Cash Flow Statement Topic 4

Alexei Alvarez, CFA, FRM

Fabricio Chala, CFA, FRM
Cash Flow Statement

❖  The cash flow statement provides information on actual cash

inflows and outflows, and is not affected by the accrual
principle.
❖  We can understand the impact of the accrual principle on the
profits of the company and how this differs from the cash
generated by the firm.
❖  Basically, the cash flow statement is the “cash-basis”
counterpart of the income statement, adjusting for the variations
in the balance sheet.
Cash Flow Statement Accounts
Cash Flow from Operations (CFO)
Inflows
-  Cash Collected from Customers
-  Interests and Dividends Received (US GAAP/IFRS)
-  Sale of an Asset under Trading
Cash Flow from Investments (CFI)
Inflows
-  Sale of Fixed Asset
-  Sale of Investments in Debt/Equity
-  Principal Received from Loans to Third Parties
-  Interest and Dividends Received (IFRS Only)
Cash Flow from Financing (CFF)
Inflows
-  Debt Issued
-  Proceeds from the Issuance of Stocks
Outflows
-  Cash Paid to Employees/Suppliers
-  Cash Paid for other Expenses
-  Purchase of an Asset under Trading
-  Interest Paid (US GAAP/IFRS)
-  Dividends Paid to Stockholders (IFRS)
-  Taxes Paid (US GAAP: All taxes /IFRS: Can classify
investment-related taxes as CFI)
Outflows
-  Purchase of Fixed Assets
-  Purchase of Investments in Debt/Equity
-  Loans to Third Parties
-  Investment-related taxes (allowed under IFRS)
Outflows
-  Debt Principal Repayment
-  Stock Buybacks
-  Dividends Paid to Stockholder (US GAAP/IFRS)
-  Interest Paid (IFRS)
Differences between IFRS and U.S. GAAP

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
Direct Method

❖  Each line of the income statement is converted from the accrual principle
to cash-based accounting

Direct Method (CFO)

+ Cash Collections
- Cash Paid to Suppliers
- Cash Paid for Operating Expenses
- Cash Paid for Interest*
- Cash Paid for Taxes
* Mandatory under US GAAP, IFRS allows firm sto report interest
payments either under CFF or CFO

❖  The direct and indirect methods only differ in the components of the
CFO. The CFI and CFF are calculated in the same way under any of the
two methods
Direct Method

1.  Cash received from customers

Revenue−∆Accounts receivable
2.  Cash paid to suppliers
COGS+∆Inventory−∆Accounts payable
3.  Cash paid to employees
Salary and wage expense−∆Salary and wage payable
4.  Cash paid for interest
Interest expense−∆Interest payable
Indirect Method

❖  Net income is converted into CFO by adjusting for transactions that

affect the income statement but do not generate a cash outflow or
inflow
Indirect Method
Net Income(CFO)
+ Depreciation/Amortization
+ Loss (- Gain) for the "Sale of Fixed Assets" *
- Increase in Accounts Receivable
- Increase in Inventories
-Increase in Expenses Paid in Advance
+ Increase in Accounts Payable
+ Increase in Wages Payable
+ Increase in Interest Payable
+ Increase in Taxes Payable
+ Increase in Deferred Liabilities
* will be added back in the CFI
Indirect Method

❖  Inverse relationship between changes in assets and changes in

cash
(Cash is used to purchase assets)
❖  Direct relationship between changes in liabilities and changes in
cash
(Cash is used to pay liabilities)
❖  In summary, we start from the net income and correct it for non-
cash expenses, changes in assets or liabilities, gains/losses from
the sale of fixed assets, among others
Example
Income Statement

Income Statement, Year ended 31 Dec 20X6

Sales 100,000
Expenses
COGS 40,000
Wages 5,000
Depreciation 7,000
Interest 500
Total Expenses 52,500
Income from continuing op. 47,500
Gain from sale of land 10,000
Pre-tax income 57,500
Provision for taxes 20,000
Net income 37,500
Common dividends declared 8,500
Example
Balance Sheet
Comparative Balance Sheets, 31 December 20X6 and 20X5
20X6 20X5 20X6 20X5
Current Assets Current Liabilities
Cash 33,000 9,000 Accounts Payable 12,500 8,000
Accounts Receivable 10,000 9,000 Wages Payable 4,500 8,000
Inventory 5,000 7,000 Taxes Payable 5,000 4,000
Total Current Assets 48,000 25,000 Dividends Payable 6,000 1,000
Deferred Liabilities * 20,000 15,000
Non-Current Assets (*) Sales in advance

Land 35,000 40,000 Non-Current Liabilities

Gross PP&E 85,000 60,000 Bonds 15,000 10,000
Accum. Dep. (16,000) (9,000) Total Liabilities 63,000 46,000
Net PP&E 69,000 51,000 Shareholder’s Equity
Goodwill 10,000 10,000 Common Stock 40,000 50,000
Total Non-Current Assets 114,000 101,000 Retained Earnings 59,000 30,000
Total Equity 99,000 80,000
Total Assets 162,000 126,000 Total Liabilities + Equity 162,000 126,000
Relationship with Balance Sheet accounts

Accounts Receivable Inventories Accounts payable

Beginning accounts Beginning inventories Beginning accounts payable
receivable
Plus: Revenues Plus: Purchases Plus: Purchases
Minus: Cash collected from Minus: Cost of goods sold Minus: Cash paid to
customers suppliers
Ending accounts receivable Ending inventory Ending accounts payable
 Relationship between A/R, A/P and Inv.
with the I/S and Cash Flows

Accounts Receivable Retained earnings

Initial balance 9,000 100,000 Sales
Sales on credit 100,000 Cost of Goods Sold 40,000
99,000 Cash rec. from customers
Final Balance 10,000

Inventories
Initial balance 7,000 Cash
Purchases 38,000 Cash rec. from customers 99,000
40,000 Goods Sold 33,500 Cash paid to suppliers
Final Balance 5,000

Accounts Payable
8,000 Initial balance
38,000 Purchases on credit
Cash paid to suppliers 33,500
12,500 Final Balance

*Purchases = COGS + ∆ Inventories

Cash Flow from Investments

❖  Result from the acquisition or sale of long-term assets (fixed and

intangible assets) and investments.
+ Inflows from the Sale of Fixed Assets
+ Inflows from the Sale of Investments (Debt/
Stocks)
+ Principal Received from Loans to Third Parties
- Purchase of Fixed Assets
- Investments in Debt/Stocks
- Loans to Third Parties
Cash Paid for New PP&E = PP&E Gross t + Gross Cost of PP&E Sold - PP&E Gross t-1

Cash Received for Sale of PP&E = Book Value of PP&E + Gain (-Loss) from Sale
Cash Flow from Financing

❖  Result of transactions that affect the capital structure of the

company.
+ Principal Received from Debt Issuance
+ Proceeds from the Issuance of Stocks
- Interest Paid on Debt*
- Principal Repayment
- Stock Buy-backs
- Dividends Paid to Stockholders
* only IFRS allows the firm to report interest in the CFO or CFF,
US GAAP requires the firm to report interest as part of the CFO
Net Borrowing = New Debt - Debt Repayment

Net Cash Flow from Stockholders = New Issuance - Buybacks - Dividends Paid
What should we care about?

CFO
❖  CFO lower than CFI and CFF is not sustainable in the long term.
A mature company must generate a CFO that compensates the
CFI and CFF.
❖  CFO should be generated by sales and not by decrease in assets
❖  Earnings quality: stable relation between CFO and net income.
Accounting profits well above the CFO indicate an aggressive
accounting policy.
What should we care about?

CFI
❖  A firm that does not invest will not grow in the future
❖  The CFI can be increased by selling fixed assets, which is not
sustainable
CFF
❖  Who receives the cash flows? Creditors or shareholders?
Definition: Working Capital

❖  Working Capital: Cash that a company needs to fund its daily

operations (inventories, accounts receivable, minimum cash and
other current assets).
WC = C. Assets - C. Liabilities
❖  However, for valuation purposes financial analysts often make
distinctions between “free” liabilities (e.g. accounts payable or
accruals) and interest-bearing liabilities. A Net Operating Working
Capital (NOWC) would be:
NOWC = (C. Assets – Cash & Securities) – Non Interest-bearing C. Liabilities
❖  Which accounts should we exclude from NOWC?
❖  Cash: not part of the company’s operations and is invested in banks or liquid
assets (do not have the same risk as the company’s operations). Is there any
case where we should include it?
❖  Short-term Investments and Interest-Bearing Current Liabilities: they are
both non-operating (are not part of the company’s business).
Definition: Working Capital

CURRENT
LIABILITIES
CURRENT
ASSETS
Working
Capital
NON-CURRENT
LIABILITIES

NON-CURRENT
ASSETS
EQUITY

➡  WC changes are usually linked to changes in sales (proportional)

Definition: Working Capital

Non Interest-
CURRENT bearing Cur. Liab.
LIABILITIES
CURRENT Net Operating
ASSETS Working
Capital

NON-CURRENT Cash & Securities

LIABILITIES

NON-CURRENT
ASSETS
EQUITY

➡  WC changes are usually linked to changes in sales (proportional)

Free Cash Flow

❖  Free Cash Flow to the Firm (FCFF): cash available to the firm’s
sources of financing after making investments in fixed assets
and working capital necessary to sustain operations. It is freely
available to creditors and owners of the company.
❖  Free Cash Flow to Equity (FCFE): cash available to shareholders
after paying creditors.
Free Cash Flow to the Firm

Starting from the Income Statement, we should adjust net income

by non-cash transactions and payments that have already been
made to creditors:
FCFF = NI + NCC - ∆ WC + Int (1-t) - CAPEX

✍  NI: Net Income

✍  NCC: Non-cash charges (depreciation, amortization and
gain/loss from non-recurring items)
✍  ∆ WC: Changes in Working Capital
✍  Int (1-t): Interest incorporating tax shield
✍  CAPEX: Capital Expenditure (Investment in Fixed Assets)
Free Cash Flow to the Firm

❖  We can further expand FCFF:

FCFF = EBIT (1-t) + Dep - Δ WC - CAPEX
FCFF = EBITDA (1-t) + Dep×(t) - Δ WC - CAPEX
❖  We can simplify this formula by starting from the Cash Flow Statement:
FCFF = NI + NCC - Δ WC +Int (1-t) - CAPEX

CFO
FCFF = CFO + Int (1-t) - CAPEX
❖  EBIT: Earnings Before Interest and Taxes
❖  EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortisation
Free Cash Flow to Equity

❖  Starting from the Income Statement, we need to adjust the net

income by non-cash transactions:

FCFE = NI + NCC - ∆ WC - CAPEX + NB

❖  NI: Net Income

❖  NCC: Non-cash charges (depreciation, amortization and gain/
loss from non-recurrent items)
❖  Δ WC: Changes in Working Capital
❖  CAPEX: Capital Expenditures (Investment in Fixed Assets)
❖  NB: Net Borrowing
Free Cash Flow to Equity

Starting from the cash flow statement, we can simplify the

formula:
FCFE = NI + NCC - Δ WC - CAPEX + NB

CFO

FCFE = CFO - CAPEX + NB

❖  We can also calculate the FCFE from the FCFF:

❖  FCFF = CFO + Int (1-t) - CAPEX

FCFE = FCFF - Int (1-t) + NB

Key Takeaways

❖  The Income Statement is governed by the accrual principle

while the cash flow statement is based on the cash principle.
❖  The cash flow statement is comprised of the CFO, CFI and CFF.
❖  Working capital is the company's short-term cash needs to be
able to carry out its operations.
❖  FCFE: is the cash available to the equity holders after paying
creditors
FCFE = NI + NCC - ∆ WC - CAPEX + NB

❖  FCFF: is the cash available to the firm’s sources of financing

after investing in CAPEX and Working Capital
FCFF = NI + NCC - ∆ WC + Int (1-t) - CAPEX
Key Concepts
❖  Cash Flow Statement
❖  Cash principle
❖  Cash Flow from Operating
activities
❖  CFO – direct method
❖  CFO – indirect method
❖  Cash Flow from Investing
activities
❖  Cash Flow from Financing
activities
❖  Working Capital
❖  Net Operating Working
Capital
❖  Free Cash Flow to the Firm
❖  Free Cash Flow to Equity
❖  EBITDA
❖  Capital Expenditure
❖  Net Borrowing