Chapter 6: Understanding Cash Flow Statements

Chapter 6Understanding Cash Flow StatementsPresenters namePresenters titledd Month yyyyCustomization 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 OUTCOMESCompare 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 non-cash 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.1overviewStatement of Cash Flows: OverviewFormat of Statement of Cash FlowsPreparing a Statement of Cash FlowsAdditional Analytical ConsiderationsCopyright 2013 CFA Institute22Copyright 2013 CFA Institute3

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.

The cash flow statement provides information about a companys 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)20113882010(110)200945An 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?3Copyright 2013 CFA Institute4

APPLE, Inc.

LOS. Analyze and interpret both reported and common-size cash flow statements.

As a basis for comparisonand relating to the question of how much cash is enough/too much on the previous slidethis slide shows the statement of cash flows for Apple.In 2010, for example, Apples 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. 4Classification of activities on the statement of cash flowsOperating 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 principalIssue or repurchase stockPay dividends

Copyright 2013 CFA Institute5LOS. 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.

This slide lists the three categories of cash flows: operating, investing, and financing.Examples of each category are listed. 5Colgate: cash flows classified by activity201120102009Net cash provided by operations2,896 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 Copyright 2013 CFA Institute6LOS. 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.

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.

6Colgates operating cash flows Copyright 2013 CFA Institute7

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.

This slide shows the operating activities section of Colgates 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 Colgates 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 2010. The companys 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 2009. The decrease in 2011 as compared to 2010 was primarily due to an increase in voluntary benefit plan contributions. 7Colgates investing cash flows Copyright 2013 CFA Institute8

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.

This slide shows the investing activities section of Colgates statement of cash flows.The slide also includes the amount of cash provided by operations. In every year, Colgates 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 Companys 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 Companys 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.8Colgates financing cash flows Copyright 2013 CFA Institute9

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.

This slide shows the financing activities section of Colgates 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.9Common-size statement of cash flow for Colgate (abbreviated)201120102009Operating ActivitiesNet income including noncontrolling interests15.3%14.9%15.6% Net cash provided by operations17.3%20.6%21.4% Net cash used in investing activities7.2%4.2%5.5% Net cash used in financing activities7.4%16.9%14.8%Copyright 2013 CFA Institute10Each line item is presented as a percentage of net revenue.LOS. Analyze and interpret both reported and common-size cash flow statements.

In common-size analysis of a companys 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 Colgates 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.10Colgates cash flows: summaryOverall, $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 activitiesa typical profile for a mature company.Colgates operating cash flow exceeded net income in every yeara desirable profile for a mature company.In every year, Colgates 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, Colgates cash flows represent a positive profile.

Copyright 2013 CFA Institute11LOS. 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.

11Colgates operating cash flows:indirect methodCopyright 2013 CFA Institute12

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.

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.Colgates 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 numberin the indirect methodlinks 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 Colgates operating cash compare with its net income over the three years? It exceeds it in every year.

12Indirect vs. direct method for presenting operating cash flowsIndirect methodBegins 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 methodShows 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 Institute13LOS. Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.

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 companys 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 resultnet incomethe 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.13Indirect vs. direct method for presenting operating cash flowsIndirect methodIFRS permit.U.S. GAAP permit.Used by the majority of companies, whether reporting under IFRS or U.S. GAAP.Direct methodIFRS encourage.

U.S. GAAP encourage, but requires a reconciliation of net income to cash flow from operating activities.

Copyright 2013 CFA Institute14LOS. 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).

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. 14Tech datas operating cash flows:example of direct methodCopyright 2013 CFA Institute15

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).

Tech Datas 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.15Classification of cash flows under IFRS vs. U.S. GAAPCopyright 2013 CFA Institute16ItemIFRSU.S. GAAPInterest receivedInterest paidDividends receivedDividends paidOperating or investingOperating or financingOperating or investingOperating or financingOperatingOperatingOperatingFinancingBank overdraftsConsidered part of cash equivalentsNot considered part of cash and cash equivalents; classified as financing.Taxes paidGenerally operating, but a portion can be allocated to investing or financingOperatingLOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).

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).

16Portugal telecoms operating cash flows: another example of direct methodCopyright 2013 CFA Institute17

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).

Portugal Telecoms 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 Telecoms 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.17Portugal telecoms investing cash flows Copyright 2013 CFA Institute18

LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).

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 Telecoms 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.18Portugal telecoms financing cash flows Copyright 2013 CFA Institute19

LOS. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).

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 Telecoms statement of cash flows illustrates the choice to report interest expense in financing activities.19noncash 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 Institute20LOS. Describe how noncash investing and financing activities are reported.

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 companys 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.

20Copyright 2013 CFA Institute21

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.

The cash flow statement provides information about a companys 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)20113882010(110)200945Overall, $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.

21Copyright 2013 CFA Institute22

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.

This slide shows the bottom few lines of Colgates statement of cash flows and the top line of Colgates 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 Colgates cash balance at the end of 2010, which of course is also its cash balance at the beginning of 2011.22Preparation of the Statement of Cash Flows: StepsStep 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 Institute23LOS. 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.

Slide lists steps in preparing statement of cash flows.

23ExampleA 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.

24Copyright 2013 CFA InstituteLOS. 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.

The accompanying Excel spreadsheet posts the transactions listed on this slide into a tabular summary from which an ending balance sheet can be created.24Step 1. Determine the change in cashBeginning balanceEnding balanceChangeCash0115 115 Accounts receivable010 10 Building050 50 Accumulated depreciation0(10)(10)Total assets0165165 Accounts payable015 15 Common stock0100 100 Retained earnings050 50 Total liabilities and equity0165 165 This step is straightforward. The information is on the comparative balance sheets. Change was $115.Copyright 2013 CFA Institute25LOS. 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.

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.

25Step 2. Determine the net cash flow from operating activities, beginning with Net Income for the indirect methodIncome statementCredit sales$ 100SG&A expense40Depreciation expense10Net income$ 50Net income$ 50+ Depreciation expense+10Noncash expense Change in receivables10Only collected $90 + Change in payables+15Only paid $25Cash from operating activities$ 65Copyright 2013 CFA Institute26LOS. 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.

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 flowsNote: Other refinements may be necessary to eliminate nonoperating items if, for example, the company reported a gain on sale of investment.

26Step 3. Determine net cash flows from investing and financing activitiesBeginning balanceEnding balanceChangeCash0115 115 In first stepAccounts receivable010 10 In operatingBuilding050 50 ?Accumulated depreciation0(10)(10)In operatingTotal assets0165165 Accounts payable015 15 In operatingCommon stock0100 100 ?Retained earnings050 50 In operating*Total liabilities0165 165 Examine all other changes in the balance sheet accounts.*There are no dividends in this example; all changes in retained earnings are from net incomeCopyright 2013 CFA Institute27LOS. 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.

We are checking off each balance sheet item as we go.We have dealt with all the checked items in the first two steps.

27Investing cash flowsDetermine 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&EEnding 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 Institute28LOS. 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.

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 firms activities at the beginning of the example.Note that we are looking at gross PP&E, not net.28Financing cash flowsDetermine financing cash flows by examining changes in debt and equity accounts. In this example, we have only common stock.Beginning stock + Issuances Repurchases = Ending stockEnding 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 Institute29LOS. 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.

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 firms 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.29Step 3. Determine net cash flows from investing and financing activitiesBeginning balanceEnding balanceChangeCash0115 115 In first stepAccounts receivable010 10 In operatingBuilding050 50 In investingAccumulated depreciation0(10)(10)In operatingTotal assets0165165 Accounts payable015 15 In operatingCommon stock0100 100 In financingRetained earnings050 50 In operating*Total liabilities0165 165 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 Institute30LOS. 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.

We are checking off each balance sheet item as we go.All the items have been dealt with.

30Company ABCCash Flow Statement for the period endedOperating cash flowNet income50Depreciation expense+ 10Increase in accounts receivable 10Increase in accrued liabilities+ 15Total operating cash flow+ 65Investing cash flowCapital expenditure 50Financing cash flowIssue of stock+ 100Total change in cash+ 115Beginning cash balance0Ending cash balance115Indirect methodCopyright 2013 CFA Institute31LOS. 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.

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.31Alternative Step 2. Determine the net cash flow from operating activities, beginning with each line item for the direct methodIncome statementCredit sales$ 100SG&A expense40Depreciation expense10Net income$ 50Cash from customers$ 90Credit sales ($100) minus Change in receivables ($10)Cash paid for expenses25SG&A expenses ($40) minus increase in payables ($15)Cash from operating activities$ 65Copyright 2013 CFA Institute32LOS. 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.

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.

32Company ABCCash Flow Statement for the period endedCash collected from customers+ 90Cash paid to suppliers 25Total operating cash flow+ 65Investing cash flowCapital expenditure 50Financing cash flowIssue of stock+ 100Total change in cash+ 115Beginning cash balance0Ending cash balance115direct methodCopyright 2013 CFA Institute33LOS. 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.

Cash from customers = Sales ($100) Change in receivables ($10) = $90Cash to suppliers = SG&A expense ($40) Change in payables ($15) = $25If 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.

33Free Cash FlowFree Cash Flow to the Firm (FCFF): Cash flow available to the companys 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 companys 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 Institute34LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

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 companys 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.

34Compute FCFF Net Income+ Noncash charges Working capital investment

+ Interest expense (1 Tax rate) Fixed capital investments= FCFFInterest, a cash flow available to one of the capital providers, which has been deducted from net income, so it must be added back35Copyright 2013 CFA InstituteLOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

FCFF is the cash flow available to the companys 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(1Tax rate) FCInv WCInv

where

NI= Net incomeNCC = Noncash charges (such as depreciation and amortization)Int= Interest expenseFCInv= 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. 35FCFF 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= FCFFCFO already has added noncash items to net income and deducted working capital investmentCopyright 2013 CFA Institute36LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

Conveniently, FCFF can also be computed from cash flow from operating activities asFCFF = CFO + Int(1Tax rate) FCInv

36Compute FCFE Net Income+ Noncash charges Working capital investment

Fixed capital investment+ Net new borrowing (or minus net debt repayments)= FCFE

Copyright 2013 CFA Institute37Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt.LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

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.

37Cash flow performance ratiosRatioCalculationWhat It MeasuresCash flow to revenueCFO Net revenueOperating cash generated per dollar of revenueCash return on assetsCFO Average total assetsOperating cash generated per dollar of asset investmentCash return on equityCFO Average shareholders equityOperating cash generated per dollar of owner investmentCash 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 basisCopyright 2013 CFA Institute38LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

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 companys past performance (trend and cross-sectional) and develop expectations about the companys 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.38Cash flow coverage ratiosRatioCalculationWhat It MeasuresDebt coverageCFO Total debtFinancial risk and financial leverageInterest coverage(CFO + Interest paid + Taxes paid) Interest paidAbility to meet interest obligationsReinvestmentCFO Cash paid for long-term assets Ability to acquire assets with operating cash flowsDebt paymentCFO Cash paid for long-term debt repaymentAbility to pay debts with operating cash flowsDividend paymentCFO Dividends paidAbility to pay dividends with operating cash flowsInvesting and financingCFO Cash outflows for investing and financing activitiesAbility to acquire assets, pay debts, and make distributions to ownersCopyright 2013 CFA Institute39LOS. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

Ratios based on cash flows provide information that help an analyst better understand the companys past performance (trend and cross-sectional) and develop expectations about the companys 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 companys expenditures and commitments.

39Summary The cash flow statement provides information about a companys 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 companys profitability, performance, and financial strength.

Copyright 2013 CFA Institute4040