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Statement of Cash Flows
Credit Analysis Course forKuwait Investment Authority
Citibank
George Werner
This presentation was provided to Citibank by George Werner for the Kuwait Investment Authority Seminar. It is for educational purposes only and should not beconstrued as investment advice or a recommendation with respect to any of the information presented. The content and views expressed in this presentation are
those of George Werner and are subject to change without notice. George Werner is not affiliated with Citibank.This is confidential and proprietary information and may not be copied or reproduced.
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Table of Contents
I. Statement of Cash Flows
II. Cash Flow from Operations (CFO)
III. Cash Flow from Investing and Financing
IV. Cash Flow Problem Areas
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I. Statement of Cash Flows
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Purpose
To provide relevant information about cash and cashequivalent receipts and payments during a period bycategorizing the cash movements into three distinct
activities:
Operations
Investing
Financing
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Reconcile net income and cash
Separate cash from non-cash activities
Assess ability of firm to meet cash obligations
Assess potential future cash flows
Uses
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Operating activities
Cash effects of transactions that determine net income
Investing activitiesMaking, collecting loans
Acquiring, disposing of investments
Acquiring, disposing of PP & E, other assets
Financing activities Liability, Equity transactions
Organized Into Three Activity Areas
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II. Cash Flow from Operations (CFO)
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Direct method Preferred by auditors
Lists all gross cash receipts and disbursementsrelated to operations
Gives a better measure of the size of cash flows inboth directions and gives more detail on certainaccounts indicating where a cash need might arise
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Indirect method
Usually allowed by auditors
Starts with net income and adjusts for non-cash itemsin order to convert to cash flow from operations (CFO)
Preferred by analysts who project future cash flows byfirst estimating future income levels
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Most firms use the indirect method (cheaper and less revealing)
so credit analyst has to be able to convert as well as possible While a net CFO number is of less use for analysis than
information about the components and their magnitudes, it doesprovide a better measure of performance than does net income,as it is less subject to distortion. It is not distortion free, however
Note: CFO has a financing, not profit measurement focus and isthus suited to the evaluation and projection of short term liquidity
The ability to generate cash from operations the business ofthe businessis an indicator of the firms true financial health
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In effect, the direct method presents net income as ifit were on a cash basis
Cash collected from operations
less Cash payments for expenses
equals
Cash income before taxes
less Cash tax payments
equals
Net cash provided by (used in) operations
Direct Method
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In the U.S., FASB requires a supplemental schedulewhich reconciles this statement to net income, as wellas
Cash collected from customers
Interest, dividends receivedOther cash receipts
Cash paid to employees, suppliers
Interest paid
Taxes paidOther operating cash payments
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A proxy for the direct method (which requires access tothe transaction journal) is to calculate
Sales - increase in AR
less
(COGS + increase in inventories + decrease in AP)
less
Interest paid and operating expenses (adjusted fordepreciation, amortizations, accruals and the like)
equals
Cash income before taxes
less
Cash tax payments
equals
Net cash provided by (used in (if negative)) operations
Derived Direct Method
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This is the most widely used on a global basis
Procedure:
Determine the change in cash using beginning andending balance sheets
Determine the cash flow from operations using Incomestatement and beginning and ending balance sheets
Determine the cash flows from investing, financing usingbeginning and ending balance sheets
Indirect Method
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Net income
plus
Depreciation, amortization, other non-cash
less adjustments
Increase in accounts receivable
Increase in inventory
Increase in other operating assets
Decrease in accounts payable
Decrease in other operating liabilities
equals
Net cash provided by (used in) operations
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In addition, the firm must disclose Interest paid
Income taxes paid
The cash flow from operations calculated bythe direct method and the indirect method willbe (must be) identical
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III. Cash Flow from Investing
and Financing
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Calculation
The calculation of the cash flows from investing andfrom financing then follows as
Investing
~ Changes in non-operating asset accounts
Financing
~ Changes in non-operating liability and equity accounts
Adding the three components will (must) equal the
change in cash between the beginning and endingbalance sheets
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IV. Cash Flow Problem Areas
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Cash Flow Problem Areas
Adjustments, such as depreciation, Need to be adjusted inamortizations, bond discounts or arriving at CFOpremiums, changes in deferredtaxes, change in equity inundistributed earnings, etc.
Accounts receivable and Net, if indirect method;Allowance for doubtful accounts If using direct method,
adjust only when written off
- Other working capital changese.g., dividends payable Separate changes that
result from operations from
other change Gains/losses Separate into investing
and operations
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Pensions
Adjust for difference betweenexpense and funding
Extraordinary items All taxes paid are treated asoperating use;
Extraordinary item is then treatedon a gross basis
Significant non-cash Do not appear in cash flow transactionsstatement;
Are disclosed in notes