CHAPTER 6
UNDERSTANDING CASH FLOW STATEMENTS
Presenter’s name
Presenter’s title
dd Month yyyy
OVERVIEW
• Statement of Cash Flows: Overview
• Format of Statement of Cash Flows
• Preparing a Statement of Cash Flows
• Additional Analytical Considerations
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APPLE, Inc.
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CLASSIFICATION OF ACTIVITIES ON THE
STATEMENT OF CASH FLOWS
Operating activities: Deliver or produce goods for sale and provide
services. Examples:
• Receive cash from customers
• Pay cash to suppliers
• Pay cash for operating expenses.
Investing activities: Buy or sell long-term assets and other investments.
Examples:
• Property, plant, and equipment (PP&E)
• Other companies’ securities (that are not cash equivalents)
Financing activities: Obtain or repay capital. Examples:
• Borrow from creditors and repay the principal
• Issue or repurchase stock
• Pay dividends
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COLGATE: CASH FLOWS CLASSIFIED BY
ACTIVITY
2011
Net cash provided by operations
2010
2009
2,896
3,211
3,277
Net cash used in investing activities
(1,213)
(658)
(841)
Net cash used in financing activities
Effect of exchange rate changes
Net (decrease) increase in cash and cash
equivalents
(1,242)
(53)
(2,624)
(39)
(2,270)
(121)
388
(110)
45
490
$878
600
$490
555
$600
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
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COLGATE’S OPERATING CASH FLOWS
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COLGATE’S INVESTING CASH FLOWS
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COLGATE’S FINANCING CASH FLOWS
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COMMON-SIZE STATEMENT OF CASH FLOW
FOR COLGATE (ABBREVIATED)
Each line item is presented as a percentage of net
revenue.
2011
Operating Activities
Net income including noncontrolling interests
Net cash provided by operations
Net cash used in investing activities
Net cash used in financing activities
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2010
2009
15.3% 14.9% 15.6%
17.3% 20.6% 21.4%
–7.2% –4.2% –5.5%
–7.4% –16.9% –14.8%
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COLGATE’S CASH FLOWS: SUMMARY
• Overall, $323 million net increase in cash over three years, from $555
million at the beginning of 2009 to $878 million at the end of 2011.
• Colgate consistently obtains its cash inflow from operating activities
and uses cash in investing and financing activities—a typical profile for
a mature company.
• Colgate’s operating cash flow exceeded net income in every year—a
desirable profile for a mature company.
• In every year, Colgate’s cash from operations was more than enough
to cover its capital expenditures.
• The amount of dividends paid has steadily increased over the past
three years.
• Amount of operating cash after paying for capital expenditures was
more than enough to cover the dividend payments.
• In summary, Colgate’s cash flows represent a positive profile.
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COLGATE’S OPERATING CASH FLOWS:
INDIRECT METHOD
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INDIRECT VS. DIRECT METHOD FOR
PRESENTING OPERATING CASH FLOWS
Indirect method
• Begins with net income and
adjusts to operating cash flows.
• Arguments for:
- Clearly shows the reasons for
differences between net
income and operating cash
flows.
- Mirrors forecasting approach
that begins with forecast of
income, then derives cash
flows.
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Direct method
• Shows each cash inflow and
outflow related to receipts and
disbursements.
• Arguments for:
- Provides information on the
specific sources of operating
cash receipts and payments.
- Does not net.
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INDIRECT VS. DIRECT METHOD FOR
PRESENTING OPERATING CASH FLOWS
Indirect method
• IFRS permit.
• U.S. GAAP permit.
• Used by the majority of
companies, whether
reporting under IFRS or
U.S. GAAP.
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Direct method
• IFRS encourage.
• U.S. GAAP encourage, but
requires a reconciliation of
net income to cash flow from
operating activities.
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TECH DATA’S OPERATING CASH FLOWS:
EXAMPLE OF DIRECT METHOD
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CLASSIFICATION OF CASH FLOWS UNDER
IFRS VS. U.S. GAAP
Item
 Interest received
 Interest paid
 Dividends received
 Dividends paid
IFRS
Operating or investing
Operating or financing
Operating or investing
Operating or financing
 Bank overdrafts
Considered part of cash Not considered part
equivalents
of cash and cash
equivalents;
classified as
financing.
Generally operating, but Operating
a portion can be
allocated to investing or
financing
 Taxes paid
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U.S. GAAP
Operating
Operating
Operating
Financing
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PORTUGAL TELECOM’S OPERATING CASH FLOWS:
ANOTHER EXAMPLE OF DIRECT METHOD
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PORTUGAL TELECOM’S INVESTING
CASH FLOWS
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PORTUGAL TELECOM’S FINANCING
CASH FLOWS
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NONCASH INVESTING AND
FINANCING ACTIVITIES
• Noncash transaction: Any transaction that does not
involve an inflow or outflow of cash (e.g., exchange of one
no-monetary asset for another).
• Not incorporated in the cash flow statement.
• Must be disclosed.
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Cash at beginning
and end of year
links to the balance
sheet.
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Cash at beginning and end of year links to the
balance sheet.
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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.
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EXAMPLE
A new 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.
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STEP 1. DETERMINE THE CHANGE IN CASH
This step is straightforward. The information is on the
comparative balance sheets. Change was $115.
Cash
Accounts receivable
Building
Accumulated depreciation
Total assets
Accounts payable
Common stock
Retained earnings
Total liabilities and equity
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Beginning Ending
balance
balance Change
0
115
115
0
10
10
0
50
50
0
(10)
(10)
0
165
165
0
15
15
0
100
100
0
50
50
0
165
165
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STEP 2. DETERMINE THE NET CASH FLOW FROM
OPERATING ACTIVITIES, BEGINNING WITH NET
INCOME FOR THE INDIRECT METHOD
Income statement
Credit sales
SG&A expense
Depreciation expense
Net income
Net income
+ Depreciation expense
– Change in receivables
+ Change in payables
Cash from operating activities
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$ 100
–40
–10
$ 50
$ 50
+10
–10
+15
$ 65
Noncash expense
Only collected $90
Only paid $25
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STEP 3. DETERMINE NET CASH FLOWS FROM
INVESTING AND FINANCING ACTIVITIES
Examine all other changes in the balance sheet accounts.
Beginning Ending
balance balance Change
Cash
0
115
115  In first step
Accounts receivable
0
10
10  In operating
Building
0
50
50
?
Accumulated depreciation
0
(10)
(10)In operating
Total assets
0
165
165
Accounts payable
0
15
15  In operating
Common stock
0
100
100
?
Retained earnings
0
50
50  In operating*
Total liabilities
0
165
165
*There are no dividends in this example; all changes in retained earnings are from
net income
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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.
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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.
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STEP 3. DETERMINE NET CASH FLOWS FROM
INVESTING AND FINANCING ACTIVITIES
Examine all other changes in the balance sheet accounts.
Beginning Ending
balance balance Change
Cash
0
115
115  In first step
Accounts receivable
0
10
10  In operating
Building
0
50
50  In investing
Accumulated depreciation
0
(10)
(10)In operating
Total assets
0
165
165
Accounts payable
0
15
15  In operating
Common stock
0
100
100  In financing
Retained earnings
0
50
50  In operating*
Total liabilities
0
165
165
*There are no dividends in this example, so all change was net
income.
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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
50
+ 10
– 10
+ 15
+ 65
Investing cash flow
Capital expenditure
– 50
Financing cash flow
Issue of stock
+ 100
Total change in cash
Beginning cash balance
Ending cash balance
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+ 115
0
115
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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
$ 100
–40
–10
$ 50
Cash from customers
$ 90
Cash paid for expenses
Cash from operating activities
–25
$ 65
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Credit sales ($100) minus
Change in receivables ($10)
SG&A expenses ($40) minus
increase in payables ($15)
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DIRECT METHOD
Company ABC
Cash Flow Statement for the period ended
Cash collected from customers
Cash paid to suppliers
Total operating cash flow
+ 90
– 25
+ 65
Investing cash flow
Capital expenditure
– 50
Financing cash flow
Issue of stock
+ 100
Total change in cash
Beginning cash balance
+ 115
0
Ending cash balance
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115
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FREE CASH FLOW
Free Cash Flow to the Firm (FCFF): Cash flow available to the
company’s suppliers of capital (debt and equity).
- After all operating expenses (including taxes) have been paid.
- After all operating investments have been made for fixed capital and
working capital.
Free Cash Flow to Equity (FCFE): Cash flow available to the
company’s common stockholders.
- After all operating expenses (including taxes) have been paid.
- After borrowing costs (principal and interest) have been paid.
- After all operating investments have been made for fixed capital and
working capital.
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COMPUTE FCFF
Net Income
+ Noncash charges
– Working capital investment
+ Interest expense × (1 – Tax rate)
– Fixed capital investments
Interest, a cash
flow available to
one of the capital
providers, which
has been
deducted from
net income, so it
must be added
back
= FCFF
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FCFF CAN ALSO BE COMPUTED FROM CASH
FLOW FROM OPERATING ACTIVITIES
Net income
+ Noncash charges
– Working capital investment
= Cash from operating activities
CFO already has
added noncash
items to net
income and
deducted working
capital
investment
+ Interest Expense × (1 – Tax rate)
– Fixed capital investments
= FCFF
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COMPUTE FCFE
Net Income
+ Noncash charges
– Working capital investment
– Fixed capital investment
+ Net new borrowing (or minus net debt repayments)
= FCFE
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Positive FCFE means that the
company has an excess of
operating cash flow over amounts
needed for capital expenditures and
repayment of debt.
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CASH FLOW PERFORMANCE RATIOS
Ratio
Cash flow to
revenue
Cash return on
assets
Cash return on
equity
Cash to income
Cash flow per
share
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Calculation
CFO ÷ Net revenue
What It Measures
Operating cash generated
per dollar of revenue
CFO ÷ Average total assets Operating cash generated
per dollar of asset
investment
CFO ÷ Average
Operating cash generated
shareholders’ equity
per dollar of owner
investment
CFO ÷ Operating income
Cash generating ability of
operations
(CFO – Preferred dividends) Operating cash flow on a
÷ Number of common shares per-share basis
outstanding
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CASH FLOW COVERAGE RATIOS
Ratio
Debt coverage
Calculation
CFO ÷ Total debt
Interest coverage (CFO + Interest paid +
Taxes paid) ÷ Interest paid
Reinvestment
CFO ÷ Cash paid for longterm assets
Debt payment
CFO ÷ Cash paid for longterm debt repayment
CFO ÷ Dividends paid
Dividend
payment
Investing and
CFO ÷ Cash outflows for
financing
investing and financing
activities
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What It Measures
Financial risk and financial
leverage
Ability to meet interest
obligations
Ability to acquire assets
with operating cash flows
Ability to pay debts with
operating cash flows
Ability to pay dividends
with operating cash flows
Ability to acquire assets,
pay debts, and make
distributions to owners
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SUMMARY
• The cash flow statement provides information about a company’s cash
receipts and cash payments during an accounting period.
• Cash flows are categorized as operating, investing, and financing.
• Compared with U.S. GAAP, IFRS provide companies with more
choices in classifying some cash flow items as operating, investing, or
financing activities.
• The operating activities section of the statement of cash flows can be
presented using the direct method or the indirect method.
• Two approaches to developing common-size cash flow statements are
the total cash inflows/total cash outflows method and the percentage of
net revenues method.
• Cash flow ratios measure a company’s profitability, performance, and
financial strength.
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