Chapter – 03

ANALYSIS OF CASH
FLOWS
 Statement of Cash Flows
Cash flow data supplement the information
provided by the income statement as both
link consecutive balance sheet.

The classification of cash flows among the

following activities are essential to the
analysis of cash flow data:
• Cash flows among operating activities
• Investing cash flow (CFI)
• Financing Cash Flow (CFF)
• Cash Flow from operating Activities:
(cash form operations or CFO) measures
the amount generated or used by the firm
as a result of its production and sales of
goods and services.

• Investing Cash Flow:

(CFI) reports the amount of cash used to
acquire assets such as plant and
equipment as well as investments and
entire businesses

• Financing Cash Flows:

(CFF) contains the cash flow
consequences of the firm’s capital
structure (debt and equity) decisions.
Firms with significant Foreign operations
separately report a fourth category, The effect
of exchange rate changes on cash, which
accumulates the effects of changes in
exchange rates on the translation of foreign
currencies
 Direct and indirect method
of cash flow statement
SFAS 95, statement of cash flows (1987), and IAS 7
(1992) govern the preparation of cash flow
statement under U.S and IAS GAAP, respectively.

Both standard permit firms to report cash from

operation either directly by reporting major
categories of gross cash receipts and payments, or
indirectly by reconciling accrual-based net income to
CFO.
 Under the indirect method, CFO
is computed by adjusting net
income for all

1. Noncash revenues and expenses (for example,

depreciation expense)
2. Nonoperating items included in net income (for
example, gains from property sales)
3. Noncash changes in operating assets and liabilities
(operating changes in receivables, payables)
Cash flow statement prepared using the indirect
method have a significant Drawback. Because the

indirect format reports the net cash flow form

operations, it does not facilitate the comparison
and analysis of operating cash inflows and
outflows by function with the revenue and
expense activity that generated them, as is
possible from direct method cash flow statements.
 Preparation of a
Statement of Cash Flows
Transactional Analysis

Transactional analysis is a technique that

can be used to create a cash flow
statement for firms that do not prepare
such statements in accordance with SFAS
95 and IAS 7. It can also be used to
convert indirect method cash flow from
operations to the direct method.
 Objective of Transactional
Analysis
• To understand the relationship
between the accruals of revenues,
expenses, assets & liabilities and
their cash flow consequences.

• To facilitate analysis by classifying

gross cash flows between operating,
investment & financing activities.
 The relationship between balance sheet changes
and cash flows can be summarized as follows:

• Increases (decreases) in assets represent net cash

outflows (inflows ). If an asset increases, the firm
must have paid cash in changes.

•Increases (decreases) in liabilities represent net

cash inflows (outflows). When a liability increases,
the firm must have received cash in exchange.
 Analysis of Cash Flow
Information
The statement of cash flow provides
information about:
• A firm’s ability to generate cash flows from
operation
• Trends in cash flow components & cash
consequences of investing & financing
decisions
• Management decision regarding financial
policy, dividend policy & investment for
growth
Free Cash Flows & Valuation
• FCF is an important but elusive concept
often used in cash flow analysis.
• It is intended to measure the cash
available to the firm for discretionary uses
after making all required cash outlays.

• Discretionary uses include growth oriented

capital expenditures & acquisitions, debt
reduction, and payment to stockholders.
Free Cash Flows & Valuation
• The basic definition used by many analysts
for FCF is cash flow from operation less
the amount of capital expenditures
required to maintain the firm’s present
productive capacity.

• The larger the firm’s FCF, the healthier it

is, because it has more cash available for
growth, debt payment & dividend.
 Relationship of Income &
Cash Flows
• The estimation of revenues & expenses
require management judgment and are
subject to modification as more
information about the operating cycle
becomes available.

• Furthermore accrual accounting by itself

fails to provide adequate information
about the liquidity of the firm and long
term solvency.
 Income, Cash Flow &
Liquidity
• Growth companies may provide weak
operating cash flows as they must
finance growth in current operating
assets.

• The cash flow statement provides

information about the firm’s liquidity
& its ability to finance its growth
from internally generated funds.
 Analysis of Trends
• Review individual cash flow items

• Examine the trend of different cash flow

components over time & their relationship
to related income statement.

• Consider the interrelationship between

cash flow components over time.