OVERVIEW CHAPTER 6 UNDERSTANDING CASH FLOW STATEMENTS

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1 CHAPTER 6 UNDERSTANDING CASH FLOW STATEMENTS Presenter s name Presenter s title dd Month yyyy OVERVIEW Statement of Cash Flows: Overview Format of Statement of Cash Flows Preparing a Statement of Cash Flows Additional Analytical Considerations Copyright 2013 CFA Institute 2 APPLE, Inc. Copyright 2013 CFA Institute 3 Copyright 2013 CFA Institute 4

2 CLASSIFICATION OF ACTIVITIES ON THE STATEMENT OF CASH FLOWS Operating activities: Deliver or produce goods for sale and provide services. Examples: Receive cash from customers Pay cash to suppliers Pay cash for operating expenses. Investing activities: Buy or sell long-term assets and other investments. Examples: Property, plant, and equipment (PP&E) Other companies securities (that are not cash equivalents) Financing activities: Obtain or repay capital. Examples: Borrow from creditors and repay the principal Issue or repurchase stock Pay dividends COLGATE: CASH FLOWS CLASSIFIED BY ACTIVITY Net cash provided by operations 2,896 3,211 3,277 Net cash used in investing activities (1,213) (658) (841) Net cash used in financing activities (1,242) (2,624) (2,270) Effect of exchange rate changes (53) (39) (121) Net (decrease) increase in cash and cash equivalents 388 (110) 45 Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $878 $490 $600 Copyright 2013 CFA Institute 5 Copyright 2013 CFA Institute 6 COLGATE S OPERATING CASH FLOWS COLGATE S INVESTING CASH FLOWS Copyright 2013 CFA Institute 7 Copyright 2013 CFA Institute 8

3 COLGATE S FINANCING CASH FLOWS COMMON-SIZE STATEMENT OF CASH FLOW FOR COLGATE (ABBREVIATED) Each line item is presented as a percentage of net revenue Operating Activities Net income including noncontrolling interests 15.3% 14.9% 15.6% Net cash provided by operations 17.3% 20.6% 21.4% Net cash used in investing activities 7.2% 4.2% 5.5% Net cash used in financing activities 7.4% 16.9% 14.8% Copyright 2013 CFA Institute 9 Copyright 2013 CFA Institute 10 COLGATE S CASH FLOWS: SUMMARY Overall, $323 million net increase in cash over three years, from $555 million at the beginning of 2009 to $878 million at the end of Colgate consistently obtains its cash inflow from operating activities and uses cash in investing and financing activities a typical profile for a mature company. Colgate s operating cash flow exceeded net income in every year a desirable profile for a mature company. In every year, Colgate s cash from operations was more than enough to cover its capital expenditures. The amount of dividends paid has steadily increased over the past three years. Amount of operating cash after paying for capital expenditures was more than enough to cover the dividend payments. In summary, Colgate s cash flows represent a positive profile. COLGATE S OPERATING CASH FLOWS: INDIRECT METHOD Copyright 2013 CFA Institute 11 Copyright 2013 CFA Institute 12

4 INDIRECT VS. DIRECT METHOD FOR PRESENTING OPERATING CASH FLOWS INDIRECT VS. DIRECT METHOD FOR PRESENTING OPERATING CASH FLOWS Indirect method Begins with net income and adjusts to operating cash flows. Arguments for: - Clearly shows the reasons for differences between net income and operating cash flows. - Mirrors forecasting approach that begins with forecast of income, then derives cash flows. Direct method Shows each cash inflow and outflow related to receipts and disbursements. Arguments for: - Provides information on the specific sources of operating cash receipts and payments. - Does not net. Indirect method IFRS permit. U.S. GAAP permit. Used by the majority of companies, whether reporting under IFRS or U.S. GAAP. Direct method IFRS encourage. U.S. GAAP encourage, but requires a reconciliation of net income to cash flow from operating activities. Copyright 2013 CFA Institute 13 Copyright 2013 CFA Institute 14 TECH DATA S OPERATING CASH FLOWS: EXAMPLE OF DIRECT METHOD CLASSIFICATION OF CASH FLOWS UNDER IFRS VS. U.S. GAAP Item IFRS U.S. GAAP Interest received Operating or investing Operating Interest paid Operating or financing Operating Dividends received Operating or investing Operating Dividends paid Operating or financing Financing Bank overdrafts Considered part of cash equivalents Taxes paid Generally operating, but a portion can be allocated to investing or financing Not considered part of cash and cash equivalents; classified as financing. Operating Copyright 2013 CFA Institute 15 Copyright 2013 CFA Institute 16

5 PORTUGAL TELECOM S OPERATING CASH FLOWS: ANOTHER EXAMPLE OF DIRECT METHOD PORTUGAL TELECOM S INVESTING CASH FLOWS Copyright 2013 CFA Institute 17 Copyright 2013 CFA Institute 18 PORTUGAL TELECOM S FINANCING CASH FLOWS NONCASH INVESTING AND FINANCING ACTIVITIES Noncash transaction: Any transaction that does not involve an inflow or outflow of cash (e.g., exchange of one no-monetary asset for another). Not incorporated in the cash flow statement. Must be disclosed. Copyright 2013 CFA Institute 19 Copyright 2013 CFA Institute 20

6 Cash at beginning and end of year links to the balance sheet. Cash at beginning and end of year links to the balance sheet. Copyright 2013 CFA Institute 21 Copyright 2013 CFA Institute 22 PREPARATION OF THE STATEMENT OF CASH FLOWS: STEPS EXAMPLE Step 1. Determine the change in cash. Step 2. Determine the net cash flow from operating activities. Use both the current year's income statement and information on current assets and liabilities from the comparative balance sheets. Step 3. Determine net cash flows from investing and financing activities. Examine all other changes in the balance sheet accounts. Step 4. Include summary of net increase (decrease) in cash, cash at beginning, and cash at end. Step 5. Disclose any significant noncash transactions separately at the bottom of the statement. A new company has the following transactions: Sells stock for $100. Buys a building for $50. Its primary line of business is selling a service, so it has no COGS (cost of goods sold) and no inventory. Makes credit sales of $100, and subsequently collects $90. Accrues SG&A (selling, general, and administrative) expense of $40, and subsequently pays cash of $25. Records depreciation expense of $10. Copyright 2013 CFA Institute 23 Copyright 2013 CFA Institute 24

7 STEP 1. DETERMINE THE CHANGE IN CASH This step is straightforward. The information is on the comparative balance sheets. Change was $115. Beginning balance Ending balance Change Cash Accounts receivable Building Accumulated depreciation 0 (10) (10) Total assets Accounts payable Common stock Retained earnings Total liabilities and equity STEP 2. DETERMINE THE NET CASH FLOW FROM OPERATING ACTIVITIES, BEGINNING WITH NET INCOME FOR THE INDIRECT METHOD Income statement Credit sales $ 100 SG&A expense 40 Depreciation expense 10 Net income $ 50 Net income $ 50 + Depreciation expense +10 Noncash expense Change in receivables 10 Only collected $90 + Change in payables +15 Only paid $25 Cash from operating activities $ 65 Copyright 2013 CFA Institute 25 Copyright 2013 CFA Institute 26 STEP 3. DETERMINE NET CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES Examine all other changes in the balance sheet accounts. Beginning Ending balance balance Change Cash In first step Accounts receivable In operating Building ? Accumulated depreciation 0 (10) (10) In operating Total assets Accounts payable In operating Common stock ? Retained earnings In operating* Total liabilities *There are no dividends in this example; all changes in retained earnings are from net income Copyright 2013 CFA Institute 27 INVESTING CASH FLOWS Determine investing cash flows by examining changes in long-term assets. In this example, we have only PP&E. Beginning PP&E + Purchases Dispositions = Ending PP&E Ending PP&E Beginning PP&E = Purchases Dispositions (i.e., investing cash flows) PP&E increased by $50, indicating cash spent acquiring PP&E. We also know this from the transaction list at the beginning of the example. Copyright 2013 CFA Institute 28

8 FINANCING CASH FLOWS Determine financing cash flows by examining changes in debt and equity accounts. In this example, we have only common stock. Beginning stock + Issuances Repurchases = Ending stock Ending stock Beginning stock = Issuances Repurchases Stock account increased by $100, indicating cash was raised by issuing stock. We also know this from the transaction list at the beginning of the example. Copyright 2013 CFA Institute 29 STEP 3. DETERMINE NET CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES Examine all other changes in the balance sheet accounts. Beginning Ending balance balance Change Cash In first step Accounts receivable In operating Building In investing Accumulated depreciation 0 (10) (10) In operating Total assets Accounts payable In operating Common stock In financing Retained earnings In operating* Total liabilities *There are no dividends in this example, so all change was net income. Copyright 2013 CFA Institute 30 INDIRECT METHOD Company ABC Cash Flow Statement for the period ended Operating cash flow Net income 50 Depreciation expense + 10 Increase in accounts receivable 10 Increase in accrued liabilities + 15 Total operating cash flow + 65 Investing cash flow Capital expenditure 50 Financing cash flow Issue of stock Total change in cash Beginning cash balance 0 Ending cash balance 115 Copyright 2013 CFA Institute 31 ALTERNATIVE STEP 2. DETERMINE THE NET CASH FLOW FROM OPERATING ACTIVITIES, BEGINNING WITH EACH LINE ITEM FOR THE DIRECT METHOD Income statement Credit sales $ 100 SG&A expense 40 Depreciation expense 10 Net income $ 50 Cash from customers $ 90 Cash paid for expenses 25 Cash from operating activities $ 65 Credit sales ($100) minus Change in receivables ($10) SG&A expenses ($40) minus increase in payables ($15) Copyright 2013 CFA Institute 32

9 DIRECT METHOD Company ABC Cash Flow Statement for the period ended Cash collected from customers + 90 Cash paid to suppliers 25 Total operating cash flow + 65 Investing cash flow Capital expenditure 50 Financing cash flow Issue of stock Total change in cash Beginning cash balance 0 Ending cash balance 115 FREE CASH FLOW Free Cash Flow to the Firm (FCFF): Cash flow available to the company s suppliers of capital (debt and equity). - After all operating expenses (including taxes) have been paid. - After all operating investments have been made for fixed capital and working capital. Free Cash Flow to Equity (FCFE): Cash flow available to the company s common stockholders. - After all operating expenses (including taxes) have been paid. - After borrowing costs (principal and interest) have been paid. - After all operating investments have been made for fixed capital and working capital. Copyright 2013 CFA Institute 33 Copyright 2013 CFA Institute 34 COMPUTE FCFF FCFF CAN ALSO BE COMPUTED FROM CASH FLOW FROM OPERATING ACTIVITIES Net Income + Noncash charges Working capital investment + Interest expense (1 Tax rate) Fixed capital investments Interest, a cash flow available to one of the capital providers, which has been deducted from net income, so it must be added back Net income + Noncash charges Working capital investment = Cash from operating activities + Interest Expense (1 Tax rate) CFO already has added noncash items to net income and deducted working capital investment = FCFF Fixed capital investments = FCFF Copyright 2013 CFA Institute 35 Copyright 2013 CFA Institute 36

10 COMPUTE FCFE CASH FLOW PERFORMANCE RATIOS Net Income + Noncash charges Working capital investment Fixed capital investment + Net new borrowing (or minus net debt repayments) = FCFE Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt. Ratio Calculation What It Measures Cash flow to revenue CFO Net revenue Operating cash generated per dollar of revenue Cash return on assets CFO Average total assets Operating cash generated per dollar of asset investment Cash return on equity CFO Average shareholders equity Operating cash generated per dollar of owner investment Cash to income CFO Operating income Cash generating ability of Cash flow per share (CFO Preferred dividends) Number of common shares outstanding operations Operating cash flow on a per-share basis Copyright 2013 CFA Institute 37 Copyright 2013 CFA Institute 38 CASH FLOW COVERAGE RATIOS Ratio Calculation What It Measures Debt coverage CFO Total debt Financial risk and financial leverage Interest coverage (CFO + Interest paid + Taxes paid) Interest paid Ability to meet interest obligations Reinvestment CFO Cash paid for longterm assets Ability to acquire assets with operating cash flows Debt payment CFO Cash paid for longterm debt repayment Ability to pay debts with operating cash flows Dividend CFO Dividends paid Ability to pay dividends payment Investing and financing CFO Cash outflows for investing and financing activities with operating cash flows Ability to acquire assets, pay debts, and make distributions to owners SUMMARY The cash flow statement provides information about a company s cash receipts and cash payments during an accounting period. Cash flows are categorized as operating, investing, and financing. Compared with U.S. GAAP, IFRS provide companies with more choices in classifying some cash flow items as operating, investing, or financing activities. The operating activities section of the statement of cash flows can be presented using the direct method or the indirect method. Two approaches to developing common-size cash flow statements are the total cash inflows/total cash outflows method and the percentage of net revenues method. Cash flow ratios measure a company s profitability, performance, and financial strength. Copyright 2013 CFA Institute 39 Copyright 2013 CFA Institute 40