This is the fourth week of our Level I CFA Program review of the financial statement material. We look at the Statement of Cash Flows this week, a statement that shows the inflows and outflows of cash over the period. Actual cash flow is much harder to manipulate compared to the income statement so analysts use this statement heavily in their work. Make the Statement of Cash Flows your new best friend.
Check out the introduction to Level I CFA Program Financial Statements
Check out the Level I CFA Program Income Statement Review
Check out the Level I CFA Program Balance Sheet Review
Understanding the Statement of Cash Flows
Like the Income Statement, the Statement of Cash Flows shows activity over the period. Remember, this is different from the Balance Sheet which shows assets, liabilities and equity only at one point in time. To compare Cash Flow numbers with Balance Sheet data, you’ll need to take an average of the beginning and ending balance sheet number for an appropriate comparison.
Understand also that cash flow is not the same as net income. Income is an accounting idea based on revenue earned and matched expenses but may not mean the company is generating cash.
A company’s cash flows are separated into one of three sections; operating, investing and financing.
Cash Flow from Operations is the cash generated from normal day-to-day operations. Throughout the cash flow statement, it will be important to distinguish between inflows and outflows of cash. Cash inflows for operations include: collection on sales and accounts receivable, receipt of interest or dividends. Cash outflows for operations include: payments to suppliers and accounts payable, payments to employees, interest payments and payment of income taxes.
Cash Flow from Investing Activities is the purchase or sale of long-term assets, assets like PP&E or long-term investments that will help generate sales for years to come. Cash inflows for investing include sales of non-current assets. Cash outflows here include the purchase of non-current assets.
Cash Flow from Finance is the borrowing and repayment of debt, issuing stock or paying dividends. Cash inflows include issuing stock or bonds. Cash outflows include paying debt or dividends and buying back shares.
The Statement of Cash Flows is connected to the balance sheet through cash. The sum of the three cash sections on the statement, plus the beginning balance of cash from the balance sheet will equal the ending cash balance for the end of the period.
You are going to be spending a lot of your time working through cash flow statements as a new analyst. The Statement of Cash Flows can be constructed from information given on the other two financial statements. The best way to understand the statement, and a must-know topic for the CFA exams, is mastering the two methods for calculating and reporting the statement: the Direct and Indirect methods.
I’m not going to write out the methods here. It’s something you need to write out and study in detail and both methods are shown in the curriculum and in the Finquiz Notes. It can seem tedious to practice through the methods but you need to do it to learn how the statement is constructed through cash changes. Practice with real company financial statements to see if you come out with the same numbers.
Cash Flow Analysis
Performance ratios used with the Statement of Cash Flows include: cash flow to sales, cash return to assets or equity, and cash flow per share. These are all pretty easy to remember and not nearly as important as two other concepts in the reading.
Other than a basic understanding of the cash flow statement, the most important section in the reading is on Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). You will use these two concepts throughout the curriculum and absolutely must master them.
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
The calculation for FCFE is fairly easy but you need to make sure not to get the components confused with FCFF. FCFE is CFO minus investments in fixed capital plus net borrowing, or the cash flow available to common equity holders without placing a burden on operations.
FCFE can be more volatile than other cash flow measures because of the capital expenditures spending, so you might have to use a multi-year average if the test question mentions it. Though you will probably not be asked to do so on the test, some analysts adjust CFA for nonrecurring expenses before calculating FCFE. A big focus in the CFA curriculum is conservative practices, almost always favored when a choice is given. Adjusting items for non-recurring events and taking the average of volatile accounts over a period of time are more conservative and provide a more stable estimate.
Make sure you can go from FCFF to FCFE or can get there from multiple routes. Thinking through the various accounts and why they are included will help get these concepts down. PRACTICE, PRACTICE, PRACTICE.
FCFF = CFO + interest(1-tax rate) – Fixed Capital Investment
FCFF = EBITDA(1-tax rate)+depreciation expense(tax rate) + (increase in deferred tax) – (investments in fixed and working capital)
FCFE = FCFF – interest(1-tax rate) + net borrowing
Most CFA candidates haven’t had as much experience with the Statement of Cash Flows or haven’t taken time to really master the direct and indirect method so spend some time on the reading to really understand the statement.
‘til next time, happy studyin’
Joseph Hogue, CFA