Level I Review: Cash Flows and Financial Analysis

We covered the first half of study session eight last week with a review of the Balance Sheet and Income Statement. We wrap up our review this week with the Statement of Cash Flows and Financial Analysis Techniques.

Cash Flows are an Analyst’s Best Friend

The Statement of Cash Flows is where you will likely spend much of your time in your first years as an analyst. This reconciliation of cash in and out of a business over a period can be constructed completely from the other two statements. It is also less easily manipulated than the income statement and provides a powerful check against aggressive accounting assumptions on the income statement.
There are two methods of constructing the Statement of Cash Flows, direct and indirect. While it may be tempting to pick one method of cash flow statement construction, you absolutely must know both methods. There is no better practice to understand how the company operates, i.e. how the company uses assets, liabilities and income to generate cash for equity holders. Knowing the power of cash flows over reported income will make you a superb analyst.

Cash versus Accrual Accounting

While the other two statements follow an accrual method of matching expenses and revenues made during the period, the Statement of Cash Flows shows the cash receipts and payments during the period. It is a reconciling statement in the company’s cash and cash equivalents during the period. Because it shows actual inflows and outflows, it is much more difficult to manipulate by management and widely used by analysts.
The general structure for the statement is that,

  • Change in Cash = Cash from operations (CFO) + Cash from Investing (CFI) + Cash from Financing (CFF) + any effects of exchange rates

There is a lot of material here but the first thing you need to master is distinguishing between a cash outflow and a cash inflow. It is all about whether an account is a source of cash or a use of cash. Once you’ve got that understood, everything else is intuitive and more easily understood.
Assets are sources of cash, if you see a decrease in an asset (on the balance sheet) that means the company converted that asset to cash, i.e. cash inflow.
Liabilities are a use of cash, a decrease in a liability account means the company used cash to pay for that decrease, i.e. cash outflow.

Cash Flow from Operations

Besides cash from sales of goods or services, an important part of CFO is the adjustments from items on the balance sheet and income statement. These adjustments happen because of the accounting difference between accrual-based and cash accounting.

  • Depreciation for assets, expensed on the income statement as a use of a capital asset, is not a use of cash so must be added back to net income. This account is extremely important for a lot of capital-intensive sectors like energy and real estate. The company’s continual investment in new equipment or depreciable assets will be an important check against depreciation.
  • Change in operating assets and liabilities that have already been accounted for on the balance sheet but had not yet settled in cash, i.e. accounts receivable, inventories, accounts payable, etc. This is the company’s ‘working capital’ and is important in analyzing the true efficiency of operations. These are all short-term assets and liabilities used in the day-to-day operation of the enterprise.
  • One confusing aspect of the statement is remembering how dividends and interest are shown. Dividends received and interest received and paid are shown as cash flow from operations, while dividends paid are shown as financing.

Cash Flow from Investing

While operating assets and liabilities, or working capital, is shown as cash flow from operations, cash flows for the purchase or sale of long-term assets is shown as investing. This makes intuitive sense if you think of these assets as an investment in long-term production. Items include fixed assets, long-term investments and business acquisitions or divestitures.

Cash Flow from Financing

Financing includes borrowing or repaying debt principal but not interest which is taken as a cost of operations and shown under CFO. Similarly, since equity capital (common and preferred stock) is raised as a financing vehicle, issuing or repurchasing shares and paying dividends is shown as CFF.

Converting the Statement to Direct Method

Most firms use the indirect method to prepare cash flows so the most common need is to convert the statement to the direct method. Firms reporting under the direct method must also present a reconciliation to the indirect method ( U.S. GAAP). The direct method details the firm’s operating cash receipts and payments from customers, suppliers, employees, etc. while removing a lot of the effects of accrual accounting. CFI and CFF are the same for both methods.
You must be able to arrive at CFO using the direct method.
The general formula for the direct method is:
Net Cash from Operations =
Cash Collected from Customers
– Cash paid to suppliers
– Cash paid to employees
– Cash paid for operating expenses
– Cash paid for interest
+ Cash received from dividends and interest
Start with Revenues
+/- change in unearned revenue
+/- Change in Accounts Receivable
= Cash collected from customers
Cost of goods sold
+/- change in inventory
+/- change in accounts payable
= Cash paid to suppliers
Salaries and wages expense
+/- change in wages payable
= Cash paid to employees
Other operating expenses
+/- change in prepaid expenses
+/- change in accrued liabilities
= Cash paid for other operating expenses
Interest expense
+/- change in interest payable
= Cash paid for interest
Dividend and interest income
+beginning interest receivable
– Ending interest receivable
= Cash received from dividends and interest

The Indirect Method

Since most statements use this method, you will not usually have to do the work but it is important to know how to put it together. The method starts with net income and adjusts for cash and non-cash items.
Net Income
+ Non-cash charges (depreciation, amortization, depletion expense)
+ increases in current operating liabilities
+ decreases in current operating assets
+ increases in deferred income tax liability
– increases in current operating assets
– decreases in current operating liabilities
– decreases in deferred tax liability
+ any losses on investing or financing activities (loss on sale or write-downs, loss on debt retirement)
– any gains on investing or financing activities

= Net cash from operations

Free Cash Flow

Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exam, especially at level II. It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been accountable. Basically, it is the extra cash available to owners (of debt or equity) after the company’s future operations have been funded.
Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:
Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense
Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:
Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing

  • Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
  • Understand how to arrive at FCFE or FCFF with CFO
  • FCFF = CFO + INT (1-t) – invest fixed capital
  • FCFE= CFO – invest fixed capital +/- net borrowing

There are a few performance and coverage ratios you should remember as well. Most are relatively simple, just the CFO over an account from one of the other statements. Remember that any account from the balance sheet must be averaged between the beginning and ending value since the balance sheet is a point-in-time estimate rather than activity over the period.

GAAP and IFRS Differences

The difference in cash flow reporting for GAAP and IFRS are extremely testable so you must remember them for the exam. The material is relatively brief and lends itself easily to a flash card.
Interest paid – can be classified as operating or financing cash flows in IFRS but only as operating cash flows under GAAP.
Interest and dividends received – can be classified as operating or investing cash flows under IFRS but only as operating cash flows under GAAP.
Dividends paid – can be classified as operating or financing cash flows under IFRS but only as financing cash flows under GAAP.
Companies reporting under IFRS need to separate their income tax account if possible under operating, investing or financing while all income taxes are reported under operating cash flows in GAAP.
The direct method is preferred under both IFRS and GAAP but the indirect method may also be used. Under GAAP, a company must also provide a reconciliation to the indirect method if the direct method is used in the statements.

Financial Analysis Techniques

The introductory material on ratios, common-size techniques, regression analysis and the use of graphs is probably secondary to actually understanding the formulas that follow and what they mean. Understand the basic concept behind the broad range of techniques and any advantages/limitations to each.
There are an immense number of formulas shown, I counted more than 50 in the FinQuiz study notes including multiple ways to get at the same idea. The likelihood of seeing any individual formula on the exam is relatively small so I would spend more time on the bigger picture and the three financial statements. Make a flash card for each formula and run through them until you are familiar with the concept and inputs to each formula. Once you’ve got a particular formula, put the card in your secondary pile which you may only need to review every month or so. This should be enough to reproduce it on the exam if needed.
Study Session 9 digs deeper into the balance sheet with readings on inventories, income taxes, and non-current assets and liabilities.
‘til next time, happy studyin’
Joseph Hogue, CFA

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