Com 4FK3 Financial Statement Analysis Week 2, 2012 Cash Flow Analysis

2 Cash Flow Background Standard for the statement of cash flows first set in 1987 Funds flow statement required since 1960s but not standardized Useful because net income and cash flows are not always directly related

3 Direct Method Starts with cash received Deducts cash paid out Unconnected to income statement Rarely seen in practice

4 Indirect Method Starts with Net Income Adds back expenses that didn’t have a cash component ( depreciation, deferred taxes, etc. ) Subtracts other cash outflows that did not appear on the income statement Reverses gains and losses… cash effect of such sales moved to investing cash flow

5 Depreciation as a Source of Cash A frequent complaint with the indirect method is that the classifications can be confusing Reason for depreciation as a source of cash, is that net income is the main source of cash but depreciation was subtracted from net income although no cash changed hands

6 Capital Assets Purchases appear as an investing cash flow instead of capitalization and depreciation for balance sheet use Cash flows from disposals also show up in the investing section Gain or loss on the sale is not important to the actual amount of cash involved

7 Equity Investing A company that owns 20% - 50% of another company usually shows the results using the equity method –Enron; unincorporated partnerships Cash flow statement removes the effect of the declared income Cash dividends in operating cashflows

8 Add-backs and Subtractions Other non-current revenues and expenses –minority interest in consolidated subsidiaries –deferred income taxes –amortization of intangibles –restructuring provisions –changes in accounting practices

9 Working Capital from Operations A subtotal of net income and the additions and subtractions for non-cash effects of non-current assets and liabilities Not required under FASB Significantly higher for firms that are capital intensive

10 Changes in Working Capital WC = current assets - current liabilities –Increases in current assets are deducted as a use of cash, decreases increase cash –Current liabilities are the reverse Main WC accounts other than cash –Accounts receivable –Inventory –Accounts payable

11 Working Capital Mature companies rarely see large changes in working capital accounts As a new company grows; working capital accounts usually grow as well Companies with longer business cycles will have larger working capital accounts

12 Correlation Studies show high correlation between net income and working capital from operations –main difference is depreciation and amortization which don’t change often Studies show low correlation between net income and cash from operations –debate over relative value of using net income of CFO for valuing firms

13

14 Introduction Phase Characterised by; –low revenue –negative net income and CFO –investing cash outflows required –main source of cash is financing

15 Growth Phase Characterised by; –increasing revenue –net income becomes positive –CFO positive later due to WC requirements –significant investing cash outflows required –main source of cash is financing

16 Mature Phase Revenue and net income positive but growth rate declines, eventually shrinking OCF exceeds financing as source of cash Financing cash flows decrease, eventually negative as loans are paid off and dividends are paid to shareholders Less investment needed, may become negative as revenue declines

17 Decline Phase Revenue shrinks to zero Net income declines, frequently becomes negative CFO declining, approaching zero Investing becomes positive as unused assets are sold off Financing cash flows negative

18

19 Group Composition You should have your groups finalized Case presentations begin next week

20 Preparation of Cash Flow Statement All publicly traded firms in Canada and USA are required to publish a cash flow statement on a regular basis Smaller, or private firms may not prepare a statement of cash flows Analysis of balance sheet can allow an analyst to make a cash flow statement, but slightly lower quality due to lack of access to the full accounting data

21 Accounts Receivable Changes show up in operating cash flows If more credit was extended than collected from the previous period, this is a use of cash If accounts receivable declined, this is a source of cash since more was collected from customers than sales

22 Marketable Securities GAAP places these in investing cash flows Purchasing such securities is a cash outflow Selling securities becomes an inflow Gains and losses need to be removed from operating cash flows Reason for changes not considered

23 Inventories Changes in inventory show up as an operating cash flow Increasing inventories are a use of cash Decreasing inventories are a source of cash High growth firms often see increasing inventory balances

24 Other Current Assets Usually prepayments of expenses Typically an operating cash flows Disclosure in notes could alter that

25 Investments in Securities From subsidiaries accounted for by the equity method Purchase or sale should be under investing Share of net income (-) and receipt of dividends (+) should be in operations Often difficult to disaggregate as information is not always disclosed

26 PPE Buying and selling property, plant and equipment is an investing cash flow Gains and losses may have appeared in net income and should be removed from the operating cash flows

27 Accumulated Depreciation Changes in accumulated depreciation are usually related to depreciation expense and should be added back to operating income Changes can also be related to sales of fixed assets, and those changes should also be excluded… often challenging to identify

28 Other Assets Including; goodwill, patents, trademarks, copyrights, licences, etc. Any changes from amortization is added back to CFO Any changes due to purchase or sale would be included in investing and any gain or loss should be backed out of operations

29 Accounts Payable An increase here would mean that assets have been received but not yet paid for, so the actual use of cash is less than CGS, so operating cash flows would increase A decrease would be a use of cash and would be added to operating cash flows

30 Notes Payable Short term borrowing from banks, GAAP classifies this as a financing activity Very similar in many ways to accounts payable but classified differently

31 Current Portion of Long-term Debt Has 2 components –actual repayment of long-term debt, a financing cash flow –reclassification of long-term debt to current, not a cash flow

32 Other Current Liabilities Usually an operating cash flow –an increase is a cash inflow –a decrease is a cash outflow

33 Long-term Debt Reason for change is important –New debt issued; financing cash inflow –Reclassification to current; not a cash flow –Early retirement of debt; financing outflow –Conversion to common stock; not a cash flow

34 Deferred Income Taxes Income taxes declared as an expense but not payable (yet) according to the tax code –an increase is an operating inflow because it was deducted from net income but doesn’t effect cash flows –a decrease means that previous tax deferrals are catching up on the company and would be an operating outflow

35 Other Non-current Liabilities Pensions and retirement benefit changes should show up in operating cash flows Most other changes should show up in financing Usually considered a financing activity if not enough information is given

36 Summary Statement of cash flows is relatively new Cash flows do not necessarily track income flows, a firm with good net income may be in financial trouble Many differences in accounting principals have no impact on cash flows Allows the calculation of free cash flows used in several valuation models