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Cash Flow Analysis

CHAPTER

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc., All Rights

Statement of Cash Flows


Relevance of Cash Flows

Cash Defined -- refers to cash and cash


equivalents.
Cash equivalents are short-term, highly liquid
investments that are (1) readily convertible to
known amounts of cash, and (2) near maturity
(typically within 3 months) with limited risk of price
changes due to interest rate shifts.

Statement of Cash Flows


Relevance of Cash Flows
Cash is the beginning and the end of a companys operating cycle.
Net cash flow is the end measure of
profitability.
Cash repays loans, replaces equipment,
expands facilities, and pays dividends.
Analyzing cash inflows and outflows helps assess liquidity,
solvency, and financial flexibility.
Liquidity is the nearness to cash of assets and liabilities.
Solvency is the ability to pay liabilities when they mature.
Financial flexibility is the ability to react to opportunities and
adversities.

Statement of Cash Flows


Relevance 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?
What is the source of cash for redeeming preferred stock?
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 from new financing?

Statement of Cash Flows


Cash Flow Relations
Illustration: Consider two consecutive years balance sheets divided into
(1) cash, and (2) all other balance sheet accounts:
Accounts

Year 1 Year 2

Cash and cash equivalents

$3,000

$5,000

Noncash accounts:
Noncash current assets
Noncurrent assets
Current liabilities
Long-term liabilities
Equity accounts
Net noncash balance

$(9,000)
(6,000)
8,000
3,000
7,000
$3,000

$(11,000)
(8,000)
10,000
5,000
9,000
$5,000

Note:
Change in cash from Year 1 to Year 2 (increase of $2,000) = Change in noncash
balance sheet accounts ($2,000 increase) from Year 1 to Year 2

Statement of Cash Flows


Cash Flow Relations
Interrelations between cash and noncash balance sheet
accounts can be generalized:
Net changes in cash are explained by net changes in
noncash balance sheet accounts.
Changes within or among noncash balance sheet
accounts do not affect cash. Yet, there is disclosure of all
significant financing and investing activities in
a separate schedule of noncash investing and financing
activities.
Changes within the components of cash
are not reported.

Statement of Cash Flows


Reporting by Activities
Statement of cash flows reports receipts and payments by
operating, financing, and investing activities
Operating activities are the earningrelated activities
of a company.
Investing activities are means of acquiring and
disposing of noncash assets.
Financing activities are means of contributing,
withdrawing, and servicing funds to support business
activities.

Statement of Cash Flows


Net Cash Flows from Operations

Indirect Method
-Net income is adjusted for non-cash income (expense) items
and accruals to yield cash flow from operations

Direct Method
-Each income item is adjusted for its related accruals
*Both methods yield identical results-only the presentation format
differs.

Statement of Cash Flows


Indirect Method

Net Cash Flows from Operations


Net Income
+ Depreciation
+/- Gains (losses) on sales of assets
+/- Cash generated (used) by current assets & liabilities
Net cash flows from operating activities

Statement of Cash Flows


Depreciation Add-Back
Add Back

Sales
- Expenses
- Depreciation and amortization expense
Net Income
+ Depreciation expense
+/- Gains (losses) on sales of assets
+/- Cash generated (used) by current assets
and liabilities
Net cash flows from operating activities

Statement of Cash Flows


Income vs. Cash Flows Example

Consider a $100 sale on account


(1) In period of sale, net income is increased by $100 but no
cash has been generated.
Net Income
100
Depreciation and amortization expense
0
Gains (losses) on sale of assets
0
Change in accounts receivable
(100)
Net Cash flow from operations
0

In period of collection no income is recorded.


Net Income
0
Depreciation and amortization expense
0
Gains (losses) on sale of assets
0
Change in accounts receivable
100
Net Cash flow from operations 100

Statement of Cash Flows


Constructing the Statement

Assets
Liabs/Equity

Increase
(Outflow)
Inflow

Decrease
Inflow
(Outflow)

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


(2) Adjust Net Income for non-cash expenses and gains
(3) Recognize cash inflows (outflows) from changes in current assets
and liabilities
(4) Sum to yield net cash flows from operations
(5) Changes in long-term assets yield net cash flows from investing
activities
(6) Changes in long-term liabilities and equity accounts yield net cash
flows from financing activities
(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

Statement of Cash Flows


Steps in Constructing the Statement

Note: assets costing $30,000 were purchased during Year 2 and were financed in whole by the manufacturer.

Statement of Cash Flows


Special Topics

Equity Method Investments Under equity method accounting,


investor records its proportionate share of investee company profits. The
position of reported earnings in excess of dividends received should be
eliminated as it is non-cash earnings.

Acquisitions of Companies with Stock Acquisitions made with


stock are non-cash. As a result, changes in balance sheet accounts reflecting
the acquired company will not equal cash inflows (outflows) reported in the
Statement of Cash Flows.

Postretirement Benefit Costs The excess of net postretirement


benefit expense over cash benefits paid must be added to net income in
computing net cash flows from operations

Securitization of Accounts Receivable Reductions in receivables


as a result of securitization increases net cash flows from operations.
Securitizations are a financing activity and should be interpreted as such.

Cash From Operations


Indirect Method for CFO
Deriving
DerivingOperating
OperatingCash
CashFlows
Flowsfrom
fromIncome
Incomefor
forGould.
Gould.
Item
Item
Net
Netincome,
income,accrual
accrualbasis
basis

Amount
Amount
(in
thousands)
(in thousands)
$$54
54

Add
Add(deduct)
(deduct)adjustment
adjustmenttotocash
cashbasis:
basis:
Depreciation
Depreciation
Gain
Gainon
onsale
saleofofassets
assets

35
35
(5)
(5)

Increase
Increaseininreceivables
receivables
Decrease
Decreaseinininventories
inventories

(9)
(9)
66

Decrease
Decreaseininprepaids
prepaids

33

Decrease
Decreaseininaccounts
accountspayable
payable

(5)
(5)

Increase
Increaseininaccrued
accruedexpenses
expenses

44
_____
_____

Cash
Cashflows
flowsfrom
fromoperations
operations(Exhibit
(Exhibit7.3)
7.3)

$113
$113

Explanation
Explanation
Starting
Startingpoint
pointofofconversion
conversion
Depreciation
Depreciationhas
hasno
nocash
cashoutflow.
outflow.
Remove
Removegain
gain(because
(becauseititisisonoperating)cash
onoperating)cash
inflow
inflowisiscash
cashfrom
frominvesting
investingactivities.
activities.
Cash
Cashflow
flowfrom
fromsales
salesisisless
lessthan
thanaccrual
accrualsales.
sales.
Cash
Cashoutflow
outflowfor
forinventory
inventoryexceeds
exceedsaccrual
accrual
inventory
cost
included
in
cost
inventory cost included in costofofsales.
sales.
Cash
Cashoutflow
outflowoccurred
occurredwhen
whenprepaids
prepaidswere
were
purchased-current
purchased-currentexpense
expenseisisnon-cash
non-cash
Cash
Cashoutflows
outflowsfor
forpurchases
purchases(included
(includedinincost
costofof
goods
goodssold)
sold)isisless
lessthan
thanaccrual
accrualpurchases
purchasescost.
cost.
Expense
Expensehas
hasbeen
beenrecognized
recognizedbut
butno
nocash
cashpaid
paid
yet.
yet.

Cash From Operations


Reporting Formats for CFO
Companies Reporting Cash Flows using Indirect or
Direct Formats
Direct Method
3%

Indirect Method
97%

Cash From Operations


Interpreting Accrual Income and Operating Cash Flow

Cash From Operations


Alternative Cash Flow Measure
Net
Net income
income plus
plus major
major noncash
noncash expenses
expenses
(typically
(typicallydepreciation
depreciationand
andamortization)
amortization)

Cash From Operations


Alternative Cash Flow Measure - Illustration
Assume
Assumetwo
twocompanies
companies(A
(Aand
andB)
B)each
eachinvest
invest$50,000
$50,000in
inmachinery
machineryyielding
yielding
$45,000
$45,000 per
per year
year cash
cash flows
flows before
before depreciation.
depreciation. Assuming
Assuming aa five
fiveyear
year
useful
usefullife
lifeand
andno
nosalvage
salvagevalue
valuefor
forthe
themachinery,
machinery,results
resultsfor
forthe
theentire
entirefivefiveyear
yearperiod
periodare:
are:

Cash
Cashprovided
providedby
byoperations
operations($45,000
($45,000xx55years)
years)
Cost
of
the
machine
Cost of the machine
Income
Incomefrom
fromoperating
operatingmachine
machine
Average
Averageyearly
yearlynet
netincome
income

Five-Year
Five-YearPeriod
Period
$225,000
$225,000
$$(50,000)
(50,000)
$175,000
$175,000
$$ 35,000
35,000

Cash From Operations


Alternative Cash Flow Measure - Illustration

Year
Year
11
22
33
44
55
Total
Total

Income
Income
before
before
Depreciation
Depreciation
$$ 45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
$225,000
$225,000

Company
CompanyA:
A:
Straight-Line
Straight-Line
Depreciation
Depreciation

Depreciation
Depreciation
$10,000
$10,000
10,000
10,000
10,000
10,000
10,000
10,000
10,000
10,000
$50,000
$50,000

Net
NetIncome
Income
$$ 35,000
35,000
35,000
35,000
35,000
35,000
35,000
35,000
35,000
35,000
$175,000
$175,000

Company
CompanyB:
B:
Sum-of-the-YearsSum-of-the-YearsDigits
DigitsDepreciation
Depreciation

Depreciation
DepreciationNet
NetIncome
Income
$16,667
$$ 28,333
$16,667
28,333
13,334
31,666
13,334
31,666
10,000
35,000
10,000
35,000
6,667
38,333
6,667
38,333
3,332
41,668
3,332
41,668
$50,000
$175,000
$50,000
$175,000

Income
Incomebefore
beforedepreciation
depreciationfor
forthese
thesetwo
twocompanies
companiesisisidentical--this
identical--thisfaithfully
faithfullyreveals
revealsidentical
identical
earning
power.
earning power.
Income
Incomeafter
afterdepreciation
depreciationisisconsiderably
considerablydifferent
differentacross
acrossthe
theyearsthis
yearsthisdoes
doesnot
notreflect
reflect
changes
in
earning
power.
changes in earning power.

Cash From Operations


Business Conditions and Cash Flows
While
While both
both successful
successful and
and unsuccessful
unsuccessful companies
companies can
can
experience
experience problems
problems with
with cash
cash flows
flows from
from operations,
operations,
the
thereasons
reasonsare
aremarkedly
markedlydifferent.
different.
We
We must
must interpret
interpret changes
changes in
in operating
operating working
working capital
capital
items
itemsin
in light
lightof
of economic
economiccircumstances.
circumstances.
Inflationary
Inflationaryconditions
conditionsadd
addto
tothe
the
financial
financial burdens
burdensof
of companies
companies
and
andchallenges
challengesfor
foranalysis.
analysis.

Cash From Operations


Free Cash Flow
Cash
Cashflows
flowsfrom
fromoperations
operations
Deduct:
Deduct: Net
Net capital
capital expenditures
expenditures required
required to
to
maintain
maintainproductive
productive capacity
capacity
_______________________________
_______________________________
Equals
Equals Free
Freecash
cash flow
flow (FCF)
(FCF)

Cash From Operations


Free Cash Flow
Positive
Positive free
free cash
cash flow
flow reflects
reflects the
the amount
amount available
available for
for
business
business activities
activities after
after allowances
allowances for
for financing
financing and
and
investing
investing requirements
requirements to
to maintain
maintain productive
productive capacity
capacity at
at
current
currentlevels.
levels.
Growth
Growth and
and financial
financial flexibility
flexibility depend
depend on
on adequate
adequate free
free cash
cash
flow.
flow.
Recognize
Recognizethat
thatthe
theamount
amountof
ofcapital
capitalexpenditures
expenditures
needed
neededto
tomaintain
maintainproductive
productivecapacity
capacityis
isgenerally
generally
not
notdisclosedinstead,
disclosedinstead,most
mostuse
usetotal
totalcapital
capital
expenditures,
expenditures,which
whichis
isdisclosed,
disclosed,but
butcan
caninclude
include
outlays
outlaysfor
forexpansion
expansionof
ofproductive
productivecapacity.
capacity.

Cash From Operations


Cash Flow as Validators

The
The statement
statement of
of cash
cash flows
flows is
is
useful
useful in
in identifying
identifying misleading
misleading
or
or erroneous
erroneous operating
operating results
results
or
or expectations.
expectations.

Cash From Operations


Specialized Cash Flow Ratios
Cash
Cash Flow
Flow Adequacy
Adequacy Ratio
Ratio Measure
Measure of
of aa companys
companys ability
ability to
to
generate
generate sufficient
sufficient cash
cash from
from operations
operations to
to cover
cover capital
capital expenditures,
expenditures,
investments
in
inventories,
and
cash
dividends:
investments in inventories, and cash dividends:
Three-year
Three-yearsum
sumof
ofcash
cashfrom
fromoperations
operations
Three-year
Three-yearsum
sumof
ofexpenditures,
expenditures,inventory
inventoryadditions,
additions,and
andcash
cashdividends
dividends