Reading 23: Understanding Cash Flow Statements.
Cash-flow categories
Cash from operating activities (CFO)
Cash from investing activities (CFI)
Cash from financing activities (CFF)
Reporting non-cash investing and financing activities
Is not reported in the cash flow statement but must be disclosed in the footnote or other supplemental documents
Different presentation between IFRS and GAAP
Direct vs. Indirect method of presenting CFO
Direct method
each line item of the accrued-based income statement is adjusted to get cash receipts or cash payment.
Advantage: it presents clearly the firm's operating cash receipt/payment
Indirect method
Net income is adjusted for non-cash transactions (depreciations, gains/losses from asset sales, etc.) and for change in balance sheet items.
Advantage: focus on the difference between net income and operating cash flow.
How Cash Flow Statement connects to Income Statement and Balance Sheet
Operating activities relate to Current Assets.
Financing activities relate to non-current liability and equity
Timing of revenue/expense recognition that differs from cash receipt/payment is reflected in changes in balance sheet accounts.
Preparing the Cash Flow Statement
CFO
Direct
Sum cash inflow/outflow for operating activities
Cash paid for inputs
CoGS adjusted for changes in inventory and account payables.
Cash operating expenses
SG&A adjusted for changes in related accrued liabilities or prepaid expenses.
Cash interest paid
Interest expense adjusted for changes in related accrued liabilities or prepaid expenses.
Cash taxed paid
Income tax expense adjusted for changes in tax payable and changes in deferred tax assets and liabilities.
Cash collection from customers
Sales adjusted for changes in receivables and unearned revenue.
Indirect
Begin with net income, and adjust it for gains/ losses related to investing or financing cash flows, non-cash changes to income, and changes in balance sheet operating items.
CFI
is calculated by determining the changes in asset accounts that result from investing activities.
Cash flow from selling an asset = book value + any gain from the sale (or minus any loss)
CFF
is the sum of net cash flows from creditors (new borrowing - principal repaid) + net cash flows from shareholders (new equity issued - shares repurchased - cash dividend paid)
Convert Indirect to Direct CFO
Adjusting each income statement for changes in associated balance sheet accounts and by eliminating non-cash and non-operating items.
Analyzing Cash Flow Statement
Reported cash flow statement
Determine if a company is generating positive operating cash flow overtime, that is > capital spending needs
Determine if the accounting policies are causing reported earning to diverge from operating cash flow.
Common-size cash flow statement
Ways to common-sizing
Free Cash Flow formulas
Free Cash Flow to the Firm (FCFF)
Pre-leverage
Free Cash Flow to Equity (FCFE)
Post-leverage
Why need CFS
to know How company generates and spends cash
Net income from accrual accounting --> Not telling about the sources and uses of cash to meet liablilites and operating needs
Cash inflow/outflow from transaction that affect a firm's net income
Cash inflow/outflow from acquisition/ disposal of long-term assets and certain investment.
Cash inflow/outflows from transactions affecting firm's capital structure.
Explain the changes in Cash from Balance Sheet
Cash dividends received
Cash interest received
Other cash income
Components
Purchases of PP&E
Proceeds from sales of assets
Investment in joint ventures and affiliates
Payments for business acquired
Purchases and sales of marketable securities
(except Trading securities - as part of CFO if firms are financial institutions, and cash equivalents (part of balance sheet cash)
Purchases and sales of intangibles
Components
Issue, repurchase and redemption of
Common stock
Preferred stock
Debt
Dividend payments
Dividends received are CFO under GAAP
Excludes indirect financing via accounts payable (CFO)
Include
Converting debt or preferred into common equity
Assets acquired under capital leases
Purchase of assets via issuance of debt/equity
Exchanging one non-cash asset for another
Stock dividends
Interest received
GAAP: CFO
IFRS: CFO or CFI (depends on the nature of the business)
Interest paid
GAAP: CFO
IFRS: CFO or CFF (depends on the nature of the business)
Dividends received
GAAP: CFO
IFRS: CFO or CFI (depends on the nature of the business)
Dividend paid
GAAP: CFF
IFRS: CFF or CFO (depends on the nature of the business)
Taxes paid
GAAP: CFO
IFRS: CFO (tax from daily activities) or CFI (tax from disposing assets) or CFF (tax from retiring debt early)
Bank overdraft
GAAP: CFF (as if it is debt instrument)
IFRS: Part of Cash & Cash equivalents
Cash inflows or outflows
Assets increase
Cash outflows
Assets decrease
Cash inflows
Liabilities/equity increase
Cash inflows
Liabilities/equity decrease
Cash outflows
How to construct
Step 1: Starting point: Net income
step 2: Adjust net income for changes in relevant balance sheet items
An asset increases: deduct (cash)
A liability increases: add (cash)
An asset decreases: add (cash)
A liability decreases: deduct (cash)
Step 3: Eliminate Depreciation and amortization by adding them back (as they are non-cash expenses)
Step 4: Eliminate gains on disposal by deducting them and losses on disposal by adding them back (as these are CFI, not CFO)
Working Capital = Current Asset - Current Liability
CFO = Net income + non-cash charges - non-cash Working Capital
CFI = Investment (outflows) in assets - cash received (inflows) on asset sales
Cash collections = Net sales - ΔAccounts receivable + Δadvances from customers
Cash paid for input = CoGS - \(\Delta \)inventory + \(\Delta \)accounts payable
Cash interest = interest expense + \(\Delta \)interest payable
How to convert Indirect to Direct CFO
1) Take each income statement item in turn (e.g. sales)
2) Move to the balance sheet and identify asset and liability accounts that relate to that income statement item (e.g. accounts receivable)
3) Calculate the change in the balance sheet item during the period (ending balance - opening balance)
4) Apply the rule
An asset increases: deduct (cash)
A liability increases: add (cash)
An asset decreases: add (cash)
A liability decreases: deduct (cash)
5) Adjust the income statement amount by the change in the balance sheet
6) Tick off the items dealt with in both the income statement and balance sheet
7) Move to the next item on the income statement and repeat
8) Ignore depreciation/ amortization and gains/ losses on the disposal of assets as these are non-cash or non-CFO items
9) Keep moving down the income statement until all items included in net income have been addressed applying step 1-8
10) Sum up the amounts and we have CFO
Some questions
Is enough cash generated to pay off maturing debt
Need for additional finance? (when CFO is not enough)
Ability to meet unexpected obligations?
Flexibility to take advantage of new opportunities
Analyze the major sources and uses of cash flow (CFO, CFI or CFF)
Where are the major sources and uses?
Is CFO positive and sufficient to cover capex?
Analyze CFO
What are the major determinants of CFO? (only in Direct-method CFO)
is CFO higher or lower than net income? (earnings quality is high if backed by cash)
How consistent is CFO?
Analyze CFI
What is cash being spent on?
Is the company investing in PPE?
What acquisitions have been made?
Analyze CFF
How is the company financing CFI and CFO?
Is the company raising or repaying capital?
What dividends are being returned to owners?
Do regular operation (CFO) generate enough cash to sustain the business?
show each inflow/outflow as % of total inflow/outflow.
So that can see trend analysis or cross-section analysis
Show each item as % of revenue; or
Free Cash Flow (FCF) is cash available for discretionary uses
\( FCFF = NI + NCC -WCInv + Int(1-T)-FCInv = CFO + Int(1-T)-FCInv\)
Free Cash Flow to the Firm (FCFF) = Net income + Non-cash charges + [Interest expense x (1-T)] -fixed capital investment - working capital investment.
or = CFO + [Interest expense x (1-T)] -fixed capital investment - working capital investment.
is the cash flow available for distribution to common shareholders after all obligations has been paid
FCFE= CFO - Fixed Capital Investment + net borrowing.
\( FCFE = CFO- FCInv + \Delta DebtIncrease\)
if save interest, then will lose tax shield
\( FCFE = FCFF - Int(1-T) + \Delta DebtIncrease\)
Cash flow performance ratios
Cash flow to revenue\( =\frac{CFO}{Sales}\)
Cash return on assets\( =\frac{CFO}{Avg.TotalAssets}\)
Cash return on equity\( =\frac{CFO}{Avg.Equity}\)
Cash to income\( =\frac{CFO}{OperatingIncome}\)
Cash flow per share\( =\frac{CFO-Pref.Div}{No.CommonStock}\)
IFRS: If dividend paid were treated as CFO, then they must be added back
Cash flow coverage ratios
Debt coverage\( =\frac{CFO}{Total.Debt}\)
Interest Coverage\( =\frac{CFO+interest+tax}{Interest_{paid}}\)
IFRS: if interest paid was treated as CFF, no addition is required
Numerator: cash-based version of EBIT
Reinvestment\( =\frac{CFO}{Cash_{longtermAsset}}\)
Debt payment\( =\frac{CFO}{Cash_{longtermPrincipalDebtPayment}}\)
Dividend payment\( =\frac{CFO}{Dividends_{paid}}\)
Investing and Financing\( =\frac{CFO}{CashOutflow_{CFI,CFF}}\)
including purchasing/sale of trading securities (even for non-financial firm)