Book 3 - FRA - Cash Flow Statement Flashcards
What is CFS, what is it used for and what information does it provide?
The cash flow statement provides information beyond that available from the income statement, which is based on accrual, rather than cash, accounting. The cash flow statement provides the following:
- Information about a company’s cash receipts and cash payments during an accounting period.
- Information about a company’s operating, investing, and financing activities.
- An understanding of the impact of accrual accounting events on cash flows.
The cash flow statement provides information to assess the firm’s liquidity, solvency, and financial flexibility. An analyst can use the statement of cash flows to determine whether:
- Regular operations generate enough cash to sustain the business.
- Enough cash is generated to pay off existing debts as they mature.
- The firm is likely to need additional financing.
- Unexpected obligations can be met.
- The firm can take advantage of new business opportunities as they arise.
Describe CFO and what it includes?
Cash flow from operating activities (CFO), sometimes referred to as “cash flow from operations” or “operating cash flow,” consists of the inflows and outflows of cash resulting from transactions that affect a firm’s net income.
Describe CFI and what it includes?
Cash flow from investing activities (CFI) consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.
Describe CFF and what it includes?
Cash flow from financing activities (CFF) consists of the inflows and outflows of cash resulting from transactions affecting a firm’s capital structure.
Describe how non-cash investing and financing activities are reported.
Noncash investing and financing activities are not reported in the cash flow statement since they do not result in inflows or outflows of cash.
Noncash transactions must be disclosed in either a footnote or supplemental schedule to the cash flow statement. Analysts should be aware of the firm’s noncash transactions, incorporate them into analysis of past and current performance, and include their effects in estimating future cash flows.
Contrast cash flow statements prepared under IFRS and GAAP.
IFRS allow more flexibility in the classification of cash flows. Under IFRS, interest and dividends received may be classified as either operating or investing activities. Dividends paid to the company’s shareholders and interest paid on the company’s debt may be classified as either operating or financing activities.
Another important difference relates to income taxes paid. Under U.S. GAAP, all taxes paid are reported as operating activities, even taxes related to investing and financing transactions. Under IFRS, income taxes are also reported as operating activities unless the expense is associated with an investing or financing transaction.
Describe Direct Method CFS?
Under the direct method, each line item of the accrual-based income statement is converted into cash receipts or cash payments.
Under the direct method, the starting point is the top of the income statement, revenues, adjusted to show cash received from customers.
Describe Indirect Method CFS?
Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. These adjustments include eliminating noncash expenses (e.g., depreciation and amortization), nonoperating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.
Notice that under the indirect method, the starting point is net income, the “bottom line” ofthe income statement.
What are the disclosure requirements for CFS under Direct and Indirect methods?
Under U.S. GAAP, a direct method presentation must also disclose the adjustments necessary to reconcile net income to cash flow from operating activities. This disclosure is the same information that is presented in an indirect method cash flow statement. This reconciliation is not required under IFRS.
Under IFRS, payments for interest and taxes must be disclosed separately in the cash flow statement under either method (direct or indirect). Under U.S. GAAP, payments for interest and taxes can be reported in the cash flow statement or disclosed in the footnotes.
What are the arguments in favor of methods of preparing CFS?
The primary advantage of the direct method is that it presents the firm’s operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. Therefore, the direct method provides more information than the indirect method. This knowledge of past receipts and payments is useful in estimating future operating cash flows.
The main advantage of the indirect method is that it focuses on the differences in net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow. Analysts forecast net income and then derive operating cash flow by adjusting net income for the differences between accrual accounting and the cash basis of accounting.
Describe how the cash flow statement is linked to the income statement and the balance sheet?
The cash flow statement reconciles the beginning and ending balances of cash over an accounting period.
Describe the steps in the preparation of direct cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
The following are common components of cash flow that appear on a statement of cash flow presented under the direct method:
- Cash collected from customers, typically the main component of CPO.
- Cash used in the production of goods and services (cash inputs) .
- Cash operating expenses.
- Cash paid for interest.
- Cash paid for taxes.
When using the direct method, ignore depreciation expense-it’s a noncash charge.
Investing cash flows (CFI) are calculated by examining the change in the gross asset accounts that result from investing activities, such as property, plant, and equipment, intangible assets, and investment securities. Related accumulated depreciation or amortization accounts are ignored since they do not represent cash expenses.
Financing cash flows (CFF) are determined by measuring the cash flows occurring between the firm and its suppliers of capital. Cash flows between the firm and its creditors result from new borrowings (positive CFF) and debt principal repayments
(negative CFF). Note that interest paid is technically a cash flow to creditors, but it is included in CPO under U.S. GAAP. Cash flows between the firm and its shareholders occur when equity is issued, shares are repurchased, or dividends are paid. CFF is the sum of these two measures:
Describe the steps in the preparation of indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Under the indirect method of presenting CFO, we begin with net income and
adjust it for differences between accounting items and actual cash receipts and cash disbursements.
The steps in calculating CFO under the indirect method can be summarized as follows:
- *Step 1:** Begin with net income.
- *Step 2:** Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land).
**Step3: **Add back all non cash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue.
Step4: add or subtract changes to balance sheet operating accounts as follows:
- Increases in the operating asset 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 (uses of cash) are subtracted.
How to convert cash flows from the indirect to direct method.
Cash collectionsfrom customers:
- Begin with net sales from the income statement.
- Subtract (add) any increase (decrease) in the accounts receivable balance as reported in the indirect method. If the company has sold more on credit than has been collected from customers, accounts receivable will increase and cash collections will be less than
- Add (subtract) an increase (decrease) in unearned revenue. Unearned revenue includes cash advances from customers. Cash received from customers when the goods or services have yet to be delivered is not included in net sales, so the advances must be added to net sales in order to calculate cash collections.
Cash payments to suppliers:
- Begin with cost ofgoods sold (COGS) as reported in the income statement.
- If depreciation and/or amortization have been included in COGS (they increase COGS), these noncash expenses must be added back when computing the cash paid
- Reduce (increase) COGS by any increase (decrease) in the accounts payable balance as reported in the indirect method. Ifpayables have increased, then more was spent on credit purchases during the period than was paid on existing payables, so cash payments are reduced by the amount of the increase in payables.
- Add (subtract) any increase (decrease) in the inventory balance as disclosed in the indirect method. Increases in inventory are not included in COGS for the period but still represent the purchase of inputs, so they increase cash paid to suppliers.
- Subtract an inventory write-offthat occurred during the period. An inventory write-off, as a result of applying the lower of cost or market rule, will reduce ending inventory and increase COGS for the period. However, no cash flow is associated with the write-off.
Analyze and interpret Operating Cash Flow.
An analyst should identify the major determinants of operating cash flow. Positive operating cash flow can be generated by the firm’s earnings-related activities. However, positive operating cash flow can also be generated by decreasing noncash working capital, such as liquidating inventory and receivables or increasing payables. Decreasing noncash working capital is not sustainable, since inventories and receivables cannot fall below zero and creditors will not extend credit indefinitely unless payments are made when due.
Operating cash flow also provides a check of the quality of a firm’s earnings. A stable relationship of operating cash flow and net income is an indication of quality earnings.
