Understanding Financial Statements Handout Final

8/4/2019 Understanding Financial Statements Handout Final

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Understanding Financial Statements

Training Program Handbook

Corporate and Professional Services (CaPS)


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Evalueserve.com Pvt Ltd

Reading Material for CaPS Participants

Introduction

Training participants are required to go through this module prior to the start of

training.The aim of the module is to:

Familiarize the reader with the format and basic terminologies of the three

financial statements

Using financial statements to understand business position of a company

Linkage between the three statements

Note: The accounting guideline followed in the handbook is US GAAP, unless stated

otherwise

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Reading Material for CaPS Participants

Contents

Introduction ...............................................................................................................21Income Statement ...................................................................................................5

Overview of Income Statement..........................................................................................5

Readings for Income Statement........................................................................................5

Learning Outcomes Income Statement..........................................................................5

1.1Introduction ...................................................................................................................6

1.2Basic Components, Format and Terminologies ............................................................6

1.3Chapter Summary .......................................................................................................10

2Balance Sheet .......................................................................................................12

Overview of Balance Sheet.............................................................................................12

Readings for Balance Sheet............................................................................................12Learning Outcomes Balance Sheet..............................................................................12

2.1Introduction .................................................................................................................13

2.2Basic Components, format, and Terminology .............................................................13

2.3Analysis of Balance Sheet..........................................................................................20

2.4Chapter Summary .......................................................................................................23

2.5Answers to the questions ............................................................................................23

3Cash Flow Statement ............................................................................................25

Overview of Cash Flow Statement..................................................................................25

Readings for Cash Flow Statement.................................................................................25

Learning Outcomes - Cash Flow Statement....................................................................25

3.1Introduction .................................................................................................................26

3.2Basic Components, Format, and Terminology ...........................................................26

3.3Cash Flow from Operations (CFO) and Free Cash Flow ............................................28

3.4Analysis of Cash flow Statement................................................................................ 32

3.5Important Cash Flow Ratios .......................................................................................32

3.6Chapter Summary .......................................................................................................34

3.7Answers to the Questions ...........................................................................................34

34

4Appendix ................................................................................................................35

5Evalueserve Disclaimer ........................................................................................36

2011 Evalueserve Ltd. All Rights Reserved


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Understanding Income Statement


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1 Income Statement

Overview of Income Statement

Income statement can reveal a lot of insights on the company, such as how the company has grown in thepast, is it able to retain its clients, does it need to offer discounts to sell its products and is it doing better orworse than its peers? Income statement can also help us understand the efficiency of companys operations,its distribution systems, productivity of its employees, etc.

This module will help you use the income statement to get insights on a companys business and financialperformance.

Readings for Income Statement

Introduction to the Income Statement

Components of an Income Statement

Learning Outcomes Income Statement

At the end of this module, you will be able to

Understand the format/presentation of the income statement

Understand revenue recognition principals

Learn to identify revenue drivers

Understand operating/non-operating income

Learn to analyze a companys Gross and EBIT margins

Understand definition/significance of non-recurring items

Understand and analyze earnings per share (basic and diluted)

2011 Evalueserve Ltd. All Rights Reserved Page 5 of 36


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1.1 Introduction

Income statement is one of the most important financial statements used by companies to report their earningsover a specific period of time, e.g., yearly, quarterly, etc. It is also known as Profit and Loss Statement or

Statement of Revenue and Expense.

1.2 Basic Components, Format and Terminologies

Income statement reports the effect of a companys current operations on its financial performance. Itsummarizes the revenues earned, the expenses incurred and the net profit generated for a given period oftime. Income statement can be presented in the following two formats:

Format A where items are clubbed in respective heads such as COGS, selling expenses, andadministrative expenses

Format B where items are presented separately such as raw material cost, employee cost, andtransportation expenses

FORMAT A | FORMAT B

PARTICULARS $ MN | PARTICULARS $ MN

Sales 8,000 Sales 9,000

Less: Cost of Goods Sold 3,000 Less: Raw Material Cost/Labor Cost 3,750

Gross Profit 5,000 Less: Marketing and Administrative Cost 1,500

Less:Selling, general, and AdministrationExpenses

1,500 Less: R&D Cost 133

Operating Income beforeDepreciation and Amortization(EBITDA)

3,500 Less: Other (Income) Expenses 256

Less: Depreciation, Amortization 300 Pretax Income 3,361

Operating Profit or Earnings beforeInterest & Taxes (EBIT)

3,200 Less: Interest Expenses 110

Less: Interest Expense 100 Less: Income Tax 390

Non-Operating Income 300 Net Income 2,861

Less: Non-Operating Expenses 200

Pretax Accounting Income/EarningsBefore Taxes (EBT)

3,200

Less: Income Taxes 700

Net Income 2,500

Following are the terminologies which are related to the Income statement:

LINE ITEMS DEFINITION

Revenue or Sales

The first line item on any Income Statement is Revenue or Sales. It pertains to the sales abusiness generates from selling goods or rendering services during the specified time period forwhich the income statement is prepared. For instance, a firm prepares customized researchreports for its clients by charging $25 per hour of effort spent. If the firm spends 160 hours a monthon making those reports, then the revenue for that month would be $4,000. It is also known as TopLine.



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Cost of GoodsSold (COGS) orCost of Revenueor Cost of Sales

Cost of Goods Sold or Cost of Sales refers to the total of direct expenses incurred by a companyto produce/sell a product. This refers to costs that can be directly associated to the production of agood or service. It includes the purchase price of raw material and expenses incurred in turning theraw material into a finished product, e.g., expenses incurred for raw materials, labor, and other

manufacturing overheads used in the production of goods/services.

Gross Profit

Gross Profit reflects the total revenues less the cost incurred in generating that revenue (cost ofgoods sold). In other words, it refers to the amount that a company can generate as profits if itdoes not pay other expenses besides direct costs.

Gross Profit = (Total Revenue) (Cost of Goods Sold)

OperatingExpenses

Operating Expenses means costs incurred by the company during the course ofoperating/running the business. Apart from direct costs, it also includes the following:

Research and Development Costs (R&D costs)

Selling, General, and Administrative Expenses: includes expenses such as salaries,commissions, travel expenses, and advertising and promotion expenditure.

Operating IncomebeforeDepreciation/EBITDA

Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) refers to the incomegenerated by the company from its operations. Note that it does not include line items such asincome from investment in other businesses. It is calculated after the deduction of Cost of GoodsSold and Operating Expenses from the Total Revenues figure.

EBITDA = (Gross Profit) (Operating Expenses)

Depreciation

Depreciation is an expense allocated to the asset costs, which is spread across the useful life ofthe asset.

It can be calculated using straight line (SLM) method or written down value method (WDV).SLM calculates depreciation by taking the purchase price of an asset less its salvage value dividedby the total productive years the asset can be reasonably expected to benefit the company (usefullife). For example if an asset worth $100 is expected to be used for 5 years, at the end of which it

will have zero value, its depreciation will be $ 20 per year.WDV method calculates depreciation by charging a fixed rate on the reducing balance of the asset.In the above example, lets say the fixed rate is 20% then the first years depreciation will be $20,the second years depreciation will be ($100 $20) * 20%, i.e., $16, and the third years ($100 $20 $16) * 20%, i.e., $12.8.Similarly, it can be calculated for the rest of the years.

Amortization

It refers to the allocation of costs of intangible assets, such as patents and copyrights, over the lifeof such assets. For example, a pharma company buys a patent for the manufacture of a vaccinefor $30 million. The patent will last for 15 years. The amortization expense to be charged everyyear for the next 15 years will be 30/15= $2 million per year.

The intangible assets with a finite life are amortized and assets with infinite life are impaired. Forexample, goodwill is tested for impairment, whereas patents/copyrights, etc., are amortized.

Operating Profit(EBIT)

Profit earned from ordinary business activities before the deduction of interest expenses andincome tax expenses is called Operating Profit. It is also known as Earning Before Interest and

Taxes.

Interest Expense Expense incurred by the company on its borrowings (debt) is called Interest Expense.



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Unusual or

Infrequent Items

As can be inferred from the name, these are either unusual or infrequent, but not both. Theexample includes asset impairment, gain/loss on sale of asset, and restructuring cost. Theseitems are reported before tax.

Impairment refers to the decline in the value of asset below its fair-market value. Impairment takes

place due to a change in product demand, technology, or a decline in the operational efficiency ofthe asset. For example, a bank provided a housing loan to an individual. The individual failed topayback the entire loan amount. The part of the loan amount not paid by the individual forms thepart of impairment losses for the bank.

Non-OperatingIncome

It refers to the income generated from activities other than the regular operations of the business,for instance, profit from the sale of a building/land.

PretaxAccountingIncome (EBT)

Deducting the Interest Expense from the Operating Income leads to the Pretax Income. It is alsoreferred to as Earnings Before Tax (EBT) or Profit Before Tax (PBT).

As the name suggests, these earnings are arrived at prior to the deduction of income taxes.

Income Taxes

It refers to the estimated tax liability for the year. This is usually different from the actual tax paid bya company, which is determined by a countrys tax rules. There are three important termspertaining to taxes as follows:

Income tax expenses Expenses based on current period pretax income (PBT in the financialstatements)

Current taxes Taxes actually paid/to be paid by the company

Deferred tax Difference between income tax expense and current taxes

Net Income or NetProfit (PAT)

Net Income refers to the amount that the company has actually earned or lost during theaccounting period, net of all costs, including depreciation, interest, and taxes. It is the moneyattributable to equity shareholders of the company after deducting for preferred dividends, if any.

Extraordinaryitems

Items that are both unusual and infrequent in nature are called extraordinary items. For examplelosses on early retirement of debt and losses due to natural disasters. Extraordinary items arepresented as net of taxes, after income from continuing operations.

Preferred StockDividends

A payment made to preference stock holders for investments made by them in the business iscalled Preferred Stock Dividends.

Preference stock: Preferred stock is regarded as a security, which has features similar to stocksand bonds. While it entitles owner a stake in the company, just like a common stock, it also pays afixed dividend like a bond. Preference shares can also be convertible preference shares and thesecan convert into a certain number of equity shares at a specific date.

Preference shareholders usually do not have voting rights but carry a preferential right overcommon stockholders to receive dividend. Preference shares are usually issued by companies thatdo not want to dilute their shareholding.

Minority interest

Minority interest is the part of PAT that belongs to minority share holders. Minority interestappears in the consolidated accounts and reflects the share of profit of subsidiaries that is notowned by the parent company. According to the US GAAP as well as IFRS guidelines, companiesneed to show the minority interest separately and show the profit after accounting for minorityinterest.

Professors note: Minority interest is only an accounting concept, for the calculation of acompanys net worth, we consider minority interest as a part of the net worth.

Dividend

Profit that is redistributed to shareholders is called dividends. While the companys profit after taxideally belongs to shareholders, companys management has discretion to decide how much theywant to distribute to shareholders. Part of profit that is distributed as dividend (Dividend/PAT) iscalled dividend pay out ratio.

Dividends are very powerful tools to understand the financial health of a company, becausedividends (except stock dividend) are paid in cash and can not be manipulated through accountinggimmicks.



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1.2.1 Operating and Non-operating Section of Income Statement

Income statement can be further sub-divided into two parts operating and non-operating. While theoperating section reveals information about revenues and expenses arising out of day-to-day regularbusiness operations, the non-operating section provides revenue gain and expense/loss due to activities notdirectly linked to the companys regular operations.

For example, a chemical manufacturing company may report income on the sale of land or a profit on the saleof investment; these items are not directly related to its operations. Similarly, the company could report non-operating expenses such as loss on sale of land and loss on an investment. Some of the non-operating items,such as sale of investment, are very regular and may appear every year.

Operating and Non-Operating section of Income Statement: Given below is the example ofAcer limited,which clearly mentions the operating and non-operating items in the income statement:

(Note: NT$ = Currency is New Taiwanese Dollar)

Source: Company Annual Report 2008


Operating Section:This includes the line items

like revenue, COGS, GP,

SG&A, R&D etc. All these line

items are closely related to

day to day operations. So

these items are classified as

operating items

Non-Operating Section:

This includes an income/ gain

or losses/ expenses related to

items not closely related to

day to day operations. E.g.

interest expenses/ income,

gain/ losses on purchase or

disposal of assets, etc.


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1.3 Chapter Summary

Income statement reports the effect of a companys current operations on its financial position. It summarizesthe revenues earned; expenses incurred, and measure net profit for a given period of time. Income statement

can be presented in two formatsone where items are clubbed in respective heads such as COGS, Sellingexpenses, administrative expenses and other where items are presented separately such as raw material cost,employee cost, and transportation expenses.

Some of the key terms related to P&L include revenue, COGS, depreciation, interest, non-recurring items,EBIT, PAT, and EPS. Revenues refer to the sales generated by a company for a particular period, COGSrefers to the direct cost incurred for revenue generation, and selling expenses denote marketing costs incurredto make sales. Depreciation is an expense that is recorded in the P&L to allocate the cost of fixed assets overits useful life. Interest refers to the interest paid/to be paid on a companys debt obligations. EBIT, EBT arevarious terms used to denote the profitability of a company.

Revenues on the income statement are recognized when sales are made or services are performed and notwhen cash is received. Once the revenue has been recognized, expenses pertaining to the revenues that havebeen recognized are shown in the P&L, and if the company has incurred expenses for which revenue has notbeen recognized, they are shown as assets. Expenses are recognized regardless of whether any payment hasbeen made towards those goods or services. It does not reflect cash receipts or cash disbursements.

Components of COGS vary depending on what the direct costs of running the business are, forexample

For a manufacturing company COGS will include raw material costs and labor costs

For a service provider, such as consulting company, COGS will only include employee cost

For a company with significantly automated operations, COGS will only have raw material cost anddepreciation

Following are the measures of a companys profitability:

Gross margins (Sales COGS)/sales indicates the profitability after direct expenses have been met

PBIT profitability after all operating expenses have been met

PBT profitability after accounting for operating and non-operating expenses

PAT profit after accounting for all costs, including taxes

EPS earnings per share, this denotes the amount of profits attributable to equity shareholders

While analyzing profitability one should try to understand the following:

How absolute profits have changed over years?

How profit margins have changed over years?

How are profit margins compared to peers?



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Understanding Balance Sheet


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2 Balance Sheet

Overview of Balance Sheet

While the Income Statement provides an overview of companys profitability over a period of time, BalanceSheet provides a snapshot of the financial strength/financial position/financial condition of a company at agiven point of time (usually at the end date of an accounting period, year or a quarter).

In this module, you will learn about the important components of a balance sheet and their accountingtreatment.

You will also learn about the ratios that are helpful in analyzing the balance sheet.

Readings for Balance Sheet

Components of the balance sheet

Accounting of balance sheet items

Analyzing liquidity & working capital

Analyzing capital structure

Learning Outcomes Balance Sheet

At the end of this module, you will be able to

Understand the format/components of the balance sheet

Understand important balance sheet concepts and classifications

Understand components of shareholders equity

Learn to analyze liquidity, working capital using turnover ratios

Learn to analyze capital structure using leverage ratios

Understand definition/significance of Invested Capital



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2.1 Introduction

Balance sheet is one of the important financial statements used by a company to report its financial position orfinancial condition on a particular date, which is called a Balance Sheet date. Balance sheet date is usually the

end of an accounting period, which could be a year, or a quarter, e.g., Balance Sheet as on December 31,2009. However, some companies adopt a fiscal year ending, i.e., a date other than December 31, 2010, e.g.,Balance Sheet as on March 31, 2010.

2.2 Basic Components, format, and Terminology

Balance Sheet has three major components what the company owns (assets), what it owes to outsiders(liabilties) and to internal owners (stockholders equity). These are explained as follows:


Assets Liabilities Equity

It refers to the resources that arecontrolled and owned by an entity,these resources have futureeconomic value that can bemeasured and expressed in amonetary value for financial reportingpurposes. Asset can be of two types

non-current assets or current

assets.

Current Assets An asset whichcan be converted into cash within aperiod of one year, e.g., receivables,inventory, cash & cash equivalent.

Non-Current Assets Asset whichcan not be classified as current assetand which can not be easilyconverted into cash in a period ofone year is a non-current asset. Non-current assets can be of two types tangible assets (land, machine, etc.)and Intangible assets (goodwill).

Balance Sheet

It refers to the present obligationsof an entity. Its settlement results inthe outflow of the cash/funds.Liabilities can be of two types non-current liabilities and current

liabilities.Current Liabilities Liabilitieswhich are to be paid off with in aperiod of one year, e.g., accountpayables, current portion of long-term debt, etc.

Non-Current Liabilities Liabilities which a company owesfor a period of more than one year,e.g., long-term debt, deferred taxliabilities, etc.

It is the residual interest of theowners in the assets of the entityafter deducting all the liabilties.It isalso known as Net Worth or NetAssets. It comprises the following:

Share Capital Funds raised bythe company by issuing shares to

the public.Retained Earnings It is thecumulative net income which isretained by the company afterdistributing dividends.

Reserves These are created outof retained earnings to meet futurefund requirements, such ascontingencies, etc.

Comprehensive Income Changesin the value of balance sheet itemsthat do not flow through the P&Lare reflected here.

= +

Authors Note

The fact that the balance sheet is prepared on a particular date is significant. For example, cash & cashequivalents (which are usually the first line item on the Balance Sheet) represent the amount of cash & cashequivalents on December 31; the amount could be materially different on December 30 or January 1.

By definition, the account balances on a Balance Sheet must tally, i.e., the total of all assets must beequal to the sum of liabilities and stockholders equity. This is because, from an economic

perspective, each dollar of assets must be funded by a dollar of liabilities or equity. Therefore, theBalance Sheet equation is expressed as follows:

Asset = Liabilities + Stockholders Equity


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Account format: The assets are presented on the left hand side and liabilities and equity are presented on theright hand side.

ACCOUNT FORMAT - SAMPLE BALANCE SHEET OF ABC LIMITED AS ON 31ST DECEMBER 20XX

ASSETS $ MN LIABILITIES & STOCKHOLDERS EQUITY $ MN

Current Assets 5,000 Current Liabilities 4,000

Fixed Assets 8,000 Other Liabilities

Intangible Assets 1,200 Long-Term Debt 7,000

Financial Investment 1,000 Deferred Taxes 200

Total Liabilities 11,200

Owners Equity 4,000

Total Assets 15,200 Total Liabilities and Stockholders Equity 15,200

Report format: The assets, liabilities, and equity are presented in one single column, starting with assets and

then moving to assets and liabilities.REPORT FORMAT SAMPLE BALANCE SHEET OF ABC LIMITED AS ON 31ST DECEMBER 20XX

ASSETS $ MN

Current Assets 5,000

Fixed Assets (tangible) 8,000

Intangible Assets 1,200

Financial Investments 1,000

Total Assets 15,200

LIABILITIES & STOCKHOLDERS EQUITY $ MN

Current Liabilities 4,000

Other Liabilities

Long-term Debt 7,000

Deferred Taxes 200

Total Liabilities 11,200

Stockholders Equity 4,000

Total Liabilities and Stockholders Equity 15,200



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Accountants usually prepare classified balance sheets. Classified means that the balance sheet accounts arepresented in distinct groupings, categories, or classifications. Given below are the definitions of some importantclassifications/categories:


CURRENTASSETS

AssetAssets are the economic resources which are controlled by the company. They can betangible or intangible in nature.

Current Assets

These are the items which can be converted into cash or be used up completely within 12months (one year) or within the firms operating cycle1(which is generally one year). Currentassets are presented in the order of liquidity (ease of convertibility to cash), i.e., cash,marketable securities, short-term investments, accounts receivable, inventory, prepaidinsurance.

Cash & Cashequivalents

Cash and cash equivalents include cash in any form (cash awaiting deposit or in a bankaccount) and cash substitutes (e.g., marketable securities or short-term investments), whichreflect cash that is not needed immediately in the business and is temporarily invested toearn a return. These investments are in instruments with short-term maturities (less than oneyear) such as treasury bills, certificates, notes, bonds and commercial paper (unsecuredpromissory notes of large business firms), and shares and mutual funds

Restricted cash

The cash is available with the company but it is not allowed to use it. This could be in theform of minimum cash balance that a company is required to keep at all times as a part of itsagreement with its lenders. It could also be a fixed deposit that has been pledged to raisemoney.

AccountsReceivables

Accounts receivables are the amounts due from customers on account of credit sales and arereported on the balance sheet as their net realizable value, that is, the actual amount of theaccount less an allowance for doubtful accounts. The allowance for doubtful accounts can beimportant in assessing earnings quality. Therefore, management must estimate based onfactors such as past experience, knowledge of customer quality, the state of economy, thefirms collection policies, etc. The estimation of this account will affect both the valuation ofaccounts receivables on the balance sheet and the recognition of bad debt expense on theincome statement.

The analyst must pay attention to changes in the allowance account both relative to level ofsales and the amount of accounts receivables outstanding and to the justification for anyvariations in the past.

Inventory

Inventory refers to raw materials, work in progress or finished goods that are there with thecompany at a point in time. While a manufacturing firms inventory is in the form of rawmaterials, a retailers inventory is largely the finished items that are stocked in theshowrooms.

Prepaid ExpensesThese include expenses which are paid in advance such as insurance premium, advance tax,etc. For example, companies are required to pay part of the tax in the beginning (usually first

quarter).

NON

CURRENT

ASSETS

Non-Current Assets

Assets which produce economic benefits for more than one year are non-current assets.They are of the following two types:

Tangible Non-Current Assets Those non-current assets which have physical substanceare known as tangible non-current assets, e.g., property, plant and equipment, investmentproperties building given on rent, etc. Tangible assets are depreciated each year.

Intangible Non-Current Assets These include non-current assets which are not physicalin nature. These assets do not have any physical value but are very valuable, e.g.,copyrights, patents, trademarks, and goodwill.

Investments

These represent the funds invested by the company into various financial instruments suchas bonds and notes.

Financial Instruments can be simple (equity or bonds, etc.) or complex (derivatives, foreigncurrency instruments, etc.). This could also represent companys investment in anothercompany where it holds less than 51% ownership.

1 The Operating Cycle is the time required to purchase or manufacture inventory, sell the product, and collect cash. For most companies,

the operating cycle is less than one year, but in some industries such as tobacco and wine it is longer.



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Deferred TaxAssets

It measures the assets that the firm expects to get in future periods for overpaying taxes incurrent and past periods. Deferred tax asset on a company's balance sheet may benefit thecompany by lowering future income taxes.

Liability

It refers to the obligation of a company, settlement of which results in cash outflow. It is of two

typesCurrent and Non Current.

CURR

ENTLIABILITY

Current LiabilitiesCurrent liabilities are the claims against assets, which are expected to be settled within 12months or one operating cycle. It includes accounts payable, short-term debt, current portionof LT debt, accrued liabilities, etc.

Accounts PayablesAccounts payable is an amount that must be paid off within the credit period provided by theseller against the goods or services.

Financial Liabilities(Current Portion)

The long-term debt that is to be paid off within the current year qualifies under Current Portionof Long-Term Debt.

Accrued Liabilities

These are result of recognition of the expenses in financial statements prior to its payments.For example, salaries of the employees recognized as expenses at the end of the financialyear. For instance, let us assume that a company pays salary on January 1, however onDecember 31 the salaries will be accrued and will reflect in the balance sheet under accrued

liabilities.

Deferred Revenue

Sometimes a company collects the cash in advance for the goods or services which itpromises to render to its customers in the future. Such collected money is known as DeferredRevenue or Unearned Revenue. Examples of such transactions can be advance paymentsby the customers for the magazine subscription, etc.

Deferred TaxLiability (DTL)

It measures the liability that the firm sees in the future as a consequence of underpayingtaxes in the current or past periods. The liability will take the form of higher taxes in futureperiods (and a higher effective tax rate)

Financial Liabilities(Long Term)

This represents the money which a company has borrowed for more than one year andqualifies under long-term debt (financial liability) or non-current liabilities.

EQUITY

Share Capital &Paid-in Capital

Share capital is the fund raised by the companies by issuing common2orpreferential3 sharesto individuals or institutional investors. Paid-in Capital is the difference between the issue

price and the face value of a share. It is also called Contributed Capital or Capital Surplus.For Example, if a share has a face value of $15 and is issued at $20 and 100 such shares areissued

Share capital = $15 * 100= $1500

Paid in capital/share premium = $5 * 100 = $500

Treasury StockThese are the shares which are bought back by the issuing company; it reduces the numberof outstanding stocks in the market. The company may buy back the stock because it hascash, and it believes that its own shares are good investment.

EQUITY

Retained Earnings(RE)

These are the undistributed earnings of the company after meeting out the requirements suchas paying dividend. Retained earnings are calculated as follows:

RE (Current Year) = RE (Beginning of the Year) + Net Income Dividends Paid

Retained earnings should not be confused with unused cash, since these are the funds whicha company elects to reinvest in the operations of the business.

ReservesThese are created from retained earnings for meeting future requirements, such as bad debt,warranty, and restructuring requirements.

Accumulated otherComprehensiveIncome

Unrealized gains/losses in the market value of investments in available-for-sale securities,changes in the value of certain derivative instruments, and adjustment related to foreigncurrency translations are reported as part of comprehensive income.

ContingentLiabilities

Liabilities that could result in cash outflow for the company, subject to occurrence of certainevents. For example, a pending court case, a guarantee given on behalf of a subsidiary etc.These are not recorded in the financial statements but are detailed in the notes to thefinancial statements.

2Common Shares is an equity instrument through which companies raise capital from the Stock Market. By issuing common stock, owners

sell a part of their ownership in the company to others.3 Preferential Shares is as a security which has features similar to stocks and bonds. While it entitles owner a stake in the company,

just like a common stock, it also pays a fixed dividend like a bond.



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2.2.1 Exercise

1. Balance sheet summarizes:

Operating results for a period

Financing position at a point in time

Financing and investing activities for a period Profit at a point in time

2. What is common between Current assets and Current Liabilities?

Current assets are claims against current liabilities

If current assets increase, then there will be a corresponding increase incurrent liabilities

Current assets and current liabilities can be converted into cash

Current assets and current liabilities are those items that will be satisfiedand converted into cash, respectively, in one year or one operating cycle, whichever is longer

3. Which of the following items could cause the recognition of accrued liabilities?

Sale, interest income, rent

Sale, interest income, taxes

Salaries, rent, insurance

Salaries, interest income, interest expense

4. Which of the following can be classified as long-term debt?

Mortgages, current maturities of long-term debt, bonds

Mortgages, long-term notes payables, bonds due in 10 years

Account payables, bonds, obligations under leases

Accounts payables, long-term notes payables, long-term warranties

5. What does the additional paid-in capital indicates? The difference between par and stated value of the common stock

The price changes that result for stock trading subsequent to its originalvalue

The market price of all common stocks issued

The amount by which the original sales price of the stock exceeds the par value

6. What do the retained earnings account measure?

Cash held by the company since inception

Payments made to the shareholders in the form of cash or stock dividends

All undistributed earnings

Financial resources currently available to satisfy financial obligations

7. What accounts are most likely to be found in shareholders equity section?

Common stock, long-term debt, preferred stock

Common stock, additional paid-in capital, liabilities

Common stock, retained earnings, dividends payable

Common stock, additional paid-in capital, retained earnings



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2.2.2 Non-Current Assets


Tangible Assets

Non-current Assets

Intangible Assets

Assets which produce economic benefits for more than one year

Assets having physical existence,e.g., plants, properties, equipment, machines,etc.

Assets which do not have any physicalexistence,e.g., goodwill, copyright, etc.

Assets are

Impairment if the book value becomes lower than the fair value

How they are recorded in Balance Sheet?

Tangible Assets are recorded asBook Value of the Asset AccumulatedDepreciationWhere, Book Value of the assets includesPurchase priceCosts related to bringing the assets to its

locationInstallation costsBorrowing costs

How they are recorded?Intangible Assets are recorded asSeparately Acquired Intangible Assets (for

example, patents)Recognized at purchase price +

attributable costsAcquired in Business Acquisition (e.g.,. license

acquired as a part of running business)Recognized at fair value at

acquisition date

Depreciated over their useful life Amortized over their useful life


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2.2.3 Understanding Debt Short-term (current) and long-term (non-current)

2.2.4 Shareholders Equity


Share & Paid-inCapital

Capital raised via

equity market has two

components one

share capital, which

is the face value of

the stock and the

other is paid-in

capital, which is - the

premium paid by the

investors for the

stock.

Retained Earnings

Cumulative Net

Income left after

paying the dividends

to the investors.

Sometimes part of

retained earnings is

set aside as

contingency reserves

such as bad debt.

Treasury Stock

These are shares that

a company purchases

back from the open

market. The

companies retire it or

keep it for future

issuance. If the

company keeps the

share for future

reissuance, it creates

contra equity account

generally a negative

number which reflects

the stocks purchased

(account with negative

numbers) and hence

are not retired.

AccumulatedComprehensive

Income

Unrealizedgains/losses in the

market value of

investments, foreign

currency translationgains losses are

reflected here

Shareholders Equity and its Components

LoanIt is a type of debt which is an agreement betweentwo parties a borrower and a lender in which asum of money is borrowed fom the lender with thecondition that it be returned or repaid at a later date,along with the interest charges

Debt

Debt (Bond) SecuritiesThe securities are sold to more than one party. The

borrower is the seller of the security and lenders are

the buyers

Debt is amount which is borrowed by the company for a specified period of time. If the period is less than one year then it

is classified as current debt else non-current debt.

Both the types can be current ornon-current innature depending on the term of liability.


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Please refer to the following snippet of the Shareholders Equity Section of the Balance Sheet:

2.3 Analysis of Balance Sheet

2.3.1 Balance Sheet Analysis

Balance sheet should be analyzed to seek the following information:

1. Asset quality

2. Liquidity condition (adequacy of the cash)

3. Funding mix

4. Operational efficiency

5. Returns

Note: We will learn to analyze the balance sheet in the classroom session, but we need to familiarize ourselveswith the following ratios before we discuss analyzing balance sheet.

For the analysis of Balance Sheet, one needs to have an idea of certain important ratios. These ratios are animportant part of the balance sheet analysis; given below is the explanation of some of the important ratios:

RATIOS DEFINITION/INTERPRETATION

Days Sales ofInventory

(DSI)

This number indicates the number of days a company takes to covert its inventory (inventoryincludes the work in progress inventory) into sales. Its formula is

DSI = 360/Inventory Turnover

where, Inventory Turnover = Cost of Goods Sold/Average Inventory

Interpretation:

A Lower DSI vis--vis peer is, generally, good for the company; it means inventory gets replacedwith newer one in less time than the industry. It indicates that inventory is quickly getting convertedinto finished good and getting sold. If a company has DSI of 15 days, it indicates on an average ittakes the company 15 days to convert its inventory into sales.

High DSI vis--vis peers means company is not able to replace its inventory quickly; it could bebecause sales are decreasing due to which inventory is kept for a long time.

Days SalesOutstanding

(DSO)

This number indicates the number of days a company takes to collect the revenue after the sale of

product or service. Its formula isDSO = 360/Account Receivables Turnover

where, Account Receivables Turnover = Net Revenue/Average Accounts Receivables

Interpretation:

Lower DSO vis--vis industry indicates that a company takes less time to collect its revenues

High DSO vis--vis industry indicates that a company gives more credit period to its customers;this has to be investigated further.

Days PayableOutstanding

(DPO)

This number indicates the number of days a company takes to pay outstanding to the suppliers,from which the inventory or finished goods has been purchased. Its formula is

DPO = 360/Account Payables Turnover

where, Account Payables Turnover = Cost of Goods Sold/Average Accounts Payables

Interpretation:

Less DPO indicates that a company pays the cash to its suppliers quickly or a company has shortpayment cycle.

High DPO indicates that a company has longer credit period. If DPO is very high vis--vis industryaverage, one needs to investigate the reasons. Sometimes, if a company is facing financialdifficulties, it may not be able to pay its suppliers on time.



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Cash ConversionCycle (CCC)

This is measured in days indicating the number of days a company takes to convert its resourcesinto cash. Its formula is

CCC = DSI + DSO DPO

Interpretation:CCC measures the time between cash outflow and inflow. It is an extremely important measure ofthe efficiency of the retailers and similar businesses. It basically measures How fast a companycan convert its products into cash through sales. The shorter the cycle, the less time capital is tiedup in the business process, and thus the company has more cash available to spend on its growth.

Current Ratio

It is a liquidity measure of the companys ability to pay short-term obligations. It is calculated as

Current Ratio = Current Assets/Current Liabilities

Interpretation:

Current ratio greater than one is an indication that a company has enough liquidity to meet short-term liabilities. However, sometimes companys current ratio could look higher because it hasobsolete inventory and old debtors. Since some of the inventory and debtors could be non current(old and not liquid), current ratio is not a very helpful measure of liquidity.

Quick (Acid Test)Ratio

It is another liquidity measure which takes into account only those current assets which are most

liquid in nature to the short-term obligations. It is calculated asQuick Ratio = (Cash & Cash Equivalent + Marketable Securities + Account Receivables)/Current

Liabilities

Interpretation:

Higher the quick ratio better will be the companys ability to meet its short-term liquidity needs,which is good for the creditor.

Cash Ratio

It is another liquidity measure which takes into account only cash and cash equivalent as currentassets to the short-term obligations. It is calculated as

Quick Ratio = Cash & Cash Equivalent/Current Liabilities

Interpretation:

It further refines the Current and Quick Ratio. This is seen by the most conservative investors.

Return on Asset(ROA)

It measures the amount of profit the company is able to make by using its assets. It is calculated as

ROA = Net Income/fixed assetsInterpretation:

ROA gives an idea of how effectively a company can convert its invested money into net income. Ifthe return on assets is showing an improving trend, it indicates that the company is able to utilizeits assets more efficiently.

Return on Equity

(ROE)

It is another profitability measure which talks about the returns a company is generating for itsshare holders.

ROE = Net Income/Average Shareholders Equity

Interpretation:

It measures how much profit a company generates with the money shareholders have invested.

It is calculated by PAT/Average equity

ROE can be further broken down into three components, and such analysis is known as DU-PontAnalysis

ROE = (Net income/sales)* (sales/assets)* (assets/equity)

= Net profit margin * Asset Turnover * Leverage

ROE is a function of its profitability, efficiency of using assets, and use of leverage. Higherleverage results in the deployment of lower equity and therefore improves return on equity.However, leverage is optimal only up to a point, because excessive leverage would mean thatcreditors would not provide further capital and also interest expenses would increase andprofitability would decrease.

Return onInvested Capital(ROIC)

It measures operating profits generated out of total invested capital. It is more comprehensive thanROE because unlike ROE it considers both debt and equity in the denominator.

ROIC = EBIT/(Average Total Assets Average Current Liabilities)

WorkingCapital/Total

Sales Ratio

This ratio is known as working capital productivity ratio. It is an indicator of the working capitalintensity of companys operations.

WC / TS = [ (Debtor + Inventory + Prepaid Assets) - (All current liabilities except short term debt) ] /Total Sales



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Debt to EquityRatio (D/E)

It quantifies the relationship between the capital invested by owners & investors and the fundsprovided by creditors.

D/E = Debt/Equity

Interpretation:The higher the ratio, the greater the risk to a current or future creditor. A lower ratio means acompany is more financially stable and is probably in a better position to borrow now and in thefuture. However, one needs to remember that usage of debt (in optimal amount) enhances returns(so long as cost of debt is lower than the returns generated by the business), hence some amountof debt is desirable.

Debt to Totalcapital ratio

It indicates the percentage of the debt in the capital structure of the company or proportion ofassets financed by debt. Capital structure.

D/E = Debt/ Debt + Equity)

Interest Coverage

Ratio (ICR)

It determines the ability of the company to pay interest on the outstanding debt out of its operatingincome. It can be calculated as

ICR = EBITDA(normalized)/ Interest Expense

Normalized EBITDA: It is calculated by adding back non-recurring expenses

Interpretation:

If the ratio exhibits a declining trend and falls below one, it indicates that a companys operatingearnings are not sufficient to meet the interest charges.

2.3.2 Exercise

1. If the DSI have been rising for a company, it indicates

It has been managing its inventory efficiently

Sales may be slowing down

It may be giving higher credit period to its customers

2. The cash conversion cycle is

DSI + DSO DPO

DSI DSO + DPO

DSI + DSO + DPO

3. The flaw of the current ratio is

That it may not depict liquidity position accurately

It may not depict solvency position adequately

Both of these

None of these

4. ROIC the denominator is

Shareholders equity

Debt + equity

Debt +equity + current liabilities

5. Higher debt equity vis--vis industry average ratio indicates

Increasing creditworthiness

Increasing credit risk

None of these



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2.4 Chapter Summary

Balance sheet is the statement of financial position (SOFP)of the company till date. It represents the assetsowned by the company and the liabilities that a company owes. Liabilities are divided into two parts debt and

equity. Following are the important terms related to Balance Sheet:Shareholders Equity: The capital provided by the owners and the profit generated by the company

Current Liability: The obligations which are due within a year

Long-term Liability: Obligations that are for a period longer than a year

Current Assets: Items which can be converted into cash within 12 months period

Fixed Assets: Assets which consist of physical substance e.g., property, plant, equipment, etc.

While analyzing the balance sheet following ratios are helpful:

Working capital ratios: Days Inventory, Debtor Days, Payable Days, Working capital/Sales

Liquidity: Current ratio, Quick ratio

Leverage: Debt/Equity, Debt to Total Capital

Return ratios: Return on Asset, Return on Invested Capital, and Return on Equity

2.5 Answers to the questions

Section 2.2.1

Answer 1: Option 2

Answer 2: Option 4

Answer 3: Option 3

Answer 4: Option 2

Answer 5: Option 4

Answer 6: Option 3

Answer 7: Option 4

Section 2.3.2

Answer 1: Option 2

Answer 2: Option 1

Answer 3: Option 1

Answer 4: Option 2

Answer 5: Option 2



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Understanding Cash Flow Statement


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3 Cash Flow Statement

Overview of Cash Flow Statement

Cash flow statement helps understanding the cash generating capabilities of a company over a period of time.The cash generated can be different (more or less) than the profit made by a company.

This module will help you understand important terms related to cash flow statement; it will also acquaint youwith the different formats of cash flow statement and will help you in interpreting cash flow statement to getmore insights on the operational efficiency and financial soundness of a firm.

Readings for Cash Flow Statement

Analyzing Operating cash

Analyzing Free Cash Flow

Learning Outcomes - Cash Flow Statement

At the end of this module, you would be able to

Understand the format/presentation of the cash flow statement

Understand how to analyze the three basic sections of cash flow statement

Find the line items which are contributing and consuming the cash

Understand the characteristics of cash generation for different industries, e.g., capital intensive, laborintensive.

Understand the free cash flow and its different types with respect to firm and equity



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3.1 Introduction

Cash flow statement conveys the information on cash generated/spent in one operating cycle from variousactivities, these activities are divided under three basic headsoperating activities, investing activities, and

financing activities.Cash flow statement can also be used to extract information on how much cash has been generated fromoperations and how has it been utilized.

Cash flow statement captures the income statement and various line items of the balance sheet. While makinga financial model, cash flow statement serves as an important link between P&L and balance sheet.

3.2 Basic Components, Format, and Terminology


Cash Flow from

Operations

Cash generated from operating activities, which includes all the activities which are related to thebusinesss operations

For example, if a company that sells food items generates $100 of cash from sale of land, $100 willnot be included in cash flow from operating activities.

Cash Flow FromInvesting

Cash generated of investing activities where investing activities are related to purchase/sale of fixedassets, investments in financial market products or other companies

Cash Flow FromFinancing

Cash generated of financing activities where financing activities are related to issuing capital (bondor common shares/any other instrument, repayments of the debt, repurchase of the companysstock (treasury stocks), dividend payment, etc.

Non Cash ChargesThese are expenses which do not require actual cash outlay. Example of such charges isdepreciation and amortization.

Free Cash Flow

from Firm

Cash which is available to the companys debt and equity holders after meeting all the operationsrelated expenses. It can be calculated as

FCFF = Net income + Non-cash charges + Interest * (1 Tax) CAPEX Working Capital

Or

FCFF = Cash flow from operations + Interest * (1 Tax) CAPEX

Free Cash Flowfrom Equity

Cash which is available to the companys equity holders after meeting all the operations relatedexpenses and expenses related to creditors. It can be calculated as

FCFE = CFO CAPEX + New Debt Issued Debt Repaid

3.2.1 Preparation of the Cash Flow Statement

There are two methods for preparing the cash-flow statement:

Direct method

Indirect method

Direct method for creating a cash flow includes major gross cash receipts and payments. While preparing thecash flow statement, it is important to identify the cash inflow and outflow items and separate them underrespective activities heads.


Authors Note

Q: Why do we need the cash flow, we already have P&L statement which gives information on the

profitability of a company?

The net profits generated by the company can be different from the cash generated by it. This is on account

of accrual method for accounting where the revenues are recognized even though the cash has not been

received and expenses are recognized even when cash has not been spent. So, net income represents the

periodic earnings of the company where as cash flow statement represents the actual cash generated by

the company in the said period.


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The direct method for preparing the cash flow actually removes the effect of accruals.

Indirect method Starts with the Net Income (which is taken from Income statement) and is adjusted with allthe transactions related to non-cash items and further this number is adjusted with the changes in the workingcapital to arrive at Cash from Operations.

An increase in an asset account is deducted from net income, and an increase in a liability account is addedback to net income. This method converts accrual-basis net income (or loss) into cash flow by using aseries of additions and deductions.

3.2.1.1 Format of Cash Flow Statement Direct Method and Indirect methodDIRECT METHOD FORMAT INDIRECT METHOD FORMAT

CASH FLOW STATEMENT(IN $ MILLION)

2008 2009CASH FLOW STATEMENT

(IN $ MILLION)2008 2009

Cash flows from operatingactivities:

Cash flows from operatingactivities:

Cash received from customers 149,661140,25

2Net Income 5,910 5,896

Interest received 838 738 Adjustments to reconcile net income to cash

Cash paid to suppliers for inventory -99,936 -83,035 Depreciation and amortization 2,984 2,501

Cash Paid to employees -26,382 -25,498 Deferred income taxes 136 118

Cash paid for other OPEX -21,350 -20,848 Cash provided (used) by CA & CL

Interest paid -2,277 -1,274 Accounts receivable -3,339 -448

Taxes Paid -4,321 -4,706 Inventories -7,006 -2,331

- - - Prepaid Expenses 295 -82

- - - Accounts payable -1,051 902

- - - Account Liabilities -1,696 -927

Change in cash from operatingactivities

-3,767 5,629 Change in cash from operatingactivities

-3,767 5,629

Cash flows from investingactivities:

Cash flows from investingactivities:

Additions to PP&E -4,773 -3,982 Additions to PP&E -4,773 -3,982

Other investing activities 0 0 Other investing activities 0 0

Change in cash from investingactivities

-4,773 -3,982Change in cash from investingactivities

-4,773 -3,982

Cash flows from financingactivities:

Cash flows from financingactivities:

Sale of common stock 183 124 Sale of common stock 183 124Increase (decrease) in STborrowings

1,854 1,326 Increase (decrease) in ST borrowings 1,854 1,326

Additions to long term borrowings 7,882 629 Additions to long term borrowings 7,882 629

Reductions of long term borrowings -1,593 -127 Reductions of long term borrowings -1,593 -127

Dividend paid -1,862 -1,841 Dividend Paid -1,862 -1,841

Change in cash from financingactivities

6,464 111Change in cash from financingactivities

6,464 111

Change in cash and cashequivalents

-2,076 1,758 Change in cash and cash equivalents -2,076 1,758

Cash &cash equivalents atbeginning of year

12,462 10,704 Cash &cash equivalents at beginningof year

12,462 10,704

Cash & cash equivalents at end ofthe year

10,386 12,462Cash & cash equivalents at end of theyear

10,386 12,462



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Note: Indirect method of cash flow statement is much more prevalent than direct method primarily because inmost of the reporting formats indirect method of reporting is preferred. So, in our further discussions, we

will consider indirect method.

3.2.2 Treatment of some items in US GAAP while preparing cash flow statement:

TREATMENT U.S. GAAP

Dividend Paid Financing Activity

Dividend Received Operating Activity

Interest Paid Operating Activity

Interest Received Operating Activity

Income tax Paid All taxes paid as classified as Operating Activity

3.3 Cash Flow from Operations (CFO) and Free Cash Flow

3.3.1 Cash Flow from Operating Activities (CFO)It reports the cash generated from sales and the cash used in the production process and sale process. Theitems for this segment are derived from Income Statement and working capital accounts (current assets andcurrent liabilities in balance sheet).

Examples of Balance Sheet items classified as operating cash flows include changes in the following:

Receivables Reported as current assets in Balance Sheet

Inventories Reported as current assets in Balance Sheet

Prepaid expenses Reported as current assets in Balance Sheet

Taxes, interest and miscellaneous payables Reported as current liabilities in Balance Sheet

Deferred taxes Reported as current assets or current liabilities depending on the nature of deferred taxes

Examples of Income Statement items classified as operating cash flows include the following:

Cash sales

Cash cost of sales

Cash general and administrative expenses

Cash taxes

Interest paid and received

Dividends received



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Let us understand with an example How to prepare cash flow statement from income statement andbalance sheet statement?

INCOME STATEMENT (IN$) 2007 (CY) BALANCE SHEET (IN $) 2006 (PY) 2007 (CY)

Sales 200,000 AssetsExpenses Current assets

COGS 90,000 Cash 10,000 79,550

Wages 5,000 Accounts receivable 9,000 12,000

Depreciation 5,000 Inventory 10,000 15,000

Interest 500 Non current assets

Total expenses 100,500 Land 50,000 40,000

EBIT 99,500 Gross PP&E 70,000 100,000

Gain from sale of land 7,000 Accumulated Depreciation 9,000 14,000

Pretax income 106,500 Net PP&E 61,000 86,000

Provision of taxes 31,950 Goodwill 10,000 10,000

Net income 74,550 Total assets 150,000 242,550

Dividends Paid 6,500

Liabilities

Current liabilities

Accounts Payable 5,000 10,000

Wages Payable 8,000 5,000

Interest Payable 3,000 3,500

Taxes Payable 4,000 5,000

Dividends Payable 1,000 4,000

Non current liabilities

Bonds 10,000 20,000

Deferred Taxes 15,000 25,000

Stock holders equity(SHE)

Common Stock 50,000 48,000

Retained Earnings 54,000 122,050

Total Liabilities & SHE 150,000 242,550

Solution

CASH FLOW STATEMENT (IN $) 2007 COMMENTSPAT 74,550 From Income Statement Net Income

Gain from sale of land (7,000) From Income Statement Gain from sale of land (one time gain)

Depreciation 5,000 Adding Back Non-Cash Charges taken from Income Statement

Working capital NOTE:

for Assets - the change is calculated as from (Previous year, PY Current Year, CY)

for Liabilities the change is calculated as from (CY PY)

Increase in receivable (3,000) From Balance Sheet - for Assets : (PY CY)

Increase in inventories (5,000) From Balance Sheet - for Assets : (PY CY)

Increase in payable 5,000 From Balance Sheet - for Liabilities : (CY PY)

Decrease in wages payable (3,000) From Balance Sheet - for Liabilities : (CY PY)

Increase in interest payable 500 From Balance Sheet - for Liabilities : (CY PY)

increase in taxes payable 1,000 From Balance Sheet - for Liabilities : (CY PY)

Increase in deferred taxes 10,000 All taxes are considered operational activity

Change in working capital 5,500



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CASH FLOW STATEMENT (IN $) 2007 COMMENTS

Cash flow from operations 78,050 (A)

Cash flow from investing

Cash from sale of land 17,000From Balance Sheet difference between the value of Land and

adding to it the gains from sale of landCapital expenditure (30,000) From Balance sheet difference in the Gross PP&E

Cash flow from Investing (13,000) (B)

Cash flow from financing

Increase in borrowing 10,000 From Balance sheet difference in the value of the Bond

Change in common stock (2,000) From Balance sheet difference in the value of Common Stock value

Cash dividends (3,500)

From Income Statement Dividends = 6500, From balance Sheetthere are some dividend payables which have increased by 3000that means from current declared dividends company had only paid6500 (4000-1000) = 3500, so a (3500) will come as dividends paid

Cash flow from Financing 4,500 (C)

Change in Cash 69,550 (D) = (A) + (B) + (C)

Cash at the beginning of the year 10,000 PY cash taken from Balance Sheet - Cash of 2006

Cash at the end of the year 79,550Adding (D) to Beginning Cash to get ending Cash balance forthe year

3.3.2 Understanding Free Cash Flow (FCF)


Free Cash Flow to Firm (FCFF)

Free Cash Flow

Free Cash Flow to Equity (FCFE)

It is a measure of the cash that is available after mandatory/compulsory cash requirements of a firm havebeen met. FCF is the cash that is left after deploying all the money required to run a business (buying rawmaterial, paying salaries, spending for maintenance expenditure for running a business, etc)

Cash flow available to the companys suppliersof capital (both equity and debt holders) aftermeeting all the expenses and necessaryinvestments

Cash flow available to the companys equityholders after meeting all the expenses


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3.3.2.1 How to interpret FCFF?

3.3.2.2 Example of computing free cash flow:The following are selected numbers from the financial statements of XYZ Inc. for 2009 and 2010 (in USDmillions)

(IN USD MILLIONS)

2009

(IN USD MILLIONS)

2010

Revenues 544.0 620.0

(Less) Operating Expenses (465.1) (528.5)

(Less) Depreciation (12.5) (14.0)

= Earnings before Interest andTaxes

66.4 77.5

(Less) Interest Expenses (16.4) (17.5)

= Pre Tax Income 60.0 70.0

(Less) Taxes (@ 30%) (18.0) (21.0)

= Net Income 48.0 49.0

Working Capital 175.0 240.0

The working capital in 2008 was USD 180 million

During Fiscal 2009, the company has raised debt of USD 10 million, while it raised USD 15 million debt infiscal 2010. The company has also paid debt of USD 5 million and USD 7 million in 2009 and 2010,respectively.

The firm had capital expenditure of USD 15 million in 2009 and USD 18 million in 2010.

Determine the value of FCFF & FCFE in 2009 and 2010 based on the above given information?


Positive and growing

Free Cash Flow to Firm

Negative

Firm is able to meet itsinterest/dividend paymentobligations.

It can then be allocated forgrowing and expanding the

business.Management has a lot of

flexibility in its decisionmaking. It can internallyfinance new projects.

If a company is experiencingnegative flow, it will have tolook elsewhere for funds tothink about growing the

business.It could be there for a firmwhich is in the rapid growthphase.

Stable

It indicates that the company

is mature.


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Solution:

FCFF in 2009 = Net income + Non-cash charges + Interest * (1 Tax) CAPEX Working Capital

= USD (48.0 + 12.5 + 16.4 (1 - 0.3) 15 (175 180))

= USD 61.98

FCFE in 2009 = FCFF + New Debt Issuance Debt Repayments= USD (61.98 + 10 5)

= USD 66.98

FCFF in 2010 = USD (49.0 + 14 + 17.5 (1 0.3) 18 (240 175))

= USD 7.75

FCFE in 2010 = FCFF + New Debt Issuance Debt Repayments

= USD (-7.75 + 15 7)

= USD 0.25

Note:FCFF & FCFE are different from each other mainly because of differences in the capital structure. FCFEis calculated when the companys capital structure is not volatile. On the contrary, if a company has negative

FCFE and significant debt outstanding, FCFF should be used to compute the free cash flow and for the same

reason it is preferred over FCFE.

3.4 Analysis of Cash flow Statement

Questions that are answered from the Cash flow Statement:

Is company generating cash from operations?

Trends in CFO, PAT versus CFO

How much cash is generated and consumed for working capital needs?

How has company funded its growth

Internal generation / funded, Refinance, Borrowings, Equity

Analyze the following ratio:

CFO/Capex

Net borrowings versus Capex,

Debt repayment versus fresh debt

What is the cash left for shareholders after the company has met its growth needs?

FCFE/FCFF

Note:We will learn to analyze the cash flow statement in the classroom session, but we need to be familiar

with the interpretation of cash flow before we discuss analysis of cash flow statement.

3.5 Important Cash Flow Ratios

3.5.1 Performance Ratios

There are certain ratios which are helpful in analyzing the cash flow better, lets understand the important ones:

1. Cash flow to revenue: CFO/RevenuesIt measures the amount of operating cash flow generated for each dollar of revenue.

2. Cash to income : CFO/Operating Income also CFO to PATIt indicates the capability of the company to generate cash from the operations. It also determines howmuch earnings are cash earnings and is an important indicator of earnings quality of a company.

3. Cash Flow Adequacy Ratio: CFO/(CAPEX + Debt Repayment + Dividend Payment)It measures how well a company can cover annual payments of items such as debt, CAPEX and dividend.It is an important indicator to judge liquidity position of a company.



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3.5.2 Coverage Ratios

1. Debt Coverage: CFO/Total DebtIt measures the financial risk and leverage

2. Interest Coverage: (CFO + Interest Paid + Tax Paid)/Interest Paid

It measures the companys ability to meet interest obligations3. Dividend payment: CFO/Dividend paid

It measures the companys ability to pay the dividend

3.5.3 Questions

Q1. How it is possible for a firm to be profitable and still go bankrupt?

If earnings have increased more rapidly than sales

If the firm has positive net income but has failed to generate cash from operations

If net income has been adjusted for inflationIf sales have not improved even though credit policies have been eased

Q2. Which of the following statement is false?

A negative cash flow can occur in a year in which net income is positive

An increase in account receivable represents accounts not yet collected in cash

An increase in account payable represents accounts not yet collected in cash

To obtain cash flow from operations, the reported net income must be adjusted

Q3. Which of the following would lead to cash flow problems?

Obsolete inventory, account receivables of inferior quality, easing of credit by suppliers

Slow moving inventory, account receivable of inferior quality, tightening of credit by suppliers

Obsolete inventory, increasing notes payable, easing of credit by suppliers

Obsolete inventory, improved quality of account receivables, easing of credit by suppliers

Q4. Which of the following is false?

FCFF is a more popular measure than FCFE for valuing a company.

FCFF can never be smaller than FCFE.

If there are no debt holder, FCFF will be equal to FCFE.

Interest costs are not deducted in calculation of FCFF.



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3.6 Chapter Summary

Cash Flow statement provides the information on the actual cash inflows and outflows during a period. Itsegregates the information on cash flow movement under three activitiesoperating activities, investing

activities and financing activities.There are two methods of the representation known as Direct Method and Indirect Method. In general, most ofthe companies report the cash flow statement using indirect method.

The users of cash flow statement are interested in knowing the trends in free cash flow (FCF); Free Cash flowrefers to the cash that is left for equity and debt holders after meeting necessary expenses to run a business.

While analyzing the cash flow statement one need to take care the following:

Trend in the Cash generated from operations (CFO)

Compare CFO with Net Income

How company is funding its growth plans by CFO or by external sources of capital

Analyze the Free cash flow

3.7 Answers to the Questions

Section 3.5.3

Answer 1: Option 2

Answer 2: Option 3

Answer 3: Option 2

Answer 4: Option 2



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4 Appendix

Earnings_per_Share



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5 Evalueserve Disclaimer

The information contained herein has been obtained from sources believed to be reliable. Evalueservedisclaims all warranties as to the accuracy, completeness or adequacy of such information. Evalueserve shallhave no liability for errors, omissions or inadequacies in the information contained herein or for interpretationsthereof.

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