Lecture 4

Understanding Cash Flow Statement

Cash Flow Statement

provides information beyond that available from the income statement, which is based on accrual, rather than cash, accounting.

reports changes in cash due to operating, investing and

financing activities over a period of time.

Cash Flow Statement

Provides:

Information about a companys cash receipts and

cash payments during an accounting period

Information about a companys operating,

investing and financing activities

An understanding of the impact of accrual

accounting events on CFs.

An analyst can use the statement of CFs to determine whether:

Regular operations generate enough cash to sustain the business

Enough cash is generated to pay off existing debts as they mature

The firm is likely to need additional financing Unexpected obligations can be met The firm can take advantage of new business opportunities as they arise

Statement of Cash Flows Format

Net cash from operating activities + Net cash from investing activities + Net cash from financing activities = Net change in cash balance

Cash Flow Components

Cash flows can be divided into three types: . Cash from operating (CFO): . Cash from investing (CFI):

. Cash from financing (CFF):

Cash Flow from Operating (CFO)

consists of the inflows and outflows of cash resulting from transactions that affect a firms net income. Cash from Operating Activities (U.S. GAAP)

Cash Inflow Cash collected from customers Interest and dividends received Sale proceeds from trading securities Operating Cash Flow

Cash Outflow Cash paid to employees and suppliers Cash paid for other expenses Acquisition of trading securities Interest paid Taxes paid

Operating cash outflows exclude these income statement items: Depreciation and amortization (and other noncash items) Gains or losses on disposal of PP&E

Noncash Investing and Financing Activities

Non cash investing and financing activities: are not reported in the cash flow statement since they do not result in inflows or outflows of cash.
Non cash transactions must be disclosed in either a footnote or supplemental schedule to the cash flow statement.

Cash from investing (CFI)

consists of the inflows and outflows of cash resulting from acquisition or disposal of long term assets and certain investments. Cash from Investing Cash Flow (U.S. GAAP)

Cash Inflow Sale proceeds from fixed assets Sale proceeds from debt and equity investments Principal received from loans made to others

Cash Outflow Acquisition of fixed assets Investing Cash Flow Acquisition of debt and equity investments Loans made to others

Cash from financing (CFF)

consists of the inflows and outflows of cash resulting from transactions affecting a firms capital structure.

Cash from Financing Cash Flow (U.S. GAAP)

Cash Inflow Principal amounts of debt issued Proceeds from issuing stock Financing Cash Flow

Cash Outflow Principal paid on debt Payments to reacquire stock Dividends paid to shareholders

Distinguish Cash Flow Statements Under IFRS and U.S. GAAP

US.GAAP: dividends paid to the firms SHDs are reported as financing activities interest paid is reported in operating activities interest received and dividends received from investments are reported as operating activities. All taxes are reported as operating activities

 IRFS: Interest and dividends received are reported as operating or investing activities Dividends paid to the companys SHDs and interest paid on the companys debt are reported as operating or financing activities.

Income taxes are reported as operating activities

unless the expense is associated with an investing or

financing transaction.

Example
Consider a company sells land that was held for

investment for $1 million. Income taxes on the sale total

$160.000. Under US.GAAP, the firm reports an inflow of cash from investing activities of $1 million and an outflow of cash from operating activities of $160.000 Under IFRS, the firm can report a net inflow of $840.000 from investing activities.

Examples
Example 1 A company recorded the following in Year 1: Proceeds from issuance of long term debt $300,000 Purchase of equipment $200,000 Loss on sale of equipment $70,000 Proceeds from sale of equipment $120,000 Equity in earnings of affiliate $10,000 On the Year 1 cash flow statement, the company would report net cash flow from investing activities closest to: A. -$150,000 B. -$80,000 C. $200,000 D. $300,000

Cash Flow Statement: Linkages and Preparation

Linkages of CFS with BS: Assets = Liabilities + Owners Equity
Cash + Noncash assets = Liabilities + Shareholder Equity

C + N$A = L + CC + AOCI + RE C= L+ CC + AOCI + RE N$A

CC : Contributed Capital AOCI: Accumulated Other Comprehensive Income RE: Retained Earnings

Cash Flow Statement: Linkages and Preparation

Linkages of CFS with BS:
- Any differences between the accrual basic and cash basic of accounting for an operating transaction result in an increase or decrease in some short term asset or liability on the balance sheet. - Investing activities typically relate to long term asset section of BS and its financing activities typically relate to the equity and long term debt section of BS. - Each item on BS is also related to IS and/or CFS through the change in the beginning and ending balance.

Method for Preparing Cash Flow Statement

Direct Method Indirect Method

Direct Method
Each line item of the accrual-based income statement is converted into cash receipts or cash payments. Begins with cash inflows from customer and then deducts cash outflows for purchases, operating expenses, interest and taxes. Example:

Indirect Method
Net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. The starting point is net income

Example:

Distinguish between Direct Method and Indirect Method

Both methods are permitted under US.GAAP and IFRS The difference between the two methods relates to the presentation of cash flow from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods

Direct Operating Cash Flow Indirect Investing Cash Flow Direct

Financing Cash Flow

Direct

Preparation of Direct and Indirect Cash Flow Statements

Points to remember Steps in Presenting CFO of Direct Method Steps in Presenting CFO of Indirect Method Presenting CFI, CFF

Examples

Points to Remember
CFO is calculated differently, but the result is the same under both methods The calculation of CFI and CFF is identical under both methods There is an inverse relationship between changes in assets and changes in cash flows. There is a direct relationship between changes in liabilities and changes in cash flow.

Steps in Presenting CFO of Indirect Method

Step 1: Begin with net income
Step 2: Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land) Step 3: Add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue.

Step 4: Add and subtract changes to balance sheet operating accounts as follows:
Increases in operating assets accounts (uses of cash) are subtracted, while decreases (sources of cash) are added. Increases in the operating liability accounts (sources of cash) are added, while decreases (use of cash) are subtracted.

Steps in Presenting CFO of Direct Method

Direct method shows only cash payments and cash receipts over the period.
Common components of cash flow appear on cash flow presented under the direct method: Cash received from customers Cash paid to suppliers

Cash paid to employees

Cash paid for other operating expenses Cash paid for Interest

Cash paid for taxes

Presenting CFI, CFF

The presentation of CFI and CFF is identical, regardless of whether the direct or indirect method is used for operating cash flows. CFI and CFF are always presented using the direct method.

Common Size Cash Flow Statement

Common size analysis can be used to analyze the cash flow statement
The cash flow statement can be converted to common size format by expressing each line item as a percentage of revenue. A revenue based common size cash flow statement is useful in identifying trends and forecasting future cash flow.

Example: Common-size Cash Flow Statement Analysis

Triple Y Corporations common-size cash flow statement is shown in the table below. Explain the decrease in Triple Ys total cash flow as a percentage of revenues.

Triple Y Corporation Cash Flow Statement (Percent of revenues) Year 20X9 20X8 20X7 Net Income 13.40% 13.40% 13.50% Depreciation 4.00% 3.90% 3.90% Accounts Receivable -0.60% -0.60% -0.50% Inventory -10.30% -9.20% -8.80% Prepaid expenses 0.20% -0.20% 0.10% Accrued liabilities 5.50% 5.50% 5.60% Operating Cash Flow 12.20% 12.80% 13.80% Cash from sale of fixed assets 0.70% 0.70% 0.70% Purchase of plant and equipment -12.30% -12.00% -11.70% Investing Cash Flow -11.60% -11.30% -11.00% Sale of Bonds 2.60% 2.50% 2.60% Cash Dividends -2.10% -2.10% -2.10% Financing cash flow 0.50% 0.40% 0.50% Total cash flow 1.10% 1.90% 3.30%

Homework
Cash Flow and Life Cycle Phase