Analysis of Cash Flows


Analyzing Cash Flows

Statement of Cash Flows

Statement of Cash Flows

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?


Internal Uses of CFS

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

Preparing a Statement of Cash Flows

Prepared by

• 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

The inflows less the outflows balance to and explain the change in cash.


Four Parts of a Statement of Cash Flows


Operating activities

Investing activities

Financing activities


Four Parts of a Statement of Cash Flows


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.


Classification of Cash Flows

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.

Cash flow from operating activities

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;

In effect, the income statement is changed from accrual basis to cash basis

Investing Activities

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;

Financing Activities

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.

Format of the Cash Flow Statement

Name of the Company

Cash Flow Statement

For the period

Cash from operating activities

Cash from investing activities



Cash from financing activities

Net Change in Cash


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

Determination of Cash Flows From

Operating 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

Comparison of Methods

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.

Only operating activities section is different between the methods, investing and financing sections are the same


How to prepare cash flow statement

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

Algebraic Formulation*

Assets = Liabilities + Shareholders’ Equity or A = L + SHE

Assets are either cash (C) or not (Non-Cash)

Thus reorganizing

C + Non Cash Assets (NCA) = L + SE

 C +  NCA =  L +  SE

Where  means the change in the balance of the item from the previous period.

Solving for change in cash:

 C =  L +  SE  NCA

Based on Stickney and Weil, 10 th ed. Financial Accounting Slides

Algebraic Formulation (Cont.)

 C =  L +  SE  NCA

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.

Indirect Method – cash flow from operations

Adjusting Net Income of the period (accrual) to cash basis income



Increase in non-cash assets shows that cash was spent, so cash outflow.


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

Indirect Method- operating activities-

Adjustments to net income

Net income

+ 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

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


Notes Receivable (from loans to other companies)

Accounts Receivable

Merchandise Inventory

Prepaid Operating Expenses

Interest Receivable


Property,Plant and Equipment-PPE-net

2008 2007






























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




























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














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












Cashflow from investing

Sale of PPE (note will be received in 2009)

Purchase of PPE (44.000)

Loans extended( to other companies) (19.000)

Purchase of land

Cashflow from investing



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)

Effects of a Sale of a Long-Term Assets on Cash Flows

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 nnnn

Accumulated Depreciation nnnn

Asset nnnn

Gain (or loss) on sale nnnn

Sale of an Asset

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.

Steps to prepare CFS – indirect CFO


Start with Net Income


Adjust Net Income for non-cash expenses and gains


Recognize cash inflows (outflows) from changes in current assets and liabilities


Sum to yield net cash flows from operations


Changes in long-term assets yield net cash flows from investing activities


Changes in long-term liabilities and equity accounts yield net cash flows from financing activities


Sum cash flows from operations, investing, and financing activities to yield net change in cash


Add net change in cash to the beginning cash balance to yield ending cash

Comparison of Cash Flow to Net Income

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)?

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

Analysis Implications of Cash Flows

Interpreting Cash Flows and Net Income

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))

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 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

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