Chapter 10 The Analysis of the Cash Flow Statement.

Chapter 10Chapter 10

The Analysis of the

Cash Flow Statement

The Analysis of Cash Flow The Analysis of Cash Flow StatementStatement

Link to Previous Chapter

This chapter reformulates the cash flow statement to capture

the operating and financing activities.

This Chapter

Chapter 11 lays out the analysis of the reformulated

financial statements.

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How is the cash flow statement reformulated to

separate operating and

financing flows?

How is free cash flow identified in reformulated

statements ?

What adjustments

must be made to GAAP cash flow

statements ?

Chapter 9 reformulated the balance sheet and income

statement to capture the operating and financing activities.

What you will learn from this What you will learn from this chapterchapter

• 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

• Problems that arise in analyzing cash flows from GAAP statements of cash flow

• What reformulated cash flow statements tell you

• How to examine the quality of reported cash flow from operations

The Calculation of Free Cash The Calculation of Free Cash FlowFlow

Three methods to calculate FCF:

1. Use the sources of cash flow equation:

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

2. Use the disposition of cash flows equation:

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.

NOAOIIC

d+NFOFENIC

Calculation of Free Cash Flow: Calculation of Free Cash Flow: Nike, Inc.: 2004Nike, Inc.: 2004

VF

Method 1:

C – I = OI -

Operating income 2004 Net operating assets 2004 Net operating assets 2003 Free cash flow 2004

$ 4,551 4,330

$ 1,035

(221)

$814

Method 2: C – I = NFE - FO + d

Net financial expenses 2004 Net financial obligations 2004 Net financial obligations 2003 Net dividend 2004 Free cash flow 2004

(289)

302

$ 16

591

207

$814

Calculation of Free Cash Flow:Calculation of Free Cash Flow:Reebok, 2004Reebok, 2004

Method 1:

C – I = OI -

Operating income, 2004 Net operating assets, 2004 Net operating assets, 2003 Free cash flow, 2004

$1,212

731

$ 237

481

$ (244)

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

Net financial expenses, 2004 Net financial obligations, 2004 Net financial obligations, 2003 Net dividend, 2004 Minority interest in income Change in minority interest in balance sheet Free cash flow, 2004

(23)

(316)

$ 18

(293)

23 5

3

___________

$ (244)

The Standard GAAP The Standard GAAP Statement of Cash FlowsStatement of Cash Flows

Standard Statement of Cash Flows

“Cash Flow from Operations”

- “Cash Used in Investing Activities”

+ “Cash from Financing Activities”

= in Cash and Cash Equivalents

Reformulated Statement of Reformulated Statement of Cash FlowsCash 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

Indirect Method for Cash Flow from Indirect Method for Cash Flow from OperationsOperations

Net income

+ Accruals

= Cash from operations

Nike’s statement (to follow) employs the

indirect method (as do almost all firms):

2004

Net income $ 945.6 million

Accruals 568.8

Cash provided by operations $1,514.4 million

Nike, Inc. GAAP Statement Nike, Inc. GAAP Statement of Cash Flowsof Cash Flows

2004 2003 2002

Cash provided (used) by operations: Net income 945.6 474.0 663.3 Income charges not affecting cash: Cumulative effect of accounting change - 266.1 5.0 Depreciation 252.1 239.3 223.5 Deferred income taxes 19.0 55.0 15.9 Amortization and other 58.3 23.2 48.1 Income tax benefit from exercise of stock options 47.2 12.5 13.9 Changes in certain working capital components: Decrease (increase) in accounts receivable 82.5 (136.3) (135.2) (Increase) decrease in inventories (55.9) (102.8) 55.4 (Increase) decrease in prepaids and (103.5) 60.9 16.9 other current assets Increase in accounts payable, accrued 269.1 30.1 175.4 liabilities and income taxes payable Cash provided by operations 1,514.4 922.0 1,082.2

Cash provided (used) by investing activities: Purchases of short-term investments (400.8) -Additions to property, plant and (213.9) (185.9) (282.8) equipment and other Disposals of property, plant and equipment 11.6 14.8 15.6 Increase in other assets (53.4) (46.3) (28.7) (Decrease) increase in other liabilities (0.9) 1.8 (6.9) Acquisition of subsidiary, net of cash acquired (289.1) - -

Cash used by investing activities (946.5) (215.6) (302.8)

Year Ended May 31,

(In millions)

Nike, Inc. GAAP Statement Nike, Inc. GAAP Statement of Cash Flows (cont.)of Cash Flows (cont.)

2004 2003 2002

Cash provided (used) by financing activities: Proceeds from long-term debt issuance 153.8 90.4 329.9 Reduction in long-term debt (206.6) (55.9) (80.3) including current portionDecrease in notes payable (0.3) (351.1) (433.1) Proceeds from exercise of stock options 253.6 44.2 59.5 and other stock issuancesRepurchase of stock (419.8) (196.3) (226.9) Dividends - common and preferred (179.2) (137.8) (128.9)

Cash used by financing activities (398.5) (606.5) (479.8)

Effect of exchange rate changes 24.6 (41.4) -28.1

Net increase in cash and equivalents 194.0 58.5 271.5 Cash and equivalents, beginning of year 634.0 575.5 304.0 Cash and equivalents, end of year 828.00$ 634.00$ 575.50$

Supplemental disclosure of cash flow information:Cash paid during the year for:Interest, net of capitalized interest 37.80$ 38.90$ 54.20$ Income taxes 418.6 330.2 262.0

Year Ended May 31,

(In millions)

Direct Method for Cash from Direct Method for Cash from OperationsOperations

Cash inflows- Cash outflows

= Cash from operations

2001 2002Operating ActivitiesSources of cash

Cash received from customersProgress payments 3,102 1,438 Other collections 11,148 7,003

Interest received 17 17 Income tax refunds received 23 15 Other cash receipts 244 10

Cash provided by operating activities 14,534 8,483

Uses of cash Cash paid to suppliers and employees 13,251 7,250 Interst paid 333 165 Income taxes paid 126 57 Other cash payments 7 1

Cash used in operating activities 13,717 7,473

Net cash provided by operating activities 817 1,010

Northrop Grumman Corp.

Problems with the Standard Problems with the Standard StatementStatement

1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section

2. Transactions in financial assets are included in the investments section rather than in the financing section

3. Cash interest is included in the operating rather than in the financing section

4. Tax cash flows are all included in the operating section, and not allocated to operating and financing

5. The statement does not incorporate non-cash transactions

1. Operating Cash and Cash in 1. Operating Cash and Cash in Financial Assets: NikeFinancial Assets: Nike

Change in cash and cash equivalents $194 million

Increase in operating cash $ 8 millionIncrease in financial assets 186

$194 million

The determination of operating cash: use a normal percentage of sales for the industry

See Nike’s reformulated balance sheet in Exhibit 9.3 in chapter 9.

2. Transactions in Financial 2. Transactions in Financial Assets: Lucent TechnologiesAssets: Lucent Technologies

Fiscal Year Ending September

1999 1998 1997

Net income 4,766 1,035 449 Cash from operating activities (276) 1,860 2,129 Cash in investing activities: Capital expenditures (2,215) (1,791) (1,744) Proceeds from the sale or disposal of property, plant and equipment 97 57 108 Purchases of equity investments (307) (212) (149) Sales of equity investments 156 71 12 Purchases of investment securities (450) (1,082) (483) Sales or maturity of investment securities 1,132 686 356 Dispositions of businesses 72 329 181 Acquisitions of businesses - net of cash acquired (264) (1,078) (1,584) Cash from mergers 61 - - Other investing activities - net (69) (80) (68) Net cash used in investing activities (1,787) (3,100) (3,371)

Net sales of financial assets 682 (396) (127)

Adjusted cash investment in operations (2,469) (2,704) (3,244)

3. and 4. Net Interest Payments 3. and 4. Net Interest Payments and Taxes on Net Interest and Taxes on Net Interest

Payments: NikePayments: Nike

In millions

Interest payments $37.8Interest income (15.0)Net interest payments

before tax 22.8Tax benefit (at 37.1%) 8.5 $14.3

Add back to GAAP Cash from Operations

5. Non-cash Transactions5. Non-cash Transactions

•Acquisitions with shares

•Asset exchanges

•Assets acquired with debt

•Capitalized leases

•Installment purchases

•Debt converted to equity

The Reformulated Statement of The Reformulated Statement of Cash Flows: the AdjustmentsCash Flows: the Adjustments

Reformulating GAAP Cash Flow Statements

GAAP Free Cash Flow

+ Net cash interest outflow (after tax)

+ Investments in financial assets

- Sale of financial assets

- Noncash investments

- Increase in operating cash

= Free Cash Flow

GAAP Financing Flow

+ Net cash interest outflow (after tax)

- Noncash financing

+ Purchase of financial assets

- Sales of financial assets

+ Increase in cash equivalents

= Financing Cash Flow

Nike, Inc. Reformulated Nike, Inc. Reformulated Statement of Cash FlowsStatement of Cash Flows

Free Cash Flow:

Reported cash from operations

Net interest paid after tax

Cash investments reported

Investment in operating cash

Investment in financial assets

Free cash flow

Financing Flow to Claimants

Debt financing:

Issue of long-term debt

Reductions in long-term debt

Investment in financial assets

Net interest payment (after tax)

Investments in cash equivalents

(net of exchange rate effect on cash)

Equity financing:

Share issues

Shares repurchases

Dividends

Total financing flows

$947

8

(401)

(154)

207

401

14

161

(254)

420

179

$1514

14

1,528

554

$974

629

345

974

Why Free Cash Flow from Adjusted Cash Why Free Cash Flow from Adjusted Cash Flow Statements May not Reconcile to the Flow Statements May not Reconcile to the

Methods 1 and 2Methods 1 and 2

• “Other assets” and “other liabilities” are not identified as either operating or financing

• Cash dividends in the cash flow statement differ from dividends in the equity statement

• Cash from share issues in the cash flow statement may differ from share issues in the equity statement

• Details for adjustments 3,4 and 5 are not available

• Cash flow numbers of foreign subsidiaries are translated at average exchange rates whereas balance sheet numbers are translated at end-of-year exchange rates

• Stock options involve “as if” cash flows

The Calculation of Cash Flow The Calculation of Cash Flow from Operationsfrom Operations

The practical matter of distinguishing cash flow from operations from cash flow from investment activities is not an easy one: the cash flow from operations in the GAAP statement is not a clean measure.

• Some cash flows from investment activities are classified as cash flows from operations

– R&D expenditures

– Investment in inventories

• Taxes on gains from assets sales are classified as cash flow from operations

Note, however, that for a calculation of FCF (C – I), a misclassification between investment and operating activities has no effect

The Quality of the Reported Cash The Quality of the Reported Cash Flow from Operations (CFO) Number Flow from Operations (CFO) Number

as an Indicator of Profitabilityas an Indicator of Profitability

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

•Firms can delay payments to generate cash flow

•Firms can sell receivables to generate cash flow

•Firms can reduce advertising expenditures to generate cash flow

•Firms can reduce R & D expenditures to generate cash flow

•Non-cash transactions are not in CFO

•Structured financing can make borrowing look like cash from operations: Enron

•Capitalization policy shifts CFO to cash investment