CFA LEVEL I & II 2012 © Kaplan Financial Limited
Financial Reporting and Analysis
Mastering the Cash Flow Statement
CFA® Levels I & II
Importance of Cash Flow Statement
Net income from accrual accounting does not tell us about the sources and uses of cash to meet liabilities and operating needs
The statement of cash flows has three components under both IFRS and US GAAP:
� Cash provided or used by operating activities
� Cash provided or used by investing activities
� Cash provided or used in financing activities
LOS 27.a Compare/Classify: CFAI pg 273 Schweser pg 108
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Operating Cash Flows (CFO)
Cash received from customers
Cash dividends received
Cash interest received
Other cash income
Payments to suppliers
Cash expenses (wages etc)
Cash interest paid
Cash taxes paid
CFO
$
X
X
X
X
(X)
(X)
(X)
(X)
X/(X)
LOS 27.a Compare/Classify: CFAI pg 273 Schweser pg 108
Understanding the Cash Flow Statement
Investing Cash Flows (CFI)
� Purchases of property, plant, and equipment
� Proceeds from sales of assets
� Investments in joint ventures and affiliates
� Payments for businesses acquired
� Purchases and sales of intangibles
� Purchases or sales of marketable securities
Excludes:
� Trading securities (part of CFO)
� Cash equivalents (part of B/S cash)
LOS 27.a Compare/Classify: CFAI pg 273 Schweser pg 108
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Financing Cash Flows
Issue and redemption of:
� Common stock
� Preferred stock
� Treasury stock repurchases
� Debt
� Dividend payments (dividends rec’d CFO—U.S. GAAP)
Excludes:
� Indirect financing via accounts payable (CFO)
LOS 27.a Compare/Classify: CFAI pg 273 Schweser pg 108
Understanding the Cash Flow Statement
Non-Cash Investing and Financing Activities
Several types of transactions do not involve the payment or receipt of cash and are not reflected in financing and investing cash flows, but are disclosed in the footnotes or other schedules
Non-cash financing and investing activities:
� Converting debt or preferred into common equity
� Assets acquired under capital leases
� Purchase of assets via issuance of debt/equity
� Exchanging one non-cash asset for another
� Stock dividends
LOS 27.b Describe: CFAI pg 275 Schweser pg 110
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
U.S. GAAP vs. IFRS
Interest received
Interest paid
Dividends received
Dividends paid
Taxes paid
Bank overdraft
CFO
CFO
CFO
CFF
CFO
CFF
CFO or CFI
CFO or CFF
CFO or CFI
CFO or CFF
CFO or CFI & CFF
*
U.S. GAAP
(SFAS 95)
IAS GAAP
(IAS 7)
* Considered part of cash and cash equivalents
LOS 27.c Contrast: CFAI pg275 Schweser pg 110
Understanding the Cash Flow Statement
Statement of Cash Flow: Direct vs. Indirect Method
Direct vs. indirect method refers only to the calculation of CFO, the value of CFO is the same for both methods; CFI and CFF are unaffected
� Direct method: Identify actual cash inflows and outflows; e.g., collections from customers, amount paid to suppliers
� Indirect method: Begin with net income and make necessary adjustments to get operating cash flow
LOS 27.d Demonstrate/Explain: CFAI pg 277 Schweser pg 111
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Linkages Between Statements
Accounts Receivable ‘T’ Account
Amount B/Fwd
Sales
Amount C/Fwd
18,000
20,000
200,000
218,000 218,000
Cash collections198,000
This year’s balance sheet
Last year’s balance sheet
This year’s income statement
LOS 27.e Describe: CFAI pg 287 Schweser pg 113
- 5
Understanding the Cash Flow Statement
Direct Method CFO1. Take each income statement item in turn
– e.g., sales
2. Move to the balance sheet and identify asset and liability accounts that relate to that income statement item—e.g., accounts receivable
3. Calculate the change in the balance sheet item during the period (ending balance – opening balance)
4. Apply the rule:Increases in an asset: deduct Increase in a liability: addDecrease in an asset: addDecrease in a liability: deduct
LOS 27.g Convert: CFAI pg 302 Schweser pg 120
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Direct CFO
5. Adjust the income statement amount by the change in the balance sheet
6. Tick off the items dealt with in both the income statement and balance sheet
7. Move to the next item on the income statement and repeat
8. Ignore depreciation/amortization and gains/losses on the disposal of assets as these are non-cash or non-CFO items
LOS 27.g Convert: CFAI pg 302 Schweser pg 120
Understanding the Cash Flow Statement
9. Keep moving down the income statement until all items included in net income have been addressed applying steps 1-8
10. Total up the amounts and you have CFO
Direct CFO
LOS 27.g Convert: CFAI pg 302 Schweser pg 120
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Ecclestone Industries—Example
Ecclestone Industries has the following income statement for 20X9 and balance sheets for 20X8 and 20X9. You are to construct the statement of cash flows using the indirect method.
Additional information:Equipment was purchased for $50,000Ecclestone has a tax rate of 40%
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
Income Statement for Year to 31 December 20X9
Sales revenueExpenses:
Cost of goods soldSalariesDepreciationInterest
Gain from sale of PPEPre-tax incomeProvision for taxesNet income
$ 200,000
105,00095,00020,000
115,00040,00075,000
$
80,00010,00014,0001,000
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Ecclestone Balance Sheet DataBalance Sheets
Current assetsCashAccounts receivableInventory
Non-current assetsGross PPEAccum. Depr.
Total Assets
20X8$
18,00018,00014,000
282,000
252,000
20X9$
66,00020,00010,000
312,000
324,000
(80,000) (84,000)
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
Balance Sheets
Current liabilitiesAccounts payableSalaries payableInterest payableTaxes payableDividends payable
Noncurrent liabilitiesBondsDeferred taxes
Stockholders’ equityCommon stockRetained earnings
Total Liabilities & Equity
20X8$
10,00016,0006,0008,0002,000
20,00030,000
100,00060,000
252,000
20X9$
18,0009,0007,000
10,00012,000
30,00040,000
80,000118,000
324,000
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Cash InflowsSalesLess: Increase in A/RCash collected from customers
Direct cash outflowsCost of goods soldAdd: Decrease in inventoryPurchasesAdd: Increase in A/PCash paid to suppliers
Operating expense (wages)Less: Decrease in salaries payableCash paid to employees
200,000(2,000)
(80,000)4,000(76,000)8,000
198,000
(68,000)
(10,000)(7,000)
(17,000)
Direct CFO
-8
LOS 27.g Convert: CFAI pg 302 Schweser pg 120
Understanding the Cash Flow Statement
(28,000)
(40,000)10,000
2,000
(1,000)1,000
Direct cont.
Cash outflowsInterest ExpenseAdd: Increase in interest payable
Cash interest paid
Tax ExpenseAdd: Increase in deferred tax liab.Tax payableAdd: Increase in taxes payable
Cash taxes paid
$ $
CFO
0
85,000
(30,000)
-7
LOS 27.g Convert: CFAI pg 302 Schweser pg 120
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Indirect Method CFOSteps
1. Start with net income
2. Adjust net income for changes in relevant balance sheet items:
Increases in an asset: deduct Increase in a liability: addDecrease in an asset: addDecrease in a liability: deduct
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
Indirect method continued
3. Eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at net income but are non-cash expenses)
4. Eliminate gains on disposal by deducting them and losses on disposal by adding them back (these are CFI, not CFO)
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Net income 75,000Non Cash ChargesAdd: Depreciation 14,000Less: Gain from sale of PPE (20,000)Add: Increase in deferred taxes 10,000
Current asset adjustmentsLess: Increase in accounts receivable (2,000)Add: Decrease in inventory 4,000
Current liability adjustmentsAdd: Increase in accounts payable 8,000Less: Decrease in salaries payable (7,000)Add: Increase in interest payable 1,000Add: Increase in taxes payable 2,000
$
Cash flow from operations 85,000
Ind
irect
Meth
od
So
luti
on
-10
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
Calculating CFI
CFI =
investment in assets – cash received on asset sales
Net book value =
Gross PPE – accumulated depreciation
Gain (loss) on sale = sales price – net book value
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Ecclestone CFI
Gross Plant and Equip.
Beginning PPE
Additions
PPE disposal
Ending PPE
282,000
50,000
(20,000)
312,000
Accumulated Depr.
Begin Acc. Depr.
Depr. Expense
AD for disposal
End Acc. Depr.
80,000
14,000
(10,000)
84,000
Calculating NBV of asset sold
NBV of disposal = 20,000 – 10,000 = 10,000
-5
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFI = cash additions – cash received on disposal
Sale Proceeds
NBV of disposal
Gain(loss) on sale
30,000
10,000
20,000
$
CFI = –additions + proceeds
CFI = –$50,000 + $30,000 = –$20,000
Ecclestone CFI
-2
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Computing CFF
� Change in debt
� Change in common stock
� Cash dividends paid
Net income
Dividends declared
∆ in retained earnings
$
X
(X)
X
Dividends declared
∆Dividends payable
Cash paid
$
(X)
X
(X)
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
� Change in debt
� Change in common stock
� Cash dividends paid
Net income
Div declared
∆ in R/E
$
75,000
(17,000)
58,000
Dividends decl.
∆ Div. payable
Cash div. paid
$
(17,000)
10,000
(7,000)
Ecclestone CFF$
10,000
(20,000)
(7,000)
(17,000)
-7
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
$
85,000
(20,000)
(17,000)
48,000
18,000
66,000
Putting the Cash Flow Statement Together
Cash flow from operations
Cash flow from investments
Cash flow from financing
Net increase in cash
Cash balance 12/31/X8
Cash balance 12/31/X9
-6
LOS 27.f Describe: CFAI pg 289 Schweser pg 114
Understanding the Cash Flow Statement
Cash Flow Statement Analysis
Do regular operations generate enough cash to sustain the business?
Is enough cash is generated to pay off maturing debt?
Highlights the need for additional finance
Ability to meet unexpected obligations
The flexibility to take advantage of new business opportunities
Benefits for the analyst
LOS 27.h Analyze/Interpret: CFAI pg 303 Scweser pg 123
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Analysis
1. Analyze the major sources and uses of cash flow (CFO, CFI, CFF)
� Where are the major sources and uses?
� Is CFO positive and sufficient to cover capex?
2. Analyze CFO
� What are the major determinants of CFO?
� Is CFO higher or lower than NI?
� How consistent is CFO?
LOS 27.h Analyze/Interpret: CFAI pg 303 Scweser pg 123
Understanding the Cash Flow Statement
Analysis3. Analyze CFI
� What is cash being spent on?
� Is the company investing in PP&E?
� What acquisitions have been made?
4. Analyze CFF
� How is the company financing CFI and CFO?
� Is the company raising or repaying capital?
� What dividends are being returned to owners?
LOS 27.h Analyze/Interpret: CFAI pg 303 Scweser pg 123
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Free Cash Flow (FCF)
� FCF is cash available for discretionary uses
� Frequently used to value firms
� FCFF = NI + NCC - WCInv + Int (1-T) – FCInv
� FCFF = CFO + Int (1-T) – FCInv
� FCFE = CFO – FCInv + Net debt increase
LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125
Understanding the Cash Flow Statement
Free Cash Flow (FCF) Ecclestone
� FCFF = CFO + Int (1 – T) – FCInv
$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000
� FCFE = CFO – FCInv + Net debt increase
$75,000 = $85,000 – $20,000 + $10,000
� FCFE = FCFF – Int (1 – T) + Net debt increase
$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000
-5
LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Cash Flow Performance Ratios
Cash flow to revenue
Cash return on assets
Cash return on equity
Cash to income
CFO
Net revenue
CFO
Ave total assets
CFO
Ave equity
CFO
Operating income
LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125
Understanding the Cash Flow Statement
Cash Flow Performance Ratios
Cash flow per share*CFO – pref div
No common stock
*IFRS: If dividends paid were treated as CFO, they must be added back
LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Cash Flow Coverage Ratios
Debt coverage
Interest coverage*
Reinvestment
CFO
Total debt
CFO + interest + tax
Interest paid
CFO
Cash paid for long-term assets*IFRS: If interest paid was
treated as CFF, no addition is required
LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125
Understanding the Cash Flow Statement
Cash Flow Coverage Ratios
Debt payment
Dividend payment
Investing and financing
CFO
Cash paid for long-term debt repayment
CFO
Dividends paid
CFO
Cash outflows for CFI & CFF
LOS 27.i Calculate/Interpret: CFAI pg 312 Schweser pg 125
Understanding the Cash Flow Statement
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Cash InflowsSalesLess: Increase in A/RCash collected from customers
Direct cash outflowsCost of goods soldAdd: Decrease in inventoryPurchasesAdd: Increase in A/PCash paid to suppliers
Operating expense (wages)Less: Decrease in salaries payableCash paid to employees
200,000(2,000)
(80,000)4,000
(76,000)8,000
198,000
(68,000)
(10,000)(7,000)
(17,000)
Direct from Indirect CFO
(28,000)
(40,000)10,000
2,000
(1,000)1,000
Direct from Indirect, cont.
Cash outflowsInterest ExpenseAdd: Increase in interest payable
Cash interest paid
Tax ExpenseAdd: Increase in deferred tax liab.Tax payableAdd: Increase in taxes payable
Cash taxes paid
$ $
CFO
0
85,000
(30,000)
CFA LEVEL I & II 2012 © Kaplan Financial Limited
Net income 75,000 Add: Depreciation 14,000Less: Gain from sale of PPE (20,000)Add: Increase in deferred taxes 10,000
Current asset adjustmentsLess: Increase in accounts receivable (2,000)Add: Decrease in inventory 4,000
Current liability adjustmentsAdd: Increase in accounts payable 8,000Less: Decrease in salaries payable (7,000)Add: Increase in interest payable 1,000Add: Increase in taxes payable 2,000
$
Cash flow from operations 85,000
Ind
irect
Meth
od
So
luti
on
Ecclestone CFI
Gross Plant and Equip.
Beginning PPE
Additions
PPE disposal
Ending PPE
282,000
50,000
(20,000)
312,000
Accumulated Depr.
Begin Acc. Depr.
Depr. Expense
AD for disposal
End Acc. Depr.
80,000
14,000
(10,000)
84,000
Calculating NBV of asset sold
NBV of disposal = 20,000 – 10,000 = 10,000
CFA LEVEL I & II 2012 © Kaplan Financial Limited
CFI = cash additions – cash received on disposal
Sale Proceeds
NBV of disposal
Gain(loss) on sale
30,000
10,000
20,000
$
CFI = –additions + proceeds
CFI = –$50,000 + $30,000 = –$20,000
Ecclestone CFI
� Change in debt
� Change in common stock
� Cash dividends paid
Net income
Div declared
∆ in R/E
$
75,000
(17,000)
58,000
Dividends decl.
∆ Div. payable
Cash div. paid
$
(17,000)
10,000
(7,000)
Ecclestone CFF$
10,000
(20,000)
(7,000)
(17,000)
CFA LEVEL I & II 2012 © Kaplan Financial Limited
$
85,000
(20,000)
(17,000)
48,000
18,000
66,000
Putting the Cash Flow Statement Together
Cash flow from operations
Cash flow from investments
Cash flow from financing
Net increase in cash
Cash balance 12/31/X8
Cash balance 12/31/X9
Free Cash Flow (FCF) Ecclestone
� FCFF =
$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000
� FCFE =
$75,000 = $85,000 – $20,000 + $10,000
� FCFE =
$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000
CFO + Int (1 – T) – FCInv
CFO – FCInv + Net debt increase
FCFF – Int (1 – T) + Net debt increase