cash inflow
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cash inflowTRANSCRIPT
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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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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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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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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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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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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