CFA Level I: Cash Flow Statements

The three major financial statements analysts look over to evaluate a company are the income statements, balance sheet and cash flow statements. The income statement shows how the company is using its assets and liabilities to generate revenue. The cash flow statement is an overview of the inflows and outflows of cash, and shows the net cash levels at the end of the reporting period. Finally, the balance sheet is an overview of the assets and liabilities that a company has, including what is owed to shareholders.

Cash Flow Accounting

All three statements are interrelated. For instance, net income goes into retained earnings, will determine the changes in shareholder’s equity. The cash levels on the balance sheet are effected by the net cash flows. And in the indirect method of cash flow accounting, the net income is adjusted until we arrive at net cash flow from operations.

Alternatively, in the direct format method, we take break down all the cash inflow and outflows of a company that result in a change in operating cash flow. While both methods are allowed under IFRS and GAAP, the direct format is preferred.

When accounting for cash flows, often times year-to-year increases or decreases in accounts like inventories or prepaid expenses are the cash flows.

There are a few more differences between the IFRS and GAAP methods of cash flow accounting.  Under the IFRS, carious flows from interest received, interest paid, dividends and taxes can be considered either operating cash flows or investing/financing activities. Under the us GAAP, such activities are strictly operating cash flows, with the exception of dividends paid, which are a financing activity.

Components of Cash Flow Statements

The cash flow statement is usually broken down between 3 classifications of cash flows. These are the operating activities cash flow, investing activities, and financing activities.

  • Operating cash flows: These cash flows are the result of daily operation of a company. Some inflows include sales of goods and services, interest and dividend inflows, and other activities which create revenue but are not financing or investing activities, such as securities dealing. Some outflows include payments to employees, suppliers, governments and lenders, and other expenses related to revenue creation.
  • Investing Activities: These cash flows are created when long-term assets are bought or sold, and include their maintenance and disposal fees. Some inflows would be from sale of property, plants, equipment, non-trading securities or debt, intangibles. Outflows would be activities which involved the purchase of the above.
  • Financing Activities: These cash flows occur when the company obtains capital through the issuance of debt or equity. Inflows come from the issues, while outflows come in the form share repurchases, dividend issues and principal payments on long-term debt. Note that interest payments are part of operating cash flows.

Free Cash Flows

Apart from allowing us to answer general questions about major sources of cash flows, and evaluating the significance of operating, investing and financing activities on cash levels, we also can use cash flows to determine the amount of free cash flows, which is the excess operating cash flow after capital expenditures. This can be seen as the amount of cash the company makes after all expenses are accounted for, and it is particularly useful for forecasting the value of companies.

There are two kinds of free cash flows. Free cash flow to firm is the cash flow available to the company’s lenders and equity capital contributors, after all expense have been paid and investments in working capital and fixed capital have been made.

  • FCFF: NI + NCC + Int(1 – Tax) – FCInv – WCInv
    • NI = Net Income
    • NCC = non-cash charges like depreciation & amortization
    • Interest(1-t) added back because it is available to lenders
    • FCInv = Capex
    • WCInv = Change in working capital
  • FCFF: CFO + Int(1– t) – FCInv – WCInv
    • CFO = Cash flow from operating activities
    • If interest paid is under CFO (IFRS possibility) then interest does not need to be added

Free cash flow to equity is cash that is available to common shareholders of a company. It is similar to FCFF, but takes out operating expenses including principal and interest borrowing costs.

  • FCFE: CFO – FCInv + Net Borrowing
    • If net borrowing is negative, then it is net debt repayment

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