Mastering the Cash Flow Statement CFA Levels I & II Lecture...Mastering the Cash Flow Statement CFA ® Levels I & II Importance of Cash Flow Statement Net income from accrual accounting

CFA LEVEL I & II 2012 © Kaplan Financial Limited

Financial Reporting and Analysis

Mastering the Cash Flow Statement

CFA® Levels I & II

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

LOS 27.a Compare/Classify: CFAI pg 273 Schweser pg 108

Understanding the Cash Flow Statement


Operating Cash Flows (CFO)

Cash received from customers

Cash dividends received

Cash interest received

Other cash income

Payments to suppliers

Cash expenses (wages etc)

Cash interest paid

Cash taxes paid

CFO

$

X

X

X

X

(X)

(X)

(X)

(X)

X/(X)



Investing Cash Flows (CFI)

� Purchases of property, plant, and equipment

� Proceeds from sales of assets

� Investments in joint ventures and affiliates

� Payments for businesses acquired

� Purchases and sales of intangibles

� Purchases or sales of marketable securities

Excludes:

� Trading securities (part of CFO)

� Cash equivalents (part of B/S cash)




Financing Cash Flows

Issue and redemption of:

� Common stock

� Preferred stock

� Treasury stock repurchases

� Debt

� Dividend payments (dividends rec’d CFO—U.S. GAAP)

Excludes:

� Indirect financing via accounts payable (CFO)



Non-Cash Investing and Financing Activities

Several types of transactions do not involve the payment or receipt of cash and are not reflected in financing and investing cash flows, but are disclosed in the footnotes or other schedules

Non-cash financing and investing activities:

� Converting debt or preferred into common equity

� Assets acquired under capital leases

� Purchase of assets via issuance of debt/equity

� Exchanging one non-cash asset for another

� Stock dividends

LOS 27.b Describe: CFAI pg 275 Schweser pg 110



U.S. GAAP vs. IFRS

Interest received

Interest paid

Dividends received

Dividends paid

Taxes paid

Bank overdraft

CFO

CFO

CFO

CFF

CFO

CFF

CFO or CFI

CFO or CFF

CFO or CFI

CFO or CFF

CFO or CFI & CFF

*

U.S. GAAP

(SFAS 95)

IAS GAAP

(IAS 7)

* Considered part of cash and cash equivalents

LOS 27.c Contrast: CFAI pg275 Schweser pg 110


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

� 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

LOS 27.d Demonstrate/Explain: CFAI pg 277 Schweser pg 111



Linkages Between Statements

Accounts Receivable ‘T’ Account

Amount B/Fwd

Sales

Amount C/Fwd

18,000

20,000

200,000

218,000 218,000

Cash collections198,000

This year’s balance sheet

Last year’s balance sheet

This year’s income statement

LOS 27.e Describe: CFAI pg 287 Schweser pg 113

- 5


Direct Method CFO1. 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)

4. Apply the rule:Increases in an asset: deduct Increase in a liability: addDecrease in an asset: addDecrease in a liability: deduct

LOS 27.g Convert: CFAI pg 302 Schweser pg 120



Direct 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



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

Direct CFO




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 $50,000Ecclestone has a tax rate of 40%

LOS 27.f Describe: CFAI pg 289 Schweser pg 114


Income Statement for Year to 31 December 20X9

Sales revenueExpenses:

Cost of goods soldSalariesDepreciationInterest

Gain from sale of PPEPre-tax incomeProvision for taxesNet income

$ 200,000

105,00095,00020,000

115,00040,00075,000

$

80,00010,00014,0001,000




Ecclestone Balance Sheet DataBalance Sheets

Current assetsCashAccounts receivableInventory

Non-current assetsGross PPEAccum. Depr.

Total Assets

20X8$

18,00018,00014,000

282,000

252,000

20X9$

66,00020,00010,000

312,000

324,000

(80,000) (84,000)



Balance Sheets

Current liabilitiesAccounts payableSalaries payableInterest payableTaxes payableDividends payable

Noncurrent liabilitiesBondsDeferred taxes

Stockholders’ equityCommon stockRetained earnings

Total Liabilities & Equity

20X8$

10,00016,0006,0008,0002,000

20,00030,000

100,00060,000

252,000

20X9$

18,0009,0007,000

10,00012,000

30,00040,000

80,000118,000

324,000




Cash InflowsSalesLess: Increase in A/RCash collected from customers

Direct cash outflowsCost of goods soldAdd: Decrease in inventoryPurchasesAdd: Increase in A/PCash paid to suppliers

Operating expense (wages)Less: Decrease in salaries payableCash paid to employees

200,000(2,000)

(80,000)4,000(76,000)8,000

198,000

(68,000)

(10,000)(7,000)

(17,000)

Direct CFO

-8



(28,000)

(40,000)10,000

2,000

(1,000)1,000

Direct cont.

Cash outflowsInterest ExpenseAdd: Increase in interest payable

Cash interest paid

Tax ExpenseAdd: Increase in deferred tax liab.Tax payableAdd: Increase in taxes payable

Cash taxes paid

$ $

CFO

0

85,000

(30,000)

-7




Indirect Method CFOSteps

1. Start with net income

2. Adjust net income for changes in relevant balance sheet items:

Increases in an asset: deduct Increase in a liability: addDecrease in an asset: addDecrease in a liability: deduct



Indirect method continued

3. Eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at net income but are non-cash expenses)

4. Eliminate gains on disposal by deducting them and losses on disposal by adding them back (these are CFI, not CFO)




Net income 75,000Non Cash ChargesAdd: Depreciation 14,000Less: Gain from sale of PPE (20,000)Add: Increase in deferred taxes 10,000

Current asset adjustmentsLess: Increase in accounts receivable (2,000)Add: Decrease in inventory 4,000

Current liability adjustmentsAdd: Increase in accounts payable 8,000Less: Decrease in salaries payable (7,000)Add: Increase in interest payable 1,000Add: Increase in taxes payable 2,000

$

Cash flow from operations 85,000

Ind

irect

Meth

od

So

luti

on

-10



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




Ecclestone CFI

Gross Plant and Equip.

Beginning PPE

Additions

PPE disposal

Ending PPE

282,000

50,000

(20,000)

312,000

Accumulated Depr.

Begin Acc. Depr.

Depr. Expense

AD for disposal

End Acc. Depr.

80,000

14,000

(10,000)

84,000

Calculating NBV of asset sold

NBV of disposal = 20,000 – 10,000 = 10,000

-5



CFI = cash additions – cash received on disposal

Sale Proceeds

NBV of disposal

Gain(loss) on sale

30,000

10,000

20,000

$

CFI = –additions + proceeds

CFI = –$50,000 + $30,000 = –$20,000

Ecclestone CFI

-2




Computing CFF

� Change in debt

� Change in common stock

� Cash dividends paid

Net income

Dividends declared

∆ in retained earnings

$

X

(X)

X

Dividends declared

∆Dividends payable

Cash paid

$

(X)

X

(X)



� Change in debt



Net income

Div declared

∆ in R/E

$

75,000

(17,000)

58,000

Dividends decl.

∆ Div. payable

Cash div. paid

$

(17,000)

10,000

(7,000)

Ecclestone CFF$

10,000

(20,000)

(7,000)

(17,000)

-7




$

85,000

(20,000)

(17,000)

48,000

18,000

66,000

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


-6



Cash Flow Statement Analysis

Do regular operations generate enough cash to sustain the business?

Is enough cash is generated to pay off maturing debt?

Highlights the need for additional finance

Ability to meet unexpected obligations

The flexibility to take advantage of new business opportunities

Benefits for the analyst

LOS 27.h Analyze/Interpret: CFAI pg 303 Scweser pg 123



Analysis

1. Analyze the major sources and uses of cash flow (CFO, CFI, CFF)

� Where are the major sources and uses?

� Is CFO positive and sufficient to cover capex?

2. Analyze CFO

� What are the major determinants of CFO?

� Is CFO higher or lower than NI?

� How consistent is CFO?



Analysis3. Analyze CFI

� What is cash being spent on?

� Is the company investing in PP&E?

� What acquisitions have been made?

4. Analyze CFF

� How is the company financing CFI and CFO?

� Is the company raising or repaying capital?

� What dividends are being returned to owners?




Free Cash Flow (FCF)

� 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

LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125


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




Cash Flow Performance Ratios

Cash flow to revenue

Cash return on assets

Cash return on equity

Cash to income

CFO

Net revenue

CFO

Ave total assets

CFO

Ave equity

CFO

Operating income



Cash Flow Performance Ratios

Cash flow per share*CFO – pref div

No common stock

*IFRS: If dividends paid were treated as CFO, they must be added back




Cash Flow Coverage Ratios

Debt coverage

Interest coverage*

Reinvestment

CFO

Total debt

CFO + interest + tax

Interest paid

CFO

Cash paid for long-term assets*IFRS: If interest paid was

treated as CFF, no addition is required



Cash Flow Coverage Ratios

Debt payment

Dividend payment

Investing and financing

CFO

Cash paid for long-term debt repayment

CFO

Dividends paid

CFO

Cash outflows for CFI & CFF




Cash InflowsSalesLess: Increase in A/RCash collected from customers

Direct cash outflowsCost of goods soldAdd: Decrease in inventoryPurchasesAdd: Increase in A/PCash paid to suppliers

Operating expense (wages)Less: Decrease in salaries payableCash paid to employees

200,000(2,000)

(80,000)4,000

(76,000)8,000

198,000

(68,000)

(10,000)(7,000)

(17,000)

Direct from Indirect CFO

(28,000)

(40,000)10,000

2,000

(1,000)1,000

Direct from Indirect, cont.

Cash outflowsInterest ExpenseAdd: Increase in interest payable

Cash interest paid

Tax ExpenseAdd: Increase in deferred tax liab.Tax payableAdd: Increase in taxes payable

Cash taxes paid

$ $

CFO

0

85,000

(30,000)


Net income 75,000 Add: Depreciation 14,000Less: Gain from sale of PPE (20,000)Add: Increase in deferred taxes 10,000

Current asset adjustmentsLess: Increase in accounts receivable (2,000)Add: Decrease in inventory 4,000

Current liability adjustmentsAdd: Increase in accounts payable 8,000Less: Decrease in salaries payable (7,000)Add: Increase in interest payable 1,000Add: Increase in taxes payable 2,000

$

Cash flow from operations 85,000

Ind

irect

Meth

od

So

luti

on

Ecclestone CFI

Gross Plant and Equip.

Beginning PPE

Additions

PPE disposal

Ending PPE

282,000

50,000

(20,000)

312,000

Accumulated Depr.

Begin Acc. Depr.

Depr. Expense

AD for disposal

End Acc. Depr.

80,000

14,000

(10,000)

84,000

Calculating NBV of asset sold

NBV of disposal = 20,000 – 10,000 = 10,000


CFI = cash additions – cash received on disposal

Sale Proceeds

NBV of disposal

Gain(loss) on sale

30,000

10,000

20,000

$

CFI = –additions + proceeds

CFI = –$50,000 + $30,000 = –$20,000

Ecclestone CFI

� Change in debt



Net income

Div declared

∆ in R/E

$

75,000

(17,000)

58,000

Dividends decl.

∆ Div. payable

Cash div. paid

$

(17,000)

10,000

(7,000)

Ecclestone CFF$

10,000

(20,000)

(7,000)

(17,000)


$

85,000

(20,000)

(17,000)

48,000

18,000

66,000

Putting the Cash Flow Statement Together

Cash flow from operations

Cash flow from investments

Cash flow from financing

Net increase in cash



Free Cash Flow (FCF) Ecclestone

� FCFF =

$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000

� FCFE =

$75,000 = $85,000 – $20,000 + $10,000

� FCFE =

$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000

CFO + Int (1 – T) – FCInv

CFO – FCInv + Net debt increase

FCFF – Int (1 – T) + Net debt increase

Documents

Mastering the Cash Flow Statement CFA Levels I & II Lecture...Mastering the Cash Flow Statement CFA ® Levels I & II Importance of Cash Flow Statement Net income from accrual accounting