Transcript Business F768 - McMaster University

Com 4FK3
Financial Statement Analysis
Week 2, 2012
Cash Flow Analysis
Cash Flow Background
• Standard for the statement of cash flows
first set in 1987
• Funds flow statement required since 1960s
but not standardized
• Useful because net income and cash flows
are not always directly related
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Direct Method
• Starts with cash received
• Deducts cash paid out
• Unconnected to income statement
• Rarely seen in practice
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Indirect Method
• Starts with Net Income
• Adds back expenses that didn’t have a cash
component (depreciation, deferred taxes, etc.)
• Subtracts other cash outflows that did not
appear on the income statement
• Reverses gains and losses… cash effect of
such sales moved to investing cash flow
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Depreciation as a Source of Cash
• A frequent complaint with the indirect
method is that the classifications can be
confusing
• Reason for depreciation as a source of cash,
is that net income is the main source of cash
but depreciation was subtracted from net
income although no cash changed hands
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Capital Assets
• Purchases appear as an investing cash flow
instead of capitalization and depreciation
for balance sheet use
• Cash flows from disposals also show up in
the investing section
• Gain or loss on the sale is not important to
the actual amount of cash involved
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Equity Investing
• A company that owns 20% - 50% of
another company usually shows the results
using the equity method
– Enron; unincorporated partnerships
• Cash flow statement removes the effect of
the declared income
• Cash dividends in operating cashflows
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Add-backs and Subtractions
• Other non-current revenues and expenses
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minority interest in consolidated subsidiaries
deferred income taxes
amortization of intangibles
restructuring provisions
changes in accounting practices
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Working Capital from Operations
• A subtotal of net income and the additions
and subtractions for non-cash effects of
non-current assets and liabilities
• Not required under FASB
• Significantly higher for firms that are
capital intensive
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Changes in Working Capital
• WC = current assets - current liabilities
– Increases in current assets are deducted as a use
of cash, decreases increase cash
– Current liabilities are the reverse
• Main WC accounts other than cash
– Accounts receivable
– Inventory
– Accounts payable
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Working Capital
• Mature companies rarely see large changes
in working capital accounts
• As a new company grows; working capital
accounts usually grow as well
• Companies with longer business cycles will
have larger working capital accounts
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Correlation
• Studies show high correlation between net
income and working capital from operations
– main difference is depreciation and
amortization which don’t change often
• Studies show low correlation between net
income and cash from operations
– debate over relative value of using net income
of CFO for valuing firms
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Introduction Phase
• Characterised by;
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low revenue
negative net income and CFO
investing cash outflows required
main source of cash is financing
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Growth Phase
• Characterised by;
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increasing revenue
net income becomes positive
CFO positive later due to WC requirements
significant investing cash outflows required
main source of cash is financing
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Mature Phase
• Revenue and net income positive but
growth rate declines, eventually shrinking
• OCF exceeds financing as source of cash
• Financing cash flows decrease, eventually
negative as loans are paid off and dividends
are paid to shareholders
• Less investment needed, may become
negative as revenue declines
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Decline Phase
• Revenue shrinks to zero
• Net income declines, frequently becomes
negative
• CFO declining, approaching zero
• Investing becomes positive as unused assets
are sold off
• Financing cash flows negative
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Group Composition
• You should have your groups finalized
• Case presentations begin next week
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Preparation of Cash Flow Statement
• All publicly traded firms in Canada and
USA are required to publish a cash flow
statement on a regular basis
• Smaller, or private firms may not prepare a
statement of cash flows
• Analysis of balance sheet can allow an
analyst to make a cash flow statement, but
slightly lower quality due to lack of access
to the full accounting data
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Accounts Receivable
• Changes show up in operating cash flows
• If more credit was extended than collected
from the previous period, this is a use of
cash
• If accounts receivable declined, this is a
source of cash since more was collected
from customers than sales
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Marketable Securities
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GAAP places these in investing cash flows
Purchasing such securities is a cash outflow
Selling securities becomes an inflow
Gains and losses need to be removed from
operating cash flows
• Reason for changes not considered
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Inventories
• Changes in inventory show up as an
operating cash flow
• Increasing inventories are a use of cash
• Decreasing inventories are a source of cash
• High growth firms often see increasing
inventory balances
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Other Current Assets
• Usually prepayments of expenses
• Typically an operating cash flows
• Disclosure in notes could alter that
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Investments in Securities
• From subsidiaries accounted for by the
equity method
• Purchase or sale should be under investing
• Share of net income (-) and receipt of
dividends (+) should be in operations
• Often difficult to disaggregate as
information is not always disclosed
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PPE
• Buying and selling property, plant and
equipment is an investing cash flow
• Gains and losses may have appeared in net
income and should be removed from the
operating cash flows
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Accumulated Depreciation
• Changes in accumulated depreciation are
usually related to depreciation expense and
should be added back to operating income
• Changes can also be related to sales of fixed
assets, and those changes should also be
excluded… often challenging to identify
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Other Assets
• Including; goodwill, patents, trademarks,
copyrights, licences, etc.
• Any changes from amortization is added
back to CFO
• Any changes due to purchase or sale would
be included in investing and any gain or
loss should be backed out of operations
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Accounts Payable
• An increase here would mean that assets
have been received but not yet paid for, so
the actual use of cash is less than CGS, so
operating cash flows would increase
• A decrease would be a use of cash and
would be added to operating cash flows
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Notes Payable
• Short term borrowing from banks, GAAP
classifies this as a financing activity
• Very similar in many ways to accounts
payable but classified differently
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Current Portion of Long-term Debt
• Has 2 components
– actual repayment of long-term debt, a financing
cash flow
– reclassification of long-term debt to current, not
a cash flow
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Other Current Liabilities
• Usually an operating cash flow
– an increase is a cash inflow
– a decrease is a cash outflow
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Long-term Debt
• Reason for change is important
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New debt issued; financing cash inflow
Reclassification to current; not a cash flow
Early retirement of debt; financing outflow
Conversion to common stock; not a cash flow
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Deferred Income Taxes
• Income taxes declared as an expense but not
payable (yet) according to the tax code
– an increase is an operating inflow because it
was deducted from net income but doesn’t
effect cash flows
– a decrease means that previous tax deferrals are
catching up on the company and would be an
operating outflow
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Other Non-current Liabilities
• Pensions and retirement benefit changes
should show up in operating cash flows
• Most other changes should show up in
financing
• Usually considered a financing activity if
not enough information is given
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Summary
• Statement of cash flows is relatively new
• Cash flows do not necessarily track income
flows, a firm with good net income may be
in financial trouble
• Many differences in accounting principals
have no impact on cash flows
• Allows the calculation of free cash flows
used in several valuation models
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