7 CHAPTER CASH FLOW ANALYSIS 1

What you will learn from this chapter 2  Relevance of Cash Flows  What cash flow statements tell you  What is free cash flow  The difference between the direct and indirect calculations of cash from operations  Problems that arise in analyzing cash flows statements

Relevance of Cash Flows  Keep in mind: Cash flow is a company’s lifeblood.  Cash - refers to cash and cash equivalents.  Cash equivalents are short-term, highly liquid investments.  Net cash flow is the end measure of profitability. e.g Cash repays loans, replaces equipment, expands facilities, and pays dividends.  Analyzing cash inflows and outflows helps assess liquidity, solvency, and financial flexibility.  Liquidity is the nearness to cash of assets and liabilities.  Solvency is the ability to pay liabilities when they mature.  Financial flexibility is the ability to react to opportunities and adversities. 3

Analyzing the Statement of Cash Flows 4 Is an important analytical tool for creditors, investors and other users of financial statement data. Indicates  Firm’s ability to generate cash flows in the future  Firm’s capacity to meet cash obligations  Firm’s future external financing needs  Firm’s success in productively managing investing activities  Firm’s effectiveness in implementing financing and investing strategies

Roots = Financing Activities Trunk & Branches = Investing Activities Fruit = Operating Activities Businesses are like Fruit Trees

The Standard GAAP Statement of Cash Flows 6 IncreaseDecrease Assets(Outflow)Inflow LiabilitiesInflow(Outflow) Shareholder equityInflow(Outflow)

Cash Inflows and Outflows

Preparing a Statement of Cash Flows (cont.) How Cash Flows During an Accounting Period Total Inflows less Total Outflows = Change in cash for the accounting period Operating Activities Investing Activities Financing Activities Inflows Outflows

Accrual Based StatementsCash Flow Statement Income Statement items & Changes in Current Assets and Current Liabilities Operating activities: Adjust net income for accruals and non-cash charges to get cash flows Balance Sheet: Changes in Non-Current Assets Investing activities: Inflows from sale of assets and Outflows from purchases of assets Balance Sheet: Changes in Non-Current Liabilities and Equity Financing activities: Inflows and outflows from loan and equity transactions The Statement of Cash Flows : Steps in Constructing the Statement

Statement of Cash Flows Net Cash Flows from Operations 10 Indirect Method -Net income is adjusted for non-cash income (expense) items and accruals to yield cash flow from operations Direct Method -Each income item is adjusted for its related accruals *Both methods yield identical results-only the presentation format differs. Net Income + Depreciation -/+ Gains (losses) on sales of assets +/- Cash generated (used) by current assets & liabilities Net cash flows from operating activities

(C) 2007 Prentice Hall, Inc.4-11 Calculating Cash Flow from Operating Activities (cont.) Shows  cash collections from customers  interest and dividends collected  other operating cash receipts  cash paid to suppliers and employees  interest paid  taxes paid  other operating cash payments The Direct Method

Statement of Cash Flows Depreciation Add-Back 12 Sales - Expenses - Depreciation and amortization expense Net Income + Depreciation expense +/- Gains (losses) on sales of assets +/- Cash generated (used) by current assets and liabilities Net cash flows from operating activities Add Back

1.The company purchased a truck during the year at a cost of $30,000 that was financed in full by the manufacturer. 2.A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year for $7,000. There were no other sales of depreciable assets. 3.Dividends paid during Year 2 are $51,000

Statement of Cash Flows Steps in Constructing the Statement 14 Note: assets costing $30,000 were purchased during Year 2 and were financed in whole by the manufacturer.

Non-cash Transactions 15 Acquisitions with shares Asset exchanges Assets acquired with debt Capitalized leases Installment purchases Debt converted to equity

Deriving Operating Cash Flows from Income for Gould. Amount Item(in thousands)Explanation Net income, accrual basis$ 54Starting point of conversion Add (deduct) adjustment to cash basis: Depreciation35Depreciation has no cash outflow. Gain on sale of assets(5)Remove gain (because it is onoperating)—cash inflow is cash from investing activities. Increase in receivables(9)Cash flow from sales is less than accrual sales. Decrease in inventories6Cash outflow for inventory exceeds accrual inventory cost included in cost of sales. Decrease in prepaids3Cash outflow occurred when prepaids were purchased-current expense is non-cash Decrease in accounts payable(5)Cash outflows for purchases (included in cost of goods sold) is less than accrual purchases cost. Increase in accrued expenses4Expense has been recognized but no cash paid _____yet. Cash flows from operations (Exhibit 7.3)$113 Deriving Operating Cash Flows from Income for Gould. Amount Item(in thousands)Explanation Net income, accrual basis$ 54Starting point of conversion Add (deduct) adjustment to cash basis: Depreciation35Depreciation has no cash outflow. Gain on sale of assets(5)Remove gain (because it is onoperating)—cash inflow is cash from investing activities. Increase in receivables(9)Cash flow from sales is less than accrual sales. Decrease in inventories6Cash outflow for inventory exceeds accrual inventory cost included in cost of sales. Decrease in prepaids3Cash outflow occurred when prepaids were purchased-current expense is non-cash Decrease in accounts payable(5)Cash outflows for purchases (included in cost of goods sold) is less than accrual purchases cost. Increase in accrued expenses4Expense has been recognized but no cash paid _____yet. Cash flows from operations (Exhibit 7.3)$113 Cash From Operations Indirect Method for CFO 16

Positive free cash flow reflects the amount available for business activities after allowances for financing and investing requirements to maintain productive capacity at current levels. Cash flows from operations Deduct:-Net capital expenditures required to maintain productive capacity -Dividends on preferred stock and common stock (assuming a payout policy) EqualsFree cash flow (FCF) 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. Positive free cash flow reflects the amount available for business activities after allowances for financing and investing requirements to maintain productive capacity at current levels. Cash flows from operations Deduct:-Net capital expenditures required to maintain productive capacity -Dividends on preferred stock and common stock (assuming a payout policy) EqualsFree cash flow (FCF) 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 Flow 17

Free Cash Flow Exercise Calculate Free Cash Flow from following information Net Income$ 500,000 Depreciation$ 50,000 Gains on sales of assets$ 60,000 Net capital expenditures required to$ 150,000 maintain productive capacity Dividends on preferred stock$ 80,000 Cash generated by current assets$ 15,000 and liabilities 2. Calculate Free Cash Flow from following information Net Income$ 450,000 Depreciation$ 25,000 Loss on sales of assets$ 90,000 Net capital expenditures required to$ 250,000 maintain productive capacity Dividends on preferred stock$ 100,000 Cash used by current assets$ 10,000 and liabilities

Class Exercise Make Quick Money Co. transactions for the year ended December 31, 19x9, included the following: (1) Purchased real estate for $500,000, which was borrowed from a bank. (2) Sold investment securities worth $600,000. (3) Paid dividends of $300,000. (4) Issued 500 shares of common stock for $350,000. (5) Purchased machinery and equipment for $175,000. (6) Paid $750,000 toward a bank loan. (7) Accounts receivable outstanding of $100,000 were paid. (8) Accounts payable were increased by $190,000. Calculate Make Quick Money net cash used in its a. investing activities and b. financing activities.

4. Prepare Cash Flow Statement using Indirect method 20

21

22

23