Cash Flow Statement This module provides an introduction to the cash flow statement, one of the essential financial statements. We’ll show how to create a cash flow statement using the indirect method and cover free cash flow as well. We suggest completing the balance sheet and income statement modules prior to working on this module. Author: Stu James © 2015-17 Stu James and Management by the Numbers, Inc.

Introduction to the Cash Flow Statement The cash flow statement is the third essential financial statement for a company and is a required filing for all public companies. Understanding how to read and interpret a cash flow statement is an important skill for a business person or investor. The cash flow statement provides important information about the sources and uses of cash: From operating activities From investing activities From financing activities MBTN | Management by the Numbers

Sample Cash Flow Statement Here is a (very) simplified cash flow statement for Whole Foods, Inc. for the quarter ending Jan 18, 2015. What can we say about this cash flow statement? Whole Foods, Inc. Quarter ending Jan 18, 2015 $millions Net Cash Flow-Operating $387 Net Cash Flow-Investing ($251) Net Cash Flow-Financing ($59) Net Cash Flow $77 First, note that there are 3 general areas of cash flow: operations, investing, and financing. At Whole Foods, all of their positive cash flow came from operations. This is generally a sign of a healthy and profitable company. Now let’s look at these three areas of cash flow in more detail. MBTN | Management by the Numbers

Cash Flow from Operating Activities Let’s start with cash flow from operating activities (CFO). This category of cash flow starts with net income and then makes any adjustments necessary to get a more complete picture of how much cash was generated (or lost) from operating activities. This would include adding back depreciation and other non-cash expenses, and adjusting for any changes in accounts receivable, liabilities, and inventories. Whole Foods, Inc. Cash Flow Statement (Operating Activities) $Millions Net Income $ 167 Depreciation 131 Adjustments to Net Income 30 Changes in Accounts Receivable (6) Changes in Liabilities 109 Changes in Inventories (53) Other Changes in Operating Act. 9 Total Cash Flow from Operating Activities $ 387 MBTN | Management by the Numbers

Cash Flow from Investing Activities Next is cash flow from investing activities (CFI). This category of cash flow addresses more long-term asset or liability decisions, which would include purchase or sale of long-term assets (land, building, equipment, securities, etc.); long-term borrowing arrangements with suppliers or customers; and transactions relating to mergers and acquisitions. Whole Foods, Inc. Cash Flow Statement (Investing Activities) $Millions Capital Expenditures (100) Investments (Net) 28 Other Cash Flows from Investing (179) Total Cash Flow from Investing Activities (251) MBTN | Management by the Numbers

Cash Flow from Investing Activities Cash Flow from Financing Activities Cash Flow from Investing Activities Last is cash flow from financing activities (CFF). Whole Foods, Inc. Cash Flow Statement (Financing Activities) $Millions Dividends Paid (43) Sale / Purchase of Stock (20) Net Borrowings Other Cash Flows from Financing 4 Total Cash Flow from Financing Activities (59) This category of cash flow captures the company’s own financial choices such as selling or repurchasing their own stock and/or bonds, paying dividends (and associated taxes), and repayment of debt principal, including capital leases. Insight What are the benefits / drawbacks of using cash to issue dividends and/or buy back stock? Why might a company choose to do both? MBTN | Management by the Numbers

Methodologies Methodologies There are two methods of creating a statement of cash flows – the direct method and the indirect method. These two methods only differ in how the cash flow from operations (CFO) are calculated. The Direct Method uses actual cash flows from operations – adding cash inflows from receipts from sales, dividends, and interest, and subtracting cash outflows for purchases, operating expenses, interest payments and tax payments. The Indirect Method starts with the net income generated on an accrual basis and is adjusted by adding back depreciation, net changes in accounts payable, liabilities, inventory, and other balance sheet accounts. MBTN | Management by the Numbers

Methodologies Methodologies If a company uses cash based accounting rather than accrual (usually only small companies), the direct method is likely to be easier as the income statement is closely related to cash flow. However, the vast majority of companies use an accrual accounting system and the indirect method. Here, cash flow from operations is based on the current and previous period’s Income Statement and Balance Sheet using the following adjustments: If Account Balance Increases: Adjustment to Net Income Accounts Receivable, Inventory Decrease Accounts Payable Increase Non-Cash Expenses (Depreciation, Amort) For example, if accounts receivable increases by $1000 in a period, cash flow would decrease by $1000. MBTN | Management by the Numbers

Creating a Cash Flow Statement (Indirect Method) Let’s go through an example of creating a cash flow statement using the indirect method. Question 1: Paul runs a bakery in Paris, Kentucky. From his income statement we know that Net Income for 2014 is $76,000 and depreciation for the year totals $145,000. From the balance sheets for 2013 and 2014, we see the following account balances: Account 2013 2014 Accounts Receivable 36 66 Current Liabilities 51 98 Inventory 14 41 Using this information, calculate the Cash Flow from Operating Activities (CFO). MBTN | Management by the Numbers

Answer: CFO (Indirect Method) Based on the rules for creating a cash flow statement using the indirect method, we come up with the results below. Now, before you move to the next slide, think through these rules and see if they make sense to you. Accounts Receivable (or other liabilities) are what you owe, so if your “loans” increased in the past period, you would have more cash flow, right? Paul’s Bakery Cash Flow Statement (Operating Activities) $000s Net Income $ 76 Depreciation 145 Changes in Accounts Receivable (30) Changes in Liabilities 47 Changes in Inventories (27) Cash Flow from Operating Activities $ 211 Depreciation is expensing something that was already paid for in cash in a previous period, so no cash is used for depreciation, which is why we need to add it. Think through the other two categories on your own. MBTN | Management by the Numbers

Creating a Cash Flow Statement (Indirect Method) Question 2: Paul also purchased a new oven for $15,000 and sold his old one for $3,000. Paul also was able to arrange for a $50,000 line of credit from a local grocery store in exchange for an exclusive right to distribute his bread in Paris. Paul also sold 1000 shares of stock in his company to his sister-in-law for $20,000 and received a loan from a local bank for $30,000. Using this information, create the Cash Flow from Investing Activities (CFI) and the Cash Flow from Financing Activities portions of the Cash Flow Statement. Insight Note that the direct and indirect methods of creating the CFI and CFF are basically the same. While one could analyze the differences in the balance sheet accounts, generally it is easier to summarize these transactions directly. MBTN | Management by the Numbers

Answer: CFI / CFF Answer: CFI / CFF Based on the rules for these sections of the Cash Flow Statement, we can derive the CFI and CFF as shown on the left. The only item that might be a little tricky is the grocery store line of credit. Since this is from a customer and there is an non-financial obligation associated with it (exclusive distribution rights), it would be with the CFI rather than the CFF. Paul’s Bakery Cash Flow Statement (Investing Activities) $000s Capital Expenditures (15) Proceeds from Equipment Sale 3 Loan from Business Partners 50 Total Cash Flow from Investing Activities 38 Paul’s Bakery Cash Flow Statement (Financing Activities) $000s Sale / Purchase of Stock 20 Net Borrowings 30 Total Cash Flow from Financing Activities 50 Question 3: What is Paul’s Net Cash Flow for the period? MBTN | Management by the Numbers

Free Cash Flow Free Cash Flow Answer: Paul’s Net Cash Flow is the total of the CFO, CFI, and CFF or, $211 + $38 + $50 = $299,000. Therefore, Paul is cash flow positive. This brings us to our final topic for this module – Free Cash Flow Free Cash Flow (FCF) is what cash is available for distribution from a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its operations. Definition: Free Cash Flow (FCF) = Cash Flow from Operating Activities – Expenditures Necessary to Maintain Assets (“CapEx”)– Interest Charges MBTN | Management by the Numbers

Free Cash Flow Free Cash Flow What is complicated about this definition is that the Expenditures Necessary to Maintain Assets (also known as Capital Expenditures or “CapEx”) is not something that is reported on an annual or quarterly basis and is at best an estimate by management, and therefore subject to manipulation or at least uncertainty. However, some investors prefer this measure, though imperfect, to Net Income as it may provide a clearer measure of how much cash the company is capable of generating. Question 3: If Paul’s CapEx is $20,000 and interest payments are $5,000, what is his Free Cash Flow? Answer: We know that Free Cash Flow = CFO - CapEx - Interest Therefore, substituting in our values: FCF = $211K - $20K - $5K = $186,000 MBTN | Management by the Numbers

Further Reference Further Reference MBTN Balance Sheet and Income Statement modules which cover the other two major financial statements. MBTN Financial Metrics I module which covers financial measures of profitability. MBTN | Management by the Numbers