Statement of Cash Flows

Chapter 13

Venu Madhav Tatiparti

List of Topics
• Statement of Cash flows in perspective : 483
• Purpose and Structure of the Statement of Cash flows: 483-488
• Computing Net Cash Flow from Operating Activities: 488-493
• Interpreting the Statement of Cash Flows: 499-501
Learning objectives
• Objectives of Financial Statement Analysis
• How ROE and ROA are used to evaluate profitability
• How competitive forces and business strategies affect ROA
• Assessing Liquidity and Solvency
• Understanding capital market ratios
Why Cash Flow Statement?
• Statement of Profit and Loss doesn’t capture the cash generated/paid during the year.
• Accrual earnings are subject to managerial discretion:
• Accrual accounting relies on subjective judgments that may introduce measurement
error and uncertainty into reported earnings.
• One-time write-offs and restructuring charges can reduce the quality of reported
earnings.
• Management can readily manipulate accrual income.
• For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings
—to evaluate performance and creditworthiness.
Cash Flow Statement
Cash and Cash Equivalents
• Cash equivalents are short-term, highly liquid investments that are
• readily convertible to known amounts of cash, and
• near maturity (typically within 3 months)
• Examples: Cash and Bank Balance, short term liquid investments.
Operating activities
• Result from events or transactions that enter into the determination of net income; i.e., the
cash-based revenues and expenses of a company.
• Cash inflows
• Cash sales and collections
• Advances from customers
• Cash outflows:
• To suppliers
• For Expenses
• To government
Investing activities
• Result from the purchase or sale of productive assets like plant and equipment, long-term investments,
and from acquisitions and divestitures.
• Cash inflows:
• From sale of fixed assets
• From sale of investments with maturity > 3 months
• Interest and Dividend Income
• Cash outflows:
• To purchase fixed assets
• To purchase investments with maturity > 3 months
• To make loans to other entities.
Financing activities
• Result when a company sells its own stocks or bonds, pays dividends or buys back its own shares, or
borrows money and repays the amounts borrowed.
• Cash inflows:
• From sale of common stock.
• From issuance of long-term debt (bonds and loans).
• Cash outflows:
• To shareholders as dividends.
• To redeem long-term debt
• To buyback shares
• To lenders as interest
Let’s Solve
• Problem 13.1
Preparation of Cash flow from Operations
• The standard prescribes two methods that can be applied to arrive at the cash flow
from operations:
• Direct method
• Indirect method
CFO (Indirect Method)
CFO (Indirect Method)
• Objective: Determine net cash provided/used by operating activities by converting net
profit from an accrual basis to a cash basis.
• Common adjustments to Net Profit (Loss):
• Add back non-cash expenses/losses (e.g.: depreciation and amortization expense
and bad debt expense).
• Deduct non-cash gains.
• Add back Interest Expense and Subtract Interest and Dividend Income
• Changes in working capital
Changes to Working Capital
• Δ Accounts Receivable
• Δ Inventory
• Δ Accounts Payable
• Δ Prepaid Expenses
• Δ Tax Payable
Working Capital Adjustments
• In general, increases in assets is a use of cash – increases in current assets represent
a use of cash in operations. Decreases in current assets are sources of cash from
operations.
• In general increases in liabilities is a source of cash – increases in current liabilities
represent a source of cash from operations. Decreases in current liabilities are uses
of cash from operations.
Operating Activities – Gains and Losses on Asset Sales
• Because companies report the actual amount of cash as a source of cash in the
investing activities section received from the sale and the loss or gain is reflected in
the net profit at the top of the operating activities section, to avoid double-counting:
• Any loss on sale is added to net profit in the operating section.
• Any gain on sale is deducted from net profit in the operating section.
Computing Operating Cash Flows
• Three Sources of Information:
• Comparative balance sheets
• Current profit and loss account
• Additional information
Let’s Solve
• Problem 13.4
Source: Cash Flow Patterns as a Proxy for Firm Life Cycle, V. Dickinson (2011)
Review Problems
• In Class: 13.1, 13.4
• Practice Problems: 13.2, 13.8