“ Add your company slogan ”

Chapter 4:
Understanding Cash
Flow Statements

LOGO
 Contents
1 Components and Format of The Cash Flow
Statement
2 The Cash Flow Statement: Linkages and
Preparation
3 Cash Flow Statement Analysis

5
1. Components and Format of The Cash Flow Statement

Classification of Cash Flows and

1.1 Noncash Activities

A Summary of Differences between IFRS

1.2
and VAS

Direct and Indirect Cash Flow Formats for

1.3 Reporting Operating Cash Flow

www.themegallery.com
Purpose of the Statement of Cash Flows

How Where
Wheredoes
doesaa
How does
doesaa
company company
companyspend
spendits
its
companyobtain
obtainits
its
cash? cash?
cash?
cash?

What
Whatexplains
explainsthe
the
change
changein
inthe
thecash
cash
balance?
balance?
Purposes of Statement of Cash Flows

 Help investors, creditors, & others to:

 Assess the enterprise’s ability to generate positive
future net cash flows.
 Assess the enterprise’s ability to meet its
obligations, its ability to pay dividends, & its needs
for external financing.
 Assess the reasons for differences between net
income & associated cash receipts & payments.
Transactions affecting cash flows - Examples

Effect on Cash
Transaction Increase Decrease No effect
1. Amortization of intangible
asset
2. Conversion of preferred stock
to common stock
3. Sales on account
4. Purchase of inventory on
account
5. Declaration of a dividend
6. Payment of accounts payable
7. Collection of accounts
receivable
8. Depreciation on factory
building
9. Sale of building at a loss
10. Retirement of debt through
issuance of common stock
1.1. Classification of Cash Flows and Noncash Activities

Classifying Cash Flows

 Operating Activities
 Involve the cash effects of transactions that create
revenues and expenses & enter into the
determination of net income.
 Investing Activities
 Involve the acquisition and disposal of long-term
assets.
 Invest in other companies
 Financing Activities
 Involve changes in the size and composition of the
contributed equity and borrowings.

www.themegallery.com
1.1. Classification of Cash Flows and Noncash Activities

Operating Activities

Investing Activities
Classifying
Cash Flows

Financing Activities
 Operating Activities

 Includes company’s day-to-day activities that

create revenues.
 E.g., selling inventory, providing services and
other activities not classified as investing and
financing.

www.themegallery.com
Operating Activities

Outflows
Outflows
•• Salaries
Salariesand
andwages
wages
•• Payments
Paymentsto tosuppliers
suppliers
•• Taxes
Taxesand
andfines
fines
•• Interest
Interest paid
paidto tolenders
lenders
 Investing Activities

 Include purchasing and selling long-term

assets and other investment.
 Other liabilities include both long-term and short-
term investment in equity and debt (bond and
loans) issued by other companies.
But exclude:
a. Any securities considered as cash equivalents
b. Securities held for dealing or trading purposes

www.themegallery.com
 Investing Activities
Inflows
Inflows
•• Selling
Sellinglong-term
long-termassets
assets
(PP&E,
(PP&E, intangible
intangibleand
andother
other
long-term
long-termassets)
assets)
•• Selling
Sellingnon-trading
non-tradingsecurities
securities
•• Collecting
Collectingprincipal
principalon
onloans
loans
•• Cash
Cashdividends
dividendsreceived
received
•• Interest
Interest from
fromborrowers
borrowers
Outflows
Outflows
•• Purchasing
Purchasinglong-term
long-term
productive
productiveassets
assets
•• Purchasing
Purchasingequity
equity
investments
investments
•• Purchasing
Purchasingdebt
debt investments
investments
12
 Financing Activities

 Include obtaining or repaying capital (equity,

debt)

www.themegallery.com
 Financing Activities

Inflows
Inflows
•• Issuing
Issuingits
itsown
ownequity
equity
securities
securities
•• Issuing
Issuingbonds
bondsand
andnotes
notes
•• Issuing
Issuingshort-
short-and
andlong-term
long-term
liabilities
liabilities

Outflows
Outflows
•• Pay
Paydividends
dividends
•• Purchasing
Purchasingtreasury
treasurystock
stock
•• Repaying
Repayingcash
cashloans
loans
•• Paying
Payingowners’
owners’withdrawals
withdrawals
14
 Types of activities affecting cash flow

Item Operating Investing Financing

1. Payment of federal income taxes.
2. Dividend payments to shareholders.
3. Repayment of long-term debt.
4. Loans made to another company.
5. Collection of accounts receivable.
6. Salaries paid to employees.
7.Payment of interest on bond debt.
8. Dividends received from investments.
9. Cash paid to acquire treasury stock.
10. Purchase of equipment for cash.
 Noncash Investing and Financing
 Is
Is any
any transaction
transaction that
that does
does not
not involve
involve an
an inflow
inflow or
or
outflow
outflow ofof cash.
cash.
 E.g.,
E.g.,
 exchange
exchangeone
onenon-monetary
non-monetaryasset
asset for
forother
othernon-
non-
monetary
monetaryasset.
asset.
 Pay
Paydividends
dividendsby byissuing
issuingcommon
commonstock.
stock.
 Conversion
Conversionofof convertible
convertiblebond
bondor
orconvertible
convertiblepreferred
preferred
stock
stock
 Significant
Significant noncash
noncash transactions
transactions areare not
not incorporated
incorporated
in
in the
the cash
cash flow
flow statement,
statement, butbut they
they may
may effect
effect aa
company’s
company’s capital
capital or
or asset
asset structure
structure
required
required toto be
be disclosed
disclosed in in aa separate
separate note
note or
or aa
supplementary
supplementary schedule
schedule to to the
the cash
cash flow
flow statement.
statement.
www.themegallery.com
 Noncash Investing and Financing

Items
Items requiring
requiring separate
separate disclosure
disclosure
include:
include:
 Retirement
Retirement of of debt
debt by
by issuing
issuing equity
equity
securities.
securities.
 Conversion
Conversion of of preferred
preferred stock
stock toto
common
common stock.
stock.
 Leasing
Leasing ofof assets
assets inin aa capital
capital lease
lease
transaction.
transaction.
1.2. A Summary of Differences between IFRS and VAS

Topic IFRS VAS

Classification of cash flows:
• Interest received
• Interest paid
• Dividends received
• Dividend paid
• Tax paid
Operating or Investing Investing
Operating or financing Operating
Operating or investing Investing
Operating or financing Financing
Generally operating, but Operating
a portion can be
allocated to investing or
financing if it can be
specifically identified
with these categories.

www.themegallery.com
 Format of the Statement of Cash Flows
Company Name
Statement of Cash Flows
For Period Ended Date
Cash flows from operating activities:
[List of individual inflows and outflows]
Net cash provided (used) by operating activites $ #####
Cash flows from investing activities:
[List of individual inflows and outflows]
Net cash provided (used) by investing activites #####
Cash flows from financing activities:
[List of individual inflows and outflows]
Net cash provided (used) by financing activites #####
Net increase (decrease) in cash $ #####
Cash (and equivalents) balance at beginning of period #####
Cash (and equivalents) balance at end of period $ #####
 Statement of Cash Flows – An
example
Statement of Cash Flows
For the year ended Dec. 31 2013
(abstract)
(in $ millions)
A B
Net cash from operating activities (30) 40
Net cash from investing activities 20 0
Net cash from financing activities 40 (10)
Net increase in cash 30 30
Impact of Product Life Cycle on Cash Flows
 Impact of Product Life Cycle on Cash
Flows An example

(in $ millions)
A B C D
Net cash from operating activities (60) 30 120 (10)
Net cash from investing activities (100) 25 30 (40)
Net cash from financing activities 70 (110) (50) 120
Net Income (40) 10 100 (5)
1.3. Methods to prepare Statement of Cash Flows

There are two acceptable methods to

determine Cash Flows from Operating
Activities:
•Direct Method
•Indirect Method
 Preparation Methods

Direct Method vs. Indirect Method

Different in calculating net cash flow from
operating activities:
 The DIRECT method deducts from operating cash
receipts and operating cash paid.
 The INDIRECT method adjusts net income for
items that affected reported net income but did not
affect cash.
 Income statement format

Revenue
- COGS
= Gross profit
- SG&A
- Depreciation expense
= Operating profit (EBIT)
- Interest expense
= IBT
- Tax
= Net income
Cash flows from Operating activities (Direct method)

Cash Cash Net cash provided by

receipts payments Operating Activities
To suppliers

To employees
From sales of Net Cash Provided
goods & services For operating expenses by Operating
to customers Activities

For interest

For taxes
 Cash Flows from Investing Activities

Additions
 Cash proceeds from
the disposal of plant
assets.
 Cash proceeds from
the sale of investment
in securities.
Deductions
 Cash payment for
purchases of new
plant assets.
 Cash payments for
investing in securities.

Net cash flows from investing activities

 Cash Flows from Financing
Activities

Additions Deductions
 Cash received from Cash payment for
issuing shares or repayments of loans.
debts. Cash payments for
dividends.

Net cash flows from financing activities

 Analyzing the Cash Account
B&G company

Cash
Cash
Balance,
Balance, Jan.
Jan. 1,1, 2013
2013 22,000
22,000 Payments
Paymentsfor
for merchandise
merchandise 150,000
150,000
Receipts
Receiptsfrom
from customers
customers 466,000
466,000 Payments
Paymentsfor
for wages
wages 145,000
145,000
Receipts
Receiptsfrom
from sale
sale ofofland
land 25,000
25,000 Payments
Paymentsfor
for interest
interest 10,000
10,000
Receipts
Receiptsfrom
from stock
stockissuance
issuance 35,000
35,000 Payments
Paymentsfor
for taxes
taxes 20,000
20,000
Payments
Paymentsfor
for equipment
equipment 70,000
70,000
Payments
Paymentsfor
for bond
bond retirement
retirement 50,000
50,000
Payments
Paymentsfor
for dividends
dividends 40,000
40,000
Balance,
Balance, Dec.
Dec. 31,
31, 2013
2013 63,000
63,000
 Advantages of Direct Method
 More consistent with the objective of statement
of cash flows – to provide information about
cash receipts & cash payments.
 Shows sources & purposes of cash receipts &
payments.
 Net Income vs. Net Cash Flow from
Operating Activities

Earned
incomes Adjusted by:
•Noncash revenues and Net cash
expenses
Net flow from
Income •Non-operating gains
and losses Operating
•Changes in current activities
assets and current
Incurred liabilities
expenses
 Cash Flows from Operating Activities
(Indirect Method)

Net Income
Additions Deductions
 Noncash expenses  Non cash income
 Non operating losses  Non operating gains
 Decreases in current  Increases in current
assets assets
 Increases in current  Decreases in current
liabilities liabilities

Net cash flow from operating activities

 Indirect Method

Let’s prepare a Statement of

Cash Flows for B&G Company
using the Indirect Method.
 Preparation of the Statement of
Cash Flows: Steps

 Step 1. Determine the change in cash.

 Step 2. Determine the net cash flow from operating activities.
Use both the current year's income statement and information on
current assets and liabilities from the comparative balance sheets.
 Step 3. Determine net cash flows from investing and financing
activities. Examine all other changes in the balance sheet
accounts.
 Step 4. Include summary of net increase (decrease) in cash,
cash at beginning, and cash at end.
 Step 5. Disclose any significant noncash transactions
separately at the bottom of the statement.

Copyright © 2013 CFA Institute 37

 Example

ABC company has the following transactions:

 Sells stock for $100.
 Buys a building for $50. Its primary line of business is
selling a service, so it has no COGS (cost of goods sold)
and no inventory.
 Makes credit sales of $100, and subsequently collects $90.
 Accrues SG&A (selling, general, and administrative)
expense of $40, and subsequently pays cash of $25.
 Records depreciation expense of $10.

Copyright © 2013 CFA Institute 38

 Step 1. Determine the change in cash

This step is straightforward. The information is on the

comparative balance sheets. Change was $115.

Beginning Ending
balance balance Change
Cash
Accounts receivable
Building
Accumulated depreciation
Total assets
Accounts payable
Common stock
Retained earnings
Total liabilities and equity

Copyright © 2013 CFA Institute 39

 Step 2. Determine the net cash flow from operating
activities, beginning with Net Income for the indirect
method

Income statement
Credit sales
SG&A expense
Depreciation expense
Net income

Net income
+ Depreciation expense
– Change in receivables
+ Change in payables
Cash from operating activities
Copyright © 2013 CFA Institute 40
 Step 3. Determine net cash flows from
investing and financing activities

Examine all other changes in the balance sheet accounts.

Beginning Ending Cash flow from
balance balance Change which activity?
Cash 0 115 115
Accounts receivable 0 10 10
Building 0 50 50
Accumulated depreciation 0 (10) (10)
Total assets 0 165 165
Accounts payable 0 15 15
Common stock 0 100 100
Retained earnings 0 50 50
Total liabilities 0 165 165
*There are no dividends in this example; all changes in retained earnings are from
net income
Copyright © 2013 CFA Institute 41
 Investing cash flows

 Determine investing cash flows by examining changes in

long-term assets. In this example, we have only PP&E.
 Beginning PP&E + Purchases – Dispositions = Ending
PP&E
 Ending PP&E – Beginning PP&E = Purchases –
Dispositions (i.e., investing cash flows)

 PP&E increased by $50, indicating cash spent acquiring

PP&E.

 We also know this from the transaction list at the

beginning of the example.
Copyright © 2013 CFA Institute 42
 Financing cash flows

 Determine financing cash flows by examining changes in

debt and equity accounts. In this example, we have only
common stock.
 Beginning stock + Issuances – Repurchases = Ending
stock
 Ending stock – Beginning stock = Issuances –
Repurchases

 Stock account increased by $100, indicating cash was

raised by issuing stock.

 We also know this from the transaction list at the

beginning of the example.

Copyright © 2013 CFA Institute 43

 INDIRECT METHOD
Company ABC
Cash Flow Statement for the period ended
Operating cash flow
Net income
Depreciation expense
Increase in accounts receivable
Increase in accrued liabilities
Total operating cash flow

Investing cash flow

Capital expenditure

Financing cash flow

Issue of stock

Total change in cash

Beginning cash balance
EndingCopyright
cash©balance
2013 CFA Institute 44
 Alternative Step 2. Determine the net cash flow from
operating activities, beginning with each line item
for the direct method

Income statement
Credit sales
SG&A expense
Depreciation expense
Net income

Cash from customers

Cash paid for expenses

Cash from operating activities
Copyright © 2013 CFA Institute 45
 DIRECT METHOD
Company
ABC

Cash collected from customers

Cash paid to suppliers
Total operating cash flow

Investing cash flow

Capital expenditure

Financing cash flow

Issue of stock

Total change in cash

Beginning cash balance
Ending cash balance
Copyright © 2013 CFA Institute 46
 Advantages of Indirect Method

 Focus on the differences between net

income & net cash flow from operating
activities.
Reveals a link between the financial
statements.
 Less costly to prepare.
 Must be prepared even if the direct method is
used.
 B&G company

Additional
Additional Information
Information for
for 2013:
2013:
•• Net
Net income
incomewas
was$105,000.
$105,000.
•• Cash
Cashdividends
dividendsdeclared
declaredand
andpaid
paidwere
were$40,000.
$40,000.
•• Bonds
Bondspayable
payableof
of $50,000
$50,000were
wereredeemed
redeemedfor
for
$50,000
$50,000cash.
cash.
•• Common
Commonstock
stockwas
wasissued
issuedfor
for$35,000
$35,000cash.
cash.
 B&G Company
Statement of Cash Flows
For the Year Ended December 31, 2013
Cash flows from operating activities
Net income
Adjustments to accrual-basis net income:
Depreciation expense
Increase in accounts receivable
Decrease in inventory
Decrease in accounts payable
Total adjustments
Net cash provided by operating activities
Cash flows from investing activities
Proceeds from sale of land
Purchase of equipment
Net cash used by investing activities
Cash flows from financing activities
Proceeds from issuance of common stock
Redemption of bonds
Payment of dividends
Net cash used by financing activities
Net increase in cash
Cash, January 1, 2013
 2. Linkages of the Cash Flow Statement with
the Income Statement and Balance Sheet

2.1. Linkages of the Cash Flow Statement with the

Balance Sheet
Total Asset = Liabilities + Equity
Cash + Non Cash Assets = Liabilities + Equity

C + NC = L + E

C: cash L: Liabilities
NC: non-cash E: Equity
C + NC = L + E

C = L + E - NC
 2. Linkages of the Cash Flow Statement with the
Income Statement and Balance Sheet
 2.2. Linkages of the Cash Flow Statement with
the Income Statement
Net Income = Income – Expenses

Income Expenses

Cash income Cash expenses

Non Cash income Non cash expense
 Net Income = (Cash income – Cash charges) +
(Non cash income – Non cash charges)

P = (CI – CC) + (NCR – NCC)

CR: cash income CC: Cash charges

NCR: non-cash income NCC: Noncash charges
 2.2. Linkages of the Cash Flow Statement with the
Income Statement

C = P – (NCI – NCC)
 3. Cash Flow Statement Analysis

 3.1. Evaluation the sources and Uses of Cash

 3.2. Common-Size Analysis of the Cash Flow
Statement
 3.3. Free cash flow to the Firm and Free cash
flow to Equity
 3.4. Cash flow ratios

www.themegallery.com
3.1. Evaluation of the Source and Uses of Cash

• In evaluating sources and uses of cash, the analyst

should focus to assess the following categories:
Step 1. Evaluate where the major sources and uses
of cash flow are between operating, investing, and
financing activities.
Step 2. Evaluate the primary determinants of operating
cash flow.
Step 3. Evaluate the primary determinants of investing
cash flow.
Step 4. Evaluate the primary determinants of financing
cash flow.
3.1. Evaluation of the Source and Uses of Cash

 Step 1. Evaluate where the major sources and uses of

cash flow are between operating, investing, and
financing activities.
Answer the following questions:
•What are the major sources and uses of cash flow?
•Is operating cash flow positive and sufficient to cover capital
expenditures?
A mature company is expected and desirable that:
•Operating activities are the primary source of cash flow
•Operating cash flow is positive and sufficient to cover capital
expenditures.

www.themegallery.com
Impact of Product Life Cycle on Cash Flows
 Impact of Product Life Cycle on Cash
Flows An example

(in $ millions)
A B C D
Net cash from operating activities (60) 30 120 (10)
Net cash from investing activities (100) 25 30 (40)
Net cash from financing activities 70 (110) (50) 120
Net Income (40) 10 100 (5)
3.1. Evaluation of the Source and Uses of Cash
 Step 2. Evaluate the primary determinants of
operating cash flow.
 What are the major determinants of operating cash
flow?
 Is operating cash flow higher or lower than net
income? Why?
 How consistent are operating cash flow
For a mature company:
 Operating cash flow should be higher than net
income because net income includes non cash
expenses
 If has large income but poor operating cash flow may
indicate poor earning quality.
www.themegallery.com
 Step 3. Evaluate the primary determinants of
investing cash flow.

 Where the cash is being spent (or received)?

 If the company is making major capital
investment, where the cash coming from to
cover these investment?
 If assets are being sold, why? and assess the
effects on the company.

www.themegallery.com
 Step 4. Evaluate the primary determinants of
financing cash flow.

 What are the nature of the company’s capital

sources?
 Whether the company is raising capital or
repaying capital?
 Why capital is being raised or repaid?

www.themegallery.com
 3.2. Common Size analysis

 Two alternative approaches:

 1st Approach: express each line item of cash inflow
(outflow) as percentage of total inflow (or outflow) of
cash
 2nd Approach: express each line item as percentage
of net revenue (net sales)

www.themegallery.com
3.3. Free Cash Flow

Free Cash Flow

 Free cash flow for firm (FCFF)

FCFF = CFO + IDrc + Int(1-t) - FCIvn

 CFO: Cash flow from operating activities
 IDrc: Interest, dividend and return collected
 Int: Interest expense
 t: Tax rate
 FCInv: Capital Expenditure
 Free cash flow for Equity (FCFE)

1st calculation method:

FCFE = CFO + IDrc – FCIvn + Net borrowing (or
– net debt payment)
CFO: Cash flow from operating activities
IDrc: Interest, dividend and return collected
Int: Interest expense
t: Tax rate
FCInv: Capital Expenditure
www.themegallery.com
 Free cash flow for Equity (FCFE)

2st calculation method:

FCFE = FCFF – Int*(1-t) + NB (or –
NDP)

www.themegallery.com
 Specialized Cash Flow Ratios

Cash Flow Adequacy Ratio – Measure of a company’s ability to

generate sufficient cash from operations to cover capital expenditures,
investments in inventories, and cash dividends:
Three-year sum of cash from operations
Three-year sum of expenditures, inventory additions, and cash dividends

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 – Dividends
Gross plant + Investment + Other assets + Working capital
 “ Add your company slogan ”

http://blogcongdong.com

LOGO