Understanding Cash Flow Statements. In this reading,
we will talk about the components and format of the
cash flow statement. We will talk about the linkages
between the balance sheet, income statement, and
cash flow statement. We will talk about how the cash
flow statement is prepared and that is, perhaps,
the most testable element of this reading. And then
finally, we will talk about cash flow statement analysis.
The cash flow statement provides important information
about the company's cash receipts and payments
during an accounting period. Note that the income statement
gives us information about revenue, expenses, and
net income, but revenue, expenses, and net income are
all based on accrual accounting. So just because
a net income is high doesn't necessarily mean that
the company generated a lot of cash. On the other hand,
the cash flow statement tells us exactly how much
cash is coming in and from what sources. The cash flow
statement is a vital information source that assists
users to evaluate a company's liquidity, solvency,
and financial flexibility. For an analyst, it is crucial to estimate
future cash flows as you will see in later readings.
To value a company, we need future cash flows and
then we discount those future cash flows in order
to come up with a current value of a company, so clearly
it is essential to value or to estimate these future
cash flows. The cash flows can then, also help us determine
whether there is sufficient money to pay for investments,
whether there is sufficient money to pay back windows
and equity holders. Coming now to the components
and format of the cash flow statement. The cash flow
statement has three parts; the first part shows
us cash flows related to operating activities. Operating
activities are activities that are part of the day
to day business operations of the company and here
are the classic examples of operating activities. The
second part of the cash flow statement is investing
activities. These are activities associated with acquisition
and disposal of long-term assets, and the third
part is financing activities. Activities related
to obtaining or repaying capital and here are the
examples of financing activities. i just want to make a note here that operating
activities in the context of the cash flow statement
is not exactly the same as the operating part of a income
statement, because in a income statement under the
operating segments you might see items such as,
gain on sale of equipment, so on the income statement
that appears as operating item. However, on a cash
flow statement, the cash related to the sale of equipment
would show up as a investing activity. Let us look
at a quick example, JFK Enterprises recorded the
following, and we need to look at these entries, and
determine what is the net cash flow from investing
activities. For a question like this, you need to,
look for two items; one is you need to look for cash
flows and whether the cash flow is a investing activity.
So let us create two additional columns whether
or not each item is a cash flow, and the second is whether
or not it is investing activity. Purchase of equipment,
this is a cash flow, equipment falls under investing
activity, so this is investing gain from sale of
a van. So van is equipment so it would be investing,
but it is not a cash flow so gain from sale is not a cash
flow in of itself. However, the receipts from sale
of the van...this would be a cash flow, and this is a investing
activity. Dividends paid are not investing activity,
this is a financing activity so clearly, it does
not fall in here. Interest and preferred dividend
paid, again this would not fall under investing,
and salaries paid would also not fall under investing.
So, we are only left with these two elements. The purchase
of equipment means that money went out, so that is negative.
Receipt from sale of van would be a positive. So the
net cash flow is -70 + 18 which gives us a net outflow
of 52,000. So, negative 52,000 is the investing activity. We
can either say it's negative or we can say that it
is a outflow. This is a very important slide from
a testability perspective and it talks about the
summary of differences between IFRS and US GAAP
related to different cash flow items. When a company
receives interest, income should be classified
as operating or investing. A company receives interest
income when it invests in the bonds of another company.
Now, notice i used the term 'invest' what IFRS says is that
this interest received could be either shown as
a operating cash flow or a investing cash flow. So,
IFRS gives flexibility to companies to decide how
to categorize interest received. US GAAP, however, says that interest received is always
an operating cash flow. Interest paid, this is where a company
issues a bond or this is where a company borrows money
and then pays interest. IFRS says, that this cash flow
can be classified as operating or financing. US
GAAP says, that it is always operating, and I hope you
can see the rationale behind this financing option
in IFRS. When a company is issuing a bond that is a financing
mechanism, so, the interest paid when a company
issues a bond could arguably be classified as a financing
activity. Dividends received, this is where a company invests
in the shares of another company and receives dividends.
IFRS says, that the cash received as...the dividends
received could be classified as operating or investing.
US GAAP says, that this has to be shown as operating
and finally, dividends paid. This would be dividend
on the company's own stock. Under IFRS, the classification
would be operating or financing. Under US GAAP, the
categorization is financing. Notice US GAAP does
not give any options, so in a sense, remembering the
US GAAP categorization is easier. It is always operating
except when a company pays dividends. With IFRS, you
need to recognize that there is always an option.
One of the options, is always operating, and the other
option depends on whether the activity is financing
or investing. You must learn this table. The curriculum
provides a little more detail related to other cash
flow elements such as bank overdraft, taxes paid,
and then the curriculum also talks about the format
of the cash flow statement. You can simply read these.
I don't think they are overly testable, but still
it would not hurt to go over this material. From a format
perspective, IFRS allows both direct or indirect,
but the direct is encouraged. US GAAP also says direct
or indirect, direct is again encouraged. A reconciliation
of net income to cash flow from operating activities
must be provided regardless of the method used.
As you probably gathered, from the previous slide
a cash flow statement can be presented in either
a direct format or a indirect format, and specifically,
it is the operating activities that can be presented
in one of these two formats. The direct format is
easy to understand. Essentially, it is taking the
income statement and expressing the items on the
income statement from a cash perspective. So instead
of saying revenue we say cash collected from
customers, instead of saying cost of goods sold we say
cash paid to suppliers and so on. At the bottom, we
have the operating cash flow and this will be arrived
at by taking the cash from customers and then subtracting
all these cash payments. With the indirect format,
we start with the net income and make several adjustments
to come up with the operating cash flow. Non-cash
activities. A non cash transaction is any transaction
that does not involve an outflow or inflow of
cash. It must be disclosed in either a footnote or
supplemental schedules to the cash flow statement.
An analysts should incorporate non-cash transaction
into analysis of past and current performance and
include their effects in estimating future cash flows.
An example of a non-cash activity is given right here.
The conversion of a face value 1 million convertible
bond to 1 million worth of common stock. Now, this
is clearly non-cash, but this might have implications
on how much money is available to common shareholders
in the future.