UNDERSTANDING THE,CASH FLOW STATEMENT
LOS 34.g: Describe the process of converting a statement of cash Hows
Most firms present the cash flow statement using the indirect method. For analysis, it may be beneficial to convert an indirect cash flow statement to a direct cash flow statement.
The only difference between the indirect and direct methods of presentatio n is in the.
cash flow from operations (CFO) section. CFO under the direct method can be __ computed using a combination of the income statement and a statement of cash Haws
prepared under the indirect method.
©2008Schweser Pagell9.
Study Session 8
Cross-Reference to CFA Institute Assigned Reading#34 - Understanding the Cash Flow Statement
There are two major sections in CFO under the direct method: cash inflows (receipts) and cash outflows (payments). ~!e will illustrate the conversion process using some frequently used accounts. Please note that the list below is for illustrative purposes only and is far from all-inclusive of what may be encountered'in practice. The general principle here is to adjust each income statement item for its corresponding balance sheet accounts and to eliminate noncash and nonoperating transactions.
Cash collections from customers:
1. Begin with net sales from the income statement.
2. Subtract (add) any increase (decrease) in the accounts receivable balance as reported in the indirect method. If the company has sold more on credit than has been collected from customers, accounts receivable will increase and cash
collections will be less than net sales.
3. Add (subtract) an increase (decrease) in unearned revenue. Unearned revenue includes cash advances from customers. Cash received from customers when the goods or services have yet to be delivered is not included in net sales, so the advances must be added to net sales in order to calculate cash collections.
Cash payments to suppliers:
1. Begin with cOSt of goods sold (COGS) as reported in the income statement.
2. If depreciation and/or amortization have been included in COGS (they increase COGS), these items must be added backto COGS when computing the cash paid to suppliers.
3. Reduce (increase) COGS by any increase (decrease) in the accounts payable balance as reported in the indirect method. If payables have increased, then more was spent on credit purchases during the period than was paid on existing payables, so cash .payments are reduced by the amount of the increase in payables.
4. Add (subtract) any increase (decrease) in the inventory balance as disclosed in the indirect method. Increases in inventory are not included in COGS for the period but still represent the purchase of inputs, so they increase cash paid to suppliers.
5. Subtract an inventory write-off that occurred during the period. An inventory write-off, as a result of applying the lower of cost or market rule, will reduce ending inventory and increase COGS for the period. However, no cash flow is associated with the write-off.
Other items in a direct method cash flow statement folIow the same principles. Cash taxes paid, for example, can be derived by starting with income tax expense on the income statement. Adjustment must be made for changes in related balance sheet accounts (deferred tax assets and liabilities, and income taxes payable).
Cash operating expense is equaltoselling, general, and administrative expense (SG&A) from the income statement, increased (decreased) for any increase (decrease) in prepaid expenses. Any increase in prepaid expenses is a cash outflow that is not included in SG&A for the current period.
Page 120 ©2008Schweser
Study Session 8 Cross-Referenceto CFA Institute Assigned Reading #34 - Understanding the Cash Flow Statement
~ Professor's Note: Converting an indirect statement of cash flows to a direct
~ statement of cash flows involves the same steps as constructing a direct statement from the income statement and balance sheets.
LOS 34.h: Analyze and interpret a cash flow statement using both total currency amounts and common-size cash flow statements.
Major Sources and Uses of Cash
Cash flow analysis begins with an evaluation of the firm's sources and uses of cash from operating, investing, and financing activities. Sources and uses of cash change as the firm moves through its life cycle. For example, when a firm is in the early stages of growth, it may experience negative operating cash flow as it uses cash to finance increases in inventory and receivables. This negative operating cash flow is usually financed externally by issuing debt or equity securities. These sources of financing are not sustainable. Eventually, the firm must begin generating positive operating cash flow or the sources of external capital may no longer be available. Over the long term, successful firms must be able to generate operating cash flows that exceed capital expenditures and provide a return to debt and equiryholders.
Operating Cash Flow
An analyst should identify the major determinants of operating cash flow. Positive operating cash flow can be generated by the firm's earning-related activities. However, positive operating cash flow can also be generated by decreasing noncash working capital, such as liquidating inventory and receivables or increasing payables. Decreasing noncash working capital is not sustainable, since inventories and receivables cannot fall below zero and creditors will not extend credit indefinitely unless payments are made when due.
Operating cash flow also provides a check of the quality of a firm's earnings. A stable relationship of operating cash flow and net income is an indication of quality earnings.
(This relationship can also be affected by the business cycle and the firm's life cycle.) Earnings that significantly exceed operating cash flow may be an indication of
aggressive (or even improper) accounting choices such as recognizing revenues too soon or delaying the recognition of expenses. The variability of net income and operating cash flow should also be considered.
Investing Cash Flow
The sources and uses of cash from investing activities should be examined. Increasing capital expenditures, a use of cash, is usually an indication of growth. Conversely, a firm may reduce capital expenditures or even sell capital assets in order to save or generate cash. This may result in higher cash outflows in the future as older assets are replaced or growth resumes. As mentioned above, generating operating cash flow that exceeds capital expenditures is a desirable traie.
©2008 Schwescr Page 121
Stud," Session 8
Cross-ReferencetoCFA Institute Assigned Reading#34 - Understanding the Cash Flow Statement Financing Cash Flow
The financing activities section of the cash flow statement reveals information about whether the firm is generating cash flowby issuing debt or equity. Ie also provides information about whether the firm is using cashto repay debt, reacquire srock, or pay dividends. For example, an analyst would certainly wantto know if a firm issued debt and used the proceedsto reacquire stOck or pay dividendsto shareholders.
Common-Size Cash Flow Statement
Like the income statement and balance sheet, common-size analysis can be usedto
analyze the cash flow statement.
The cash flow statement can be convertedtocommon-size format by expressing each line item as a percentage of revenue. Alternatively, each inflow of cash can be expressed as a percentage of total cash inflows and each outflow of cash can be expressed as a percentage of tOtal cash outflows.
Total cash flow
Page122 ©2008 Schweser
'iruJy .'icssion K Cross-Reference to CFA Institute Assigned Reading #34 - Understanding the Cash Flow Statement
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