2. The statement of cash flows
reports the entity’s cash flows
(cash receipts and cash payments)
during the period.
Purpose of The Statement of
Cash Flows: Basic Concepts
3. Purposes of the Statement
of Cash Flows
• The statement of cash flows is designed to fulfill the
following:
– predict future cash flows
– evaluate management decisions
– determine the ability to pay dividends plus interest and
principal
– show the relationship of net income to changes in the
firm’s cash
4. Components and Relationships
Between the Financial Statements
It is important to understand that the income statement,
balance sheet and cash flow statement are all interrelated.
The income statement is a description of how the assets and
liabilities were utilized in the stated accounting period.
The cash flow statement explains cash inflows and outflows,
and will ultimately reveal the amount of cash the company has
on hand; this is reported in the balance sheet as well.
We will not explain the components of the balance sheet and
the income statement here since they were previously
reviewed.
5. Statement
of Retained
Earnings
12/31/x1 For the Year Ended 12/31/x2 12/31/x2
(a point in time) (a period of time) (a point in time)
Statement
of Cash
Flows
Income
Statement
Balance
Sheet
Balance
Sheet
6. Organization of the
Statement of Cash Flows
• A business may be evaluated in terms of three types of
business activities:
1 Operating activities
2Investing activities
3 Financing activities
7. Three Sources of Information:
1. Comparative balance sheets
2. Current income statement
3. Additional information
Preparing the Statement of Cash FlowsPreparing the Statement of Cash Flows
8. 1. Cash Flow from Operating Activities
(CFO)
• CFO is cash flow that arises from normal operations such
as revenues and cash operating expenses net of taxes.
This includes:
Cash inflow (+)
• Revenue from sale of goods and services
• Interest (from debt instruments of other entities)
• Dividends (from equities of other entities)
• Cash outflow (-)
• Payments to suppliers
• Payments to employees
• Payments to government
• Payments to lenders
• Payments for other expense
9. 2. Cash Flow from Investing Activities
(CFI)
• CFI is cash flow that arises from investment activities
such as the acquisition or disposition of current and fixed
assets.
This includes:
• Cash inflow (+)
• Sale of property, plant and equipment
• Sale of debt or equity securities (other entities)
• Collection of principal on loans to other entities
• Cash outflow (-)
• Purchase of property, plant and equipment
• Purchase of debt or equity securities (other entities)
• Lending to other entities
10. 3. Cash flow from financing activities
(CFF)
• CFF is cash flow that arises from raising (or decreasing)
cash through the issuance (or retraction) of additional
shares, short-term or long-term debt for the company's
operations.This includes:
• Cash inflow (+)
• Sale of equity securities
• Issuance of debt securities
• Cash outflow (-)
• Dividends to shareholders
• Redemption of long-term debt
• Redemption of capital stock
11. Illustration: Classify each of these
transactions by type of cash flow activity.
Format of the Statement of Cash FlowsFormat of the Statement of Cash Flows
1. Issued 100,000 shares of $5 par value
common stock for $800,000 cash.
2. Borrowed $200,000, signing a 5-year note
bearing 8% interest.
3. Purchased two semi-trailer trucks for
$170,000 cash.
4. Paid employees $12,000 for salaries and
wages.
5. Collected $20,000 cash for services
provided.
Financing
Financing
Investing
Operating
Operating
12. Which is an example of a cash flow from an
operating activity?
a. Payment of cash to lenders for interest.
b. Receipt of cash from the sale of capital stock.
c. Payment of cash dividends to the company’s
stockholders.
d. None of the above.
SO 4 Prepare a statement of cash flows using the indirect method.
Review QuestionReview Question
13. Which is an example of a cash flow from an investing
activity?
a. Receipt of cash from the issuance of bonds
payable.
b. Payment of cash to repurchase outstanding
capital stock.
c. Receipt of cash from the sale of equipment.
d. Payment of cash to suppliers for inventory.
SO 4 Prepare a statement of cash flows using the indirect method.
Review QuestionReview Question
14. Format of the SCF
• FASB Statement 95 approved two methods for reporting
cash flows from operating activities.
1 Direct method (preferred)
2Indirect method
15. The Direct Method
Cash Flow from Operations
Under the direct method, (net) cash flows from
operating activities are determined by taking
cash receipts from sales, adding interest and
dividends, and deducting cash payments for
purchases, operating expenses, interest and
income taxes.We'll examine each of these
components below:
16. The Direct Method
• Cash collections are the principle components of CFO.These are the
actual cash received during the accounting period from customers.
They are defined as:
Cash Collections Receipts from Sales = Sales + Decrease (or -
increase) in Accounts Receivable
17. The Direct Method
• Cash payment for purchases make up the most important cash
outflow component in CFO. It is the actual cash dispersed for
purchases from suppliers during the accounting period.
It is defined as:
Cash payments for purchases = cost of goods sold + increase (or -
decrease) in inventory + decrease (or - increase) in accounts payable
18. The Direct Method
• cash payment for operating expenses is the cash outflow related to
selling general and administrative (SG&A), research and
development (R&A) and other liabilities such as wage payable and
accounts payable.
It is defined as:
Cash payments for operating expenses = operating expenses +
increase (or - decrease) in prepaid expenses + decrease (or -
decrease) in accrued liabilities
19. The Direct Method
• Cash interest is the interest paid to debt holders in cash.
It is defined as:
Cash interest = interest expense – increase (or + decrease) interest
payable + amortization of bond premium (or - discoun
20. The Direct Method
• Cash payment for income taxes is the actual cash paid in the form
of taxes.
It is defined as:
Cash payments for income taxes = income taxes + decrease
(or - ncrease) in income taxes payable
21.
22. Prepare SCF
1. The company purchased a truck during
the year at a cost of $30,000 that was
financed in full by the manufacturer.
2. A truck with a cost of $10,000 and a
net book value of $2,000 was sold
during the year for $7,000. There were
no other sales of depreciable assets.
3. Dividends paid during Year 2 are
$51,000
27. CLASSWORK -SCF
Menghai Pizza Dec 31, 2000
Cash payment of
Dividend
(35,000) Retirement of
Common stock
(25,000)
Acquisition of
Parahata Pizza
(14,000) Purchase of
equipment
(30,000)
Cash Payment for
interest
(10,000) Cash payment to
suppliers
(85,000)
Cash payment for
Salaries
(45,000) Cash collected from
customers
250,000
Sale of equipment 38,000 Cash at Dec
31,1999
50,000
Required:
Prepare SCF
28. CLASSWORK 1-Solution
CF FROM OA
Cash collection from
customers
250,00
0
Cash payment to
Suppliers
(85,000
)
Cash payment for
Salaries
(45,000
)
Cash payment for
interest
(10,000
)
Net cash from OA 110,00
0
CF from IA
Sales of equipment 38,000
Purchase of equipment (30,000
CF FROM FA
Retirement of
Common stock
(25,000
)
Payment of dividend (35,000
)
Net cash from FA (60,000)
Net increase in cash 44,000
Cash at beginning of
year
50,000
Menghai PizzaMenghai Pizza
Statement of Cash FlowsStatement of Cash Flows
YearEnded December 31, 2000YearEnded December 31, 2000
29. Why Cash Flow Analysis?
• Profits and cash flows are very different things
• Profits under the accounting system are
calculated on accrual basis rather than cash basis
Overview
Analysis
Budgeting
Example
30. Why Cash Flow Analysis?
• As an investor much better to look at both
Income Statement and the Statement of Cash
Flows
• As management, very important to analyze the
different types of inflows/outflows
Overview
Analysis
Budgeting
Example
31. Types of Analysis
• Statement of CF Analysis
• Free Cash Flows
• Payback Period
• Net PresentValue
• Internal Rate of Return
Overview
Analysis
Budgeting
Example
32. The cash flow statement will reveal
the following to analysts:
How the company obtains and spends cash
Why there may be differences between net income and
cash flows
If the company generates enough cash from operation
to sustain the business
If the company generates enough cash to pay off
existing debts as they mature
If the company has enough cash to take advantage of
new investment opportunities
33. Free Cash Flow (FCF)
Free cash flow (FCF) is the amount of cash that a
company has left over after it has paid all of its expenses,
including net capital expenditures. Net capital
expenditures are what a company needs to spend
annually to acquire or upgrade physical assets such as
buildings and machinery to keep operating.
34. Free Cash Flows
Operating Income
+Depreciation
= EBITDA (Earnings before interest, taxes,
Depreciation, and amortization)
-cash tax payments
= after tax cash flows from operations
Overview
Analysis
Budgeting
Example
35. Payback Period
• Cash flow analysis from capital budgeting
perspective.
• A criteria used in capital budgeting. Defined as
the number of years required to recover initial
cash investment
Overview
Analysis
Budgeting
Example
36. Payback Period: Example
10000
Year 1
Year 2
Year 3
Year 4
Year 5
Payback 3.3
5000
4000
5000
It will take 3 years to recover 7000 and the .3 of the 4th year to
recover the remaining 3000. Therefore the payback in this
example is 3.3.
Initial Investment in project
Cash inflows after -tax
1000
1000
Overview
Analysis
Budgeting
Example
37. Net PresentValue
• In simple terms NPV is the sum of discounted
cash inflows from a project- the projects initial
outlay
• If NPV is > 0 accept else reject
Overview
Analysis
Budgeting
Example
38. NPV: Example
InitialOutlay -30000
RequiredRate 12%
NotDiscounted Discounted
Year 1Inflow 10000 $8,928.57
Year 2Inflow 15000 $11,957.91
Year 3Inflow 12000 $8,541.36
Year 4Inflow 10000 $6,355.18
Year 5Inflow 11000 $6,241.70
Sum 58000 $42,024.72
NPV $12,024.72
Wetake the sumofthe
discounted values and
subtract the initial
outlay.
Overview
Analysis
Budgeting
Example
39. Internal Rate of Return
• Discount rate that equates the present value of
inflows with the present value of outflows. In
simple terms it reflects the rate of return for a
project
Overview
Analysis
Budgeting
Example
40. IRR: Example
Initial Outlay -3817
Year 1 Cash Inflow 1000
Year 2 Cash Inflow 2000
Year 3 Cash Inflow 3000
IRR 22%
Excel has a very handy
function that calculates
the IRR. Make sure you
enter the whole range of
values including the initial
outlay, which is entered
as a negative value.
Overview
Analysis
Budgeting
Example
41. What is Capital Budgeting?
• Capital budgeting is the decision making process
through which firms decide which projects get
the funding
• Financial plans for most firms are based on the
capital budgeting analysis using cash flows
Overview
Analysis
Budgeting
Example
42. Comprehensive Example
Cost of new plant and Equipment 9,700,000
Other Costs 300,000
Total Cost 10,000,000
Total Unit Sales Year Sold
1 50,000
2 100,000
3 100,000
4 70,000
5 50,000
Sales price per unit 150
Variable cost 80
Fixed Costs 500000
Required Working Capital 100000
Depreciation 2,000,000
We just added the total cost
of plant with other costs and
divided it by 5 years to get a
straight line decpreciation.
This example is something similar to what many
firms would deal with in the real world. We will
first derive Free Cash Flows and then apply the
NPV and IRR techniques that we learned earlier.
Overview
Analysis
Budgeting
Example
43. Comprehensive Example
STEP 1
Year 0 1 2 3 4 5
Units Sold 50,000 100,000 100,000 70,000 50,000
Sale Price 150 150 150 150 150
Sales Revenue 7500000 15000000 15000000 10500000 7500000
Less: Variable Costs 4000000 8000000 8000000 5600000 4000000
Less: Fixed Costs 500000 500000 500000 500000 500000
EBDIT 3000000 6500000 6500000 4400000 3000000
Less: Depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
EBIT 1,000,000 4,500,000 4,500,000 2,400,000 1,000,000
Taxes (@ 34%) 340000 1530000 1530000 816000 340000
EBIT, TAXES and DEPRECIATION are calculated here
In this example we've calculated EBIT along with taxes that we will use to derive Operating
Cash Flow on the next slide. We subtract depreciation here so we can pay less taxes. The
depreciation will be added back in the next step as it is a non-cash item.
Overview
Analysis
Budgeting
Example
44. Comprehensive Example
STEP2
Year 0 1 2 3 4 5
EBIT 1,000,000 4,500,000 4,500,000 2,400,000 1,000,000
Minus: Taxes 340000 1530000 1530000 816000 340000
Plus:Depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
Operating Cash Flows 2,660,000 4,970,000 4,970,000 3,584,000 2,660,000
Operating Cash Flows
Depreciation is added back here as we move toward Free
cash flows. Here Operating Cash Flows are derived.
Overview
Analysis
Budgeting
Example
45. Comprehensive Example
STEP 3
Year 0 1 2 3 4 5
-100000 10000
Working Capital Needs
In this example we have an initial outflow of
working capital that is recouped completely in
the last year at the termination of the project.
So in year one we subtract it and add it back
in year 5.
Overview
Analysis
Budgeting
Example
46. Comprehensive Example
STEP 4
Year 0 1 2 3 4 5
Operating Cash Flow 2,660,000 4,970,000 4,970,000 3,584,000 2,660,000
Less: Net working capital -100000 0 0 0 0 100000
Less: Initial Outlay -10,000,000
Free Cash Flow -10,100,000 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000
Free Cash Flow
Finally we have the free cash flows that we can use in our
NPV and IRR calculations.
Overview
Analysis
Budgeting
Example
47. Comprehensive Example
Now, using the date calculate the NPV and the IRRforthe Project
Initial Outlay -10,100,000
Cash inflows/Year 0 1 2 3 4 5
2,660,000 4,970,000 4,970,000 3,584,000 2,760,000
Depending on the answeralso recommend ifthe project should be accepted.
Overview
Analysis
Budgeting
Example
48. Comprehensive Example
Year 0 1 2 3 4 5
Not Discounted 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000
Discounted 2418181.818 4107438 3734034.6 2447920.2 1713742.9
Initial Outlay -10,100,000
Required Rate 10.00%
NPV 4,321,317
SOLUTION
Several ways to do so, first you can get
the discounted cashflows for each year
and then add all of them up along with the
initial outlay. A simple way is to use the
NPV function in excel. This is positive so
we should go ahead with the project.
This rate depends on the firms required rate of return. Its
dependent on different factors which we can't get into in
this presentation. But most firms do have a given
required rate of return for their projects.
Overview
Analysis
Budgeting
Example
49. Comprehensive Example
Year 0 1 2 3 4 5
Not Discounted -10,100,000 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000
IRR 26%
SOLUTION
Note that IRR is best solved for with a financial
calculator or using a spreadsheet program. Here the
excel function for IRR was used to come up with this
value.
Overview
Analysis
Budgeting
Example
50. Practice Problem
Cost of new plant and Equipment 1,500,000
Other Costs 300,000
Total Cost 1,800,000
Total Unit Sales Year Sold
1 10,000
2 20,000
3 5,000
4 60,000
5 250,000
Sales price per unit 175
Variable cost 85
Fixed Costs 500000
Required Working Capital 100000
Depreciation 360,000
We just added the total cost
of plant with other costs and
divided it by 5 years to get a
straight line decpreciation.
This example is something similar to what many
firms would deal with in the real world. We will
first derive Free Cash Flows and then apply the
NPV and IRR techniques that we learned earlier.
1). This difference between profits and cash flows is very important. Under the accrual based accounting on which the double entry accounting system is based, records income when it is earned rather than when the cash is actually received.
2). This means that even though a firm is showing a profit during a year, it could actually have a huge cash outflow during the year and could be in trouble if it is not analyzing its liquidity situation through a cash flow analysis.
1). With recent accounting scandals, cash flow analysis has become extremely important. Many investment banks such as Goldman Sachs, do not even use the income statement in many of their analysis and valuations. They prefer using the statement of cash flows as according to them this portrays a better position of a firm and it’s future earning potential.
2). Second area where cash flow analysis becomes extremely important is in capital budgeting and corporate finance. This is something that is extremely important for firms both long-term viability and strategy. This will be the focus of this training presentation and we will walk through a comprehensive example to see how important this analysis is and how it can help us make better decisions.
1). The first two in this list are analysis that are used by external stakeholders of a firm. These first two types of analysis would only be done in a publicly traded company. Investors, debtors and shareholders would be interested in analyzing the statement of cash flows and conducting a free cash flow analysis.
2). The last three analysis in the list are the ones that would be used by management of the firm to determine the feasibility of a project. These three types of analysis are also considered part of the capital budgeting criteria/process. Note though that these analysis start with free cash flows.
1). Free cash flows are cash flows after all the operating expenses and the investments of the firms have been paid for. This is the amount that is available to the shareholders and the creditors. Therefore this type of analysis is done by creditors and shareholders. This also has value for internal management as their calculations for NPV and IRR require free cash flows.
This is one of the most simple kind of analysis. Another variation of this is the discounted payback. In discounted payback all the cash flows are discounted to account for the time value of money.
Payback is usually a good rough estimate but most firms do not use it as it ignores the time value of money. The criteria in a payback is usually if the payback time is less than the firms required payback.
This is the most common cash analysis used by almost all firms/corporations. We will see a simple example of this in the next slide and will also see it again in our comprehensive example at the end.
This example is self explanatory, excel has a function that can perform the NPV calculations for you. Just make sure that you subtract the initial outlay by adding it to the NPV. Make sure to give the initial outlay a negative sign.
The formula for present value equals Cash Flow/(1+required rate)^Years Passed
This is also self explanatory. Will be explained more on the next slide through an example.
You’ll need excel or a financial calculator to calculate IRR. It becomes tedious and time consuming to do it manually.
Capital budgeting is one of the most important function of the finance guys and also many internal accountants in a firm and corporation. The successful implementation of this analysis has a great effect on the firms long-term viability and the firms strategy. Cash flow analysis is a huge aspect of capital budgeting and we have mentioned that previously. The basic tools used in capital budgeting analysis are NPV , IRR, Payback which have been covered previously.
In this section I will touch the important principles that we need to worry about in a capital bugdeting while doing cash flow analysis. The comprehensive example will combine all these principles together in one example.
Here we see a real world example. We will use this data to calculate the free cash flows and then use those cash flows to calculate the NPV and IRR.
STEP 1:
Here we basically calculate the EBIT using the data we were give and also calculate the taxes. The tax rate used here is 34 % which is the US corporate tax rate.
One thing to note here is that we subtract depreciation here so we have to pay less taxes even though depreciation is a non cash charge. We will add depreciation back before we come up with the final free cash flow figure.
STEP 2:
Here we come up with the operating cash flows and we also add back the depreciation.
STEP 3:
Here we figure in the working capital needs.
STEP 4:
Here we finally calculate the free cash flows which we can use to determine the NPV and IRR for the project and determine its feasibility to the firm.
Problem for the audience to figure out first
Solution with the NPV for the project.
Solution with the IRR calculation.
This is a comprehensive exercise for the audience. Instead of having 10 more slides that walk them through the answer, a link has been attached to the excel sheets that contains the answers and step by step walk you through the whole process. The Excel sheet can also be modified to be used in future projects and can be very handy in that regard.
