Statement of Cash Flows
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?
Along side with cash budget CFS is used: To assess liquidity Determine if short-term financing is necessary To determine dividend policy Decide to distribute; or increase or decrease To evaluate the investment and financing decisions
• • • calculating changes in all of the balance sheet accounts, including cash listing the changes in all of the accounts except cash as inflows or outflows categorizing the flows by operating, financing, or investing activities
Cash Operating activities Investing activities Financing activities 4-5
Cash • • • Cash and highly liquid short-term marketable securities Also called cash equivalents If a company separates marketable securities into two accounts (cash and cash equivalents and short-term investments), the short-term investments are classified as investing activities.
Operations -- cash flows related to selling goods and services; that is, the principle business of the firm.
Investing -- cash flows related to the acquisition or sale of noncurrent assets.
Financing -- long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow.
Examples (IAS No.7): cash received from customers through sale of goods or services performed; cash received from non-operating activities such as dividends from investments, interest revenue, commissions, and fees; cash payments to suppliers or employees; cash payments for taxes and other expenses;
Examples of investing activities include: cash payments to acquire property, plant, and equipment (PPE), other tangible or intangible assets, and other long-term assets; and sale of such assets loans extended to other companies; and collection of such loans;
Examples of financing activities are : cash received from issuing share capital; cash proceeds from issuing bonds, loans, notes, mortgages and other short or long-term borrowings; cash repayment of loans and other borrowings; and cash payments to shareholders as dividends.
Name of the Company Cash Flow Statement
For the period …
Cash from operating activities Cash from investing activities A B Cash from financing activities Net Change in Cash C D = (A+B+C) increase or (decrease) + Beginning Cash balance Ending Cash balance CB, from the beginning balance sheet =CB + D should equal to ending cash balance in the ending balance sheet Non-cash Investing and Financing Activities
Direct Method Income Statement items are converted to cash flows individually Indirect Method Net income or loss is adjusted for accruals such as accounts receivable and payable, and for non-cash expenses such as depreciation reconciliation of the accrual based and cash based accounting
Direct method of presentation calculates cash flow from operations by subtracting cash disbursements to supplies, employees, and others from cash receipts from customers.
The indirect method calculates cash flow from operations by adjusting net income for non-cash revenues and expenses.
Most firms present their cash flows using the indirect method.
Firms could prepare their own cash flow statement directly from the cash account.
however, we need two consecutive balance sheets and the income statement that covers the period between the two balance sheets
Assets = Liabilities + Shareholders’ Equity
Thus reorganizing or A = L + SHE Assets are either cash (C) or not (Non-Cash)
C + Non Cash Assets (NCA) = L + SE
Where means the change in the balance of the item from the previous period.
Solving for change in cash:
Based on Stickney and Weil, 10 th ed. Financial Accounting Slides http://www.swlearning.com/accounting/stickney/tenth_edition/stickney.html
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.
Adjusting Net Income of the period (accrual) to cash basis income Assets INCREASE Increase in non-cash assets shows that cash was spent, so cash outflow.
DECREASE Decrease in non-cash assets shows that they provided cash so cash inflow.
Liabilities and Shareholders’ equity Increase in liabilities cash savings; increase in SHE cash received; so cash inflow Decrease in liabilities or SHE shows cash paid; so cash outflow
+ noncash expenses: depreciation, amortization, uncollectible account expense,etc + loss on sale of asset + increases in current liabilities + decreases in current assets - gain on sale of asset - decrease in current liabilities increase in current assets = Cashflow from operating activities
Noncash expenses, such as depreciation expense, are added back – because they were deducted to measure net income but did not require any cash payment in the current period They are not truly sources of cash, even though they are associated with cash inflows but reversal of an accrued expense
Portakal Company Prepare Cash Flow Statement Accounts with Debit Balances
Cash Notes Receivable (from loans to other companies) Accounts Receivable Merchandise Inventory Prepaid Operating Expenses Interest Receivable Land Property,Plant and Equipment-PPE-net
increase (decrease) (1.750) 19.000
300 800 45.000
Accounts with Credit Balances
Accounts Payable Accrued Wages Payable Income Taxes Payable Unearned Revenues Bank Notes Payable - long term Common Stock; TL 15 par value Additional Paid in Capital Retained Earnings 45.000
Portakal Company Income Statement
Sales Revenue Cost of Goods Sold Depreciation Expense Salary and Wages Expense Administrative Expenses Loss on Sale of Equipment Other Operating Expenses Interest Revenue Interest Expense Income Tax Expense Net Income 0
(375.000) (43.000) (125.000) (80.000) (4.000) (5.000) 4.000
(20.000) (28.000) 74.000
The company paid TL 50.000 of Bank Notes and borrowed new bank loan. The company declared and paid cash dividends.
The company sold equipment with a cost of TL 12000 and accumulated depreciation of TL 6000 for TL 2000 receving a note in return to be collected in 2009. The company purchased equipment for TL 46.000; paid TL 44.000 in 2008 and gave a note for Jan. 2009.
The company issued common stock during the year .
Portakal Company Cash Flow Statement
Cashflow from Operating Activities Net Income Add back noncash: Depreciation Expense Loss on Sale of Equipment
adjustments that increase cash: increase in Acct.Payable
Increase in Acc.Wages Payable increase in Income Taxes payable increase in unearned revenued adjustments that decrease cash: increase in Accts Rec.
increase in Merch. Inv.
Increase in Prepaid Expense increase in interest recev.
Cashflow from operations
(13.800) (38.000) (300) (800) (52.900)
Cashflow from investing Sale of PPE (note will be received in 2009) Purchase of PPE Loans extended( to other companies) Purchase of land
Cashflow from investing
(44.000) (19.000) (45.000)
Cashflow from financing Bank Notes Payable - long term Common Stock; TL 15 par value Additional Paid in Capital Payment of Bank loan Payment of Dividends
Cashflow from financing
Net Change in Cash (1.750)
A few transactions complicate the derivation of a cash flow statement from a comparative balance sheet, for example, the sale of a long-term (or fixed) asset.
Recall the journal entry for the sale of an asset: Cash
Gain (or loss) on sale
Each of the four parts of the above journal entry require an adjustment in the cash flow statement.
The first line, cash, adds a line to the investing section.
The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account.
The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts.
The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.
(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
Net income is an accrual based concept and purports to show the long-term.
Cash flows purport to show the short term.
Consider the outlook for both short-term and long-term and consider that each is either good or poor.
A strong growing firm would show both good long-term and good short-term outlooks.
A failing firm would show both poor long-term and poor short term outlooks.
What about a firm with good cash flows (short-term) but poor net income (long-term)?
What about a firm with poor cash flows (short-term) but good net income (long-term)?
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.
Interpreting Cash Flows and Net Income
• 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?
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
Alternative Cash Flow Measures
– EBITDA (earnings before interest, taxes, depreciation, and amortization)
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.
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.
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))
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 disclosed—instead, most use total capital expenditures, which is disclosed, but can include outlays for expansion of productive capacity.
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.
Cash Flow Adequacy Ratio – Measure of a generate sufficient cash from operations to cover capital expenditures, investments in inventories, and cash dividends: company’s ability to 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