Mastering the
Cash Flow Statement & Free
Cash Flow
CFA® Levels I & II
Jonathan.bone@kaplan.co.uk
Financial Reporting and Analysis
LOS 27.a Compare/Classify: CFAI pg 253
Schweser pg 109
Understanding the Cash
Flow Statement
Importance of Cash Flow Statement
Net income from accrual accounting does not tell us
about the sources and uses of cash to meet liabilities
and operating needs
The statement of cash flows has three components
under both IFRS and US GAAP:
Cash provided or used by operating activities
Cash provided or used by investing activities
Cash provided or used in financing activities
CFA LEVEL I 2013
©2012 Kaplan Financial Limited
1
LOS 27.c Contrast: CFAI pg 255
Schweser pg 111
Understanding the Cash
Flow Statement
U.S. GAAP vs. IFRS
U.S. GAAP
(SFAS 95)
Interest received
Interest paid
Dividends received
Dividends paid
Taxes paid
Bank overdraft
CFO
CFO
CFO
CFF
CFO
CFF
IAS GAAP
(IAS 7)
CFO or CFI
CFO or CFF
CFO or CFI
CFO or CFF
CFO or CFI & CFF
*
* Considered part of cash and cash equivalents
LOS 27.d Distinguish/Describe:
CFAI pg 256 Schweser pg 112
Understanding the Cash
Flow Statement
Statement of Cash Flow:
Direct vs. Indirect Method
Direct vs. indirect method refers only to the
calculation of CFO, the value of CFO is the same
for both methods; CFI and CFF are unaffected
CFA LEVEL I 2013
Direct method: Identify actual cash inflows and
outflows; e.g., collections from customers, amount
paid to suppliers
Indirect method: Begin with net income and make
necessary adjustments to get operating cash flow
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LOS 27.e Describe: CFAI pg 266
Schweser pg 114
Understanding the Cash
Flow Statement
Linkages Between Statements
Last year’s
balance sheet
Accounts Receivable ‘T’ Account
Amount B/Fwd
18,000
198,000
Sales
Cash collections
200,000
20,000
This year’s
income statement
218,000
Amount C/Fwd
218,000
This year’s
balance sheet
-5
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Understanding Cash Flow Statements
Cash Inflows and Outflows
General rules regarding increases and
decreases in balance sheet items over time:
Increase Decrease
Assets
outflow
inflow
Liabilities & Equity inflow
outflow
e.g.: An increase in AR or inventory uses cash
An increase in payables generates cash
Adjust net income for these changes
(indirect)
CFA LEVEL I 2013
©2012 Kaplan Financial Limited
3
Understanding the Cash
Flow Statement
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Ecclestone Industries—Example
Ecclestone Industries has the following income
statement for 20X9 and balance sheets for 20X8 and
20X9. You are to construct the statement of cash flows
using the indirect method.
Additional information:
Equipment was purchased for $50,000
Ecclestone has a tax rate of 40%
Understanding the Cash
Flow Statement
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Income Statement for Year to 31 December 20X9
$
Sales revenue
Expenses:
Cost of goods sold
Salaries
Depreciation
Interest
Gain from sale of PPE
Pre-tax income
Provision for taxes
Net income
CFA LEVEL I 2013
$
200,000
80,000
10,000
14,000
1,000
105,000
95,000
20,000
115,000
40,000
75,000
©2012 Kaplan Financial Limited
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LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Understanding the Cash
Flow Statement
Ecclestone Balance Sheet Data
Balance Sheets
20X9
$
Current assets
Cash
Accounts receivable
Inventory
Non-current assets
Gross PPE
Accum. Depr.
18,000
18,000
14,000
66,000
20,000
10,000
282,000
(80,000)
312,000
(84,000)
Total Assets
252,000
324,000
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Balance Sheets
CFA LEVEL I 2013
20X8
$
Understanding the Cash
Flow Statement
20X8
$
20X9
$
10,000
16,000
6,000
8,000
2,000
18,000
9,000
7,000
10,000
12,000
Current liabilities
Accounts payable
Salaries payable
Interest payable
Taxes payable
Dividends payable
Noncurrent liabilities
Bonds
Deferred taxes
Stockholders’ equity
Common stock
Retained earnings
20,000
30,000
30,000
40,000
100,000
60,000
80,000
118,000
Total Liabilities & Equity
252,000
324,000
©2012 Kaplan Financial Limited
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LOS 27.g Convert: CFAI pg 302
Schweser pg 120
Understanding the Cash
Flow Statement
Direct Method CFO
1. Take each income statement item in turn
– e.g., sales
2. Move to the balance sheet and identify asset
and liability accounts that relate to that income
statement item—e.g., accounts receivable
3. Calculate the change in the balance sheet item
during the period (ending balance – opening
balance)
Increases in an asset: deduct
4. Apply the rule:
Increase in a liability: add
Decrease in an asset: add
Decrease in a liability: deduct
LOS 27.g Convert: CFAI pg 302
Schweser pg 120
Understanding the Cash
Flow Statement
Direct Method CFO
5. Adjust the income statement amount by the
change in the balance sheet
6. Tick off the items dealt with in both the income
statement and balance sheet
7. Move to the next item on the income statement
and repeat
8. Ignore depreciation/amortization and gains/losses
on the disposal of assets as these are non-cash
or non-CFO items
CFA LEVEL I 2013
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LOS 27.g Convert: CFAI pg 302
Schweser pg 120
Understanding the Cash
Flow Statement
Direct Method CFO
9. Keep moving down the income statement
until all items included in net income have
been addressed applying steps 1-8
10. Total up the amounts and you have CFO
LOS 27.g Convert: CFAI pg 302
Schweser pg 120
Understanding the Cash
Flow Statement
Direct Method CFO
Cash Inflows
Sales
Less: Increase in A/R
Cash collected from customers
200,000
(2,000)
Direct cash outflows
Cost of goods sold
Add: Decrease in inventory
Purchases
Add: Increase in A/P
Cash paid to suppliers
(80,000)
4,000
(76,000)
8,000
Operating expense (wages)
Less: Decrease in salaries payable
Cash paid to employees
198,000
(68,000)
(10,000)
(7,000)
(17,000)
-8
CFA LEVEL I 2013
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Understanding the Cash
Flow Statement
LOS 27.g Convert: CFAI pg 302
Schweser pg 120
Direct Method, cont.
$
Cash outflows
Interest Expense
Add: Increase in interest payable
Cash interest paid
(1,000)
1,000
Tax Expense
(40,000)
Add: Increase in deferred tax liab. 10,000
Tax payable
(30,000)
Add: Increase in taxes payable
2,000
Cash taxes paid
CFO
$
0
(28,000)
85,000
-7
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Understanding the Cash
Flow Statement
Indirect Method CFO
CFO = NI + NCC - WCinv
+ Depreciation
+ Amortisation
+ Loss on asset disposal
- Gain on asset disposal
+ Loss on early debt retirement
- Gain on early debt retirement
+ Increase in DTL, decrease in DTA
- Decrease in DTL, increase in DTA
+ Non cash expenses (provisions)
CFA LEVEL I 2013
∆Current assets
excluding cash and
investments
∆ Current liabilities
excluding debt
instruments and
dividends payable
= change in non-cash
working capital
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LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Understanding the Cash
Flow Statement
Indirect Method CFO (Alternative)
75,000 + 4,000 + 6,000 = 85,000
CFO = NI + NCC - WCinv
20x8
20x9
$
$
50,000 96,000
(18,000) (66,000)
32,000 30,000
$
14,000 Current assets
+
- Disposal gain (20,000) -Cash & Inv’
10,000
+ ↑ DTL
4,000
NCC
Current liabilities 42,000 56,000
-Debt & divs’
(2,000) (12,000)
40,000 44,000
Working Capital (8,000) (14,000)
∆ WC = (6,000)
Depn
-6
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Understanding the Cash
Flow Statement
Calculating CFI
CFI =
investment in assets – cash received on asset sales
Net book value =
Gross PPE – accumulated depreciation
Gain (loss) on sale = sales price – net book value
CFA LEVEL I 2013
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Understanding the Cash
Flow Statement
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Ecclestone CFI
Calculating NBV of asset sold
Gross Plant and Equip.
Beginning PPE
Accumulated Depr.
282,000 Begin Acc. Depr.
80,000
50,000 Depr. Expense
14,000
PPE disposal
(20,000) AD for disposal
(10,000)
Ending PPE
312,000 End Acc. Depr.
84,000
Additions
NBV of disposal = 20,000 – 10,000 = 10,000
-5
Understanding the Cash
Flow Statement
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Ecclestone CFI
CFI = cash additions – cash received on disposal
$
Sale Proceeds
30,000
NBV of disposal
10,000
Gain(loss) on sale 20,000
CFI = –additions + proceeds
CFI = –$50,000 + $30,000 = –$20,000
-2
CFA LEVEL I 2013
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Understanding the Cash
Flow Statement
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Computing CFF
Change in debt
Change in common stock
Cash dividends paid
$
Net income
Dividends declared
$
X
Dividends declared
(X)
(X)
∆Dividends payable
X
∆ in retained earnings X
Cash paid
(X)
Understanding the Cash
Flow Statement
LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Ecclestone CFF
Change in debt
Change in common stock
Cash dividends paid
$
Net income
Div declared
∆ in R/E
75,000
$
10,000
(20,000)
(7,000)
(17,000)
Dividends decl.
(17,000) ∆ Div. payable
58,000
Cash div. paid
$
(17,000)
10,000
(7,000)
-7
CFA LEVEL I 2013
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LOS 27.f Describe: CFAI pg 267
Schweser pg 115
Understanding the Cash
Flow Statement
Putting the Cash Flow Statement
Together
Cash flow from operations
Cash flow from investments
Cash flow from financing
Net increase in cash
Cash balance 12/31/X8
Cash balance 12/31/X9
$
85,000
(20,000)
(17,000)
48,000
18,000
66,000
-6
LOS 27.i Calculate/Interpret: CFAI pg 287
Schweser pg 126
Understanding the Cash
Flow Statement
Free Cash Flow (FCF)
CFA LEVEL I 2013
FCF is cash available for discretionary uses
Frequently used to value firms
FCFF = NI + NCC - WCInv + Int (1-T) – FCInv
FCFF = CFO + Int (1-T) – FCInv
FCFE = CFO – FCInv + Net debt increase
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LOS 27.i Calculate/Interpret: CFAI pg 287
Schweser pg 126
Understanding the Cash
Flow Statement
Free Cash Flow (FCF) Ecclestone
FCFF = CFO + Int (1 – T) – FCInv
$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000
FCFE = CFO – FCInv + Net debt increase
$75,000 = $85,000 – $20,000 + $10,000
FCFE = FCFF – Int (1 – T) + Net debt increase
$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000
-5
Solutions
Financial Reporting and Analysis
CFA LEVEL I 2013
©2012 Kaplan Financial Limited
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Direct CFO
Cash Inflows
Sales
Less: Increase in A/R
Cash collected from customers
200,000
(2,000)
Direct cash outflows
Cost of goods sold
Add: Decrease in inventory
Purchases
Add: Increase in A/P
Cash paid to suppliers
(80,000)
4,000
(76,000)
8,000
Operating expense (wages)
Less: Decrease in salaries payable
Cash paid to employees
198,000
(68,000)
(10,000)
(7,000)
(17,000)
Direct CFO, cont.
$
Cash outflows
(1,000)
Interest Expense
Add: Increase in interest payable 1,000
Cash interest paid
Tax Expense
(40,000)
Add: Increase in deferred tax liab. 10,000
Tax payable
(30,000)
Add: Increase in taxes payable
2,000
Cash taxes paid
CFO
CFA LEVEL I 2013
©2012 Kaplan Financial Limited
$
0
(28,000)
85,000
14
Understanding the Cash
Flow Statement
Indirect Method CFO
75,000 + 4,000 + 6,000 = 85,000
CFO = NI + NCC - WCinv
20x8
20x9
$
$
50,000 96,000
(18,000) (66,000)
32,000 30,000
$
14,000 Current assets
+
- Disposal gain (20,000) -Cash & Inv’
10,000
- ↑ DTL
4,000
NCC
Current liabilities 42,000 56,000
-Debt & divs’
(2,000) (12,000)
40,000 44,000
Working Capital (8,000) (14,000)
∆ WC = (6,000)
Depn
-6
Ecclestone CFI
Calculating NBV of asset sold
Gross Plant and Equip.
Beginning PPE
Accumulated Depr.
282,000 Begin Acc. Depr.
80,000
50,000 Depr. Expense
14,000
PPE disposal
(20,000) AD for disposal
(10,000)
Ending PPE
312,000 End Acc. Depr.
84,000
Additions
NBV of disposal = 20,000 – 10,000 = 10,000
CFA LEVEL I 2013
©2012 Kaplan Financial Limited
15
Ecclestone CFI
CFI = cash additions – cash received on disposal
$
Sale Proceeds
30,000
NBV of disposal
10,000
Gain(loss) on sale 20,000
CFI = –additions + proceeds
CFI = –$50,000 + $30,000 = –$20,000
Ecclestone CFF
Change in debt
Change in common stock
Cash dividends paid
$
Net income
Div declared
∆ in R/E
CFA LEVEL I 2013
75,000
$
10,000
(20,000)
(7,000)
(17,000)
Dividends decl.
(17,000) ∆ Div. payable
58,000
Cash div. paid
©2012 Kaplan Financial Limited
$
(17,000)
10,000
(7,000)
16
Putting the Cash Flow Statement
Together
Cash flow from operations
Cash flow from investments
Cash flow from financing
Net increase in cash
Cash balance 12/31/X8
Cash balance 12/31/X9
$
85,000
(20,000)
(17,000)
48,000
18,000
66,000
Free Cash Flow (FCF) Ecclestone
FCFF = CFO + Int (1 – T) – FCInv
$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000
FCFE = CFO – FCInv + Net debt increase
$75,000 = $85,000 – $20,000 + $10,000
FCFE = FCFF – Int (1 – T) + Net debt increase
$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000
CFA LEVEL I 2013
©2012 Kaplan Financial Limited
17