FINANCIAL STATEMENT ANALYSIS

1. 1 FINANCIAL STATEMENT ANALYSIS Lecture 4

2. 2 The Statement of Cash Flows Provides information about cash inflows and outflows during an accounting period. Shows how cash makes its way from the Income Statement to the Balance Sheet.

3. 3 The Statement of Cash Flows Con’t. Required by SFAS #95 - Statement of Cash Flows Replaced the Statement of Changes in Financial Position in 1988 Is created from existing Balance Sheet and Income Statement data

4. 4  The Statement of Cash Flows Con’t. “A positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash. The best source in financial statement data for learning about the generation of cash from operations is the statement of cash flows”

5. 5 Income Flows vs. Cash Flows Cash flows do not equal income flows Why not? Accrual accounting used for net income (i.e. revenue reported but no cash received) Noncash expenses (i.e. depreciation)

6. 6 Cash Flows from Operations Indirect method 2 types of adjustments: Non-“working capital” accounts (Type 1) Adjustments for changes in working capital accounts (Type 2) What is working capital? Current assets minus current liabilities

7. 7 Cash Flows from Operations Non-“working capital” accounts depreciation deferred income taxes stock option expense gain/loss on disposition of PP&E Important – Here, the flow is already reported on the income statement so balance sheet comparisons are not applicable. Working capital accounts accounts receivable, inventories, etc. accounts payable, current liabilities, etc.

8. 8 Net Income relative toCash Flows from Operations Type 1 adjustments usually increase cash flows over net income Type 2 adjustments’ effects depend on: Firm’s stage in life cycle Length of firm’s operating cycle

9. 9 Product Life Cycle Introduction/Early Growth: Revenues are low Net income may be negative (losses) Negative CF from operating activities Negative CF from investing activities External financing (Positive CF from financing)

10. 10 Product Life Cycle Growth: 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 Changes in non-current accounts will be changes from investing activities.Changes in non-current accounts will be changes from investing activities.

11. 11 Product Life Cycle Maturity: Peak revenues Net income also peaks 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.)

12. 12 Product Life Cycle Decline: 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

13. 13  The Statement of Cash Flows Con’t. It also helps identify cash needs to fund growing revenue and related growing accounts receivable concerns. Many companies get in trouble during rapid growth phases when they find they can’t pay their operational bills because cash is coming in too slowly.

14. 14 Objectives of the Lecture To explain how the statement of cash flows is prepared To interpret the information presented in the statement

15. 15 Preparing a Statement of Cash Flows Begins with a return to the balance sheet Prepared by calculating changes in all of the balance sheet accounts

16. 16 Preparing a Statement of Cash Flows - Continued The easiest way to understand how to prepare a Statement of Cash Flows is to assume that the change in each item is directly related to cash and nothing else. For instance: Balance Sheet item 2002 2003 Inventory $1 mil. $2 mil. ? Cash $6 mil. $5 mil. ? $1 million in cash was used to increase inventory = Cash Outflow.

17. 17 Preparing a Statement of Cash Flows - Continued Balance Sheet item 2002 2003 Inventory $2 mil. $1 mil. ? Cash $6 mil. $7 mil. ? $1 million in cash was generated from inventory sales = Cash Inflow.

18. 18 Preparing a Statement of Cash Flows - Continued Balance Sheet item 2002 2003 Accounts Payable $3 mil. $1 mil. ? Cash $6 mil. $4 mil. ? $2 million in cash was used to pay a bill = Cash Outflow

19. 19 Preparing a Statement of Cash Flows - Continued Summary 2002 2003 Cash Flow Inventory 1 $1mil. $2 mil. $(1 mil.) Inventory 2 $2mil. $1 mil. $ 1 mil. Accounts Payable 1 $3mil. $1 mil. $ (2 mil.) Cash Flow from Ops. $ (2 mil.) Very, very simple Cash Flow statement!

20. 20 Preparing a Statement of Cash Flows Continued Cash Operating activities Investing activities Financing activities

21. 21 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

22. 22 Preparing a Statement of Cash Flows Notable Exceptions: Marketable securities—these are considered to be Investing Activities, regardless of short-term nature Notes payable—if payable to banks, are considered financing activities, even if very short-term Current portion of long-term debt—financing

23. 23 Preparing a Statement of Cash Flows Continued Cash & Cash equivalents:

24. 24 Preparing a Statement of Cash Flows Continued Short-term investments:

25. 25 Preparing a Statement of Cash Flows Continued Delivering or producing goods for sale and providing services The cash effects of transactions and other events that enter into the determination of income

26. 26 Preparing a Statement of Cash Flows Continued Cash flows resulting from sales of goods Purchase of inventories, Payment of operating expenses

27. 27 Preparing a Statement of Cash Flows Continued Acquiring/disposing of securities that are not cash equivalents Acquiring/disposing of productive assets Lending money/collecting on loans

28. 28 Preparing a Statement of Cash Flows Continued Borrowing from creditors/repaying the principal Obtaining resources from owners Providing owners with a return on investment

29. 29 Preparing a Statement of Cash Flows Continued

30. 30 *Data from SEC website, www.sec.gov

31. 31 Preparing a Statement of Cash Flows Continued Look at changes in balance sheet accounts from beginning to end of accounting period

32. 32 Preparing a Statement of Cash Flows Continued Transfer the account changes to the appropriate area of a statement of cash flows

33. 33 Preparing a Statement of Cash Flows Continued

34. 34 Calculating Cash Flow from Operating Activities Direct Method Indirect Method

35. 35 Direct vs. Indirect Method Direct Method – Start with Revenue and works down to actual cash flow Indirect Method – Start with Income and works back to cash flow Very Very important Note - Remember, it is a statement of Cash “FLOWS”. The entry for balance sheet items is based on the change between periods, the equivalent of a “flow”. The entry for Operating/Income/Earnings statement items is the actual number (these numbers already are a “Flow”).

36. 36 Calculating Cash Flow from Operating Activities Continued Shows cash collections from customers, interest and dividends collected, other operating cash receipts, cash paid to suppliers and employees, interest paid, taxes paid and other operating cash payments

37. 37 Calculating Cash Flow from Operating Activities Continued Starts with net income and adjusts for deferrals; accruals; noncash items, such as depreciation and amortization; and nonoperating items, such as gains and losses on asset sales

38. 38 Calculating Cash Flow from Operating Activities Continued 593 firms out of 600 (99%) used the indirect method in 2003 according to Accounting Trends and Techniques

39. 39 Calculating Cash Flow from Operating Activities Continued

40. 40 Calculating Cash Flow from Operating Activities Continued

41. 41 Calculating Cash Flow from Operating Activities Continued

42. 42 Calculating Cash Flow from Operating Activities Continued

43. 43 Analyzing the Statement of Cash Flows Is an important analytical tool for creditors, investors and other users of financial statement data

44. 44 Analyzing the Statement of Cash Flows Con’t. Firm’s ability to generate cash flows in the future Firm’s capacity to meet cash obligations Firm’s future external financing needs

45. 45 Analyzing the Statement of Cash Flows Con’t. Firm’s success in productively managing investing activities Firm’s effectiveness in implementing financing and investing strategies

46. 46 Cash Flow from Operations Pay dividends or invest in new equipment Service debt

47. 47 Cash Flow from Operations Continued It is also possible for a firm to be profitable and go bankrupt

48. 48 Cash Flow from Operations Continued How? The problem is cash

49. 49 Cash Flow from Operations Continued The ongoing operation of any business depends upon its success in generating cash from operations

50. 50 Statement of Cash Flows Cash flow from operating activities Cash inflows Cash outflows

51. 51  Statement of Cash Flows Continued The success or failure of the firm in generating cash from operations The underlying causes of the positive or negative operating cash flow

52. 52  Statement of Cash Flows Continued The magnitude of positive or negative operating cash flow Fluctuations in cash flow from operations over time

53. 53 Summary Analysis of the Statement of Cash Flows Provides an approach to analyzing a statement of cash flows that can be used for any firm that provides comparative cash flow data

54. 54 Analysis of the Statement of Cash Flows (cont.)

55. 55 Summary Analysis of the Statement of Cash Flows Con’t. The information underlines the importance of internal cash generation—from operations—and the implications for investing and financing activities when this does and does not occur

56. 56 Analysis of Cash Inflows Capital expenditures and expansion Repayments of debt Payments of dividends

57. 57  Analysis of Cash Inflows Con’t. When analyzing the cash outflows, the analyst should consider the necessity of the outflow and how the outflow was financed

58. 58  Summary Cash Flow Table.