Handout CASH FLOW ANALYSIS B.Prahalathan Dept.

of Commerce & Financial Management, University of Kelaniya, SriLanka Learning Objectives: − explain the meaning, usefulness and purpose of cash flow statement − identify cash flow from three different activities − understand two different methods of preparing cash flow statement − understand free cash flow − study various types of cash flow ratios − test solvency by calculating cash flow ratios − study how to use cash ratios as a measure of financial health CASH FLOW ANALYSIS The income statement is based on the accrual method, and net income may not represent cash generated from operations. Net income, based on accrual accounting, is not the same thing as cash earnings. When the timing of revenue or expense recognition differs from the receipt or payment of cash, it is reflected in changes in balance sheet accounts. A company may be generating positive and growing net income but may be headed for insolvency because insufficient cash is being generated from operating activities. Constructing a statement of cash flows is very important in an analysis of a firm’s activities and prospects. THE CASH FLOW STATEMENT The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period, showing how these cash flows link the ending cash balance to the beginning balance shown on the company ’ s balance sheet. The cash flow statement reconciles the beginning and ending balances of cash over an accounting period. The change in cash is a result of the firm’s operating, investing, and financing activities. + + + = + Operating Activities Investing Activities Financing Activities Change in cash balance Beginning Cash Balance Ending Cash Balance. Page 1 of 5

A firm’s cash receipts and cash payments are classified on the cash flow statement as operating, investing, or financing activities. a. Cash flow from operating activities b. Cash flow from financing activities c. Cash flow from investing activities

METHODS OF PRESENTING CASH FLOW STATEMENT There are two acceptable formats for reporting cash flow from operations. 1. Direct method 2. Indirect method 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. MAJOR SOURCES AND USES OF CASH Cash flow analysis begins with an evaluation of the firm’s sources and uses of cash from operating, investing, and financing activities. Sources and uses of cash change as the firm moves through its life cycle. a. Operating Cash Flow b. Investing Cash Flow c. Financing Cash Flow STEPS IN PREPARING THE CASH FLOW STATEMENT The preparation of the cash flow statement uses data from both the income statement and the comparative balance sheets. As noted earlier, companies often only disclose indirect operating cash flow information, whereas analysts prefer direct-format information. a. Operating Activities: Direct Method b. Investing Activities: Direct Method c. Financing Activities: Direct Method CASH FLOW STATEMENT ANALYSIS The analysis of a company’s cash flows can provide useful information for understanding a company’s business and earnings and for predicting its future cash flows. a. Analysis of major sources and uses of cash, cash flow, b. Common-size analysis, c. Conversion of the cash flow statement from the indirect method to the direct method, Page 2 of 5

d. Computation of free cash flow and e. Cash flow ratios. FREE CASH FLOW Free cash flow is a measure of cash that is available for discretionary purpose. 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 a more precise free cash flow measure, such as free cash flow to the firm (FCFF) or free cash flow to equity (FCFE). There are measures of free cash flow. 1. Free cash flow to the firm 2. Free cash flow to equity

FREE CASH FLOW TO THE FIRM Free cash flow to the firm [FCFF] is the cash available to all investors, both equity owners and debt holders. FCFF can be calculated by starting with either net income or operating cash flow. FREE CASH FLOW TO EQUITY Free cash flow to equity [FCFE] is the cash flow that would be available for distribution to common shareholders. OTHER CASH FLOW RATIOS The cash flow statement can be analysed by comparing the cash flows either over time or to those of other firms. Cash flow ratios can be categorized; i. ii. Performance ratio Coverage ratio

PERFORMANCE RATIO i. Cash flow-to-revenue ii. iii. iv. v. Cash return-on-asset ratio Cash return-on-equity ratio Cash-to-income ratio Cash flow per share

COVERAGE RATIO Page 3 of 5

i. ii. iii. iv. v.

Debt coverage ratio Reinvestment ratio Debt payment ratio Dividend payment ratio Investing and financing ratio

HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS Creditors and lenders began using cash flow ratios because those ratios give more information about a company's ability to meet its payment commitments than do traditional balance sheet working capital ratios such as the current ratio or the quick ratio. When a loan officer evaluates, the risk he is taking by lending to a particular company, his greatest concern is whether the company can pay the loan back, with interest, on time. Traditional working capital ratios indicate how much cash the company had available on a single date in the past. Cash flow ratios, on the other hand, test how much cash was generated over a period of time and compare that to near-term obligations, giving a dynamic picture of what resources the company can muster to meet its commitments. a. Operating cash flow (OCF) Ratio - Company's ability to generate resources to meet current liabilities] b. Fund Flow Coverage Ratio – Coverage of unavoidable expenditures c. Cash Interest Coverage Ratio - Company’s ability to meet interest payments d. Cash current debt coverage ratio - Company’s Ability to Repay Its Current Debts e. Cash Flow Adequacy Ratio HOW TO USE CASH RATIOS AS A MEASURE OF FINANCIAL HEALTH Beyond questions of immediate corporate solvency, financial analyst needs to measure a client's ability to meet ongoing financial and operational commitments and its ability to finance growth. a. How readily can the company repay or refinance its long-term debt? b. Will it be able to maintain or increase its current dividend to stockholders? c. How readily will it be able to raise new capital? Banks, credit-rating agencies and investment analysts understandably are very concerned with these questions. Accordingly, they have developed several ratios to provide answers to them.

a. Capital Expenditure Ratio [Company's ability to cover debt after maintenance or investment on plant and equipment]
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b. Total debt (cash flow to total debt) ratio [Company's ability to cover future debt obligations]
c. Total Free Cash flow Ratio [Company’s ability to meet future Cash Commitments]

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