Part 5. Understanding Cash Flow Statements Flashcards
Cash flow statement
This provides information beyond that available from income statement based on accrual than cash, accounting.
This provides:
- information about company’s cash receipts and payments during accounting period.
- information about company’s operating, investing and financing activities.
- Understanding impact of accrual accounting events on cash flows.
This also provides information to assess firms liquidity, solvency and financial stability.
This provides:
- regular operations generate enough cash to sustain business.
- enough cash is generated to pay off existing debts as they mature.
- firm likely to need additional financing.
- unexpected obligations can be met.
- firm can take advantage of new business opportunities as they arise.
Cashflow statement sources
- Income statement items
2. Changes in balance sheet accounts
Cash flow from operating activities (CFO)
This consists of inflows and outflows of cash resulting from transactions that affect firms net income.
Cash flow from investing activities (CFI)
This consists of inflows and outflows of cash resulting from the acquisition or disposal of LT assets and certain investments.
They are calculated by examining 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 amortisation accounts are ignored since they do not represent cash expenses.
Cash flows from financing activities (CFF)
This consists of the inflows and out flows of cash resulting from transactions affecting a firms capital structure.
These are determined by measuring the cash flows occurring between the firm and its suppliers of capital.
Positive CFF - cashflows between firm and its creditors result from new borrowings.
Negative CFF - cashflows between firm and its creditors result from debt principle payments.
Cashflows between firm and shareholders occur when:
- equity is issued
- shares are repurchased
- dividends are paid
Noncash investing and financing activities
These are not reported in the cash flow statement since they do not result in inflows or outflows of cash.
e.g. firm acquires real estate with financing provided by the seller, the firm made an investing and financing decision, this transaction is the equivalent of borrowing the purchase price.
IFRS vs US GAAP
US GAAP:
- dividends paid to firm shareholders are reported as financing activities, while the interest paid is reported in operating activities.
- Interest and dividends received from investments are reported as operating activities.
- taxes paid are reported as operating activities, even taxes related to investing and financing transactions.
- for a company that sells land for $1m, income tax on sale total $160,000, with reports of inflow of cash from investing of $1m, and outflow from operating activities as $160,000.
IFRS:
- Allow more flexibility in the classification of cash flows, with interest and dividends received classified as operating or investing activities, but dividends paid to shareholders and interest on company debt as operating or financing activities.
- Income tax is reported as operating activities unless expense is associated with an investing or financing transaction.
- The firm will only report net inflow of $840,000.
Direct method
Each line item of the accrual-based income statement is converted into cash receipts or payments, where the accrual method of accounting means the timing of revenue and expense recognition may differ from the timing of related cash flows.
Indirect method
The 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 non-cash expenses (e.g. depreciation and amortisation)
- non-operating items (e.g. gains and losses)
- Changes in balance sheet accounts from accrual accounting events
Direct method vs indirect
Pros:
Direct method:
- this presents firms operating cash receipts and payments, whereas indirect only presents the net result of receipts and payments.
- Provides more information; where knowledge of past receipts and payments is useful in estimating future operating cash flows.
Indirect method:
- Focuses on the difference between net income and operating cash flow.
- Provide useful links to income statements when forecasting future operating cash flow.
- Forecasts net income, and derives operating cash flow by adjusting net income for the difference between accrual accounting and cash basis of accounting.
Important points about indirect and direct methods:
- CFO is calculated differently, but result is same under both methods.
- Calculation of CFI and CFF is identical under both methods.
- There is an inverse relationship between changes in assets, and cashflows, e.g. an increase in asset account is use of cash, and decrease in asset account is source of cash.
- There is a direct relationship between changes in liabilities and cashflow, where an increase in liability account is source of cash, and decrease in liability is use of cash.
- Source of cash are positive numbers (cash inflows) and uses of cash are negative numbers (cash outflows).
Common components of cash flow that appear on statement of cash flow presented under direct method:
- Cash collected from customers, typically main component of CFO.
- Cash used in production of g/s (cash inputs)
- Cash operating expenses.
- Cash paid for interest.
- Cash paid for taxes.
Indirect method adjustments
- For CFO, we begin with net income and adjust for differences between accounting items and actual cash receipts and cash disbursements.
- Depreciation is deducted in calculating net income, but does not require cash outlay in the current period, thus must add depreciation (and amortization) to net income when calculating CFO.
- Net income must subtract gains on disposal of assets, proceeds from sales of fixed assets are an investing cash flow, with gains/loss as a portion of such proceeds, so subtracted/added under net income.
- Adjust net income for the change in balance sheet accounts.
- A change in accounts payable indicates a difference between purchases and the amount paid to suppliers.
Cash life cycle
- When a firm in early stages of growth, it may experience negative operating cash flow, as uses cash to finance increase in inventory and receivables.
- Negative operating cash flow financed externally by issuing debt or equity securities.
- These sources of financing are not sustainable as eventually firm will generate positive operating cash flow that exceed capital expenditures and provide return to debt and equity holders.
Determinants of operating cashflow
- Positive operating cash flow geenrated by firms earnings related activities generated by decreasing non cash working capital , e.g. liquidating inventor and receivables/increasing payables.
- Decreasing noncash working capital is not sustainable as inventories cannot fall below zero, and creditors will not extend credit indefinitely.
- Stable relationship of operating cashflow and net income is indication of quality earnings; affected also by business cycle and firms life cycle.
- Earnings exceed operating cash flow indicates aggressive accounting choices such as recognising revenues soon or delaying recognition of expenses, where variability of net income and operating cashflow should be considered.
