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Understanding the Statement of Cash Flows

Understanding the Statement of Cash Flows. Chapter 4. Contents. Understand the cash flow statement and how it relates to other financial statements Direct and indirect methods of presenting operating cash flows Investing and financing activities Disclosure of noncash transactions

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Understanding the Statement of Cash Flows

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  1. Understanding the Statement of Cash Flows Chapter 4

  2. Contents • Understand the cash flow statement and how it relates to other financial statements • Direct and indirect methods of presenting operating cash flows • Investing and financing activities • Disclosure of noncash transactions • Free cash flow and analysis Ch 4

  3. Importance of cash flows • Accrual-based accounting requires reporting revenues when earned and expenses when incurred – not when cash is exchanged. • A company cannot pay employees, creditors and others with accrual-based net income. • Valuation models used in financial analysis are often based on projections of future cash flows. Ch 4

  4. Statement of Cash Flows • Summarizes all activity in the cash accounts of the firm via three categories: • Operating • Indirect format • Direct format • Investing • Financing Ch 4

  5. Ch 4

  6. NokiaCash flow summary (EURm) Ch 4

  7. Operating activities • Primarily captures • Income statement items • Short-term/operating assets • Short-term/operating liabilities • Methods of presentation • Indirect • Direct Ch 4

  8. Cash Flows from Operating ActivitiesIndirect method • Reconciles accrual-based net income with cash generated via operations • Begin with accrual-basis net income • Adjust accrual items to reflect cash basis • Noncash items (depreciation and amortization) • Changes in working capital (current assets, current liabilities) • Reclassify nonoperating items • Appear in other sections of the Statement • Gains/losses on sales of fixed assets or debt extinguishment Ch 4

  9. Adjustments on Net Income to Derive Operating Cash Flows Add back noncash expenses • Depreciation and amortization Add working capital decreases • Decreases in current assets • Increases in current liabilities Subtract working capital increases • Increases in current assets • Decreases in current liabilitie Adjust nonoperating items (e.g., gain from sale of fixed assets) • Accruals = Operating Income – Operating cash Flows Ch 4

  10. Ch 4

  11. Ch 4

  12. Cash Flows from Operating ActivitiesDirect method • Cash from customers • Cash to suppliers • Cash for wages • Cash for SGA • Cash for interest… Ch 4

  13. Calculating Cash from customers + Beginning balance in Accounts Receivable + Revenues • Ending Accounts Receivable = Cash received from customers Beginning A/R + Sales – Payments received = Ending A/R Ch 4

  14. Calculating Cash paid to suppliers + Cost of (sales) revenue +/- Increase (decrease) in inventory -/+ Increase (decrease) in accounts payable = Cash paid to suppliers The cost of what was sold adjusted for changes in inventory and payments made. Ch 4

  15. Motorola’s Cash from Operating Activities in Direct Method Format Ch 4

  16. Nokia’s Cash from Operating Activities in Direct Method Format Ch 4

  17. Cash Flows from Investing Activities • Typically involves noncurrent capital (long-term) assets • Cash acquisitions of investments, property • Cash generated upon disposal of assets • Noncash acquisitions/disposals are reported as Supplemental Information rather than in the body of the Statement of Cash Flows Ch 4

  18. Ch 4

  19. Ch 4

  20. Cash Flows from Financing Activities • Long-term liabilities • Cash from borrowing • Cash used for repayment of principle • Under IAS cash interest payments may be here • Equity • Cash from stock issuance • Cash used to purchase treasury shares • Cash used for dividend payments Ch 4

  21. Ch 4

  22. Ch 4

  23. Statement of Cash FlowsAdditional Disclosures • Cash paid for interest • Cash paid for taxes • Presented at end of statement (GAAP) or in body of statement (IAS) • May also highlight significant noncash transactions Ch 4

  24. Ch 4

  25. Ch 4

  26. Cash analysis • Determine and examine all sources and uses of cash • Determine 2 definitions of free cash flows • To the Firm, available to both debt and equity holders • To Equity, available to equity holders only • Important for valuation (present value of expected future free cash flow) Ch 4

  27. Free Cash Flow to the Firm Operating cash flow Plus: Interest Paid Times (1-tax rate) Less: Investments in Fixed Capital Free Cash Flow to the Firm (to both debt holders and stock holders) Ch 4

  28. Free Cash Flow to Equity Operating cash flow Less: Investments in Fixed Capital Plus: New Debt Borrowing Less: Debt Repayment Free Cash Flow to Equity Ch 4

  29. Earnings before Interest, Taxes, Depreciation and Amortization EBITDA Net income (loss) Plus: Interest expense Plus: Tax expense Plus: Depreciation & Amortization expense Free Cash Flow Estimate (to firm) Ch 4

  30. Relevance of Cash Flows and Income over a Company’s Life Cycle Free cash flow + Operating cash flow Financing cash flow Income Inception Growth Maturity Decline Investing cash flow Ch 4

  31. Earnings and Cash Flow, which is more value relevant? • If you could trade stocks based on perfect foresight of next year’s --earnings --cash flow which will help you earn higher returns? • The power to predict future cash flows Ch 4

  32. Financial Accounting Relevance of Accounting Numbers Relation between Accounting Numbers and Stock Prices Ch 4

  33. Accruals--The Cornerstone Relation between Stock Prices and Various Income and Cash Flow Measures for a Large Sample of Companies NIBX = Net Income before Extraordinary Items and Discontinued Operations; NI = Net Income; OCF = Operating Cash Flow; FCF = Free Cash Flows; NCF = Net Cash Flow (Change in Cash). Ch 4

  34. Accruals--The Cornerstone Relation between Stock Returns and both Income and Operating Cash Flows for Different Horizons of a Large Sample of Companies . Ch 4 Source: Dechow, P

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