1. Chapter 6 Understanding Cash Flow Statements
Presenter’s name
Presenter’s title
dd Month yyyy
Customization notes:
The third section of this presentation shows a simple example of how to prepare a statement of cash flows. Depending on the sophistication of the audience, that section can either be deleted (if the audience is already proficient in preparing the statement of cash flows) or expanded to include more complex examples (if the presenter wants to emphasize statement preparation and has additional time for the presentation).
LEARNING OUTCOMES
Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
Describe how noncash investing and financing activities are reported.
Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
Describe how the cash flow statement is linked to the income statement and the balance sheet.
Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Convert cash flows from the indirect to direct method.
Analyze and interpret both reported and common-size cash flow statements.
Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

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

3. Increase (decrease) in cash (in millions) 2011 388 2010 (110) 2009 45
LOS. Describe how the cash flow statement is linked to the income statement and the balance sheet.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 262–263, 281–286
The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period.
Starting at the bottom of the statement of cash flows, we see the increase and decrease in cash and cash equivalents each year.
Increase (decrease) in cash (in millions)
2010 (110)
An 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 2011.
In general, what are the implications of too little cash? Too much?
Copyright © 2013 CFA Institute

4. APPLE, Inc.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 281–286
As a basis for comparison—and relating to the question of how much cash is enough/too much on the previous slide—this slide shows the statement of cash flows for Apple.
In 2010, for example, Apple’s cash and cash equivalents increased by $6 billion to $11.3 billion. Apple generated $18.6 billion from operating activities and needed only around $3 billion for expenditures on PP&E (property, plant, and equipment), intangible assets, and acquisitions. Apple paid no dividends. Even after $11 billion of net purchases of marketable securities (net purchases were $57,793 billion – $24,930 billion from maturities – $21,788 billion from sales), the company still had a significant increase in cash and cash equivalents.
Copyright © 2013 CFA Institute

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
LOS. Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
Pages 247–249
This slide lists the three categories of cash flows: operating, investing, and financing.
Examples of each category are listed.
Copyright © 2013 CFA Institute

6. Colgate: cash flows classified by activity
2011
2010
2009
Net cash provided by operations
2,896
3,211
3,277
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
490
600
555
Cash and cash equivalents at end of year
$878
$490
$600
LOS. Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 247–249, 281–286
Colgate consistently obtains its cash inflow from operating activities.
It uses cash in investing and financing activities.
This profile shows a positive overall cash flow and is fairly typical for a mature company: Cash generated in operations is used to make investments for the future and also to repay capital providers.
In contrast, a start-up company would obtain cash from financing activities and use the cash to make investments for the future. A start-up company might not have positive cash from operations immediately.
We will examine reasons for notable changes.
Copyright © 2013 CFA Institute

7. Colgate’s operating cash flows
LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 250–251, 281–286
This slide shows the operating activities section of Colgate’s statement of cash flows.
Rather than spend too much time on individual reconciling items, first focus on the overall relationship between net income and operating cash flows. Over the long term, for a mature company, operating cash flows should exceed net income.
If a company has rising net income and falling cash flow, it can be a red flag.
For example, it might signal potential problems (e.g., slowing collection of accounts receivable).
However, such a pattern could occur naturally in the early years of a business.
How does Colgate’s operating cash flow compare with its net income over the three years? It exceeds it in every year.
Net cash from operations decreased in 2011 compared with The company’s MD&A (management discussion and analysis) explains: “Net cash provided by operations in 2011 was $2,896 as compared with $3,211 in 2010 and $3,277 in The decrease in 2011 as compared to 2010 was primarily due to an increase in voluntary benefit plan contributions.”
Copyright © 2013 CFA Institute

8. Colgate’s investing cash flows
LOS. Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 247–249, 281–286
This slide shows the investing activities section of Colgate’s statement of cash flows.
The slide also includes the amount of cash provided by operations.
In every year, Colgate’s cash from operations was more than enough to cover its capital expenditures.
In 2011, the amounts were cash from operations of $2,896 million and capital expenditures of $537 million.
Investing activities used $1,213 million in 2011, compared with $658 million and $841 million during 2010 and 2009, respectively.
In its MD&A, Colgate says the increase was primarily because of the purchase of the Sanex business for $966 million. Refer to the item “Payment for acquisitions, net of cash acquired.”
Colgate also discloses that the Sanex acquisition was funded in part by proceeds from the sale of the Company’s euro-denominated investment portfolio. Refer to the items “Proceeds from sale of marketable securities and investments,” which is greater than “Purchases of marketable securities and investments” in 2011.
Colgate also discloses that the purchase price was partially offset by the sale of the Company’s laundry detergent business in Colombia for $215 million and the receipt of the first installment of $24 million from the sale of a Mexico City site.
Copyright © 2013 CFA Institute

9. Colgate’s financing cash flows
LOS. Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 247–249, 281–286
This slide shows the financing activities section of Colgate’s statement of cash flows.
Financing activities used $1,242 million of cash during 2011, much less than the $2,624 million and $2,270 million during 2010 and 2009, respectively.
There are two reasons behind the difference:
First, the company had higher net proceeds from the issuance of debt. The proceeds from debt issuance in 2011 were $5,843 million compared with principal payments of debt of $4,429 million.
Second, the company had a lower level of share repurchases. The amount of share repurchases were $1,806 million in 2011 versus $2,020 million in 2010.
The amount of dividends paid has steadily increased over the past three years.
Referring to amounts from previous slides, it can be noted that the amounts of operating cash after paying for capital expenditure, $2,359 million (cash from operations of $2,896 million less capital expenditure of $537 million), was more than enough to cover the dividend payments of $1,203 million.
Copyright © 2013 CFA Institute

10. Common-size statement of cash flow for Colgate (abbreviated)
Each line item is presented as a percentage of net revenue.
2011
2010
2009
Operating Activities
Net income including noncontrolling interests
15.3%
14.9%
15.6%
Net cash provided by operations
17.3%
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%
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 281–286
In common-size analysis of a company’s income statement, each income and expense line item is expressed as a percentage of net revenues (net sales).
For the common-size balance sheet, each asset, liability, and equity line item is expressed as a percentage of total assets.
For the common-size cash flow statement, there are two alternative approaches:
Express each line item as a percentage of net revenue.
Express each line item of cash inflow (outflow) as a percentage of total inflows (outflows) of cash.
This slide shows each category of Colgate’s statement of cash flow, presented as a percentage of net revenues.
Operating cash flows are consistently close to 20% of net revenues, although 2011 is somewhat lower.
Investing cash flows as (an absolute) percentage of net revenues are higher in 2011 than in previous years. As discussed, this mainly reflects the Sanex acquisition.
Financing cash flows as (an absolute) percentage of net revenues are lower in 2011 than in previous years. As discussed, this mainly reflects the net debt proceeds and the lower amount of share repurchases.
Copyright © 2013 CFA Institute

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 2011.
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.
LOS. Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
LOS. Analyze and interpret both reported and common-size cash flow statements.
Pages 247–249, 281–186
Copyright © 2013 CFA Institute

12. Colgate’s operating cash flows: indirect method
LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
LOS. Describe how the cash flow statement is linked to the income statement and the balance sheet.
Pages 250–251, 262–263
There are two acceptable formats for reporting cash flow from operating activities (also known as cash flow from operations or operating cash flow), defined as the net amount of cash provided from operating activities: the direct and the indirect methods.
The amount of operating cash flow is identical under both methods; only the presentation format of the operating cash flow section differs.
The presentation format of the cash flows from investing and financing is exactly the same, regardless of which method is used to present operating cash flows.
Colgate’s statement is an example of the indirect method of presenting operating activities. It is indirect because it starts with net income and then “undoes” accrual accounting and reclassifies certain amounts to get back to cash provided by operations.
The net income number—in the indirect method—links to the income statement.
Rather than spending too much time on individual reconciling items here, first focus on the overall relationship between net income and operating cash flows. Over the long term, for a mature company, operating cash flows should exceed net income.
If a company has rising net income and falling cash flow, it can be a red flag.
For example, it might signal potential problems (e.g., slowing collection of accounts receivable).
However, such a pattern could occur naturally in the early years of a business.
How does Colgate’s operating cash compare with its net income over the three years? It exceeds it in every year.
Copyright © 2013 CFA Institute

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.
LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
Pages 250–251
The indirect method shows how cash flow from operations can be obtained from reported net income as the result of a series of adjustments.
The indirect format begins with net income. To reconcile net income with operating cash flow, adjustments are made
for noncash items,
for nonoperating items, and
for the net changes in operating accruals.
The main argument for the indirect approach is that it shows the reasons for differences between net income and operating cash flows.
Another argument for the indirect method is that it mirrors a forecasting approach that begins by forecasting future income and then derives cash flows by adjusting for changes in balance sheet accounts that occur because of the timing differences between accrual and cash accounting.
The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities.
The direct method shows each cash inflow and outflow related to a company’s cash receipts and disbursements. In other words, the direct method eliminates any impact of accruals and shows only cash receipts and cash payments.
The primary argument in favor of the direct method is that it provides information on the specific sources of operating cash receipts and payments. This is in contrast to the indirect method, which shows only the net result of these receipts and payments.
Just as information on the specific sources of revenues and expenses is more useful than knowing only the net result—net income—the analyst gets additional information from a direct-format cash flow statement. The additional information is useful in understanding historical performance and in predicting future operating cash flows.
Copyright © 2013 CFA Institute

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.
LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Pages 249–261
IFRS and U.S. GAAP both encourage the use of the direct method but permit either method.
U.S. GAAP encourage the use of the direct method but also require companies to present a reconciliation between net income and cash flow (which is equivalent to the indirect method).
If the indirect method is chosen, no direct-format disclosures are required.
The majority of companies, reporting under IFRS or U.S. GAAP, present using the indirect method for operating cash flows.
Copyright © 2013 CFA Institute

15. Tech data’s operating cash flows: example of direct method
LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Pages 249–261
Tech Data’s statement of cash flows is an example of the direct method of presenting operating activities. It is called “direct” because it does not start with net income; rather, it just shows cash collected from clients.
Tech Data is a U.S. GAAP reporting company.
Note that U.S. GAAP require interest paid to be presented in operating activities, whereas IFRS permit companies to choose whether to present interest paid in operating or in financing. The next slide summarizes differences in categorization.
Copyright © 2013 CFA Institute

16. Classification of cash flows under IFRS vs. U.S. GAAP
Item
IFRS
U.S. GAAP
Interest received
Interest paid
Dividends received
Dividends paid
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
LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Pages 249–250
The slide summarizes the key differences for classification of cash flows between IFRS and U.S. GAAP.
Most significantly, IFRS allow more flexibility in the reporting of such items as interest paid or received and dividends paid or received and in how income tax expense is classified.
U.S. GAAP classify interest and dividends received from investments as operating activities.
IFRS allow companies to classify interest and dividends received from investments as either operating or investing cash flows.
U.S. GAAP classify interest expense as an operating activity, even though the principal amount of the debt issued is classified as a financing activity.
IFRS allow companies to classify interest expense as either an operating activity or a financing activity.
U.S. GAAP classify dividends paid to stockholders as a financing activity.
IFRS allow companies to classify dividends paid as either an operating activity or a financing activity.
U.S. GAAP classify all income tax expenses as an operating activity.
IFRS also classify income tax expense as an operating activity, unless the tax expense can be specifically identified with an investing or financing activity (e.g., the tax effect of the sale of a discontinued operation could be classified under investing activities).
Copyright © 2013 CFA Institute

17. Portugal telecom’s operating cash flows: another example of direct method
LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Pages 249–261
Portugal Telecom’s statement of cash flows is an example of the direct method of presenting operating activities. It is called “direct” because it does not start with net income rather; it just shows cash collected from clients.
Portugal Telecom’s statement also illustrates the requirement that cash flow from continuing and discontinued operations be presented separately.
Portugal Telecom is an IFRS reporting company.
Unlike U.S. GAAP, IFRS do not require the company to report interest received and paid in the operating section of the statement of cash flows.
Copyright © 2013 CFA Institute

18. Portugal telecom’s investing cash flows
LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Pages 249–261
As noted earlier, U.S. GAAP classify interest and dividends received from investments as operating activities.
IFRS allow companies to classify interest and dividends received from investments as either operating or investing cash flows.
This excerpt from Portugal Telecom’s statement of cash flows illustrates the choice to report interest income and dividends received in investing activities.
Investing cash flows from continuing and discontinued operations are presented separately but not shown here to make the slide more readable.
Copyright © 2013 CFA Institute

19. Portugal telecom’s financing cash flows
LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Pages 249–261
As noted earlier, U.S. GAAP classify interest expense as an operating activity, even though the principal amount of the debt issued is classified as a financing activity. In contrast, IFRS allow companies to classify interest expense as either an operating activity or a financing activity.
This excerpt from Portugal Telecom’s statement of cash flows illustrates the choice to report interest expense in financing activities.
Copyright © 2013 CFA Institute

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.
LOS. Describe how noncash investing and financing activities are reported.
Page 249
Companies may also engage in noncash investing and financing transactions.
A noncash transaction is any transaction that does not involve an inflow or outflow of cash.
For example, if a company exchanges one nonmonetary asset for another nonmonetary asset, no cash is involved.
Similarly, no cash is involved when a company issues common stock either for dividends or in connection with conversion of a convertible bond or convertible preferred stock.
Because no cash is involved in noncash transactions (by definition), these transactions are not incorporated in the cash flow statement.
However, because such transactions may affect a company’s capital or asset structures, any significant noncash transaction is required to be disclosed, either in a separate note or a supplementary schedule to the cash flow statement.
Copyright © 2013 CFA Institute

21. Cash at beginning and end of year links to the balance sheet.
LOS. Describe how the cash flow statement is linked to the income statement and the balance sheet.
Pages 262–263
The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period.
Starting at the bottom of the statement of cash flows, we see the increase and decrease in cash and cash equivalents each year.
Increase (decrease) in cash (in millions)
2010 (110)
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 2011.
In general, what are the implications of too little cash? Too much?
The amount of cash at the beginning and the end of the year links to the balance sheet. See next slide.
Copyright © 2013 CFA Institute

22. Cash at beginning and end of year links to the balance sheet.
LOS. Describe how the cash flow statement is linked to the income statement and the balance sheet.
Pages 262–263
This slide shows the bottom few lines of Colgate’s statement of cash flows and the top line of Colgate’s balance sheet.
The amount of cash at the beginning and the end of the year links to the balance sheet.
The amount of $490 million was Colgate’s cash balance at the end of 2010, which of course is also its cash balance at the beginning of 2011.
Copyright © 2013 CFA Institute

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.
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
Slide lists steps in preparing statement of cash flows.
Copyright © 2013 CFA Institute

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 $10.
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
The accompanying Excel spreadsheet posts the transactions listed on this slide into a tabular summary from which an ending balance sheet can be created.
Copyright © 2013 CFA Institute

25. Step 1. Determine the change in cash
This step is straightforward. The information is on the comparative balance sheets. Change was $115.
Beginning balance
Ending balance
Change
Cash
115
Accounts receivable 10
Building 50
Accumulated depreciation
(10)
Total assets
165
Accounts payable 15
Common stock
100
Retained earnings
Total liabilities and equity
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
This is a new company, so beginning balances are all $0.
The company sells stock for $100, increasing cash by $100 and common stock by $100.
It buys a building for $50. Its primary line of business is selling a service, so it has no COGS and no inventory. It decreased cash by $50 and increased building assets by $50.
It makes credit sales of $100 and subsequently collects $90. It increased cash by $90, accounts receivable by $10, and retained earnings by $100.
It accrues an SG&A expense of $40 and subsequently pays cash of $25. It decreased cash by $25, decreased retained earnings by $40, and increased accounts payable by $15.
It records a depreciation expense of $10. It decreased retained earnings by $10 and increased accumulated depreciation (contra asset) by $10.
Copyright © 2013 CFA Institute

26. Net income + Depreciation – Changes in assets + Changes in liabilities
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
+10
Noncash expense
– Change in receivables
–10
Only collected $90
+ Change in payables
+15
Only paid $25
Cash from operating activities
$ 65
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
Net income is reduced by depreciation expense, but notice that this expense is completely (and always) noncash.
Thus, to convert from accrual income to cash-based income, we have to undo the effects of all noncash items, such as depreciation.
Change in receivables and payables from beginning and ending balance sheets.
Formula for calculating Operating Cash Flow:
Net income + Depreciation – Changes in assets + Changes in liabilities
= Operating cash flows
Note: Other refinements may be necessary to eliminate nonoperating items if, for example, the company reported a gain on sale of investment.
Copyright © 2013 CFA Institute

27. Step 3. Determine net cash flows from investing and financing activities
Examine all other changes in the balance sheet accounts.
Beginning balance
Ending balance
Change
Cash
115
In first step
Accounts receivable 10
In operating
Building 50 ?
Accumulated depreciation
(10)
Total assets
165
Accounts payable 15
Common stock
100
Retained earnings
In operating*
Total liabilities
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
We are checking off each balance sheet item as we go.
We have dealt with all the checked items in the first two steps.
*There are no dividends in this example; all changes in retained earnings are from net income
Copyright © 2013 CFA Institute

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.
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
PP&E went up by $50, so assume that $50 cash was spent acquiring PP&E, which we know explicitly from the description of the firm’s activities at the beginning of the example.
Note that we are looking at gross PP&E, not net.
Copyright © 2013 CFA Institute

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.
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
PP&E went up by $50, so assume that $50 cash was spent acquiring PP&E, which we know explicitly from the description of the firm’s activities at the beginning of the example.
Because the stock account rose by $100, we assume that $100 of cash was received, which again, we know explicitly.
Copyright © 2013 CFA Institute

30. Step 3. Determine net cash flows from investing and financing activities
Examine all other changes in the balance sheet accounts.
Beginning balance
Ending balance
Change
Cash
115
In first step
Accounts receivable 10
In operating
Building 50
In investing
Accumulated depreciation
(10)
Total assets
165
Accounts payable 15
Common stock
100
In financing
Retained earnings
In operating*
Total liabilities
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
We are checking off each balance sheet item as we go.
All the items have been dealt with.
*There are no dividends in this example, so all change was net income.
Copyright © 2013 CFA Institute

31. Cash Flow Statement for the period ended
Indirect method
Company ABC
Cash Flow Statement for the period ended 
Operating cash flow
Net income 50
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 balance
Ending cash balance
115
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Pages 263–276
Having completed all the steps, this slide presents the statement of cash flows.
This statement shows Step 4 (including the summary of net increase [decrease] in cash, cash at beginning, and cash at end). In this example, Step 5 (disclose any significant noncash transactions separately, at the bottom of the statement) is not relevant because there were no significant noncash transactions.
Copyright © 2013 CFA Institute

32. Credit sales ($100) minus Change in receivables ($10)
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
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
LOS. Convert cash flows from the indirect to direct method.
Pages 263–277
Create the operating cash flows with the direct method; work through each line item of the income statement.
There are credit sales of $100, but based on the increase in receivables of $10, one can tell that the company only collected $90 in cash.
There was an SG&A expense of $40, but based on the increase in payables of $15, one can tell that the company only paid cash of $25.
The depreciation expense is noncash, so it should not be included.
If working from a statement of cash flows prepared with the indirect method, it is necessary to remove all nonoperating items from revenue (e.g., gain on sale of equipment) and to remove all noncash expenses from expenses.
Copyright © 2013 CFA Institute

33. Cash Flow Statement for the period ended
direct method
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 balance
Ending cash balance
115
LOS. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
LOS. Convert cash flows from the indirect to direct method.
Pages 263–277
Cash from customers = Sales ($100) – Change in receivables ($10) = $90
Cash to suppliers = SG&A expense ($40) – Change in payables ($15) = $25
If working from a statement of cash flows prepared with the indirect method, it is necessary to remove all nonoperating items from revenue (e.g., gain on sale of equipment) and to remove all noncash expenses from expenses.
Copyright © 2013 CFA Institute

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 borrowing costs (principal and interest) have been paid.
LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Pages 286–288
It was mentioned earlier that it is desirable that operating cash flows are sufficient to cover capital expenditures (also known as fixed capital expenditures).
The excess of operating cash flow over capital expenditures is known generically as free cash flow.
For purposes of valuing a company or its equity securities, an analyst may want to determine and use other cash flow measures, such as free cash flow to the firm (FCFF) or free cash flow to equity (FCFE).
FCFF is the cash flow available to the company’s suppliers of debt and equity capital after all operating expenses (including income taxes) have been paid and necessary investments in working capital and fixed capital have been made.
CFO represents cash flow from operating activities under U.S. GAAP or under IFRS where the company has included interest paid in operating activities.
Under IFRS, if interest paid was included in financing activities, then CFO does not have to be adjusted for Int(1 – Tax rate).
Under IFRS, if the company has placed interest and dividends received in investing activities, these should be added back to CFO to determine FCFF. In addition, if dividends paid were subtracted in the operating section, these should be added back in to compute FCFF.
Copyright © 2013 CFA Institute

35. Compute 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
Net Income + Noncash charges – Working capital investment + Interest expense × (1 – Tax rate) – Fixed capital investments = FCFF
LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Pages 286–288
FCFF is the cash flow available to the company’s suppliers of debt and equity capital after all operating expenses (including income taxes) have been paid and necessary investments in working capital and fixed capital have been made.
FCFF can be computed starting with net income as
FCFF = NI + NCC + Int(1–Tax rate) – FCInv – WCInv
where
NI = Net income
NCC = Noncash charges (such as depreciation and amortization)
Int = Interest expense
FCInv = Capital expenditures (fixed capital, such as equipment)
WCInv = Working capital expenditures
The reason for adding back interest is that FCFF is the cash flow available to the suppliers of debt capital as well as equity capital.
Copyright © 2013 CFA Institute

36. FCFF can also be computed from cash flow from operating activities
CFO already has added noncash items to net income and deducted working capital investment
Net income + Noncash charges – Working capital investment = Cash from operating activities + Interest Expense × (1 – Tax rate) – Fixed capital investments = FCFF
LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Pages 286–288
Conveniently, FCFF can also be computed from cash flow from operating activities as
FCFF = CFO + Int(1–Tax rate) – FCInv
Copyright © 2013 CFA Institute

37. Compute FCFE Net Income + Noncash charges – Working capital investment
– Fixed capital investment
+ Net new borrowing (or minus net debt repayments)
= FCFE
LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Pages 286–288
FCFE: Free cash flow after investment in working capital and fixed capital, available to equityholders only.
Net new borrowing excludes interest payments to debtholders, excludes principal repayments to debtholders, and includes any increases in borrowing.
Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt. This cash would be available for distribution to owners.
Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt.
Copyright © 2013 CFA Institute

38. Cash flow performance ratios
Calculation
What It Measures
Cash flow to revenue
CFO ÷ Net revenue
Operating cash generated per dollar of revenue
Cash return on assets
CFO ÷ Average total assets
Operating 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 income
CFO ÷ Operating income
Cash generating ability of operations
Cash flow per share
(CFO – Preferred dividends) ÷ Number of common shares outstanding
Operating cash flow on a per-share basis
LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Pages 288–290
If the company reports under IFRS and includes total dividends paid as a use of cash in the operating section, total dividends should be added back to CFO as reported, and then preferred dividends should be subtracted. Recall that CFO reported under U.S. GAAP and IFRS may differ depending on the treatment of interest and dividends, received and paid.
Ratios based on cash flows provide information that help an analyst better understand the company’s past performance (trend and cross-sectional) and develop expectations about the company’s future prospects.
This slide list several performance ratios based on operating cash flow. In general, these ratios measure the cash return relative to alternative financial items.
Copyright © 2013 CFA Institute

39. Cash flow coverage ratios
Calculation
What It Measures
Debt coverage
CFO ÷ Total debt
Financial risk and financial leverage
Interest coverage
(CFO + Interest paid + Taxes paid) ÷ Interest paid
Ability to meet interest obligations
Reinvestment
CFO ÷ Cash paid for long- term assets
Ability to acquire assets with operating cash flows
Debt payment
CFO ÷ Cash paid for long- term debt repayment
Ability to pay debts with operating cash flows
Dividend payment
CFO ÷ Dividends paid
Ability 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
LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Pages 288–290
Ratios based on cash flows provide information that help an analyst better understand the company’s past performance (trend and cross-sectional) and develop expectations about the company’s future prospects.
This slide list several coverage ratios based on operating cash flow. In general, these ratios measure the extent to which operating cash flow “covered” various of the company’s expenditures and commitments.
Copyright © 2013 CFA Institute

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