Reading 20: Understanding Cash Flow Statement Flashcards
Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items.
- Cash flow from operating activities (CFO) consists of the inflows and outflows of cash resulting from transactions that affect a firm’s net income.
- 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.
- Cash flow from financing activities (CFF) consists of the inflows and outflows of cash resulting from transactions affecting a firm’s capital structure, such as issuing or repaying debt and issuing or repurchasing stock.
Describe how non-cash investing and financing activities are reported.
Noncash investing and financing activities, such as taking on debt to the seller of a purchased asset, are not reported in the cash flow statement but must be disclosed in the footnotes or a supplemental schedule.
Contrast cash flow statements prepared under IFRS and US GAAP.
- Under U.S. GAAP, dividends paid are financing cash flows. Interest paid, interest received, and dividends received are operating cash flows. All taxes paid are operating cash flows.
- Under IFRS, dividends paid and interest paid can be reported as either operating or financing cash flows. Interest received and dividends received can be reported as either operating or investing cash flows. Taxes paid are operating cash flows unless they arise from an investing or financing transaction.**
Compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method.
Under the direct method of presenting CFO, each line item of the accrual-based income statement is adjusted to get cash receipts or cash payments. The main advantage of the direct method is that it presents clearly the firm’s operating cash receipts and payments.
Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales, and for changes in balance sheet items. The main advantage of the indirect method is that it focuses on the differences between net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow.
Describe how the cash flow statement is linked to the income statement and the balance sheet.
Operating activities typically relate to the firm’s current assets and current liabilities. Investing activities typically relate to noncurrent assets. Financing activities typically relate to noncurrent liabilities and equity.
Timing of revenue or expense recognition that differs from the receipt or payment of cash is reflected in changes in balance sheet accounts.
Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
The direct method of calculating CFO is to sum cash inflows and cash outflows for operating activities.
* Cash collections from customers—sales adjusted for changes in receivables and unearned revenue.
* Cash paid for inputs—COGS adjusted for changes in inventory and accounts payable.
* Cash operating expenses—SG&A adjusted for changes in related accrued liabilities or prepaid expenses.
* Cash interest paid—interest expense adjusted for the change in interest payable.
* Cash taxes paid—income tax expense adjusted for changes in taxes payable and changes in deferred tax assets and liabilities.
The indirect method of calculating CFO begins with net income and adjusts it for gains or losses related to investing or financing cash flows, noncash charges to income, and changes in balance sheet operating items.
CFI is calculated by determining the changes in asset accounts that result from investing activities. The cash flow from selling an asset is its book value plus any gain on the sale (or minus any loss on the sale).
CFF is the sum of net cash flows from creditors (new borrowings minus principal repaid) and net cash flows from shareholders (new equity issued minus share repurchases minus cash dividends paid).
Demonstrate the conversion of cash flows from the indirect to direct method.
An indirect cash flow statement can be converted to a direct cash flow statement by adjusting each income statement account for changes in associated balance sheet accounts and by eliminating noncash and non-operating items.
Analyze and interpret both reported and common-size cash flow statements.
An analyst should determine whether a company is generating positive operating cash flow over time that is greater than its capital spending needs and whether the company’s accounting policies are causing reported earnings to diverge from operating cash flow.
A common-size cash flow statement shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows.
Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt holders.
* FCFF = net income + noncash charges + [cash interest paid × (1 − tax rate)] − fixed capital investment − working capital investment.
* FCFF = CFO + [cash interest paid × (1 − tax rate)] − fixed capital investment.
Free cash flow to equity (FCFE) is the cash flow that is available for distribution to the common shareholders after all obligations have been paid.
FCFE = CFO − fixed capital investment + net borrowing
Cash flow performance ratios, such as cash return on equity or on assets, and cash coverage ratios, such as debt coverage or cash interest coverage, provide information about the firm’s operating performance and financial strength.
