F-401: Financial Statement Analysis and Valuation

CFA Level 1: Financial Reporting and Analysis

Reading 23: Understanding Cash Flow Statements

Prepared By:
Md Imran Hossain
Assistant Professor
Department of Finance
University of Dhaka
Email: [email protected]
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 Statement of Cash Flows (SCF) and its Importance/Usage
• The statement of cash flows (SCF) provides information about a company’s cash
receipts and cash payments during an accounting period.
• SCF (Cash basis) vs I/S (accrual basis)
• A reconciliation between reported income and cash flows from operating
activities provides useful information about when, whether, and how a
company is able to generate cash from its operating activities.
• A company with healthy credit sales and net income on its I/S; however, with
zero cash inflow, the company would not survive.
• SCF also provides a reconciliation of the beginning and ending cash on the B/S.
• A company’s investing and financing activities in SCF answers:
• Does the company generate enough cash from its operations to pay for
its new investments, or is the company relying on new debt issuance to
finance them?
• Does the company pay its dividends to common stockholders using cash
generated from operations, from selling assets, or from issuing debt?
• In summary, information about the sources and uses of cash helps creditors,
investors, and other statement users evaluate the company’s liquidity, solvency,
and financial flexibility. 2
 Three activities/components of SCF
(under both IFRS and US GAAP)

❑ Operating activities include the company’s day-to-day activities that create cash
receipts and cash payments, such as selling inventory and providing services,
and cash payments for inventories, salaries, taxes etc.
❑ Investing activities include purchasing and selling long-term assets and other
investments (i.e., PPE; intangible assets; and both long-term and short-term
investments in the equity and debt issued by other companies).
• Investments in equity and debt securities exclude-
a) any securities considered cash equivalents and
b) securities held for dealing/trading purposes (considered operating activities).
❑ Financing activities include obtaining or repaying capital, such as equity and
long-term debt. Examples: issuing or repurchasing stock (common or preferred)
or bonds and borrowing or repaying debt.
• Note: Any significant Non-cash financing and investing transaction (e.g., issuing
common stock either for dividends or in connection with conversion of a
convertible bond or convertible preferred stock), should be reported in a
separate note or a supplementary schedule SCF.
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SCF: Differences between IFRS and US GAAP

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 Formats/Methods of Preparing SCF (or CFO)
❑ Direct method:
✔ It shows the specific cash inflows and outflows related to a company’s cash
receipts and disbursements that result in reported cash flow from operating
(CFO) activities.
✔ It eliminates any impact of accruals and shows only cash receipts and payments.
✔ It provides information on the specific sources of operating cash receipts &
payments.
✔ It is useful in understanding historical performance and in predicting future
operating cash flows.
❑ Indirect method:
• It shows how cash flow from operations (CFO) can be obtained from reported
net income as the result of a series of adjustments.
• It begins with net income. To reconcile net income with CFO, adjustments are
made for non-cash items, for non-operating items, and for the net changes in
operating accruals.
• It shows the reasons for differences between net income and operating cash
flows (OCF).
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 Formats/Methods of Preparing SCF (or CFO):
Viewpoints of IFRS vs US GAAP
• IFRS and US GAAP both permit either method but encourage direct method.

• US GAAP encourage the use of the direct method but also require companies to
present a reconciliation between net income and cash flow (equivalent to the
indirect method). However, if the indirect method is chosen, no direct-format
disclosures are required.

• The majority of companies, reporting under IFRS or US GAAP, present using the
indirect method for operating cash flows (reasons: easier and less costly).

• Many users of financial statements prefer the direct format, because of the
importance of information about operating receipts and payments in assessing a
company’s financing needs and capacity to repay existing obligations.

• Both investing and financing activities format are the same in direct and
indirect methods. Only format of operating activities differ.
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 Linkages of the SCF with the I/S and B/S
B/S
I/S Liabilitie
Assets s&
Equity
Revenues
(-) Expenses
______________ CA CL
Net Income
FA LTD

Equit
y

SCF Operating Investing Financing

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Math: Preparing SCF from I/S and B/S info

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Math: Preparing SCF from I/S and B/S info (cont’d)

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 Math solution: Preparing SCF under DIRECT method
• Let’s first calculate the key items as workings:

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 Math solution: Preparing SCF under DIRECT method (cont’d)
• Let’s first calculate the key items as workings (cont’d):

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 Math solution: Preparing SCF under DIRECT method (cont’d)
• Let’s first calculate the key items as workings (cont’d):

Some initial hints before calculation:

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 Math solution: Preparing SCF under DIRECT method (cont’d)
• Let’s first calculate the key items as workings (cont’d):

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 Math solution: Preparing SCF under DIRECT method (cont’d)
• Let’s first calculate the key items as workings (cont’d):

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Math solution: Overall SCF under DIRECT method (cont’d)

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 Alternatively: Preparing SCF under INDIRECT method
Guidelines for calculating CFO under INDIRECT method
It begins with net income. To reconcile net income with CFO, adjustments are made for
non-cash items, for non-operating items, and for the net changes in working capital (CA and
CL).

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Math solution: Overall SCF under INDIRECT method

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3-step process of Conversion of CFs from Indirect method to Direct method

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 Four Tools for Cash Flow Statement Analysis

1. Evaluation of the Sources and Uses of Cash

2. Common-Size Analysis of the SCF

3. Free Cash Flow to the Firm (FCFF) and Free Cash Flow to
Equity (FCFE)

4. Cash Flow Ratios

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1. Evaluation of the Sources and Uses of Cash

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 2. Common-Size Analysis of the SCF

Two alternative approaches:

a) Inflow/Outflow approach:
Express each line item of cash inflow (outflow) as a
percentage of total inflows (outflows) of cash.

(b) Net Revenue approach:

Self study: Exhibit 14 & 15 and Example 9

• It is desirable that operating cash flows are sufficient to cover capital

• The excess of operating cash flow over capital expenditures is known

• For purposes of valuing a company or its equity securities, an analyst may want
to determine and use other cash flow measures, such as free cash flow to the
firm (FCFF) or free cash flow to equity (FCFE).

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3. Free Cash Flow to the Firm (FCFF) (cont’d)

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3. Free Cash Flow to the Equity (FCFE) (cont’d)

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4. Cash Flow Ratios

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 Advice

• Please practice Examples inside the chapter as

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‘xiè xiè’
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