mastering the cash flow statement & free cash flow cfa® levels

1CFA LEVEL I 2013 ©2012 Kaplan Financial Limited 1

Financial Reporting and Analysis

Mastering the Cash Flow Statement & Free

Cash Flow

CFA® Levels I & [email protected]

Importance of Cash Flow Statement

Net income from accrual accounting does not tell us about the sources and uses of cash to meet liabilities and operating needs

The statement of cash flows has three components under both IFRS and US GAAP:

� Cash provided or used by operating activities

� Cash provided or used by investing activities

� Cash provided or used in financing activities

LOS 27.a Compare/Classify: CFAI pg 253 Schweser pg 109

Understanding the Cash Flow Statement


U.S. GAAP vs. IFRS

Interest received

Interest paid

Dividends received

Dividends paid

Taxes paid

Bank overdraft

CFO

CFO

CFO

CFF

CFO

CFF

CFO or CFI

CFO or CFF

CFO or CFI

CFO or CFF

CFO or CFI & CFF

*

U.S. GAAP

(SFAS 95)

IAS GAAP

(IAS 7)

* Considered part of cash and cash equivalents

LOS 27.c Contrast: CFAI pg 255 Schweser pg 111


Statement of Cash Flow: Direct vs. Indirect Method

Direct vs. indirect method refers only to the calculation of CFO, the value of CFO is the same for both methods; CFI and CFF are unaffected

� Direct method: Identify actual cash inflows and outflows; e.g., collections from customers, amount paid to suppliers

� Indirect method: Begin with net income and make necessary adjustments to get operating cash flow

LOS 27.d Distinguish/Describe: CFAI pg 256 Schweser pg 112



Linkages Between Statements

Accounts Receivable ‘T’ Account

Amount B/Fwd

Sales

Amount C/Fwd

18,000

20,000

200,000

218,000 218,000

Cash collections198,000

This year’s balance sheet

Last year’s balance sheet

This year’s income statement

LOS 27.e Describe: CFAI pg 266 Schweser pg 114

- 5


Cash Inflows and OutflowsGeneral rules regarding increases and decreases in balance sheet items over time:

Increase Decrease

Assets outflow inflow

Liabilities & Equity inflow outflow

e.g.: An increase in AR or inventory uses cash

An increase in payables generates cash

Adjust net income for these changes (indirect)

Understanding Cash Flow StatementsLOS 27.f Describe: CFAI pg 267 Schweser pg 115


Ecclestone Industries—Example

Ecclestone Industries has the following income statement for 20X9 and balance sheets for 20X8 and 20X9. You are to construct the statement of cash flows using the indirect method.

Additional information:Equipment was purchased for $50,000Ecclestone has a tax rate of 40%

LOS 27.f Describe: CFAI pg 267 Schweser pg 115


Income Statement for Year to 31 December 20X9

Sales revenueExpenses:

Cost of goods soldSalariesDepreciationInterest

Gain from sale of PPEPre-tax incomeProvision for taxesNet income

$ 200,000

105,00095,00020,000

115,00040,00075,000

$

80,00010,00014,0001,000




Ecclestone Balance Sheet DataBalance Sheets

Current assetsCashAccounts receivableInventory

Non-current assetsGross PPEAccum. Depr.

Total Assets

20X8$

18,00018,00014,000

282,000

252,000

20X9$

66,00020,00010,000

312,000

324,000

(80,000) (84,000)



Balance Sheets

Current liabilitiesAccounts payableSalaries payableInterest payableTaxes payableDividends payable

Noncurrent liabilitiesBondsDeferred taxes

Stockholders’ equityCommon stockRetained earnings

Total Liabilities & Equity

20X8$

10,00016,000

6,0008,0002,000

20,00030,000

100,00060,000

252,000

20X9$

18,0009,0007,000

10,00012,000

30,00040,000

80,000118,000

324,000




Direct Method CFO1. Take each income statement item in turn

– e.g., sales

2. Move to the balance sheet and identify asset and liability accounts that relate to that income statement item—e.g., accounts receivable

3. Calculate the change in the balance sheet item during the period (ending balance – opening balance)

4. Apply the rule:Increases in an asset: deduct Increase in a liability: addDecrease in an asset: addDecrease in a liability: deduct

LOS 27.g Convert: CFAI pg 302 Schweser pg 120


Direct Method CFO

5. Adjust the income statement amount by the change in the balance sheet

6. Tick off the items dealt with in both the income statement and balance sheet

7. Move to the next item on the income statement and repeat

8. Ignore depreciation/amortization and gains/losses on the disposal of assets as these are non-cash or non-CFO items




9. Keep moving down the income statement until all items included in net income have been addressed applying steps 1-8

10. Total up the amounts and you have CFO

Direct Method CFO



Cash InflowsSalesLess: Increase in A/RCash collected from customers

Direct cash outflowsCost of goods soldAdd: Decrease in inventoryPurchasesAdd: Increase in A/PCash paid to suppliers

Operating expense (wages)Less: Decrease in salaries payableCash paid to employees

200,000(2,000)

(80,000)4,000

(76,000)8,000

198,000

(68,000)

(10,000)(7,000)

(17,000)

Direct Method CFO

-8




(28,000)

(40,000)10,000

2,000

(1,000)1,000

Direct Method, cont.

Cash outflowsInterest ExpenseAdd: Increase in interest payable

Cash interest paid

Tax ExpenseAdd: Increase in deferred tax liab.Tax payableAdd: Increase in taxes payable

Cash taxes paid

$ $

CFO

0

85,000

(30,000)

-7



Indirect Method CFO

CFO = NI + NCC - WCinv



+ Depreciation+ Amortisation+ Loss on asset disposal- Gain on asset disposal+ Loss on early debt retirement- Gain on early debt retirement+ Increase in DTL, decrease in DTA- Decrease in DTL, increase in DTA+ Non cash expenses (provisions)

∆Current assets excluding cash and investments∆ Current liabilitiesexcluding debt instruments and dividends payable

= change in non-cash working capital


Indirect Method CFO (Alternative)



75,000 + 4,000 + 6,000 = 85,000

+ Depn

- Disposal gain + ↑ DTLNCC

Current assets-Cash & Inv’

Current liabilities-Debt & divs’

Working Capital

$14,000

(20,000)10,0004,000

20x8 20x9$ $

50,000 96,000(18,000) (66,000)32,000 30,000

42,000 56,000(2,000) (12,000)40,000 44,000(8,000) (14,000)∆WC = (6,000)


-6

Calculating CFI

CFI =

investment in assets – cash received on asset sales

Net book value =

Gross PPE – accumulated depreciation

Gain (loss) on sale = sales price – net book value




Ecclestone CFI

Gross Plant and Equip.

Beginning PPE

Additions

PPE disposal

Ending PPE

282,000

50,000

(20,000)

312,000

Accumulated Depr.

Begin Acc. Depr.

Depr. Expense

AD for disposal

End Acc. Depr.

80,000

14,000

(10,000)

84,000

Calculating NBV of asset sold

NBV of disposal = 20,000 – 10,000 = 10,000

-5



CFI = cash additions – cash received on disposal

Sale Proceeds

NBV of disposal

Gain(loss) on sale

30,000

10,000

20,000

$

CFI = –additions + proceeds

CFI = –$50,000 + $30,000 = –$20,000

Ecclestone CFI

-2




Computing CFF

� Change in debt

� Change in common stock

� Cash dividends paid

Net income

Dividends declared

∆ in retained earnings

$

X

(X)

X

Dividends declared

∆Dividends payable

Cash paid

$

(X)

X

(X)



� Change in debt



Net income

Div declared

∆ in R/E

$

75,000

(17,000)

58,000

Dividends decl.

∆Div. payable

Cash div. paid

$

(17,000)

10,000

(7,000)

Ecclestone CFF$

10,000

(20,000)

(7,000)

(17,000)

-7




$

85,000

(20,000)

(17,000)

48,000

18,000

66,000

Putting the Cash Flow Statement Together

Cash flow from operations

Cash flow from investments

Cash flow from financing

Net increase in cash

Cash balance 12/31/X8


-6



Free Cash Flow (FCF)

� FCF is cash available for discretionary uses

� Frequently used to value firms

� FCFF = NI + NCC - WCInv + Int (1-T) – FCInv

� FCFF = CFO + Int (1-T) – FCInv

� FCFE = CFO – FCInv + Net debt increase

LOS 27.i Calculate/Interpret: CFAI pg 287 Schweser pg 126



Free Cash Flow (FCF) Ecclestone

� FCFF = CFO + Int (1 – T) – FCInv

$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000

� FCFE = CFO – FCInv + Net debt increase

$75,000 = $85,000 – $20,000 + $10,000

� FCFE = FCFF – Int (1 – T) + Net debt increase

$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000

-5

LOS 27.i Calculate/Interpret: CFAI pg 287 Schweser pg 126


Financial Reporting and Analysis

Solutions


Cash InflowsSalesLess: Increase in A/RCash collected from customers

Direct cash outflowsCost of goods soldAdd: Decrease in inventoryPurchasesAdd: Increase in A/PCash paid to suppliers

Operating expense (wages)Less: Decrease in salaries payableCash paid to employees

200,000(2,000)

(80,000)4,000

(76,000)8,000

198,000

(68,000)

(10,000)(7,000)

(17,000)

Direct CFO

(28,000)

(40,000)10,000

2,000

(1,000)1,000

Direct CFO, cont.

Cash outflowsInterest ExpenseAdd: Increase in interest payable

Cash interest paid

Tax ExpenseAdd: Increase in deferred tax liab.Tax payableAdd: Increase in taxes payable

Cash taxes paid

$ $

CFO

0

85,000

(30,000)


Indirect Method CFO


75,000 + 4,000 + 6,000 = 85,000

+ Depn

- Disposal gain - ↑ DTLNCC

Current assets-Cash & Inv’

Current liabilities-Debt & divs’

Working Capital

$14,000

(20,000)10,0004,000

20x8 20x9$ $

50,000 96,000(18,000) (66,000)32,000 30,000

42,000 56,000(2,000) (12,000)40,000 44,000(8,000) (14,000)∆WC = (6,000)


-6

Ecclestone CFI

Gross Plant and Equip.

Beginning PPE

Additions

PPE disposal

Ending PPE

282,000

50,000

(20,000)

312,000

Accumulated Depr.

Begin Acc. Depr.

Depr. Expense

AD for disposal

End Acc. Depr.

80,000

14,000

(10,000)

84,000

Calculating NBV of asset sold

NBV of disposal = 20,000 – 10,000 = 10,000


CFI = cash additions – cash received on disposal

Sale Proceeds

NBV of disposal

Gain(loss) on sale

30,000

10,000

20,000

$

CFI = –additions + proceeds

CFI = –$50,000 + $30,000 = –$20,000

Ecclestone CFI

� Change in debt



Net income

Div declared

∆ in R/E

$

75,000

(17,000)

58,000

Dividends decl.

∆Div. payable

Cash div. paid

$

(17,000)

10,000

(7,000)

Ecclestone CFF$

10,000

(20,000)

(7,000)

(17,000)


$

85,000

(20,000)

(17,000)

48,000

18,000

66,000

Putting the Cash Flow Statement Together

Cash flow from operations

Cash flow from investments

Cash flow from financing

Net increase in cash



Free Cash Flow (FCF) Ecclestone

� FCFF =

$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000

� FCFE =

$75,000 = $85,000 – $20,000 + $10,000

� FCFE =

$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000

CFO + Int (1 – T) – FCInv

CFO – FCInv + Net debt increase

FCFF – Int (1 – T) + Net debt increase

mastering the cash flow statement & free cash flow cfa® levels

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