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

2. 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

3. 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 to examine the quality of reported cash flow from operations

4. 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.

5. Calculation of Free Cash Flow: Nike, Inc.: 2004

6. Calculation of Free Cash Flow: Reebok, 2004

7. The Standard GAAP Statement of Cash Flows

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

9. Indirect Method for Cash Flow from Operations
Net income
+ Accruals
= Cash from operations
Nike’s statement (to follow) employs the
indirect method (as do almost all firms):
2004
Net income $ million
Accruals
Cash provided by operations $1, million

10. Nike, Inc. GAAP Statement of Cash Flows

11. Nike, Inc. GAAP Statement of Cash Flows (cont.)

12. Direct Method for Cash from Operations
Cash inflows
Cash outflows
= Cash from operations

13. 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

14. 1. Operating Cash and Cash in Financial Assets: Nike
Change in cash and cash equivalents $194 million
Increase in operating cash $ 8 million
Increase in financial assets
$194 million
The determination of operating cash: use a normal
percentage of sales for the industry
See Nike’s reformulated balance sheet in Exhibit 9.3 in chapter 9.

15. 2. Transactions in Financial Assets: Lucent Technologies

16. 3. and 4. Net Interest Payments and Taxes on Net Interest Payments: Nike
In millions
Interest payments $37.8
Interest income (15.0)
Net interest payments
before tax
Tax benefit (at 37.1%)
$14.3
Add back to GAAP Cash from Operations

17. 5. Non-cash Transactions
Acquisitions with shares
Asset exchanges
Assets acquired with debt
Capitalized leases
Installment purchases
Debt converted to equity

18. The Reformulated Statement of Cash Flows: the Adjustments

19. 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
Investment in financial assets
Free cash flow
Financing Flow to Claimants
Debt financing:
Issue of long-term debt
Reductions in long-term debt
Net interest payment (after tax)
Investments in cash equivalents
(net of exchange rate effect on cash)
Equity financing:
Share issues
Shares repurchases
Dividends
Total financing flows
$947 8
(401)
(154)
207
401 14
161
(254)
420
179
$1514
1,528
554
$974
629
345
974

20. 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 of foreign subsidiaries are translated at average exchange rates whereas balance sheet numbers are translated at end-of-year exchange rates
Stock options involve “as if” cash flows

21. 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

22. 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 (e.g. depreciation)
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
Structured financing can make borrowing look like
cash from operations: Enron
Capitalization policy shifts CFO to cash investment