1. CASH FLOW ANALYSIS
1

2. Learning Objectives
explain the meaning, usefulness and purpose of
cash flow statement
identify cash flow from three different activities
understand two different methods of preparing
cash flow statement
understand free cash flow
study various types of cash flow ratios
test solvency by calculating cash flow ratios
2

3. CASH FLOW ANALYSIS
•The income statement is based on the accrual method, and
net income may not represent cash generated from
operations.
•Net income, based on accrual accounting, is not the same
thing as cash earnings.
•When the timing of revenue or expense recognition differs
from the receipt or payment of cash, it is reflected in
changes in balance sheet accounts.
3

4. • A company may be generating positive and
growing net income but ………………….
• may be headed for insolvency because
insufficient cash is being generated from
operating activities.
• Therefore constructing a statement of cash flows is
very important in an analysis of a firm’s activities
and its prospects. 4

5. THE CASH FLOW STATEMENT
•The cash flow statement provides information
about…………….a company’s cash receipts and
cash payments during an accounting period.
•showing how these cash flows link the ending cash
balance to the beginning balance shown on the
company ’ s balance sheet.
5

6. • The cash flow statement reconciles the beginning
and ending balances of cash over an accounting
period.
• The change in cash is a result of the firm’s
operating, investing, and financing activities.
+ Operating Activities
+ Investing Activities
+ Financing Activities
= Change in cash balance
+ Beginning Cash Balance
- Ending Cash Balance.
6

7. The cash flow statement provides information beyond that
available from the income statement, which is based on
accrual, rather than cash accounting.
The cash flow statement provides the following.
—provide information on cash inflows, outflows for
a period.
—Information about a company’s cash receipts and
cash payments during an accounting period.
7

8. —Information about a company’s operating,
investing and financing activities.
—An understanding of the impact of accrual
accounting events on cash flows.
—provides information to assess the firm’s liquidity,
solvency, and financial flexibility.
8

9. An analyst can use the statement of cash flows to
determine whether;
Regular operation generate enough cash to sustain
the business
Enough cash is generated to pay off existing debts
as they mature.
The firm is likely to need additional financing
Unexpected obligations can be met.
The firm can take advantage of new business
opportunities as they arise.
9

10. A firm’s cash receipts and cash payments are
classified on the cash flow statement as
operating, investing, or financing activities.
Cash flow from operating activities
Cash flow from financing activities
Cash flow from investing activities
10

11. CASH FLOW FROM OPERATING
ACTIVITIES
•Sometimes it is referred to as “cash flow from
operations/operating cash flow.
•Operating activities include the company’s
day-to-day activities that create revenues,
such as selling inventory and providing
services.
11

12. • Cash inflows result from cash sales and from
collection of accounts receivable.
Examples……………………..
• cash receipts from the provision of services and
royalties, commissions, and other revenue.
• To generate revenue, companies undertake
activities such as manufacturing inventory,
purchasing inventory from suppliers, and paying
employees.
12

13. Cash outflows result from cash
payments……………………
•for inventory, salaries, taxes, and other operating-
related expenses and from paying accounts payable.
•Additionally, operating activities include cash
receipts and payments related to securities held for
dealing or trading purposes (as opposed to being held
for investment).
13

14. CASH FLOW FROM INVESTING ACTIVITES
•Investing activities include purchasing and selling
investments. …………….
•Investments include property, plant, and
equipment; other long-term assets; and
•both long-term and short-term investments in the
equity and debt (bonds and loans) issued by other
companies.
14

15. Cash inflows in the investing category include……….
•cash receipts from the sale of non-trading
securities; property, plant, and equipment; or
•other long-term assets.
Cash outflows include …………………………
•cash payments for the purchase of these assets.
15

16. CASH FLOW FROM FINANCING
ACTIVITIES
•Financing activities include obtaining or repaying
capital, such as equity and long-term debt.
•Cash inflows in this category include…………….
cash receipts from issuing stock (common or
preferred) or bonds and cash receipts from
borrowing.
16

17. Cash outflows include …………………
•cash payments to repurchase stock (e.g., treasury
stock),
•to pay dividends, and
•to repay bonds and other borrowings.
Note that indirect borrowing using accounts payable
is not considered a financing activity—such
borrowing would be classified as an operating
activity.
17

18. NON CASH INVESTING/FINANCING
ACTIVITIES
—These activities are not reported in the cash flow
statement since they do not result in flows or
outflows of cash.
—These are significant investing and financing
activities that do not directly affect cash.
—These activities involve only on long-term assets,
long-term liabilities and stock holder’s equity.
18

19. • These transactions must be disclosed in either
footnote or supplement schedule to the cash flow
statement.
• Analyst should incorporate these transactions into
analysis of past and current performance, and
include their effects in estimating future cash
flows.
EXAMPLE:
• Issuance of common stock to retire long-term debt
• Purchase of equipment with a note payable
• Issuance of stock to acquire land
19

20. MAJOR SOURCES AND USES OF CASH
•Cash flow analysis begins with an evaluation of the
firm’s sources and uses of cash from operating,
investing, and financing activities.
•Sources and uses of cash change as the firm moves
through its life cycle.
For example:
In the early stage of growth…………………
•Experience negative operating cash flow
20

21. • Negative operating cash flow usually financed
externally by issuing debt or equity securities
• Over the long term firm must be able to generate
operating cash flows that exceed capital
expenditure and provide a return to debt and
equity holders.
21

22. CASH FLOWS FROM INVESTING
ACTIVITIES
Cash flows are related to an entity’s life cycle stage
– Significant cash outflows in the emerging and growth stages
of business
– They become positive and peak during business maturity
– CFIs trend toward zero as a firm declines and ceases
operations
22

23. CASH FLOWS FROM FINANCING
ACTIVITIES
CFFs are related to an entity’s life cycle stage
– Significant cash inflows in the emerging and growth
stages of business
– They decline during business maturity
– CFFs negative as a firm declines and ceases
operations (return of investment)
23

24. OPERATING CASH FLOW & ANALYST
•An analyst should identify the major determinants
of operating cash flow.
•Positive operating cash flow can be generated by
the firm’s earnings related activities.
•Positive operating cash flow can also be generated
by decreasing non-cash working capital, such as
liquidating inventory and receivables or increasing
payables.
24

25. • Operating cash flow also provides a check of the
quality of a firm’s earnings.
• A stable relationship of operating cash flow and
net income is an indication of quality earnings
• Earnings that significantly exceed operating cash
flow may be an indication of aggressive
accounting choices. Ex: recognizing revenues too
soon or delaying the recognition of expenses.
• The variability of net income and operating cash
flow should also be considered.
25

26. INVESTING CASH FLOW
—The sources and uses of cash from investing
activities should be examined.
—A firm may reduce capital expenditure or sell
capital assets in order to save or generate cash.
—Increasing capital expenditure is usually an
indication of growth.
—Generating operating cash flow that exceeds
capital expenditures is a desirable trait.
26

27. FINANCING CASH FLOW
•This cash flow reveals information about whether
the firm is generating cash flow by issuing debt or
equity.
•This also provides information about whether the
firm is using cash to repay debts, re acquire stock or
pay dividends.
27

28. LINKAGES OF THE CASH FLOW STATEMENT WITH
THE INCOME STATEMENT AND BALANCE SHEET
•Cash is an asset. The statement of cash flows
ultimately shows the change in cash during an
accounting period.
•The beginning and ending balances of cash are
shown on the company’s balance sheets for the
previous and current years,
•and the bottom of the cash flow statement
reconciles beginning cash with ending cash.
28

29. The beginning and ending balance sheet values ofThe beginning and ending balance sheet values of
cash and cash equivalents are linked through thecash and cash equivalents are linked through the
cash flow statementcash flow statement..
BeginningBalance + - E n d in g Balance
B egin ning cash Cashreceipts(from
operating,investin g,
andfinancin g
activities)
Cashpayments
(foroperating,
in vestin g, and
financing activities)
Endingcash
29

30. Retained Earnings
BeginningBalance + - E n d in g Balance
B eg in n in g retained
earnings
Net income or minus
net loss from the
income statement for
year
Dividends Endingretained
earnings
30

31. • A company’s operating activities are reported on
an accrual basis in the income statement……………..
• Any differences between the accrual basis and the
cash basis of accounting for an operating
transaction result in an increase or decrease in
some (usually) short-term asset or liability on the
balance sheet.
31

32. For example
−if revenue reported using accrual accounting is
higher than the cash actually collected, the result
will be an increase in accounts receivable.
•If expenses reported using accrual accounting are
lower than cash actually paid, the result will be a
decrease in accounts payable
32

33. • A company’s investing activities typically relate to
the long-term asset section of the balance sheet,
and
• its financing activities typically relate to the equity
and long-term debt sections of the balance sheet.
• Each item on the balance sheet is also related to
the income statement and/or cash flow statement
through the change in the beginning and ending
balance.
33

34. Knowing any three of these four items makes it easy
to compute the fourth.
Understanding these interrelationships between the
balance sheet, income statement, and cash flow
statement is useful in not only understanding the
company’s financial health but also in detecting
accounting irregularities.
BeginningBalance + - E n d in g Balance
B e g in n in g A c c o u n ts
R e c e iv a b le
Income Statement
Revenue
Cash Collected from
Customers
EndingAccounts
Receivables
34

35. METHODS OF PRESENTING CASH FLOW
STATEMENT
There are two acceptable formats for reporting cash
flow from operations.
1.Direct method
2.Indirect method
35

36. 36

37. DIRECT METHOD
•This method converts an accrual –basis income
statement into cash-basis income statement.
•That is, the direct method reports gross cash
receipts and cash disbursements related to
operations.
37

38. DIRECT METHOD……………Cont/………….
•Creditors preferred the direct method. The direct
method reports total amounts of cash flowing in
and out of a company from operating activities.
•This offers most analysts a better format to readily
assess the amount of cash inflows and outflow.
• When companies report using the direct method, they
must disclose a reconciliation of net income to cash flows
from operations (the indirect method) in a separate
schedule
38

39. INDIRECT METHODINDIRECT METHOD
•Under this method net income is converted to operating
cash flow by making adjustments for transactions that
affect net income but are not cash transactions.
These adjustments includesThese adjustments includes
•Eliminating non-cash expenses [depreciation/amortization]
•Non-operating items [gain/losses]
•Changes in balance sheet accounts [resulting from accrual
accounting events]
Total cash flow from operating activities is exactly the
same under both methods, only the presentation method is
different.
39

40. Statement of Cash Flows
• Consider first the net cash from operations.
Indirect method

41. Statement of Cash Flows
• Depreciation and amortization add-back.
Preparation of the Statement of Cash Flows

42. Statement of Cash Flows
• Adjustments for changes in balance sheet
accounts can be summarized as follows:
Preparation of the Statement of Cash Flows

43. STEPS IN PREPARING THE CASH FLOW STATEMENT
•The preparation of the cash flow statement uses data
from both the income statement and the comparative
balance sheets.
•As noted earlier, companies often only disclose indirect
operating cash flow information, whereas analysts
prefer direct-format information.
•Operating Activities: Direct Method
•Investing Activities: Direct Method
•Financing Activities: Direct Method
43

44. OPERATING ACTIVITIES: DIRECT METHOD
•First determine how much cash received from its
customers
•how much cash was paid to suppliers and to
employees as well as
•how much cash was paid for other operating
expenses, interest, and income taxes.
44

45. Cash Received from Customers
•To determine the cash receipts from its customers, it
is necessary to adjust this revenue amount by the
net change in accounts receivable for the year.
•If accounts receivable increaseIf accounts receivable increase during the year,
revenue on an accrual basis is higher than cashrevenue on an accrual basis is higher than cash
receipts from customersreceipts from customers, and vice versa.
45

46. Revenue $23,598
L e s s : In c re a s e in a c c o u n ts re c e iv a b le (55)
Cash re c e iv e d from customers $ 2 3 ,5 4 3
Cash re c e iv e d from c u s to m e r s a ff e c ts the a c c o u n ts r e c e iv a b le accounta s follows:
B e g in n in g a c c o u n ts receivable $957
P lu s revenue 23,598
Minus c a s h c o lle c te d from customers ( 2 3 ,5 4 3 )
Ending a c c o u n ts receivable $1,012
The a c c o u n ts r e c e iv a b le accountinformationcana ls o be p re s e n te d a s follows:
B e g in n in g a c c o u n ts receivable $957
P lu s re v e n u e 23,598
Minus endingaccounts receivable (1,012)
Cash c o lle c te d from customers $ 2 3 ,5 4 3
46

47. Cash Paid to Suppliers
−To determine purchases from suppliers, cost of goods sold
is adjusted for the change in inventory.
−If inventory increased during the year, then purchases
during the year exceeded cost of goods sold, and vice versa.
−If accounts payable increased during the year, then
purchases on an accrual basis are higher than they are on a
cash basis, and vice versa.
47

48. Cost of goods sold $11,456
Plus: Increase in inventory 707
Equals purchases from suppliers $12,163
Less: Increase in accounts payable (263)
Cash paid to suppliers $11,900
48

49. Once purchases have been determined, cash paid to
suppliers can be calculated by adjusting purchases
for the change in accounts payable.
49

50. Purchases from suppliers affect the inventory
account, as shown below
−The cash paid to suppliers was $11,900, determined as follows:
Beginning inventory $3,277
Plus purchases 12,163
Minus cost of goods sold (11,456)
Ending inventory $3,984
Purchases from suppliers $12,163
Less: Increase in accounts payable (263)
Cash paid to suppliers $11,900
50

51. Cash Paid to Employees
To determine the cash paid to employees, it is
necessary to adjust salary and wage expense by the
net change in salary and wage payable for the year.
If salary and wage payable increased during the year,If salary and wage payable increased during the year,
then salary and wage expense on an accrual basis isthen salary and wage expense on an accrual basis is
higher than the amount of cash paidhigher than the amount of cash paid for this expense,
and vice versa.
51

52. The amount of cash paid to employees is reflected in
the salary and wage payable account, as shown
below:
Salary and wage expense $4,123
Less: Increase in salary and wage payable (10)
Cash paid to employees $4,113
Beginning salary and wages payable $75
Plus salary and wage expense 4,123
Minus cash paid to employees (4,113)
Ending salary and wages payable $85 52

53. Cash Paid for Other Operating Expenses
•To determine the cash paid for other operating expenses, it is
necessary to adjust the other operating expenses amount on the incomeother operating expenses amount on the income
statement by the net changes in prepaid expenses and accrued expensestatement by the net changes in prepaid expenses and accrued expense
liabilities for the yearliabilities for the year.
•If prepaid expenses increasedprepaid expenses increased during the year, other operatingother operating
expenses on a cash basis were higher than on an accrual basisexpenses on a cash basis were higher than on an accrual basis, and
vice versa.
• Likewise, if accrued expense liabilities increasedif accrued expense liabilities increased during the year,
other operating expenses on a cash basis were lower than on anoperating expenses on a cash basis were lower than on an
accrual basisaccrual basis, and vice versa.
53

54. Cash Paid for Other Operating Expenses………….
Other operating expenses $3,577
Less: Decrease in prepaid expenses (23)
Less: Increase in other accrued
liabilities
(22)
Cash paid for other operating
expenses
$3,532
54

55. Cash Paid for Interest……………….
•To determine the cash paid for interest, it is necessary to
adjust interest expense by the net change in interest
payable for the year.
•If interest payable increasesIf interest payable increases during the year, then interestinterest
expense on an accrual basis is higher than the amount ofexpense on an accrual basis is higher than the amount of
cash paid for interestcash paid for interest, and vice versa.
Interest expense $246
Plus: Decrease in interest payable 12
Cash paid for interest $258
55

56. Alternatively, cash paid for interest may also be determined
by an analysis of the interest payable account, as shown
below:
Beginning interest payable $74
Plus interest expense 246
Minus cash paid for interest (258)
Ending interest payable $62
56

57. Cash Paid for Income Taxes…………………………….
•To determine the cash paid for income taxes, it is necessary
to adjust the income tax expense amount on the income
statement by the net changes in taxes receivable, taxes
payable, and deferred income taxes for the year.
•If taxes receivable or deferred tax assets increase during
the year, income taxes on a cash basis will be higher than on
an accrual basis, and vice versa.
•Likewise, if taxes payable or deferred tax liabilities increase
during the year, income tax expense on a cash basis will be
lower than on an accrual basis, and vice versa.
57

58. Cash Paid for Income Taxes…………………………….
Income tax expense $1,139
Less: Increase in income tax payable (5)
Cash paid for income taxes $1,134
58

59. INVESTING ACTIVITIES: DIRECT METHOD***
•The second and third steps in preparing the cash flow statement are to
determine the total cash flows from investing activities and from
financing activities.
•The presentation of this information is identical, regardless of whether
the direct or indirect method is used for operating cash flows. Investing
cash flows are always presented using the direct method.
FINANCING ACTIVITIES: DIRECT METHOD***
•As with investing activities, financing activities are always presented
using the direct method
59

60. • Total Liabilities = Total liabilities - Par value of preferred
stock
• The higher ratio indicates that the company has lost some
ground with respect to covering all its debts with net
tangible assets.
60

61. COMMON SIZE CASH FLOW STATEMENT
• In common-size analysis of a company’s income
statement, each income and expense line item is
expressed as a percentage of net revenues (net sales).
• For the common-size balance sheet, each asset, liability,
and equity line item is expressed as a percentage of total
assets.
61

62. • For the common-size cash flow statement, there are two
alternative approaches.
•
• The first approach is to express each line item of cash
inflow (outflow) as a percentage of total inflows
(outflows) of cash.
• second approach is to express each line item as a
percentage of net revenue.
62

63. FREE CASH FLOWFREE CASH FLOW
The excess of operating cash flow over capital expenditures
is known generically as free cash flow.
For purposes of valuing a company or its equity securities,
an analyst may want to determine a more precise free cash
flow measure.
Methods of Measure of Free cash flowMethods of Measure of Free cash flow
1. free cash flow to the firm (FCFF)free cash flow to the firm (FCFF)
2.2.free cash flow to equity (FCFE).free cash flow to equity (FCFE).
63

64. FREE CASH FLOW TO THE FIRMFREE CASH FLOW TO THE FIRM
• Free cash flow to the firm [FCFF] is the cash available to
all investors, both equity owners and debt holders.
• FCFF can be calculated by starting with either net income
or operating cash flow.
64

65. FREE CASH FLOW TO EQUITY
Free cash flow to equity [FCFE] is the cash flow that would
be available for distribution to common shareholders.
65

66. CASH FLOW RATIOSCASH FLOW RATIOS
• The cash flow statement can be analysed by comparing the
cash flows either over time or to those of other firmseither over time or to those of other firms.
• profits are very important for a company. companies thatcompanies that
appear very profitable can actually be at a financial risk ifappear very profitable can actually be at a financial risk if
they are generating little cash from these profitsthey are generating little cash from these profits
• For example, if a company makes a ton of sales on credit, they
will look profitable but haven't actually received cash for the
sales, which can hurt their financial health since they have
obligations to pay.
• Cash flow ratios can be categorizedCash flow ratios can be categorized
 Performance ratioPerformance ratio
 Coverage ratioCoverage ratio 66

67. Performance ratioPerformance ratio
• Cash flow-to-revenue
• Cash return-on-asset ratio
• Cash return-on-equity ratio
• Cash flow per share
67

68. Cash flow-to-revenue
The cash flow-to-revenue ratio, also known as the
operating cash flow-to-sales ratio or the cash flow-
to-sales ratio, is the ratio of operating cash flow to
revenue.
It indicates management's ability to turn revenuemanagement's ability to turn revenue
into profits and net cash flowinto profits and net cash flow.
68

69. •Management, investors and other stakeholders can use
the cash flow-to-revenue ratio to evaluate the
effectiveness of internal cost controls.
•A high ratio usually means the company is able to turnable to turn
a higher percentage of its revenue into profits and neta higher percentage of its revenue into profits and net
cash flow.cash flow.
•A flat or increasing trend line is generally an indicationindication
of consistent sales growth and effective expenseof consistent sales growth and effective expense
management.management.
•Poor receivables collection and higher expensesPoor receivables collection and higher expenses are
some of the reasons for a declining trend line. 69

70. Operating cash flow depends on net income, which is
revenue minus expenses. Therefore, if a company
generates higher revenue, it must keep expenses steady
relative to revenue to drive operating cash flow and the
cash flow-to-revenue ratio higher.
If revenue declines, the company must make a
corresponding reduction in expenses to maintain the
same cash flow-to-revenue ratio.
Other strategies to increase the ratio include using
credit instead of cash for purchases, tightening credit
requirements and following up on overdue accounts.70

71. Cash return-on-asset ratio
cash return on assets is designed to measure
management’s success in making operating decisions
Cash return on assets measures management’s
success in generating cash from operating
activities.
Because CFO is available to pay dividends and to
finance investments, a high ratio is desirable.
71

72. • This ratio used to compare a businesses performance
among other industry members.
• The ratio can be used internally by the company's
analysts, or by potential and current investors.
• When a high cash return on assets ratio is listed, it can
indicate to investors that a higher return is anticipated.
• This is due to the theory that the higher the ratio, the
more cash the company has made available for
reinvestment in the company either through
replacements.
72

73. Cash Return On Equity Ratio
The cash return on equity ratio is the ratio of cash
flow from operations to average shareholders'
equity.
This ratio measures the amount of cash generated
from operations per one dollar of average
shareholders' equity.
73

74. Cash flow per shareCash flow per share
A measure of a firm's financial strength
•Many analysts and investors place more weight on
cash flow per share than earnings per share.
•Because EPS is more easily manipulated, its reliability
can at times be questionable. Cash, on the other
hand, is difficult to fake.
•Therefore, cash flow per share is a useful measure formeasure for
the strength of a firm and the sustainability of itsthe strength of a firm and the sustainability of its
business model.business model.
74

75. Cash flow per share...........................Cash flow per share...........................
•cash flow per share takes into consideration a
company's ability to generate cash.
•it is regarded by some analysts as a more accurate
measure of a company's financial situation than the
earnings per share metric.
75

76. COVERAGE RATIO
i.Debt coverage ratio
ii.Cash flow interest coverage ratio/Interest
coverage Ratio
iii.Reinvestment ratio
iv.Dividend payment ratio
v.Free Cash Flow to Operating Cash Flow Ratio
76

77. Debt-Coverage Ratio/Debt-Coverage Ratio/Cash Flow Coverage RatioCash Flow Coverage Ratio
•The cash flow coverage ratio is an indicator of the ability of
a company to pay interest and principal amount.
•This ratio tells the number of times the financial obligations
of a company are covered by its earnings.
•A ratio equal to 1 or more than 1 means
- good financial health
– meet its financial obligations through the cash
generated by operating activities.
•A ratio of less than one is an indicator of bankruptcy of the
company within two years if it fails to improve its financial77

78. Debt-Coverage Ratio/Cash Flow Coverage Ratio…………..cont/……
―It is an important indicator of the liquidity position of a
company.
Cash Flow Coverage Ratio = Operating Cash Flows / Total
Debt
Cash Flow Coverage Ratio = (Net Earnings + Depreciation
+ Amortization) / Total Debt
78

79. Cash flow interest coverage ratio/InterestCash flow interest coverage ratio/Interest
coverage Ratiocoverage Ratio
• This ratio measures the firm’s ability to meet itsfirm’s ability to meet its
interest obligationsinterest obligations
• Interest coverage is regarded as a measure of a
company’s creditworthiness
• Banks and financial analystsfinancial analysts also rely on this ratio as
a rule of thumb to measure the fundamentalfundamental
strength of a business.strength of a business.
79

80. Reinvestment RatioReinvestment Ratio
• This measures the firm’s ability to acquire long-
term assets with operating cash flow
80

81. Dividend Payment RatioDividend Payment Ratio
This ratio measures the firm’s ability to make dividend
payments from operating cash flow.
81

82. 82
Free Cash Flow to Operating Cash Flow RatioFree Cash Flow to Operating Cash Flow Ratio
• Ratio measures the relationship between free cash flow
and operating cash flow.
• FCF considered to be an essential outflow of funds to
maintain a company's competitiveness and efficiency.
• FCF available to a company to use for expansion,
acquisitions, and/or financial stability .
• The higher the percentage of this ratio indicates that
company is in the greater financial strength.

83. 83
HOW TO TEST SOLVENCY WITH CASH FLOWHOW TO TEST SOLVENCY WITH CASH FLOW
RATIOSRATIOS
• Creditors and lenders began using cash flow ratios
because
• those ratios give more information about a company's
ability to meet its payment commitments than
traditional balance sheet working capital ratios.
• Traditional working capital ratios indicate how much
cash the company had available on a single date in the
past.

84. 84
HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS…………………………………………………………………………..HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS…………………………………………………………………………..
 Cash flow ratios, on the other hand, test
 how much cash was generated over a period of time and
 compare that to near-term obligations,
 giving a dynamic picture of what resources the company
must have to meet its commitments.

85. 85
Operating cash flow (OCF/CFO) RatioOperating cash flow (OCF/CFO) Ratio
[Company's ability to generate resources to meet current liabilities]
• The numerator of the OCF ratio consists of net cash provided by
operating activities.
• The denominator is all current liabilities, taken from the balance
sheet.
Operating cash flow (OCF) =

86. 86
Operating Cash MarginOperating Cash Margin
• Thus, the operating cash margin ratio indicates
performance based on cash generating ability –
as opposed to a profit margin ratio with its focus on
accrual based accounting income.
• This ratio is useful to evaluate cash managementcash management
performanceperformance, as well as, credit granting policiescredit granting policies and
receivable collections.
• it is more effective to focus a comparative analysis on
companies within the same industry

87. 87
Cash Generating PowerCash Generating Power
 The ratio demonstrates a company’s ability to generate
cash and the proportion of the cash generated solely by
operations compared to the total cash inflow
 Year to year comparisons of the cash generating power
for a company should be evaluated, as well as,
comparisons with industry competitors.
 Significant decreases in the ratio over time would be a
source of concern that merits investigation.

88. 88
External Financing IndexExternal Financing Index
 This ratio compares cash flows provided by financing activities
with cash generated from operations.
 The ratio indicates the extent of dependenceextent of dependence on external
sources as a means of financing.
 The larger the ratio, the more dependent a company is on
external funding and this can lead to higher level of
financial risk.
OperationsfromFlowCash
ActivitiesFinancingfromFlowCash
IndexFinancingExternal =

89. 89
Capital Asset RatioCapital Asset Ratio
• The capital asset ratio shows a company’s ability to meet itsThe capital asset ratio shows a company’s ability to meet its
capital expenditure needs from cash generated bycapital expenditure needs from cash generated by
operating activities rather than from financing activitiesoperating activities rather than from financing activities
• A ratio of 1.0 or greater means that debt financing is not
necessary for capital expenditures.
nsAcquisitioAssetCapitalforOutflowsCash
DividendsforPaidCash-DisposalAssetCapitalfromInflowsCashCFO
RatioAssetCapital
+
=

90. 90
Earnings QualityEarnings Quality
 In the earnings quality ratio both CFO and net income are
adjusted for the effects of interest and income taxes that
result from differences between cash payments versus
accruals and deferrals.
 This provides the extent of deviation between operating cash
flows and reported earnings.
 Non-cash items such as depreciation, amortization, losses
and gains, are a typical cause for normal deviation of CFO
from earnings.

91. 91
• However, the underlying cause of any potentially abnormal
or substantial deviations needs to be investigated.
• Therefore, during the evaluation process it is important to
not only understand that a difference exists and to monitor
its direction and size, it is equally important to identify the
underlying cause.
• For example, based on comparisons over time, an earnings
quality ratio that is falling increasingly further below 1.0
could indicate a possible problem such as fictitious
receivables or unrecorded payables.

92. 92
Accounting Shenanigans on the Cash Flow Statement
– Investors’ increasedInvestors’ increased focus on the cash flow
statement is beneficial.
– Analysing the cash flow statement is integralintegral
partpart to understanding a company’s financial
performance and position
– because it often provides a check to the qualityprovides a check to the quality
of the earningsof the earnings shown in the income statement.

93. 93
CASH FLOW MANIPULATION
Accrual accounting is easily manipulated because of the
many estimates and judgements involvedmany estimates and judgements involved.
Management has several ways to manipulate operating
cash flow, including
• deciding how to allocate cash flow between categories
• changing the timing of receipts of cash flows.
•A financial analyst should investigate the quality of a
company’s cash flows and determine whether increases in
operating cash flow are sustainable.

94. 94
METHODS OF MANIPULATING CASH FLOW
•Stretching Accounts payables
•Financing Accounts payables
•Securitizing Accounts Receivables
•Repurchasing Stock to Offset Dilution

95. 95
Stretching Accounts payablesStretching Accounts payables
•Transaction with suppliers is usually reported as operating
activities in the cash flow statement.
•A firm can temporarily increase operating cash flow by
simply stretching accounts payable[delaying payments]
• delaying payment is no-cost financing.
•stretching payables is not a sustainable source of increased
cash flows, since suppliers may refuse to extend credit.

96. 96
Stretching Accounts payables...................../cont....
One way to determine whether a firm is stretching its
payable is to examine the number of days in accounts
payable./days accounts payable (Days A/P)
As a rule of thumb, a well managed company's days
accounts payable do not exceed 40 to 50 days.

97. 97
Financing Accounts payables
 By entering into a financial agreement with 3rd
party[financial
institution] can delaying cash payment.
 Financing accounts payable allows the firm to manage the timing
of the reporting operating cash flow.
 When accounts payable due---------------financial institutor makes
the payment to suppliers on behalf of firm-----then firm
reclassifies the A/C payable to short-term financing.

98. 98
• So firm might time the arrangement. By doing so, lower CFO is
offset by higher operating cash flow from other sources
Ex:
1. seasonal cash flow
2. Cash flow from receivables sales/ securitization
 When the firm repays to the financial institution, report the cash
outflow as financing activity not an operating activity.
 That means the firm has delayed the out flow of cash.
 Financial institution will charge a fee to handle this arrangements.

99. 99
Borrowing against receivables/Securitizing Accounts
Receivables
• A firm can convert A/C receivables into cash by
• Borrowing against the receivables[collateral]
• Selling securitizing the receivables
• When borrowing [use receivables as collateral] the
inflow of cash is reported as financing activity

100. 100
Securitizing Accounts Receivables
• Companies will securitize illiquid assets into liquid assets in
order to increase their overall liquidity.
• Accounts receivable securitization is the process of bundling
together the accounts receivables asset and selling that to
investors as a security.
 The inflow of cash is reported as an operating activity in the
cash flow statement -------- since transaction is reported as a
sale.

101. 101
Securitizing Accounts Receivables....................
• Securitising may affect earnings ----- securitizing of receivables
may give gain in some cases.
— At the time of securitization gain is the result of difference
between book value and fair value.
— Through number of estimates
 Expected default rate
 Expected payment rate
 Discount rate.

102. 102
Benefits of Securitizing
1. Securitized debt has a lower interest cost than corporate debt
2. Securitization can increase a companies total liquidity
3. Securitization can enhance the enterprise value
AR securitization is only available to large companies having broad
customer base.
When the firm has limited amounts of AR, increasing/ accelerating
CFO is not suitable.

103. 103
Repurchasing Stock to Offset Dilution
 When a firm’s stock options are exercised, shares must be Issued
 When stock price[mkt] > Exercise price, then more shares will be
issued.....EPS will be diluted as shares are issued.
 Firms often repurchase stock to offset the dilutive effects of stock
option exercise
 Cash received from option[inflow] cash
outflow[repurchase]...both reported as financing activities. Since
there is tax benefit when options are exercised.
 For analytical purpose, net cash outflow for share repurchase[to
avoid dilution] should be reclassified from financing activities to
operating activities.

104. 104
"Stock options are contracts; they don't represent ownership in
anything. They are merely contracts that grant you certain rights".
Option that gives its holder the right to buy or sell a firm's common
stock (ordinary shares) at a specified price and by a specified date.
call option - an option to buy
put option - an option to sell
The "Call" option gives its buyer the right to "buy" shares of a stock
at a specified price on or before a given date.
The "Put" option gives its buyer the right to "sell" shares of a stock at
a specified price on or before a given date.

105. 105
Definition of 'Exercise Price
 The price at which the underlying security can be purchased (call
option) or sold (put option)
 The exercise price is determined at the time the option contract is
formed.

106. 106
An employee stock option (ESO)
 It is a call option on the common stock of a company, granted by
the company to an employee as part of the employee's
remuneration package.
 The objective is to give employees an incentive to behave in ways
that will boost the company's stock price.
 If the company's stock market price rises above the call price, the
employee could exercise the option, pay the exercise price and
would be issued with ordinary shares in the company.

107. 107
An employee stock option (ESO) …………………………
 The employee would experience a direct financial benefit of the
difference between the market and the exercise prices.
 Another substantial reason that companies issue employee stock
options as compensation is to preserve and generate cash flow.