Cash Flow Statement Analysis. The analysis of a company's
cash flows can provide useful information for understanding
a company's business and earnings and for predicting
its future cash flows. There are several things you can
do when you evaluate the cash flow statement. Number
1; you can evaluate where the major sources and
uses of cash flow are between the major categories
of operating, investing, and financing activities.
As you might imagine for a start-up, operating cash
flow might be low or negative. Investing cash flow
might be high, in the sense that there is lots of money
being spent on investing. So, that would be a big negative
number, and financing activity would have to be positive,
because money is being raised, but eventually as the
company matures, then operating cash flow should
be going up, investing cash flow might be stabilizing, and
in terms of financing, we would be looking at money
flowing back to the shareholders or the investors.
We also need to look at whether the operating cash
flows will cover the capital expenditures of the
company. We can also evaluate the primary determinants
of operating cash flow. So, this is now drilling into
the CFO segment of the cash flow statement. We can
compare operating cash flow with income. What we
would like to see over a period of time is, operating cash
flow and net income moving together. If we have a
situation where net income is going up, but CFO is
either flat or down that means that the company is
probably recognizing revenue too aggressively,
or maybe not considering expenses that it should
be considering. We should also look at the consistency
of operating cash flows, if cash flows are up and down
a lot that would suggest relatively high risk in
this business. We can evaluate the primary determinants
of investing cash flow. Now, if a company is getting a
lot of money, because it is selling its equipment
then that will raise questions about the company's
future ability to generate cash. We should also
evaluate the primary determinants of financing
cash flow. So, this will give us an indication about
the company's capital structure and plans related
to how future operations will be funded. Common-
Size Analysis. If you recall with the income statement
our common size analysis involves taking every
number on the income statement and dividing by revenue.
With the balance sheet, a common size analysis involves
taking every number on the balance sheet and dividing
by total assets. With the cash flow statement, we
can use two approaches; one approach is to express
every line item of cash inflow as a percentage of
total inflows, and every line item of outflow as a
percentage of total outflows. So, if we create a simple
example over here. Let's say a given company has
receipt from customers equal to 900, the sale of
equipment for a given period is 50, and the issue of shares
is 50. So, let's say the total inflows are 1000. Using the
first method, we then take each of these major
inflows and in the simplistic example, let's say these
are all the inflows, then we take receipt from customers,
900 as a percentage of total. So, we are saying that 90%
of our inflow is coming from here, we have about 5%
coming from the sale of equipment, and 5% coming from
the issue of shares. You can see that a more detailed analysis
will tell us where a company is getting its money
from. If you notice that a company is getting most
of its money from this source; sale of equipment then
that would clearly be a concern. For a strong company,
most of the inflow should be coming from customers
from it's core operation. Another way of dealing
with the common size statement is to take every number
and express it as a percentage of revenue. The revenue
obviously would come from the income statement. Here
again, we take the actual number, say 950 and 50,
and let's say that the total revenue is equal to 1100,
then we simply take the percentage of 1100. So, 900
divided by 1150 divided by 1100 and so on. So, these are just two different
techniques, and in the industry both are used. Moving
now to, Free Cash Flow to Firm, or FCFF, and free cash flow to equity. These are
important concepts, especially for the CFA level
2 exam. At level 1, you need to understand the basics
and ideally memorize the formulas that I'm going
to share with you, but this becomes much more important
at later levels. So, let's understand the concept, a firm generates cash,
so let's say there are revenues and then a company pays off
all its expenses. Who does the cash belong to? The
lenders and the shareholders, in a sense, these other
investors, they have a claim against the cash that
the firm generates. Free cash flow to firm, is essentially
the cash which is available to all the suppliers
of capital. The lenders, these might be bond holders,
for example, and the shareholders. You need to learn
the formula for this free cash flow to firm. The formula
is net income, this comes from the income statement,
plus non-cash charges. Why are we adding non-cash
charges like depreciation? Because net income was
arrived at, after subtracting depreciation. So,
we are simply adding it back, because we are looking
at a cash flow. Then we also add back, after tax interest.
Why? The reason is we are looking at cash available to all suppliers of capital. Net income was arrived at after subtracting
interest, but we want to know how much money is also
available to the lenders. So, we add back after-tax
interest, but then we have to subtract the investments
in fixed-capital, and the investments in working
capital. The reason being that when we calculate
free cash flow to firm, we want to look at the free cash
flow, assuming that the company will sustain, and
to sustain, obviously the company needs to make investments
in fixed capital and working capital. So, during a given period,
there will be certain fixed capital investments.
They have to be subtracted and there will be working
capital investments; they need to be subtracted
either. So, this overall expression tells us the
free cash flow to firm, firm here being all the suppliers
of capital. Another way of expressing this formula is given right here, free cash flow to firm
can also be written as CFO, cash flow from operations,
plus after-tax interest minus the investment
in fixed capital. Now, here we are assuming that the
interest amount has been subtracted to come up with
CFO, that's why the after-tax interest is added
back, and then we subtract the investment in fixed
capital. We do not subtract investment in working
capital, because that is already addressed in CFO.
Free cash flow to equity is given by these expressions.
This is the money that is available to shareholders.
So, a firm generates cash, first the lenders get their
money back, the interest, as well as the debt repayments,
and then what is left is called the free cash flow
to equity, or free cash flow available to equity holders.
That is expressed as follows: CFO, which is cash flow
from operations minus the fixed capital investment
and then any net borrowing. If a company is borrowing
money, then this would be positive. If the company
is paying back more money then it is borrowing then
this would be negative, and that negative is expressed
over here, so minus net debt repayments. Coming
now to cash flow ratios, and these are not as bad as
they might look. You can simply read these a few times
and I will help you understand what we are talking
about. Cash flow to revenue ratio, here we are looking
at the cash flow from operations divided by revenue,
and here we don't necessarily have a good number or a bad
number. We really need to look at numbers relative
to the industry, but all else equal, a high cash flow
from operations relative to revenue is a good sign.
Cash return on assets. This is the cash flow from
operations divided by total assets. Here again
all else equal, the higher the better. Cash return on
equity, is the cash flow from operations divided
by average shareholders equity over a given period. Cash to
income, this is CFO divided by operating income, here the key is
for this ratio to remain relatively stable. If this
ratio is going down, that would imply that a company
might be showing higher operating income, then it
should be. Cash flow per share, is the cash flow from
operations minus the preferred dividends divided
by the number of shares outstanding. This is roughly
analogous to EPS, where instead of using earnings,
we are using cash flow from operations. More ratios--
debt coverage. This is the cash flow from operations
so how much cash flow a company is generating divided by total
debt. You want a high ratio, because for a certain level
of debt, a high cash flow from operation is a good
thing. If you have low total debt and high cash flow
from operations, that means that the financial
risk and financial leverage is low. Interest coverage
ratio. This is equal to the cash flow from operations
plus interest paid plus taxes paid divided by interest paid.
Now, why do we have all these pluses over here? To come
up with CFO, if you recall we typically subtract interest
and we also subtract taxes. So, we are looking at how
much total money is available to pay interest. Therefore,
we add back the interest amount and tax paid amount
and divide by interest paid. Here again, a high ratio is
good, so a high ratio tells us that the interest
payments can be made very easily, because if interest
amounts are small and cash flow is high, then the ratio
is high. If you are lending money to an entity, you would
be looking for high coverage ratios. The reinvestment
ratio, is cash flow from operations divided by cash paid for
long-term assets. Debt repayment; CFO divided by cash paid
for long-term debt repayment. Dividend payments;
CFO divided by dividend payments, and what it measures? Ability
to pay debts with outstanding cash flows, or ability
to pay dividends with operating cash flow. Investing
and financing. The CFO divided by cash flows from investing
and financing activities. This tells us about the
ability to acquire assets, pay debts, and make distributions
to owners. I don't think it is hugely important
for you to memorize all these ratios, but just by
looking at them you should get a sense for what they
are measuring. So, we now come to the end of this very
important reading. A quick summary; you need to understand
operating activities, investing activities, and
financing activities. Operating has to do with the
core day to day operation of a company. Investing has
to do with buying or selling of long-term assets
or investments, and financing activity has to do
with the flow of cash between the company and providers
of capital. You need to understand how different
cash flow items are treated under IFRS and US GAAP,
and the critical ones to understand are interest received,
interest paid, dividends received, and dividends
paid. So, the table which I showed you, must be memorized.
You need to understand the direct format and the
indirect format for the cash flow statement. Remember
that this distinction only applies in the CFO segment.
CFF and CFI only have a direct format. You need to
recognize that the cash flow statement can be derived
from the income statement and balance sheet. Very
simplistically, we take items out of the income
statements, such as revenue, and then we look at the
change in accounts receivable to come up with the
cash flow or the cash received from customers. We
need to understand the steps in preparing both the
direct and the indirect cash flow statements. I think
this particular item is highly testable. We talked
about cash flow analysis. You need to be on top of
that, and the concept behind free cash flow to firm,
and free cash flow to equity. As always go over
the summary, review the learning objectives, try
to do all the examples in the curriculum. If you find
them too long don't spend too much time on them. Just
try to get a flavor for what they are about, but definitely
do the practice problems and also try to do practice
problems from other sources. That is it.