CASH FLOW ANALYSIS

Statement of Cash Flows

Relevance of Cash
• Cash is the most liquid of assets.
– Offers both liquidity and flexibility.
– Both the beginning and the end of a company’s
operating cycle.
• Contrast: Accrual accounting and Cash basis
accounting.
– Net cash flow as the end measure of profitability.
– Cash flow analysis helps in assessing liquidity,
solvency, and financial flexibility.
Statement of Cash Flows
Relevance of Cash
• Statement of cash flows (SCF) helps address
questions such as:
 How much cash is generated from or used in operations?
 What expenditures are made with cash from operations?
 How are dividends paid when confronting an operating loss?
 What is the source of cash for debt payments?
 How is the increase in investments financed?
 What is the source of cash for new plant assets?
 Why is cash lower when income increased?
 What is the use of cash received from new financing?
Statement of Cash Flows
Reporting by Activities
• The SCF reports cash receipts and cash payments by
operating, financing, and investing activities:
• Operating activities are the earning-related activities
of a company.

Beyond revenue and expense activities

represented in an income statement, they include
the net inflows and outflows of cash resulting
from related operating activities like extending
credit to customers, investing in inventories, and
obtaining credit from suppliers.
 1

Cash Flows from Investing Activities

• Cash inflows from investing activities

normally arise from selling fixed assets,
investments, and intangible assets.
• Cash outflows from investing activities
normally include payments to purchase
fixed assets, investments, and intangible
assets.
 1

Cash Flows from Financing Activities

• Cash inflows from financing activities

normally arise from issuing debt or equity
securities.
• Cash outflows from financing activities
include paying cash dividends, repaying
debt, and acquiring treasury stock.
Statement of Cash Flows
Reporting by Activities
• Investing activities are means of acquiring and
disposing of noncash assets.
– Involve assets expected to generate income; lending funds and
collecting the principal on these loans.
• Financing activities are means of contributing,
withdrawing, and servicing funds to support business
activities.
– Include borrowing and repaying funds with bonds and other
loans; contributions and withdrawals by owners and their return
on investment.
 Changes in Specific Accounts
increase decrease
If noncash assets If noncash assets
Non- are increased, are decreased,
cash then cash was spent, then they provided cash
Assets so cash is an outflow, so cash is an inflow,
negative sign. positive sign.
If liab. or S.E. If liab. or S.E.
Liabilities increased, then cash decreased, then cash
and was obtained, was spent,
Shareholders’ so cash in an inflow, so cash in an outflow,
Equity positive sign. negative sign.
Algebraic Formulation
Recall the basic accounting equation:
Assets = Liabilities + Shareholders’ Equity
or A = L + SE
Assets are either cash (C) or non cash assets
(N$A), so
C + N$A = L + SE
 C +  N$A =  L +  SE
Where  means the change in the balance,
Rearranging gives the basic equation for the
statement of cash flows:
 C =  L +  SE -  N$A
Algebraic Formulation (Cont.)
C =  L +  SE -  N$A
• The change in cash,  C, is the increase or
decrease in the cash account.
• This amount must equal changes in liabilities
plus changes in shareholders’ equity minus
changes in assets other than cash.
• Thus, we can identify the causes in the
change in the cash account by studying the
changes in non-cash accounts.
Noncash Expenses
• Noncash expenses, such as depreciation expense, are
added back.

• Items that are truly not sources of cash, even though

they are associated with cash inflows; rather, a reversal
of the accrual process that required the expenses to be
recognized without regard for the cash flow.
1

No Cash Flow Per Share

Cash flow per share should not be
reported on a company’s financial
statements for the following reasons:
1. Users may misinterpret cash flow
per share as the per-share amount
available for dividends.
2. Users may misinterpret cash flow
per share as equivalent to earnings
per share.
Statement of Cash Flows
Constructing the Cash Flow Statement
• Indirect Method
– Net income is adjusted for non-cash income
(expense) items and accruals to yield cash flow from
operations
• Direct Method
– Each income item is adjusted for its related accruals

• Both methods yield identical results-only the

presentation format differs.
1

Cash Flows from Operating Activities

The direct method reports operating

cash inflows (receipts) and cash
outflows (payments).
 1

The indirect method reports operating cash

flows by beginning with net income and
adjusting it for revenues and expenses that do
not involve the receipt or payment of cash.
1

The primary advantage of the indirect

method is that it reconciles the difference
between net income and net cash flows from
operations. Also, the indirect method is less
costly to use than the direct method.

Over 99% of companies

use the indirect method.
 1
Cash Flow from Operations: Direct and Indirect Methods

the same
 2
Adjustments to Net Income (Loss) Using the Indirect Method

Step 1

Step 2
Step 3
 2

Cash Flows from Operating Activities—Indirect Method

Step 1
Step 2

Step 3
Statement of Cash Flows
Preparation of the SCF (Indirect method)
• Consider first the net cash from operations.
Statement of Cash Flows
Preparation of the Statement of Cash Flows
• Depreciation and amortization add-back.
Statement of Cash Flows
Income v/s Cash Flows - Example
Consider a $100 sale on account
(1) In period of sale, net income is increased by $100 but no cash
has been generated.
Net Income 100
Depreciation and amortization expense 0
Gains (losses) on sale of assets 0
Change in accounts receivable (100)
Net Cash flow from operations 0

• In period of collection no income is recorded.

Net Income 0
Depreciation and amortization expense 0
Gains (losses) on sale of assets 0
Change in accounts receivable 100
Net Cash flow from operations 100
Statement of Cash Flows
Preparation of the Statement of Cash Flows
• Adjustments for changes in balance sheet
accounts can be summarized as follows:
Statement of Cash Flows
Constructing the Statement

1. The company purchased a truck

during the year at a cost of $30,000
that was financed in full by the
manufacturer.

2. A truck with a cost of $10,000 and a net

book value of $2,000 was sold during
the year for $7,000. There were no
other sales of depreciable assets.

3. Dividends paid during Year 2 are $51,000

Statement of Cash Flows
Steps in Constructing the Statement

(1) Start with Net Income

(2) Adjust Net Income for non-cash expenses and gains

(3) Recognize cash inflows (outflows) from changes in current assets

and liabilities
(4) Sum to yield net cash flows from operations

(5) Changes in long-term assets yield net cash flows from investing
activities
(6) Changes in long-term liabilities and equity accounts yield net cash
flows from financing activities
(7) Sum cash flows from operations, investing, and financing activities to
yield net change in cash
(8) Add net change in cash to the beginning cash balance to yield
ending cash
Statement of Cash Flows
 2
Statement of Comprehensive Income and Comparative
Statement of Financial Position

(continued)
 2
Statement of Comprehensive Income and Comparative Statement
of Financial Position
 2

Statement
of Cash
Flows—
Indirect
Method
Analysing Cash Flow Information
Cash flow analysis can be used to address a variety of
questions regarding a firm's cash flow dynamics:
• How strong is the firm's internal cash flow generation?
• Is the cash flow from operations positive or negative?
• If it is negative, why?
• Is it because the company is growing?
• Is it because its operations are unprofitable?
• Or is it having difficulty managing its working capital properly?
• Does the company have the ability to meet its short-term financial
obligations, such as interest payments, from its operating cash
flow?
• Can it continue to meet these obligations without reducing its
operating flexibility?
Statement of Cash Flows
Special Topics
• Equity Method Investments
– The investor records as income its percentage interest in the
income of the investee company and records dividends
received as a reduction of the investment balance.
– The portion of undistributed earnings is noncash income and
should be eliminated from the SCF.
• Acquisitions of Companies with Stock
– Such acquisitions are non-cash.
– Changes in balance sheet accounts reflecting the acquired
company will not equal cash inflows (outflows) reported in the
SCF.
Statement of Cash Flows
Direct Method
• The direct (or inflow-outflow) method reports gross
cash receipts and cash disbursements related to
operations—essentially adjusting each income
statement item from accrual to cash basis
– Reports total amounts of cash flowing in and out of a company
from operating activities
– Preferred by analysts and creditors
– Implementation costs
– When companies report using the direct method, they must
disclose a reconciliation of net income to cash flows from
operations (the indirect method) in a separate schedule
Statement of Cash Flows
Converting from Indirect to Direct Method
Analysis Implications of Cash Flows

Limitations in Cash Flow Reporting

• Some limitations of the current reporting of cash flow:
– Practice does not require separate disclosure of cash flows
pertaining to either extraordinary items or discontinued
operations.
– Interest and dividends received and interest paid are classified
as operating cash flows.
– Income taxes are classified as operating cash flows.
– Removal of pretax (rather than after-tax) gains or losses on
sale of plant or investments from operating activities distorts
our analysis of both operating and investing activities.
Analysis Implications of Cash Flows

Interpreting Cash Flows and Net Income

Analysis Implications of Cash Flows

Interpreting Cash Flows and Net Income

• An income statement records revenues when earned and
expenses when incurred.
– It does not show the timing of cash inflows and outflows, nor the effect
of operations on liquidity and solvency.
– This information is available in the SCF.
• Cash flows from operations (CFO) is a broader view of operating
activities than is net income.
– It is not a measure of profitability.
• Note: A net measure, be it net income or cash flows from
operations, is of limited usefulness. The key is information about
components of these net measures.
Analysis Implications of Cash Flows

Interpreting Cash Flows and Net Income

• Accounting accruals determining net income rely on
estimates, deferrals, allocations, and valuations.
– Subjectivity
• Note: CFO effectively serve as a check on net income, but
not a substitute for net income.
• CFO exclude elements of revenues and expenses not
currently affecting cash.
– Our analysis of operations and profitability should not proceed
without considering these elements.
Analysis of Cash Flows
• In evaluating sources and uses of cash, the analyst
should focus on questions like:
 Are asset replacements financed from internal or external
funds?
 What are the financing sources of expansion and business
acquisitions?
 Is the company dependent on external financing?
 What are the company’s investing demands and opportunities?
 What are the requirements and types of financing?
 Are managerial policies (such as dividends) highly sensitive to
cash flows?
Analysis of Cash Flows
Inferences from Analysis of Cash Flows
• Inferences from analysis of cash flows include:
– Where management committed its resources
– Where it reduced investments
– Where additional cash was derived from
– Where claims against the company were reduced
– Disposition of earnings and the investment of discretionary
cash flows
– The size, composition, pattern, and stability of operating cash
flows
Analysis of Cash Flows
Alternative Cash Flow Measures
• Net income plus depreciation and amortization
– EBITDA (earnings before interest, taxes,
depreciation, and amortization)
Analysis of Cash Flows
Issues with EBITDA
• The using up of long-term depreciable assets is a real expense
that must not be ignored.
• The add-back of depreciation expense does not generate cash. It
merely zeros out the noncash expense from net income as
discussed above. Cash is provided by operating and financing
activities, not by depreciation.
• Net income plus depreciation ignores changes in working capital
accounts that comprise the remainder of net cash flows from
operating activities. Yet changes in working capital accounts often
comprise a large portion of cash flows from operating activities.
Analysis of Cash Flows
Company and Economic Conditions
• While both successful and unsuccessful companies can
experience problems with cash flows from operations, the
reasons are markedly different.

• We must interpret changes in operating working capital items

in light of economic circumstances.

• Inflationary conditions add to the

financial burdens of companies
and challenges for analysis.
Analysis of Cash Flows
Free Cash Flow

Another definition that is widely used:

FCF = NOPAT - Change in NOA

(net operating profits after tax (NOPAT) less the

increase in net operating assets (NOA))
Components of ROI

Operating and non-operating activities - Distinction

BALANCE SHEET
Operating assets ..................... OA Financial liabilities .................. FL
Less operating liabilities ........ (OL) Less financial assets ............. (FA)
Net financial obligations......... NFO
Stockholders’ equity................ SE

Net operating assets.............. Net financing ................ NFO + SE

NOA
Analysis of Cash Flows
Free Cash Flow
Positive free cash flow reflects the amount available for business
activities after allowances for financing and investing requirements
to maintain productive capacity at current levels.

Growth and financial flexibility depend on adequate free cash flow.

Recognize that the amount of capital expenditures

needed to maintain productive capacity is
generally not disclosed—instead, most use total
capital expenditures, which is disclosed, but can
include outlays for expansion of productive capacity.
Analysis of Cash Flows
Cash Flow as Validators

• The SCF is useful in identifying misleading or erroneous

operating results or expectations.

SCF provides us with important clues on:

Feasibility of financing capital expenditures.
Cash sources in financing expansion.
Dependence on external financing.
Future dividend policies.
Ability in meeting debt service requirements.
Financial flexibility to unanticipated needs/opportunities.
Financial practices of management.
Quality of earnings.
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
CF analysis
• The CF statement is useful for analysing highly leveraged companies as it
concentrates on CFs rather than reported profits.
• For this reasons the CF statement is a key to analysing troubled or
marginal companies.

• When a company is facing financial problems its BS may contain

overstated assets perhaps due to delayed write-offs or failure to reflect the
full extent of its liabilities.
• In this case, the IS may also lose its value to the extent that the company's
operating results are ‘distorted’ by acctg. choices.
CF Analysis
• The CF statement is also useful for assessing the company’s financial
flexibility.

• Financial flexibility refers to a company's capacity to, in the event of a

business downturn, change its cost/funding structure & minimise its cost of
capital to stay competitive.
• Some expenditure such as advertising, R&D which a company may cut without disrupting
operations in the short run are essential to long term competitiveness .
• Cutting these expenditures may show immediate cash savings but the cost to its future
revenue generating capacity is not apparent.
• Similarly, inadequate outlay on repairs & maintenance can adversely affect the ongoing
success of an organisation.
CF & the company business life-cycle
• The typical pattern of cash generation & the usage is invariably linked to
the company's life cycle i.e. whether the company is just starting up, 'taking
off’, growing rapidly, maturity or declining.

• Studying the company's CF & linking this with the particular point in its life
cycle allows the analyst to focus on pertinent areas for investigation.

• For example, if the company is clearly in a declining stage with poor demand for its
products, any upbeat comments about future earnings disseminated by mgmt. should be
treated with caution.
• Companies that are undergoing natural & inevitable transition from rapid to moderate
growth or from moderate growth to contraction trend to understate declining growth
prospects. A careful analysis of the CF statement may reveal any 'window dressing’
techniques that may have been used to mask the underlying conditions facing the
company.
CF & the company business life-cycle
• Start-up
• Revenue growth is typically slow & gradual in the start-up phase resulting in little profit or
oven losses. The company is just organising itself & making known its products to the
market. Start-up companies are strong cash users & require more funds for CAPEXs,
marketing & operational purposes that may be generated from operations. With limited
revenue at this stage the risk is high that the organisation might fail if it is not well-funded.

• Growth-Emerging
• In this phase, sales & profit accelerate rapidly. Companies in this phase have cash
requirements that outstrip their ability to generate them. The cash requirements centre on
aggressively expending productive facilities to meet demand. Companies in this phase are
still financially fragile. Unless a companies can capitalise on economies of scale the more
cost effective producers will drive it out of the market.
• Therefore, the emerging growth company has to grow rapidly to survive, with extensive
marketing efforts & accompanying higher costs. As the company is usually highly dependent
on eternal funding, it is more vulnerable to unexpected turn in business conditions than, an
established growth economy.
 CF & the company business life-cycle
• Growth-established
• Established growth companies are better able to fund their growth internally. Depreciation is
now substantial & with a large potion of the intended or potential market penetrated demand
for new capacity slows. Sales & earnings decelerate as the market nears saturation. Hence,
capital requirement are not as intense though the company may face other issues such as
product obsolescence & challenges in product/service innovation necessary to satisfy
increasingly sophisticated customer demand.
• Maturity
• In this phase, sales opportunities are limited to the replacement of the products sold plus new
sales from population growth. Price competition may increase may increase, as companies
embark on a strategy for market share. Companies in this phase have modest capital
requirements, since demand for their products grow more slowly, requiring only limited
additions to manufacturing capacity.
• Companies at this stage may be cash cows, & the shareholders may be rewarded with good
dividend payouts. However the companies may shift the emphasis of capital spending from
capacity expansion to capacity modernization as a means of improving production efficiency
as well as making acquisitions where industry consolidation may become inevitable.
Tardiness in adopting such strategic responses may be fatal as the company’s business
moves to the decline phase.
• Decline
• Maturity does not automatically lead to decline, but over long periods industries that
do not adapt or are unable to adapt do get swept away by technological changes.
Sharply declining sales & earnings, corporate liquidations or take over activities
characterise industries in a decline phase seeking to reinvent themselves.
•