FINANCIAL REPORTING AND ANALYSIS: INCOME

STATEMENTS, BALANCE SHEETS, AND CASH FLOW

STATEMENTS

UNDERSTANDING THE CASH FLOW STATEMENTS

 DISCLAIMER
CFA INSTITUTE DOES NOT ENDORSE, PROMOTE, REVIEW,
OR WARRANT THE ACCURACY OF THE PREPARATORY
SOURCES OFFERED BY LOMONOSOV MOSCOW STATE
UNIVERSITY OR VERIFY OR ENDORSE THE PASS RATES
CLAIMED BY LOMONOSOV MOSCOW STATE UNIVERSITY.

CFA®, AND CHARTERED FINANCIAL ANALYST® ARE

TRADEMARKS OWNED BY CFA INSTITUTE.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 2

 CASH FLOWS FROM OPERATING, INVESTING, AND FINANCING ACTIVITIES
CASH FLOW ITEMS

 A firm's cash receipts and payments are classified on cash flow statements as
operating, investing, or financing activities.

 Cash flow from operating activities (CFO) consists of the inflows and outflows of
cash resulting from ongoing regular business activities.

 Cash flow from investing activities (CFI) consists of the inflows and outflows of
cash resulting from the acquisition or disposal of long-term assets and some
investments [e.g. buying another company to take over its operations].

 Cash flow from financing activities (CFF) consists of the inflows and outflows of
cash resulting from transactions affecting a firm's capital structure.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 3

 CASH FLOWS FROM OPERATING, INVESTING, AND FINANCING ACTIVITIES
CASH FLOW ITEMS

Cash flow from operating activities examples (US GAAP)

Inflows Outflows
Cash collected from customers Cash paid to employees and suppliers
Interest and dividends received Cash paid for other expenses
Sale of securities (trading portfolio) Buying of securities (trading portfolio)
Interest paid
Taxes paid
Cash flow from investing activities examples (US GAAP)
Sale proceeds from fixed assets Acquisition of fixed assets
Sale of securities (AFS, HTM) Buying of securities (AFS, HTM)
Principal received from loans Loans made
Cash flow from financing activities examples (US GAAP)
Principal amounts of debt issucd Principal paid on debt
Procceds from issuing stock Payments to buy own stock
Dividends paid to shareholders

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 4

 REPORTING OF NON-CASH INVESTING AND FINANCING ACTIVITIES

 Noncash investing and financing activities are not reported in the cash flow
statement since they do not result in cash inflows or outflows. Examples:

• Purchase asset for equity;

• Exchange of debt for equity;

• Exchange of non-cash assets.

 Noncash transactions must be disclosed in either a footnote or supplemental

schedule to the cash flow statement.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 5

 CASH FLOW STATEMENTS PREPARED UNDER INTERNATIONAL FINANCIAL REPORTING
STANDARDS (IFRS) AND US GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP)

US GAAP IFRS
Dividends paid Financing activity Operating or financing activity
Dividents
Operating activity Operating or investment activity
received
Interest paid Operating activity Operating or financing activity
Interest received Operating activity Operating or investment activity
Operating activity, unless
Taxes paid Operating activity associated with investing or
financing transaction

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 6

 DIRECT AND INDIRECT METHODS OF PRESENTING CASH FROM OPERATING
ACTIVITIES AND ARGUMENTS IN FAVOR OF EACH METHOD

 The are two methods of presenting operating cash flow statement: the direct
method and the indirect method.

• Direct method - each line item of the accrual-based income statement is

converted into cash receipts or cash payments [provides specific sources of
operating cash receipt and payments].

• Indirect method - net income is converted to operating cash flow by making

adjustments for non-cash transactions [show differences between net
income and operating cash flow].

 The amount of operating cash flow is the same under both methods.

 The presentation format for investing and financing cash flows is the same.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 7

 DIRECT AND INDIRECT METHODS OF PRESENTING CASH FROM OPERATING
ACTIVITIES AND ARGUMENTS IN FAVOR OF EACH METHOD

A Corp, Indirect method

Net income 20 000
Adjustments to reconcile net income to operating
cash flow
Depreciation and amortization 9 000
Deferred income taxes 400
Increase in accounts receivable -800
Increase in inventory -25 000
Decrease in prepaid expenses 500
Increase in accounts payable 14 000
Increase in accrued liabilities 800
Operating cash flow 18 900

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 8

 DIRECT AND INDIRECT METHODS OF PRESENTING CASH FROM OPERATING
ACTIVITIES AND ARGUMENTS IN FAVOR OF EACH METHOD

B Corp, Direct method

Cash received from customers 70 000
Cash paid to suppliers and employees 50 000
Dividends received 100
Net interest and other financial expenses 2 500
paid
Taxes paid 4 000
Operating cash flow 126 600

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 9

 DIRECT AND INDIRECT METHODS OF PRESENTING CASH FROM OPERATING
ACTIVITIES AND ARGUMENTS IN FAVOR OF EACH METHOD

 Under U.S. GAAP, a direct method presentation must also disclose the
adjustments necessary to reconcile net income to cash flow from operating
activities (the same information that is presented via indirect method).

 Under U.S. GAAP, a direct method presentation must also disclose the
adjustments necessary to reconcile net income to cash flow from operating
activities (the same information that is presented via indirect method).

 This reconciliation is not required under IFRS. Under IFRS, payments for interest
and taxes must be disclosed separately under either method [reported in the
cash flow statement or disclosed in the footnotes under U.S. GAAP].

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 10

 HOW IS THE CASH FLOW STATEMENT LINKED TO
THE INCOME STATEMENT AND THE BALANCE SHEET?

Operating cash flow Beginning inventory balance

+ Investing cash flow + Inventory purchases
+ Financing cash flow - Cost of goods sold
= Change in cash balance = Ending inventory balance
+ Beginning cash balance
= Ending cash balance Beginning account receivable
+ Revenue
- Cash collected from customers
= Ending account receivable

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 11

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

 Analysts prefer direct cash flow format and companies often report cash flows
via indirect format.

 Direct cash flow statement can be approximated using income and balance
sheet statement [two balance sheets should be available – current and
previous].

 The first step is compute operational cash flow accounts. The second and third
steps in preparing the cash flows from investing and financing activities.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 12

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

Decrease in account receivable

 Cash collected from customers + Revenue
= Cash collected from customers

COGS
+ Inventory increase
= Purchases from supplliers
 Cash paid to suppliers - Increase in accounts payable
= Cash paid to customers

Salary and wages expence

- Increase in salary payable
= Cash paid to employees
 Cash paid to employees

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 13

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

Other operating expense

 Cash operating expenses + Increase in prepayed expence
Increase in other accrued
-
liability
Cash paid for other operating
=
expense

 Cash paid for interest Interest expense

- Increase in interest payable
= Cash paid for interest

Income tax expense

 Cash paid for taxes - Increase in income tax payable
= Cash paid for income taxes

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 14

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

Beginning balance equipment (BS)

 Investing activities + Equipment purchased (information note)
- Ending balance equipment (BS)
= Historical cost of equipment sold

Beginning balance accumulated depreciation (BS)

+ Depreciation expence (IS)
- Ending balance accumulated depreciation (BS)
= Accumulated depreciation on equipment sold

Historical cost of equipment sold

(calculated above)
Accumulated depreciation on equipment sold
-
(calculated above)
= Book value of equipment sold
+ Gain on equipment sold
= Cash received from sale of equipment

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 15

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

 Financing activities

• Net cash flows from creditors = new borrowings - principal amounts repaid

• Net cash flows from shareholders = new equity issued - share repurchases –
cash dividends paid.

Net income
- Change in retained earnings
= Dividends paid

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 16

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

 Using the indirect method, operating cash flow is calculated in four steps:
• Start from net income.
• Subtract gains or add losses that resulted from financing or investing cash
flows (such as sale of land).
• Add back noncash charges to income (e.g. depreciation and amortization)
and subtract all noncash components of revenue.
• Add or subtract changes to balance sheet operating accounts:
• Increases in the operating asset accounts (uses of cash) are subtracted,
while decreases (sources of cash) are added.
• Increases in the operating liability accounts (sources of cash) are
added, while decreases (uses of cash) are subtracted.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 17

 THE PREPARATION OF DIRECT AND INDIRECT CASH FLOW STATEMENTS
CONVERTING CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD

Indirect cash flow adjustments for operating cash flow example

Net income 40 000
- Gain from sale of land -10 000
+ Depreciation 8 000
Subtotal 38 000
Changes in operating accounts
- Increase in receivables -1 000
+ Decrease in inventories 3 000
+ Increase in accounts payable 5 000
- Decrease in wages payable -4 000
+ Increase in interest payable 700
Cash flow from operations 41 700

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 18

 ANALYSIS AND INTERPRETATION OF REPORTED AND
COMMON-SIZE CASH FLOW STATEMENTS

 Evaluate major sources and uses of cash between operating, investing, and
financing activities.

 Evaluate primary determinants of operating cash flows.

• Quality of earnings [revenue and cash flow]
• Working capital changes, receivables, payables

 Evaluate primary determinants of investing cash flows.

• Is company is making capital investments
• How much put aside as liquid investments (e.g. bonds)
• Have capital assets been sold

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 19

 ANALYSIS AND INTERPRETATION OF REPORTED AND
COMMON-SIZE CASH FLOW STATEMENTS

 Evaluate primary determinants of financing cash flows.

• Raising of repaying capital
• Nature of capital sources

 Common-Size Cash Flow Statement

 The cash flow statement can be converted to common-size format by expressing

each line item as a percentage of revenue.

 Alternatively, each inflow/outflow of cash can be expressed as a percentage of

total cash inflows/outflows.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 20

 ANALYSIS AND INTERPRETATION OF REPORTED AND
COMMON-SIZE CASH FLOW STATEMENTS

Common-size cash flow statement example [Revenue of 500 000]

Net income 40 000 8,0%
Gain from sale of land -10 000 -2,0%
Depreciation 8 000 1,6%
Subtotal 38 000 7,6%
Changes in BS operating accounts 0,0%
Increase in receivables -1 000 -0,2%
Decrease in inventories 3 000 0,6%
Increase in accounts payable 5 000 1,0%
Decrease in wages payable -4 000 -0,8%
Increase in interest payable 700 0,1%
Cash flow from operations 3 700 0,7%
Cash from sale of fixed assets 5 000 1,0%
Purchase plant and equipment -35 000 -7,0%
Investing cash flow -30 000 -6,0%
Sale of bonds 10 000 2,0%
Cash dividends -8 000 -1,6%
Financing cash flow 2 000 0,4%
Total cash flow -24 300 -4,9%

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 21

 FREE CASH FLOW TO THE FIRM, FREE CASH FLOW TO EQUITY
PERFORMANCE AND COVERAGE CASH FLOW RATIOS

 Free cash flow is an excess of operating cash flows over capital expenditures

• Free cash flow to the firm (FCFF) is the cash flow available to the company’s
suppliers of debt and equity capital.

• FCFF = NI + NonCash + [IntExp x (1 - Tax)] - FClnv – WClnv, where

NI = net income,
NonCash = noncash charges (depreciation and amortization),
IntExp = interest expense,
FClnv = fixed capital investment (net capital expenditures),
WCInv = working capital investment.

• FCFF = CFO + [IntExp x (1- Tax)] – ICF, where

CFO = cash flow from operations.

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 22

 FREE CASH FLOW TO THE FIRM, FREE CASH FLOW TO EQUITY
PERFORMANCE AND COVERAGE CASH FLOW RATIOS

 Free cash flow to equity (FCFE) is the cash flow that would be available for
distribution to common shareholders.

• FCFE = CFO - FCInv + Net borrowing , where

Net borrowing = debt issued - debt repaid.

 Cash Flow Ratios CFO

Cash flow - to - revenue 
net revenue

CFO
Cash return - on - assets 
average total assets

CFO
Cash return - on - equity 
average total equity

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 23

 FREE CASH FLOW TO THE FIRM, FREE CASH FLOW TO EQUITY
PERFORMANCE AND COVERAGE CASH FLOW RATIOS

 Cash Flow Ratios

CFO
Cash - to - income 
operating income

CFO - preferred dividends

Cash flow per share 
weighted average number of common shares

 Coverage Ratios

CFO
Debt coverage 
Total debt

CFO
Debt payment 
cash paid for to long term debt

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 FREE CASH FLOW TO THE FIRM, FREE CASH FLOW TO EQUITY
PERFORMANCE AND COVERAGE CASH FLOW RATIOS

 Coverage Ratios

CFO  Interest paid  Taxes paid

Interest coverage 
Interest paid

CFO
Investment and financing 
cash outflow from investing and financing activities

CFO
Dividents paid 
dividents paid

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 25

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume III  Reading 25

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume III  Reading 25  Practice Problems
MOODLE  CFA® Level I 2019  TESTS  FRA #2

READING 25 UNDERSTANDING THE CASH FLOW STATEMENTS 26