Mastering the Cash Flow Statement & Free Cash Flow

(1)

Financial Reporting and Analysis

Mastering the

Cash Flow Statement & Free

Cash Flow

CFA

®

_{Levels I & II}

[email protected]

Importance of Cash Flow Statement

Net income from accrual accounting does not tell us

about the sources and uses of cash to meet liabilities

and operating needs

The statement of cash flows has three components

under both IFRS and US GAAP:

Cash provided or used by

operating

activities

Cash provided or used by

investing

activities

Cash provided or used in

financing

activities

LOS 27.a Compare/Classify: CFAI pg 253

Schweser pg 109

Understanding the Cash Flow Statement

(2)

U.S. GAAP vs. IFRS

Interest received

Interest paid

Dividends received

Dividends paid

Taxes paid

Bank overdraft

CFO

CFF

CFO

CFF

CFO or CFI

CFO or CFF

CFO or CFI

CFO or CFF

CFO or CFI & CFF

*

U.S. GAAP

(SFAS 95)

IAS GAAP

(IAS 7)

* Considered part of cash and cash equivalents

LOS 27.c Contrast: CFAI pg 255 Schweser pg 111

Statement of Cash Flow:

Direct vs. Indirect Method

Direct vs. indirect method refers only to the

calculation of CFO, the value of CFO is the same

for both methods; CFI and CFF are unaffected

Direct method

: Identify actual cash inflows and

outflows; e.g., collections from customers, amount

paid to suppliers

Indirect method

: Begin with net income and make

necessary adjustments to get operating cash flow

LOS 27.d Distinguish/Describe:

CFAI pg 256 Schweser pg 112

(3)

Linkages Between Statements

Accounts Receivable ‘T’ Account

Amount B/Fwd

Sales

Amount C/Fwd

18,000

20,000

200,000

218,000

Cash collections

198,000

This year’s balance sheet Last year’s balance sheet This year’s income statement

LOS 27.e Describe: CFAI pg 266 Schweser pg 114

- 5

Cash Inflows and Outflows

General rules regarding increases and

decreases in balance sheet items over time:

Increase Decrease

Assets

outflow

inflow

Liabilities & Equity inflow

outflow

e.g.: An increase in AR or inventory uses cash

An increase in payables generates cash

Adjust net income for these changes

(indirect)

Understanding Cash Flow Statements LOS 27.f Describe: CFAI pg 267

(4)

Ecclestone Industries—Example

Ecclestone Industries has the following income

statement for 20X9 and balance sheets for 20X8 and

20X9. You are to construct the statement of cash flows

using the indirect method.

Additional information:

Equipment was purchased for $50,000

Ecclestone has a tax rate of 40%

LOS 27.f Describe: CFAI pg 267 Schweser pg 115

Income Statement for Year to 31 December 20X9

Sales revenue

Expenses:

Cost of goods sold

Salaries

Depreciation

Interest

Gain from sale of PPE

Pre-tax income

Provision for taxes

Net income

$

200,000

105,000

95,000

20,000

115,000

40,000

75,000

$

80,000

10,000

14,000

1,000

(5)

Ecclestone Balance Sheet Data

Balance Sheets

Current assets

Cash

Accounts receivable

Inventory

Non-current assets

Gross PPE

Accum. Depr.

Total Assets

20X8

$

18,000

14,000

282,000

252,000

20X9

$

66,000

20,000

10,000

312,000

324,000

(80,000)

(84,000)

Balance Sheets

Current liabilities

Accounts payable

Salaries payable

Interest payable

Taxes payable

Dividends payable

Noncurrent liabilities

Bonds

Deferred taxes

Stockholders’ equity

Common stock

Retained earnings

Total Liabilities & Equity

20X8

$

10,000

16,000

6,000

8,000

2,000

20,000

30,000

100,000

60,000

252,000

20X9

$

18,000

9,000

7,000

10,000

12,000

30,000

40,000

80,000

118,000

324,000

(6)

Direct Method CFO

1. Take each income statement item in turn

– e.g., sales

2. Move to the balance sheet and identify asset

and liability accounts that relate to that income

statement item—e.g., accounts receivable

3. Calculate the change in the balance sheet item

during the period (ending balance – opening

balance)

4. Apply the rule:

Increases in an asset: deduct

Increase in a liability: add

Decrease in an asset: add

Decrease in a liability: deduct

LOS 27.g Convert: CFAI pg 302 Schweser pg 120

Direct Method CFO

5. Adjust the income statement amount by the

change in the balance sheet

6. Tick off the items dealt with in both the income

statement and balance sheet

7. Move to the next item on the income statement

and repeat

8. Ignore depreciation/amortization and gains/losses

on the disposal of assets as these are

non-cash

or non-CFO items

(7)

9. Keep moving down the income statement

until all items included in net income have

been addressed applying steps 1-8

10. Total up the amounts and you have CFO

Direct Method CFO

Cash Inflows

Sales

Less: Increase in A/R

Cash collected from customers

Direct cash outflows

Cost of goods sold

Add: Decrease in inventory

Purchases

Add: Increase in A/P

Cash paid to suppliers

Operating expense (wages)

Less: Decrease in salaries payable

Cash paid to employees

200,000

(2,000)

(80,000)

4,000

(76,000)

8,000

198,000

(68,000)

(10,000)

(7,000)

(17,000)

Direct Method CFO

-8

(8)

(28,000)

(40,000)

10,000

2,000

(1,000)

1,000

Direct Method, cont.

Cash outflows

Interest Expense

Add: Increase in interest payable

Cash interest paid

Tax Expense

Add: Increase in deferred tax liab.

Tax payable

Add: Increase in taxes payable

Cash taxes paid

$

CFO

0 85,000

(30,000)

-7

Indirect Method CFO

CFO = NI + NCC - WC

_inv LOS 27.f Describe: CFAI pg 267

Schweser pg 115

+ Depreciation

+ Amortisation

+ Loss on asset disposal

- Gain on asset disposal

+ Loss on early debt retirement

- Gain on early debt retirement

+ Increase in DTL, decrease in DTA

- Decrease in DTL, increase in DTA

+ Non cash expenses (provisions)

∆Current assets

excluding cash and

investments

∆ Current liabilities

excluding debt

instruments and

dividends payable

= change in non-cash

(9)

Indirect Method CFO (Alternative)

75,000 + 4,000 + 6,000 = 85,000

+ Dep

n

- Disposal gain

+ ↑ DTL

NCC

Current assets

-Cash & Inv’

Current liabilities

-Debt & divs’

Working Capital

$

14,000

(20,000)

10,000

4,000

20x8

20x9

$

50,000 96,000

(18,000) (66,000)

32,000 30,000

42,000 56,000

(2,000) (12,000)

40,000 44,000

(8,000) (14,000)

∆

WC = (6,000)

CFO = NI + NCC - WC

_inv -6

Calculating CFI

CFI =

investment in assets – cash received on asset sales

Net book value =

Gross PPE – accumulated depreciation

Gain (loss) on sale = sales price – net book value

LOS 27.f Describe: CFAI pg 267

Schweser pg 115

(10)

Ecclestone CFI

Gross Plant and Equip.

Beginning PPE

Additions

PPE disposal

Ending PPE

282,000

50,000

(20,000)

312,000

Accumulated Depr.

Begin Acc. Depr.

Depr. Expense

AD for disposal

End Acc. Depr.

80,000

14,000

(10,000)

84,000

Calculating NBV of asset sold

NBV of disposal = 20,000 – 10,000 = 10,000

-5

CFI = cash additions – cash received on disposal

Sale Proceeds

NBV of disposal

Gain(loss) on sale

30,000

10,000

20,000

$

CFI = –additions + proceeds

CFI = –$50,000 + $30,000 = –$20,000

Ecclestone CFI

(11)

Computing CFF

Change in debt

Change in common stock

Cash dividends paid

Net income

Dividends declared

∆

in retained earnings

$

X

(X)

X

Dividends declared

∆Dividends payable

Cash paid

$

(X)

X

(X)

LOS 27.f Describe: CFAI pg 267

Schweser pg 115

Change in debt

Change in common stock

Cash dividends paid

Net income

Div declared

∆

in R/E

$

75,000

(17,000)

58,000

Dividends decl.

∆

Div. payable

Cash div. paid

$

(17,000)

10,000

(7,000)

Ecclestone CFF

$

10,000

(20,000)

(7,000)

(17,000)

-7

(12)

$

85,000

(20,000)

(17,000)

48,000

18,000

66,000

Putting the Cash Flow Statement

Together

Cash flow from operations

Cash flow from investments

Cash flow from financing

Net increase in cash

Cash balance 12/31/X8

Cash balance 12/31/X9

-6

Free Cash Flow (FCF)

FCF is cash available for discretionary uses

Frequently used to value firms

FCFF = NI + NCC - WCInv + Int (1-T) – FCInv

FCFF = CFO + Int (1-T) – FCInv

FCFE = CFO – FCInv + Net debt increase

LOS 27.i Calculate/Interpret: CFAI pg 287 Schweser pg 126

(13)

Free Cash Flow (FCF) Ecclestone

FCFF = CFO + Int (1 – T) – FCInv

$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000

FCFE = CFO – FCInv + Net debt increase

$75,000 = $85,000 – $20,000 + $10,000

FCFE = FCFF – Int (1 – T) + Net debt increase

$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000

-5

LOS 27.i Calculate/Interpret: CFAI pg 287 Schweser pg 126

Financial Reporting and Analysis

Solutions

(14)

Cash Inflows

Sales

Less: Increase in A/R

Cash collected from customers

Direct cash outflows

Cost of goods sold

Add: Decrease in inventory

Purchases

Add: Increase in A/P

Cash paid to suppliers

Operating expense (wages)

Less: Decrease in salaries payable

Cash paid to employees

200,000

(2,000)

(80,000)

4,000

(76,000)

8,000

198,000

(68,000)

(10,000)

(7,000)

(17,000)

Direct CFO

(28,000)

(40,000)

10,000

2,000

(1,000)

1,000

Direct CFO, cont.

Cash outflows

Interest Expense

Add: Increase in interest payable

Cash interest paid

Tax Expense

Add: Increase in deferred tax liab.

Tax payable

Add: Increase in taxes payable

Cash taxes paid

$

CFO

0 85,000

(30,000)

(15)

Indirect Method CFO

75,000 + 4,000 + 6,000 = 85,000

+ Dep

n

- Disposal gain

- ↑ DTL

NCC

Current assets

-Cash & Inv’

Current liabilities

-Debt & divs’

Working Capital

$

14,000

(20,000)

10,000

4,000

20x8

20x9

$

50,000 96,000

(18,000) (66,000)

32,000 30,000

42,000 56,000

(2,000) (12,000)

40,000 44,000

(8,000) (14,000)

∆

WC = (6,000)

CFO = NI + NCC - WC

_inv -6

Ecclestone CFI

Gross Plant and Equip.

Beginning PPE

Additions

PPE disposal

Ending PPE

282,000

50,000

(20,000)

312,000

Accumulated Depr.

Begin Acc. Depr.

Depr. Expense

AD for disposal

End Acc. Depr.

80,000

14,000

(10,000)

84,000

Calculating NBV of asset sold

(16)

CFI = cash additions – cash received on disposal

Sale Proceeds

NBV of disposal

Gain(loss) on sale

30,000

10,000

20,000

$

CFI = –additions + proceeds

CFI = –$50,000 + $30,000 = –$20,000

Ecclestone CFI

Change in debt

Change in common stock

Cash dividends paid

Net income

Div declared

∆

in R/E

$

75,000

(17,000)

58,000

Dividends decl.

∆

Div. payable

Cash div. paid

$

(17,000)

10,000

(7,000)

Ecclestone CFF

$

10,000

(20,000)

(7,000)

(17,000)

(17)

$

85,000

(20,000)

(17,000)

48,000

18,000

66,000

Putting the Cash Flow Statement

Together

Cash flow from operations

Cash flow from investments

Cash flow from financing

Net increase in cash

Cash balance 12/31/X8

Cash balance 12/31/X9

Free Cash Flow (FCF) Ecclestone

FCFF =

$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000

FCFE =

$75,000 = $85,000 – $20,000 + $10,000

FCFE =

$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000

CFO + Int (1 – T) – FCInv

CFO – FCInv + Net debt increase