Presentation on theme: "Statement of Cash Flows"— Presentation transcript:
1 Statement of Cash Flows Analyzing Cash FlowsStatement of Cash Flows
2 Statement of Cash Flows helps address questions such as:How much cash is generated from or used in operations?What expenditures are made with cash from operations?How are dividends paid when confronting an operating loss?What is the source of cash for debt payments?How is the increase in investments financed?What is the source of cash for new plant assets?Why is cash lower when income increased?What is the use of cash received from new financing?
3 Internal Uses of CFS Along side with cash budget CFS is used: To assess liquidityDetermine if short-term financing is necessaryTo determine dividend policyDecide to distribute; or increase or decreaseTo evaluate the investment and financing decisions
4 Preparing a Statement of Cash Flows Prepared bycalculating changes in all of the balance sheet accounts, including cashlisting the changes in all of the accounts except cash as inflows or outflowscategorizing the flows by operating, financing, or investing activitiesThe inflows less the outflows balance to and explain the change in cash.
5 Four Parts of a Statement of Cash Flows Operating activitiesInvesting activitiesFinancing activities
6 Four Parts of a Statement of Cash Flows Cash and highly liquid short-term marketable securitiesAlso called cash equivalentsIf a company separates marketable securities into two accounts (cash and cash equivalents and short-term investments), the short-term investments are classified as investing activities.
7 Classification of Cash Flows Operations -- cash flows related to selling goods and services; that is, the principle business of the firm.Investing -- cash flows related to the acquisition or sale of noncurrent assets.Financing -- long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow.
8 Cash flow from operating activities Examples (IAS No.7):cash received from customers through sale of goods or services performed;cash received from non-operating activities such as dividends from investments, interest revenue, commissions, and fees;cash payments to suppliers or employees;cash payments for taxes and other expenses;In effect, the income statement is changed from accrual basis to cash basis
9 Investing Activities Examples of investing activities include: cash payments to acquire property, plant, and equipment (PPE), other tangible or intangible assets, and other long-term assets; and sale of such assetsloans extended to other companies; and collection of such loans;
10 Financing Activities Examples of financing activities are : cash received from issuing share capital;cash proceeds from issuing bonds, loans, notes, mortgages and other short or long-term borrowings;cash repayment of loans and other borrowings; andcash payments to shareholders as dividends.
11 Format of the Cash Flow Statement Name of the CompanyCash Flow StatementFor the period …Cash from operating activities ACash from investing activities BCash from financing activities CNet Change in Cash D = (A+B+C) increase or (decrease)+ Beginning Cash balance CB, from the beginning balance sheetEnding Cash balance =CB + D should equal to ending cashbalance in the ending balance sheetNon-cash Investing and Financing Activities
12 Determination of Cash Flows From Operating Activities Direct MethodIncome Statement items are converted to cash flows individuallyIndirect MethodNet income or loss is adjusted for accruals such as accounts receivable and payable, and for non-cash expenses such as depreciationreconciliation of the accrual based and cash based accounting
13 Comparison of MethodsDirect method of presentation calculates cash flow from operations by subtracting cash disbursements to supplies, employees, and others from cash receipts from customers.The indirect method calculates cash flow from operations by adjusting net income for non-cash revenues and expenses.Most firms present their cash flows using the indirect method.Only operating activities section is different between the methods, investing and financing sections are the same.
14 How to prepare cash flow statement Firms could prepare their own cash flow statement directly from the cash account.however, we need two consecutive balance sheets and the income statement that covers the period between the two balance sheets
15 Algebraic Formulation* Assets = Liabilities + Shareholders’ Equityor A = L + SHEAssets are either cash (C) or not (Non-Cash)Thus reorganizingC + Non Cash Assets (NCA) = L + SE C + NCA = L + SEWhere means the change in the balance of the item from the previous period.Solving for change in cash: C = L + SE - NCABased on Stickney and Weil, 10th ed. Financial Accounting Slides
16 Algebraic Formulation (Cont.) C = L + SE - NCAThe change in cash, C, is the increase or decrease in the cash account.This amount must equal changes in liabilities plus changes in shareholders’ equity minus changes in assets other than cash.Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts.
17 Indirect Method – cash flow from operations Adjusting Net Income of the period (accrual) to cash basis incomeIncrease in non-cashassets shows that cashwas spent,so cash outflow.Decrease in non-cashassets shows thatthey provided cashso cash inflow.Increase in liabilitiescash savings;increase in SHE cashreceived;so cash inflowDecrease in liabilitiesor SHE showscash paid;so cash outflowAssetsLiabilitiesandShareholders’equityINCREASEDECREASE
18 Indirect Method- operating activities- Adjustments to net income + noncash expenses: depreciation, amortization, uncollectible account expense,etc+ loss on sale of asset+ increases in current liabilities+ decreases in current assets- gain on sale of asset- decrease in current liabilitiesincrease in current assets= Cashflow from operating activities
19 Noncash ExpensesNoncash expenses, such as depreciation expense, are added back – because they were deducted to measure net income but did not require any cash payment in the current periodThey are not truly sources of cash, even though they are associated with cash inflows but reversal of an accrued expense
25 Effects of a Sale of a Long-Term Assets on Cash Flows A few transactions complicate the derivation of a cash flow statement from a comparative balance sheet, for example, the sale of a long-term (or fixed) asset.Recall the journal entry for the sale of an asset:Cash nnnnAccumulated Depreciation nnnnAsset nnnnGain (or loss) on sale nnnn
26 Sale of an AssetEach of the four parts of the above journal entry require an adjustment in the cash flow statement.The first line, cash, adds a line to the investing section.The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account.The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts.The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.
27 Steps to prepare CFS – indirect CFO Start with Net IncomeAdjust Net Income for non-cash expenses and gainsRecognize cash inflows (outflows) from changes in current assets and liabilitiesSum to yield net cash flows from operationsChanges in long-term assets yield net cash flows from investing activitiesChanges in long-term liabilities and equity accounts yield net cash flows from financing activitiesSum cash flows from operations, investing, and financing activities to yield net change in cashAdd net change in cash to the beginning cash balance to yield ending cash
28 Comparison of Cash Flow to Net Income Net income is an accrual based concept and purports to show the long-term.Cash flows purport to show the short term.Consider the outlook for both short-term and long-term and consider that each is either good or poor.A strong growing firm would show both good long-term and good short-term outlooks.A failing firm would show both poor long-term and poor short term outlooks.What about a firm with good cash flows (short-term) but poor net income (long-term)?What about a firm with poor cash flows (short-term) but good net income (long-term)?
29 Analysis Implications of Cash Flows Some limitations of the current reporting of cash flow:Practice does not require separate disclosure of cash flows pertaining to either extraordinary items or discontinued operations.Interest and dividends received and interest paid are classified as operating cash flows.Income taxes are classified as operating cash flows.Removal of pretax (rather than after-tax) gains or losses on sale of plant or investments from operating activities distorts our analysis of both operating and investing activities.Limitations in Cash Flow Reporting
31 Analysis Implications of Cash Flows Interpreting Cash Flows and Net Income
32 Analysis of Cash FlowsIn evaluating sources and uses of cash, the analyst should focus on questions like:Are asset replacements financed from internal or external funds?What are the financing sources of expansion and business acquisitions?Is the company dependent on external financing?What are the company’s investing demands and opportunities?What are the requirements and types of financing?Are managerial policies (such as dividends) highly sensitive to cash flows?
33 Inferences from Analysis of Cash Flows Inferences from analysis of cash flows include:Where management committed its resourcesWhere it reduced investmentsWhere additional cash was derived fromWhere claims against the company were reducedDisposition of earnings and the investment of discretionary cash flowsThe size, composition, pattern, and stability of operating cash flowsInferences from Analysis of Cash Flows
34 Alternative Cash Flow Measures Analysis of Cash FlowsNet income plus depreciation and amortizationEBITDA (earnings before interest, taxes, depreciation, and amortization)Alternative Cash Flow Measures
35 Analysis of Cash Flows Issues with EBITDA The using up of long-term depreciable assets is a real expense that must not be ignored.The add-back of depreciation expense does not generate cash. It merely zeros out the noncash expense from net income as discussed above. Cash is provided by operating and financing activities, not by depreciation.Net income plus depreciation ignores changes in working capital accounts that comprise the remainder of net cash flows from operating activities. Yet changes in working capital accounts often comprise a large portion of cash flows from operating activities.Issues with EBITDA
36 Company and Economic Conditions Analysis of Cash FlowsWhile both successful and unsuccessful companies can experience problems with cash flows from operations, the reasons are markedly different.We must interpret changes in operating working capital items in light of economic circumstances.Inflationary conditions add to thefinancial burdens of companiesand challenges for analysis.Company and Economic Conditions
37 Analysis of Cash Flows Free Cash Flow Another definition that is widely used:FCF = NOPAT - Change in NOA(net operating profits after tax (NOPAT) less the increase in net operating assets (NOA))
38 Analysis of Cash Flows Free Cash Flow Growth and financial flexibility depend on adequate free cash flow.Recognize that the amount of capital expenditures needed to maintain productive capacity is generally not disclosed—instead, most use total capital expenditures, which is disclosed, but can include outlays for expansion of productive capacity.Free Cash FlowPositive free cash flow reflects the amount available for business activities after allowances for financing and investing requirements to maintain productive capacity at current levels.
39 Cash Flow as Validators Analysis of Cash FlowsThe SCF is useful in identifying misleading or erroneous operating results or expectations.Cash Flow as ValidatorsSCF provides us with important clues on:Feasibility of financing capital expenditures.Cash sources in financing expansion.Dependence on external financing.Future dividend policies.Ability in meeting debt service requirements.Financial flexibility to unanticipated needs/opportunities.Financial practices of management.Quality of earnings.
40 Specialized Cash Flow Ratios Cash Flow Adequacy Ratio – Measure of a company’s ability to generate sufficient cash from operations to cover capital expenditures, investments in inventories, and cash dividends:Three-year sum of cash from operationsThree-year sum of expenditures, inventory additions, and cash dividendsCash Reinvestment Ratio – Measure of the percentage of investment in assets representing operating cash retained and reinvested in the company for both replacing assets and growth in operations:Operating cash flow – DividendsGross plant + Investment + Other assets + Working capital