Understanding Cash Flow Statements 2014 Level I Financial Reporting and Analysis IFT Notes for the CFA exam
Contents 1. Introduction... 3 2. Components and Format of the Cash Flow Statement... 3 3. The Cash Flow Statement: Linkages and Preparation... 7 4. Cash Flow Statement Analysis... 15 Summary... 19 Next Steps... 20 This document should be read in conjunction with the corresponding reading in the 2014 Level I CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute. Copyright Irfanullah Financial Training. All rights reserved. Page 2
1. Introduction The cash flow statement provides important information about a company s cash receipts and payments during an accounting period. Reconciliation between reported income and cash flows provides useful information about when, whether and how a company is able to generate cash from its operating activities. The cash flow statement is a vital information source that assists users to evaluate a company s liquidity, solvency and financial flexibility. For an analyst, it is crucial to estimate future cash flows. Future cash flows help in estimating the value of a company. Future cash flows also indicate how much money is available to invest, and pay the debt holders and equity holders. 2. Components and Format of the Cash Flow Statement 2.1 Classification of Cash Flows and Non-Cash Activities Under both IFRS and U.S. GAAP cash flows in the cash flow statement are categorized as: Operating activities: These are the company s day-to-day activities that create revenues such as selling inventory and providing services. Examples of cash flows from operating activities include sales of goods and services (R), cost of providing good and services (X), and short term assets and liabilities directly related to operating activities (A), (L). Investing activities: These are activities associated with acquisition and disposal of longterm assets. Examples of such cash flows include purchase or sale of property, plant and equipment (A) and purchase or sale of other entities equity and debt securities (A). Financing activities: These are activities related to obtaining or repaying capital. Examples of such cash flows include issuance or repurchase of a company s own preferred or common stock (L), issuance or repayment of debt (L) and dividend payments (E). Worked Example 1 JFK Enterprises recorded the following for the year 2012: Purchase of equipment $70,000 Copyright Irfanullah Financial Training. All rights reserved. Page 3
Gain from sale of van $8,000 Receipts from sale of van $18,000 Dividends paid on ordinary share capital $10,000 Interest and preference dividend paid $12,000 Salaries paid $40,000 What is the net cash flow from investing activities? Solution: We first need to identify cash flows associated with investing activities. These are the purchase of equipment and the receipts from the sale of van. The gain from sale of van is not a cash flow item. The remaining items pertain to either operating or financing cash flows. Therefore, the net cash flow from investing activities is: Net Cash Flow from Investing Activities = Purchase of equipment + Receipt from sale of van Net Cash Flow from Investing Activities = -70,000 + 18,000 = $52,000 IFRS provides companies with some flexibility in reporting interest and dividends. However, under U.S. GAAP discretion is not permitted in classifying interest and dividends. The differences between the two standards are shown in the table below. Cash flow 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 2.2 A Summary of Differences between IFRS and U.S. GAAP IFRS and U.S. GAAP also have some differences with regard to bank overdrafts, taxes paid and the format of the cash flow statement. These are summarized in the table below. Copyright Irfanullah Financial Training. All rights reserved. Page 4
Cash Flow IFRS U.S. GAAP Bank overdrafts Taxes Paid Format of statement Considered part of cash equivalents Generally operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories Direct or indirect; direct is encouraged Not considered part of cash equivalents and classified as financing Operating Direct or indirect; direct is encouraged. A reconciliation of net income to cash flow from operating activities must be provided regardless of method used 2.3 Direct and Indirect Methods for Reporting Cash Flow from Operating Activities There are two acceptable formats for reporting cash flow from operating activities: direct and indirect. The amount of cash flow is the same under both methods; only the presentation format of the operating cash flows section differs. The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities. The direct method eliminates the impact of accruals and shows only cash receipts and payments. The indirect method shows how cash flow from operations can be obtained from reported net income as a result of a series of adjustments. The format begins with net income and adjustments are made for non-cash items, for non-operating items, and for net changes in operating accruals. 2.3.1 An Indirect-Format Cash Flow Statement Prepared Under IFRS The following table shows the format for a cash flow statement prepared using the indirect method. Notice that we start with net income. Next, we adjust for non-cash items such as depreciation and non-operating items such as deferred income tax. We then account for changes in working capital. This is necessary because these changes in working capital result from applying accrual accounting and do not necessarily correspond to an actual cash movement. Copyright Irfanullah Financial Training. All rights reserved. Page 5
Indirect Method Net income Adjustments to reconcile net income to cash flow provided by operating activities: Depreciation and amortization Deferred income tax Increase in account receivable Increase in inventory Decrease in prepaid expenses Increase in accounts payable Increase in accrued liabilities Operating cash flow 2.3.2 A Direct-Format Cash Flow Statement Prepared Under IFRS The following table shows the format for a cash flow statement prepared using the direct method. Notice that cash received from customers, as well as other operating items, are clearly shown. Direct Method Cash collection from customers Cash paid to suppliers Cash paid for operating expenses Cash paid for interest Cash paid for taxes Operating cash flow It is important to note what encompasses a non-cash transaction. A non-cash transaction is any transaction that does not involve an outflow or inflow of cash. It must be disclosed in either a Copyright Irfanullah Financial Training. All rights reserved. Page 6
footnote or a supplemental schedule to the cash flow statement. Analysts should incorporate noncash transactions into the analysis of past and current performance and include their effects in estimating future cash flows. An example of a non-cash transaction is the conversion of face value $1,000,000 convertible bonds to common stock. 3. The Cash Flow Statement: Linkages and Preparation 3.1 Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet Cash is an asset. The cash flow statement ultimately shows the change in cash during an accounting period. The beginning and ending balances of cash are shown on the balance sheet and the bottom of the cash flow statement reconciles beginning cash with ending cash. This relationship is illustrated through a simple scenario. Assume that beginning cash is 100, cash receipts are 50, cash payments are 40 and ending cash is 110. These can be shown using the table below, which demonstrates the relationship and linkage between the cash flow statement and the balance sheet. Beginning Balance Sheet 1 Jan 2010 Statement of Cash Flows for Year Ended 31 December 2010 Ending Balance Sheet at 31 Dec 2010 Beginning Cash Plus: Cash Receipts Less: Cash Payments Ending Cash 100 50 40 110 Because a company s operating activities are reported on an accrual basis in the income statement, any differences between the accrual basis and cash basis for accounting result in an increase or decrease in some asset or liability on the balance sheet. Let s consider an example of how items on the balance sheet are related to the income statement and/or cash flow statement through the change in beginning and ending balances. Suppose the beginning accounts receivable is 200, the revenue during the year is 5000 and the cash collected from customers is 4800. What is the ending Copyright Irfanullah Financial Training. All rights reserved. Page 7
accounts receivables? The table below makes it easy to compute the missing amount. We see that the ending accounts receivables will be 400. Balance Sheet at 1 Jan 2010 Income Statement Statement of Cash Flows Balance Sheet at 31 Dec 2010 Beginning A/R Plus: Revenue Less: Cash Collected From Customers Ending A/R 200 5,000 4,800 400 3.2 Steps in Preparing the Cash Flow Statement The first step in preparing a cash flow statement is to determine the total cash flows from operating activities. As discussed earlier, there are too methods to compute this. Both methods are discussed in the sections below. 3.2.1 Operating Activities: Direct Method 3.2.1.1 Cash Received from Customers To determine the approximate cash receipts, it is necessary to adjust the revenue amount by the net change in accounts receivables for the year. If the accounts receivables increase during the year, revenue on an accrual basis is higher than cash receipts from customers and vice versa. Hence, increase in accounts receivables should be subtracted from revenue to get the amount of cash received from customers. Consider a company which reported revenue of 10 million. Accounts receivable for the year went up from 1 million to 3 million. In this case the cash received from customers is 10 (3 1) = 8 million. 3.2.1.2 Cash Paid to Suppliers To determine purchases from suppliers, cost of goods sold is adjusted for the change in inventory. If inventory increased during the year, then purchases during the year exceeded cost of goods sold, and vice versa. Next, we can calculate the cash paid to suppliers by adjusting purchases for the change in accounts payable. If accounts payable increased during the year, then purchases on an Copyright Irfanullah Financial Training. All rights reserved. Page 8
accrual basis would be higher than they would be on a cash basis, and vice versa. Hence, the increase in accounts payable should be subtracted from purchases to obtain the amount of cash paid to suppliers. Consider a company with COGS of 150 million for a particular period. During this period inventory increased by 8 million and accounts payable went up by 12 million. The cash paid to suppliers is 150 + 8 12 = 146 million. 3.2.1.3 Cash Paid to Employees To determine the cash paid to employees, it is necessary to adjust salary and wages expense by the net change in salary and wages payable for the year. If salary and wages payable increased during the year, then the salary and wage expenses on an accrual basis would be higher than the amount of cash paid for his expense. Hence, any increase in the payable amount would be deducted from the salary and wage expense to get the amount of cash paid to employees. 3.2.1.4 Cash Paid for Other Operating Expenses To determine the cash paid for other operating expenses, it is necessary to adjust the other operating expenses amount on the income statement by the net changes in prepaid expenses and accrued expenses liabilities for the year. If prepaid expenses increased during the year, other operating expenses on a cash basis would be higher than on an accrual basis, and vice versa. Likewise, if accrued expense liabilities increased during the year, other operating expenses on a cash basis would be lower than on an accrual basis, and vice versa. Hence, to compute the cash paid for other operating expenses, we will add increases in prepaid expenses and less increases in other accrued liabilities from the other operating expenses item on the income statement. 3.2.1.5 Cash Paid for Interest To determine the cash paid for interest, it is necessary to adjust interest expense by the net change in interest payable for the year. If the interest payable increases during the year, then the interest expense on an accrual basis will be higher than the amount of cash paid for the interest. Hence, we Copyright Irfanullah Financial Training. All rights reserved. Page 9
will subtract any increases in interest payable from the interest expense amount to calculate the amount of cash paid for interest. 3.2.1.6 Cash Paid for Income Taxes To determine the cash paid for income taxes, it is necessary to adjust income tax expense by the net change in taxes receivable, taxes payable and deferred income taxes for the year. If the tax receivable or deferred tax assets increase during the year, the income taxes on a cash basis will be higher than on an accrual basis, and vice versa. Hence, we will add any increases in tax receivable and deferred tax asset to compute cash paid for income taxes. If the taxes payable or deferred tax liabilities increase during the year, the income tax expense on a cash basis will be lower than on an accrual basis, and vice versa. Hence, we will subtract any increases in taxes payable and deferred tax liabilities from income tax expense to compute cash paid for income taxes. Note: this topic is covered in more detail in the reading on income taxes. There are some useful shortcuts for determining operating cash flows. The steps are mentioned below: (i) Determine whether cash flow is income (+) or an expense (-) (ii) Increase in asset will have a negative impact on cash flow (iii) Decrease in asset will have a positive impact on cash flow (iv) Increase in liability will have a positive impact on cash flow (v) Decrease in liability will have a negative impact on cash flow To see how this short-cut works let us revisit the example where we determined the cash collected from customers. Recall that revenue was 10 million and accounts receivable went up by 2 million. Note that revenue of 10 million represent income (+). Accounts receivable is an asset which goes up by 2. Since an increase in assets is subtracted, the cash collected from customers is 10 2 = 8. Not let us revisit the example where we calculated the cash paid to suppliers. Recall that COGS was 150 million, inventory increased by 8 million and accounts payable went up by 12 million. Copyright Irfanullah Financial Training. All rights reserved. Page 10
COGS is an expense and hence tagged as (-). Increase in inventory is (-). Increase in accounts payable is (+). Hence, cash paid to suppliers is -150-8 + 12 = -146. 3.2.2 Investing Activities The second step in preparing the cash flow statement is to determine the total cash flow from investing activities (CFI). The presentation of CFI is identical under both direct and indirect methods. CFI is calculated by examining the change in the gross asset account that results from investing activities. Typically, this change results from purchases or sale of equipment (long term assets). To determine the cash paid for new equipment, it is necessary to also analyze whether old assets have been sold or not. The following diagram illustrates the process behind determining the cash paid for new equipment. To determine the cash inflow from the sale of equipment, the accumulated depreciation account and gains or losses on the sale of equipment are analyzed. This is illustrated in the figure below. Copyright Irfanullah Financial Training. All rights reserved. Page 11
Let us now consider a simple example for calculating the cash received from the sale of equipment. The balance sheet extract for Jackal Labs Ltd shows the machinery and accumulated depreciation balances for the years 2011 and 2012. 2011 2012 Machinery (Gross) $80 million $91 million Accumulated depreciation $25 million $31 million Further information provided is as follows: Gain on sale of machinery Depreciation expense for 2012 Capital expenditure on machinery $1.5 million $7 million $14 million The equation for cash received from sale of machinery: Cash received = Historical cost of equipment sold - Accumulated depreciation of equipment sold + Gain on sale of equipment We know the gain is $1.5 million. Calculate the other components in the equation: Historical cost of equipment sold = beginning balance + equipment purchased ending balance of equipment = 80 + 14 91 = 3 million Accumulated depreciation on equipment sold = beginning value of depreciation + depreciation expense ending value of depreciation = 25 million + 7 million 31 million = 1 million Using our original equation, we can now find the cash received from sale of machinery: Cash received = Historical cost of equipment sold - Accumulated depreciation of equipment sold + Gain on sale of equipment = 3 1 + 1.5 = $3.5 million. 3.2.3 Financing Activities Cash flow from financing activities refers to cash flows between the firm and the suppliers of capital. Suppliers of capital include creditors, bondholders and shareholders. Similar to investing activities, the presentation of cash flows from financing activities is also identical under both Copyright Irfanullah Financial Training. All rights reserved. Page 12
methods. The figure below summarizes the calculation of net cash flows from creditors, bondholders and shareholders. 3.2.4 Overall Statement of Cash Flows: Direct Method Once we have determined the cash flows from operating, investing and financing activities, we present them together in the form of a cash flow statement. Using the direct method, it should look like the sample cash flow statement below. Operating Activities Cash collected from customers $50,000 Cash paid for rent -4,000 Cash paid to employees -3,000 Cash paid for utilities -2,000 Cash flow from operating activities $41,000 Investing Activities Purchase of equipment -$75,000 Purchase of securities -5,000 Sale of securities 2,000 Cash flow from investing activities -$78,000 Financing Activities Issuance of stock $400,000 Increase in notes payable 25,000 Repurchase of treasury stock -500 Cash flow from financing activities $424,500 Total cash flow $387,500 Starting value of cash $500 Ending value of cash $388,000 Copyright Irfanullah Financial Training. All rights reserved. Page 13
3.2.5 Overall Statement of Cash Flows: Indirect Method While investing and financing cash flows must be presented using the direct method, operating cash flows can also be presented using the indirect method. To do so, we begin with net income and add back all noncash charges to income and subtract all noncash components of revenue. An example of a noncash charge is depreciation expense. Next, we subtract any gains that resulted from financing or investing cash flows. An example of such an item is the gain on sale of equipment. We then add or subtract changes to balance sheet operating accounts. This means that any increases in the operating asset account (use of cash) are subtracted, while decreases (source of cash) are added. Increase in the operating liability accounts (sources of cash) are added, while decreases (uses of cash) are subtracted. The end result is the net cash provided by operating activities. Consider a company with net income of 50 million in 2013. Depreciation expense is 5 million. Gain on sale of equipment is 2 million. Increase in A/R is 3 million. Increase in A/P is 1 million. Increase in inventory is 4 million. The operating cash flows using the indirect method will look as follows: Cash Flow from Operating Activities Net Income 50 Add non-cash charges (depreciation) + 5 Less gain on sale of equipment - 2 Less increase in A/R -3 Add increase in A/P +1 Less increase in inventory -4 Cash flow from operating activities 47 3.3 Conversion of Cash Flows From the Indirect Method to the Direct Method If a direct format is not available, an analyst can convert cash flows from operating activities reported under the indirect method. This is a three-step process: Aggregate all revenues and all expenses Remove all noncash items from aggregated revenues and expenses and break up remaining items into relevant cash flow items Convert accrual amounts to cash flow amounts by adjusting for working capital changes Copyright Irfanullah Financial Training. All rights reserved. Page 14
4. Cash Flow Statement Analysis The analysis of a company s cash flows can provide useful information for understanding a company s business and earnings and for predicting its future cash flows. 3.4 Evaluation of the Sources and Uses of Cash Evaluation of the cash flow statement should involve the following: Evaluate where the major sources and uses of cash flow are between operating, investing and financing activities. Major sources of cash for a company can vary with its stage of growth. For example, for a mature company it is expected that operating activities are the primary source of cash flows. However, for all companies analysts must analyze whether operating cash flows are positive and cover capital expenditures. Evaluate the primary determinants of operating cash flow. Analysts should compare operating cash flow with net income. If a company has large net income but poor operating cash flow, it may be a sign of poor earnings quality. In addition, analysts need to look at consistency of operating cash flows. Evaluate the primary determinants of investing cash flow. This is useful for letting the analyst know how much is being invested for the future in property, plant and equipment and how much is put aside in liquid investments. Evaluate the primary determinants of financing cash flow. In case of borrowings, analysts should consider when repayment will be required. In case of issuance or repurchase of common shares, it is important to analyze why capital is being raised or repaid. 3.5 Common-Size Analysis of the Statement of Cash Flows In common-size analysis of a company s cash flow statement, there are two alternative approaches. In the first approach, we express each line item of cash inflow (outflow) as a percentage of total inflows (outflows). An example of a common-size cash flow statement using this approach is shown below. Copyright Irfanullah Financial Training. All rights reserved. Page 15
Inflows Actual % of Total Inflow Receipt from customers 900 90% Sale of Equipment 50 5% Issue of Shares 50 5% Total 1000 100% In the second approach, we express each line item as a percentage of revenue. An example of such a statement is shown below. In this example, we have assumed total revenue is 1,200. Inflows Actual % of Total Revenue Receipt from customers 900 75% Sale of Equipment 50 4% Issue of Shares 50 4% Total 1000 83% The common-size cash flow statement makes it easier to see trends in cash flow rather than just looking at the total amount. The second approach is useful for to the analyst in forecasting future cash flows. 3.6 Free Cash Flow to the Firm and Free Cash Flow to Equity The excess of operating cash flow over capital expenditures is known as free cash flow. For purposes of valuing a company or its equity securities, an analyst may want to determine and use other cash flow measures, such as free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Copyright Irfanullah Financial Training. All rights reserved. Page 16
FCFF is the cash flow available to the company s suppliers of debt (lenders) and equity capital (shareholders) after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made. The formula for computing FCFF is: FCFF = NI + NCC + Int(1-Tax rate) FCInv WCInv Or FCFF = CFO + Int(1-Tax rate) FCInv where NI = Net income NCC = Non-cash charges Int = Interest expense FCInv = Capital expenditures WCInv = Working capital expenditures CFO = Cash flow from operations where the company has included interest paid in operating activities FCFE is the cash flow available to the company s stockholders after all operating expenses and borrowing costs (principal and interest) have been paid and necessary investments in working capital and fixed capital have been made. The formula for computing FCFE is: FCFE = CFO FCInv + Net borrowing In case net borrowing is negative, FCFE can be calculated as: FCFE = CFO FCInv Net debt repayment 3.7 Cash Flow Ratios There are several ratios useful for an analysis of the cash flow statement. These ratios generally fall into cash flow performance (profitability) ratios and cash flow coverage (solvency) ratios. The calculation and interpretation of these ratios are summarized in the tables below. Copyright Irfanullah Financial Training. All rights reserved. Page 17
Performance Ratios Cash flow to revenue Cash return on assets Cash return on equity Calculation CFO Net revenue CFO Average total assets CFO Average shareholders equity What It Measures Operating cash generated per dollar of revenue Operating cash generated per dollar of asset investment Operating cash generated per dollar of owner investment Cash to income CFO Operating income Cash generating ability of operations Cash flow per share (CFO Preferred dividends) Number of common shares outstanding Operating cash flow on a pershare basis Coverage Ratios Calculation What It Measures Debt coverage CFO Total debt Financial risk and financial leverage Interest coverage Reinvestment Debt payment Dividend payment Investing and financing (CFO + Interest paid + Taxes paid) Interest paid CFO Cash paid for long-term assets CFO Cash paid for long-term debt repayment CFO Dividends paid CFO Cash outflows for investing and financing activities Ability to meet interest obligations Ability to acquire assets with operating cash flows Ability to pay debts with operating cash flows Ability to pay dividends with operating cash flows Ability to acquire assets, pay debts, and make distributions to owners Copyright Irfanullah Financial Training. All rights reserved. Page 18
Summary Note: This summary has been adapted from the CFA Program curriculum. The cash flow statement provides important information about a company s cash receipts and cash payments during an accounting period as well as information about a company s operating, investing, and financing activities. Although the income statement provides a measure of a company s success, cash and cash flow are also vital to a company s long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company s liquidity, solvency, and financial flexibility. Key concepts are as follows: Cash flow activities are classified into three categories: operating activities, investing activities, and financing activities. Significant non-cash transaction activities (if present) are reported by using a supplemental disclosure note to the cash flow statement. Cash flow statements under IFRS and U.S. GAAP are similar; however, IFRS provide companies with more choices in classifying some cash flow items as operating, investing, or financing activities. Companies can use either the direct or the indirect method for reporting their operating cash flow: a) The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and operating cash outflows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement. b) The indirect method reconciles net income to operating cash flow by adjusting net income for all non-cash items and the net changes in the operating working capital accounts. The cash flow statement is linked to a company s income statement and comparative balance sheets and to data on those statements. Although the indirect method is most commonly used by companies, an analyst can generally convert it to an approximation of the direct format by following a simple three-step process. Copyright Irfanullah Financial Training. All rights reserved. Page 19
An evaluation of a cash flow statement should involve an assessment of the sources and uses of cash and the main drivers of cash flow within each category of activities. The analyst can use common-size statement analysis for the cash flow statement. Two approaches to developing the common-size statements are the total cash inflows/total cash outflows method and the percentage of net revenues method. The cash flow statement can be used to determine free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). The cash flow statement may also be used in financial ratios that measure a company s profitability, performance, and financial strength. Next Steps Work through the examples in the curriculum. Solve the practice problems in the curriculum. Solve the IFT Practice Questions associated with this reading. Review the learning outcomes presented in the curriculum. Make sure that you can perform the implied actions. Copyright Irfanullah Financial Training. All rights reserved. Page 20