Ch 8 - Cash Flow Analysis and Planning Flashcards
What is the basic equation of a cash flow statement?
Cash flow from/for operating activities
+
Net cash flow from/for investing activities
+
Net cash flow from/for financing activities
=
Net increase (or decrease) in cash for the period
+
Cash balance at beginning of period
=
Cash balance at end of period
How are operating activities calculated?
- List net income
- Add non-cash items: Depreciation and (gain on sale of long-term asset)
- (Increase) or decrease in current assets
- Increase or (decrease) in current liabilities
What are investing activities?
“Follow the money” when calculating this portion for cash flow statement.
[Investing activities]
- Purchasing/expanding/disposing long-term assets and investments that are not cash equivalents or held for trading.
- Activities related to making cash advances and loans to other parties
What are financing activities + examples?
“Follow the money” when calculating this portion for cash flow statement.
[Financing activities]
- Business activities related to raising capital.
[Examples]
- Borrowed cash received from a bank.
- Cash used to repay a bank loan.
- Cash received from an investor in exchange for company shares.
- Cash used to pay dividends to shareholders.
- Cash used to buy back shares.
[Review] What are two two approaches in classifying interest/dividends paid/received?
IFRS APPROACH 1:
- All classified as operating cash flow
IFRS APPROACH 2:
- Interest Paid: Financing cash flow
- Interest Received: Investing cash flow
- Dividends Paid: Financing cash flow
- Dividends Received: Investing cash flow
What are considered liquidity ratios?
[Basic liquidity]
- Current ratio (%)
- Quick ratio (%)
[Liquidity ratios – cash conversion cycle]
- Inventory turnover and days inventory outstanding (DIO)
- Accounts receivable turnover and days’ sales outstanding (DSO)
- Accounts payable turnover and days’ payables outstanding (DPO)
What does the current ratio measure? What is it expressed as?
- Measures the company’s ability to pay current obligations (those payable within one year).
- Answers the question, “does the company have enough resources to meet it’s short-term obligations?”
Current ratio: What’s the ideal output?
- Ratio of 1.0 or greater is considered satisfactory – implies that the company has enough current assets to cover all of its current obligations in the short term.
- A ratio of less than 1.0 indicates the company would run into problems if it had to repay all its current liabilities immediately.
What does the Quick (a.k.a. acid-test) ratio measure? What is it expressed as?
- Measures company’s ability to pay current obligations without selling or liquidating its inventory. The premise is that, in an immediately critical situation, the company should be able to pay all its short-term liabilities without relying on the sale of inventory
Quick (a.k.a. acid-test) ratio: What’s the ideal output?
- if a company’s QUICK ratio is CONSIDERABLY < than its CURRENT ratio, this implies that the company’s current assets are heavily comprised of inventory
- Not red flag, but implies further analysis should be done to confirm the company’s financial health
- A ratio exceeding 1.0 implies that the company can pay off all its current liabilities without having to sell any inventory.
What does the inventory turnover ratio measure? What is it expressed as?
- measures a company’s effectiveness in selling its inventory throughout the period.
- The ratio tells you how many times a company has sold its average level of inventory in a specified period (example, 4)
What does the Days’ inventory outstanding (DIO) ratio measure? What is it expressed as? What is a good output?
Tells us how long, in days, it takes to sell the average level of inventory.
What does the accounts receivable turnover ratio measure? What is it expressed as?
- measures a company’s effectiveness in collecting its accounts receivable or, looked at another way, how efficiently a company collects its revenue.
- This ratio tells you how many times a company collects its accounts receivable in a specified period
accounts receivable turnover ratio: What is a good output?
- The higher the ratio the better, because it implies that the company is collecting its A/R more times or more frequently throughout the analysis period (therefore more cash).
- However, a ratio that is too high can signal that the company’s credit terms are too aggressive, and it could be losing out on potential customers.
What does the Accounts payable turnover (a.k.a. payables turnover) ratio measure? What is it expressed as?
Measures the number of times a company pays its creditors in a specified period
Accounts payable turnover (a.k.a. payables turnover) ratio: What is a good output?
- As a rule of thumb, companies prefer this ratio to be lower rather than higher, without impacting its business relationships
- Should look at credit terms – may show lending institutions whether they are able to pay their debts on time
What does the days’ payables outstanding (DPO) ratio measure?
indicates how long, in days, it takes for the company pay off its accounts payable.
How can a company maximize its liquidity and cash on hand?
By collecting receivables as quickly as possible but make payments as slowly as possible in order to maximize its liquidity and cash on hand
What are solvency ratios? What are solvency ratios used?
- Solvency ratios (a.k.a. leverage ratios) assess a company’s ability to take on additional debt in the future
[Solvency Ratios Used in Cash Flow]
- Debt ratio
- Times-interest-earned (TIE) ratio
What does the debt ratio measure?
- Measures the extent to which a company’s assets are financed by debt:
- Just understand that if a company chooses to maintain a high level of debt, it needs to ensure that it can cover its associated interest costs and eventually pay back the debt.
Debt ratio: What is a good output? What is it expressed as?
- High debt ratio is associated with higher credit risk – implies that the company has financed its growth primarily with debt, with a legal requirement to pay interest consistently and the principal eventually.
- Ratio of 1 implies that all of a company’s assets are financed by debt, whereas a ratio of 0.5 implies that half of the company’s assets are financed by debt.
What does the times-interest-earned ratio measure?
- Measures the number of times a company can pay its interest expense with the operating income that it generates.
- When companies take on debt to finance their operations, they need to ensure they can cover the interest costs associated with debt
times-interest-earned ratio: What is a good output? What is it expressed as?
- The higher the TIE ratio the better – implies that the company is capable of paying off its interest obligations through its normal operations.
- A low ratio could imply that the company isn’t generating sufficient operating income to cover its interest obligations, or that it is carrying a large amount of debt (or paying a high cost of debt).
