Unit 4:

Analysis of Cash Flows statement

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 Analysis of Cash Flows statement
What is a cash flow statement?
• A cash flow statement reports the inflows and outflows of cash (and
cash equivalents) under the headings of Operating, Investing, and
Financing Activities.
• ‘Cash equivalents are short-term, highly liquid investments that are
readily convertible to known amounts of cash and are subject to an
insignificant risk of changes in value.’
– Commercial paper
– Marketable securities
– Money market funds
– Short-term government bonds
– Treasury bills
• What value does the cash flow statement analysis add to the
interpretation of financial statements?, and
• Why not just look at cash in the balance sheet?
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 NATURE OF CASH FLOWS

The Cash flow statement is

analogiuos to the water flowing
into a sink, the balance is
determined with the speed of
inflows vs. outflows

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 Benefits/value of a cash flow statement
• The balance sheet reveals the opening and
closing balance of cash.
• Cash flow statement provides information
about what caused the observed movement
in the cash balance – reconciles the closing
balance of cash to opening balance.
• Two perspectives for cash flow analysis: How solvent the

– measuring the degree of business solvency business is

– business valuation.
Serves as in put in
business valuation

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Benefits/value of a cash flow statement
Cont.
• Measuring business solvency
– A business cannot operate/survive without sufficient
cash.
– However, under accrual accounting evaluating cash
performance is difficult. Since accrual accounting is based on income earned
which normally is not in cash, hence we need to

• Business valuation supplement the Income Statement and Statement of

Financial Position with the Cash Flow Statement

– Cash is central to valuing any company.

– Dividends a key determinant of valuation can only be
paid if there is sufficient cash.
– Often share price in capital market is a function of
future expected dividends.

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 Example:
Statement of cash flows
• Divided into three sections:
– operating activities
– investing activities
– financing activities.
• The fundamental purpose is to reconcile opening
and closing balances of cash and cash equivalent
accounts. Fundamentally the cash flow statement
reconciles the opening cash balance to the
closing cash balance.

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 Statement of cash flows
The statement of cash flow helps to evaluate:
1. The entity’s ability to generate future cash flows.
2. The entity’s ability to pay dividends and meet
obligations.
3. Provides reasons for the difference between net
income and net cash provided (used) by
operating activities.
4. The investing and financing transactions during
the period.

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 Statement of cash flows Cont.
The statement of cash flow can help answer the
following questions:
– Did the company generate cash from operations?
– If it generated cash flow from operations, how did it use that cash?
– How did profit increase when there was a net decrease in cash flow
from operations?
– Is cash flow greater or less than net profit?
– How was the expansion in the plant and equipment financed?
– Did investments increase/decrease? What were the changes?
– How much debt was repaid?
– How much money was borrowed during the year?
– What amount was paid in dividends?

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 Operating activities
• Cash flows related to the provision of goods and services:
– receipts from customers
Return on our investments
– interest and dividends received outside our main business

– payments to suppliers and employees

– interest paid
– income tax paid.

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 Investing activities
• Cash flows related to the sale and acquisition of noncurrent
assets and investments that are not cash equivalents:
– purchases/sales of property and equipment
– purchases/sales of equity investments
– purchases/sales of businesses
– collection/make loans to other enterprises.

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 Financing activities
• Cash flows related to changing the size and/or composition of
the financial structure:
– borrowing/repaying debt
– issuing shares/buy back of shares
– dividends paid.

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 Summary classification of cash flow
transactions:
Operating Investing Financing

Receipts from: Receipts from: Receipts from:

 Sale of goods and  Sales of property,  Issue of shares
services plant and equipment  Borrowings
 Interest or  Repayment of loans
dividends received by other entities
 Sale of shares held
as investments

Payments for: Payments for: Payments for:

 Purchase of  Acquisition of  Dividend
inventory property, plant and distributions
 Wages of equipment  Share buy-backs
employees Taxes  Acquisition of shares  Repayment of
to governments and debentures for borrowings
 Interest to lenders investment purposes

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 Summary of the Firms Cash Flows Anatomy
How cash flows into and out of
the business

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 Exclusions These are transactions that do not pass through
the cash statements

The statement of cash flows excludes

non-cash investing and financing activities,
such as:
– Purchase of investments or property by incurring
long-term debt.
– Acquiring another business entity by issuing
shares. In all these transactions no cash changes
hand but an investment of a financing
– Conversions of liabilities to equity.
decision is executed

– Acquiring equipment by entering into a lease.

– Acquiring investments or property in exchange
for other investments or property.

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 Significant non-cash activities
Transactions that do not affect cash are NOT
reported in the body of the statement of cash
flows. However, these items are reported:
• In a separate schedule at the bottom of the
statement of cash flows, or
• In a separate note or supplementary schedule
to the financial statements.

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 Reporting of Cash Flows Now that we know the significance of the cashflow statement, how do

• There are two main approaches in reporting cash

we report the cash flows?

flows: Direct and Indirect

– Under the direct method of reporting: The direct and indirect reporting
of cashflows only affects the
• operating cash flows: cash flow from operations and
not the other two
– Cash inflows and outflows from operating activities, such as
receipts from customers and payments to suppliers and employees,
are listed directly in the operating cash flow section of the
statement. People who do not have
direct access to the
– Under the indirect method of reporting, company documents can
rely on the indirect
• the operating cash flow section: method

– Begins with the accrual net profit figure from the income
statement.
– Then lists a series of adjustments, including non-cash expenses
(e.g. depreciation) and changes in current asset and liability
accounts other than cash.
– Concludes with net cash flow from operating activities.
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 Operating cash flows
• A company that has negative cash flows from
operations over an extended period is in
trouble.
• But, if they have positive operating cash flows,
how are they using them?
– pay off debt (financing)
– pay dividends (financing)
– buy more NCAs (investing)
– place in securities market (investing).

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 Interpreting the Cash flow Statement
• Comparing sections within the cash flow
statement: This simply means comparing the different
segments within the cash flow statement

– Study the movement between the three sections:

operating, investing and financing.
– Relationships between them can tell you about how
well the company is managing its cash flows.
– Also indicative of maturity of business.
By analysing the cash flow statement; once
can easily see the maturity of a business

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 How to calculate cash flows
So, how do we determine the cash flows

• We can find the total cash flows by using

information from the balance sheet, income
statement and other sources.
Digging cash flow transactions; this
requires that you know the
relationship between the items in the
financial statements

20,000

50,000 50,000

Hence by knowing the relationships

between the accounts receivables and
the Credit Sales, we can determine
there was a cash flow of 30,000

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 Salaries payable
CASH ? O/BAL. 500

SAL. EXP. 600

C/BAL. 200

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 Salaries payable
CASH 900 O/BAL. 500

SAL. EXP. 600

C/BAL. 200

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 The indirect method
• So far we have dealt with the direct method
of producing cash flows from operations:
– By directly calculating each cash flow.
• You may also do it indirectly:
– adjust net profit after tax for non-cash items.
• Note: The indirect method only applies to
cash flow from operations.

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 How to convert net income to cash flow
from operations

Accrual method Cash method

Revenue earned Non-cash expenses
+ (e.g. depreciation)
– Expenses incurred
+ Decreases in current assets
Increases in current liabilities
Net profit
Increases in current assets
– Decreases in current liabilities
Cash flow from
operations

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Determine net cash provided (used) by
operating activities
1. Get net profit from the income statement.
2. Add to net profit for expenses that did not affect cash
(i.e. depreciation, amortization and loss on sale) and
deduct from net profit for revenues that did not affect
cash (i.e. gain on sale of equipment etc.).
3. Add (subtract) the changes in the current asset and
current liability accounts.

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 Non-cash items
• Some items are included in operating profit
after tax that are not included in the cash
flow from operations:
– depreciation and amortisation
– gains/losses from sale of noncurrent assets.
• These need to be removed from net profit to
get to cash from operations.

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 Eliminating non-cash differences
• In calculating profit we would have deducted the following
items:
Loss on sale (25)
Depreciation expense (88)
Goodwill amortisation (10)

and added
Gain on sale 50

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 Back to cash flow
• To get back to cash flow from operations we do the opposite (i.e.
add back these items):

Operating profit after tax 56

Loss on sale +25
Depreciation expense +88
Goodwill amortisation +10
Gain on sale (50)
Subtotal
129

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Interpretation the Cash Flow Statement
• The statement of cash flows is useful in identifying hidden liquidity
problems. In this regard, look for the following warning signals:
– A significant decline in operating cash flows, or in the
quality of earnings ratio (operating cash flow/net profit)
relative to the prior period. Interpretation:
• If caused by a large increase in receivables, is it possible that the
company is having difficulties collecting its receivables?
• If caused by a large increase in inventories, is it possible that the
company is having difficulties selling its inventories?
 A significant increase in payables.
Interpretation:
• Is it possible that the company is delaying a liquidity problem
by not paying its short-term obligations on a timely basis?

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 Interpretation (cont’d)
More warning signals from the statement of cash flows:
• A significant increase in cash provided from sales of investments
or property. Interpretation:
– Is it possible that the company is selling off its noncurrent assets in order
to avoid a liquidity problem?
• Net cash flow from investing activities that is a positive number.
Interpretation:
– Is it possible that the company is unable to find worthwhile growth
opportunities?
• When trying to make assertions from a statement of cash flows,
we need to consider it simultaneously with the balance sheet
and income statement.

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 Quality of credit granting
• If the income statement shows:
increasing sales and steady bad debts,
• And the balance sheet shows:
increasing accounts receivables,
• Check the Cash Flow Statement:
Are they receiving the cash from customers or
should they provide for more bad debts?

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 Organisational Short-Term Financial Planning
Process

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