Financial Statements - The Cash Flow Statement

I. Introduction Components and Relationships Between the Financial Statements It is important to understand that the income statement, balance sheet and cash flow statement are all interrelated. The income statement is a description of how the assets and liabilities were utilized in the stated accounting period. The cash flow statement explains cash inflows and outflows, and will ultimately reveal the amount of cash the company has on hand; this is reported in the balance sheet as well. We will not explain the components of the balance sheet and the income statement here since they were previously reviewed. Figure 6.13: The Relationship between the Financial Statements

Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis. The cash flow statement will reveal the following to analysts: 1. 2. 3. 4. 5. How the company obtains and spends cash Why there may be differences between net income and cash flows If the company generates enough cash from operation to sustain the business If the company generates enough cash to pay off existing debts as they mature If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows The statement of cash flows is segregated into three sections: 1. Operating activities 2. Investing activities 3. Financing activities

1. Cash Flow from Operating Activities (CFO) CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes. This includes: Cash inflow (+) 1. Revenue from sale of goods and services 2. Interest (from debt instruments of other entities) 3. Dividends (from equities of other entities) Cash outflow (-) 1. Payments to suppliers 2. Payments to employees 3. Payments to government 4. Payments to lenders 5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)

CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets. This includes:

Cash inflow (+) 1. Sale of property, plant and equipment 2. Sale of debt or equity securities (other entities) 3. Collection of principal on loans to other entities Cash outflow (-) 1. Purchase of property, plant and equipment 2. Purchase of debt or equity securities (other entities) 3. Lending to other entities

3. Cash flow from financing activities (CFF) CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes: Cash inflow (+) 1. Sale of equity securities 2. Issuance of debt securities Cash outflow (-) 1. Dividends to shareholders 2. Redemption of long-term debt 3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions Information for the preparation of the statement of cash flows is derived from three sources: 1. Comparative balance sheets 2. Current income statements 3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash. Examples Include:

Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.

Financial Statements - Cash Flow Computations - Indirect Method

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two ways: 1. The indirect method 2. The direct method

The Indirect Method The indirect method is preferred by most firms because is shows a reconciliation from reported net income to cash provided by operations. Calculating Cash flow from Operations Here are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income. 2. Add back non-cash expenses. o (Such as depreciation and amortization) Add back losses Subtract out gains 3. Adjust for gains and losses on sales on assets. o o

4. Account for changes in all non-cash current assets. 5. Account for changes in all current assets and liabilities except notes payable and dividends payable.

In general, candidates should utilize the following rules: Increase in assets = use of cash (-) Decrease in assets = source of cash (+) Increase in liability or capital = source of cash (+) Decrease in liability or capital = use of cash (-)

The following example illustrates a typical net cash flow from operating activities:

Cash Flow from Investment Activities Cash Flow from investing activities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on

loans. Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities Cash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not. Here's the calculation of the cash flows from financing using the indirect method:

Financial Statements - Cash Flow Computations - Direct Method

The Direct Method The direct method is the preferred method under FASB 95 and presents cash flows from activities through a summary of cash outflows and inflows. However, this is not the method preferred by most firms as it requires more information to prepare.

Cash Flow from Operations Under the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends, and deducting cash payments for purchases, operating expenses, interest and income taxes. We'll examine each of these components below:

Cash collections are the principle components of CFO. These are the actual cash received during the accounting period from customers. They are defined as: Formula 6.7 Cash Collections Receipts from Sales = Sales + Decrease (or - increase) in Accounts Receivable

Cash payment for purchases make up the most important cash outflow component in CFO. It is the actual cash dispersed for purchases from suppliers during the accounting period. It is defined as: Formula 6.8 Cash payments for purchases = cost of goods sold + increase (or - decrease) in inventory + decrease (or increase) in accounts payable Cash payment for operating expenses is the cash outflow related to selling general and administrative (SG&A), research and development (R&A) and other liabilities such as wage payable and accounts payable. It is defined as:

Formula 6.9 Cash payments for operating expenses = operating expenses + increase (or - decrease) in prepaid expenses + decrease (or - increase) in accrued liabilities

Cash interest is the interest paid to debt holders in cash. It is defined as:

Formula 6.10 Cash interest = interest expense - increase (or + decrease) interest payable + amortization of bond premium (or - discount)

Cash payment for incometaxes is the actual cash paid in the form of taxes. It is defined as:

Formula 6.11 Cash payments for income taxes = income taxes + decrease (or - increase) in income taxes payable

Look Out! Note: Cash flow from investing and financing are computed the same way it was calculated under the indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the direct method.

Look Out! Candidates must know the following: Though the methods used differ, the results are always the same. CFO and CFF are the same under both methods. There is an inverse relationship between changes in assets and changes in cash flow.

Financial Statements - Free Cash Flow

Free Cash Flow (FCF)

Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating. Formula 6.12 Free cash flow = cash flow from operating activities - net capital expenditures (total capital expenditure - after-tax proceeds from sale of assets) The FCF measure gives investors an idea of a company's ability to pay down debt, increase savings and increase shareholder value, and FCF is used for valuation purposes. Free Cash Flow to the Firm (FCFF) Free cash flow to the firm is the cash available to all investors, both equity and debt holders. It can be calculated using Net Income or Cash Flow from Operations (CFO). The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF is the cash flow allocated to all investors including debt holders, the interest expense which is cash available to debt holders must be added back. The amount of interest expense that is available is the after-tax portion, which is shown as the interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. . This makes the calculation of FCFF using CFO equal to: FCFF = CFO + [Int x (1-tax rate)] FCInv Where: CFO = Cash Flow from Operations Int = Interest Expense FCInv = Fixed Capital Investment (total capital expenditures) This formula is different for firm's that follow IFRS. Firm's that follow IFRS would not add back interest since it is recorded as part of financing activities. However, since IFRS allows dividends paid to be part of CFO, the dividends paid

would have to be added back. The calculation using Net Income is similar to the one using CFO except that it includes the items that differentiate Net Income from CFO. To arrive at the right FCFF, working capital investments must be subtracted and non-cash charges must be added back to produce the following formula: FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv Where: NI = Net Income NCC = Non-cash Charges (depreciation and amortization) Int = Interest Expense FCInv = Fixed Capital Investment (total capital expenditures) WCInv = Working Capital Investments Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking on debt (Net Borrowing). The formula equals: FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

Financial Statements - Management Discussion and Analysis & Financial Statement Footnotes
I. Management Discussion and Analysis The Securities Exchange Commission (SEC) requires this section to be included with the financial statements of a public company and is prepared by management This narrative section usually includes the following; A description of the company's primary business segments and future trends A review of the company's revenues and expenses Discussions pertaining to the sales and expense

trends Review of cash flow statements and future cash flow needs including current and future capital expenditures A review of current significant balance sheet items and future trends, such as differed tax liabilities, among others A discussion and review of major transactions (acquisitions, divestitures) that may affect the business from an operational and cash flow point of view A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent events

Financial Statement Footnotes These footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements. Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates reported in the consolidated financial statements. Included in the footnotes are the following:

A summary of significant accounting policies such as: o The revenues-recognition method used o Depreciation methods and rates Balance sheet and income statement breakdown of items such as: o Marketable securities o Significant customers (percentage of customers that represent a significant portion of revenues) o Sales per regions o Inventory

Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans and capital structure.

Supplemental schedules often detail disclosures required by audited statements, as well as the accounting methods and assumptions used by management. Supplemental schedules can include information such as natural resources reserves, an overview of specific business lines, or the segmentation of income or other line items by geographical area or customer distribution. Management's Discussion and Analysis (MD&A) presents management's perspective on the financial performance and business condition of the firm. U.S. publicly-held companies must provide MD&As that include a discussion of the operations of the company in detail by usually comparing the current period versus prior period Analyst Interpretation As reporting standards continue to change and evolve, analysts must be aware of new accounting approaches and innovations that can affect how businesses treat certain transactions, especially those that have a material impact on the financial statements. Analysts should use the financial reporting framework to guide them on how to determine the financial statement impact of new types of products and business operations. One way to keep up to date on evolving standards and accounting methods is to monitor the standard setting bodies and professional organizations like the CFA Institute that publish position papers on the subject. Companies that prepare financial statements under IFRS or US GAAP must disclose their accounting policies and estimates in the footnotes, as well as any policies requiring management's judgment in the management's discussion and analysis. Public companies must also disclose their

estimates for the impact of newly adopted policies and standards on the financial statements.