Ch_07.doc

Chapter 7
Cash Flow Analysis
REVIEW Cash is the residual of cash inflows less cash outflows for all prior
periods of a company. Net cash flows, or simply cash flows, refer to the
current period's cash inflows less cash outflows. Cash flows are different
from accrual measures of performance. Cash flow measures recognize inflows
when cash is received not necessarily earned, and outflows when cash is
paid not necessarily incurred. The statement of cash flows reports cash
flow measures for three primary business activities: operating, investing,
and financing. Operating cash flows, or cash flows from operations, is the
cash basis counterpart to accrual net income. Information on cash flows
helps us assess a company's ability to meet obligations, pay dividends,
increase capacity, and raise financing. It also helps us assess the quality
of earnings and the dependence of income on estimates and assumptions
regarding future cash flows. This chapter describes cash flows and their
relevance to our analysis of financial statements. We describe current
reporting requirements and their implications for our analysis of cash
flows. We explain useful analytical adjustments to cash flows using
financial data to improve our analysis. We direct special attention to
transaction reconstruction, T-account, and conversion analyses.
OUTLINE | |
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|Statement of Cash Flows |
|Relevance of Cash |
|Reporting by Activities |
|Constructing the Cash Flow Statement |
|Special Topics |
|Reporting Cash Flows from Operations |
|Indirect Method |
|Direct Method |
|Converting from Indirect to Direct Method |
|Adjustments to Cash Flow Components |
|Additional Disclosures and Adjustments |
|Analysis Implications of Cash Flows |
|Limitations in Cash Flow Reporting |
|Interpreting Cash Flows and Net Income |
|Alternative Cash Flow Measures |
|Company and Economic Conditions |
|Free Cash Flow |
|Cash Flows as Validators |
|Specialized Cash Flow Ratios |
|Cash Flow Adequacy Ratio |
|Cash Reinvestment Ratio |
|Appendix 7A Analytical Cash Flow Worksheets | ANALYSIS OBJECTIVES | |
|Explain the relevance of cash flows in analyzing business activities. |
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|Describe reporting of cash flows by business activities. |
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|Describe the preparation and analysis of the statement of cash flows. |
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|Interpret cash flows from operating activities. |
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|Analyze cash flows under alternative company and business conditions. |
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|Describe alternative measures of cash flows and their usefulness. |
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|Illustrate an analytical tool in evaluating cash flows (Appendix 7A). |
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QUESTIONS 1. The term cash flow was probably first coined by analysts. They
recognized that the accrual system of income measurement permits the
introduction of a variety of alternative accounting treatments and
consequent distortions. The crude concept of cash flow-net income plus
major noncash expenses (such as depreciation)-was derived to bypass these
distortions and bring income measurement closer to the discipline of
actual cash flows. This cash flow measure, still a popular surrogate for
cash from operations (CFO), is crude because it falls short of reliably
approximating in most cases the correct measure of CFO.
Confusion with the term cash flow derives from several sources. One
source of confusion stems from the initial and incorrect computation of
the crude measure of cash flow as income plus major noncash expenses. The
figure fails to reflect actual cash flows. Another and more serious
confusion arises from the assertion by some, and particularly by managers
dissatisfied by the level of their reported net income, that cash flow is
a measure of performance superior to or more valid than net income. This
assertion implicitly assumes that depreciation, and other noncash costs,
are not genuine expenses. Experience shows that only net income is
properly regarded as a measure of performance and can be related to the
equity investment as an indicator of operating performance. If we add
back depreciation to net income and compute the resulting return on
investment, we are, in effect, confusing the return on investment with an
element of return on investment in fixed assets. 2. While fragmentary information on the sources and uses of cash can be
obtained from comparative balance sheets and from income statements, a
comprehensive picture of this important area of activity can be gained
only from a statement of cash flows (SCF). The SCF provides information
to help answer questions such as:
. What amount of cash is generated by operations?
. What utilization is made of cash provided by operations?
. What is the source of cash invested in new plant and equipment?
. What use is made of cash from a new bond issue or the issuance of
common stock?
. How is it possible to continue the regular dividend in the face of an
operating loss?
. How is debt repayment achieved?
. What is the source of cash used to redeem the preferred stock?
. How is the increase in investments financed?
. Why, despite record profits, is the cash position lower than last
year? 3. SFAS 95 requires that the statement of cash flows classify cash receipts
and cash payments by operating, financing and investing activities. Operating activities encompass all the earning-related activities of the
enterprise. They encompass, in addition to all the income and expense
items found on the income statement, all the net inflows and outflows of
cash that operations impose on the enterprise. Such operations include
activities such as the extension of credit to customers, investment in
inventories, and obtaining credit from suppliers. This means operating
activities relate to all items in the statement of income (with minor
exceptions) as well as to balance sheet items that relate to operations
mostly working capital accounts such as accounts receivable, inventories,
prepayments, accounts payable, and
accruals. SFAS 95 also specifies that operating activities include all
transactions and events that are not of an investing or financing nature.
Financing activities include obtaining resources from owners and
providing them with a return of or a return on (dividends) their
investment. They also include obtaining resources from creditors and
repaying the amounts borrowed or otherwise settling the obligations.
Investing activities include acquiring and selling or otherwise disposing
of both securities that are not cash equivalents and productive assets
that are expected to generate revenues over the long-term. They also
include lending money and collecting on such loans. 4. We can distinguish among three categories of adjustments that convert
accrual basis net income to cash from operations: (i) Expenses, losses,
revenues, and gains that do not use or generate cash such as those
involving noncash accounts (except those in ii), (ii) Net changes in
noncash accounts (mostly in the operating working capital group) that
relate to operations-these modify the accrual-based revenue and expense
items included in income, (iii) Gains and losses (such as on sales of
assets) that are transferred to other sections of the SCF so as to show
the entire cash proceeds of the sale. 5. The two methods of reporting cash flow from operations are:
Indirect Method: Under this method net income is adjusted for noncash
items required to convert it to CFO. The advantage of this method is that
it is a reconciliation that discloses the differences between net income
and CFO. Some analysts estimate future cash flows by first estimating
future income levels and then adjusting these for leads and lags between
income and CFO (that is, nonc