Reading 26 - Understanding Cash Flow Statements

Question 1

Give a summary of cash flow statements and why they’re useful.

Answer 1

The cash flow statement provides important information about a company’s cash receipts and cash payments during an accounting period as well as information about a company’s operating, investing, and financing activities. Although the income statement provides a measure of a company’s success, cash and cash flow are also vital to a company’s long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility.

Question 2

How are cash flow activities classified?

Answer 2

Cash flow activities are classified into three categories: operating activities, investing activities, and financing activities. Significant non-cash transaction activities (if present) are reported by using a supplemental disclosure note to the cash flow statement.

Question 3

What are the differences in cash flow statements under IFRS and US GAAP?

Answer 3

Cash flow statements under IFRS and US GAAP are similar; however, IFRS provide companies with more choices in classifying some cash flow items as operating, investing, or financing activities.

Question 4

What are the choices for companies in reporting their operating cash flows? Define each.

Answer 4

Companies can use either the direct or the indirect method for reporting their operating cash flow:

• The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and operating cash outflows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement.
• The indirect method reconciles net income to operating cash flow by adjusting net income for all non-cash items and the net changes in the operating working capital accounts.

Question 5

Where are cash flow statements linked?

Answer 5

The cash flow statement is linked to a company’s income statement and comparative balance sheets and to data on those statements.

Question 6

In cash flow analysis, what can an analyst do when dealing with indirect method format used by companies?

Answer 6

Although the indirect method is most commonly used by companies, an analyst can generally convert it to an approximation of the direct format by following a simple three-step process.

Question 7

What should an evaluation of cash flow statements involve?

Answer 7

An evaluation of a cash flow statement should involve an assessment of the sources and uses of cash and the main drivers of cash flow within each category of activities.

Question 8

How can analysts use common-size statement analysis for cash flows and how do they develop them?

Answer 8

The analyst can use common-size statement analysis for the cash flow statement. Two approaches to developing the common-size statements are the total cash inflows/total cash outflows method and the percentage of net revenues method.

Question 9

What can be used to determine free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)?

Answer 9

The cash flow statement can be used to determine free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

Question 10

How are ratios used in cash flow statement analysis?

Answer 10

The cash flow statement may also be used in financial ratios that measure a company’s profitability, performance, and financial strength.

Question 11

Under both IFRS and U.S. GAAP, cash flows are classified into the following categories:

Answer 11

Cash flow from operating activities (CFO)
Cash flow from investing activities (CFI)
Cash flow from financing activities (CFF)

Question 12

Under both IFRS and U.S. GAAP, define cash flow from operating activities (CFO).

Answer 12

Cash flow from operating activities (CFO): These are inflows and outflows of cash related to a firm’s day‐to‐day business activities.

Question 13

Under both IFRS and U.S. GAAP, define cash flow from investing activities (CFI).

Answer 13

Cash flow from investing activities (CFI): These are inflows and outflows of cash generated from the purchase and disposal of long‐term investments. Long‐term investments include plant, machinery, equipment, intangible assets, and nontrading debt and equity securities.
Note: Investments in securities that are considered highly liquid (cash equivalents) are not included in investing activities. Neither are securities held for trading. Cash flows associated with the purchase and sale of highly liquid cash equivalents and of securities for trading purposes are classified under cash flow from operating activities.

Question 14

Under both IFRS and U.S. GAAP, define cash flow from financing activities (CFF).

Answer 14

Cash flow from financing activities (CFF): These are cash inflows and outflows generated from issuance and repayment of capital (interest‐bearing debt and equity).
Note: Indirect short-term borrowings from suppliers that are classified as accounts payable, and changes in receivables from customers are not considered financing activities; they are classified as operating activities.

Question 15

Identify the inflows and outflows of cash flow from operating activities (CFO).

Answer 15

CFO
Inflows:

Cash collected from customers.
Interest and dividends received.
Proceeds from sale of securities held for trading.

Outflows:

Cash paid to employees.
Cash paid to suppliers.
Cash paid for other expenses.
Cash used to purchase trading securities.
Interest paid.
Taxes paid.

Question 16

Identify the inflows and outflows of cash flow from investing activities (CFI).

Answer 16

CFI

Inflows:

Sale proceeds from fixed assets.
Sale proceeds from long-term investments.

Outflows:

Purchase of fixed assets.
Cash used to acquire LT investment securities.

Question 17

Identify the inflows and outflows of cash flow from investing activities (CFF).

Answer 17

Inflows:

Proceeds from debt issuance.
Proceeds from issuance of equity instruments.

Outflows:

Repayment of LT debt.
Payments made to repurchase stock.
Dividends payments.

Question 18

What is a very important note about cash flows?

Answer 18

Note: There is a difference in how some cash flows are classified under IFRS and U.S. GAAP. These differences are discussed in LOS 27c and are very important from the examination perspective.

Question 19

Describe how non-cash investing and financing activities are reported on cash flow statements.

Answer 19

Noncash investing and financing activities are not reported on the cash flow statement because these transactions do not involve any receipt or payment of cash.

Question 20

In the context of cash flow statements, give examples of noncash investing and financing activities include:

Answer 20

• Barter transactions where one nonmonetary asset is exchanged for another. 

• Issuance of common stock for dividends or when holders of convertible bonds 
or convertible preferred stock convert their holdings into ordinary shares of the 
company. 

• Acquisition of real estate with financing provided by the seller.

Question 21

What must we remember about company’s requirements to disclose any significant noncash investing and financing activities?

Answer 21

Remember that companies are required to disclose any significant noncash investing and financing activities in a separate note or a supplementary schedule to the cash flow statement.

Question 22

Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounted principles (U.S. GAAP).

Answer 22

Cash flow statements prepared under IFRS and U.S. GAAP differ along the following lines: 


Classification of cash flows: Certain cash flows are classified differently under IFRS and U.S. GAAP. IFRS offers more flexibility regarding the classification of certain cash flows. 


Presentation format: There is a difference in the presentation requirements for cash flow from operating activities. 
Table 2 highlights important differences between IFRS and U.S. GAAP with respect to cash flow statements. 


Question 23

In cash flow statements: what are the differences between IFRS and U.S. GAAP?

Answer 23

Topic: IFRS – U.S. GAAP

Classification of cash flows:

Interest received: Operating or investing – Operating

Interest Paid: Operating or financing – Operating

Dividends received: Operating or investing – Operating

Dividends paid: Operating or financing – Operating

Bank overdrafts: Considered part of cash equivalents – Not considered part of cash and cash equivalents and classified as financing

Taxes Paid: Generally operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories – Operating

Format of statement:

Format of statement: Direct or indirect; direct is encouraged – direct or indirect; direct is encouraged. A reconciliation of net income to cash flow from operating activities must be provided regardless of method used.

Question 24

Under both IFRS and U.S. GAAP, there are two acceptable formats for presenting the cash flow statement. What are these two acceptable formats?

Answer 24

The direct method and the indirect method. These methods differ only in the presentation of the CFO section of the cash flow statement; calculated values for CFO are the same under both. Further, the presentation of CFF and CFI are exactly the same under both formats.

Question 25

Under both IFRS and U.S. GAAP, there are two acceptable formats for presenting the cash flow statement. Define direct method.

Answer 25

Direct method: Under the direct method, income statement items that are reported on an accrual basis are all converted to cash basis. All cash receipts are reported as inflows, while cash payments are reported as outflows.

Question 26

Describe the similarities of the presentation of CFO under the direct method vs. presentation of the income statement.

Answer 26

Presentation of CFO under the direct method has similarities with the presentation of the income statement. The income statement starts with total sales and deducts direct and indirect costs to arrive at net income. The direct method of calculating CFO starts with cash sales and deducts all cash payments for direct and indirect costs to arrive at cash flow from operations.

Indirect method: Under the indirect method, cash flow from operations is calculated by applying a series of adjustments to net income. These adjustments are made for noncash items (e.g., depreciation), nonoperating items (e.g., gains on sale of noncurrent assets), and changes in working capital accounts resulting from accrual accounting. Exhibit 1-2 illustrates the presentation of CFO under the indirect method.

Question 27

Direct Method vs. Indirect Method

Answer 27

• The direct method explicitly lists the actual sources of operating cash inflows and outflows, whereas the indirect method only provides net results for these inflows and outflows. The argument is similar to the one for having an income statement that lists all revenue and expense items, as opposed to one that only provides the end result (i.e., net income). The information provided in the direct format is very useful in evaluating past performance and making projections of future cash flows. 

• The indirect method provides a list of items that are responsible for the difference between net income and operating cash flow. These differences can then be used when estimating future operating cash flows. The indirect method facilitates forecasting of future cash flows since forecasts of future net income simply have to be adjusted for changes in balance sheet accounts that are caused by differences between accrual and cash accounting. 


Question 28

Explain the following direct method balance sheet.

Answer 28

Question 29

Explain the following indirect method balance sheet.

Answer 29

Question 30

When defining the links between the cash flow statement, income statement, and balance sheet: What does the sum of cash flow from operating, investing, and financial activities equal?

Answer 30

The sum of cash flow from operating, investing, and financing activities equals the change in cash over the year.

CFO + CFI + CFF = Change in cash


Year-end cash balance (1) – beginning-of-year cash balance (2) = Change in cash

(1) Current year’s balance sheet
(2) Previous year’s balance sheet

Question 31

When defining the links between the cash flow statement, income statement, and balance sheet: How are operating income and expense items recognized on the income statement?

Answer 31

Operating income and expense items are recognized on the income statement on an accrual basis, which means that revenues and expenses are recognized when incurred, irrespective of when the associated cash flows occur. When the timing of an expense or revenue item differs from the associated cash flow, it is reflected in changes in balance sheet accounts. For example, if revenue is recognized prior to the receipt of cash, accounts receivable will increase.

Beginning accounts receivable (1) + Revenues (2) − Cash received from customers (3) = Ending accounts receivable

(1) Previous year’s balance sheet
(2) Current year’s income statement
(3) Current year’s cash flow statement

Question 32

When defining the links between the cash flow statement, income statement, and balance sheet: If an expense is incurred but not paid for, how is it charged?

Answer 32

It is charged on the income statement and accounts payable increase.

Beginning accounts payable + Purchases (1) − Cash paid to suppliers = Ending accounts payable

(1) Purchases = COGS + Ending Inventory – Beginning Inventory

These changes in current assets and current liabilities are then used to reconcile net income to operating cash flows under the indirect method.

Question 33

On the balance sheet, where are CFI and CFF calculated from?

Answer 33

CFI is calculated from changes in asset balances under the noncurrent assets section of the balance sheet.

CFF is calculated from changes in the equity and noncurrent debt sections of the balance sheet.

A company’s retained earnings (on the balance sheet) represent cumulative net income that has not been distributed to shareholders. Every year, if the company makes a profit, some of it may be distributed to shareholders as dividends, while the rest is added to retained earnings.

Question 34

How can retained earnings be dealt with on a balance sheet?

Answer 34

A company’s retained earnings (on the balance sheet) represent cumulative net income that has not been distributed to shareholders. Every year, if the company makes a profit, some of it may be distributed to shareholders as dividends, while the rest is added to retained earnings.

Beginning retained earnings (1) + Net income (2) − Dividends declared (3) = Ending retained earnings.

(1) Previous year’s balance sheet
(2) Current year’s income statement
(3) Notes in the financial statement

Question 35

What is the relationship between assets and cash?

Answer 35

Let’s consider an asset account, inventory.

• If inventory levels have increased from the previous year, more liquidity of the firm 
is tied up in inventories. This is a use of cash for the firm. 

• If inventory levels have decreased over the year, less of the firm’s cash is tied up in 
inventory. This is a source of cash for the firm.


• Increases* in current assets are uses of cash and decreases in current assets are sources of 
cash. Changes in asset balances and cash are negatively related. 


Question 36

What is the relationship between liabilities and cash?

Answer 36

Now let’s move on to a liability account, accounts payable. 


• If the total amount due to the firm’s creditors has increased over the year, it implies 
that the firm has borrowed more money. This represents a source of cash to the firm. 

• If the amount payable to creditors has fallen over the year, some creditors have 
been paid back, which is a use of cash for the firm.

• Increases* in current liabilities are sources of cash, while decreases in current liabilities are 
uses of cash. Changes in liability balances and cash are positively related. 


Question 37

What are the three steps in completing the direct method format for presenting the cash flow statement?

Answer 37

Step 1: Start with sales on the income statement. Go through each income statement account and adjust it for changes in related working capital accounts on the balance sheet. This serves to remove the effects of the timing difference between the recognition of revenues and expenses and the actual receipt or payment of cash. 


Step 2: Determine whether changes in these working capital accounts indicate a source or use of cash. Make sure you put the right sign in front of the income statement item. Sales are an inflow item so they have a positive effect on cash flow, while COGS, wages, taxes, and interest expense are all outflow items that have negative effects on cash flow.


Step 3: Ignore all nonoperating items (e.g., gain/loss on sale of plant and equipment) and noncash charges (e.g., depreciation and amortization). 


Question 38

What are the three steps in completing the indirect method format for presenting the cash flow statement?

Answer 38

Step 1: Start with net income. Go up the income statement and remove the effects of all noncash expenses and gains from net income. For example, the negative effect of depreciation is removed from net income by adding depreciation back to net income. Cash‐based net income will be higher than accrual‐based net income by the amount of noncash expenses. 


Step 2: Remove the effects of all nonoperating activities from net income. For example, the positive effect of a gain on sale of fixed assets on net income is removed by subtracting the gain from net income. 


Step 3: Make adjustments for changes in all working capital accounts. Add all sources of cash (increases in current liabilities and declines in current assets) and subtract all uses of cash (decreases in current liabilities and increases in current assets). 


Question 39

What are the cash flow from operating activities (CFO) under the direct method?

Answer 39

Cash received from customers

Cash paid to suppliers

Cash paid to employees

Cash paid for other operating expenses

Cash paid for interest

Cash paid for income taxes

Question 40

In calculating the Direct Method to compute cash flow from operating activities CFO, define cash collections from customers.

Answer 40

Total sales adjusted for changes in related working capital accounts are known as cash collections from customers:

Cash collections = (1) Sales − (2) Increase in accounts receivable

(1) If the sale results in an inflow of cash, we put a positive sign before the sales figure
(2) Accounts receivable is an asset. An increase in an asset is a use of cash.

Question 41

In calculating the Direct Method to compute cash flow from operating activities CFO, define cash payment to suppliers.

Answer 41

Cost of goods sold adjusted for changes in related working capital items is known as cash payments to suppliers:

Cash paid to suppliers = −COGS − Increase in inventory + (1) Increase in A/C payable

(1) Accounts payable is a liability. An increase in liability is a source of cash.

Question 42

In calculating the Direct Method to compute cash flow from operating activities CFO, define salaries and wages.

Answer 42

Salaries and wages adjusted for related working capital accounts:


Cash salaries and wages = −Wages and salaries + Increase in wages and salaries payable

COGS, salaries, wages, taxes, interest expense, and other expenses are outflows of cash, so we put a negative sign before them.

Question 43

In calculating the Direct Method to compute cash flow from operating activities CFO, define depreciation.

Answer 43

Depreciation is a noncash expense so it is ignored altogether.

In calculating the Direct Method to compute cash flow from operating activities CFO, define other operating expenses.

Other operating expenses adjusted for changes in related working capital accounts:

Other operating expenses (cash) = −Other operating expenses (accrual basis) + Decrease in prepaid expenses + Increase in other accrued liabilities


Question 44

In calculating the Direct Method to compute cash flow from operating activities CFO, define gain on sale of equipment.

Answer 44

Gain on sale of equipment relates to the sale of a long‐lived asset. The proceeds from this transaction are classified under investing activities and ignored in the calculation of CFO.

Question 45

In calculating the Direct Method to compute cash flow from operating activities CFO, define interest expense.

Answer 45

Interest expense adjusted for related working capital accounts:


Cash interest paid = −Interest expense − Decrease in interest payable

Question 46

In calculating the Direct Method to compute cash flow from operating activities CFO, define income tax expense.

Answer 46

Income tax expense adjusted for related working capital accounts:

Cash taxes paid = −Income tax expense + Increase in taxes payable

Question 47

In calculating the cash flow from operating activities CFO using the indirect method, identify working capital accounts that are either a SOURCE of cash or a USE of cash.

Increase in accounts receivable

Increase in inventory

Decrease in prepaid expenses

Increase in accounts payable

Increase in salaries and wages payable

Decrease in interest payable

Increase in income tax payable

Increase in accrued liabilities

Answer 47

Increase in accounts receivable (use)


Increase in inventory (use)


Decrease in prepaid expenses (source)


Increase in accounts payable (source)


Increase in salaries and wages payable (source)

Decrease in interest payable (use)

Increase in income tax payable (source)

Increase in accrued liabilities (source)

Question 48

What are the adjustments (Additions) to net income using the indirect method?

Answer 48

Noncash items
:

• Depreciation expense of tangible assets
• Amortization expense of intangible assets
• Depletion expense of natural resources
• Amortization of bond discount

Nonoperating losses:

• Loss on sale or write‐down of assets 

• Loss on retirement of debt 

• Loss on investments accounted for under the equity 
method


Increase in deferred income tax liability.

Changes in working capital resulting from accruing higher amounts for expenses than the amounts of cash payments or lower amounts for revenues than the amounts of cash receipts:


• Decrease in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses) 

• Increase in current operating liabilities (e.g., 
accounts payable and accrued expense liabilities) 


Question 49

What are the adjustments (Subtractions) to net income using the indirect method?

Answer 49

Noncash items (e.g., amortization of bond premium)

Nonoperating items:

• Gain on sale of assets 

• Gain on retirement of debt 

• Income on investments accounted for under the 
equity method


Decrease in deferred income tax liability 


Changes in working capital resulting from accruing lower amounts for expenses than for cash payments or higher amounts for revenues than for cash receipts:

• Increase in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses) 

• Decrease in current operating liabilities (e.g., accounts payable and accrued expense liabilities) 


Question 50

What is the basic principle when calculating cash flow from investing activities?

Answer 50

Calculating cash flow from investing activities requires us to consider the effects of transactions relating to long‐lived assets and long-term investments on cash.

Question 51

In fundamental accounting, what does the value of gross fixed assets indicate?

Answer 51

The value of gross fixed assets indicates the historical cost of the fixed assets owned by the company at the balance sheet date. If the figure for gross fixed assets changes from one year to the next, there has been an investing activity. If gross fixed assets increase, there has been a fixed asset purchase, and if gross fixed assets decrease, there has been a fixed asset disposal.

Beginning gross fixed assets + Purchase price of new fixed assets − Historical cost of disposed fixed assets = Ending gross fixed assets.

Question 52

In fundamental accounting, what does the net fixed asset equal?

Answer 52

Net fixed assets equal gross fixed assets minus accumulated depreciation.

Question 53

In fundamental accounting, what is the calculation for accumulated depreciation on sold equipment?

Answer 53

Beginning gross fixed assets + Purchase price of new fixed assets − Historical cost of disposed fixed asset = Ending gross fixed assets

Beginning accumulated depreciation + Current year’s depreciation on all assets − Accumulated depreciation on sold asset = Ending accumulated depreciation.

Question 54

In fundamental accounting, what is the calculation for book value of sold equipment?

Answer 54

Book value of sold equipment = Historical cost − Accumulated depreciation

Question 55

In fundamental accounting, what is the calculation for proceeds from sale of equipment?

Answer 55

Selling price − Book value = Gain/loss on sale of equipment

Question 56

What is important to do on the balance sheet once a long-lived asset is sold?

Answer 56

The historical cost and accumulated depreciation of a long‐lived asset is removed from the balance sheet once it is sold.

Question 57

How is cash flow from financing activities generated? How is it distributed? (CFF)

Answer 57

Cash flow from financing activities is generated from the issuance and repayment of capital (long-term debt and equity) and distributions in the form of dividends to shareholders.

Question 58

In calculating cash flow from financing activities, which areas are identified as inflows and outflows of cash?

Answer 58

Long-term debt

Equity

Dividends

Question 59

In calculating cash flow from financing activities, define what would be considered an inflow and an outflow of cash from long-term debt.

Answer 59

Long-term debt: An increase in long‐term debt from one year to the next implies cash inflows from new borrowings. A decrease implies debt repayment and an outflow of cash.

Ex. Over the course of the year, ABC’s long-term debt fell by $600. This implies that $600 was used by the company to retire debt.

Question 60

In calculating cash flow from financing activities, define what would be considered an inflow and an outflow of cash from equity.

Answer 60

Equity: An increase in common stock from one year to the next implies cash inflows from issuance of new shares. A decrease implies a share repurchase that results in a cash outflow.

Ex. ABC has repurchased $300 of common stock over the year, which reduces cash flow from financing activities.

Question 61

In calculating cash flow from financing activities, define what would be considered an inflow and an outflow of cash from dividends.

Answer 61

Dividends: Cash dividends paid out can be computed from the following relationship:

Cash dividends paid out = Beginning dividends payable + Dividends declared − Ending dividends payable.

Dividends declared = Beginning retained earnings + Net income − Ending retained earnings.

Ex. Notice that ABC’s retained earnings increased by only $1,000 even though income
was $1,500. This implies that $500 of net income was appropriated to the company’s shareholders as dividends. Even though our example never explicitly mentions dividends, we must ensure that net income reconciles with the change in retained earnings. ABC declared $500 of dividends and paid them out as well. If the company had not paid them, we would have seen an increase in dividends payable of $500 over the year.

Question 62

What does the combined effects of CFO, CFI and CFF give us?

Answer 62

Change in cash and cash equivalents over the year.

The net increase in cash on the cash flow statement must equal the difference between the cash balances for 2007 and 2008. The company’s cash balance in 2007 was $1,150, and in 2008 was $2,300. Notice that the difference between the two amounts ($1,150) is also the net increase in cash calculated on the cash flow statement.

Question 63

There is a three‐step process for converting an indirect cash flow statement into a direct statement:

Answer 63

Step 1: Aggregate all revenues and all expenses

Step 2: Remove the effect of noncash items from aggregated revenues and expenses and separate the adjusted revenues and expenses into their respective cash flow items. 


Step 3: Convert the accrual-based items into cash-based amounts by adjusting for changes in corresponding working accounts.

Question 64

There is a three‐step process for converting an indirect cash flow statement into a direct statement: Define Step 1.

Answer 64

• Aggregate all operating and nonoperating revenues and gains such as sales and gains from sale of assets. 

• Aggregate all operating and nonoperating expenses such as wages, depreciation, interest, and taxes. 


Question 65

There is a three‐step process for converting an indirect cash flow statement into a direct statement: Define Step 2.

Answer 65

Step 2: Remove the effect of noncash items from aggregated revenues and expenses and separate the adjusted revenues and expenses into their respective cash flow items. 


• Deduct noncash revenue items such as gain on sales of assets from total revenue. 

• Deduct noncash expense items such as depreciation from total expenses. 

• Break down the adjusted expenses into cash outflow items, such as cost of goods 
sold, wages, interest expense, and tax expense.

Question 66

There is a three‐step process for converting an indirect cash flow statement into a direct statement: Define Step 3.

Answer 66

Step 3: Convert the accrual-based items into cash-based amounts by adjusting for changes in corresponding working accounts.

An increase (decrease) in an asset account is a cash outflow (inflow). An increase (decrease) in a liability account is a cash inflow (outflow).

• Convert revenue into cash receipts from customers by adjusting for accounts receivable and unearned revenue. 

• Convert COGS into cash payments to suppliers by adjusting for inventory and accounts payable. 

• Convert wages, interest, and tax expenses into cash amounts by adjusting for wages payable, interest payable, taxes payable, and deferred taxes. 


Question 67

Define the importance of cash flow analysis.

Answer 67

Cash flow analysis helps us evaluate how well a business is being run and to estimate its future cash flows. The analysis begins with understanding the sources and uses of cash and determining which components of the cash flow statement these sources and uses can be attributed to. The analysis also includes an evaluation of the determinants of each of the components.

Question 68

In cash flow analysis, what are the major sources and uses of cash?

Answer 68

Sources and uses of cash depend upon the company’s stage of growth.

• Companies in the early stages of growth may have negative operating cash flows as cash is used by the company to finance inventory rollout and receivables. These negative operating cash flows are supported by financing inflows from issuance of debt or equity. 

• Inflows of cash from financing activities are not sustainable. Over the long term, a company must generate positive cash flows from operating activities that exceed capital expenditures and payments to providers of debt and equity capital. 

• Companies in the mature stage of growth usually have positive cash flows from operating activities. These inflows can be used for debt repayment and stock repurchases. They can also be used by the company to expand its scale of operations (investing activities). 


Question 69

In cash flow analysis, define how we analyze operating cash flow.

Answer 69

• Changes in relevant asset and liability accounts should be used to determine whether business operations are a source or use of cash. 

• Operating cash flow should be compared to net income. If high net income is not being translated into high operating cash flow, the company might be employing aggressive revenue recognition policies. 

• Companies should ideally have operating cash flows that exceed net income. 

• The variability of operating cash flow and net income is an important determinant 
of the overall risk inherent in the company.

Question 70

In cash flow analysis, define how we analyze investing cash flow.

Answer 70

• Changes in long‐term asset and investment accounts are used to determine sources and uses of investing cash flows. 

• Increasing outflows may imply capital expenditures. Analysts should then evaluate how the company plans to finance these investments (i.e., with excess operating cash flow or by undertaking financing activities).

Question 71

In cash flow analysis, define how we analyze financing cash flow.

Answer 71

• Changes in interest‐bearing debt and equity are used to determine sources and uses of financing cash flow. 

• If debt issuance contributes significantly to financing cash flow, the repayment schedule must be considered. 

• Increasing use of cash to repay debt, repurchase stock, or make dividend payments might indicate a lack of lucrative investment opportunities for the company. 


Question 72

There are two ways to construct common-size cash flow statements:

Answer 72

1) Express each item as a percentage of net revenues. This is the most commonly used format. 

2) Express each cash inflow item as a percentage of total cash inflows, and each cash outflow item as a percentage of total cash outflows. 


Question 73

What do common-size cash flow statements make easier?

Answer 73

Common‐size cash flow statements make it easier to identify trends in cash flows, and help in forecasting future cash flows as individual items are expressed as a percentage of revenues.

Question 74

Define free cash flow

Answer 74

Free cash flow is the excess of a company’s operating cash flows over capital expenditure undertaken during the year. Free cash flow to the firm and free cash flow to equity are more precise measures of free cash flow as they identify specifically whom the cash is available to.

Question 75

Define free cash flow to the firm (FCFF) with equation.

Answer 75

Free cash flow to the firm (FCFF) is cash that is available to equity and debt holders after the company has met all its operating expenses and satisfied its capital expenditure and working capital requirements.

FCFF = NI + NCC + [Int × (1 - tax rate)] - FCInv - WCInv

where:


NI = net income


NCC = noncash charges


FCInv = fixed capital investment (net capital expenditure)

WCInv = working capital investment


Int = Interest expense

Notice that net income that has been adjusted for noncash charges and changes in working capital accounts equals the company’s operating cash flows. Therefore:

FCFF = CFO + [Int × (1 - tax rate)] - FCInv

Question 76

What is an important note, under IFRS, in regards to interest and dividends in the calculation of FCFF?

Answer 76

Note: Under IFRS, if the company has classified interest and dividends received as investing activities, they should be added to CFO to determine FCFF. If dividends paid were deducted from CFO, they should be added back to CFO to calculate FCFF. Dividends must not be adjusted for taxes as dividends paid are not tax-deductible.

Question 77

Define free cash flow to equity (FCFE) with equation.

Answer 77

Free cash flow to equity (FCFE) refers to cash that is available only to common shareholders.

FCFE = CFO - FCInv + Net borrowing

Question 78

What does a positive FCFE suggest?

Answer 78

A positive FCFE suggests that the company has operating cash flows available after payments have been made for capital expenditure and debt repayment. This excess belongs to common shareholders.

Question 79

What is an important note, under IFRS, in regards to deducted dividends paid in calculating CFO?

Answer 79

Note: Under IFRS, if the company has deducted dividends paid in calculating CFO, dividends must be added back to calculated FCFE.

Question 80

Define the purpose of cash flow ratios.

Answer 80

The information available on cash flow statements can be used to compute cash flow ratios. These ratios, like income statement and balance sheet ratios, can be used for comparing the company’s performance over time (time-series analysis) or against other companies within the same industry (cross‐sectional analysis). Cash flow ratios can be categorized as performance (profitability) ratios and coverage (solvency) ratios.

Question 81

For cash flow ratios, list the performance cash flow ratios.

Answer 81

Cash flow to revenue

Cash return on assets

Cash return on equity

Cash to income


Cash flow per share

Question 82

For cash flow ratios, list the coverage cash flow ratios.

Answer 82

Debt coverage

Interest coverage

Reinvestment


Debt payment

Dividend payment

Investing and financing

Question 83

For cash flow ratios, under performance ratio, what is the formula for cash flow to revenue and what does it measure?

Answer 83

CFO / Net revenue


Cash generated per unit of revenue.

Question 84

For cash flow ratios, under performance ratio, what is the formula for cash return on assets and what does it measure?

Answer 84

CFO / Average total assets

Cash generated from all resources, equity, and debt.

Question 85

For cash flow ratios, under performance ratio, what is the formula for cash return on equity and what does it measure?

Answer 85

CFO / Average shareholders’ equity

Cash generated from owner resources.

Question 86

For cash flow ratios, under performance ratio, what is the cash to income and what does it measure?

Answer 86

CFO / Operating income

The ability of business operations to generate cash.

Question 87

For cash flow ratios, under performance ratio, what is the formula for cash flow per share and what does it measure?

Answer 87

(CFO – Preferred dividends) / Number of common shares outstanding

Operating cash flow available for each shareholder.

Question 88

For cash flow ratios, under coverage ratios, what is the formula for debt coverage and what does it measure?

Answer 88

CFO / Total debt

Leverage and financial risk.


Question 89

For cash flow ratios, under coverage ratios, what is the formula for interest coverage and what does it measure?

Answer 89

(CFO + Interest paid + Taxes paid) / Interest paid

Ability to satisfy interest obligations.

Question 90

For cash flow ratios, under coverage ratios, what is the formula for reinvestment and what does it measure?

Answer 90

CFO / Cash paid for long-term assets

Ability to buy long‐term assets with operating cash flows.

Question 91

For cash flow ratios, under coverage ratios, what is the formula for debt payment and what does it measure?

Answer 91

CFO / Cash paid for long-term debt repayment

Ability to meet debt obligations with operating cash flows.

Question 92

For cash flow ratios, under coverage ratios, what is the formula for dividend payment and what does it measure?

Answer 92

CFO / Dividends paid

Ability to make dividend payments with operating cash flows.

Question 93

For cash flow ratios, under coverage ratios, what is the formula for investing and financing and what does it measure?

Answer 93

CFO / Cash outflows for investing and financing activities

Ability to buy long-term assets, settle debt obligations and make dividend payments from operating cash flows.