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CHAPTER 6 UNDERSTANDING CASH FLOW STATEMENTS Presenter’s name Presenter’s title dd Month yyyy.

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Presentation on theme: "CHAPTER 6 UNDERSTANDING CASH FLOW STATEMENTS Presenter’s name Presenter’s title dd Month yyyy."— Presentation transcript:

1 CHAPTER 6 UNDERSTANDING CASH FLOW STATEMENTS Presenter’s name Presenter’s title dd Month yyyy

2 OVERVIEW Statement of Cash Flows: Overview Format of Statement of Cash Flows Preparing a Statement of Cash Flows Additional Analytical Considerations Copyright © 2013 CFA Institute 2

3 3

4 4 APPLE, Inc.

5 CLASSIFICATION OF ACTIVITIES ON THE STATEMENT OF CASH FLOWS Operating activities: Deliver or produce goods for sale and provide services. Examples: Receive cash from customers Pay cash to suppliers Pay cash for operating expenses. Investing activities: Buy or sell long-term assets and other investments. Examples: Property, plant, and equipment (PP&E) Other companies’ securities (that are not cash equivalents) Financing activities: Obtain or repay capital. Examples: Borrow from creditors and repay the principal Issue or repurchase stock Pay dividends Copyright © 2013 CFA Institute 5

6 COLGATE: CASH FLOWS CLASSIFIED BY ACTIVITY Net cash provided by operations2,8963,2113,277 Net cash used in investing activities (1,213) (658) (841) Net cash used in financing activities (1,242) (2,624) (2,270) Effect of exchange rate changes(53)(39) (121) Net (decrease) increase in cash and cash equivalents 388 (110)45 Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $878 $490 $600 Copyright © 2013 CFA Institute 6

7 COLGATE’S OPERATING CASH FLOWS Copyright © 2013 CFA Institute 7

8 COLGATE’S INVESTING CASH FLOWS Copyright © 2013 CFA Institute 8

9 COLGATE’S FINANCING CASH FLOWS Copyright © 2013 CFA Institute 9

10 COMMON-SIZE STATEMENT OF CASH FLOW FOR COLGATE (ABBREVIATED) Operating Activities Net income including noncontrolling interests15.3%14.9%15.6% Net cash provided by operations17.3%20.6%21.4% Net cash used in investing activities–7.2%–4.2%–5.5% Net cash used in financing activities–7.4%–16.9%–14.8% Copyright © 2013 CFA Institute 10 Each line item is presented as a percentage of net revenue.

11 COLGATE’S CASH FLOWS: SUMMARY Overall, $323 million net increase in cash over three years, from $555 million at the beginning of 2009 to $878 million at the end of Colgate consistently obtains its cash inflow from operating activities and uses cash in investing and financing activities—a typical profile for a mature company. Colgate’s operating cash flow exceeded net income in every year—a desirable profile for a mature company. In every year, Colgate’s cash from operations was more than enough to cover its capital expenditures. The amount of dividends paid has steadily increased over the past three years. Amount of operating cash after paying for capital expenditures was more than enough to cover the dividend payments. In summary, Colgate’s cash flows represent a positive profile. Copyright © 2013 CFA Institute 11

12 COLGATE’S OPERATING CASH FLOWS: INDIRECT METHOD Copyright © 2013 CFA Institute 12

13 INDIRECT VS. DIRECT METHOD FOR PRESENTING OPERATING CASH FLOWS Indirect method Begins with net income and adjusts to operating cash flows. Arguments for: -Clearly shows the reasons for differences between net income and operating cash flows. -Mirrors forecasting approach that begins with forecast of income, then derives cash flows. Direct method Shows each cash inflow and outflow related to receipts and disbursements. Arguments for: -Provides information on the specific sources of operating cash receipts and payments. - Does not net. Copyright © 2013 CFA Institute 13

14 INDIRECT VS. DIRECT METHOD FOR PRESENTING OPERATING CASH FLOWS Indirect method IFRS permit. U.S. GAAP permit. Used by the majority of companies, whether reporting under IFRS or U.S. GAAP. Direct method IFRS encourage. U.S. GAAP encourage, but requires a reconciliation of net income to cash flow from operating activities. Copyright © 2013 CFA Institute 14

15 TECH DATA’S OPERATING CASH FLOWS: EXAMPLE OF DIRECT METHOD Copyright © 2013 CFA Institute 15

16 CLASSIFICATION OF CASH FLOWS UNDER IFRS VS. U.S. GAAP Copyright © 2013 CFA Institute 16 ItemIFRSU.S. GAAP  Interest received  Interest paid  Dividends received  Dividends paid Operating or investing Operating or financing Operating or investing Operating or financing Operating Financing  Bank overdrafts Considered part of cash equivalents Not considered part of cash and cash equivalents; classified as financing.  Taxes paid Generally operating, but a portion can be allocated to investing or financing Operating

17 PORTUGAL TELECOM’S OPERATING CASH FLOWS: ANOTHER EXAMPLE OF DIRECT METHOD Copyright © 2013 CFA Institute 17

18 PORTUGAL TELECOM’S INVESTING CASH FLOWS Copyright © 2013 CFA Institute 18

19 PORTUGAL TELECOM’S FINANCING CASH FLOWS Copyright © 2013 CFA Institute 19

20 NONCASH INVESTING AND FINANCING ACTIVITIES Noncash transaction: Any transaction that does not involve an inflow or outflow of cash (e.g., exchange of one no-monetary asset for another). Not incorporated in the cash flow statement. Must be disclosed. Copyright © 2013 CFA Institute 20

21 Copyright © 2013 CFA Institute 21 Cash at beginning and end of year links to the balance sheet.

22 Copyright © 2013 CFA Institute 22 Cash at beginning and end of year links to the balance sheet.

23 PREPARATION OF THE STATEMENT OF CASH FLOWS: STEPS Step 1. Determine the change in cash. Step 2. Determine the net cash flow from operating activities. Use both the current year's income statement and information on current assets and liabilities from the comparative balance sheets. Step 3. Determine net cash flows from investing and financing activities. Examine all other changes in the balance sheet accounts. Step 4. Include summary of net increase (decrease) in cash, cash at beginning, and cash at end. Step 5. Disclose any significant noncash transactions separately at the bottom of the statement. Copyright © 2013 CFA Institute 23

24 EXAMPLE A new company has the following transactions: Sells stock for $100. Buys a building for $50. Its primary line of business is selling a service, so it has no COGS (cost of goods sold) and no inventory. Makes credit sales of $100, and subsequently collects $90. Accrues SG&A (selling, general, and administrative) expense of $40, and subsequently pays cash of $25. Records depreciation expense of $ Copyright © 2013 CFA Institute

25 STEP 1. DETERMINE THE CHANGE IN CASH Beginning balance Ending balanceChange Cash0115 Accounts receivable010 Building050 Accumulated depreciation0(10) Total assets0165 Accounts payable015 Common stock0100 Retained earnings050 Total liabilities and equity0165 This step is straightforward. The information is on the comparative balance sheets. Change was $115. Copyright © 2013 CFA Institute 25

26 STEP 2. DETERMINE THE NET CASH FLOW FROM OPERATING ACTIVITIES, BEGINNING WITH NET INCOME FOR THE INDIRECT METHOD Income statement Credit sales$ 100 SG&A expense–40 Depreciation expense–10 Net income$ 50 Net income$ 50 + Depreciation expense+10Noncash expense – Change in receivables–10Only collected $90 + Change in payables+15Only paid $25 Cash from operating activities$ 65 Copyright © 2013 CFA Institute 26

27 STEP 3. DETERMINE NET CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES Beginning balance Ending balanceChange Cash0115 In first step Accounts receivable010 In operating Building050 ? Accumulated depreciation0(10) In operating Total assets0165 Accounts payable015 In operating Common stock0100 ? Retained earnings050 In operating* Total liabilities0165 Examine all other changes in the balance sheet accounts. *There are no dividends in this example; all changes in retained earnings are from net income Copyright © 2013 CFA Institute 27

28 INVESTING CASH FLOWS Determine investing cash flows by examining changes in long-term assets. In this example, we have only PP&E. Beginning PP&E + Purchases – Dispositions = Ending PP&E Ending PP&E – Beginning PP&E = Purchases – Dispositions (i.e., investing cash flows) PP&E increased by $50, indicating cash spent acquiring PP&E. We also know this from the transaction list at the beginning of the example. Copyright © 2013 CFA Institute 28

29 FINANCING CASH FLOWS Determine financing cash flows by examining changes in debt and equity accounts. In this example, we have only common stock. Beginning stock + Issuances – Repurchases = Ending stock Ending stock – Beginning stock = Issuances – Repurchases Stock account increased by $100, indicating cash was raised by issuing stock. We also know this from the transaction list at the beginning of the example. Copyright © 2013 CFA Institute 29

30 STEP 3. DETERMINE NET CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES Beginning balance Ending balanceChange Cash0115 In first step Accounts receivable010 In operating Building050 In investing Accumulated depreciation0(10) In operating Total assets0165 Accounts payable015 In operating Common stock0100 In financing Retained earnings050 In operating* Total liabilities0165 Examine all other changes in the balance sheet accounts. *There are no dividends in this example, so all change was net income. Copyright © 2013 CFA Institute 30

31 Company ABC Cash Flow Statement for the period ended Operating cash flow Net income50 Depreciation expense+ 10 Increase in accounts receivable– 10 Increase in accrued liabilities+ 15 Total operating cash flow+ 65 Investing cash flow Capital expenditure– 50 Financing cash flow Issue of stock+ 100 Total change in cash+ 115 Beginning cash balance0 Ending cash balance115 INDIRECT METHOD Copyright © 2013 CFA Institute 31

32 ALTERNATIVE STEP 2. DETERMINE THE NET CASH FLOW FROM OPERATING ACTIVITIES, BEGINNING WITH EACH LINE ITEM FOR THE DIRECT METHOD Income statement Credit sales$ 100 SG&A expense–40 Depreciation expense–10 Net income$ 50 Cash from customers$ 90 Credit sales ($100) minus Change in receivables ($10) Cash paid for expenses–25 SG&A expenses ($40) minus increase in payables ($15) Cash from operating activities$ 65 Copyright © 2013 CFA Institute 32

33 Company ABC Cash Flow Statement for the period ended Cash collected from customers+ 90 Cash paid to suppliers– 25 Total operating cash flow+ 65 Investing cash flow Capital expenditure– 50 Financing cash flow Issue of stock+ 100 Total change in cash+ 115 Beginning cash balance0 Ending cash balance115 DIRECT METHOD Copyright © 2013 CFA Institute 33

34 FREE CASH FLOW Free Cash Flow to the Firm (FCFF): Cash flow available to the company’s suppliers of capital (debt and equity). -After all operating expenses (including taxes) have been paid. -After all operating investments have been made for fixed capital and working capital. Free Cash Flow to Equity (FCFE): Cash flow available to the company’s common stockholders. -After all operating expenses (including taxes) have been paid. -After borrowing costs (principal and interest) have been paid. -After all operating investments have been made for fixed capital and working capital. Copyright © 2013 CFA Institute 34

35 COMPUTE FCFF Net Income + Noncash charges – Working capital investment + Interest expense × (1 – Tax rate) – Fixed capital investments = FCFF Interest, a cash flow available to one of the capital providers, which has been deducted from net income, so it must be added back 35 Copyright © 2013 CFA Institute

36 FCFF CAN ALSO BE COMPUTED FROM CASH FLOW FROM OPERATING ACTIVITIES Net income + Noncash charges – Working capital investment = Cash from operating activities + Interest Expense × (1 – Tax rate) – Fixed capital investments = FCFF CFO already has added noncash items to net income and deducted working capital investment Copyright © 2013 CFA Institute 36

37 COMPUTE FCFE Net Income + Noncash charges – Working capital investment – Fixed capital investment + Net new borrowing (or minus net debt repayments) = FCFE Copyright © 2013 CFA Institute 37 Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt.

38 CASH FLOW PERFORMANCE RATIOS RatioCalculationWhat It Measures Cash flow to revenue CFO ÷ Net revenueOperating cash generated per dollar of revenue Cash return on assets CFO ÷ Average total assetsOperating cash generated per dollar of asset investment Cash return on equity CFO ÷ Average shareholders’ equity Operating cash generated per dollar of owner investment Cash to incomeCFO ÷ Operating incomeCash generating ability of operations Cash flow per share (CFO – Preferred dividends) ÷ Number of common shares outstanding Operating cash flow on a per-share basis Copyright © 2013 CFA Institute 38

39 CASH FLOW COVERAGE RATIOS RatioCalculationWhat It Measures Debt coverageCFO ÷ Total debtFinancial risk and financial leverage Interest coverage(CFO + Interest paid + Taxes paid) ÷ Interest paid Ability to meet interest obligations ReinvestmentCFO ÷ Cash paid for long- term assets Ability to acquire assets with operating cash flows Debt paymentCFO ÷ Cash paid for long- term debt repayment Ability to pay debts with operating cash flows Dividend payment CFO ÷ Dividends paidAbility to pay dividends with operating cash flows Investing and financing CFO ÷ Cash outflows for investing and financing activities Ability to acquire assets, pay debts, and make distributions to owners Copyright © 2013 CFA Institute 39

40 SUMMARY The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period. Cash flows are categorized as operating, investing, and financing. Compared with U.S. GAAP, IFRS provide companies with more choices in classifying some cash flow items as operating, investing, or financing activities. The operating activities section of the statement of cash flows can be presented using the direct method or the indirect method. Two approaches to developing common-size cash flow statements are the total cash inflows/total cash outflows method and the percentage of net revenues method. Cash flow ratios measure a company’s profitability, performance, and financial strength. Copyright © 2013 CFA Institute 40


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