Financial
Statement
Analysis
K.R. Subramanyam
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
7-2
Cash Flow Analysis
07
CHAPTER
7-3
Statement of Cash Flows
Relevance of Cash
• Cash is the most liquid of assets.
– Offers both liquidity and flexibility.
– Both the beginning and the end of a company’s
operating cycle.
• Contrast: Accrual accounting and Cash basis
accounting.
– Net cash flow as the end measure of profitability.
– Cash flow analysis helps in assessing liquidity,
solvency, and financial flexibility.
7-4
Statement of Cash Flows
Relevance of Cash
• Statement of cash flows (SCF) helps address
questions such as:
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?
7-5
Statement of Cash Flows
Reporting by Activities
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.
7-6
Statement of Cash Flows
Reporting by Activities
7-7
Statement of Cash Flows
Reporting by Activities
7-8
Statement of Cash Flows
Constructing the Cash Flow Statement
• Indirect Method
– Net income is adjusted for non-cash income
(expense) items and accruals to yield cash flow from
operations
• Direct Method
– Each income item is adjusted for its related accruals
• Both methods yield identical results-only the
presentation format differs.
7-9
Statement of Cash Flows
• Consider first the net cash from operations.
7-10
Statement of Cash Flows
Preparation of the Statement of Cash Flows
• Depreciation and amortization add-back.
7-11
Statement of Cash Flows
Income v/s Cash Flows - Example
Consider a $100 sale on account
(1) In period of sale, net income is increased by $100 but no cash
has been generated.
Net Income 100
Depreciation and amortization expense 0
Gains (losses) on sale of assets 0
Change in accounts receivable (100)
Net Cash flow from operations 0
In period of collection no income is recorded.
Net Income 0
Depreciation and amortization expense 0
Gains (losses) on sale of assets 0
Change in accounts receivable 100
Net Cash flow from operations 100
7-12
Statement of Cash Flows
Preparation of the Statement of Cash Flows
• Adjustments for changes in balance sheet
accounts can be summarized as follows:
7-13
Statement of Cash Flows
Constructing the Statement
1. The company purchased a truck during
the year at a cost of $30,000 that was
financed in full by the manufacturer.
2. A truck with a cost of $10,000 and a net
book value of $2,000 was sold during the
year for $7,000. There were no other
sales of depreciable assets.
3. Dividends paid during Year 2 are $51,000
7-14
Statement of Cash Flows
Steps in Constructing the Statement
(1) Start with Net Income
(2) Adjust Net Income for non-cash expenses and gains
(3) Recognize cash inflows (outflows) from changes in current assets
and liabilities
(4) Sum to yield net cash flows from operations
(5) Changes in long-term assets yield net cash flows from investing
activities
(6) Changes in long-term liabilities and equity accounts yield net cash
flows from financing activities
(7) Sum cash flows from operations, investing, and financing activities to
yield net change in cash
(8) Add net change in cash to the beginning cash balance to yield
ending cash
7-15
Statement of Cash Flows
7-16
Statement of Cash Flows
Special Topics
7-17
Equity Method Investments
(Example of noncash earnings)
• Assume that Gould Corp. owns a 40% interest in Netcom Inc.
• Netcom reports net income of RM100,000 and distributes RM60,000 as
dividends.
• Gould includes RM40,000 (i.e RM100,000 * 40%) as equity earnings on its
investment in its net income
• Gould then reduces its investment balance by its dividends received,
RM24,000 (i.e RM60,000 * 40%).
• The RM16,000 (i.e RM40,000 - RM24,000) of reported investment earnings
was not received in cash
• Thus, this RM16,000 must be deducted from net income in computing net
cash received from operations
7-18
Statement of Cash Flows
Special Topics
7-19
Statement of Cash Flows
Direct Method
7-20
Statement of Cash Flows
Converting from Indirect to Direct Method
7-21
Analysis Implications of Cash Flows
Limitations in Cash Flow Reporting
• 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.
– Income taxes are classified as operating cash flows.
– 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.
7-22
Analysis Implications of Cash Flows
7-23
Analysis Implications of Cash Flows
Interpreting Cash Flows and Net Income
7-24
Analysis Implications of Cash Flows
Interpreting Cash Flows and Net Income
7-25
Analysis Implications of Cash Flows
Interpreting Cash Flows and Net Income
7-26
Analysis of Cash Flows
• In evaluating sources and uses of cash, the analyst
should focus on questions like:
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?
7-27
Analysis of Cash Flows
Case Analysis of Cash Flows of Campbell Soup
7-28
Analysis of Cash Flows
Inferences from Analysis of Cash Flows
7-29
Analysis of Cash Flows
Alternative Cash Flow Measures
• Net income plus depreciation and amortization
– EBITDA (earnings before interest, taxes,
depreciation, and amortization)
7-30
Analysis of Cash Flows
Issues with EBITDA
• The using up of long-term depreciable assets is a real expense
that must not be ignored.
• 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.
• 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.
7-31
Analysis of Cash Flows
Company and Economic Conditions
• While both successful and unsuccessful companies can
experience problems with cash flows from operations, the
reasons are markedly different.
• We must interpret changes in operating working capital items
in light of economic circumstances.
• Inflationary conditions add to the
financial burdens of companies
and challenges for analysis.
7-32
Analysis of Cash Flows
Free Cash Flow
Another definition that is widely used:
FCF = NOPAT - Change in NOA
(net operating profits after tax (NOPAT) less the
increase in net operating assets (NOA))
7-33
Analysis of Cash Flows
Free Cash Flow
Growth and financial flexibility depend on adequate free cash flow.
Recognize that the amount of capital expenditures
needed to maintain productive capacity is
generally not disclosed—instead, most use total
capital expenditures, which is disclosed, but can
include outlays for expansion of productive capacity.
7-34
Analysis of Cash Flows
Cash Flow as Validators
SCF provides us with important clues on:
Feasibility of financing capital expenditures.
Cash sources in financing expansion.
Dependence on external financing.
Future dividend policies.
Ability in meeting debt service requirements.
Financial flexibility to unanticipated needs/opportunities.
Financial practices of management.
Quality of earnings.
7-35
Specialized Cash Flow Ratios
Cash
Cash Flow
Flow Adequacy
Adequacy Ratio
Ratio –– Measure
Measure of
of aa company’s
company’s ability
ability to
to
generate
generate sufficient
sufficient cash
cash from
from operations
operations to
to cover
cover capital
capital expenditures,
expenditures,
investments
investmentsinininventories,
inventories,and
andcash
cashdividends:
dividends:
Three-year
Three-yearsum
sumof ofcash
cashfrom
fromoperations
operations
Three-year
Three-yearsum
sumof
ofexpenditures,
expenditures,inventory
inventoryadditions,
additions,and
andcash
cashdividends
dividends
Cash
CashReinvestment
ReinvestmentRatio
Ratio––Measure
Measureof
ofthe
thepercentage
percentageof
of
investment
investmentin
inassets
assetsrepresenting
representingoperating
operatingcash
cashretained
retainedand
andreinvested
reinvested
in
inthe
thecompany
companyfor
forboth
bothreplacing
replacingassets
assetsand
andgrowth
growthininoperations:
operations:
Operating
Operatingcash
cashflow
flow––Dividends
Dividends
Gross
Grossplant
plant++Investment
Investment++Other
Otherassets
assets++Working
Workingcapital
capital