Chapter 7

CASH FLOW
ANALYSIS
Materi
Kuliah ke 7
 Analyzing Cash Flows
 Cash is the residual balance from cash inflows less
cash outflows for all prior periods of a company.
 Net cash flows, or simply cash flows, refers to the
current period’s cash inflows less cash outflows.
 The statement of cash flows reports cash flow
measures for three primary business activities:
operating, investing, and financing.
 Analyzing Cash Flows

Statement of Cash from Cash Flow

Cash Flows Operations Analysis

 Reporting
 Relevance  Indirect limitations.
 Cash flows and
of cash. method. accruals.
 Reporting  Direct  Alternative
by activities. method. measure.
 Constructing  Converting  Business
conditions.
the indirect to  Free cash flow.
statement direct.  Cash flows as
validators.
 Statement of Cash Flows

 The purpose of the statement of cash flows is to provide

information on cash inflows and outflows for a period.
 It also distinguishes among the sources and uses of cash
flows by separating them into operating, investing, and
financing activities.

Relevance of Cash
Cash is the most liquid of assets and offers a
company both liquidity and flexibility. It is
both the beginning and the end of a
company’s operating cycle.
Cash analysis helps in assessing 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 and
adjust to opportunities and adversities.
The statement cash flow is important to
analysis and provides information to help
users address questions such as these:
 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?.

Reporting by Activities
The statement of cash flows reports cash
receipts and cash payments by operating,
financing, and investing activities—the
primary business activities of a company.
 Operating activities are the earning-
related 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.

Constructing the Cash Flow

Statement.
There are two acceptable methods for
reporting cash flows from operations, the
indirect and direct methods.
While both methods yield identical bottom-
line results, their format differs.
 The indirect method, net income is
adjusted for noncash income (expense)
items and accruals to yield cash flows
from operations. An advantage of this
method is the disclosure of a reconciliation
of differences between net income and
operating cash flows.
 Direct method adjusts each income item
for its related accruals and, arguably,
provides a better format to assess the
amount of operating cash inflows
(outflows).
 Preparation of the Statement of Cash
Flows
The statement of cash flows is a blend of the
income statement and the balance sheet. Net
income is first adjusted for noncash income and
expense items to yield cash profits that are, then,
further adjusted for cash generated and used by
balance sheet transactions to yield cash flows from
operations, as well as investing and financing
activities.

Consider first the net cash from operations. Its computation is

as follows:
Net income
+ Depreciation and amortization expense
± Gains (losses) on sales of assets
± Cash generated (used) by current assets and liabilities
Net cash flows from operating activities
The depreciation (amortization) process, then, allocates that
cost over their useful lives to match the expense against the
revenues generated by those assets with the following
accounting entries:

Depreciation expense . . . . . . . . . . . . . . xxx

Accumulated depreciation . . . . . . . . . . . . . xxx
Amortization expense.. . . . . . . . . . . . . . xxx
Intangible asset . . . . . . . . . . . . . . . . . . . . . . Xxx

Because the statement of cash flows focuses on cash flows,

we need to eliminate these noncash expenses that are
recognized in the computation of net income, hence the add
back of depreciation and amortization expense.
Adding depreciation and amortization expense does not
increase operating cash flow, it merely zeros out the expense
subtracted in the computation of net income. This can easily
be seen by expanding net income as follows:

Sales
- Expenses other than depreciation and amortization
- Depreciation and amortization expense Net income.
Add
Back
+ Depreciation and amortization expense
± Gains (losses) on sales of assets
± Cash generated (used) by current assets and
liabilities

Net cash flows from operating activities

The adjustments for changes in balance sheet accounts can be
summarized as follows:

Account Increase Decrease

Assets. . . . . . . Cash Outflow Cash Inflow
Liabilities . . . . Cash Inflow Cash Outflow

We now apply these concepts in the preparation of the statement of

cash flows for Gould Corporation, whose balance sheet and income
statement are presented in Exhibits 7.1 and 7.2.

Selanjutnya lihat contoh di buku Exhibit 7.1 dan 7.2 di halaman

422.
 Analysis Implications of Cash
Flows

Cash flow information yields several implications for our

financial analysis

Limitations in Cash Flow Reporting

Following are some limitations of the 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, and interest and
dividends received as cash inflows from
investing activities.
 Income taxes are classified as operating
cash flows. This classification can distort
analysis of the three individual activities if
significant tax benefits or costs are
attributed to them in a disproportionate
manner.
 Removal of pretax (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 their
related taxes are not removed, but left in
total tax expense among operating
activities

Interpreting Cash Flows and Net Income

Our analysis of Gould Corporation focused on
the two primary financial statements directed
to operating activities: the statement of cash
flows and the income statement.
 To help us understand their combined
usefulness, we return to our analysis of Gould
Corporation as follow:

GOULD CORPORATION
Comparison of Accrual and Cash Reporting
Income Operating Statement Cash Flows
Account Amount Amount Account
Sales $660,000 $651,000 Cash collections from
Gain on sale of asset 5,000 customers
$665,000 $651,000 Total cash collections
Cost of goods sold (363,000) (362,000) Payments to suppliers
Operating expenses (183,000) Payments for
Depreciation and (176,000) expenses
amortization (35,000)
Net income $84,000 $ 113,000 Cash from operations
 Cash flows from operations is a broader
view of operating activities than is net
income.
 Cash flows from operations encompass all
earning-related activities of a company.
 This measure concerns not only revenues
and expenses but also the cash demands of
these activities.
 They include investing in customer
receivables and inventories, as well as the
financing provided by suppliers of goods
and services.
 Accounting accruals determining net
income rely on estimates, deferrals,
allocations, and valuations.
 Analysis of Cash Flows

Since conditions vary from company to company, it is

difficult to formulate a standard analysis of cash flows.

In evaluating sources and uses of cash,

the analyst should focus on questions
like these:
 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?.

Case Analysis of Cash Flows of

Campbell Soup
We use Campbell Soup Company in the
Comprehensive Case following Chapter 11.
Our analysis of these statements reveals
several insights.
Selanjutnya lihat contoh di text book halaman
430.

Alternative Cash Flow Measures

Users sometimes compute net income plus
depreciation and amortization as a crude
proxy for operating cash flow. One variant of
this measure is the popular EBITDA (earnings
before interest, taxes, depreciation, and
amortization).
Free Cash Flow
A useful analytical derivative of the statement
of cash flows is the computation of free cash
flow.

Cash flows from operations:

- Net capital expenditures required to maintain
productive capacity
- Dividends on preferred stock and common stock
(assuming a payout policy)

Free cash flow (FCF)

Another definition that is widely used and
similar in concept is:
FCF = NOPAT - Change in NOA.
 This definition defines free cash flows to
the firm as net operating profits after tax
(NOPAT) less the increase in net operating
assets (NOA).
 The increase in NOA subsumes the change
in working capital for net cash flows from
operations and the increase in long-term
operating assets (similar to the second line
in the formula presented above).
 SPECIALIZED CASH FLOW RATIOS
The following two ratios are often useful in analyzing a firm’s
flow of funds:

 Cash Flow Adequacy Ratio

 The cash reinvestment ratio is a measure of the percentage of
investment in assets representing operating cash retained and
reinvested in the company for both replacing assets and growth
in operations.
 This ratio is computed as:

Three-year sum of Cash from Operations

Three-year sum of Capital Expenditures, Inventory Additions,

and Cash Dividends
 A ratio of 1 indicates the company exactly covered
these cash needs without a need for external financing.

 Cash Reinvestment Ratio

 The cash reinvestment ratio is a measure of the
percentage of investment in assets representing operating
cash retained and reinvested in the company for both
replacing assets and growth in operations.
 This ratio is computed as:
Operating Cash Flow – Dividends

Gross Plant + Investment + Other Assets + Working Capital

A reinvestment ratio in the area of 7% to 11% is

generally considered satisfactory.