cash inflow

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1 Cash Flow Statement and other financial analysis Companies obtain different types of capital. We can broadly categories them into long term funds and short term funds. We know that whenever long term funds such as issue of shares, preference shares, debentures and public deposits are issued they are expected to be invested in long term profit generating assets such as purchase of plant and machinery, building etc. If short term funds such as over drafts, cash credit are generated, it is expected such funds should be employed in short term purpose such as purchase of stock, payment to creditors etc. All long term funds are not fully utilized for long term or all short term funds are utilized for short term. Invariably, there are movements of funds which take place from long term to short term or short term to long term. Funds are also generated from profit by doing basic functions of the organization by buying and selling of goods and services or lost when company incurs trade losses. The funds that are generated/lost from trade activity is called fund from operation/loss from operation. These funds may be utilized for long term or for short term. All funds that are generated in cash forms are studied and see the flow of cash from long term to short term or vice versa are creating any cash crunch problem to the organization. If problem arises the organization should know which funds have to be brought in i.e. short term or long term funds. The cash flow statement is prepared to know the flow of funds and their financial impact on long term or short term. Each type of fund has some impact on the overall performance of the company. Debt Equity ratio, current ratio, liquid ratio, return on capital employed, WACC, profitability, liquidity, flexibility are affected. We use CFS as the means to study the impact and adjustments required by forecasting these changes. Balance sheets and income statements are forecasted for three to five years and study the flow of cash whether they are conducive to the firm. There are many activities that prevail in any organization with respect to cash inflows and outflows. They are broadly categorized into operating, financing, investing activities. There are non cash activities too such as making provision for depreciation. The operating activities are directly connected to the goods that are dealt in. They differ from business to business. For example:- In case of a furniture dealer, the basic function of a furniture dealer is buying and selling of furniture and earn profit out of such activity is known as operating activity. The dealer in real estate, business profit/loss on sale of land falls under operating activity. The share broker’s operating activity is to buy and sale of securities and receive interest and dividend. Such activity is an operating activity. In financial accounts, such profit from such activity is known as operating profit. Income tax point of view such profits are normally taxable unless they are expressly exempted. It is to be noted that a firm earns operating profit may not be financially sound in cash during the year(s) of sale. Some times, in order to increase sales, company might have increased the debtors’ credit period say from one month to three months. All sales made in the last part of the year may not have been realized in cash which might create cash crunch problems to the

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Cash Flow Statement and other financial analysis

Companies obtain different types of capital. We can broadly categories them into long

term funds and short term funds. We know that whenever long term funds such as issue

of shares, preference shares, debentures and public deposits are issued they are expected

to be invested in long term profit generating assets such as purchase of plant and

machinery, building etc. If short term funds such as over drafts, cash credit are generated,

it is expected such funds should be employed in short term purpose such as purchase of

stock, payment to creditors etc. All long term funds are not fully utilized for long term

or all short term funds are utilized for short term. Invariably, there are movements of

funds which take place from long term to short term or short term to long term.

Funds are also generated from profit by doing basic functions of the organization by

buying and selling of goods and services or lost when company incurs trade losses. The

funds that are generated/lost from trade activity is called fund from operation/loss from

operation. These funds may be utilized for long term or for short term.

All funds that are generated in cash forms are studied and see the flow of cash from long

term to short term or vice versa are creating any cash crunch problem to the organization.

If problem arises the organization should know which funds have to be brought in i.e.

short term or long term funds. The cash flow statement is prepared to know the flow of

funds and their financial impact on long term or short term.

Each type of fund has some impact on the overall performance of the company. Debt

Equity ratio, current ratio, liquid ratio, return on capital employed, WACC, profitability,

liquidity, flexibility are affected. We use CFS as the means to study the impact and

adjustments required by forecasting these changes. Balance sheets and income statements

are forecasted for three to five years and study the flow of cash whether they are

conducive to the firm.

There are many activities that prevail in any organization with respect to cash inflows

and outflows. They are broadly categorized into operating, financing, investing activities.

There are non cash activities too such as making provision for depreciation. The

operating activities are directly connected to the goods that are dealt in. They differ from

business to business. For example:- In case of a furniture dealer, the basic function of a

furniture dealer is buying and selling of furniture and earn profit out of such activity is

known as operating activity.

The dealer in real estate, business profit/loss on sale of land falls under operating activity.

The share broker’s operating activity is to buy and sale of securities and receive interest

and dividend. Such activity is an operating activity. In financial accounts, such profit

from such activity is known as operating profit. Income tax point of view such profits are

normally taxable unless they are expressly exempted. It is to be noted that a firm earns

operating profit may not be financially sound in cash during the year(s) of sale. Some

times, in order to increase sales, company might have increased the debtors’ credit

period say from one month to three months. All sales made in the last part of the year

may not have been realized in cash which might create cash crunch problems to the

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company temporarily. Some times all stocks have been purchased in cash inorder to

receive trade discount.There shall not be any cash profits due to employment of cash in

inventory.

(A) Relevance of Cash Flows:

Explain the relevance of cash flows to analyzing business activities.

Cash is the most liquid of assets and offers a firm liquidity and flexibility. The term cash

includes cash and cash equivalents, which are short-term highly liquid investments.

The Statement of cash flows helps in assessing:

Liquidity, which represents how near assets and liabilities are to being cash.

Solvency, which represents the firm’s ability to pay liabilities when due.

Financial flexibility, which represents the firm’s ability to react and adjust to

opportunities and difficulties.

The statement of cash flows provides information to answer questions such as:

How much cash was generated from operations?

What was the cash used for?

What was the source of the cash invested in Property Plant & Equipment ?

How was the cash received from a bond issue used?

How was the firm able to pay dividends when the company experienced an

operating loss?

How was the firm able to retire its long-term debt?

How were investments financed?

Why did cash decrease when the firm experienced record profits?

(B) The Statement of Cash Flows:

Indian Accounting Standard 3 require that a Statement of Cash Flows (SCF),

accompany the income statement and balance sheet.

The SCF explains the change in cash and cash equivalents during the year,

classified by operating (i.e., earning) activities, financing activities, and investing

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activities.

SFAS 95 encourages the use of direct or inflow-outflow method, which makes

adjustments for balance sheet changes directly to revenue and expense

components of income statement, rather than to net income.

Operating Cash Flows:

Describe the elements of operating cash flows.

1. Cash flows from operations (CFO) reflect flows related to the normal operating

activities of the business.

2. These items essentially flow through the firm’s income statement and working

capital accounts. Working capital accounts are current assets and current

liabilities.

3. Cash flow from operations includes cash collection from customers and cash

payments to merchandise suppliers, for salaries, and for interest.

4. Interest and dividend revenue and interest expense are considered

are considered financing activities.

5. All income taxes arc considered operating activities, even if some arise from

financing or investing.

Investing Cash Flows:

Describe elements of investing cash

1. Cash flows from investing (CF1) reflect investing activities. These are the

acquisition of noncurrent assets (outflows) and the retirement of these assets

(inflows).

2. These items are found in the non current portion of the asset section of the

halance

sheet. Cash How from investing includes cash received from the sale of properly

plain & equipment and long-term investments in addition to the cash paid out to

purchase these noncurrent assets.

3. Investing cash flows also include cash flows from investments in joint ventures

and affiliates, long-term investment in securities.

Financing cash flows:

Describe the elements of Financing cash flows.

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1. Cash flows from financing (CFF) reflect cash received from issuing or cash paid out

retiring long-term debt (including the current portion of long-term debt), stock

(common and preferred), or in paying dividends and interest paid on such loan funds.

2. These items are found in the long-term capital section of the balance sheet and the

statement of retained earnings (RE).

3. CFF includes dividends paid to stockholders but not interest paid to creditors because

interest paid to short term funds are not considered. But if it is long term it is

considered under the head CFF.

4.

Classify a particular item as an operating cash flow, an investing cash flow, or a

financing cash flow.

The following is the format of the basic statement of cash flows:

Example:

Using the following income statement (I/S) and balance statement (B/S) items for 2009,

calculate the firm’s SCF:

(Rs.)

Sale of land 20,000

Collections from customers 70,000

Payment of interest 1,000

Cash payment of dividends 6,000

Cash received from issue of long term debt 40,000

Payment of wages 10,000

Purchase of equipment 90,000

Payment to suppliers 5,000

Cash balance on 31st march 2008 25,000

STATEMENT OR CASH FLOWS (SCF)

FOR THE PERIOD 31/12/2008 TO 31/12/2009

Cash Flow from Operations (CFO)

+ Cash Flow from Investing (CFI)

+ Cash Flow from Financing (CFF)

= Change in the cash account

+ Beginning of period cash

= Ending cash balance

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The Statement of Cash Flow for the Year ending 31/03/09 is:

Cash Flow from Operations (CFO):

Collections from customers Rs.70,000

Payment of wages (10,000)

Payment to suppliers ( 5,000)

CFO Rs.54,000

Cash Flow from Investing (CFI):

Sale of land Rs.20,000

Purchase of Equipment (90.000)

CFI (Rs.70,000)

Cash Flow from Financing (CFF):

Issuance of long-term debt Rs.40,000

Payment of dividends

Payment of interest

( 6.000)

(1000)

CFF Rs.34.000

Net Increase in cash: Rs.18,000

Cash balance on 31/03/2008 25.000

Cash balance on 31/03/2009 Rs.43,100

The ending balance of the cash account is a managerial finance decision and thus has

little analytical significance. The cash flow tells us that the investing significantly in

equipment financed by cash thrown-off from operating and by issuing long-term debt.

For analytic purposes the cash payment of interest can be reclassified as a cash flow from

financing thereby increasing CFO to Rs.55,000 and decreasing CFF to Rs.33,000.

[c] Direct and Indirect Methods

When using the indirect method, start at the bottom of the income statement with net

income and back into cash flow from operations by adjusting reported net income.

When using the direct method, start at the top of the income statement with sales then

work with the individual components of net income directly related to cash flows (e.g.

revenue, cost of goods sold, salary expense, and interest expense).

Note: These methods are equivalent since they both yield the same cash flow from

operations. These two methods differ only in the detail of presentation.

Calculating Operating Cash Flows Using the Indirect Method

Start with net income and adjust for all non-cash expenses and non-cash gains and

losses.

[Net income + non-cash expenses — non-cash gains + non-cash losses]

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Calculate the change in all other operating account items

[Increases in operating asset accounts are negative adjustments and increases in operating

liability accounts are positive adjustments]

Put it all together

[CFO = net income +/- non-cash items - change in operating assets accounts + change in

operating liability accounts]

Calculating Operating Cash Flows Using the Direct Method

Calculate cash collections

[Net sales - change in accounts receivable + other cash collections]

Calculate direct cash inputs^

[Cost of" goods sold"- change in inventory + change in accounts payable]

Calculate other cash outflows

[Cash expenses + cash taxes paid + cash interest paid]

Put it all together

[CFO = cash collections + direct cash inputs + other cash out flows]

Observe that the direct method just looks at the cash received from customers and other

operating sources and cash paid out in operating expenses. However, the indirect method

does not communicate cash inflows and outflows with the particular revenues and

expenses as is done under the direct method. Because most companies use the indirect

method, it is often necessary to convert an indirect CFO statement into a direct CFO

statement.

(D) Preparation of a Statement of Cash Flows

1. Transactional analysis reconciles changes in the balance sheet accounts with the

related income statement components in the derivation of cash flows.

This method involves looking at change in balance sheet items and comparing them

to the corresponding income statement components.

Steps:-

Start with sales, and adjust for cash effect of changes in balance sheet items.

a. Changes in accounts result in effects on cash flows.

An increase in an asset is a decrease in cash flow.

A decrease in an asset is an increase in cash flow

An increase in a liability or equity account is an increase in cash flow.

A decrease in a liability or equity account is a decrease in cash flow.

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2. The direct and indirect methods must adjust cash for changes in the working capital

balances.

a. For example, if sales grow (or fall) but the collections of receivables proceed at a

pace different from the change in sales, there will be a change in the accounts

receivable balance. This could represent either a source or use of the firm’s cash.

To determine which, subtract for increases in accounts receivable (a use of cash)

or add for decreases in accounts receivable (a source of cash) to adjust for

changes in sales and collection.

b. Similar adjustments must also be made for changes into the inventory account and

the accounts payable account. Remember, this is the flow of cash and not

accruals based income, so adjustments must be for changes in these accounts.

The following charts should help determine whether to add or subtract for

changes in working capital accounts.

Increase Decrease

Current Assets:

Accounts Receivable and Inventory

- +

Current liabilities:

Accounts Payable, Wages Payable, and Taxes and

Deferred Taxes.

+ -

Example:

Calculate cash collected from customers from the following chart that discloses sales, bad

debt expense, and year-end net receivables.

2007 2008 2009

Sales Rs.100 Rs.200 Rs.300

Bad Debts Expenses 5 5 6

Net Receivables (1998=20) 30 70 120

Cash Collected = Sales – increase or + decrease in net receivables – bad debts expense.

1999 Cash collected = Rs.100 – 10 – 5 = Rs. 85

2008 Cash collected = Rs.200 – 40 – 5 = Rs. 155

2009 Cash collected = Rs.300 – 50 – 6 = Rs. 244

During the 3-year period sales have tripled, net receivables have increased four fold, and

bad debts expenses increased only by 20%. The analysis indicates that the bad debts

expense is probably not adequate. See problem 4.

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3. Some things to remember:

Accounts receivable and advances from customers relate to cash received from

customers.

Inventories and accounts payable to cash paid out for inputs.

Prepaid expenses and rent payable related to cash expenses, interest payable to

cash paid for interest.

Income tax payable and deferred income taxes relate to cash paid for income

taxes.

Changes in property, plant & requirement relate to capital expenditures and

purchases.

Changes in short-and long-term debt, notes payable, and bonds payable relate to

cash received or used in changes in debt.

Common stock changes relate cash received or used in changes in equity

financing and retained earnings to dividends paid.

Compute, explain, and interpret a statement of cash flows using the direct method and the

indirect method.

4. Cash flow from operations using the direct and indirect methods: The following is an

example of calculating the Cash Flow Statement using the direct and indirect methods for

deriving cash flow from operations. Given the 2009 Income Statement and December

31, 2008, and 2009 balance sheets, you can calculate the Statement of Cash Flows.

Income Statement for the year 2009

Sales Revenue Rs. 100,000

Expenses:

Cost of goods sold Rs.40,000

Wages 5,000

Depreciation 6,000

Godwill amortization 1,000

Interest 500

Total Expenses 52,500

Income from Continuing operations Rs.47,500

Gain from sale of land 10,000

Pre-tax income Rs.57,500

Provision for taxes 20,000

Net income 37,500

Common dividends declared: 8,500

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BALANCE SHEET

2008

(Rs.)

2009

(Rs.)

Change

(Rs.)

Current Assets:

Cash 9,000 33,000 +24,000

Accounts receivables 9,000 10,000 +1,000

Inventory-stock 7,000 5,000 -2,000

Noncurrent Assets:

Land 40,000 35,000 - 5,000

Plant and equipment 60,000 85,000 + 25,000

Less: Accumulated depreciation (9,000) (15,000) + 6,000

Goodwill 10,000 9,000 - 1,000

Current Liabilities:

Accounts payable 5,000 9,000 4,000

Wages payable 8,000 4,500 - 3,500

Interest payable 3,000 3,500 - 500

Taxes payable 4,000 5,000 + 1,000

Dividends payable 1,000 6,000 + 5,000

Non-current Liabilities:

Bonds/Debentures 10,000 15,000 + 5,000

Deferred Taxes 15,000 20,000 + 5,000

Owners’ Equity:

Common Stock 50,000 40,000 - 10,000

Retained Earnings 30,000 59,000 + 29,000

Total Liabilities & Stockholders’ Equity 126,000 162,000

Begin by calculating the net change between the start of the period and end of the period

values for all the accounts. In the preceding balance sheet, the change has been

calculated (year to year) and put in the last column. Note that the change of +Rs.24, 000

in cash is what the statement of cash flows explains.

a. Calculating cash flows from operations using the direct method.

In the direct method, revenue and expense components of the income statement

are used separately to calculate the cash received from customers and cash paid

for the various expenses.

Depreciation, amortization, gains, and losses are not considered since they do not

directly flow thought he cash account.

The same rules for changes in current assets (subtract increases and add

decreases), current liabilities (add increases and subtract decreases0, and deferred

taxes, given on the preceding page, are used to convert cash flows from accrual

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accounting revenues and expenses to a cash basis. Using the data from the

income statement above, you can develop the CFO.

Cash flow from operations using the direct method:

Cash collections:

Cash receipts from customers

Revenues Rs.100,000

Less increase in A/R - 1,000

Cash collected from customers Rs.99,000

Direct Cash inputs:

Cash paid to suppliers of inventory (associates cost of goods sold with changes in

inventory and accounts payable).

Cost of goods sold - Rs. 40,000

Add decrease in inventory + 2,000

Add increase in acct. payable + 4,000

Cash paid to suppliers - Rs.34,000

Cash paid to employees (associates wage expense with change in wages payable)

Interest expense - Rs. 500

Add increase in interest payable + 500

Cash paid for interest Rs. 0

Cash paid for taxes (associates provision for income taxes with taxes payable and

deferred taxes).

Tax expense - Rs.20,000

Add increase in taxes payable + 1,000

Add increase in deferred tax + 5,000

Cash paid for income taxes -Rs.14,000

Cash flow from operations Rs.42,500

b. Calculating cash flow from operations using the indirect method:

Start with reported net income.

Adjust for non-cash expenses and losses. (i.e., depreciation,

amortization, and losses).

Adjust for non-cash revenues and gains. (Profit from sale of

assets).

Adjust for changes in current assets and current liabilities, and

Adjust for deferred taxes.

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Cash flow from operations using the indirect method:

Net income Rs.37,500

+ 6,000

Add depreciation expense + 1,000

Add goodwill amortization - 10,000

Subtract gain from sale of land Rs.34,000

Current Asset adjustments

Increase in accounts receivable - 1,000

Decrease in inventory + 2,000

+ 1,000

Current Liability adjustments

Increase in accounts payable + 4,000

Decrease in wages payable - 3,500

Increase in interest payable + 500

Increase in taxes payable +1,000

+ 2,000

Deferred Taxes Change

Increase in deferred taxes + 5,000

Cash flow from operations Rs. 42,500

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Keep track of the balance sheet items used by marking them off the balance sheet. They

will not be needed again when determining CFI and CPF.

C. Cash flow from investment activities for both the direct and indirect methods:

Purchase or sale of equipment: To determine how much was actually spent on

assets or received from the sale of assets, depreciation expense and goodwill

amortization reported on the income statement must be matched to the

accumulated depreciation and goodwill reported on the balance sheet. If the

increase in the accumulated depreciation account matches the depreciation

expense listed on the income statement and the decrease in goodwill matches the

amortization of goodwill listed on the income statement, as in this example, then

nothing more needs to be done. If, however, they were not the same, then

equipment must have been sold. Look in the footnotes to learn what was sold.

Sale of land: Compare the Rs.10,000 gain from the sale of land to the change in

the land account. Land decreased by Rs.5,000. 1 low much cash was actually

received from the sale of the land must be determined. Review the following

excercise:

Decrease in land (land sold) Rs. 5,000

Plus for a gain (or - for a loss) + 10,000

Cash received from land sale Rs. 15,000

Review other non-current assets. An increase in these items uses cash, while a

decrease provides cash. Plant & equipment increased by Rs.25,000; thus, cash

used to purchase PP&E was Rs.25,000.

Cash Flow from Investing Activities:

Sale of land Rs. 15,000

Purchase of PP&E - 25,000

Cash flow from investing Rs. 10,000

d. Cash flow from financing.activities for the direct and indirect methods

This involves the analysis of changes in liabilities and stockholders' equity. All

events that could have increased or decreased cash must be reconstructed.

These are:

Issuance or retirement of bonds

Issuance or retirement, of common and preferred stock

Payment of dividends

Review long-term debt and stock: increases supply cash; decreases use cash.

Bonds payable increased by Rs.5,000; thus, cash was increased by

Rs.5,000.

Common stock decreased by Rs.10,000; thus, cash was decreased by

Rs.10,000.

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Review retained earnings to determine or verify if dividends were declared and paid:

Beginning

retained earnings

+

Net

Income

-

Dividends

Declared

=

Ending

retained earnings

so:

Beginning

retained earnings

+ Net

Income

- Dividends

Declared

- Ending

retained earnings

=0

Rs.30,000 + Rs.37,500 - dividends declared - Rs.59,000 = 0

Solving for dividends,

Dividends declared = Rs.30,000 + Rs.37,500 - Rs.59,000 = Rs.8,500

Use the change in dividends payable to derive the amount of dividends actually paid.

Treat dividends as a negative (they use up cash). The same treatment would apply to any

liabilities paid off or retired.

Dividends declared - Rs.8,500

Plus increase in Dividend payable + 5,000

-----------

Dividends paid - Rs.3,500

Cash Flow from Financing Activities:

Issue of debt Rs. 5,000

Purchase of stock - 10,000

Payment of dividends - 3,500

Cash Flow from Financing - Rs. 8,500

e. The completed statement of cash flows (indirect method) is:

Cash Flow from Operations:

Net income Rs.37,500

Add depreciation expense + 6,000

Add goodwill amortization + 1,000

Add loss (none in this example)

Subtract gain from sale of land -10,000

Current Asset change

Increase in A/R - 1,000

Decrease in inventory + 2,000

Current Liabilities change

Increase in A/P + 4,000

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Decrease in wages payable - 3,500

Increase in interest payable + 500

Increase in taxes payable + 1,000

Deferred Taxes change

Increase in deferred taxes + 5.000

Cash Flow from Operations: Rs. 42,500

Cash Flow from Investing Activities:

Sale of land Rs.15,000

Purchase of property and equipment -25.000

Cash Flow from Investing: - 10,000

Cash Flow from Financing Activities:

Issue of debt Rs. 5,000

Purchase of stock - 10,000

Payment of dividends - 3,500

Cash Flow from Financing: - 8,500

Net increase in cash Rs. 24,000

Beginning cash, 1/1/01 9,000

Ending cash, 12/31/01 Rs. 33,000

Although there are none in this example, there may be notes attached to the

statement of cash flows listing investing and financing activities that did not affect

cash. Knowing how to handle non-cash transactions is important. Assume there

was a non-cash transaction where the firm acquired some PP&E assets by issuing

mortgage debt. When analyzing the balance sheet to do the statement of cash

flows, an increase in debt and increase in fixed assets should have been noted.

Since no cash flow was involved in these transactions, they should not appear on

the SCF. However, the change-in PP&E and mortgage must be accounted for. Do

this by mentioning it in the SCF notes.

(E) Analysis of Cash Flow Information

1. The cash flow statement helps predict the firm’s ability to sustain or increase cash

flow from operations by providing objective information about:

The firm’s ability to generate cash from operating activities.

Trends in the cash flow components and the cash consequences of the firm’s

investing and financing activities.

The cash flow consequences of managerial decisions such as: financial policy

(leverage) decisions, investment for growth, and dividend policy.

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2. Information in the cash flow statement:

Cash flow from operations clearly identifies non-cash expenses (depreciation and

amortization), non-operating cash flows (gains and losses and interest expense), and

changes in operating (current) assets and liabilities.

Investing cash flows separate those flows related to the purchase and sale of

PP&E from the purchase and sale of investments in affiliates and net investment in

short-term financial instruments.

Financing cash flows separate the flows between the firm and its suppliers of debt and

equity capital. Although net changes in short-term debt is communicated, cash

received or paid from issuance or retirement of long-term debt is disclosed separately.

Dividends paid and cash received from sale of stock are included in CFF. The effect

of changes in exchange rates of cash denominated in a foreign currency is a

component of CFF.

3. Income, cashflow, and the going concern assumption:

Accrual accounting concepts (e.g., revenue recognized when earned) and asset

valuations assume that the firm is an ongoing enterprise. When the going concern

assumption is subject to question, then accounting income predictive ability of future

cash flows and valuation of assets {accounts receivable, inventory, PP&E, and

goodwill) deteriorates. Under this situation cash flow from operations is more useful

than, and serves as a check to, the inherent assumptions underlying the income

statement.

1. Income, cash flow, and choice of accounting policies: Management has some

latitude in choosing accounting methods of revenue recognition. Under such

circumstances, the cash flow statement allows the analyst to distinguish

between actual events and the accounting choices used to report these events.

For example, if a firm uses the percentage of completion method, then it will

report income sooner than a similar firm that uses the completed contract method

of revenue recognition. However, the cash flow from operations will be identical

or similar. This allows the analyst to compare the two firms without reliance on

the otherwise misleading differences in income.

2. Income, cash flow, and liquidity: A company (usually new and perhaps

undercapitalized) can grow too fast and, therefore, have liquidity problems. The

cash flow statement would reveal this situation. Cash flow from operations would

not be impressive because of necessary increases in inventories and significant

increases in accounts receivable.

Typically, accounts payable cannot be increased and cash required for investment

to support growing sales is required. The cash flow statement would disclose

information about the firm's liquidity challenge and its (in) ability to finance

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future growth.

(F) Preparing a Statement of Cash Flows using the Three Box Method:

The exam will probably include preparing a statement of cash flows from a list of items.

The following steps are used in the three-box method:

Three-Box Method of Preparing a Statement of Cash Flows

Draw three boxes and three lines on a piece of paper

Label the boxes: CFO, CFI and CFF

Label the lines; Change in Cash, Beginning Cash and Ending Cash.

Review each of the items, deciding if it is + or -

Write it in a box or line.

If the item has to do with a change in the capital structure (debt or equity) or a

dividend payment put the item in the CFF box.

If the item has to do with buying or selling assets put it in the CFI box.

Put every thing else in the CFO box.

Add everything up to prepare a statement of cash flows

The only error that can be made is to put a miscellaneous or noncash flow item in the

CFO box or assign the wrong signs to the items in the box.

Using the following, try the three-box method:

Cash payment of Dividends Rs.25

Profit on sale of equipment 10

Sale of Equipment 30

Paid for used Equipment 45

Depreciation and Amortization 80

Increase in accounts payable 25

Beginning Cash 150

Dividend declared but not yet paid 15

Purchase of land 15

Net Income 35

Decrease in accounts receivable 20

Sale of preferred stock 50

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Assets acquired for debit issue 200

Increase in deferred taxes 05

Repurchase of common stock 40

A three for one stock split was declared

Beginning Cash --------------------------------------

Change in Cash --------------------------------------

Ending Cash ---------------------------------------

Solution:

Item Amount Adjustment

to arrive at

Amount

and

Direction

Cash payment of Dividends Rs.25 CFF Rs.-25

Profit on sale of equipment 10 CFO -10

Sale of Equipment 30 CFI +30

Paid for used Equipment 45 CFI -45

Depreciation and Amortization 80 CFO +80

Increase in accounts payable 25 CFO +25

Beginning Cash 150

Dividend declared but not yet paid 15

Purchase of land 15 CFI -15

CFO

CFO

CFI

CFI

CFF

CFF

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18

Net Income 35 CFO +35

Decrease in accounts receivable 20 CFO +20

Sale of preferred stock 50 CFF +50

Assets acquired for debit issue 200

Increase in deferred taxes 05 CFO +05

Repurchase of common stock 40 CFF -40

A three for one stock split was declared

Beginning Cash Rs.150

Change in Cash 110

Ending Cash Rs.260 (plug figure)

Cash flow from operations Net Income Rs.35

Add depreciation and Amortization 80

Less profit on sale of equipment -10

Add the increase in accounts payable 25

Add the decrease in accounts receivable 20

Add the increase in deferred taxes 05

CFO Rs.155

Cash flow from financing Sale of preferred stock Rs.50

Repurchase of common stock -40

Cash dividends paid -25

CFF -15

Cash Flow from investing

Purchase of land Rs.15

Sale of equipment 30

Purchase of equipment -45

CFI -30

Net Cash Flow Rs.110

Statement of Cash Flows

The change in cash must

equal the sum of CFO,

CFF and CFI

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19

Cash Flow Classification Issues*

1. Cash flows for property, plant, and equipment: Adding depreciation and decreases

in inventory back to net income to calculate cask flows from operations via the

indirect method reflects that cash was paid out earlier when the equipment or

inventory was purchased but expensed later when it is used. Here are some

inconsistencies found in cash flow from operations.

a) When cash is paid for inventories, it is classified as a cash outflow from

operations, but when cash was paid for depreciable asset it is classified as a

cash outflow from investing activities. Yet, both are investments in productive

assets.

b) Cash flow from operations is not charged for the use of operating capacity

(assets), so a firm might have a positive CFO but fail because it cannot replace

the productive capacity used to operate the business

c) Two identical firms: Firm A buys asset ; the cash paid is charged to investing.

Firm B rents (with an operating lease) the identical asset; the cash paid is

charged to operations

d) Two identical firms: Firm A buys inventory; the cash paid is charged to

operations. Firm B purchases a company with inventory; the part of the

purchase price related to that inventory is charged to investing activities

e) Investments can be poorly defined. For example, rental car companies calling

their car fleets inventory (CFO) rather than fixed assets (CFI)

2. Differences in accounting methods: Differences in accounting methods can affect

the classification of cash payments as either operating or investing activities.

If a firm capitalizes expenditures and then later amortizes or depreciates them,

(e.g., capitalizing computer software rather than expensing it or treating a lease as

a capital lease rather than an operating lease) costs are run through cash flow from

investing rather than cash flow from operations.

3. Interest paid decreases cash flow operations while dividends paid causes a

Decrease in cash inflow from financing. Both interest and dividend payments

reflect leverage or capital structure choices, not operating decisions. If payments

for equity capital (dividends) were included in CFF, should not pay for debt

(interest) also is classified as financing? If interest were a component of CFF, then

the comparison of operating cash flows of firms with different capital structures

would be facilitated.

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20

4. Non-cash transactions are financing and investing activities that do not directly

Require cash. The purchase of building by issuing a mortgage payable is an

example of a non-cash transaction. Non-cash transactions are disclosed on the

cash flow statement using footnotes. If these non-cash events were re-classified as

using cash from investing and providing cash to financing activities, then the user

would have superior information on investing and financing activities of a firm.

(H) Free Cash Flow

1. Free cash flow (FCF) is the cash generated during a period in excess

of that needed to maintain the firm’s present productive capacity:

Free cash flow = Cash flow – (Capital expenditures needed

to maintain productive capacity)

2. The larger a firm’s free cash flow; the better able the firm is to meet

Financial obligations and to grow in the future.

3. Because it is not possible for an analyst to determine the amount of a

Period’s capital expenditures that is needed for maintaining productive

capacity, many analysts simply subtract all capex cash flows from cash

flow from operations.

Free cash flow = (Cash flow from operations) + (Capital expenditures)

4. There are variations in the definition of free cash flow in actual practice:

whether this is cash flow available to the firm (use cash flow from

operations). There are also variations that subtract cash dividends.

Important note: You will see different definitions of free cash flow within

the CFA curriculum. The most popular definition is CFO – Capex.

Example:

Consider the last example (in which the change in cash is $110). What is

the firm’s free cash flow? The CFO is the starting place and then the cash

flows for acquiring and from selling property, plant and equipment, are

used to adjust CFO.

Free cash flow available to equity shareholders is:

FCF = Rs.155 45 + 30 = Rs.140

Calculating free cash flow available to all providers of capital (that is, both

CFO Purchase of

equipment

Sale of equipment

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21

debt and equity), requires adjusting for interest on debt (adding it back on a tax-adjusted

basis to CFO).

Conceptual Overview:

1. Depreciation is added back to net income since it is an expense not requiring cash.

2. An increase in accounts receivable means some of the current income was not

collected in the form of cash. In a sources and uses framework, an increase in

accounts receivable is a use of cash (-). A decrease in accounts receivable is a

source of cash (+).

3. An increase in accounts payable is a source of funds (+), and decrease in accounts

payable is a use of funds (-).

4. The indirect method starts with net income. Extraordinary items are listed above

net income so they are already in cash flow from operation. No adjustment is

needed.

5. The CFO includes cash flow from discontinued operations.

6. Taxes paid are a cash outflow and are in net income. No adjustment is needed.

7. When you sell plant & equipment for more than book value (that is you receive a

taxable gain), you must subtract the gain from net income. The cash received

from the sale of assets belong in the investment section of the SCF. Assume you

have assets with an original value of Rs.75, 000 with Rs.50, 000 in accumulated

depreciation. These were sold for Rs.30, 000. The closing entry would be:

Cash Rs.30, 000

Accumulated Depreciation Rs.50, 000

Plant & Equipment Rs.75, 000

Gain Rs.5, 000

You need to back the Rs.5, 000 gain out of income because the full Rs.30, 000 is

listed under Cash Flow from Investing.

8. What do you when a firm issues securities for assets? For example, the firm

bought a Rs.60, 000 building for Rs.100, 000 in cash, Rs.200, 000 in un-issued

common stock, and a Rs.300, 000 mortgage note.

Only the Rs.100, 000 cash paid is listed as cash flow from investing. The

remaining Rs.500, 000 of stock and debt is disclosed in the notes to the SCF as

investing or financing activities that did not affect cash.

9. When a company retires a debt issue through the issuance of stock, the firm

converts bonds into common stock. Since no cash was used in the conversion of

debt into common stock, it would not be in the financing section but would be

disclosed on the SCF as investing or financing activities that did not affect cash.

10. Declared dividends do not affect cash and are not listed on the SCF until paid.

For example, if a company declares cash divided in October, payable in January

to December holders of record.

11. A stock split is a non-cash event and is never reported on the SCF.

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22

RECAP: Calculation of Cash flows from operations using the direct method

Step 1: Net Sales

+/- Changes in A/R

+ Other cash collections

= Cash collections and other receipts

Step 2: Cost of goods sold

+/-Changes in inventory

+/-Changes in A/P

= Direct cash inputs

Step 3: Cash expenses (other cash outflows)

+ Cash taxes paid

+ Cash interest paid

= Other cash outflows

CFO = + Step 1: Cash collections

- Step 2: Direct cash inputs

- Step 3: Other cash outflows

= Cash flow from operations

RECAP: Calculation of cash flows from operations using the indirect method Net Income

Adjustment for non-cash or non-operating items in net income:

+ Non- cash expenses or losses

Non-cash revenues or gains

+/ Changes in operating asset accounts (accounts receivable and inventory)

+/- Changes in operating liability accounts ( accounts payable and wages payable)

Cash flows from operations

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PROBLEM SET: WHITE, SONDHI & FRIED, CHAPTER 3

1. Using the following information, what is the firm’s cash flow from operations?

Net Income Rs.120

Decrease in accounts receivable +20

Depreciation +25

Increase in inventory - 10

Increase in accounts payable +7

Decrease in wages payable - 5

Increase in deferred taxes +15

Profit from the sale of fixed assets +2

A. Rs.142

B. Rs.158

C. Rs.170

D. Rs.185

Use the following information to answer 2 to 4

Net Income Rs.45

Depreciation +75

Taxes paid - 25

Dividends paid 10

Cash received from sale of company building 40

Sale of preferred stock 35

Statement of Cash Flows For the period 1/1/01 to 31/12/01

Cash flow from operations (CFO) + Cash flow from investing (CFI) + Cash flow from financing (CFF) = Net cash flow (the change in the cash account)

+ Beginning of period cash = Ending cash balance

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Re-purchase of common stock 30

Purchase of machinery 20

Issuance of Bonds 50

Debt retired through issuance of common stock 45

Paid of long term bank borrowings 15

Profit on sale of building 20

2. The cash flow from operations is

A. Rs.75

B. Rs.100

C. Rs.120

D. Rs.185

3. The cash flow from investing activities is

A. Rs.30

B. Rs.20

C. Rs.70

D. Rs.50

4. The cash flow from financing activities is

A. Rs.75

B. Rs.55

C. Rs.85

D. Rs.30

5. Given the following

Sales Rs.1, 500

Increase in inventory Rs.100

Depreciation Rs.150

Increase in accounts receivable Rs.50

Decrease in accounts payable Rs.70

After tax profit margin 25%

Gain of sale of machinery Rs.30

The cash flow from operation is

A. Rs.25

B. Rs.115

C. Rs.275

D. Rs.375