ACC 4345: FSA

Analysis of the Statement

of Cash Flows
Learning Objectives
How free cash flow can be calculated from reformulated income statements and
balance sheets without a cash flow statement
How the cash conservation equation ties the cash flow statement together to
equate free cash flow and financing cash flow
The difference between the direct and indirect calculations of cash from operations

What reformulated cash flow statements tell you

How to examine the quality of reported cash flow from operations

The Calculation of Free Cash Flow
Methods of Calculating FCF:

1. Use the sources of cash flow equation:

C - I = OI - ΔNOA

that is, free cash flow is operating income adjusted for the change in net
operating assets

2. Use the disposition of cash flows equation:

C - I = NFE - ΔNFO + d

that is, free cash flow is net financial expenses, adjusted for the change in net
financial obligations, plus dividends to common shareholders.

3. FCF can also be obtained from the reformulated Statement of Cash Flows.
Calculation of Free Cash Flow:
Nike, Inc.
VF

Method 1: C – I = OI - 

Operating income 2004 $ 1,035

Net operating assets 2004 $ 4,551
Net operating assets 2003 4,330 (221)

Free cash flow 2004 $814

Method 2: C – I = NFE - FO + d

Net financial expenses 2004 $ 16

Net financial obligations 2004 (289)
Net financial obligations 2003 302 591

Net dividend 2004 207

Free cash flow 2004 $814

Calculation of Free Cash Flow:
Reebok, 2004
Method 1: C – I = OI - 

Operating income 2004 $ 237

Net operating assets 2004 $1,212
Net operating assets 2003 731 481

Free cash flow 2004 $ (244)

Method 2: C – I = NFE – ΔNFO + d +MI(income) -MI(balance sheet)

Net financial expenses 2004 $ 18

Net financial obligations 2004 (23)
Net financial obligations 2003 (316) (293)

Net dividend 2004 23

Minority interest in income 5
Change in minority interest in
balance sheet 3
___________

Free cash flow, 2004 $ (244)

 Cash Flows from Cash Flows from

Statement
Operating Activities Investing Activities

of Cash Net Cash and Cash

Flows as Cash Flows from
Financing Activities
equivalent
Increase/(decrease)

per LKAS
7 Cash and Cash
equivalent at the
Cash and Cash
equivalent at the
beginning end
CASH FLOWS FROM OPERATING ACTIVITIES

Direct Approach
 Cash collected from customers
 Cash paid to Suppliers
 Cash paid for the supply of other services and expense
Indirect Approach
 Profit for the Year
 Adjustments for Non-Cash items (Depreciation)
 Adjustments for other items (Tax, Interest etc)
 Adjustments for changes in WC
CASH Cash flows from investing activities (CFIs)

FLOWS Cash flows related to the acquisition and disposal

of three types of wealth-building resources
FROM • Property, plant, and equipment
• Intangible assets

INVESTIN • Debt and equity securities

Cash flows are related to an entity’s life cycle

G stage
• Significant cash outflows in the emerging and growth stages

ACTIVITI of business
• They become positive and peak during business maturity
• CFIs trend toward zero as a firm declines and ceases

ES operations

Anil Jayantha USJP

CASH Cash flows from financing activities (CFFs)

FLOWS Those types of cash flows related to the acquisition and

disposal of external resources needed to acquire
FROM productive assets
• Equity issues and their reacquisition (treasury stock)

FINANCIN • Equity returns on investments (cash dividends)

• Debt issues and retirements

G CFFs are related to an entity’s life cycle stage

ACTIVITI • Significant cash inflows in the emerging and growth stages of

business
• They decline during business maturity

ES • CFFs negative as a firm declines and ceases operations (return of

investment)
CASH • Correlation of CFIs and CFFs
• Sometimes cash provided by a
FLOWS financing activity can be traced to the
FROM cash used for an investment (e.g.,
issuing a bond to acquire a building)
INVESTING • Correlations between CFIs and CFFs
become more obscure as a business
AND matures
FINANCING
ACTIVITIES
Reformulated Statement of Cash Flows
Cash flow from Operations

- Cash investments

=Free Cash Flow from Operating

Activities

Cash Paid to Shareholders

+ Cash Paid to Debtholders and Issuers

=Cash Paid for Financing Activities

This format follows the cash conservation equation:

C–I=d+F
 Change in operating cash should be included in the
investment section, and the change in cash equivalents in the
financing section

Problems Transactions in financial assets are included in the

investments section rather than in the financing section

with the Cash interest is included in the operating rather than in the
financing section
Standard
Statement
Tax cash flows are all included in the operating section, and
not allocated to operating and financing

The statement does not incorporate non-cash transactions

 Non-cash Transactions

Acquisitions with shares (Share Based payment)

Asset exchanges

Assets acquired with debt

Finance leases

Installment purchases

Debt converted to equity

  Non cash charges do not affect CFO, but are a loss of value (e.g.
depreciation)

The Quality of  Firms can delay payments to generate cash flow

the Reported  Firms can sell receivables to generate cash flow
Cash Flow
from  Firms can reduce advertising expenditures to generate cash flow

Operations  Firms can reduce R&D expenditures to generate cash flow

(CFO) Number  Non-cash transactions are not in CFO

as an Indicator  Structured financing can make borrowing look like cash from
of Profitability operations: Enron

 Capitalization policy shifts CFO to cash investment

 Objectives
A company must produce enough cash from
business operations to satisfy investors
CASH Measure the relationship between operating
cash flows and those from investing and
FLOW financing activities
MEASURES Determine if an enterprise produces enough of
the right kinds of cash flows to grow the business
 • Primary cash sufficiency measures
CASH • Provides evidence as to whether an entity
produces enough cash from operations to
FLOW meet its needs
MEASURES • Cash flow adequacy is the primary measure
(CONT.) of cash sufficiency
 Cash flow adequacy is computed as: cash
flows from operations / (fixed assets
purchased + long-term debt paid + cash
dividends distributed)
CASH General interpretation: a ratio of one or more
FLOW indicates an entity’s operations produce
sufficient cash to meet necessary business
MEASURES obligations
A ratio of less than one indicates potential
(CONT.) liquidity problems
Discretionary cash flows exist if the ratio
exceeds one
 Decomposition of cash flow adequacy ratio
CASH Individually examines each component of
FLOW the cash flow adequacy ratio
MEASURES Inverts ratio’s numerator and denominator
to avoid mathematical problems
(CONT.)
 Decomposed ratio is computed as
Reinvestment ratio: fixed assets purchased /
cash flows from operations
CASH Long-term debt repayment ratio: long-term debt
FLOW paid / cash flows from operations
Dividend payout ratio: cash dividends paid /
MEASURES cash flows from operations
(CONT.) In general, analysts favor low ratios for the
components of cash flow adequacy
 • Free cash flows
• Computed as: cash flows from operations –
(capital expenditures + dividends)
• Interpretation: the more free cash the greater
CASH an entity’s amount of discretionary cash and
liquidity
FLOW • Depend on firm size
• Ignore long-term term debt repayment in the
MEASURES calculation
(CONT.) • Commingles fixed asset replacement with fixed
asset expansion
• Could exclude the purchase of productive
intangible assets in its calculation
 Depreciation impact ratio
Computed as: (depreciation + amortization
CASH expenses) / cash flows from operations
FLOW Interpretation: small ratio indicates financial
strength as the non-cash addition to income isn’t
MEASURES the driving force behind operating cash flows
A large ratio (approaching one) indicates
(CONT.) insufficient cash flow from core activities
 • Recapitalization ratio
• Computed as: reinvestment ratio / depreciation
impact ratio
CASH • Interpretation: a ratio in excess of one means
that a company’s investment in productive
FLOW resources exceeds its use of productive
resources
MEASURES • A ratio below one means capital assets are not
(CONT.) being replaced in a timely manner
• Fails to measure capitalization as opposed to
recapitalization (e.g., for an emerging firm)
 Cash efficiency measures
A company must invest wisely in productive
CASH resources
Measure the relationship between
FLOW operating cash flows and assets and
MEASURES revenues
(CONT.) Determine if an enterprise’s investments
produced enough operating cash flows
 Three measures of cash efficiency
Cash flow return on assets: cash flow from
CASH operations / total assets
Cash flow return on sales: cash flow from
FLOW operations / revenues
MEASURES Operations index: cash flow from operations /
operating income
(CONT.)
CASH • Signs of cash efficiency
FLOW • Large rates of cash returns on assets and
revenues
MEASURES • Strong correlation between operating cash
(CONT.) flows and operating income
 Cash sufficiency versus cash efficiency
An entity must produce sufficient cash to
CASH prosper
FLOW They should do in an efficient manner (i.e.,
generating maximum revenues from its
MEASURES productive base.)
Cash flow sufficiency is a necessary component
(CONT.) of cash flow efficiency