Lecture 4

Lecture 4Understanding Cash Flow StatementCash Flow Statementprovides information beyond that available from the income statement, which is based on accrual, rather than cash, accounting. reports changes in cash due to operating, investing and financing activities over a period of time.

Cash Flow StatementProvides:Information about a companys cash receipts and cash payments during an accounting periodInformation about a companys operating, investing and financing activitiesAn understanding of the impact of accrual accounting events on CFs.

An analyst can use the statement of CFs to determine whether:

Regular operations generate enough cash to sustain the businessEnough cash is generated to pay off existing debts as they matureThe firm is likely to need additional financingUnexpected obligations can be metThe firm can take advantage of new business opportunities as they arise

Statement of Cash Flows FormatNet cash from operating activities +Net cash from investing activities +Net cash from financing activities =Net change in cash balanceCash Flow ComponentsCash flows can be divided into three types:. Cash from operating (CFO):. Cash from investing (CFI):. Cash from financing (CFF):Cash Flow from Operating (CFO)

consists of the inflows and outflows of cash resulting from transactions that affect a firms net income.Cash from Operating Activities (U.S. GAAP)

Operating cash outflows exclude these income statement items: Depreciation and amortization (and other noncash items) Gains or losses on disposal of PP&ENoncash Investing and Financing ActivitiesNon cash investing and financing activities: are not reported in the cash flow statement since they do not result in inflows or outflows of cash.

Non cash transactions must be disclosed in either a footnote or supplemental schedule to the cash flow statement.

Cash from investing (CFI)consists of the inflows and outflows of cash resulting from acquisition or disposal of long term assets and certain investments.Cash from Investing Cash Flow (U.S. GAAP)

Cash from financing (CFF)consists of the inflows and outflows of cash resulting from transactions affecting a firms capital structure.Cash from Financing Cash Flow (U.S. GAAP)

Distinguish Cash Flow Statements Under IFRS and U.S. GAAPUS.GAAP: dividends paid to the firms SHDs are reported as financing activitiesinterest paid is reported in operating activities interest received and dividends received from investments are reported as operating activities.All taxes are reported as operating activities

IRFS:Interest and dividends received are reported as operating or investing activitiesDividends paid to the companys SHDs and interest paid on the companys debt are reported as operating or financing activities.Income taxes are reported as operating activities unless the expense is associated with an investing or financing transaction.

ExampleConsider a company sells land that was held for investment for $1 million. Income taxes on the sale total $160.000. Under US.GAAP, the firm reports an inflow of cash from investing activities of $1 million and an outflow of cash from operating activities of $160.000Under IFRS, the firm can report a net inflow of $840.000 from investing activities.

Examples

Cash Flow Statement: Linkages and PreparationLinkages of CFS with BS:Assets = Liabilities + Owners Equity

Cash + Noncash assets = Liabilities + Shareholder Equity

C + N$A = L + CC + AOCI + RE

C = L + CC + AOCI + RE - N$A

CC : Contributed Capital AOCI: Accumulated Other Comprehensive Income RE: Retained Earnings

Cash Flow Statement: Linkages and PreparationLinkages of CFS with BS:Any differences between the accrual basic and cash basic of accounting for an operating transaction result in an increase or decrease in some short term asset or liability on the balance sheet.Investing activities typically relate to long term asset section of BS and its financing activities typically relate to the equity and long term debt section of BS.Each item on BS is also related to IS and/or CFS through the change in the beginning and ending balance.Method for Preparing Cash Flow StatementDirect MethodIndirect MethodDirect MethodEach line item of the accrual-based income statement is converted into cash receipts or cash payments.Begins with cash inflows from customer and then deducts cash outflows for purchases, operating expenses, interest and taxes.Example:

Indirect MethodNet income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions.The starting point is net incomeExample:Distinguish between Direct Method and Indirect Method Both methods are permitted under US.GAAP and IFRSThe difference between the two methods relates to the presentation of cash flow from operating activities.The presentation of cash flows from investing activities and financing activities is exactly the same under both methods

Preparation of Direct and Indirect Cash Flow StatementsPoints to rememberSteps in Presenting CFO of Direct MethodSteps in Presenting CFO of Indirect MethodPresenting CFI, CFFExamplesPoints to RememberCFO is calculated differently, but the result is the same under both methodsThe calculation of CFI and CFF is identical under both methodsThere is an inverse relationship between changes in assets and changes in cash flows.There is a direct relationship between changes in liabilities and changes in cash flow.

Steps in Presenting CFO of Indirect MethodStep 1: Begin with net incomeStep 2: Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land)Step 3: Add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue.Step 4: Add and subtract changes to balance sheet operating accounts as follows:Increases in operating assets accounts (uses of cash) are subtracted, while decreases (sources of cash) are added.Increases in the operating liability accounts (sources of cash) are added, while decreases (use of cash) are subtracted.Steps in Presenting CFO of Direct MethodDirect method shows only cash payments and cash receipts over the period.Common components of cash flow appear on cash flow presented under the direct method:Cash received from customersCash paid to suppliersCash paid to employeesCash paid for other operating expensesCash paid for InterestCash paid for taxesPresenting CFI, CFFThe presentation of CFI and CFF is identical, regardless of whether the direct or indirect method is used for operating cash flows.CFI and CFF are always presented using the direct method.Common Size Cash Flow StatementCommon size analysis can be used to analyze the cash flow statementThe cash flow statement can be converted to common size format by expressing each line item as a percentage of revenue.A revenue based common size cash flow statement is useful in identifying trends and forecasting future cash flow.

Example: Common-size Cash Flow Statement AnalysisTriple Y Corporations common-size cash flow statement is shown in the table below. Explain the decrease in Triple Ys total cash flow as a percentage of revenues.

HomeworkCash Flow and Life Cycle Phase