PowerpointPresentation Chapter 5

Corporate FINANCE.
Theory and practice
Chapter 5
Walking through from
earnings to cash flow
P. Quiry, M. Dallocchio, Y. LeFur, A. Salvi

Corporate Finance. Theory and Practice
John Wiley & Sons, London, 2009
Corporate FINANCE. Theory and practice
Chapter 5 – WALKING THROUGH FROM EARNINGS TO CASH FLOW
TOPICS
• Analysis of earnings from a cash flow perspective
• Cash flow statement
• All accounts from Net Income will be reset to zero while net
income or loss will be added to the Retained Earning in the
Balance Sheet.
•Complete set of Financial Statements consist of:

•1. Balance Sheet (accumulative, permanent accounts)
•2. Income Statement(also called Profit and Loss, temporary
accounts for a year only)
•3. Statement of Cash Flow(operating, investing & financing
cycles)
© 2009 - John Wiley & Sons 2
Quiry, Dallocchio, LeFur, Salvi - Corporate Finance. Theory and Practice
OPERATING REVENUES
• Operating receipts should correspond to sales for the
same period, but they differ because customers may be
granted a payment period or payments of invoice from the
previous period may me received during the current period.
Sales for the period – Increase in trade

or
+ reduction in trade receivables
= operating receipts
• Operating receipts are equal to sales if sales are

immediately paid in cash.

TYPICAL COLLECTION CYCLE
Considered this as an ideal situation where all of your

customers are in sounded financial standing and no one files
bankrupt.
You can see the cash comes in 1.5 months later after sales.
© 2005 - John Wiley & Sons

4
COMPUTING RECEIVABLE RATIOS
• Receivables Turnover =
Sales / Accounts Receivable
5,000 / 956 = 5.23 times
• Days’ Sales in Receivables =
365 / Receivables Turnover
365 / 5.23 = 70 days
Note: All figures are assumed, this company will take

70 days in average to collect their Receivables.
Majority of their payment term must be in Net 45 days.
5
OPERATING COSTS
• Operating payments are the same as operating costs for
a given period only when adjusted for:
1. Timing differences arising from the company’s

payment terms=> net 30, 45, 60 days
2. The fact that some purchasers are not used during the
same period. => material purchased but products had
not be made until further months
• These difference give raise to:

• Changes in trade payables in the first case;
• Discrepancy between raw material and good for a
resale.
OPERATING COSTS
+ reduction in supplier credit
Operating payments = - increase in supplier credit
+ increase in inventories of raw materials
- reduction in inventories of
raw materials
•The only difference between operating revenues and

receipts and between operating charges and payments
are timing differences deriving from deferred payments
and deferred charges.

OPERATING COSTS
BY-FUNCTION INCOME DIFFERENCE

STATEMENT
Net sales - Change in trade receivables
(deferred payment)
- Operating costs except + Change in trade payables
depreciation, amortisation (deferred payments)
and impairment losses sales - Change in inventories of
finished goods, work in
progress, raw materials and
goods for resale (deferred
changes)
WORKING CAPITAL
•The change in WC represents a need for or a source of
financing that must be added to or subtracted from the other
financing requirements or resources.
•The change in operating working capital accounts for
the difference between EBITDA and operating cash flow.
1. If positive, it represents a financing requirement and we
defer to an increase in operating working capital.
2. If negative it represents a source of funds and we refer as
a reduction in operating working capital.
•Analysis of changes in working capital is one of the key
pillars of financial analysis.

CAPITAL EXPENDITURE
• Capital expenditure lead to a change in what the
company owns without any immediate increase or
decrease in its wealth. They have a direct impact
on cash flow statements .
• The income statement spread the capital
expenditure charge over the entire life of the asset
through depreciation and amortisation.
• So there is no direct link between cash flow
and the net income for the capital expenditure
process.

FROM THE INCOME STATEMENT... TO THE CASH FLOW STATEMENT
INCOME STATEMENT DIFFERENC CASH FLOW STATEMENT

EBITDA - Change in operating working = Operating cash flow
capital
- Capital expenditure = - Capital expenditure
+ Disposals + Disposals
Depreciation,
- amortisation and + Depreciation, amortisation and =
impairment losses on fixed impairment losses on fixed
assets assets (non-cash charges)
= EBIT (Operating profit) = Free cash flow before tax
- Financial expense net of = - Financial expense net of
financial income financial income
- Corporate income tax = - Corporate income tax
+ Proceeds from share issues = + Proceeds from share issues
- Share buy-backs - Share buy-backs
- Dividends paid = - Dividends paid
= Net income (net earnings) + Column total = Decrease in net debt

CASH FLOW STATEMENT
Net income
+ Depreciation, Amortisation
– Change In Working Capital (current asset –
current liabilities)
– Capital Expenditure Net Of Asset Disposals
– Disposals
+ Proceeds From Share Issue
– Share Buyback
– Dividend Paid
= Decrease In Net Debt

FROM NET INCOME TO CASH FLOW

• All the non cash charges that do not have an impact
on a company’s cash position are added back to the net
income to show the total financing generated internally
from by the company.
• Cash flow can be calculated by adding certain non
cash charges net of write backs to net income.
• Two approaches:
1) Top down method
2) Bottom up method


Top down method
EBITDA
-Financial expense net of financial income
-Corporate income tax
= Cash flow

CASH FLOW STATEMENT FOR INDESIT (€m)

2005 2006 2007
OPERATING ACTIVITES
Net income 50 77 105

+ Depreciation, amortisation and impairment losses on fixed assets 141 143 141
+ Other non-cash items 46 (16) (44)
= CASH FLOW 238 204 202
− Change in working capital 28 (40) (20)
= CASH FLOW FROM OPERATING ACTIVITIES (A) 207 244 222
INVESTING ACTIVITES
Capital expenditure 190 136 126

− Disposal of fixed assets 4 5 20
+/−Acquisition (disposal) of financial assets (5) (9) (12)
+/−Acquisition (disposal) of other LT assets 4 (6) (2)
= CASH FLOW FROM INVESTING ACTIVITIES (B) 182 121 95
= FREE CASH FLOW AFTER FINANCIAL EXPENSE (A − B) 24 128 129
FINANCING ACTIVITIES
Proceeds from share issues (C) 6 3 2

Dividends paid (D) 37 37 40
A − B + C − D = DECREASE/(INCREASE) IN NET DEBT (6) 94 92
Decrease in net debt can be broken down as follows: (9) 110 113
Repayment of short-, medium- and long-term borrowings
− New short-, medium- and long-term borrowings 4 5
+ Change in marketable securities (short-term investments) 12 (6) (23)
+ Change in cash and equivalents (13) (15) 2
= DECREASE/(INCREASE) IN NET DEBT (6) 94 92


•Bottom up model
Net income
+ Depreciation/amortisation /impairment losses
+/- Capital losses/gains on assets disposal
+/- Extraordinary loss/gains
= Cash flow
•Cash flow is influenced by the same accounting

policies as EBITDA

FROM CASH FLOW TO CASH FLOW FROM

OPERATING ACTIVITIES
• To go from cash flow from operating activities, we

need to adjust for the timing differences in cash flow
linked to the operating cycle.
Cash flow from the operating cycle =

Cash flow – Change in operating working capital

OTHER MOVEMENTS IN CASH
•We have now to consider the other movements

linked to the investment and financing cycles.
• The investment cycle includes:
• Capital expenditure
• Disposal of fixed assets
• Capital gains or losses
• Changes in long-term investments

CASH FLOW STATEMENT
•In the cash flow statement investing activities are

shown as financing requirements, calculated as a
difference between capital expenditure and disposal.
•Net debt reflects the level of indebtedness of a

company

CONCLUSION
• In order to have cash flow we have to start from the
income statement.
• The only difference between operating revenues
and receipts and between operating charges and
payments are timing differences deriving from deferred
payments and deferred charges.
• The change in working capital accounts for the difference
between operating cash flow and the generation of
wealth of within the operating cycle.
• For capital expenditure there is not a direct link
between cash flow and net income.

CONCLUSION
• The cash flow statement does not distinguish between

capital and remuneration related to the source of
financing.
• Cash flow must be adjusted for the change in
operating working capital to arrive at cash flow from
operating activities.

WHY EVALUATE FINANCIAL STATEMENTS
• Internal uses
– Performance evaluation –
compensation and comparison
between divisions
– Planning for the future – guide in
estimating future cash flows
• External uses
– Creditors
– Suppliers
– Customers
– Stockholders

22
Sample Balance Sheet
2009 2008 2009 2008
Cash 696 58 A/P 307 303
A/R 956 992 N/P 26 119
Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775
Total CA 2,256 1,675 LT Debt 843 1,091
Net FA 3,138 3,358 C/S 2,556 2,167
Total 5,394 5,033 Total Liab. 5,394 5,033

Assets & Equity
Numbers in millions of dollars

3-23
Sample Income
Statement
Revenues 5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income 689
EPS 3.61
Dividends per share 1.08
Numbers in millions of dollars, except EPS & DPS 3-24

Computing Liquidity Ratios
• Current Ratio = CA / CL
2,256 / 1,995 = 1.13 times
For every dollar of liability, this firm has $1.13 in assets to
pay, higher ratio means the company is cash rich.
Computing Long-term
Solvency Ratios
• Debt/Equity = TD / TE
(5,394 – 2,556) / 2,556 = 1.11 times
For every dollar of equity, this firm has $1.11 dollars of

Debts, the higher this ratio, the less chance the firm should
borrow more money.
25

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Corporate FINANCE.

Theory and practice

P. Quiry, M. Dallocchio, Y. LeFur, A. Salvi

• Cash flow statement

•Complete set of Financial Statements consist of:

Sales for the period – Increase in trade

• Operating receipts are equal to sales if sales are

© 2009 - John Wiley & Sons 3

Considered this as an ideal situation where all of your

© 2005 - John Wiley & Sons

Note: All figures are assumed, this company will take

1. Timing differences arising from the company’s

• These difference give raise to:

•The only difference between operating revenues and

© 2009 - John Wiley & Sons 7

BY-FUNCTION INCOME DIFFERENCE

© 2009 - John Wiley & Sons 9

© 2009 - John Wiley & Sons 10

FROM THE INCOME STATEMENT... TO THE CASH FLOW STATEMENT

INCOME STATEMENT DIFFERENC CASH FLOW STATEMENT

© 2009 - John Wiley & Sons 11

CASH FLOW STATEMENT

© 2009 - John Wiley & Sons 12

FROM NET INCOME TO CASH FLOW

© 2009 - John Wiley & Sons 13

FROM NET INCOME TO CASH FLOW

© 2009 - John Wiley & Sons 14

CASH FLOW STATEMENT FOR INDESIT (€m)

Net income 50 77 105

= CASH FLOW FROM OPERATING ACTIVITIES (A) 207 244 222

Capital expenditure 190 136 126

= CASH FLOW FROM INVESTING ACTIVITIES (B) 182 121 95

= FREE CASH FLOW AFTER FINANCIAL EXPENSE (A − B) 24 128 129

Proceeds from share issues (C) 6 3 2

A − B + C − D = DECREASE/(INCREASE) IN NET DEBT (6) 94 92

= DECREASE/(INCREASE) IN NET DEBT (6) 94 92

FROM NET INCOME TO CASH FLOW

•Cash flow is influenced by the same accounting

© 2009 - John Wiley & Sons 16

FROM CASH FLOW TO CASH FLOW FROM

• To go from cash flow from operating activities, we

Cash flow from the operating cycle =

© 2009 - John Wiley & Sons 17

OTHER MOVEMENTS IN CASH

•We have now to consider the other movements

• The investment cycle includes:

© 2009 - John Wiley & Sons 18

CASH FLOW STATEMENT

•In the cash flow statement investing activities are

•Net debt reflects the level of indebtedness of a

© 2009 - John Wiley & Sons 19

© 2009 - John Wiley & Sons 20

• The cash flow statement does not distinguish between

© 2009 - John Wiley & Sons 21

© 2005 - John Wiley & Sons

A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Net FA 3,138 3,358 C/S 2,556 2,167

Total 5,394 5,033 Total Liab. 5,394 5,033

Numbers in millions of dollars

Numbers in millions of dollars, except EPS & DPS 3-24

For every dollar of equity, this firm has $1.11 dollars of