1. INTRODUCTION TO CASH FLOW ANALYSIS
Chapter 10

2. CHAPTER 10 OBJECTIVES
Explain the relationships between operating, investing, and financing cash flows and stages in the business life cycle.
Convert indirect CFOs to direct CFOs.
Describe the significance of cash received as a percentage of revenues and paid as percentage of cost of goods sold to business operations.

3. CHAPTER 10 OBJECTIVES (CONT.)
Discern stability, efficiency, and inefficiency in an entity’s operating cash flows and liquidity measures.
Analyze a company or industry’s CFOs.

4. THE OBJECTIVE OF CASH FLOW ANALYSIS
An evaluation of past events and present conditions so that the amount, timing, and probability of future cash flows can be forecast 
Analyst seek to understand
Cash flows into and out of an entity
The primary sources and uses of cash
Relative consistency of cash flows over time

5. BUSINESS DECISIONS AND CASH FLOWS
Business success depends on an entity taking in more cash in its life than it pays out over time
Initial cash flows
Provided by debt and equity investors
Used to acquire productive assets
Reflect managerial decisions about how to maximize wealth

6. BUSINESS DECISIONS AND CASH FLOWS (CONT.)
The Financial Accounting Standards Board’s perspective
Requires that companies disclose a statement of cash flows
The cash flow statement should provide equity investors and creditors with information to make judgments about the
Amount of future cash flows
Timing of future cash flows
Uncertainty of future cash flows

7. BUSINESS DECISIONS AND CASH FLOWS (CONT.)
Cash flows and corporate life
An entity’s life cycle stage affects cash acquisitions and disbursements
The life cycle stages are (Exhibit 10-1)
Emergence
Growth
Maturity
Decline

8. BUSINESS DECISIONS AND CASH FLOWS (CONT.)
Cash flow relationships to life cycle stages (Exhibit 10-2)
Operating activities
Outflows during emergence and early growth
Inflows peak during maturity
Inflows decrease (trending toward zero) in decline

9. BUSINESS DECISIONS AND CASH FLOWS (CONT.)
Financing activities
Inflows during emergence and growth
Outflows during late maturity and decline (i.e., the return of investment)
Investing activities
Outflows during emergence and early growth
Inflows during late maturity
Decreasing cash inflows during business decline

10. CASH FLOWS FROM OPERATING ACTIVITIES
The most important part of cash flow statement
Reports the difference between cash received and paid for conducting core business activities
Less subjective than accrual-based disclosures
Analyst must determine the sustainability of operating cash flows

11. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.)
Direct method
The superior method of reporting
Reports cash collected from revenues and cash paid for operating expenses
Easy for financial statement users to understand
Companies do not disclose CFOs on a direct basis

12. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.)
Indirect method
The inferior method of reporting
Reconciles net income to operating cash flows
Hard for financial statement users to understand
Companies disclose CFOs on an indirect basis

13. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.)
Converting indirect operating cash flows to direct operating cash flows
Procedure for producing direct CFOs from the indirect ones reported by companies
An analyst lists each revenue and operating expense category
Each income statement account is adjusted for changes in balance sheet accounts (e.g., accounts receivable changes affect cash collected from sales)

14. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.)
Converting indirect operating cash flows to direct operating cash flows (cont.)
Certain operating expense categories are adjusted for non-cash expenses (e.g., deprecation)
Cash collected from sales minus cash paid for each expense category determines direct cash flows

15. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.)
Direct CFOs are more informative than indirect CFOs
Analyst can directly see how much cash was received from continual activities in a reporting period
Analyst can directly see how much cash was paid for continual activities in a reporting period

16. eSTUFF’S DIRECT CASH FLOWS

17. eSTUFF’S DIRECT CASH FLOWS

18. eSTUFF’S CFO RECONCILIATION

19. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.)
Drawbacks of direct CFOs
Conversion process takes time
Judgment is often required in classifying and adjusting accounts

20. INTERPRETING CFOs
Analysts judge how well an entity performs its core business activities
Cash flows from operating activities provide numerous insights
The focal point is operating cycle activity
Cash collected on sales
Cash paid for inventory

21. INTERPRETING CFOs (CONT.)
Operating cycle cash flows are classified in three categories (Exhibit 10-4)
Stable operations
Cash collected from customers as a percentage of sales remains constant over time
Cash paid to vendors as a percentage of cost of goods sold remains constant over time

22. INTERPRETING CFOs (CONT.)
Efficient operations
Cash collected from customers as a percentage of sales increases over time
Cash paid to vendors as a percentage of cost of goods sold decreases over time
Inefficient operations
Cash collected from customers as a percentage of sales decreases over time
Cash paid to vendors as a percentage of cost of goods increases over time

23. INTERPRETING CFOs (CONT.)
Operating cash flow and trends
Trend data increases insights about operating cycle cash flows (Exhibit 10-5)
Trends are sometimes difficult to deduce for existing companies

24. INTERPRETING CFOs (CONT.)
Relationships between operating cycle cash flow and short-term liquidity measures (Exhibit 10-6)
Reports the direction of change (increase or decrease) for
Inventory activity measures
Accounts receivable activity measures
Accounts payable activity measures

25. INTERPRETING CFOs (CONT.)
Changes in these activity measures can be applied to
Stable operations
Efficient operations
Inefficient operations

26. INTERPRETING CFOs (CONT.)
Forecasting operating cash flows
Uses operating cash flow history and trends to predict the future
Incorporates short-term liquidity analysis into the assessment
Knowledge of other areas of analysis (e.g., operating performance) assists in cash flow forecasts

27. APPLE COMPUTER AND THE PC INDUSTRY
Company is in its late growth or early maturity life cycle stage 
Focus of the operating cash flow analysis is on the cash provided by and used for making and selling PCs

28. APPLE COMPUTER AND THE PC INDUSTRY (CONT.)
Industry cash flows
Industry demonstrated strong operating cash flows from 1993 to 1998 (Exhibit 10-7A)
Industry’s cash flows were less than stable over time
Compaq’s poor performance reduced operating and net cash flows in (Exhibit 10-7B)

30. APPLE COMPUTER AND THE PC INDUSTRY (CONT.)
Apple Computer’s direct operating cash flows
Apple’s indirect operating cash flows were converted to a direct basis to improve interpretation (Exhibit 10-8)
The company reported positive CFOs during the period analyzed

31. APPLE COMPUTER AND THE PC INDUSTRY (CONT.)
Cash flows were positive because of Apple’s
Return to profitability
Continued reductions of inventory
Favorable changes in the account balances of current assets and restructuring costs

32. APPLE COMPUTER AND THE PC INDUSTRY(CONT.)
Operating cycle cash flows
Industry data was analyzed from 1994 to 1998 (Exhibit 10-9)
Dell and Gateway demonstrated stable operating cash flows during that time period
Apple and Compaq’s collection on sales and payments to vendors were erratic
Compaq’s paid a higher percentage on its cost of goods sold than it collected on its sales
Apple collected more than 100% of revenues in cash (a trend that cannot continue)

35. APPLE COMPUTER AND THE PC INDUSTRY(CONT.)
Operating cash flow data support the analysis of short-term liquidity
Dell and Gateway are more liquid than Apple and Compaq
Dell’s and Gateway’s operations are more stable than those of Apple and Compaq
Apple’s inability to sell computers profitability results in its lagging the industry