CB 3041
Financial Statement Analysis
Lecture 4_Part 1
Review
Purpose of the Statement of Cash Flows
➢ The statement of cash flows assists financial statement
users in understanding the cash inflows and outflows that
arise from a firm’s primary activities.
• Just as the income statement gives users an
understanding of how a firm performed during the
period, the statement of cash flows gives users an
understanding of how the firm generated and used cash
Purpose of the Statement of Cash Flows
➢ The statement of cash flows is logically organized into
three sections (operating activities, investing activities, and
financing activities).
➢ On the statement of cash flows, net cash flows equal the
(net) sum of cash flows provided by or used for operating,
investing, and financing activities.
➢ The sum of these cash flows reconciles with the increase or
decrease in cash shown on the balance sheet.
Relations among the Cash Flow Activities
➢For established companies
➢For start-up companies
Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when using
the steps in financial statement analysis:
• Step 1: Identify the characteristics of a business.
• Step 2: Identify the strategy of the firm.
• Step 3: Identify nonrecurring, unusual items.
• Step 4: Provide insight into the use of accounting
discretion by managers.
• Step 5: Analyze profitability and risk.
• Step 6: Prepare forecasted financial statements.
• Step 7: Value the firm.
Usefulness of Statement of Cash Flows
➢ In addition to the analysis of accounting quality, the
statement of cash flows is useful for identifying a firm’s
strategy and where a firm is in its life cycle as well as
liquidity and credit risk analysis.
➢ It can help gauge whether reported net income reflects the
underlying economics of the business.
➢ It highlights accounting accruals, which can provide
insight into the overall sustainability and quality of a
firm’s reported earnings.
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Introduction Stage:
• Revenues are low, net income may be negative
• Negative cash flow from operating activities
• Negative cash flow from investing activities
• External financing (positive cash flow from financing)
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Growth Stage:
• Increasing revenues, net income becomes positive
• Increasing cash flows from operations
• Continuing negative cash flows from investing activities
• Decreasing positive cash flows from financing activities
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Maturity Stage:
• Peak net income, positive cash flows from operations
• Cash flows from investing activities may begin to
increase
• Cash flows from financing activities may become
negative (repayment of debt, stock repurchases, etc.)
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Decline Stage:
• Revenues decrease, net income decreases (may become
negative)
• Cash flows from operations decreases
• Cash flows from investing activities positive (as firm
divests)
• Cash flows from financing activities negative
CB 3041
Financial Statement Analysis
Lecture 4_Part 2
Understanding the Statement of
Cash Flows
Learning Objectives
➢ Understand the relations among the statement of cash
flows, the income statement, and the balance sheet
➢ Prepare a statement of cash flows from balance sheet and
income statement data
➢ Examine how the statement of cash flows provides
information for accounting and risk analysis
Relations among Net Income, Balance Sheets,
and Cash Flows
➢ To fully interpret and analyze the information in
the statement of cash flows, you need to
understand the following three relations:
• The overall relations among the net cash flows from
operating, investing, and financing activities.
• The relation between the change in cash on the balance
sheet and the net changes on the statement of cash flows.
Relations among Net Income, Balance Sheets,
and Cash Flows
➢ The specific relation between net income and
cash flows from operations.
• types of adjustments necessary to reconcile net income
to cash flows from operations
• the overall relation between net income and cash flows
from operations
The Direct Versus the Indirect Method
➢Under GAAP and IFRS, firms may present cash flows from
operations in one of two formats: the direct method or the
indirect method.
Direct Method
➢The direct method partitions cash receipts and cash
payments into logical categories, such as cash collected
from customers, cash paid to suppliers, and cash paid to
employees.
➢The direct method must provide a separate schedule for the
reconciliation between net income and operating cash
flows.
Indirect Method
➢ Almost all companies report cash flows using the indirect
method.
➢ The indirect method does not list cash flows directly, but
instead reconciles reported net income to cash flows
from operations by “unraveling” noncash (i.e., accrual)
components of earnings.
➢ Under the indirect method, not a single line item in the
operating section reflects an actual cash flow. Instead,
amounts shown are adjustments for noncash components
of net income.
Indirect Method
➢ It provides implied statement of cash flows using
information from the balance sheet and income statement.
➢ It assumes that all of the changes in noncash assets,
liabilities, and shareholders’ equity accounts imply cash
flows. That is, it assumes that the change in each account
involves a cash flow that relates to one of the three
activities
• e.g, an increase in a liability implies borrowing, while a
decrease implies payment; changes in operating
working capital accounts are operating transactions.
Indirect Method
➢ Under the indirect method, firms begin with net income to
calculate cash flows from operations.
➢ The assumption implicit in starting with net income is that
revenues increase cash and expenses decrease cash.
Indirect Method
➢ However, remember that under accrual accounting,
recognition of revenues and expenses does not necessarily
coincide with the actual timing of cash receipts or
payments. For example, sales to customers on credit
trigger recognition of revenues, but this also triggers an
increase in accounts receivable because customers have
been extended credit and can pay later.
➢ Because of differences in the timing of cash flows and
income statement recognition, net income must be
reconciled to cash flows by adjusting for noncash effects.
Indirect Method
➢ Most firms use the indirect method because it reconciles net
income with the net amount of cash received from or used
for operations, which provides a direct link to the income
statement.
➢ Critics of the indirect method suggest that the rationale for
some of the reconciling items is difficult for less
sophisticated users to understand. For example, a decrease
in receivables is actually associated with an increase in cash
flows (reflecting cash collected from customers); however,
this adjustment is typically labeled as “Decrease in accounts
receivable” on the statement of cash flows, which might
confuse some users.
Statement of Cash Flows
under Direct and Indirect Methods
Statement of Cash Flows
under Direct and Indirect Methods
Statement of Cash Flows
under Direct and Indirect Methods
Relation between net income and cash flows
from operations
➢ Under the indirect method, not a single line item in the
operating section reflects an actual cash flow. Instead,
amounts shown are adjustments for noncash components
of net income.
➢ The presentation of cash flows from operations under the
indirect method involves two types of adjustments to net
income: 1) working capital and 2) other noncash
components of income adjustments.
1) Operating Working Capital Adjustments
➢Adjustments used to reconcile net income to cash flows
from operations involve changes in the working capital
(current asset and current liability) accounts, including:
• Accounts receivable and deferred revenue
• Inventories
• Prepaid expenses
• Accounts payable and accrued expenses
• Income taxes payable
• Other current assets and liabilities
2) Other Noncash Components of Income
Adjustments
➢Other noncash components of income must be reversed
of the starting point of the statement of cash flows:
• Depreciation and amortization expense
• Bad debt expense
• Deferred tax expense
• Stock-based compensation and pension costs
• Gains/losses on property, plant, and equipment
• Equity method income and noncontrolling interests
• Other comprehensive income
Quick Check Question 1
➢ Which of the following is an example of other noncash
component of income?
a. Inventories
b. Prepaid expenses
c. Income taxes payable
d. Bad debt expense
Adjustments ≠ the Changes on the Balance Sheet
➢The four primary reasons that changes on the balance sheet
do not match the adjustments on the statement of cash
flows include:
• Acquisitions and divestitures
• Noncash transactions
• Changes in contra accounts
• Foreign currency translation
The Relation between Net Income and Cash
Flows from Operations
➢What is the general relation between net income and cash
flows from operations?
➢When should one exceed the other?
➢Should they be approximately the same over a long time
period, and, if so, how long?
➢Net income is often less than net cash flows from
operations, but for some firms you will see net income
larger than cash flows from operations.
The Relation between Net Income and Cash
Flows from Operations
➢The tendency for operating cash flows to exceed net
income is not surprising for several reasons.
➢For example, the largest adjustments to net income in the
operating section are generally for other noncash
components of income, which are primarily addbacks to net
income rather than subtractions.
The Relation between Net Income and Cash
Flows from Operations
➢These addbacks include
• (1) depreciation and amortization expense (noncurrent
assets),
• (2) deferred tax expense (noncurrent liability),
• (3) share-based compensation (shareholders’ equity),
• (4) asset impairments and restructuring charges.
The Relation between Net Income and Cash
Flows from Operations
➢Another factor that may cause cash flow from operations to
differ from net income is the length of the operating cycle,
which encompasses the period of time from when a firm
commences production until it receives cash from
customers for the sale of the products.
➢Firms such as distilleries producing aged spirits,
construction companies, and aerospace manufacturers with
relatively long operating cycles often experience a long lag
between cash outflows for design, development, raw
materials, and labor and cash inflows from customers.
The Relation between Net Income and Cash
Flows from Operations
➢Another factor that may cause cash flow from operations to
differ from net income is the length of the operating cycle,
which encompasses the period of time from when a firm
commences production until it receives cash from
customers for the sale of the products.
The Relation between Net Income and Cash
Flows from Operations
➢Firms such as distilleries producing aged spirits,
construction companies, and aerospace manufacturers with
relatively long operating cycles often experience a long lag
between cash outflows for design, development, raw
materials, and labor and cash inflows from customers.
➢The longer the operating cycle and the more rapid the
growth of a firm, the larger the difference between net
income and cash flows from operations.
The Relation between Net Income and Cash
Flows from Operations
➢Exhibit 3.10
The Relation between Net Income and Cash
Flows from Operations
➢Exhibit 3.10 shows graphically the relation between net
income and cash flows for Clorox from 2016 to 2020.
➢First, note that net income and cash flows from operations
are positive every year, but cash flows from both investing
and financing activities are negative each year. This is
consistent with the typical pattern for a mature, profitable
firm.
The Relation between Net Income and Cash
Flows from Operations
➢Second, cash flows from operations exceed net income
every year. The excess of cash flows from operations over
net income is due primarily to the large positive
adjustments for other noncash components of income
coupled with generally positive but smaller adjustments for
working capital.
➢Third, investing and financing cash flows are negative in
each year, but when one is more negative, the other is less
negative, consistent with a balancing of various cash flow
needs.
Quick Check Question 2
➢ Given the following:
Sales $1,500
Increase in inventory 100
Depreciation 150
Increase in accounts receivable 50
Decrease in accounts payable 70
After-tax profit margin 25%
Gain on sale of machinery $30
Quick Check Question 2
➢ Cash flow from operation is ?
a. $115
b. $275
c. $375
Quick Check Question 3
➢ Net income for ABC Co. for the year ended December 31,
20X7 was $78,000. Its accounts receivable balance on
December 31, 20X7 was $121,000, and this balance was
$69,000 on December 31, 20X6. The accounts payable
balance on December 31, 20X7 was $72,000 and was
$43,000 on December 31, 20X6. Depreciation for 20X7
was $12,000, and there was an unrealized gain of $15,000
included in 20X7 income from the change in value of
trading securities.
Quick Check Question 3
➢ Which of the following amounts represents ABC Co.’s cash
flow from operations for 20X7?
a. $52,000
b. $67,000
c. $82,000
Preparing the Statement of Cash Flows
➢The statement of cash flows explains the reasons for the
change in cash during a period using this formula:
Assets = Liabilities + Shareholders’ Equity
Cash + Noncash Assets = Liabilities + Shareholders’ Equity
Δ Cash = Δ Liabilities + Δ Shareholders’ Equity – Δ Noncash Assets
Preparing the Statement of Cash Flows
Noncash Assets=Working Capital (WC)+Non Working Capital (NWC)
Liabilities=Working Capital (WC)+Non Working Capital (NWC)
Δ Cash = Δ Liabilities + Δ Shareholders’ Equity – Δ Noncash Assets
= Δ Liabilities (WC) + Δ Liabilities (NWC) + Δ SE
– Δ Noncash Assets (WC) – Δ Noncash Assets (NWC)
Operating
Activities
= Δ Liabilities (WC) – Δ Noncash Assets (WC)
– Δ Noncash Assets (NWC) + Δ Liabilities (NWC) + Δ SE
Investing Financing
Activities Activities
Preparing the Statement of Cash Flows
ΔCash = Δ Liabilities (WC) – Δ Noncash Assets (WC)
– Δ Noncash Assets (NWC) + Δ Liabilities (NWC) + Δ SE
➢ In general:
• Changes in current assets and current liabilities affect operating
activities.
• Changes in fixed assets and other noncurrent assets affect investing
activities.
• Changes in long-term liabilities and stockholders’ equity accounts
(except net income) affect financing activities.
Classifying Cash Flows
➢Interest Expense vs. Debt Repayment vs. Dividends Paid
• U.S. GAAP classifies cash expenditures for interest
expense as an operating activity but classifies cash
expenditures to redeem debt and dividends to
shareholders as a financing activity.
➢Interest Received and Dividends Received
• U.S. GAAP classifies interest and dividends as an
operating activity.
Classifying Cash Flows
➢Under IFRS, interest paid and interest and dividends
received are normally classified as operating cash flows
for financial institutions.
➢However, non-financial firms, it is allowed to classify
interest and dividend paid as either operating or financing
activities; interest and dividend received as either
operating or investing activities.
Changes in Balance Sheet Accounts
➢Classify the change in each noncash balance sheet account
into an operating, investing, or financing activity:
• Operating Activities: accounts receivable, inventories,
other current assets, depreciation, amortization on
intangible assets, accounts payable, deferred income
taxes, other current and noncurrent liabilities, and net
income
• Investing Activities: marketable and other securities;
property, plant, and equipment
• Financing Activities: notes payable, current portion of
long-term debt, long-term debt, and dividends
Changes in Balance Sheet Accounts
Balance Sheet
Worksheet for Statement of Cash Flows
Changes in Balance Sheet Accounts
➢ Accounts Receivable
• Cash Collected from Customers = Sales – Δ Accounts Receivable
• A decrease in accounts receivable indicates that the firm collected
more cash than it recognized in revenues, so the adjustment is an
addback.
• The change in accounts receivable clearly relates to operations.
➢ Marketable Securities
• Firms typically acquire marketable securities when they temporarily
have excess cash.
• U.S. GAAP and IFRS classify the cash flows associated with
purchases and sales of marketable securities as investing activities.
• Because net income includes gains or losses on sales of marketable
securities, you must subtract gains and add back losses to net income
in deriving cash flow from operations.
Changes in Balance Sheet Accounts
➢ Inventories
• Purchases of inventory = Cost of goods sold + Δ Inventories
• An increase in inventories indicates that the firm purchased inventories
more than they recognized as COGS, so the adjustment is a subtraction.
• The change in inventories relates to operations.
➢ Other Current Assets
• Other current assets typically include prepayments for various
operating costs, such as insurance and rent.
• Unless the financial statements and notes present information to the
contrary, the change in other current assets relates to operations.
Changes in Balance Sheet Accounts
➢ Property, Plant, and Equipment
• Cash flows related to purchases and sales of fixed assets are
classified as investing activities.
• Any gains or losses from sales of fixed assets needed to be adjusted
on earnings by adding back losses and subtracting gains from net
income when computing cash flows from operations.
• Impairment charges must be added back to net income for CFO.
➢ Accumulated Depreciation
• Depreciation expense is not a cash flow (ignoring income tax
consequences), hence must be added back to net income for CFO.
• If a firm sells depreciable assets during a period, the change in
accumulated depreciation includes both the effects from assets sold
(investing activities) and depreciation expense (operating
activities).
Changes in Balance Sheet Accounts
➢ Intangible Assets & Other noncurrent assets
• Unless the financial statements and notes provide contrary
information, the change in these accounts is an investing activity.
• Amortization expense is not a cash flow, hence must be added back
to net income when computing CFO.
➢ Accounts Payable
• Cash Paid to Suppliers = Purchases of Inventory – Δ Accounts
Payable
• Recall, Purchases of inventory = Cost of goods sold + Δ Inventories
• An increase in accounts payable indicates that the firm paid less cash
than its purchases, so the adjustment is an addback.
• Accounts payable are typically due to suppliers from which the firm
makes inventory purchases, hence an operating activity.
Quick Check Question 4
➢ PQR Inc. had the following transactions during 20X7:
• Purchased new fixed assets for $75,000.
• Converted $70,000 worth of preferred shares to common
shares.
• Received cash dividends of $12,000. Paid cash dividends of
$21,000
• Repaid mortgage principal $17,000.
Quick Check Question 4
➢ Assuming PQR follows U.S. GAAP, which of the
following amounts represents PQR’s cash flows from
investing and cash flows from financing in 20X7,
respectively?
➢ Cash flows from investing Cash flows from financing
a. ($5,000) ($21,000)
b. ($75,000) ($21,000)
c. ($75,000) ($38,000)
Quick Check Question 5
➢ Caterpillar manufactures heavy machinery and equipment
and provides financing for purchases by its customers.
Caterpillar reported sales and interest revenues of $51,324
million for Year 1. The balance sheet showed current and
noncurrent receivables of $15,752 million at the beginning
of Year 1 and $18,448 million at the end of Year 1.
Quick Check Question 5
➢ What is the amount of cash collected from customers
during Year 1?
a. $54,020
b. $48,628
c. $51,324
Quick Check Question 6
➢ Lowe’s Companies, a retailer of home improvement
products, reported cost of goods sold of $31,729 million for
Year 1. It reported merchandise inventories of $7,611
million at the beginning of Year 1 and $8,209 million at the
end of Year 1. It reported accounts payable to suppliers of
$3,713 million at the beginning of fiscal Year 1 and $4,109
million at the end of fiscal Year 1.
Quick Check Question 6
➢ What is the amount of cash paid to merchandise suppliers
during Year 1?
a. $32,723
b. $23,309
c. $31,931
Changes in Balance Sheet Accounts
➢ Notes Payable
• Notes Payable is the account generally used when a firm engages in
short-term borrowing from a bank or another financial institution.
• Such borrowings are typically classified as financing activities.
➢ Other Current Liabilities
• Firms generally use this account for obligations for expenses that
have been incurred related to goods and services used in operations.
• Thus, changes in other current liabilities appear as operating
activities.
Changes in Balance Sheet Accounts
➢ Long-Term Debt
• This account changes for the following reasons:
• Issuance of new long-term debt.
• Repayment of long-term debt.
• Reclassification of long-term debt from a noncurrent to a current
liability (current portion of long-term debt).
• Conversion of long-term debt to preferred or common stock.
• These items are clearly financing transactions.
• While issuance of new debt and the repayment of debt do affect
cash flows, reclassifications and conversions of debt do not affect
cash flows. Hence, these non-cash transactions do not appear on the
formal statement of cash flows.
Changes in Balance Sheet Accounts
➢ Deferred Income Taxes (Deferred Tax Liabilities/Assets)
• Income taxes currently payable equal income tax expense plus or
minus the change in deferred taxes during the period.
• Thus, changes in deferred income taxes is an operating activity.
• Firms often report both deferred tax assets and liabilities. Increases
in assets reflect cash outflows, so appear as cash outflow; the
opposite is true for deferred tax liabilities.
Changes in Balance Sheet Accounts
➢ Common Stock, Additional Paid-in Capital, and Treasury Stock
• These accounts change when a firm issues new common stock or
repurchases outstanding stock, and they appear as financing
activities.
• The Additional Paid-in Capital account also changes when firms
recognize compensation expense related to stock options. This is a
noncash expense that, like depreciation, requires an addback to net
income to compute cash flows from operations.
Changes in Balance Sheet Accounts
➢ Retained Earnings
Ending RE = Beginning RE + Net Income – Dividends
Δ Retained Earnings = Net Income – Dividends
• Net income is an operating activity, and dividends are a financing
activity
➢ Accumulated Other Comprehensive Income
• Recall that accumulated other comprehensive income is a
component of shareholders’ equity and includes various fair value
gains and losses that have not been realized.
• Therefore, the change in accumulated other comprehensive income
needs no recognition on the statement of cash flows.
Worksheet for Statement of Cash Flows_Revisit
Worksheet for Statement of Cash Flows_Revisit
Usefulness of Statement of Cash Flows
➢ Accruals represent the noncash accounting adjustments
that are employed to prepare income statements and
balance sheets, such as recognizing sales on account,
accruing expenses incurred but not paid, and so on.
➢ These accounting adjustments involve managerial
discretion. For example, revenue recognition often
requires managerial judgment about whether the company
has surpassed all hurdles for appropriate revenue
recognition. Changes in accounts receivable thus reflect
discretion by managers.
Usefulness of Statement of Cash Flows
➢ As a user of financial statements, you can view the
operating section of the statement of cash flows to
highlight questions that are informative about managerial
discretion. For example,
• Are revenue and income growth mainly driven by accruals
for receivables that might reflect aggressive revenue
recognition?
• Are firms delaying recognizing expenses by capitalizing
(rather than expensing) costs as assets?
• Is a persistent excess of net income over statement of cash
flows sustainable through growth, or does net income
reflect aggressive accruals recognition?
Usefulness of Statement of Cash Flows
➢ It can be difficult to distinguish legitimate growth in the
business from aggressive managerial discretion over
accruals, but the first step is to identify key areas where
such discretion might be aggressive.
Usefulness of Statement of Cash Flows
➢ MicroStrategy example: MicroStrategy is a provider of
software that enables businesses to conduct transaction
data through various channels and to examine information
about customers, partners, and supply chains. The
company aggressively recognized revenue upon signing a
contract with customers (and often before that). The
restatement announced in March 2000 included revised
procedures for recognizing revenues over the contract
period or after sales contracts were completed, rather than
immediately.
Usefulness of Statement of Cash Flows
Usefulness of Statement of Cash Flows
➢ For 1998, software license revenues of $72.721 million
were restated downward to $61.635 million and net
income was restated downward from a profit of $6.178
million to a loss of $2.255 million. The restatement
affected the balance sheet through decreases in accounts
receivable (for revenues recognized premature to the
finalization of the contract), increases in deferred revenue
(for revenue recognized immediately rather than spread
over the contract period), and other miscellaneous
adjustments.
Usefulness of Statement of Cash Flows
➢ Several features of MicroStrategy’s original operating
section of the statement of cash flows stand out.
• First, as you have seen in other examples discussed earlier
in the chapter, the typical relation of net income being less
than operating cash flows is reversed for MicroStrategy.
Although net income can legitimately exceed cash flows
from operations, especially for growth firms, it can be a red
flag for accounting quality issues because of managerial
discretion necessary in noncash components of net income.
Usefulness of Statement of Cash Flows
• Second, the existence of negative cash flows from
operations but positive net income represents a situation in
which managers may be keenly interested in reporting
profits rather than losses, increasing incentives to adopt
aggressive accounting practices.
• Third, the magnitude of the working capital adjustments
exceeds that of adjustments for other noncash components
of income, which indicates that the accounting for working
capital accounts has an elevated importance for the level of
reported earnings. Specifically, accounts receivable and
deferred revenues are directly associated with the
recognition of revenues.
Usefulness of Statement of Cash Flows
➢ The restatement was costly to the company’s shareholders
as the price of MicroStrategy common shares fell from
$227 to $113 over the five days after the announcement of
the restatement.
➢ Clearly, the financial statements as originally reported
contained clues investors could have used to raise
concerns about the quality of earnings possibly being low.
Problem – BTB Electronics
BTB Electronics Inc. manufactures parts,
components, and processing equipment for
electronics and semiconductor applications in the
communications, computer, automotive, and
appliance industries. Its sales tend to vary with
changes in the business cycle because the sales of
most of its customers are cyclical. Exhibit 3.30
presents balance sheets for BTB as of December
31, Year 7 through Year 9, and Exhibit 3.31
presents income statements for Year 8 and Year 9.
Problem – BTB Electronics
Problem – BTB Electronics
Problem – BTB Electronics
➢Prepare a worksheet for the preparation of a statement of
cash flows for BTB Electronics Inc. for Years 8 and 9. Notes
to the firm’s financial statements reveal the following
(Amounts in Thousands):
➢Depreciation expense was $641 in Year 8 and $625 in Year
9. No fixed assets were sold during these years.
➢Other Assets represents patents. Patent amortization was $25
in Year 8 and $40 in Year 9. BTB sold a patent during Year 9
at no gain or loss.
➢Changes in Deferred Income Taxes are operating activities.
Problem – BTB Electronics
➢Discuss the relations among net income and cash flow from
operations and the pattern of cash flows from operating,
investing, and financing activities.
