Topics to be covered:

1
Session 8

• Topics to be covered
• Cash flow analysis

2
Statement of Cash Flows

• Provides information about
• a firms liquidity and its ability to finance its
  growth internally
• trends in cash flow components and cash
  consequences of investing and financing decisions
• management decisions regarding such critical
  areas as financial policy (leverage), dividend
  policy and investment for growth

3
Cash Flows vs Net IncomeEmpirical Evidence

• Dechow (1994) showed that accrual income was a
  better predictor of future stock returns than was
  Cash Flow from Operations (CFO)
• Other studies offer consistent evidence that
  given CFO, accruals provide incremental
  information for valuation purposes
• Bowen et al. (1987) compared market reaction to
  cash flows and net income. They found that cash
  flow and net income are useful to investors
• Bottom Line It looks like the stock market uses
  both

4
Relation between Accounting Income and Cash Flows

• Accrual accounting does not provide adequate
  information about liquidity and long-term
  solvency
• Accounting income is affected by managers choice
  of accounting methods and estimates
• Accounting income allows managers to communicate
  information about expected cash flows

5
Cash Flow Algebra
6
Examples of Cash Impact of Changes inAssets and
Liabilities

• When accounts receivable increase, the periods
  sales revenue must have exceeded cash
  collections. Therefore the increase in accounts
  receivable should be deducted from sales revenue
  to derive cash collected from customers during
  the period.
• When interest payable increases, that means the
  firm did not pay all the interest expense accrued
  during the period. Therefore the increase in
  interest payable must be deducted from interest
  expense to compute the amount of interest paid
  during the period.

7
Some Cash Flow Definitions

• Cash flow from operating activities (CFO)
  measures the amount of cash used or generated by
  a firm as a result of its production and sales of
  goods and services
• Investing cash flow (CFI) reports the amount of
  cash used to acquire assets such as plant and
  equipment as well as investments and entire
  businesses

8
Some Cash Flow Definitions

• Financing cash flow (CFF) includes cash flows
  related to the firm's capital structure (debt
  equity), including proceeds from the issuance of
  equity, payment of dividends, repurchases of
  equity, and the incurrence and repayment of debt
• Free Cash Flow measures cash available to the
  firm for discretionary uses after making all
  required cash outlays
• many analysts define as cash from operations less
  capital expenditures to maintain current
  productivity capacity

9
Statement of Cash Flows

• Format
• Operations
• Direct
• Indirect
• Investing
• Financing

10
Direct Method of Determining CFO

• Similar to a cash basis income statement
• Cash Collections
• Less
• cash inputs
• cash expenses
• cash interest paid
• Used by a small number of firms

11
Indirect Method of Determining CFO

• Indirect method adjusts net income for
• Noncash revenues and expenses
• Non operating items included in income
• Noncash changes in operating assets and
  liabilities

12
Calculation of Indirect CFO

• Net Income change in
• Accounts Receivable
• Inventories
• Other Current Assets
• Accumulated Depreciation
• Accounts Payable
• Other Current Liabilities
• Deferred Income Taxes

13
Cash Flow from Investing (CFI)

• Change in
• Marketable Securities
• Investment Securities
• Property Plant Equipment
• Other Assets

14
Cash Flow from Financing (CFF)

• Change in
• Notes Payable
• Current Portion of Long Term Debt
• Long Term Debt
• Other Noncurrent Liabilities
• Common Stock
• Additional Paid in Capital
• Dividends
• Treasury Stock

15
Total Cash Flow Analysis

• Categories for Total Cash Flow Analysis
• CFO before working capital investment and
  interest payments
• CFO after investment in working capital, but
  before interest payments
• CFO after investment in working capital and
  interest payments
• Free cash flows before dividend payments and
  external financing
• Free cash flow after dividend payments
• Net cash flow after external financing

16
Uses of Total Cash Flow Statement

• do operations generate positive CF before
  investment in working capital?
• how well is working capital being managed?
• can the company meet its interest obligations?
• can the company make long-term investments with
  internal funds?
• is the dividend sustainable?
• what financing opportunities are available?

17
Cash Flow AnalysisAnalysts Perspective

• Review individual cash flow items for
  significance
• Examine the trend of different cash flow
  components over time and their relationship to
  related income statement items
• Consider interrelationship of cash flow
  components over time.