Reading 27 LOS's

Question 1

LOS 27a: Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items

Answer 1

Cash Flows from operating activities (CFO) these are inflows and outflows of cash related to a firm’s day to day business activities. (Inflows - Cash collected from customers, interest and dividends received, proceeds from sale of securities. Outflows - Cash paid to employees, suppliers, and other expenses, interest paid, taxes paid, cash used to purchase trading securities)

cash flow from investing activities (CFI) - these are inflows and outflows of cash generated from the purchase and disposal of long-term investments. Long-term investments include plant, machinery, equipment, intangible assets, and nontrading debt equity securities. ( Inflows - Sale proceeds from fixed assets, and from long term investments. Outflows - Purchase of fixed assets and cash used to acquire LT investment securities)

NOTE Investments in securities that are considered highly liquid are not including in investing activites, instead a part of operating activities.

Cash flow from financing activities (CFF) these are cash inflows and outflows generated from issuance and repayment of capital (interest bearing debt and equitiy) ( Inflows- Proceeds from debt issuance and issuance of equity instruments. Outflows- Repayments of LT debt, payments made to repurchase stock, dividends payments)

NOTE Indirect short-term borrowings from suppliers that are classified as accounts payable and changes in receivables from customers are not considered financing activities, they are operating activities.

Question 2

LOS 27b: Describe how non-cash investing and financing activities are reported

Answer 2

Noncash investing and financing are not reported on the cash flow statement because these transactions do not involve any receipt or payment of cash. Examples are:

• Barter transaction where one nonmonetary asset is exchanged for another
• Issuance of common stock for dividends or when holders of convertible bonds or convertible preferred stock convert their holdings into ordinary shares of the company
• Acquisition of real estate with financing provided by the seller

Question 3

LOS 27c: Contrast cash flow statements prepared under Iinternational Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP)

Answer 3

Cash flows that are different under IFRS compared to US GAAP.

• Interest Received, Interest Paid, and Dividends received are all Operating Actitivites under US GAAP , but can be either Operating or Financing under IFRS.
• Dividends paid are Financing under US GAAP , but can be Operating or Financing under IFRS
• Bank Overdrafts are classified as Financing under US GAAP, but are considered cash equivalents under IFRS
• Taxes Paid- are Operating under US GAAP, and are generally operating, but can be allocated to Investing or Financing under IFRS

Presentation format is a little different as well. They both allow indirect or direct, with direct being encouraged. With US GAAP, a reconciliation of net income to cash flow from operating activities must be provided regardless of method used.

Question 4

LOS 27d: Distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method

Answer 4

Direct Method Under this method, income statement items that are reported on an accrual basis are all converted to cash basis. All cash receipts are reported as inflows, while cash payments are reported as outflows

Indirect Method Under this method, cash flow from operations is calculated by applying a series of adjustments to net income. These adjustments are made from noncash items, nonoperating items, and changes in working capital accounts resulting from accrual accounting

Direct vs Indirect

• The direct method explicity lists the actual sources of operating cash inflows and outflows, whereas the indirect method only provides net results for these inflows and outflows. The information in the direct method is very useful in evaluating past performance and making projections of future cash flows
• the indirect method provides a list of items that are responsible for the difference between net income and operating cash flow. These differences can then be used when estimating future operating cash flows

Question 5

LOS 27e: Describe how the cash flow statement is linked to the income statement ane the balance sheet

Answer 5

• Sum of cash flows from operating, investing, and financing activities equals the change in cash over the year
  
  • CFO + CFI + CFF = change in cash
  • Year-end cash balance - Year-begin cash balance = Change in Cash
• Operating income and expense items are recognized on the income statement on an accrual basis. Regardless of cash flows, assets and liabilities will be changed. It is important when using these current liabilities and current assets to make your statement of cash flows, that you determine if the changes in the assets and liablities where caused because of cash flow or because of accrual recognition
• CFI is calculated from changes in asset balances under the noncurrent assets section of the balance sheet
• CFF is calculated from changes in the equity and noncurrent debt sections of the balance sheet

Question 6

LOS 27f: Describe the steps in the preparation of direct cash flow statements, including how cash flows can be computed using income statement and balance sheet data

Answer 6

Sources vs Uses of Cash

Assets

Increases in current assets are uses of cash and decreases in current assets are sources of cash. Changes in asset balances and cash are negatively related. ( Ex. If inventory increases, more liquidity of the firm is tied up, so this is a use of cash. As inventories decrease ( from selling), this becomes a source of cash)

Liabilities

Increases in current liabilities are sources of cash, while decreases are uses of cash. Changes in liability balances and cash are positively related. ( Ex- If accounts payable increases, this means the firm borrowed more money. Therefore its a source of cash. If these accounts decrease, its because cash was used to pay them off, thus a use of cash)

The Direct Method

1. Start with sales on the income statement. Go through each income statement account and adjust it for changes in related working capital accounts on the balance sheet. This serves to remove the effects of timing difference between recognition and the actual receipt.
2. Determine whether these changes are a use of cash or a source of cash.
3. Ignore all nonoperating items (gains/loss on plant equipment) and noncash charges (depreciation and ammort)

The Direct Method of Computing CFO

• Total sales adjusted for changes in related working capital accounts are known as cash collections from customers
  
  • Sales - Increase in Accounts Receivables = Cash collections
• COGS adjusted for changes in related working capital is known as cash payments to suppliers
  
  • -COGS -Increase in inventory + Increase in accounts payable = Cash paid to suppliers
• Salaries and wages adjusted for related working capital accounts
  
  • -Wages and Salaries + Increase in wages and salaries payable
• Depreciation is non cash so it is ignored all together
• Other operating expenses
  
  • -Other operating expenses + Decrease in prepaid expenses + Increase in other accrued liabilities
• Interest Expense
  
  • • Interest Expense + Increase in interest payable
• Income Tax expense
  
  • • Income tax expense + Increases in taxes payable

To summarize, Cash flow from operating activities under direct method will be

• Cash received from customers
• • Cash paid to suppliers
• • cash paid to employees
• • cash paid for other operating expenses
• • cash paid for interest
• • cash paid for income taxes

Question 7

LOS 27f: Describe the steps in the preparation of indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data

Answer 7

The Indirect Method

1. Start with net income. Go up the income statement and remove the effects of all noncash expenses and gains from net income (depreciation, gains/losses on sale of PP&E).
2. Do the opposite of what was calculated in the income statement. Example depreciation is subtracted, so we want to add it back into our net income.
3. Make adjustments for changes in working capital accounts. Add all sources of cash (increase in liabilities, decrease in assets) and subtract all uses of cash ( decrease in current liabilities, increase in current assets).

Calculating CFI

• Calculation of historical cost of sold equipment
  
  • Beginning gross fixed assets + Purchase price of new fixed assets - Historical cost of disposed fixed assets = Ending gross assets
• Calculation of accumulated depreciation on sold equipment
  
  • Beginning accumulated depreciation + Current year’s depreciation on all assets - Accumulated depreciation on sold asset = Ending accumulated depreciation
• Calculation of book value of sold equipment
  
  • Book value of sold equipment = Historical cost - Accumulated Depreciation
• Calculation of Proceeds from sale of equipment
  
  • Selling price - Book value = gain/loss on sale of equipment

Calculating CFF

Cash flow from financing activities is generated from the issuance and repayment of capital and distributions in the form of dividends to shareholders

• Long-term debt - an increase in long-term debt from one year to the next implies inflows from new borrowings. A decrease represents repayments and an outflow of cash
• Equity - An increase in common stock implies an inflow of cash, while a decrease represents repurchases and an outflow of cash
• Dividends - cash dividends paid out can be computed from the following:
  
  • Cash dividends paid out = beginning dividends payable + dividends declared - ending dividends payable
  • Dividends declared = Beginning retained earnings + Net Income - Ending retained earnings

NOTE CFI and CFF are computed the same way using both the Direct and Indirect method. ONLY CFO is computed differently with each method

Combining the effects of CFO, CFI, and CFF gives us change in cash and cash equivalents over the year

Question 8

LOS 27g: Convert cash flows from the indirect to the direct method

Answer 8

There is a 3 step process:

1. Aggregate all revenues and expenses
   
   • Aggregate all operating and nonoperating revenues and gains such as sales and gains from sales of assets
   • Aggregate all operating and nonoperating expenses such as wages, depreciation, interest, and taxes
2. Remove the effect of noncash items from aggregate revenues and expenses and seperate the adjusted revenues and expenses into their respective cash flow items
   
   • Deduct noncash revenue items such as gain on sales of assets from total revenue
   • Deduct noncash expense items such as depreciation from total expenses
   • Break down the adjusted expenses into cash outflow items, such as COGS, wages, interest expense, and tax expense
3. Convert the accrual-based items into cash-based amounts by adjusting for changes in corresponding working accounts
   
   • Convert revenue into cash receipts from customers by adjusting for accounts receivable and unearned revenue
   • Convert COGS into cash payments to suppliers by adjusting for inventory and accounts payable
   • Convert wages, interest, and tax expense into cash amounts by adjusting for wages payable, interest payable, taxes payable, and deferred taxes

Question 9

LOS 27h: Analyze and interpret both reported and common-size cash flow statements

Answer 9

Major Sources and Uses of cash

• Companies in the early stage of growth may have negative operating cash flows as cash is used to finance inventory rollout and receivables. These negative amounts are supported by financing inflows from issuance of debt and equity
• Inflows of cash from financing activities are not sustainable. Over the long term a company must produce positive cash flows that are greater than capital expenditure and payments to equity and debt holders
• Companies in the mature stage of growth usually have positive cash flows from operating activities. they can be used to repay debt and equity or to expand the company

Operating Cash Flow

• Changes in relevant asset and liability accounts should be used to determine wheter business operations are a source or use of cash
• Operating cash flow should be compared to net income. If high net income is not being translated into high operating cash flows, the company might be employing aggresive revenue recognition policies
• Companies should ideally have operating cash flows that exceed net income
• The variability of operating cash flows and net income is an important determinant of the over risk inherent to the company

Investing Cash Flow

• Changes in long-term asset and investment accounts are used to determine sources and uses of investing cash flows
• Increasing outflows may imply capital expenditures. Analysts should then evaluate how the company plans to finance these investments

Financing Cash Flow

• Changes in interest bearing debt and equity are used to determine sources and uses of financing cash flow
• If debt issuance contributes significantly to financing cash flow, the repayment schedule must be considered
• Increasing use of cash to repay debt, repurchase stock, or make dividend payments might indicate a lack of lucrative investment opportunities for the company

Common-szie analysis- There are two ways to construct common-size cash flow statements:

1. Express each item as a percentage of net revenues. This is most commonly used format
2. Express each cash inflow item as a percentage of total cash inflows, and each cash outflow item as a percentage of total cash outflows

Common size cash flows statements make it easier to identify trends in cash flows and help in forecasting future cash flows as individual items are expressed as a percentage of revenues

Question 10

LOS 27i: Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios

Answer 10

Free cash flow is the excess of a company’s operating cash flows over capital expenditure undertaken during the year.

Free Cash flow to the firm (FCFF) is cash that is available to equity and debt holders after the company has met all its operating expenses and satisfied its capital expenditure and working capital requirements

• FCFF= NI + Noncash charges + [ Interest expense x (1-tax rate) - Fixed capital investment - Working capital investment
• or FCFF= CFO [Int x (1-taxrate) - Fixed capital investment

Free cash flow to equity (FCFE) refers to cash that is available only to common shareholders

• FCFE = CFO - Fixed capital invesment + Net borrowing

These ratios, like income statement and balance sheet ratios, can be used for comparing the company’s performance over time or against other companies within the same industry. They can be categorized as performance (profitability) ratios and coverage (solvency) ratios

Performance

• Cash flow to revenue = CFO/ Net revenue
  
  • (cash generated per unit of revenue)
• Cash return to assets = CFO / Average total assets
  
  • (Cash generated from all resources, equity, and debt)
• Cash return on equity = CFO / Average shareholders equity
  
  • cash generated from owner resources
• Cash to income = CFO/ Operating activities
  
  • the ability of business operations to generate cash
• Cash flow per share = (CFO- Preferred Dividends) / Common Outstanding
  
  • operating cash flow available for each shareholder

Coverage Ratios

• Debt coverage = CFO / Total debt
  
  • leverage and financial risk
• Interest Coverage = (CFO + Interest Paid + taxes paid) / Interest paid
  
  • ability to satisfy interest obligations
• Reinvestment = CFO / Cash paid for long-term assets
  
  • Ability to buy long-term assets with operating cash flows
• Debt payment = CFO / Cash paid for long-term debt repayment
  
  • Ability to meet debt obligations with operating cash flows
• Dividend payment = CFO / Dividends paid
  
  • ability to make dividend payments with operating cash flows
• Investing and financing = CFO/ Cash outflows for investing and financing
  
  • ability to buy long-term assets, settle debt obligations, and make dividend payments from operating cash flows