The Analysis of the Cash Flow Statement Chapter 10 The Analysis of the Cash Flow Statement

The Analysis of Cash Flow Statement Link to Previous Chapter Chapter 9 reformulated the balance sheet and income statement to capture the operating and financing activities. This Chapter This chapter reformulates the How is the cash How is free cash What cash flow statement to capture flow statement flow identified adjustments the operating and financing reformulated to in reformulated must be made activities. separate statements ? to GAAP operating and cash flow financing statements ? flows? Link to Next Chapter Chapter 11 lays out the analysis of the reformulated financial statements. Link to Web Page

What you will learn from this chapter How free cash flow can be calculated from reformulated income statements and balance sheets without a cash flow statement How the cash conservation equation ties the cash flow statement together to equate free cash flow and financing cash flow The difference between the direct and indirect calculations of cash from operations Problems that arise in analyzing cash flows from GAAP statements of cash flow What reformulated cash flow statements tell you How free cash flow changes typically over a product’s life cycle

The Calculation of Free Cash Flow Three methods to calculate FCF: 1. Use the sources of cash flow equation: that is, free cash flow is operating income adjusted for the change in net operating assets 2. Use the disposition of cash flows equation: that is, free cash flow is net financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. FCF can also be obtained from the reformulated Statement of Cash Flows.

Calculation of Free Cash Flow: Nike, Inc.: 1996

Calculation of Free Cash Flow: Reebok, 1996

The Standard GAAP Statement of Cash Flows

Reformulated Statement of Cash Flows This format follows the cash conservation equation: C – I = d + F

Nike, Inc. GAAP Statement of Cash Flows

Problems with the Standard Statement 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Transactions in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing 5. The statement does not incorporate non-cash transactions 6. In the case of installment purchases, only the first installment is classified as investment

1. Operating Cash and Cash in Financial Assets: Nike Change in cash and cash equivalents $46 million Increase in operating cash $7 million Increase in financial assets 39 $46 million The determination of operating cash: use a normal percentage of sales for the industry

2. Transactions in Financial Assets: Lucent Technologies

3. and 4. Net Interest Payments and Taxes on Net Interest Payments: Nike Interest income (16,000) Net interest payments before tax (16,800) Tax benefit (at 38.5%) 6,468 $10,332 Add back to GAAP cash from operations

5. Non-cash Transactions Acquisitions with shares Asset exchanges Asset acquired with debt Capitalized lease Installment purchases

The Reformulated Statement of Cash Flows: the Adjustments

Nike, Inc. Reformulated Statement of Cash Flows Free Cash Flow Reported cash from operations Net interest paid after tax Cash investments reported Investment in operating cash Free cash flow Financing Flow to Claimants Debt financing: Additions to long-term debt Reductions to long-term debt Increase in notes payable Net interest paid, after taxes Investments in cash equivalents Equity financing Share issues (from exercise of options) Purchases of shares Dividends Total financing flows 230 7 (5) 30 (48) 10 39 (21) 19 79 330 340 237 103 26 77

Why Free Cash Flow from Adjusted Cash Flow Statements May not Reconcile to the Methods 1 and 2 “Other assets” and “other liabilities” are not identified as either operating or financing Cash dividends in the cash flow statement differ from dividends in the equity statement Cash from share issues in the cash flow statement may differ from share issues in the equity statement Details for adjustments 3,4 and 5 are not available Cash flow numbers are translated at average exchange rates whereas balance sheet numbers are translated at end-of-year exchange rates

The Calculation of Cash Flow from Operations The practical matter of distinguishing cash flow from operations from cash flow from investment activities is not an easy one: the cash flow from operations in the GAAP statement is not a clean measure. Some cash flows from investment activities are classified as cash flows from operations R&D expenditures Investment in inventories Taxes on gains from assets sales are classified as cash flow from operations Note, however, that for a calculation of FCF (C – I), a misclassification between investment and operating activities has no effect

The Quality of the Reported Cash Flow from Operations (CFO) Number as an Indicator of Profitability Non cash charges do not affect CFO, but are a loss of value (eg. depreciation) Taxes benefits of stock options are included in CFO but not the compensation expense Firms can delay payments to generate cash flow Firms can sell receivables to generate cash flow Firms can reduce advertising expenditures to generate cash flow Firms can reduce R & D expenditures to generate cash flow Non-cash transactions are not in CFO