Cash Flow Analysis

Praxis

Analysing cash flows

Framework
Statement of cash flows: Relevance of cash Cash from operations: Indirect method Direct method

Cash flow analysis

Reporting limitations Cash flows and accruals

Reporting by activities
Constructing the statement

Alternative measure
Business conditions Free cash flow

Relevance of CFS
Helps in assessing liquidity, solvency and financial

flexibility [ability to adjust] How much cash is generated from or used in operations? Cash expenses How dividends are paid in case of loss? Source of cash for debt payments How is increase in investments financed? What is source of new asset acquisition? Why is cash lower when income has increased? What is the use of cash received from new financing?

Reporting by activities
Cash receipts and payments under - Operating activities: working capital items and income statement items (except nonoperating items) - Investing activities: assets expected to generate income and investments - Financing activities: contributing, withdrawing and servicing funds (dividend)

Why disclose under three heads?

Operating activities- useful in forecasting
future operating cash flows Investing activities- expenditure made in resources to generate future income Financing activities- predicting claims on future cash flows by providers of funds

Preparation of statement of cash flows

Indirect method: net income is adjusted for noncash income (expense) items and accruals helps in relating income to cash; helps in predicting income then relating income to cash (most commonly used method) Direct method: each item is adjusted for its accruals Under both the methods, cash flow from financing and investing activities computed in the same method. Only cash from operations is computed in different manner.

Net cash from operations

Net Income + Depreciation & amortisation - Gains on sale of assets/investments + Loss on sale of assets/investments +/- Cash generated by current assets and liabilities

Cont..
If sale on credit in year-1 is Rs.100 that is collected in year 2: Year 1 Year - 2 Income 100 0 Change in debtors (100) 100 Cash flow from operations 0 100

Summary
Account Assets Liabilities Increase Cash outflow Cash Inflow Decrease Cash Inflow Cash outflow

Praxis
Balance Sheet of Praxis Limited use excel sheet

Limitations
No uniformity Discontinued operations- separate disclosure Income tax is reported as operating cash flow (should relate to all three activities)

Analysis
Source of assets replacement Source of expansion and
business

acquisition Degree of dependence on external financing Investing demands and opportunities Requirements and types of financing Sensitiveness of managerial policies like dividend to cash flow

Inferences
Quality
of managements decisions [business acquisitions/expansions/ time lag of cash flow; asset sale/acquisition impact on cash flow; where it committed resources, where it reduced investments, where claim was reduced, etc.] Disposition of earnings and investment of discretionary cash flow Size, composition, pattern and stability of cash flow Judging stability: increase in cash flow due to securitisation, reduction in inventory, increase in payables (represents deferred cash outflow) may not be sustainable

Company and Economic Conditions

Both successful and unsuccessful
companies experience cash problemsnature is different How? Increase in receivables Increase in inventories Profit More equity and debt

Free cash flow

Cash flow from operations Less: Net capital expenditures required to maintain productive capital Less: Dividends on preferred and equity stock Free cash flow Another definition: NOPAT increase in NOA (ignores dividend, as it looks at the total organisation ignoring the way it is financed)

Cont
Positive FCF- amount available for
business after allowances for financing and investing activities for maintaining productive capacity at current level Separating capex into maintenance and expansion is a problem

What does cash flow validate?

Prediction of operating results on the basis
of acquired and planned productive capacity Assessment of future expansion capacity, capital requirements Current obligations Connection between income statement and balance sheet

Cont
Capex feasibility Cash source of expansion Future dividend policies Debt servicing Quality of earnings Financial flexibility in adversity

Cash flow adequacy ratio

Measures ability to generate sufficient cash from operations to cover capex, investment in inventories, dividend 3-year period is taken to weed out cyclical fluctuation = 3-yr sum of cash from operations / 3-yr. sum of capex, inventory addition, dividend Other current assets are excluded as they are financed primarily by short-term credit Reveals cash financing of growth

Cash reinvestment ratio

Measure of the percentage of investment in assets representing operating cash retained and reinvested in the company for both replacing assets and growth in operations = operating cash flow dividend / gross plant + investment + other assets + working capital