Module 11 Flashcards
What sections of the balance sheet does the three types of cash flows roughly correspond with
operating -> current assets and liabilities
investing -> long-term assets
financing -> long term liabilities and shareholders’ equity
what are examples of cash inflows for operating activities
- receipts from customers for sales made or services rendered
- receipts of interest and dividends
- other receipts that are not related to investing or financing activities, like lawsuit settlements, refunds from suppliers
what are examples of cash outflows for operating activities
- payments to employees or suppliers
- payments to purchase inventories
- payments of interest to creditors
- payments of taxes to government
- other payments that are not related to investing or financing activities like contributions to charity
what does investing activities involve
- increasing or decreasing a company’s liquidity
- acquisition and disposal of PP&E and intangibles
- purchase and sale of stock and bonds and other securities
- lending and subsequent collection of money
what are examples of cash inflows for investing activities
- receipts from sale of PP&E and intangibles
- receipts from sales of investments in stocks, bonds, and other securities (other than cash equivalents)
- receipts from repayments of loans by borrowers
what are examples of cash outflows for investing activities
- payments to purchase PP&E assets and intangible assets
- payments to purchase stocks, bonds, and other securities (other than cash equivalents)
- payments made to lend money to borrowers
what are financing activities
when companies:
- obtain resources from owners
- return resources to owners
- borrows resources from creditors
- repays amounts borrowed
what are examples of cash inflows for financing activities
- receipts from issuance of common stock and preferred stock and from sales of treasury stock
- receipts from issuances of bonds payable, mortgage notes payable, and other notes payable
what are examples of cash outflows for financing activities
- payments to acquire treasury stock
- payments of dividends
- payments to settle outstanding bonds payable, mortgage notes payable, and other notes payable
what is the classification of activities for IFRS
- interest received can be operating or investing
- interest paid can be operating or financing
- dividends received can be operating or investing
- dividends can be operating or financing
what is the classification of activities for US GAAP
- interest received is operating
- interest paid is operating
- dividends received is operating
- dividends paid is financing
when looking at firms with different accounting standards, what should analysts do
- pay attention to the different cash flow classification
- ex. if looking at companies with IFRS, look at how they are classifying different activities
- they will need to make adjustments based on the differences (especially if the differences make significant differences)
what are the two ways to calculate operating cash flow
- indirect method
- direct method
what is the indirect method
- start with net income
- adjust it to make it the net cash flow from operating activities
why do most companies use the indirect method to report operating cash flows even though US GAAP and IFRS encourage direct method
- because its easier
- if they report direct method, they also need to show indirect method in their reports
what is the adjustment to net income when there is increases in asset accounts (like receivables, inventories, and prepaid expenses)
subtract change from net income
what is the adjustment to net income when there is decreases in asset accounts (like receivables, inventories, and prepaid expenses)
add the change to net income
what is the adjustment to net income when there is increases in liability accounts (like payable, accruals, and unearned revenue)
add them to net income
what is the adjustment to net income when there is decreases in liability accounts (like payable, accruals, and unearned revenue)
subtract them from net income
what adjustments are made first to net income
- revenues and expenses with no cash flow effects
- gains and losses with no cash flow effects
what are the adjustments of revenues and expenses and what do you do with them
- add them to net income
includes: - depreciation and amortization
- stock based compensation
- asset impairments
what are the adjustments to gains and losses of disposals
- add losses to net income
- subtract gains to net income
what are the next adjustments made to net income
adjustments for current operating assets and liabilities
what do you do with changes in investments
increases in investments are subtracted (money spent to buy investments)
what do you do with changes in PP&E
- sale of PP&E is added (money received from sale)
- purchase of PP&E is subtracted (money spent)
what do you do with changes in common stock
- increases means issued stock
- issuance of stock is added (issued stock and people bought it for money that you received)
what do you do with changes in debt
- increase in debt is added (money received from borrowing)
- decrease is debt is subtracted (money paid to pay back debt)
what do you do with changes in retained earnings
- its the changes of dividends
- payments of dividends are subtracted (payments made to shareholders)
what is the direct method
- the net cash flow from operating activities by showing the major categories of operating cash receipts and payments
- amounts are usually determined by converting the accrual revenues and expenses to corresponding cash amounts
where is the differences between indirect and direct method
- operating activities section
- investing and financing sections are the same
how do you calculate the direct method
calculate:
- amount earned from customers
- amount paid for merchandise
- amount paid for expenses (employees, insurance, income taxes)
*dont include depreciation or any gains or losses
how do you determine the cash received from customers
sales - increases in accounts receivable
how do you determine the amount paid for merchandise
- determine how much you merchandise you got (purchased): cogs - inventory sold
- determine how much you paid: purchases + decrease in accounts payable
if there is no wages payable what does it mean
wages expense = cash paid for wages
how do you determine how much cash was paid for insurance
insurance expense + increase in prepaid insurance
how to determine the cash paid for income taxes
income tax expense - increase in income tax payable
what is operating cash flow generally viewed as
- as less easy to manipulate compared to operating income or net income
- those two can be manipulated by selling assets, changing depreciation method, etc.
what does large differences between earnings and OCF or increases in such differences mean
there could be indication of earnings manipulation
what are positive signs of operating cash flow
- OCF should be the primary source of cash flow for a mature company
- OCF should be positive and higher than net income
- OCF could be negative in order to grow for new or growth-stage companies
- OCF should be consistently increasing
- OCF should be sufficient to cover CAPEX
what is a non sustainable way to cover CAPEX
increasing debt or equity to cover it
what are the primary determinants of investing cash flow
- negative cash flows (cash outflows since investments are bought) from investing activities isn’t necessarily bad since its needed to support growth (for mature companies)
- compare capex with depreciation, CAPEX should be > depreciation
what are different questions that are asked for investing cash flow
- if there is major capex, how does the company fund capex?
- how much investing cash flow is for CAPEX and how much is for liquidity investment? (stock and bonds)
- analysts should investigate what the purpose of asset selling is (if the company sold a significant amount of assets)
what are the different ways a company can fund CAPEX and which one is the better way
- through OCF
- asset selling
- financing
- should be from OCF
why is negative cash flow from financing activities not always bad
- because it can be using excess cash flow to reduce financial leverage (pay back debt)
- pay dividends and do share buybacks with excess cash to avoid excess liquidity
is paying back debt with excess cash flow good?
its a good strategy if it lowers the financial leverage to an acceptable level
why is using excess cash to pay dividends or have share buybacks good for shareholders
because they get more money/value of their existing shares increases
why is it important that the dividends paid and shares bought back are done with excess cash
- suspicious if its not
- like companies selling their buildings then leasing them back to get extra cash to then pay special dividends (also not cash from operating activities)
- can lead to bankruptcy really fast
what do you need to assess with financing cash flow
- why capital is being raised or repaid
- its bad if they use financing cash flow to fund net losses and negative operating cash flows over the long run
if a company is borrowing each year, what should you consider and how
- when the repayment may be required
- done by knowing the repayment schedule
what are the 2 approaches for common size analysis of the statement of cash flows
- express each line item of the cash inflow (outflow) as a % of net revenue
- express each line item of the cash inflow (outflow) as a % of total inflow (outflow)
what is the 4 stages in the product life cycle
- introduction
- growth
- maturity
- decline
what is the normal behaviour of revenues in the product life cycle
- revenue grows in the first 2 stages (introduction and growth)
- then levels peaks at maturity
- then declines at decline
what is the normal behaviour of net income in the product life cycle
- negative in the introduction stage (net losses)
- then peaks at maturity stage
- then it gradually decreases in the decline stage
what is the normal behaviour of cash flows in the product life cycle
- cash outflows for investing (purchases, negative cash flows) and cash inflows for financing (getting financing, positive cash flows) in the introduction stage
- in decline stage: cash outflows for financing (paying back debt, buying back stock, paying dividends, negative cash flows), get cash inflows from investing (selling assets, positive cash inflows)
- operating moves similar to investing, just peaks higher, earlier and falls lower faster
why is understanding the life cycle stage important
because life cycle affects the firms production behaviour, its investing activities, its market share, etc.
what does research show about cash flow patterns (net inflow or outflow)
that they provide a reliable way to assess the overall life cycle
if investing cash flows suddenly increase, while financing cash flows decrease, what could it mean
- lots of assets were sold (investing cash inflows)
- debt is repaid, dividends are paid out (financing cash outflows)
what does the results quality of cash flow mean
if the underlying economic performance is good
what are the different examples of good results quality
- positive OCF
- from sustainable sources (normal operations)
- adequate to cover capex, debt repayment, and dividends
- low volatility
what does the reporting quality of cash flow mean
if it reasonably reflects the underlying economic performance
what are different factors about the reporting quality of cash flows
- timing (if they are selling receivables or delaying paying payables to boost OCF)
- classification of cash flow
