BAC2684

FINANCIAL STATEMENT
ANALYSIS
Trimester 3 2022
Chapter 7
Cash Flow Analysis
Statement of Cash Flows
• Relevance of cash flow
Statement relations
of Cash • Reporting by activities
Flows • Constructing the
statement

• Indirect Method
Analyzing Cash From • Direct Method
Cash Flows Operations • Converting indirect to
direct

• Reporting limitations
• Cash flows & accruals
Cash Flows • Alternative measure
Analysis • Business conditions
• Free cash flow
• Cash flows as validators
 Statement of Cash Flows
 Cash – The residual balance from cash inflows less cash outflows for all prior
periods of company.
 Net cash flow or simply cash flows refers to current period’s cash inflows less cash
outflows.
 Cash flows are different from accrual income measures of performance.

 Cash flow measures recognize inflows when cash is received but not necessarily
earned, and recognize outflows when cash is paid but the expenses not necessarily
incurred.
 Statement of cash flows reports cash flow measures for three (3) primary business
activities; operating, investing and financing.
 Statement of Cash Flows
 Operating cash flows or cash flows from operations, are the cash basis counterpart to
accrual net income.
 Information on cash flows helps to:

- assess a company’s ability to meet obligations, pay dividends, increase capacity, and
raise financing.
- assess quality of earnings & dependence of income on estimates & assumptions
regarding future cash flows.
 Statement of Cash Flows
 Purpose of the statement of cash flow:
- To provide information on cash inflows and outflows for a period.
- It also distinguishes among the sources & uses of cash flows by separating into
operating, investing & financing.

Relevance of Cash
 Cash - most liquid of assets.
– Offers both liquidity and flexibility.
– It is both the beginning and end of company’s operating cycle.
– Company’s operating activities involve cash conversion into various assets (such
as inventories) that are used to yield receivables from credit sales.
– The operating cycle is complete when collection process returns cash to
company, enabling new operating cycle to begin.
 Statement of Cash Flows
 Financial statements are prepared based on accrual accounting where companies recognize
revenue when earned and expenses when incurred.
 However, net cash flow is the end measure of profitability. It is cash, not income that repays
loans, replaces equipment and expand facilities and pay dividends.
 Analysing a company’s cash inflow and outflows and their operating, financing and
investing sources helps in assessing the liquidity, solvency and financial flexibility of the
company.

 Liquidity – nearness to cash assets and liabilities.

 Solvency – is the ability to pay liabilities when they mature.
 Financial flexibility – is the ability to react and adjust to opportunities and adversity.
 Statement of Cash Flows
 Statement of cash flows (SCF) helps address questions such as:
 How much cash is generated from or used in operations?
 What expenditures are made with cash from operations?
 How are dividends paid when confronting an operating loss?
 What is the source of cash for debt payments?
 How is the increase in investments financed?
 What is the source of cash for new plant assets?
 Why is cash lower when income increased?
 What is the use of cash received from new financing?

Analysis of Statement of cash flows requires understanding of accounting measures

underlying its preparation and presentation.
 Statement of Cash Flows
Reporting by Activities
 SCF reports cash receipts and cash payments by operating, financing, and
investing activities – primary business activities of company.
 Operating activities - earning-related activities of company.

 Beyond revenue and expense activities represented in income statement, they

include net inflows and outflows of cash resulting from related operating
activities like extending credit to customers, investing in inventories, and
obtaining credit from suppliers.
 Operating activities relate to income statement items and to balance sheet
items relating to operations – usually working capital accounts – receivables,
inventories, prepayments, payables & accrued expenses.
 Statement of Cash Flows
 Investing activities – are means of acquiring and disposing of non-cash
assets
 These activities Involves assets expected to generate income for company –
purchase & sales of PPE and investing in securities.
 Include lending funds and collecting principal on these loans.

 Financing activities – means of contributing, withdrawing, and servicing

funds to support business activities

 These include borrowing & repaying funds with bonds & other loans.
 Include contributions & withdrawals by owners and return (dividends) on
investment.
 Statement of Cash Flows
Constructing Cash Flow Statement
 Indirect Method
– Net income is adjusted for non-cash income (expense) items and accruals to yield
cash flow from operations.
– An advantage of this method is the disclosure of a reconciliation of differences
between net income and operating cash flows.
– Users can Predict cash flows by first predicting income & then adjusting income for
leads & lags between income & cash flows – using noncash accruals.
 Direct Method
– Each income item is adjusted for its related accruals and provides better format to
assess amount of operating cash inflows (outflows)

Format for computing net cash provided by investing and financing activities is the same for both
methods - only preparation of net cash flows from operations differs.
 Statement of Cash Flows
Preparation of the SCF (Indirect method)
 SCF is a blend of income statement & balance sheet.
 Net income is first adjusted for noncash income & expense items to yield cash
profits and further adjusted for cash generated & used by balance sheet transactions
to yield cash flows from operations, as well as investing & financing activities
 Statement of Cash Flows
Preparation of the SCF (Indirect method)
 Starting point for SCF is net income adjusted for noncash depreciation & amortization
expenses. Why add-back?
- Cash outflow occurs when tangible & intangible
assets are purchased.
- Depreciation (amortization) process allocates the
cost over useful lives to match expenses against
revenue generated by those assets.
- Because SCF focuses on cash flows, need to eliminate noncash expenses that is recognized in
computation of net income, hence the add-back.
- Adding depreciation & amortization expense does not increase operating cash flow, merely
zeros out the expense subtracted in the computation of net income.
 Statement of Cash Flows
Preparation of the Statement of Cash Flows
 Depreciation and amortization add-back

 Also adjust net income for gains (losses) on sales of assets in similar manner. Purpose of adjustment is
not to eliminate investment gains (losses) in entirety but to move them out of operating section of SCF.

 Cash flows from sales of assets are reflected in net cash flows from investing activities.

 Final adjustments involve analysis of cash generated and used by changes in assets and liabilities.
 Statement of Cash Flows
Preparation of the Statement of Cash Flows

To see the effect of changes of assets & liabilities consider the following example;
$100 sales on accounts

Account receivables 100

Sales revenue 100

In period of sales, net income increased by $100, but no cash been generated as
receivable not yet collected. At this point, SCF reports net income of $100 and net
cash from operation $0.
Net income 100
Depreciation & amortization expenses 0
Gains (losses) on sales of assets 0
Change in account receivable (100)
Net cash flow from operations $ 0
 Statement of Cash Flows
Preparation of the Statement of Cash Flows
In period the receivable is collected. The reduction in account receivables
has generated $100 cash inflow & reported positive amount in SCF

Net income 0

Depreciation & amortization expenses 0

Gains (losses) on sales of assets 0

Change in account receivable 100

Net cash flow from operations $100

 Statement of Cash Flows
Preparation of the Statement of Cash Flows
The adjustments for changes in Statement of Financial Position accounts can be
summarized as follows:

Once net income has been adjusted for depreciation and amortization expense and
gains (losses) on the sale of assets, the final step in the preparation of cash flow from
operations is to examine changes in in current assets (liabilities) using the matrix
above to reflect changes as cash inflows (outflows), coded as positive (negative)
amount respectively.
Statement of Cash Flows
Constructing the Statement

1. The company purchased a truck during the year at a cost

of $30,000 that was financed in full by the manufacturer.
2. A truck with a cost of $10,000 and a net book value of
$2,000 was sold during the year for $7,000. There were
no other sales of depreciable assets.
3. Dividends paid during Year 2 are $51,000
 Statement of Cash Flows
Steps in Constructing the Statement
(1) Start with Net Income of $84,000
(2) Adjust Net Income for non-cash depreciation & amortization expenses and gain on
sale of assets is subtracted to zero out (proceeds be reflected in net cash flows from
investing activities)
(3) Recognize cash inflows (outflows) from changes in current assets and liabilities
using matrix
(4) Sum up to yield net cash flows from operations of $ 113,000

84,000


 35,000
(5,000)
(9,000)
 6,000

3,000
(5,000)
4,000
$ 113,000
 Statement of Cash Flows
Steps in Constructing the Statement
(5) Net cash flows from investing activities include purchases (p) and sales (s) of PPE assets.
Changes in long-term assets yield net cash flows from investing activities. Purchase can be
inferred from T-account for PPE
1. The company purchased a truck during the year at a cost of $30,000 that
was financed in full by the manufacturer.

2. A truck with a cost of $10,000 and a net book value of $2,000 was sold
during the year for $7,000. There were no other sales of depreciable
assets.

Plant Assets
Bal b/d 350,000
(p) 100,000 10,000 (s)
Bal b/d 440,000
 Statement of Cash Flows
Steps in Constructing the Statement
Plant Assets
Bal b/d 350,000
(p) 100,000 10,000 (s)
Bal b/d 440,000
 PPE reduced by cost of asset sold (s). Purchase (p) can be inferred as amount necessary to yield
ending balance $440,000. Of $100,000 increase in PPE, only $70,000 was paid in cash &
remainder financed by manufacturer.
 Thus, $70,000 cash payment appears as purchase in SCF.
 $30,000 equipment purchase is a noncash investing & financing activity and not reflected in
body of SCFs. Instead reference in explanatory footnotes.

1. The company purchased a truck during the year at a cost of $30,000 that was financed in
full by the manufacturer.
 Statement of Cash Flows
Steps in Constructing the Statement

2. A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year
for $7,000. There were no other sales of depreciable assets.
Journal entry for sale of assets:
Cash 7,000
Accumulated depreciation 8,000
Asset (costs) 10,000
Gain on sale 5,000

 Gain on sale $5,000 deducted from net income to zero it out of operating section and $7,000 cash proceeds
reported in investing section of SCFs.
 Net cash flows from investing activities reflect net cash outflow of -
$(70,000) purchase of assets - $7,000 sales of asset = $(63,000)
 Statement of Cash Flows
Steps in Constructing the Statement
 Gain on sale $5,000 deducted from net income to zero it out of operating section and $7,000 cash
proceeds reported in investing section of SCFs.
 Net cash flows from investing activities reflect net cash outflow of -
$(70,000) purchase of assets - $7,000 sales of asset = $(63,000)
Statement of Cash Flows
Steps in Constructing the Statement
(6) Net cash flows from financing activities reflect changes in long-term liabilities and equity accounts
yield net cash flows from financing activities.
- Repayment of mortgage ($150,000), issuance of preferred stock $175,000, and payment of dividends
($51,000)
- Net cash flows from financing activities reflect a net outflow of ($26,000)
[($150,000) + $175,000 – ($51,000)
(7) Sum cash flows from operations, investing, and financing activities to yield net change in cash
(8) Add net change in cash to the beginning cash balance to yield ending cash

Net Cash flow from operations 113,000

Net cash flows from investing activities (63,000)
Net cash flows from financing activities (26,000)
Net change in cash................................. 24,000
Beginning cash......................................... 51,000
Ending cash............................................... 75,000
Statement of Cash Flows

Statement of cash
flows also provides
explanatory notes
detailing any noncash
investing & financing
activities.
 Statement of Cash Flows
Direct Method
 Direct (or inflow-outflow) method - reports gross cash receipts and cash
disbursements related to operations — essentially adjusting each income statement item
from accrual to cash basis.
- Reports total amounts of cash flowing in and out of a company from operating
activities.
- Preferred by analysts and creditors.
- Excessive implementation costs.
- When companies report using direct method, they must disclose a reconciliation of net
income to cash flows from operations (indirect method) in separate schedule.
 Statement of Cash Flows
Direct Method
 Direct (or inflow-outflow) method
- Presents specific cash flows associated with items that affect cash flow. Items
that typically do so include:
- Cash collected from customer’s
- Interest and dividends received
- Cash paid to employees
- Cash paid to suppliers
- Interest paid
- Income taxes paid
- Advantage of direct method over indirect method - reveals operating cash
receipts and payments.
 Statement of Cash Flows
Direct Method
Cashflow from (used in) operating activities
Cash receipt from customers xxxx
Cash paid to suppliers & employees xxxx
Cash generated from operations xxxx
Interest paid (xxx)
Net cashflow from Operating activities xxxx
Cashflow from (used in) Investing activities
Proceeds from sale of equipment xxxx
Dividends received xxxx
Net cashflow from investing activities xxxx
Cashflow from (used in) from financing activities
Dividends paid xxxx
Net cash flow from financing activities xxxx
Net increase (decrease) in cash & cash equivalent xxxx
Beginning cash & cash equivalent balance xxxx
Ending cash & cash equivalent balance xxxx
 Statement of Cash Flows
Direct Method
 Direct (or inflow-outflow) method
- Standard-setting bodies encourage the use of direct method, but rarely used, for reason information
is difficult to assemble; companies simply do not collect and store information in manner required
for this format.
- Using direct method may require the chart of accounts be restructured in order to collect different
types of information. Instead, they use indirect method, which can be more easily derived from
existing accounting reports.
- Cash flow from financing and investing activities' sections will be identical under both
indirect and direct method
 Statement of Cash Flows
Converting from Indirect to Direct Method
- How do we convert cash flows from operations reported under indirect method
to direct method?
- Example from Gould Corp.
 Disaggregating net income ($84,000) into total revenues ($660,000) and
total expenses ($576,000)
 Conversion adjustments applied to relevant categories of revenue and
expenses.
 From adjustment, direct format of Gould Corp’s cash flows from operations
are presented.
 Gain from sale of equipment (transferred to investing activities) is omitted
from direct method presentation
 Statement of Cash Flows
Converting from Indirect to Direct Method
 Analysis Implication of Cash Flows
Limitations in Cash Flow Reporting
 Some limitations of current reporting of cash flow:

– Practice does not require separate disclosure of cash flows pertaining to either extraordinary
items or discontinued operations.
– Interest and dividends received and interest paid are classified as operating cash flows. Many
users consider interest paid a financing outflow & interest & dividends received as cash inflows
from investing activities.
– Income taxes are classified as operating cash flows. This classification can distort analysis of 3
individual activities if significant tax benefits or costs are attributed to them in disproportionate
manner.
– Removal of pre-tax (rather than after-tax) gains or losses on sale of plant or investments from
operating activities distorts our analysis of both operating and investing activities. This is
because related taxes are not removed but left in total tax expense among operating activities.
 Analysis Implication of Cash Flows
Interpreting Cash Flows and Net Income
 Our analysis focused on the two primary financial statements directed to operating activities:

• Statement of Cash Flows; and

• Income statement

 There is a lack of understanding on the comparative relevance of cash flows and accrual net
income in providing insights into operating activities.
 Function of income statement is to measure company profitability that is it records revenue when
earned and expenses when incurred.
 Does not show the timing of cash inflows and outflows, nor the effect of operations on liquidity
and solvency.
 This information is in the statement of cash flows, shown separately for operating, investing and
financing activities.
 Analysis Implication of Cash Flows
Interpreting Cash Flows and Net Income

 Cash flow from operations (CFO) is a broader view of operating activities than is net income.
 CFO encompass all earning-related activities of a company. This measure concerns not only revenue and
expenses but also the cash demand for these activities.
 These includes investing in accounts receivables and inventories as well as the financing provided by
suppliers of goods and services.
 Analysis Implication of Cash Flows
Interpreting Cash Flows and Net Income
 CFO focuses on liquidity aspect of operations. It is not a measure of profitability because it does
not include costs such as use of long-live assets in operations nor revenues like noncash equity in
earnings of subsidiary or non consolidated affiliates.
 A net measure, be it net income or cash flows from operations, is of limited usefulness. Key
information is about components of these net measures.
 Our evaluation of operating performance & future earning power depends not on net income but
on its components.
 Both income statement & statement of cash flow is designed to meet different need of users.
 Income statement uses accrual accounting in recognising revenue earned and expenses paid.
CFO reports revenue received in cash and expenses paid.
 The issue is not which statement is superior – it is only a matter of our immediate analysis needs.
 Analysis of Cash Flows
• In evaluating sources and uses of cash, analyst should focus on questions like:
 Are asset replacements financed from internal or external funds?
 What are the financing sources of expansion and business acquisitions?
 Is the company dependent on external financing?
 What are the company’s investing demands and opportunities?
 What are the requirements and types of financing?
 Are managerial policies (such as dividends) highly sensitive to cash flows?

Inferences from Analysis of Cash Flows

 Enables us to appraise quality of management decisions over time & it’s impact on Company’s
operating result & financial position.
 When analysis covers long time period, it can yield insight into management success in responding
to changing business conditions & ability to seize opportunities & overcome adversities.
 From the analysis of cash we can infer where management committed its resources, where it
reduced investments, where additional cash was derived from and where claims against company
were reduced.
 Analysis of Cash Flows
Company and Economic Conditions
 While both successful and unsuccessful companies can experience problems with cash flows from
operations, the reasons are markedly different.
 Successful company confronting increase investment in receivables & inventories to meet expanding
customer demand often finds growing profitability useful in obtaining additional financing from debt
& equity suppliers.
 Profitablity (positive accrual income) yield positive cash flows.
 Unsuccessful company experiences cash shortages from slowdown in receivable & inventory
turnovers, losses in operations or combination of these and other factors.
 Unsuccessful company can increase cash flows by reducing receivables & inventories, but is done at
the expense of services to customer, further depressing profits.
 These factors are signs of current & future crises & cash shortages and declining trade credit.
 Analysis of Cash Flows
Company and Economic Conditions
 Even if unsuccessful company borrows money, costs & result of borrowings only magnify the ultimate
loss. Thus, profitability is the key variable, without it, doomed to fail.
 We must interpret changes in operating working capital items in light of economic circumstances.
Increase in receivables can imply expanding consumer demand or can signal inability to collect amount
due in timely manner.
 Similar an increase in inventories, imply anticipation of increase production in response to consumer
demand or it can imply inability to accurately anticipate demand or sell products (especially if finished
goods inventory increased)
 Inflationary conditions add to financial burdens of companies and challenges for analysis.
 Analysis of Cash Flows
Free Cash Flow
Free cash flow (FCF) is a measure of how much cash a business generates after accounting for
capital expenditures such as buildings or equipment. Cash can be used for expansion, dividends,
reducing debt, or other purposes.

Defines FCF to firm as NOPAT less

Another definition that is widely used: increase in net operating assets (NOA).
Increase in NOA subsumes the change in
FCF = NOPAT - Change in NOA
working capital for net cash flows from
(net operating profits after tax (NOPAT) less the operations & increase in long-term
increase in net operating assets (NOA)) operating assets
 Analysis of Cash Flows
Free Cash Flow
 Positive Free cash flow (FCF) reflects amount available for business activities after allowances for
financing and investing requirement to maintain productive capacity at current levels.
 Growth and financial flexibility depend on adequate free cash flow.
 We must recognize that the amount of capital expenditures needed to maintain productive capacity is
generally not disclosed — instead, most use total capital expenditures, which is disclosed, but can
include outlays for expansion of productive capacity.
 Statement of cash flow does not separate capital expenditures into maintenance and expansion
components.

Cash Flow as Validators

 SCF is useful for prediction of operating results on the basis of acquired and planned productive capacity.
 Useful for assessing company’s future expansion capacity, its capital requirements, sources of cash inflows.
 The SCF is an essential bridge between income statement and SOFP. It reports company’s cash inflows & outflows
and ability to meet current obligations.
 Analysis of Cash Flows
Cash Flow as Validators

SCF provides us with important clues on:

Feasibility of financing capital expenditures.
Cash sources in financing expansion.
Dependence on external financing. (liability v Equity)
Future dividend policies.
Ability in meeting debt service requirements.
Financial flexibility to unanticipated needs/opportunities.
Financial practices of management.
Quality of earnings.
 Specialized Cash Flows
Cash Flow Adequacy Ratio – Measure a company’s ability to generate sufficient cash from
operations to cover capital expenditures, investments in inventories, and cash dividends:

Three-year sum of cash from operations

Three-year sum of capital expenditures, inventory additions, and cash dividends

Investment in other important working capital items such as accounts receivables is omitted
as they are financed by short term credit (such as growth in accounts payable. Only additions
to inventory are included.

Cash Reinvestment Ratio – Measure of percentage of investment in assets representing

operating cash retained and reinvested in the company for both replacing assets and growth in
operations:

Operating cash flow – Dividends

Gross plant + Investment + Other assets + Working capital
Specialized Cash Flow Ratio
Extract of Cash Flow Statement
 Specialized Cash Flow Ratio
Extract of Balance Sheet
Plant Assets Year 11 Current Assets Year 11
Land 56.3 Cash & cash equivalent 178.9
Building 758.7 Other temporary investment 12.8
Machinery & Equipment 1,779.3 Accounts receivable 527.4
Projects in progress 327.6 Inventories 706.7
Total 2,921.9 Prepaid Expense 92.7
Total Current Assets 1,518.5
Intangible Assets Year 11
Current liabilities Year 11
Good will 347.8
Notes payable 282.2
Other intangibles 129.9
Payable to suppliers 482.4
Total 477.6
Accrued liabilities 408.7
Other Assets Year 11 Dividend payable 37
Investment in affiliates 155.8 Accrued income tax 67.7
Non current prepaid pension expense 152.7 Total current liabilities 1,278
Other noncurrent investment 96.1
Total 404.6
 Specialized Cash Flows
Cash Flow Adequacy Ratio – Measure a company’s ability to generate sufficient cash from operations to
cover capital expenditures, investments in inventories, and cash dividends:
1,610.90
1,390.3 + 113.2 + 348.5
= 0.87
Cash Reinvestment Ratio (Year 11) – Measure of percentage of investment in assets representing
operating cash retained and reinvested in the company for both replacing assets and growth in operations:
805.2 – 137.5
(2,921.9 + 477.6) + 404.6 + (1,518.5 – 1,278)
= 16.5%
Cash Flow Adequacy Ratio – ratio of 1 indicates company exactly covered these cash needs without a need for
external financing. Ratio below 1 suggests internal cash source were insufficient to maintain dividends & current
operating growth level
Cash Reinvestment ratio – a ratio of 7% - 11% is generally satisfactory
 BOOK VALUE PER SHARE
Computation of Book Value per Share
• Book value per share is the per share amount resulting from a company’s liquidation at
amounts reported on its balance sheet.

• Book value is referring to net asset value: That is total assets reduced by claims against
them.

• The book value of common stock is equal to the total assets less liabilities and claims of
securities senior to common stock (such as preferred stock) at amounts reported on the
balance sheet (but can also include un-booked claims of senior securities).

• A simple means of computing book value is to add up common stock equity accounts and
reduce this total by any senior claims not reflected in the balance sheet (including preferred
stock dividend arrearages, liquidation premiums, or other asset preferences to which the
preferred shares are entitled)
 BOOK VALUE PER SHARE
Example
Durantte Sdn Bhd
Stockholders’ Equity
January 2, 2020
Paid in capital: RM
Preferred stock, 6%, RM 50 par, 2,000 shares authorized
2,000 shares issued 100,000
Paid in capital in excess of par - preferred 5,000
Common stock,RM1 par, 20,000,000 shares authorized,
2,000,000 shares issued 2,000,000
Paid in capital in excess of par-common 19,00,000
Total paid in capital 21,105,000
Retained earnings 9,000,000
Total stockholders’ equity 30,105,000
 BOOK VALUE PER SHARE
Computation of Book Value per Share
• Durante Sdn Bhd stockholders’ equity is as the table above. Assume preferred dividends are in arrears
for one year

Book Value (BV) attributed to Preferred Stock (P/S): RM

1. Preferred Stock balance 100,000
2. Dividends in arrears on outstanding preferred stock (2,000 x RM50 par x 6% x 1 year) 6,000
3. Outstanding preferred shares 106,000
4. Outstanding preferred shares 2,000
Book value per share on preferred stock : RM 106,000/2000 53.00

Book Value (BV) attributed to Common Stock (C/S):

Total stockholders equity 30,105,000
Book value attributed to preference share (106,000)
Outstanding common shares 29,999,000
Book value per share on common stock : RM 29,999,000 / 2,000,000 15.00
 BOOK VALUE PER SHARE
Relevance of Book Value per Share
• Book value plays an important role in analysis of financial statement. Application includes:

1. Book value, with potential adjustments is frequently used in assessing merger terms.
2. Analysis of companies composed of mainly liquid assets (finance, Investment, insurance,
and banking institutions) relies extensively on book value.
3. Analysis of high-grade bonds and preferred stocks attaches considerable importance to
asset coverage.

• These applications must recognize the accounting considerations entering into the
computation of book value per share as follows:

1. Carrying values of assets particularly long-lived assets like property, plant and
equipment are usually recorded at cost and markedly different from book value.

2. Internally generated intangible assets are often not reflected in book value, nor are
contingent assets with a reasonable probability of occurrence.
 END

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