Lesson 16 Slides

Lesson 16:
Statement of Cash Flows
Sometimes on a beautiful day, I hike up to the summit of the nearest

mountain, spread a blanket, and bask in the sun. I then open my laptop
and read Walmart’s statement of cash flows.
- Said no one, ever
Today’s Topics
- The 3 types of cash flows
Overview - Direct vs. indirect method
Preparing the - Operating section

- Investing section
Statement of Cash Flows - Financing section
- Free cash flow

Free Cash Flow - Free cash flow to equity
- Free cash flow to the firm
Today’s Topics

- Investing section
- Free cash flow

Overview of the Financial Statements
• You can find a company’s cash balance for a certain point in time
simply by looking at its balance sheet.
• The purpose of the statement of cash flows is to understand why
the cash balance changed over a period of time.
The 3 Sections of the SCF
Cash inflows and outflows from
the core business operations
Cash from Operating Activities (buying and selling inventory or
providing services)

loaning money, investing in or
Cash from Investing Activities selling securities, purchasing
long-lived assets (e.g., equipment)

borrowing money, repaying debt,
Cash from Financing Activities issuing stock, repurchasing stock,
paying dividends
The change in cash from one

period to the next is the sum of
Δ Cash the operating, investing, and
financing cash flows
Operating Cash Flows
• Cash inflows and outflows directly related to earnings
generated by the company’s core business operations
• Here are some examples:
INFLOWS OUTFLOWS
Cash received from Cash paid for
• Selling goods • Inventory
• Performing • Salaries
services • Interest
• Taxes
Investing Cash Flows
• Cash inflows and outflows related to the acquisition or sale of
productive assets (equipment, buildings, investments, etc.)
INFLOWS OUTFLOWS
• Selling PP&E • PP&E
• Selling • Investments
investments
Financing Cash Flows
• Cash inflows and outflows related to external sources of
financing (owners and creditors)
INFLOWS OUTFLOWS
• Borrowing money • Debt repayment
• Issuing stock • Stock buyback
• Dividends
Direct Method vs. Indirect Method
• There are two ways to prepare the SCF
– Direct method
– Indirect method (99% of companies use this method)
• The only difference between the two methods is the way
in which the operating section is organized
This lesson focuses primarily on

the indirect method because that
is the method predominantly used.
Example – Direct Method
Different
for the
OPERATING direct and
SECTION indirect
method
INVESTING
SECTION
Same
regardless
of method
FINANCING
SECTION
Operating Section (Direct vs. Indirect)
H OD
E T
T M
R EC
DI
EMC also reports the statement of cash flows

HOD using the indirect method
E T
T M
EC
D IR
IN
Today’s Topics

- Investing section
- Free cash flow

Preparing the Operating Section
• Here are the steps, per the indirect method:
1. Start with net income You adjust accrual-basis net income to find cash-
basis net income
2. Make adjustments to net income for non-cash revenues/gains

and expenses/losses e.g., you would add depreciation expense
because it reduced accrual-basis net income, but
it has no effect on cash-basis net income
3. Make adjustments to net income for changes

e.g., an increase in current
in accounts assets
receivable means
and current liabilities there was an increase in credit sales that have yet
to be collected. These credit sales increased
accrual-basis net income, but they have no effect
on cash-basis net income (thus, an increase in
accounts receivable would be subtracted)
4. Sum the amounts to find cash flow from operating activities

Apple – Balance Sheet
Vendor non-trade receivables

increased by $1.934b, so you
would subtract $1.934b in the
operating section of the SCF.
Apple – Statement of Cash Flows
Cash balance from
prior year balance
sheet
We subtract the
increase in vendor
non-trade receivables
because they were
included in net
income but don’t
affect cash
Change in cash flow
Cash balance from

current year balance
sheet
Apple – Statement of Cash Flows
e ction
a ting S
r
Ope
e c tion
sting S
Inve
n
Se ctio
a ncing
Fin
37,529
+ (40,419)
+
1,444
(1,446)
Making Adjustments
• We can re-arrange the fundamental accounting equation to show
how changes in non-cash assets (e.g., accounts receivable) and
liabilities affect the company’s cash balance
Assets = Liabilities + Stockholders’ equity
Cash + Non-cash assets = Liabilities + Stockholders’ equity
Cash = Liabilities - Non-cash assets + Stockholder’s equity
ΔCash = Δ Liabilities - Δ Non-cash assets + Δ Stockholders’ equity
– From above, we see that an increase in a liability account (e.g., an increase of

$100 in accounts payable from last year’s balance sheet to this year’s balance
sheet) should be added as an adjustment to net income in arriving at cash flow
from operations
– Conversely, an increase in a non-cash asset (e.g., accounts receivable) should
be subtracted as an adjustment to net income in arriving at cash flow from
operations
Cash Flows from Operations
(indirect method)
Brooklyn Corp – Indirect SCF Example
Change in
Account
7,000
19,000
(11,000)
13,500
(7,500)
10,000
(6,000)
(6,000)
20,000
Indirect Method starts with net income

0
0
3,000
Change in FOUR STEPS
Account 1. Start with net income
2. Adjust for non-cash revenues, gains,
expenses, and losses
3. Adjust net income for changes in current
assets and liabilities
7,000
4. Sum amounts to arrive at operating cash
19,000 flow
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
Operating Activities
10,000 Net Income 3,000
(6,000) Adjustments:
(6,000)
20,000
Net cash flow from operating activities
0
0
3,000
7,000
19,000 flow
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
(6,000)
20,000
0
0
3,000
Brooklyn Corp – Indirect SCF Example What are the non-cash items?
Change in Only non-cash item on

Account the income statement
7,000
19,000
(11,000)
13,500
(7,500)
10,000
(6,000)
(6,000)
20,000
0
0
3,000
7,000
19,000 flow
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
(6,000) Depreciation expense 7,500
20,000
0
0
3,000
Change in 3. Adjust net income for changes in current
Account assets and liabilities
7,000
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
20,000
0
0
3,000
7,000
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
Increase in accounts receivable (19,000)
20,000
0
0
3,000
7,000
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
Decrease in inventory 11,000
20,000
0
0
3,000
7,000
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
Increase in accounts payable 10,000
20,000
0
0
3,000
7,000
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
Decrease in unearned revenue (6,000)
20,000
0
0
3,000
7,000
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
20,000
Decrease in salaries payable (6,000)
0
0
3,000
2. Adjust for non-cash revenues, gains, expenses,
and losses
3. Adjust net income for changes in current assets
and liabilities
7,000
4. Sum amounts to arrive at operating cash flow
19,000
(11,000)
13,500
(7,500)
Brooklyn Corp
2011
10,000 Net Income 3,000
20,000
Net cash flow from operating activities 500
0
0
3,000
Change in Now that you have completed the operating
Account section, you can do the investing section and
financing section
Brooklyn Corp
7,000 Statement of Cash Flows
19,000
(11,000) 2011
Operating Activities:
Net Income 3,000
Adjustments:
13,500 Depreciation expense 7,500
(7,500) Increase in accounts receivable (19,000)
10,000 Net cash flow from operating activities 500
(6,000)
(6,000)
Investing Activities:
Purchase of Equipment (13,500)
Net cash flow used by investing activities (13,500)
Financing Activities:
20,000 Issuance of note 20,000
Net cash flow provided by financing activities 20,000
0
0
3,000
Change in The sum of cash flows from operating activities,
Account investing activities, and financing activities is the
net change in cash that occurred over the period
Brooklyn Corp
7,000
19,000 2011
(11,000) Operating Activities:
Net Income 3,000
Adjustments:
Depreciation expense 7,500
13,500 Increase in accounts receivable (19,000)
(7,500) Decrease in inventory 11,000
Net cash flow from operating activities 500
10,000
(6,000)
(6,000) Investing Activities:
Purchase of Equipment (13,500)
Net cash flow used by investing activities (13,500)
Financing Activities:
Issuance of note 20,000
20,000 Net cash flow provided by financing activities 20,000
Increase in cash 7,000

0
0
3,000
Quiz A
1. Use the comparative balance
sheets and supplemental
information provided below to
prepare a Statement of Cash
Flows (indirect method) for Cat
Café for the year ended
12/31/18.
Quiz B
1. Create a statement of
cash flows (indirect
method) for the year
ended 12/31/18 for the
company Narrative Clip.
– Operating expenses include $33,000 of
depreciation expense and $2,000 of
insurance expense.
– Equipment that cost $41,000 and had
a book value of $36,000 was sold for
$34,000 cash.
– Land was sold at its book value for
cash.
– Common stock ($1 par) was issued for
cash.
– Bonds were redeemed at their book
value for cash.
Today’s Topics

- Investing section
- Free cash flow

Free Cash Flow
• Free cash flow is a non-GAAP metric that
is used to:
– Value a company
– Assess a company’s ability to pay dividends
– Assess a company’s ability to service debt
• Because it is a non-GAAP metric, there are
several ways to calculate free cash flow
3 Ways to Calculate Free Cash Flow
Free cash flow
• The method used by most companies in their 10-K
Free cash flow to equity (FCFE)
• Also known as levered free cash flow
Free cash flow to the firm (FCFF)
• Also known as unlevered free cash flow
Each of these 3 ways for calculating free cash flow has a different purpose.
Free Cash Flow
• Most companies calculate free cash flow in
one of two ways:
free cash flow = operating cash flow – capital expenditures
free cash flow = operating cash flow – capital expenditures – cash dividends
The second way reflects the fact that companies are reluctant to cut dividends.
Thus, cash earmarked for dividends isn’t likely to be available for discretionary spending.
Free Cash Flow to Equity (FCFE)
• Levered free cash flow is used to calculate
the value of a company’s equity
– FCFE represents the amount of cash flow
theoretically available to shareholders
FCFE = operating cash flow – capital expenditures +/– net borrowings
net borrowings is the

cash received from new
debt issuances minus
debt repayments
Free Cash Flow to the Firm (FCFF)
• Unlevered free cash flow is used to calculate a
company’s enterprise value enterprise value is the value of
the company’s debt plus equity
– FCFF is the amount of cash flow theoretically available to
the firm if the company had no debt
EBIT (earnings before interest and taxes)
Less: Tax (EBIT * tax rate)
Equals: EBIAT (earnings before interest but after taxes)
Plus: Depreciation and amortization expense
Less (plus): Increase (decrease) in net working capital
Less: Capital expenditures
Equals: Free cash flow to the firm (FCFF)
FCFF is not affected by interest expense or net borrowings

(because you’re assuming the firm has zero debt).

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Lesson 16:

Statement of Cash Flows

Sometimes on a beautiful day, I hike up to the summit of the nearest

Preparing the - Operating section

- Free cash flow

Preparing the - Operating section

- Free cash flow

Cash inflows and outflows from

Cash inflows and outflows from

The change in cash from one

• Here are some examples:

• Here are some examples:

• Here are some examples:

This lesson focuses primarily on

EMC also reports the statement of cash flows

Preparing the - Operating section

- Free cash flow

2. Make adjustments to net income for non-cash revenues/gains

3. Make adjustments to net income for changes

4. Sum the amounts to find cash flow from operating activities

Vendor non-trade receivables

Change in cash flow

Cash balance from

Assets = Liabilities + Stockholders’ equity

Cash + Non-cash assets = Liabilities + Stockholders’ equity

Cash = Liabilities - Non-cash assets + Stockholder’s equity

ΔCash = Δ Liabilities - Δ Non-cash assets + Δ Stockholders’ equity

– From above, we see that an increase in a liability account (e.g., an increase of

Indirect Method starts with net income

Change in Only non-cash item on

Increase in cash 7,000

Preparing the - Operating section

- Free cash flow

• The method used by most companies in their 10-K

Free cash flow to equity (FCFE)

• Also known as levered free cash flow

Free cash flow to the firm (FCFF)

• Also known as unlevered free cash flow

net borrowings is the

FCFF is not affected by interest expense or net borrowings

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