

The cash flow statement provides information beyond that available from the income statement, which is based on accrual, rather than cash, accounting. The cash flow statement provides the following: 1. Information about a company's cash receipts and cash payments during an accounting period. 2. Information about a company's operating, investing, and financing activities. 3. An understanding of the impact of accrual accounting events on cash flows. The cash flow statement provides information to assess the firm's liquidity, solvency, and financial flexibility.

Beginning and Ending Cash Balances

The cash flow statement reconciles the beginning and ending balances of cash over an accounting period. The change in cash is a result of the firm's operating, investing, and financing activities as follows: Operating cash flow + Investing cash flow + Financing cash flow = Change in cash balance + Beginning cash balance = Ending cash balance The ending cash balance on the cash flow statement is the cash balance on the balance sheet

Examining Financing Cash Flows

The financing activities section of the cash flow statement reveals information about whether the firm is generating cash flow by issuing debt or equity. It also provides information about whether the firm is using cash to repay debt, reacquire stock, or pay dividends. For example, an analyst would certainly want to know if a firm issued debt and used the proceeds to reacquire stock or pay dividends to shareholders.

Converting Direct to Indirect

The only difference between the indirect and direct methods of presentation is in the cash flow from operations (CFO) section. CFO under the direct method can be computed using a combination of the income statement and a statement of cash flows prepared under the indirect method. There are two major sections in CFO under the direct method: cash inflows (receipts) and cash outflows (payments). The general principle here is to adjust each income statement item for its corresponding balance sheet accounts and to eliminate noncash and nonoperating transactions.

Examining Investing Cash Flows

The sources and uses of cash from investing activities should be examined. Increasing capital expenditures, a use of cash, is usually an indication of growth. A firm may reduce capital expenditures or even sell capital assets in order to save or generate cash. -This may result in higher cash outflows in the future as older assets are replaced or growth resumes. Generating operating cash flow that exceeds capital expenditures is a desirable trait.

Calculating Total Cash Flow

Total cash flow is equal to the sum of CFO, CFI, and CFF. If calculated correctly, the total cash flow will equal the change in cash from one balance sheet to the next.

Calculating Cash paid for a new asset Direct Method

When calculating cash paid for a new asset, it is necessary to determine whether old assets were sold. If assets were sold during the period, you must use the following formula: cash paid for new asset = ending gross assets + gross cost of old assets sold - beginning gross assets May be easier to think in terms of the account reconciliation format discussed earlier. Beginning gross assets + cash paid for new assets - gross cost of assets sold = ending gross assets. Given three of the variables, simply solve for the fourth.

Example of Transaction that Affects Balance Sheet Account

transactions affect each balance sheet account. For example, accounts receivable are increased by sales and decreased by cash collections. Beginning accounts receivable + Sales - Cash collections = Ending accounts receivable if beginning accounts receivable are €10,000, ending accounts receivable are €15,000, and sales are €68,000, then cash collections must equal €63,000

Converting Cash payments to suppliers

1. Begin with cost of goods sold (COGS) as reported in the income statement. 2. If depreciation and/or amortization have been included in COGS (they increase COGS), these noncash expenses must be added back when computing the cash paid to suppliers. 3. Reduce (increase) COGS by any increase (decrease) in the accounts payable balance as reported in the indirect method. If payables have increased, then more was spent on credit purchases during the period than was paid on existing payables, so cash payments are reduced by the amount of the increase in payables. 4. Add (subtract) any increase (decrease) in the inventory balance as disclosed in the indirect method. Increases in inventory are not included in COGS for the period but still represent the purchase of inputs, so they increase cash paid to suppliers. 5. Subtract an inventory write-off that occurred during the period. An inventory write-off, as a result of applying the lower of cost or market rule, will reduce ending inventory and increase COGS for the period. However, no cash flow is associated with the write-off.

Classification of Cash Flows

1. Cash Flow from Operating Activities (CFO) 2. Cash Flow from Investing Activities (CFI) 3. Cash Flow from Financing Activities (CFF)

Common components of cash flow that appear on a statement of cash flow presented under the direct method

1. Cash collected from customers, typically the main component of CFO. 2. Cash used in the production of goods and services (cash inputs). 3. Cash operating expenses. 4. Cash paid for interest. 5. `Cash paid for taxes.

Trick in Direct Method Questions

A common "trick" in direct method questions is to provide information on depreciation expense along with other operating cash flow components. When using the direct method, ignore depreciation expense—it's a noncash charge. We do consider depreciation expense in indirect method computations, but we do this solely because depreciation expense and other noncash expenses have been subtracted in calculating net income (our starting point) and need to be added back to get cash flow

Cash flow per share

A variation of basic earnings per share measured by using CFO instead of net income. cash flow per share= (CFO−preferred dividends)/(weighted average number of common shares) Note: If common dividends were classified as operating activities under IFRS, they should be added back to CFO for purposes of calculating cash flow per share.

Advantage of Indirect Method

Advantage of the indirect method is that it focuses on the difference between net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow. -Analysts forecast net income and then derive operating cash flow by adjusting net income for the differences between accrual accounting and the cash basis of accounting.

Uses of a Cash Flow Statement

An analyst can use the statement of cash flows to determine whether: 1. Regular operations generate enough cash to sustain the business. 2. Enough cash is generated to pay off existing debts as they mature. 3. The firm is likely to need additional financing. 4. Unexpected obligations can be met. 5. The firm can take advantage of new business opportunities as they arise.

Operating Cash Flow

An analyst should identify the major determinants of operating cash flow. Positive operating cash flow can be generated by the firm's earnings-related activities. However, positive operating cash flow can also be generated by decreasing noncash working capital, such as liquidating inventory and receivables or increasing payables. Decreasing noncash working capital is not sustainable, since inventories and receivables cannot fall below zero and creditors will not extend credit indefinitely unless payments are made when due.

Adjustment for Disposal of Assets under Indirect Method

Another adjustment to net income on an indirect statement of cash flows is to subtract gains on the disposal of assets. Proceeds from the sale of fixed assets are an investing cash flow. Since gains are a portion of such proceeds, we need to subtract them from net income in calculating CFO under the indirect method. Conversely, a loss would be added back to net income in calculating CFO under the indirect method.

Example of Income Tax CF Classification

Consider a company that sells land that was held for investment for $1 million. Income taxes on the sale total $160,000. Under U.S. GAAP, the firm reports an inflow of cash from investing activities of $1 million and an outflow of cash from operating activities of $160,000. Under IFRS, the firm can report a net inflow of $840,000 from investing activities.

Direct Method of Presenting Cash Flows

Each line item of the accrual-based income statement is converted into cash receipts or cash payments. -Under the accrual method of accounting, the timing of revenue and expense recognition may differ from the timing of the related cash flows Under cash-basis accounting, revenue and expense recognition occur when cash is received or paid. The direct method converts an accrual-basis income statement into a cash-basis income statement

FCFF Calculated from CFO

FCFF = CFO + [Int × (1 - tax rate)] - FCInv where: CFO = cash flow from operations Int = cash interest paid FCInv = fixed capital investment (net capital expenditures) It is not necessary to adjust for noncash charges and changes in working capital when starting with CFO, since they are already reflected in the calculation of CFO. For firms that follow IFRS, it is not necessary to adjust for interest that is included as a part of financing activities. Additionally, firms that follow IFRS can report dividends paid as operating activities. -In this case, the dividends paid would be added back to CFO. The goal is to calculate the cash flow that is available to the shareholders and debt holders. It is not necessary to adjust dividends for taxes since dividends paid are not tax deductible.

FCFF Calculated from Net Income

FCFF = NI + NCC + [Int × (1 - tax rate)] - FCInv - WCInv where: NI = net income NCC = noncash charges (depreciation and amortization) Int = cash interest paid FCInv = fixed capital investment (net capital expenditures) WCInv = working capital investment Cash interest paid, net of tax, is added back to net income. -FCFF is the cash flow available to stockholders and debt holders. Since interest is paid to (and therefore "available to") the debt holders, it must be included in FCFF.

Financing Cash Flows under the Direct Method

Financing cash flows (CFF) are determined by measuring the cash flows occurring between the firm and its suppliers of capital. Cash flows between the firm and its creditors result from new borrowings (positive CFF) and debt principal repayments (negative CFF). -Note that interest paid is technically a cash flow to creditors, but it is included in CFO under U.S. GAAP. Cash flows between the firm and its shareholders occur when equity is issued, shares are repurchased, or dividends are paid. CFF is the sum of these two measures: 1. net cash flows from creditors = new borrowings - principal amounts repaid 2. net cash flows from shareholders = new equity issued - share repurchases - cash dividends paid Cash dividends paid can be calculated from dividends declared and any changes in dividends payable.

Free Cash Flow

Free cash flow is a measure of cash that is available for discretionary purposes. This is the cash flow that is available once the firm has covered its capital expenditures. This is a fundamental cash flow measure and is often used for valuation. There are several measures of free cash flow. Two of the more common measures are: 1. free cash flow to the firm 2. free cash flow to equity

Free Cash Flow to the Firm

Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt holders. FCFF can be calculated by starting with either net income or operating cash flow.

Other Cash Flow Ratios

Just as with the income statement and balance sheet, the cash flow statement can be analyzed by comparing the cash flows either over time or to those of other firms. Cash flow ratios can be categorized as: 1. performance ratios 2. coverage ratios.

Cash flow to revenue ratio

Measures the amount of operating cash flow generated for each dollar of revenue. cash flow-to-revenue = CFO/(net revenue)

Reinvestment Ratio

Measures the firm's ability to acquire long-term assets with operating cash flow. reinvestment ratio=CFO/(cash paid for long-term assets)

Interest Coverage Ratio

Measures the firm's ability to meet its interest obligations. interest coverage=(CFO + interest paid + taxes paid)/interest paid Note: If interest paid was classified as a financing activity under IFRS, no interest adjustment is necessary.

Investing and Financing Ratio

Measures the firm's ability to purchase assets, satisfy debts, and pay dividends. investing and financing=CFO/(cash outflows from investing and financing activities)

Cash Return on Assets Ratio

Measures the return of operating cash flow attributed to all providers of capital. cash return-on-assets = CFO/average total assets

cash return-on-equity ratio

Measures the return of operating cash flow attributed to shareholders. cash return-on-equity = CFO/average total equity

Indirect Method of Preparing Cash Flow Statements

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 noncash expenses (e.g., depreciation and amortization), nonoperating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.

Cash Flow Statement Relation to Income Statement

Net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations.

How are noncash investing and financing activities reported?

Noncash investing and financing activities are not reported in the cash flow statement since they do not result in inflows or outflows of cash. Noncash transactions must be disclosed in either a footnote or supplemental schedule to the cash flow statement. Analysts should be aware of the firm's noncash transactions, incorporate them into analysis of past and current performance, and include their effects in estimating future cash flows.

Cash Flows from Debt and Equity Securities

Note that the acquisition of debt and equity investments (other than trading securities) and loans made to others are reported as investing activities. The income from these investments (interest and dividends received) is reported as an operating activity

Similarities Between Direct Method and Income Statement

Notice the similarities of the direct method cash flow presentation and an income statement. The direct method begins with cash inflows from customers and then deducts cash outflows for purchases, operating expenses, interest, and taxes

Operating Cash Flow as an indication of the quality of earnings

Operating cash flow also provides a check of the quality of a firm's earnings. A stable relationship of operating cash flow and net income is an indication of quality earnings. Earnings that significantly exceed operating cash flow may be an indication of aggressive (or even improper) accounting choices such as recognizing revenues too soon or delaying the recognition of expenses. The variability of net income and operating cash flow should also be considered.

Disclosure Requirements for Direct and Indirect Methods

Under U.S. GAAP, a direct method presentation must also disclose the adjustments necessary to reconcile net income to cash flow from operating activities. -This disclosure is the same information that is presented in an indirect method cash flow statement. -This reconciliation is not required under IFRS. Under IFRS, payments for interest and taxes must be disclosed separately in the cash flow statement under either method (direct or indirect). -Under U.S. GAAP, payments for interest and taxes can be reported in the cash flow statement or disclosed in the footnotes.

Income Tax Cash Flow Classification

Under U.S. GAAP, all taxes paid are reported as operating activities, even taxes related to investing and financing transactions. Under IFRS, income taxes are also reported as operating activities unless the expense is associated with an investing or financing transaction.

CFO under Indirect Method

Under the indirect method of presenting CFO, we begin with net income and adjust it for differences between accounting items and actual cash receipts and cash disbursements. Depreciation, for example, is deducted in calculating net income, but requires no cash outlay in the current period. -we must add depreciation (and amortization) to net income for the period in calculating CFO

Examples of Noncash Investing and Financing Activities

For example, if a firm acquires real estate with financing provided by the seller, the firm has made an investing and financing decision. This transaction is the equivalent of borrowing the purchase price. However, since no cash is involved in the transaction, it is not reported as an investing and financing activity in the cash flow statement. Another example of a noncash transaction is an exchange of debt for equity. Such an exchange results in a reduction of debt and an increase in equity. However, since no cash is involved in the transaction, it is not reported as a financing activity in the cash flow statement.

Common-Size Cash Flow Statement

Like the income statement and balance sheet, common-size analysis can be used to analyze the cash flow statement. The cash flow statement can be converted to common-size format by expressing each line item as a percentage of revenue. -Alternatively, each inflow of cash can be expressed as a percentage of total cash inflows, and each outflow of cash can be expressed as a percentage of total cash outflows. A revenue based common-size cash flow statement is useful in identifying trends and forecasting future cash flow. -Since each line item of the cash flow statement is stated in terms of revenue, once future revenue is forecast, cash flows can be estimated for those items that are tied to revenue.

cash-to-income ratio

Measures the ability to generate cash from firm operations. cash-to-income=CFO/operating income

Professor's Note on Direct vs Indirect Method

Throughout the discussion of the direct and indirect methods, remember the following points: 1.CFO is calculated differently, but the result is the same under both methods. 2. The calculation of CFI and CFF is identical under both methods. 3. There is an inverse relationship between changes in assets and changes in cash flows. -In other words, an increase in an asset account is a use of cash, and a decrease in an asset account is a source of cash. 4. There is a direct relationship between changes in liabilities and changes in cash flow. -In other words, an increase in a liability account is a source of cash, and a decrease in a liability is a use of cash. 5. Sources of cash are positive numbers (cash inflows) and uses of cash are negative numbers (cash outflows).

Interest and Dividends: GAAP vs IFRS

Under U.S. GAAP, dividends paid to the firm's shareholders are reported as financing activities while interest paid is reported in operating activities. -Interest received and dividends received from investments are also reported as operating activities Under IFRS, interest and dividends received may be classified as either operating or investing activities. -Dividends paid to the company's shareholders and interest paid on the company's debt may be classified as either operating or financing activities.

Direct Vs. Indirect Method

Under the indirect method, the starting point is net income, the "bottom line" of the income statement. Under the direct method, the starting point is the top of the income statement, revenues, adjusted to show cash received from customers. Total cash flow from operating activities is exactly the same under both methods, only the presentation methods differ

Adjustment for changes in Balance Sheet Accounts under Indirect Method

Under the indirect method, we also need to adjust net income for change in balance sheet accounts. If, for example, accounts receivable went up during the period, we know that sales during the period were greater than the cash collected from customers. -Since sales were used to calculate net income under the accrual method, we need to reduce net income to reflect the fact that credit sales, rather than cash collected were used in calculating net income. Also need to adjust for Accounts payable

Calculating Cash Flow from an asset that was sold

When calculating the cash flow from an asset that has been sold, it is necessary to consider any gain or loss from the sale using the following formula: cash from asset sold = book value of the asset + gain (or - loss) on sale

Statement of Cash Flows Connection to Balance Sheet

With a few exceptions: operating activities relate to the firm's current assets and current liabilities. Investing activities typically relate to the firm's noncurrent assets financing activities typically relate to the firm's noncurrent liabilities and equity. Transactions for which the timing of revenue or expense recognition differs from the receipt or payment of cash are reflected in changes in balance sheet accounts. -For example, when revenues (sales) exceed cash collections, the firm has sold items on credit and accounts receivable (an asset) increase. -The opposite occurs when customers repay more on their outstanding accounts than the firm extends in new credit: cash collections exceed revenues and accounts receivable decrease. When purchases from suppliers exceed cash payments, accounts payable (a liability) increase. -When cash payments exceed purchases, payables decrease