1 2013, Study Session # 8, Reading # 27 “UNDERSTANDING CASH FLOW STATEMENTS” CFS CFO CFI CFF NI BV = = = = = = Cash Flow Statement Cash Flow from Operations Cash Flow from Investing Cash Flow from Financing Net Income Book Value IS BS FCFE NCC FCFF THE CASH FLOW STATEMENT The CFS reconciles the beginning & ending balances of cash over an accounting period CFO + CFI + CFF = ∆ in cash balance + beginning cash balance = ending cash balance. 27.a = = = = = Income Statement Balance Sheet Free Cash Flow to Equity Noncash Charges Free Cash Flow to the Firm Items on CFS come from two sources I.S. items. ∆ in B.S accounts. Cash Flow Statement Activities CFO CFI Inflows & outflows of cash resulting from transactions that relating to a company’s operating activities that generate revenue. CFF Inflows & outflows resulting from acquisition or disposal of long-term assets & certain investments. Inflows & outflows of cash resulting from transactions affecting firm’s capital structure. Acquisition of debt & equity investment (other than trading securities) & loans to others are (investing). 27.b Noncash investing & financing activities are not reported in CFS. These must be disclosed in either footnotes or supplemental schedules. 27.c Key difference in CFS U.S.GAAP 27.d Dividend paid ⇒ financing. Interest paid ⇒ operating. Interest & dividend received ⇒ operating. All taxes paid ⇒ operating. IFRS Interest & dividend received ⇒ operating or investing. Dividend or interest paid ⇒ operating or financing. Taxes paid ⇒ operating unless specifically identifiable investing or financing transaction. Two CFS methods (direct & indirect), both permitted under IFRS & U.S.GAAP, direct method use is encouraged. Difference is due to presentation of CFO. Methods of Presenting CFS Direct Method Converts an accrual basis I.S into cash basis I.S Indirect Method Net income is converted to CFO by making adjustment for transactions that affect N.I but non cash items, nonoperating items, and for net changes in operating accruals. Direct method provides more information than indirect method. Indirect method focuses on the difference in net income & CFO. Copyright © FinQuiz.com. All rights reserved. 2 2013, Study Session # 8, Reading # 27 27.d Disclosure Requirements U.S.GAAP IFRS Direct method presentation must also disclose adjustments to reconcile N.I to CFO. Payment for interest & taxes can be reported in cash flow statement or in footnotes. Payments for interest & taxes must be disclosed. 27.f CFO Indirect Method Direct Method Cash collected from customers. Cash used in production of goods & services. Cash operating expenses. Cash paid for interest. Cash paid for taxes. Net income. ± G/L resulted from financing or investing CF. + Noncash charges & - Non cash revenue. operating assets (-) while are (+) Operating liability (+) while are (-). CFI Calculated by examining change in gross asset accounts that result from investing activities. Cash paid for new asset = ending gross asset + gross cost of old assets sold – beginning gross assets. Cash from asset sold = B.V of asset ± G/L on sale. CFF 27.g Determined by measuring CF occurring b/w firm & supplier of capital. Net CF from creditors = new borrowings – principal amounts repaid. Cash dividend can be calculated from an analysis of retained earnings. CFO + CFI + CFF = total CF = ∆ in balance sheet cash. Adjust I.S item for its corresponding B.S. account & eliminate noncash & non operating transactions. Illustrative conversion process of frequently used accounts is: Cash collection from customers Revenue + (–) dec (inc) in AR. Cash payment to suppliers COGS + in inventory - in inventory + AP - AP. Other items follow the same principles. Cash operating expense SG&A + in prepaid expense - in prepaid expense. –↑ in other accrued liabilities + ↓ in other accrued liabilities Copyright © FinQuiz.com. All rights reserved. 3 2013, Study Session # 8, Reading # 27 27.h Major sources & uses of cash Sources & uses of cash change as firm moves through its life cycle. Over the long term, successful firms must be able to generate CFO that exceed capital expenditure & provide a return to debt & equity holders. Operating cash flow + CFO can be generated by earning – related activities or non cash working capital (not sustainable). CFO also provides a check of the quality of a firm’s earnings Variability of N.I & CFO should also be considered. Investing cash flow capex, usually indication of growth. Firm may reduce capex or even sell capital assets to save cash. Generating CFO in excess of capex is desirable. Financing cash flow Provide information about debt & equity (using cash to repay debt, reacquire stock or pay dividends). Common-size CFS By expressing each line item as a % of revenue. Alternatively each inflow of cash as a % of total cash inflow & each outflow as % of total outflow. 27.i Free CF ⇒ measure of cash that is available for discretionary purpose (after covering capex). If firms that follow IFRS subtracted dividend paid in calculating CFO, dividends must be added back for FCFF. Free Cash Flow FCFF FCFE Cash available to all investors. FCFF = N.I + NCC + [int(1-tax rate)] – FCInv – WCInv FCFF = CFO + [int × (1- tax rate )] – FCInv Firms that follow IFRS must consider dividend & interest classification. Cash flow available to common equity holders. FCFE = CFO – FCInv + Net borrowings. Copyright © FinQuiz.com. All rights reserved.