Chapter 7
CASH FLOW ANALYSIS
STATEMENT OF CASH FLOWS
a. Relevance of Cash
Cash is the most liquid of assets and offers a company both liquidity and flexibility. It is both the
beginning and the end of a company’s operating cycle. A company’s operating activities involve
cash conversion into various assets (such as inventories) that are used to yield receivables from
credit sales. The operating cycle is complete when the collection process returns cash to the
company, enabling a new operating cycle to begin.
This statement is important to analysis and provides information to help users address questions
such as these: How much cash is generated from or used in operations? What expenditures are
made with cash from operations? How are dividends paid when confronting an operating loss?
What is the source of cash for debt payments? How is the increase in investments financed?
What is the source of cash for new plant assets? Why is cash lower when income increased?
What is the use of cash received from new financing?
b. Reporting by Activities
The statement of cash flows reports cash receipts and cash payments by operating, financing,
and investing activities—the primary business activities of a company. Operating activities are
the earning-related activities of a company. Beyond revenue and expense activities represented
in an income statement, they include the net inflows and outflows of cash resulting from related
operating activities like extending credit to customers, investing in inventories, and obtaining
credit from suppliers.
Investing activities are means of acquiring and disposing of noncash assets.
Financing activities are means of contributing, withdrawing, and servicing funds to support
business activities.
c. Constructing the Cash Flow Statement
With the indirect method, net income is adjusted for noncash income (expense) items and
accruals to yield cash flows from operations. An advantage of this method is the disclosure of a
reconciliation of differences between net income and operating cash flows.
Computation of the statement of cash flows using the direct method is provided subsequently
for comparison.
- Preparation of the Statement of Cash Flows
The statement of cash flows is a blend of the income statement and the balance sheet. Net
income is first adjusted for noncash income and expense items to yield cash profits that are,
then, further adjusted for cash generated and used by balance sheet transactions to yield
cash flows from operations, as well as investing and financing activities.
d. Special Topics
- Equity Method Investments
Under equity method accounting, the investor records as income its percentage interest in
the income of the investee company and records dividends received as a reduction of the
investment balance
- Acquisitions of Companies with Stock
Only those changes in balance sheet accounts resulting from cash transactions, however,
are reported in the statement of cash flows. As a result, the balance sheet adjustments
reported to compute operating cash flows do not equal the changes in balance sheet
accounts themselves.
- Postretirement Benefit Costs
Cash contributions to the pension plan are recorded as a reduction of cash and an increase
in the investment balance. The excess of net benefit expense over the cash contribution to
the funded plans, or cash benefits paid directly out of the company’s funds (in the case of
unfunded postretirement benefit plans), must be added to net income in computing net
cash flows from operating activities.
- Securitization of Accounts Receivable
Securitization involves the transfer of receivables to a SPE that purchases them with the
proceeds of bonds sold in the capital markets. Companies account for the reduction in
receivables as an increase in cash flow from operations since that relates to a current asset.
e. Direct Method
The direct (or inflow-outflow) method reports gross cash receipts and cash disbursements
related to operations—essentially adjusting each income statement item from accrual to cash
basis. A majority of respondents to the accounting Exposure Draft preceding current
requirements for reporting cash flows, especially creditors, preferred the direct method.
- Converting from Indirect to Direct Method
We now show how to convert cash flows from operations reported under the indirect
method to the direct method. Accuracy of conversion depends on adjustments using data
available from external accounting records. The method of conversion we describe is
sufficiently accurate for most analytical purposes.
ANALYSIS IMPLICATIONS O F C A S H F L O W S
a. Limitations in Cash Flow Reporting
Following are some limitations of the current reporting of cash flow:
- Practice does not require separate disclosure of cash flows pertaining to either
extraordinary items or discontinued operations.
- Interest and dividends received and interest paid are classified as operating cash flows.
Many users consider interest paid a financing outflow, and interest and dividends received
as cash inflows from investing activities.
- Income taxes are classified as operating cash flows. This classification can distort analysis of
the three individual activities if significant tax benefits or costs are attributed to them in a
disproportionate manner.
- Removal of pretax (rather than after-tax) gains or losses on sale of plant or investments
from operating activities distorts our analysis of both operating and investing activities. This
is because their related taxes are not removed, but left in total tax expense among
operating activities.
b. Interpreting Cash Flows and Net Income
Our analysis of Gould Corporation focused on the two primary financial statements directed to
operating activities: the statement of cash flows and the income statement. In spite of
practitioners’ best efforts to explain the combined usefulness of both operating statements, not
all users understand the dual information roles of cash flows and accrual net income.
Cash flows from operations is a broader view of operating activities than is net income. Cash
flows from operations encompass all earning-related activities of a company. This measure
concerns not only revenues and expenses but also the cash demands of these activities. They
include investing in customer receivables and inventories, as well as the financing provided by
suppliers of goods and services. This difference is evident in Exhibit 7.5, where we arrive at
operating cash receipts and disbursements by analyzing changes in operating assets and
liabilities to adjust income statement items. Cash flow from operations focuses on the liquidity
aspect of operations. It is not a measure of profitability, because it does not include important
costs like the use of long-lived assets in operations nor revenues like the noncash equity in
earnings of subsidiaries or nonconsolidated affiliates.
ANALYSIS OF CASH FLOWS
In evaluating sources and uses of cash, the analyst should focus on questions like these:
- Are asset replacements financed from internal or external funds?
- What are the financing sources of expansion and business acquisitions?
- Is the company dependent on external financing?
- What are the company’s investing demands and opportunities?
- What are the requirements and types of financing?
- Are managerial policies (such as dividends) highly sensitive to cash flows?
a. Case Analysis of Cash Flows of Campbell Soup
We illustrate the analysis of prior years’ statements of cash flows for Campbell Soup Company in
the Comprehensive Case following Chapter 11. Our analysis covers the six-year period ending July
28, Year 11. Exhibit CC.10 presents these statements in commonsize format.
b. Inferences from Analysis of Cash Flows
Inferences from our analysis of cash flows include where management committed its resources,
where it reduced investments, where additional cash was derived from, and where claims against
the company were reduced. Inferences also pertain to the disposition of earnings and the
investment of discretionary cash flows. Analysis also enables us to infer the size, composition,
pattern, and stability of operating cash flows.
c. Alternative Cash Flow Measures
One variant of this measure is the popular EBITDA (earnings before interest, taxes, depreciation,
and amortization). This measure suffers from several problems:
1. The add-back of depreciation is sometimes interpreted to mean that the expense is not
legitimate. That is incorrect. The using up of long-term depreciable assets is a real expense that
must not be ignored.
2. Some interpret the depreciation add-back to indicate that cash has been provided for the
replenishment of the long-term assets. That is also incorrect. The add-back of depreciation
expense does not generate cash. It merely zeros out the noncash expense from net income, as
discussed above. Cash is provided by operating and financing activities, not by depreciation.
3. Net income plus depreciation ignores changes in working capital accounts that comprise the
remainder of net cash flows from operating activities. Yet changes in working capital accounts
often comprise a large portion of cash flows from operating activities. Examination of working
capital components provides insight into the persistence of operating cash flows, as discussed
in the previous section.
d. Company and Economic Conditions
An income statement portrays the results of operations for a period of time. Income increases
assets, including cash and noncash (both current and noncurrent) assets. Expenses are the
consumption of assets (or incurrence of liabilities). Accordingly, net income is linked to cash flows
through adjustments in balance sheet accounts.
Inflationary conditions add to the financial burdens and challenges of companies. The more
significant challenges include replacing plant assets, increasing investments in inventories and
receivables, and implementing dividend policies based on profits that do not provide for current
costs of resources used in operations.
It is conceivable that a profitable company can find it difficult to meet current obligations and need
cash for expansion. Success through increasing sales can yield liquidity problems and restrict cash
due to a growing asset base. Accordingly, there might be insufficient cash to cover maturing
obligations. It is also important for us to distinguish performance across business activities. It is
especially important to separate operating performance and profitability from those of investing
and financing activities. All activities are essential and interconnected, but they are not identical
and reflect on different aspects of a company.
e. Free Cash Flow
A useful analytical derivative of the statement of cash flows is the computation of free cash flow. As
with other analytical measures, we must pay attention to components of the computation.
Another definition that is widely used and similar in concept is FCF NOPAT Change in NOA. This
definition defines free cash flows to the firm as net operating profits after tax (NOPAT) less the
increase in net operating assets (NOA).
Positive free cash flow reflects the amount available for business activities after allowances for
financing and investing requirements to maintain productive capacity at current levels. Growth and
financial flexibility depend on adequate free cash flow. We must recognize that the amount of
capital expenditures needed to maintain productive capacity is generally not disclosed. Rather, it is
part of total capital expenditures, which are disclosed, but can include outlays for expansion of
productive capacity. Separating capital expenditures between these two components is
problematic. The statement of cash flows does not separate capital expenditures into maintenance
and expansion components.
f. Cash Flows as Validators
The statement of cash flows is useful for prediction of operating results on the basis of acquired
and planned productive capacity. It is also of use in assessment of a company’s future expansion
capacity, its capital requirements, and its sources of cash inflows.
Moreover, the statement of cash flows provides us with important clues on: Feasibility of financing
capital expenditures. Cash sources in financing expansion. Dependence on external financing
(liabilities versus equity). Future dividend policies. Ability in meeting debt service requirements.
Financial flexibility to unanticipated needs and opportunities. Financial practices of management.
Quality of earnings.
SPECIALIZED CASH FLOW RATIOS
a. Cash Flow Adequacy Ratio
The cash flow adequacy ratiois a measure of a company’s ability to generate sufficient cash from
operations to cover capital expenditures, investments in inventories, and cash dividends. To
remove cyclical and other random influences, a three-year total is typically used in computing
this ratio.
The cash flow adequacy ratio is calculated as follows:
Three-year sum of cash from operations / Three-year sum of capital expenditures, inventory
additions, and cash dividends
b. Cash Reinvestment Ratio
The cash reinvestment ratio is a measure of the percentage of investment in assets representing
operating cash retained and reinvested in the company for both replacing assets and growth in
operations. This ratio is computed as :
Operating cash flow - Dividends Gross / plant + Investment + Other assets + Working capital