The Statement of Cash Flows

The statement of cash flowsreports the entity’s cash flows

(cash receipts and cash payments)during the period.

Purpose of The Statement of

Cash Flows: Basic Concepts

Purposes of the Statement

of Cash Flows• The statement of cash flows is designed to

fulfill the following:– predict future cash flows– evaluate management decisions– determine the ability to pay dividends plus

interest and principal– show the relationship of net income to changes

in the firm’s cash

Components and Relationships Between the

Financial StatementsIt is important to understand that the income statement,

balance sheet and cash flow statement are all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the stated accounting period.

The cash flow statement explains cash inflows and outflows, and will ultimately reveal the amount of cash the company has on hand; this is reported in the balance sheet as well.

We will not explain the components of the balance sheet and the income statement here since they were previously reviewed.

Statementof Retained

Earnings

12/31/x1 For the Year Ended 12/31/x2 12/31/x2(a point in time) (a period of time) (a point in time)

Statementof CashFlows

IncomeStatement

BalanceSheet

BalanceSheet

Organization of theStatement of Cash Flows

• A business may be evaluated in terms of three types of business activities:

1Operating activities2Investing activities3Financing activities

Three Sources of Information:1. Comparative balance sheets2. Current income statement3. Additional information

Preparing the Statement of Cash Flows

1. Cash Flow from Operating Activities (CFO)

• CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes. This includes: Cash inflow (+) • Revenue from sale of goods and services • Interest (from debt instruments of other entities) • Dividends (from equities of other entities)

• Cash outflow (-) • Payments to suppliers • Payments to employees • Payments to government • Payments to lenders • Payments for other expense

2. Cash Flow from Investing Activities (CFI)

• CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets. This includes:

• Cash inflow (+) • Sale of property, plant and equipment • Sale of debt or equity securities (other entities) • Collection of principal on loans to other entities

• Cash outflow (-) • Purchase of property, plant and equipment • Purchase of debt or equity securities (other entities) • Lending to other entities

3. Cash flow from financing activities (CFF)

• CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes:

• Cash inflow (+) • Sale of equity securities • Issuance of debt securities

• Cash outflow (-) • Dividends to shareholders • Redemption of long-term debt • Redemption of capital stock

Illustration: Classify each of these transactions by type of cash flow activity.

Format of the Statement of Cash Flows

1. Issued 100,000 shares of $5 par value common stock for $800,000 cash.

2. Borrowed $200,000, signing a 5-year note bearing 8% interest.

3. Purchased two semi-trailer trucks for $170,000 cash.

4. Paid employees $12,000 for salaries and wages.

5. Collected $20,000 cash for services provided.

FinancingFinancingInvestingOperatingOperating

Which is an example of a cash flow from an operating activity?

a. Payment of cash to lenders for interest.b. Receipt of cash from the sale of capital

stock.c. Payment of cash dividends to the

company’s stockholders.d. None of the above.

SO 4 Prepare a statement of cash flows using the indirect method.

Review Question

Which is an example of a cash flow from an investing activity?

a. Receipt of cash from the issuance of bonds payable.

b. Payment of cash to repurchase outstanding capital stock.

c. Receipt of cash from the sale of equipment.d. Payment of cash to suppliers for inventory.

SO 4 Prepare a statement of cash flows using the indirect method.

Review Question

Format of the SCF

• FASB Statement 95 approved two methods for reporting cash flows from operating activities.

1Direct method (preferred)2Indirect method

The Direct Method

Cash Flow from Operations

Under the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends, and deducting cash payments for purchases, operating expenses, interest and income taxes. We'll examine each of these components below:

The Direct Method

• Cash collections are the principle components of CFO. These are the actual cash received during the accounting period from customers.

They are defined as:Cash Collections Receipts from Sales = Sales + Decrease (or - increase) in Accounts Receivable

The Direct Method

• Cash payment for purchases make up the most important cash outflow component in CFO. It is the actual cash dispersed for purchases from suppliers during the accounting period. It is defined as:Cash payments for purchases = cost of goods sold + increase (or - decrease) in inventory + decrease (or - increase) in accounts payable

The Direct Method

• cash payment for operating expenses is the cash outflow related to selling general and administrative (SG&A), research and development (R&A) and other liabilities such as wage payable and accounts payable. It is defined as:

  Cash payments for operating expenses = operating expenses + increase (or - decrease) in prepaid expenses + decrease (or - decrease) in accrued liabilities

The Direct Method

• Cash interest is the interest paid to debt holders in cash.It is defined as:

                                  Cash interest = interest expense – increase (or +

decrease) interest payable + amortization of bond premium (or - discoun

The Direct Method

• Cash payment for income taxes is the actual cash paid in the form of taxes.

It is defined as: Cash payments for income taxes = income taxes + decrease (or - ncrease) in income taxes payable   

Prepare SCF

1. The company purchased a truck during the year at a cost of $30,000 that was financed in full by the manufacturer.

2. A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year for $7,000. There were no other sales of depreciable assets.

3. Dividends paid during Year 2 are $51,000

Statement of Cash Flows (Direct Method)

Current Assets

Add to Net Income if this account has decreased

The Indirect Method

Deduct from Net Income if this account has increased

Current Liabilities

Add to Net Income if this account has increased

The Indirect Method

Deduct from Net Income if this account has decreased

Statement of Cash Flows (Indirect Method)

CLASS WORK -SCFMenghai Pizza Dec 31, 2000Cash payment of Dividend

(35,000) Retirement of Common stock

(25,000)

Acquisition of Parahata Pizza

(14,000) Purchase of equipment

(30,000)

Cash Payment for interest

(10,000) Cash payment to suppliers

(85,000)

Cash payment for Salaries

(45,000) Cash collected from customers

250,000

Sale of equipment

38,000 Cash at Dec 31,1999

50,000

Required:Prepare SCF

CLASSWORK 1-Solution

CF FROM OACash collection from customers

250,000

Cash payment to Suppliers

(85,000)

Cash payment for Salaries

(45,000)

Cash payment for interest

(10,000)

Net cash from OA 110,000

CF from IASales of equipment 38,00

0Purchase of equipment

(30,000)

Purchase of land (14,000)

Net Cash from IA (6,000)

CF FROM FARetirement of Common stock

(25,000)

Payment of dividend

(35,000)

Net cash from FA

(60,000)

Net increase in cash

44,000

Cash at beginning of year

50,000

Cash at end of year

94,000

Menghai PizzaMenghai PizzaStatement of Cash FlowsStatement of Cash FlowsYearEnded December 31, 2000YearEnded December 31, 2000

Why Cash Flow Analysis?

• Profits and cash flows are very different things

• Profits under the accounting system are calculated on accrual basis rather than cash basis

Overview

Analysis

Budgeting

Example

Why Cash Flow Analysis?

• As an investor much better to look at both Income Statement and the Statement of Cash Flows

• As management, very important to analyze the different types of inflows/outflows

Overview

Analysis

Budgeting

Example

Types of Analysis

• Statement of CF Analysis• Free Cash Flows• Payback Period• Net Present Value• Internal Rate of Return

Overview

Analysis

Budgeting

Example

The cash flow statement will reveal the following to

analysts:

How the company obtains and spends cash Why there may be differences between net income and cash flows If the company generates enough cash from operation to sustain the business If the company generates enough cash to pay off existing debts as they mature If the company has enough cash to take advantage of new investment opportunities

Free Cash Flow (FCF)

Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating.

Free Cash Flows

Operating Income    

+Depreciation  

= EBITDA (Earnings before interest, taxes, Depreciation, and amortization)

-cash tax payments  

= after tax cash flows from operations      

Overview

Analysis

Budgeting

Example

Payback Period

• Cash flow analysis from capital budgeting perspective.

• A criteria used in capital budgeting. Defined as the number of years required to recover initial cash investment

Overview

Analysis

Budgeting

Example

Payback Period: Example1 0 0 0 0

Y e a r 1Y e a r 2Y e a r 3Y e a r 4Y e a r 5

P a y b a c k 3 . 3

5 0 0 04 0 0 05 0 0 0

It w i l l t a k e 3 y e a rs t o re c o ve r 7 0 0 0 a n d t h e . 3 o f t h e 4 t h y e a r t o re c o ve r t h e re m a in in g 3 0 0 0 . T h e re fo re t h e p a y b a c k in t h is

e x a m p le is 3 . 3 .

In i t ia l In ve s t m e n t in p ro je c t

C a s h in flo w s a ft e r - t a x1 0 0 01 0 0 0

Overview

Analysis

Budgeting

Example

Net Present Value

• In simple terms NPV is the sum of discounted cash inflows from a project- the projects initial outlay

• If NPV is > 0 accept else reject

Overview

Analysis

Budgeting

Example

NPV: ExampleI n i tia l O u tla y - 3 0 0 0 0R e q u i r e d R a te 1 2 %

N o t D is c o u n te d D is c o u n te dY e a r 1 I n f lo w 1 0 0 0 0 $ 8 , 9 2 8 .5 7Y e a r 2 I n f lo w 1 5 0 0 0 $ 1 1 ,9 5 7 .9 1Y e a r 3 I n f lo w 1 2 0 0 0 $ 8 , 5 4 1 .3 6Y e a r 4 I n f lo w 1 0 0 0 0 $ 6 , 3 5 5 .1 8Y e a r 5 I n f lo w 1 1 0 0 0 $ 6 , 2 4 1 .7 0S u m 5 8 0 0 0 $ 4 2 ,0 2 4 .7 2

N P V $ 1 2 , 0 2 4 .7 2

W e ta k e th e s u m o f th e d is c o u n te d va lu e s a n d s u b tr a c t th e in i tia l o u tla y .

Overview

Analysis

Budgeting

Example

Internal Rate of Return

• Discount rate that equates the present value of inflows with the present value of outflows. In simple terms it reflects the rate of return for a project

Overview

Analysis

Budgeting

Example

IRR: ExampleInitial Outlay -3817Year 1 Cash Inflow 1000Year 2 Cash Inflow 2000Year 3 Cash Inflow 3000

IRR 22%

Excel has a very handy function that calculates the IRR. Make sure you enter the whole range of values including the initial outlay, which is entered as a negative value.

Overview

Analysis

Budgeting

Example

What is Capital Budgeting?

• Capital budgeting is the decision making process through which firms decide which projects get the funding

• Financial plans for most firms are based on the capital budgeting analysis using cash flows

Overview

Analysis

Budgeting

Example

Comprehensive ExampleCost of new plant and Equipment 9,700,000Other Costs 300,000Total Cost 10,000,000

Total Unit Sales Year Sold1 50,0002 100,0003 100,0004 70,0005 50,000

Sales price per unit 150Variable cost 80Fixed Costs 500000Required Working Capital 100000

Depreciation 2,000,000

We just added the total cost of plant with other costs and divided it by 5 years to get a straight line decpreciation.

This example is something similar to what many firms would deal with in the real world. We will first derive Free Cash Flows and then apply the NPV and IRR techniques that we learned earlier.

Overview

Analysis

Budgeting

Example

Comprehensive Example

STEP 1

Year 0 1 2 3 4 5Units Sold 50,000 100,000 100,000 70,000 50,000Sale Price 150 150 150 150 150Sales Revenue 7500000 15000000 15000000 10500000 7500000Less: Variable Costs 4000000 8000000 8000000 5600000 4000000Less: Fixed Costs 500000 500000 500000 500000 500000EBDIT 3000000 6500000 6500000 4400000 3000000Less: Depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000EBIT 1,000,000 4,500,000 4,500,000 2,400,000 1,000,000Taxes (@ 34%) 340000 1530000 1530000 816000 340000

EBIT, TAXES and DEPRECIATION are calculated here

In this example we've calculated EBIT along with taxes that we will use to derive Operating Cash Flow on the next slide. We subtract depreciation here so we can pay less taxes. The depreciation will be added back in the next step as it is a non-cash item.

Overview

Analysis

Budgeting

Example

Comprehensive Example

STEP 2

Year 0 1 2 3 4 5EBIT 1,000,000 4,500,000 4,500,000 2,400,000 1,000,000Minus: Taxes 340000 1530000 1530000 816000 340000Plus:Depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000Operating Cash Flows 2,660,000 4,970,000 4,970,000 3,584,000 2,660,000

Operating Cash Flows

Depreciation is added back here as we move toward Free cash flows. Here Operating Cash Flows are derived.

Overview

Analysis

Budgeting

Example

Comprehensive Example

STEP 3

Year 0 1 2 3 4 5-100000 10000

Working Capital Needs

In this example we have an initial outflow of working capital that is recouped completely in the last year at the termination of the project. So in year one we subtract it and add it back in year 5.

Overview

Analysis

Budgeting

Example

Comprehensive ExampleSTEP 4

Year 0 1 2 3 4 5Operating Cash Flow 2,660,000 4,970,000 4,970,000 3,584,000 2,660,000Less: Net working capital -100000 0 0 0 0 100000Less: Initial Outlay -10,000,000

Free Cash Flow -10,100,000 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000

Free Cash Flow

Finally we have the free cash flows that we can use in our NPV and IRR calculations.

Overview

Analysis

Budgeting

Example

Comprehensive Example

Now, using the date calculate the NPV and the IRR for the Project

Initial Outlay -10,100,000Cash inflows/Year 0 1 2 3 4 5

2,660,000 4,970,000 4,970,000 3,584,000 2,760,000

Depending on the answer also recommend if the project should be accepted.

Overview

Analysis

Budgeting

Example

Comprehensive Example

Year 0 1 2 3 4 5Not Discounted 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000Discounted 2418181.818 4107438 3734034.6 2447920.2 1713742.9Initial Outlay -10,100,000Required Rate 10.00%

NPV 4,321,317

SOLUTION

Several ways to do so, first you can get the discounted cashflows for each year and then add all of them up along with the initial outlay. A simple way is to use the NPV function in excel. This is positive so we should go ahead with the project.

This rate depends on the firms required rate of return. Its dependent on different factors which we can't get into in this presentation. But most firms do have a given required rate of return for their projects.

Overview

Analysis

Budgeting

Example

Comprehensive Example

Year 0 1 2 3 4 5Not Discounted -10,100,000 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000

IRR 26%

SOLUTION

Note that IRR is best solved for with a financial calculator or using a spreadsheet program. Here the excel function for IRR was used to come up with this value.

Overview

Analysis

Budgeting

Example

Practice ProblemCost of new plant and Equipment 1,500,000Other Costs 300,000Total Cost 1,800,000

Total Unit Sales Year Sold1 10,0002 20,0003 5,0004 60,0005 250,000

Sales price per unit 175Variable cost 85Fixed Costs 500000Required Working Capital 100000

Depreciation 360,000

We just added the total cost of plant with other costs and divided it by 5 years to get a straight line decpreciation.

This example is something similar to what many firms would deal with in the real world. We will first derive Free Cash Flows and then apply the NPV and IRR techniques that we learned earlier.

Cash Flow Ratios

Cash Flow Ratios…contd.

End of Chapter