cash flow staement

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Financial Statements - The Cash Flow Statement

I. Introduction

Components and Relationships Between the Financial Statements

It is important to understand that the income statement, balance sheet and cash flow

statement are all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the

stated accounting period. The cash flow statement explains cash inflows and outflows, and

will ultimately reveal the amount of cash the company has on hand; this is reported in thebalance sheet as well.

We will not explain the components of the balance sheet and the income statement here

since they were previously reviewed.

Figure 6.13: The Relationship between the Financial Statements


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Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow

The statement of cash flow reports the impact of a firm's operating, investing and financial

activities on cash flows over an accounting period. The cash flow statement is designed to

convert the accrual basis of accounting used in the income statement and balance sheetback to a cash basis.

The cash flow statement will reveal the following to analysts:

1. How the company obtains and spends cash2. Why there may be differences between net income and cash flows3. If the company generates enough cash from operation to sustain the business4. If the company generates enough cash to pay off existing debts as they mature5. If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows

The statement of cash flows is segregated into three sections:

1. Operating activities2. Investing activities3. Financing activities

1. Cash Flow from Operating Activities (CFO)

CFO is cash flow that arises from normal operations such as revenues and cash operatingexpenses net of taxes.

This includes:

Cash inflow (+)1. Revenue from sale of goods and services2. Interest (from debt instruments of other entities)3. Dividends (from equities of other entities)

Cash outflow (-)1. Payments to suppliers2. Payments to employees3. Payments to government4. Payments to lenders5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)


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CFI is cash flow that arises from investment activities such as the acquisition or disposition

of current and fixed assets.

This includes:

Cash inflow (+)1. Sale of property, plant and equipment2. Sale of debt or equity securities (other entities)3. Collection of principal on loans to other entities

Cash outflow (-)1. Purchase of property, plant and equipment2. Purchase of debt or equity securities (other entities)3. Lending to other entities

3. Cash flow from financing activities (CFF)

CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or

retraction) of additional shares, short-term or long-term debt for the company's operations.

This includes:

Cash inflow (+)1. Sale of equity securities2. Issuance of debt securities

Cash outflow (-)1. Dividends to shareholders2. Redemption of long-term debt3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions

Information for the preparation of the statement of cash flows is derived from three

sources:

1. Comparative balance sheets2. Current income statements3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow

because they do not require the use of cash.

Examples Include:


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Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt

securities

Though these items are typically not included in the statement of cash flow, they can be

found as footnotes to the financial statements.

Financial Statements - Cash Flow Computations - IndirectMethod

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two

ways:

1. The indirect method2. The direct method

The Indirect Method

The indirect method is preferred by most firms because is shows a reconciliation from

reported net income to cash provided by operations.

Calculating Cash flow from Operations

Here are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income.2. Add back non-cash expenses.

o (Such as depreciation and amortization)3. Adjust for gains and losses on sales on assets.

o Add back losseso Subtract out gains


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4. Account for changes in all non-cash current assets.5. Account for changes in all current assets and liabilities except notes payable and

dividends payable.

In general, candidates should utilize the following rules:

Increase in assets = use of cash (-) Decrease in assets = source of cash (+) Increase in liability or capital = source of cash (+) Decrease in liability or capital = use of cash (-)

The following example illustrates a typical net cash flow from operating activities:

Cash Flow from Investment Activities

Cash Flow from investing activities includes purchasing and selling long-term assets and

marketable securities (other than cash equivalents), as well as making and collecting on


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loans.

Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities

Cash Flow from financing activities includes issuing and buying back capital stock, as well as

borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes).

Dividends paid are also included in this category, but the repayment of accounts payable or

accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:

Financial Statements - Cash Flow Computations - Direct MethodThe Direct Method

The direct method is the preferred method under FASB 95 and presents cash flows from

activities through a summary of cash outflows and inflows. However, this is not the method

preferred by most firms as it requires more information to prepare.


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Cash Flow from Operations

Under the direct method, (net) cash flows from operating activities are determined by

taking cash receipts from sales, adding interest and dividends, and deducting cash

payments for purchases, operating expenses, interest and income taxes. We'll examine

each of these components below:

Cash collectionsare the principle components of CFO. These are the actual cashreceived during the accounting period from customers.

They are defined as:

Formula 6.7

Cash Collections Receipts from Sales

= Sales + Decrease (or - increase) in Accounts

Receivable

Cash payment for purchases make up the most important cash outflow

component in CFO. It is the actual cash dispersed for purchases from suppliers

during the accounting period.

It is defined as:

Formula 6.8

Cash payments for purchases= cost of goods sold +

increase (or - decrease) in inventory + decrease (or -increase) in accounts payable

Cash payment for operating expensesis the cash outflow related to selling

general and administrative (SG&A), research and development (R&A) and other

liabilities such as wage payable and accounts payable.

It is defined as:

Formula 6.9Cash payments for operating expenses= operatingexpenses + increase (or - decrease) in prepaid expenses +decrease (or - increase) in accrued liabilities


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Cash interest is the interest paid to debt holders in cash.

It is defined as:

Formula 6.10Cash interest = interest expense - increase (or +

decrease) interest payable + amortization of bond premium(or - discount)

Cash payment for incometaxes is the actual cash paid in the form of taxes. It isdefined as:

Formula 6.11

Cash payments for income taxes

= income taxes + decrease (or - increase) in income taxespayable

Look Out!

Note: Cash flow from investing and financing are

computed the same way it was calculated under the

indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the

direct method.


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Look Out!

Candidates must know the following:

Though the methods used differ, the results are always

the same.

CFO and CFF are the same under both methods.

Thereis an inverse relationship between changes in assets

and changes in cash flow.

Financial Statements - Free Cash Flow

Free Cash Flow (FCF)


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Free cash flow (FCF) is the amount of cash that a company

has left over after it has paid all of its expenses, including

net capital expenditures. Net capital expenditures are what

a company needs to spend annually to acquire or upgrade

physical assets such as buildings and machinery to keep

operating.

Formula 6.12Free cash flow= cash flow from operating activities - net

capital expenditures (total capital expenditure - after-tax

proceeds from sale of assets)

The FCF measure gives investors an idea of a company's

ability to pay down debt, increase savings and increase

shareholder value, and FCF is used for valuation purposes.

Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm is the cash available to all

investors, both equity and debt holders. It can be calculated

using Net Income or Cash Flow from Operations (CFO).

The calculation of FCFF using CFO is similar to the

calculation of FCF. Because FCFF is the cash flow allocated

to all investors including debt holders, the interest expense

which is cash available to debt holders must be added back.

The amount of interest expense that is available is the

after-tax portion, which is shown as the interest expense

multiplied by 1-tax rate [Int x (1-tax rate)]. .

This makes the calculation of FCFF using CFO equal to:

FCFF = CFO + [Int x (1-tax rate)] FCInv

Where:

CFO = Cash Flow from Operations

Int = Interest Expense

FCInv = Fixed Capital Investment (total capitalexpenditures)

This formula is different for firm's that follow IFRS. Firm's

that follow IFRS would not add back interest since it is

recorded as part of financing activities. However, since IFRS

allows dividends paid to be part of CFO, the dividends paid


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would have to be added back.

The calculation using Net Income is similar to the one using

CFO except that it includes the items that differentiate Net

Income from CFO. To arrive at the right FCFF, working

capital investments must be subtracted and non-cash

charges must be added back to produce the following

formula:

FCFF = NI + NCC + [Int x (1-tax rate)] FCInv

WCInv

Where:

NI = Net Income

NCC = Non-cash Charges (depreciation and amortization)

Int = Interest Expense

FCInv = Fixed Capital Investment (total capital

expenditures)

WCInv = Working Capital Investments

Free Cash Flow to Equity (FCFE), the cash available to

stockholders can be derived from FCFF. FCFE equals FCFF

minus the after-tax interest plus any cash from taking on

debt (Net Borrowing). The formula equals:

FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

Financial Statements - ManagementDiscussion and Analysis & FinancialStatement Footnotes

I. Management Discussion and Analysis

The Securities Exchange Commission (SEC) requires this

section to be included with the financial statements of a

public company and is prepared by management

This narrative section usually includes the following;

A description of the company's primary businesssegments and future trends

A review of the company's revenues and expenses Discussions pertaining to the sales and expense


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trends

Review of cash flow statements and future cash flowneeds including current and future capital

expenditures

A review of current significant balance sheet itemsand future trends, such as differed tax liabilities,

among others

A discussion and review of major transactions(acquisitions, divestitures) that may affect the

business from an operational and cash flow point of

view

A discussion and review of discontinued operations,extraordinary items and other unusual or infrequent

events

Financial Statement Footnotes

These footnotes are additional information provided to the

reader in an effort to further explain what is displayed on

the consolidated financial statements.

Generally accepted accounting principles (GAAP) and the

SEC require these footnotes. The information contained in

these footnotes help the reader understand the amounts,

timing and uncertainty of the estimates reported in theconsolidated financial statements.

Included in the footnotes are the following:

A summary of significant accountingpoliciessuch as:

o The revenues-recognition method usedo Depreciation methods and rates

Balance sheet and income statementbreakdownof items such as:

o Marketable securitieso Significant customers (percentage of

customers that represent a significant portion

of revenues)

o Sales per regionso Inventory


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o Fixed assets and Liabilities (includingdepreciation, inventory, accounts receivable,

income taxes, credit facility and long-term

debt, pension liabilities or assets, contingent

losses (lawsuits), hedging policy, stock option

plans and capital structure.

Supplemental schedulesoften detail disclosures required

by audited statements, as well as the accounting methods

and assumptions used by management. Supplemental

schedules can include information such as natural resources

reserves, an overview of specific business lines, or the

segmentation of income or other line items by geographical

area or customer distribution.

Management's Discussion and Analysis

(MD&A)presents management's perspective on the

financial performance and business condition of the

firm. U.S. publicly-held companies must provide MD&As that

include a discussion of the operations of the company in

detail by usually comparing the current period versus prior

period

Analyst Interpretation

As reporting standards continue to change and evolve,

analysts must be aware of new accounting approaches andinnovations that can affect how businesses treat certain

transactions, especially those that have a material impact

on the financial statements. Analysts should use the

financial reporting framework to guide them on how to

determine the financial statement impact of new types of

products and business operations.

One way to keep up to date on evolving standards and

accounting methods is to monitor the standard setting

bodies and professional organizations like the CFA Institute

that publish position papers on the subject.

Companies that prepare financial statements under IFRS or

US GAAP must disclose their accounting policies and

estimates in the footnotes, as well as any policies requiring

management's judgment in the management's discussion

and analysis. Public companies must also disclose their


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