Chapter 5

Understanding Cash Flow Statements

Contents

 Compare cash flows from operating, investing, and

financing.
 Contrast cash flow statements prepared under IFRS and
US GAAP.
 Distinguish between the direct and indirect methods of
presenting cash from operating activities.
 Analyze and interpret both reported and common-size
cash flow statements.
 Calculate and interpret free cash flow to the firm, free
cash flow to equity, and performance and coverage cash
flow ratios.
Statement Structure

Cash flows from operations

+ Cash flows from investing activities
+ Cash flows from financing activities
= Change in cash
+ Beginning cash balance
= Ending cash balance
Supplemental disclosure: non-cash financing
and investing activities
Operating Activities (USGAAP)

The cash effects of transactions and other events

that enter into the determination of net income:

Cash inflows from Cash outflows for

 Sale of goods or  Payments for
services acquisitions of inventory
 Returns on loans  Payments to employees
(interest)  Payments for taxes
 Return on equity  Payments for interest
securities (dividends)  Payments for other
expenses
Investing Activities (USGAAP)

Lending money and collecting on those loans

and acquiring and selling investments and
productive long-term assets:
Cash inflows from Cash outflows for
 Receipts for loans  Loans to other entities
collected  Investment in debt or
 Sales of debt or equity equity securities
securities  Purchase of plant,
 Sales of plant, property, property, and equipment
and equipment
Financing Activities (USGAAP)

Borrowing and repaying long-term loans;

issuing equity securities; payment of
dividends to shareholders:
Cash inflows from Cash outflows for
 Sale of equity securities  Payment of dividends
 Sale of bonds,  Reacquisition of capital
mortgages, notes, and stock
other short- and long-  Payment of amounts
term borrowings borrowed
Differences between IFRS and USGAAP
Statement of Cash Flows – An Example
 
               
                                                                            
The Product life cycle & cash flows

A series of phases all products go through

The phases are often referred to as the:
 introductory phase
 growth phase
 maturity phase
 decline phase.
The phase a company is in affects its cash
flows.
Introductory phase & cash flows

To support asset purchases the company may

issue stock or debt. Expect:
 cash from operations to be negative
 cash from investing to be negative.
 cash from financing to be positive.
Growth phase & cash flows

The company is striving to expand its production

and sales.
Expect:
 small amounts of cash to be generated from operations
 cash from investing to be negative.
 cash from financing to be positive.
Maturity phase & cash flows

Sales and production level-off

Expect:
 cash from operations to exceed investing needs.
 cash from investing to be neutral.
 cash from financing to be negative.
Decline phase & cash flows

Sales and production decline

Expect:
 cash from operations to decline.
 cash from investing to possibly become positive.
 cash from financing to possibly become negative.
Impact of Product Life Cycle on Cash Flows
Matching scenarios of cash flows with phases of
the product life cycle.
How to use cash flows information?
Methods to prepare Statement of Cash Flows

 Direct Method vs. Indirect Method

 Different in calculating net cash flow from operating
activities:
 The DIRECT method deducts from operating cash
receipts the operating cash disbursements.
 The INDIRECT method adjusts net income for items
that affected reported net income but did not affect cash.
 Indirect Method

Changes in current assets

and current liabilities.

Cash Flows
Net
from Operating
Income
Activities

+ Losses and + Noncash

- Gains expenses such as
depreciation and
amortization.
Indirect Method

Use this table when adjusting Net

Income to Operating Cash Flows.
Company B reported revenues of $60 million, total expenses of
$35 million, and net income of $15 million in the most recent
year. If accounts receivable were $32 million at the beginning of
the year and $15 million at the end of the year, how much cash
did the company receive from customers?
A . $33 million.
B . $60 million.
C . $77 million.
Company O reported cost of goods sold for the year of $150
million. Inventory declined from $40 million to $24 million.
Accounts payable decreased from $35 million to $25 million.
How much cash did the company pay to its suppliers during the
year?
A . $144 million.
B . $156 million.
C . $176 million.
 Cash Flows from Operating Activities
(Indirect Method)

Net Income
Additions Deductions
 Noncash expenses
 Nonoperating losses  Nonoperating gains
 Decreases in current  Increases in current
assets assets
 Increases in current  Decreases in current
liabilities liabilities

Net cash flow from operating activities

Net income is £132,000, accounts payable increased
£10,000 during the year, inventory decreased £6,000
during the year, and accounts receivable increased
£12,000 during the year. Under the indirect method,
what is net cash provided by operating activities?

(a) £102,000.
(b) £112,000.
(c) £124,000.
(d) £136,000.
The following data are available for Allen Clapp
Corporation.
Net income $2,000,000
Depreciation expense 400,000
Dividends paid 600,000
Gain on disposal of land 100,000
Decrease in accounts receivable 200,000
Decrease in accounts payable 300,000
Net cash provided by operating activities is:
(a) $1,600,000.
(b) $2,200,000.
(c) $2,400,000.
(d) $2,800,000.
The following data are available for Orange Peels
Corporation.
Sale of land $100,000
Sale of equipment 50,000
Issuance of ordinary shares 70,000
Purchase of equipment 30,000
Payment of cash dividends 60,000
Net cash provided by investing activities is:
(a) $120,000.
(b) $130,000.
(c) $150,000.
(d) $190,000.
The following data are available for Something Strange!

Increase in accounts payable € 40,000

Increase in bonds payable 100,000
Sale of investment 50,000
Issuance of ordinary shares 60,000
Payment of cash dividends 30,000
Net cash provided by financing activities is:
(a) €90,000.
(b) €130,000.
(c) €160,000.
(d) €170,000.
Evaluation of the sources and uses of cash

• What are major sources and uses of cash flow? (operating,

investing, or financing activities?)
• Is operating cash flow positive and sufficient to cover capital
Step 1
expenditures?

• What are major determinants of operating cash flow?

• Is operating cash flow higher or lower than net income? Why?
Step 2

• Where is the cash coming from to cover investments?

• Why are assets being sold? What would be effects on the
Step 3 company?

• Is the company raising capital or repaying capital? Why?

• What are the nature of its capital sources?
Step 4
Common-size analysis of the statement of cash flows
Common-size analysis of the statement of cash flows
Common-size analysis of the statement of cash flows
Free cash flow

The excess of operating cash flow over capital expenditures is

known generically as free cash flow.

 Free cash flow to the firm  Free cash flow to equity

(FCFF) is the cash flow
available to the company’s
suppliers of debt and equity
capital after all operating
expenses have been paid
and necessary investments
in working capital and fixed
capital have been made.
(FCFE) is the cash flow
available to the company’s
common 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.
Apple free cash flow
 Free cash flow

FCFF = CFO + Int(1 – Tax rate) - FCInv

FCFE = CFO – FCInv +(-) Net borrowing (Net debt repayment)

FCFF: Free cash flow to the firm

FCFE: Free cash flow to equity
CFO: Cash flow from operating activities
Int: Interest expense
FCInv: Fixed capital investment (capital expenditure)
Cash flow ratios
End of chapter 5