ANALYSIS OF CASH FLOW

STATEMENT OF CASH FLOW

• The statement of cash flow reports all the cash inflows and outflows of the firm for a specific period.

• Classification:– CF from operating activities– CF from investing activities– CF from financing activities– Firms with significant foreign operations separately

report a fourth category, the effect of exchange rate changes on cash

DIRECT AND INDIRECT METHOD

• CF Statements prepared using indirect method have a significant drawback

• Because the indirect format reports the net cash flow from operations does not facilitate the comparison and analysis of operating cash inflows and outflows by function with the revenue and expense activities that generated them, as is possible from direct method cash flow statement

REPORTING VS OPERATING CHANGES IN ASSETS AND LIABILITIES

• The discrepancies between the changes in accounts reported on the balance sheet and those reported in the cash flow statement are primarily to two factors:– Acquisitions and divestitures– Foreign subsidiaries

• Effect of exchange rate changes on cash

ANALYSIS OF CASH FLOW INFORMATION

• CF Statement provides more objective information about:– A firm’s ability to generate CF from operations– Trends in CF components and cash

consequences of investing and financing decisions

– Management decisions regarding such critical areas as financial policy (leverage), dividend policy, and investment for growth.

ANALYSIS OF CASH FLOW INFORMATION

• Free cash flow:– Cash from operations less the amount of capital

expenditures required to maintain the firm’s present productive capacity.

– Lacking better information, all capital expenditure are subtracted from CFO to obtain FCF.

– FCF equals to:• CFO minus (net) capital expenditures• CFO minus CFI and thus includes expenditures (receipts) for

acquisitions (divestitures) and other investment

INCOME, CF, AND THE GOING CONCERN ASSUMPTION

• The predictability of financial statement is subject to a number of implicit assumption, including going concern.

• When the going concern assumption is subject to doubt, revenue recognition and asset valuation can no longer be taken for granted– The value of inventory and receivable declines

sharply – Long term assets also must be reexamined

INCOME, CF, AND THE CHOICE OF ACCOUNTING POLICIES

• The periodic net income differs because accounting methods and assumptions of manager differ, not because their economic activities differ

• The cash flow statement allows the analyst to distinguish between the actual events that have occurred and the accounting assumptions that have been used to report these events

INCOME, CF, AND LIQUIDITY

• Rapid growth is often accompanied by increases in capital expenditures and negative free cash flows

• Growth companies may also report weak operating cf because they must finance growth in current operating assets

• The cfs provides information about the firm’s liquidity and its ability to finance its growth from internally generated funds

• Additional analysis: trends in sale and earnings

ANALYSIS OF CASH FLOW TRENDS

• The data contained in the statement of cash flow can be used to:– Review individual cash flow items for analytic

significance– Examine the trend of different cash flow

components over time and their relationship to related income statement items

– Consider the interrelationship between cash flow components over time

CASH FLOW CLASSIFICATION ISSUES

• Cash flows involving PPE

• Differences due to some accounting methods

• Interest and dividend received

• Interest paid

• Noncash transaction