INTRODUCTION
TO CASH FLOW
ANALYSIS
Chapter 10
CHAPTER 10 OBJECTIVES
Explain the relationships between operating,
investing, and financing cash flows and
stages in the business life cycle.
 Convert indirect CFOs to direct CFOs.
 Describe the significance of cash received as
a percentage of revenues and paid as
percentage of cost of goods sold to business
operations.

CHAPTER 10 OBJECTIVES
(CONT.)
Discern stability, efficiency, and
inefficiency in an entity’s operating cash
flows and liquidity measures.
 Analyze a company or industry’s CFOs.

THE OBJECTIVE OF CASH
FLOW ANALYSIS
An evaluation of past events and present
conditions so that the amount, timing, and
probability of future cash flows can be
forecast
 Analyst seek to understand

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
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Cash flows into and out of an entity
The primary sources and uses of cash
Relative consistency of cash flows over time
BUSINESS DECISIONS AND
CASH FLOWS
Business success depends on an entity
taking in more cash in its life than it
pays out over time
 Initial cash flows

Provided by debt and equity investors
 Used to acquire productive assets
 Reflect managerial decisions about how to
maximize wealth

BUSINESS DECISIONS AND
CASH FLOWS (CONT.)
The Financial Accounting Standards Board’s
perspective
 Requires that companies disclose a statement
of cash flows
 The cash flow statement should provide
equity investors and creditors with
information to make judgments about the


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
Amount of future cash flows
Timing of future cash flows
Uncertainty of future cash flows
BUSINESS DECISIONS AND
CASH FLOWS (CONT.)
Cash flows and corporate life
 An entity’s life cycle stage affects cash
acquisitions and disbursements
 The life cycle stages are (Exhibit 10-1)

Emergence
 Growth
 Maturity
 Decline

BUSINESS DECISIONS AND
CASH FLOWS (CONT.)
Cash flow relationships to life cycle
stages (Exhibit 10-2)
 Operating activities

Outflows during emergence and early
growth
 Inflows peak during maturity
 Inflows decrease (trending toward zero) in
decline

BUSINESS DECISIONS AND
CASH FLOWS (CONT.)

Financing activities

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
Inflows during emergence and growth
Outflows during late maturity and decline (i.e., the
return of investment)
Investing activities



Outflows during emergence and early growth
Inflows during late maturity
Decreasing cash inflows during business decline
CASH FLOWS FROM
OPERATING ACTIVITIES

The most important part of cash flow
statement
Reports the difference between cash
received and paid for conducting core
business activities
 Less subjective than accrual-based
disclosures
 Analyst must determine the sustainability
of operating cash flows

CASH FLOWS FROM
OPERATING ACTIVITIES
(CONT.)

Direct method
The superior method of reporting
 Reports cash collected from revenues and
cash paid for operating expenses
 Easy for financial statement users to
understand
 Companies do not disclose CFOs on a
direct basis

CASH FLOWS FROM
OPERATING ACTIVITIES
(CONT.)

Indirect method
The inferior method of reporting
 Reconciles net income to operating cash
flows
 Hard for financial statement users to
understand
 Companies disclose CFOs on an indirect
basis

CASH FLOWS FROM
OPERATING ACTIVITIES
(CONT.)

Converting indirect operating cash flows to
direct operating cash flows



Procedure for producing direct CFOs from the
indirect ones reported by companies
An analyst lists each revenue and operating
expense category
Each income statement account is adjusted for
changes in balance sheet accounts (e.g., accounts
receivable changes affect cash collected from
sales)
CASH FLOWS FROM
OPERATING ACTIVITIES
(CONT.)

Converting indirect operating cash flows
to direct operating cash flows (cont.)
Certain operating expense categories are
adjusted for non-cash expenses (e.g.,
deprecation)
 Cash collected from sales minus cash paid
for each expense category determines
direct cash flows

CASH FLOWS FROM
OPERATING ACTIVITIES
(CONT.)

Direct CFOs are more informative than
indirect CFOs
Analyst can directly see how much cash
was received from continual activities in a
reporting period
 Analyst can directly see how much cash
was paid for continual activities in a
reporting period

eSTUFF’S DIRECT CASH
FLOWS
eSTUFF's Direct Cash Flows
Sales revenue
Change in accounts receivable
Cash received from customers
Cost of goods sold
Change in inventory
Change in accounts payable
Cash paid to suppliers
2003
$1,310
15
1,325
2002
$1,240
(35)
1,205
2001
$1,200
(20)
1,180
2000
$1,000
(120)
880
800
65
(30)
835
719
20
(30)
709
660
50
110
820
600
200
(160)
640
eSTUFF’S DIRECT CASH
FLOWS
eSTUFF's Direct Cash Flows
Selling and administrative expenses
Change in prepaid expenses
Change in accrued liabilities
Less: depreciation and amortization
Cash paid for operating expenses
Tax expense
Change in taxes payable
Cash paid for taxes
Financial expense
Change in interest expense
Cash paid for interest
2003
505
(4)
3
(141)
363
2002
462
7
(22)
(125)
322
(6)
6
16
(6)
10
14
5
19
22
(5)
17
20
20
20
10
-
$
20 $
2001
485
(5)
29
(125)
384
20 $
2000
335
10
(50)
(105)
190
20 $
10
eSTUFF’S CFO
RECONCILIATION
eSTUFF's CFO Reconciliation
CFOs--Indirect Method (as reported)
CFOs--Direct Method (as computed)
Cash received from customers
Cash paid:
To suppliers
For operations
For taxes
For interest
Net cash provided by operating act.
2003
2002
2001
2001
$107
$144
($63)
$23
$1,325
$1,205
$1,180
$880
(835)
(363)
(20)
$107
(709)
(322)
(10)
(20)
$144
(820)
(384)
(19)
(20)
($63)
(640)
(190)
(17)
(10)
$23
CASH FLOWS FROM
OPERATING ACTIVITIES
(CONT.)

Drawbacks of direct CFOs
Conversion process takes time
 Judgment is often required in classifying
and adjusting accounts

INTERPRETING CFOs
Analysts judge how well an entity
performs its core business activities
 Cash flows from operating activities
provide numerous insights
 The focal point is operating cycle
activity

Cash collected on sales
 Cash paid for inventory

INTERPRETING CFOs (CONT.)
Operating cycle cash flows are classified
in three categories (Exhibit 10-4)
 Stable operations

Cash collected from customers as a
percentage of sales remains constant over
time
 Cash paid to vendors as a percentage of
cost of goods sold remains constant over
time

INTERPRETING CFOs (CONT.)

Efficient operations


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Cash collected from customers as a percentage of
sales increases over time
Cash paid to vendors as a percentage of cost of
goods sold decreases over time
Inefficient operations


Cash collected from customers as a percentage of
sales decreases over time
Cash paid to vendors as a percentage of cost of
goods increases over time
INTERPRETING CFOs (CONT.)

Operating cash flow and trends
Trend data increases insights about
operating cycle cash flows (Exhibit 10-5)
 Trends are sometimes difficult to deduce
for existing companies

INTERPRETING CFOs (CONT.)

Relationships between operating cycle
cash flow and short-term liquidity
measures (Exhibit 10-6)
Reports the direction of change (increase
or decrease) for
 Inventory activity measures
 Accounts receivable activity measures
 Accounts payable activity measures

INTERPRETING CFOs (CONT.)

Changes in these activity measures can
be applied to
Stable operations
 Efficient operations
 Inefficient operations

INTERPRETING CFOs (CONT.)

Forecasting operating cash flows
Uses operating cash flow history and
trends to predict the future
 Incorporates short-term liquidity analysis
into the assessment
 Knowledge of other areas of analysis (e.g.,
operating performance) assists in cash flow
forecasts

APPLE COMPUTER AND THE
PC INDUSTRY
Company is in its late growth or early
maturity life cycle stage
 Focus of the operating cash flow
analysis is on the cash provided by and
used for making and selling PCs

APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)

Industry cash flows
Industry demonstrated strong operating
cash flows from 1993 to 1998 (Exhibit 107A)
 Industry’s cash flows were less than stable
over time
 Compaq’s poor performance reduced
operating and net cash flows in 1998
(Exhibit 10-7B)

Exhibit 10-7
Composite Cash Flows
1993-1998
(in millions of dollars)
6000
5000
(A) Cash Flow Activites
4000
3000
2000
1000
0
-1000
1993
1994
1995
1996
-2000
-3000
-4000
-5000
CFO
CFI
CFF
1997
1998
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)

Apple Computer’s direct operating cash
flows
Apple’s indirect operating cash flows were
converted to a direct basis to improve
interpretation (Exhibit 10-8)
 The company reported positive CFOs
during the period analyzed

APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)

Cash flows were positive because of
Apple’s
Return to profitability
 Continued reductions of inventory
 Favorable changes in the account balances
of current assets and restructuring costs

APPLE COMPUTER AND THE
PC INDUSTRY(CONT.)

Operating cycle cash flows

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Industry data was analyzed from 1994 to 1998
(Exhibit 10-9)
Dell and Gateway demonstrated stable operating
cash flows during that time period
Apple and Compaq’s collection on sales and
payments to vendors were erratic
Compaq’s paid a higher percentage on its cost of
goods sold than it collected on its sales
Apple collected more than 100% of revenues in
cash (a trend that cannot continue)
Exhibit 10-9b
Cash Received as a Percentage of Revenues
1994-1998
110.00%
100.00%
90.00%
80.00%
1994
1995
Apple
1996
Compaq
1997
Dell
Gateway
1998
Exhibit 10-9c
Cash Paid as a Percentage of Cost of Goods Sold
1994-1998
110%
105%
100%
95%
90%
85%
80%
1994
1995
Apple
1996
Compaq
1997
Dell
Gateway
1998
APPLE COMPUTER AND THE
PC INDUSTRY(CONT.)

Operating cash flow data support the
analysis of short-term liquidity
Dell and Gateway are more liquid than
Apple and Compaq
 Dell’s and Gateway’s operations are more
stable than those of Apple and Compaq
 Apple’s inability to sell computers
profitability results in its lagging the
industry
