Chapter 3 Income Statement Flashcards
Statement of Cash Flow
The purpose of the statement of cash flow is to provide a user of the financial statements with important information about how the company manages its cash
- Simplest level, merely tells the reader how much the company’s cash balance changed during the period
- Sophisticated Level - reveals just where a businesses cash came from and how it was used
Three activity categories that summarize a firms inflows and outflows of cash
1) Cash Flow from Operating activities
2) Cash Flow from investing activities
3) Cash Flow from financing activities
Cash Flow from Operating activities
CFFO
Represents the aggregate of the cash received from the sale of goods and services less the cash spent on operating expenses
Cash Flow from investing activities
CFFI
Represents the aggregate of the cash received from the ale of investments, property and equipment and intangible assets less the cash spent to acquire these various types of assets
Cash Flow from financing activities
CFFF
Represents the aggregate of the cash received from the sale of debt and equity securities less the cash paid to retire debt, repurchase equity securities or pay dividends to shareholders
There are two formats available under the GAAP to present the Statement of cash flow
1) Direct Method
2) Indirect Method
Direct Method
Cash flow from operations is computed directly from the company’s cash transactions
Indirect Method
A company computes its cash flow from operations by making various adjustments to convert its accrual-based net income to its cash flow from operations
- The objective of tis approach is to provide the user of the statement with critical information about why the firms net income did or did not translate into cash generation
Computing Cash Flow Under the Indirect Method
1) Assets (A) = Liabilities (L) + Shareholders Equity (SE)
2) Cash + Noncash Assets (NCA) = L + SE
3) ΔCash+ΔNCA = ΔL + ΔSE
4) ΔCash = ΔL - ΔNCA + ΔSE
Δ = Difference between two balance sheets
Five Steps to Cash Flow
Indirect Method
1) Calculate the change in all balance sheets
2) Classify each account into one of the three cash flow categories
3) Prepare a preliminary statement of cash flow
4) Integrate the income statement data
5) Remove nonrecurring and/or nonoperating effects from net income
1) Calculate the change in all balance sheets
Five Steps to Cash Flow
(Indirect Method)
Using just the beginning and ending balance sheets, calculate the change in each balance sheet account. To verify the accuracy of the step one calculation, simply compare the sum of changes in the assets account to the sum of the changes in the lability and shareholder equity account.
These totals must equal
2) Classify each account into one of the three cash flow categories
Five Steps to Cash Flow
(Indirect Method)
This step involves identifying the appropriate cash-slow activity category (operating, investing or financing)
- AR, Inventory, AP and Tax Payable are operating
- Changes in the notes payable (current and non current) and common stock accounts are finance
- PPE are associated with capital investment
3) Prepare a preliminary statement of cash flow
Five Steps to Cash Flow
(Indirect Method)
When preparing the indirect method, an increase in AR represents a subtraction from net income and a decline in intangible assets represents an addition to net income.
Step 3 is important to remember to reverse the sign of the change values for the asset accounts.
4) Integrate the income statement data
Five Steps to Cash Flow
(Indirect Method)
Accomplish two important actions:
1) Replace the change in retained earnings from the balance sheet with the net income from the income statement
2) Adjust net income for any noncash expenses such as depreciation of PPE and the amortization of intangibles that were deducted in the process of calculating the firms accrual net income
5) Remove nonrecurring and/or nonoperating effects from net income
Five Steps to Cash Flow
(Indirect Method)
Adjustments to remove any non-operating or nonrecurring gains and losses from the CFFO
Analysis of the statement of cash flow
Performance
Performance is defined in terms of a company’s accrual net income, where earned revenues are matched against the expenses associated with generating that revenue whether or not associated with cash
Operating Funds Ration
Cash Flow Ratios
- Indicates the portion of a company’s earnings supported by operating cash flow
Operating funds ratio = Cash Flow from Operations / Net Income
Operating cash flow to current liabilities ratio = Cash Flow from Operations / Current Liabilities
This ratio provides insights about a firms liquidity, specifically the extent to which a company’s current obligations can be satisfied by operating cash flow
Operating cash flow to current liabilities ratio = Cash Flow from Operations / Current Liabilities
Cash Conversion Ratio
Reveals the extent to which the sales re[orted on the income statement are converted into cash during the same accounting period
Cash Conversion Ratio = Cash from Sales / Net Sales
Cash from Sales
Calculated as Net Sales minus the increase in accounts receivable plus the increase in unearned revenue
EBITDA
Alternative Measures of Cash Flow
Earnings before interest, taxes, depreciation and amortization.
Thought to provide an easily calculated alternative to operating cash flow as both measures begin with net income and both measures adjust for the noncash operating expenses of depreciation and amortization
Free Cash Flow
Alternative Measures of Cash Flow
Often used by analysts to evaluate a company’s cash-flow strength.
FCF is the amount of cash that could be “freely” distributed to the owners of the company or used for general corporate purposes without affecting the ongoing operations and required investments.
FCF = CFFO - CapEx
Capital Expenditures
CapEx
The required reinvestment in the assets of a business necessary to enable the firm to maintain itself as a going concern.
Discretionary Cash Flow
(DisCF)
(Alternative Measures of Cash Flow)
Addresses the question “How much internally generated operating cash flow is available to permit a company’s management to undertake a discretionary, value-creating action?”
DisCF = CFFO - Required debt payments - Dividend Payments
Discretionary Cash Flow
Addresses the question “How much internally generated operating cash flow is available to permit a company’s management to undertake a discretionary, value-creating action?”
Discretionary Cash Flow
DisCF
Addresses the question “How much internally generated operating cash flow is available to permit a company’s management to undertake a discretionary, value-creating action?”
Earnings Persistence
USING HISTORICAL EARNINGS TO PREDICT FUTURE EARNINGS IS THE EXTENT TO WHICH EARNINGS RECUR OVER TIME
Sustainable Earnings / Permanent Earnings
Persistence of operating earnings is closely linked to value
Transitory Earnings
Include such single-period items as special items, restructuring charges, changes in accounting principle and discounted operations
Intrinsic Value
Refers to the underlying economic value of a business as a going concern, that is, the value that a business could be sold for in an efficient market
Special Item
Often include gains or lossses tgat are outside a firms normal operations
Restructuring Charges
Associated with changing a business operations (right-sizing or down-sizing)
Taking a bath
Lumping restructuring charges in years characterized by poor operating results to enhance the probability og improved performance in future years
Change in accounting principal
Mandatory accounting changes occur when an accounting regulatory body, such as FASB or IASB, changes the generally accepted accounting practice
Consistency Principle
Requires that a firm use the same accounting measurement principles from one fiscal period to the next
Extraordinary Gains (Losses)
These were gains (losses) that were both unusual and infrequent in nature
Discontinued Operations
When a company discontinues a separate business unit, it will generally incur costs to lay off employees, liquidate inventory and shutter facilities
Basic Earnings Per Share
Net income (less preferred stock dividends) divided by the actual number of common shares outstanding.
Pro Forma Earnings
Earnings before bad stuff
Accrual basis income
It’s different from cash basis, because we make some adjustments to cash. Revenue is recognized when it’s earned
