fsa 5: analysing cash flow statements II

What are the four steps in evaluating a cash flow statement?

1. Evaluate major sources and uses of cash including operating, investing, and financing activities.

2. Evaluate determinants of operating cash flow

3. Evaluate determinants of investing cash flow

4. Evaluate determinants of financing cash flow

What are the desirable sources and uses of cash flow for a mature company?

primarily generate cash from operating activities.

Excess operating cash should be used for:

• investing in profitable projects (investing)

• returning capital to investors (dividends, debt repayment, share buybacks) (financing)

Why can negative operating cash flow be acceptable for a growth company?

they invest heavily in:

• inventory

• receivables

• expanding operations

However, this is not sustainable long term; eventually operations must generate positive cash flow.

What are the major determinants of operating cash flow (CFO)?

• cash received from customers

• cash paid to suppliers and employees

• changes in working capital accounts such as:

  • receivables

  • inventory

  • payables

Why is comparing operating cash flow to net income important?

For mature companies, we want operating cash flow > net income because net income includes non-cash expenses such as depreciation and amortization.

If net income is high but CFO is weak, it may indicate:

• poor earnings quality

• aggressive accounting to boost net income

• weak cash generation

Why should analysts evaluate each investing cash flow line item?

To understand where cash is being spent or generated.

Why should analysts examine recurring borrowing activity?

To assess future repayment obligations and financial sustainability.

what are the two approaches for common size analysis of cash flow operations?

• Percentage of total inflows/outflows approach

• Percentage of net revenue approach

how are operating cash flows showin in the indirect vs direct methods

Direct: Individual operating inflows and outflows are shown separately as percentages of total inflows/outflows

Indirect: Only net operating cash flow is shown as a percentage of total inflows or outflows.

Why is the net revenue common-size approach useful for forecasting?

Because many cash flow items have predictable relationships with revenue.

Which cash flow items are commonly forecasted as a percentage of revenue?

Depreciation, capital expenditures, borrowing, and debt repayment.

What is free cash flow and why is it important?

Operating cash flow - capital expenditures

measures cash available after maintaining and expanding the business

What is Free Cash Flow to the Firm (FCFF)?

Cash flow available to both debt and equity investors after operating expenses and investments.

What is the FCFF formula using net income?

FCFF = NI + NCC + Int(1 − Tax rate) − FCInv − WCInv

• NI = Net income,

• NCC = Non-cash charges (such as depreciation and amortization),

• Int = Interest expense,

• FCInv = Capital expenditures (fixed capital, such as equipment), and

• WCInv = Working capital expenditures.

What is the FCFF formula using cash flow from operations (CFO)?

FCFF = CFO + Int(1 − Tax rate) − FCInv

• FCInv = Capital expenditures (fixed capital, such as equipment)

Under IFRS, when must CFO be adjusted when calculating FCFF?

• interest paid included in financing activities → CFO does not have to be adjusted for Int(1 – Tax rate).

• IFRS: interest and dividends received in investing activities →should be added back to CFO

• if dividends paid were subtracted in the operating section → should be added back in

What is Free Cash Flow to Equity (FCFE)?

Cash flow available to common shareholders after operating expenses, debt payments, and investments.

What is the FCFE formula?

FCFE = CFO – FCInv + Net borrowing

• FCInv = Capital expenditures (fixed capital, such as equipment)

What is the FCFE formula when net borrowing is negative?

FCFE = CFO − FCInv + Net borrowing

• FCInv = Capital expenditures (fixed capital, such as equipment)

Cash flow to revenue formula

$$\frac{\text{CFO}}{\text{net revenue}}$$

Cash return on assets

$$\frac{\text{CFO}}{\text{average total assets}}$$

Cash return on equity

$$\frac{\text{CFO}}{\text{average shareholder's equity}}$$

Cash to income

$$\frac{\text{CFO}}{\text{operating income}}$$

cash generating ability of all operations

Cash flow per share

$$\frac{\text{CFO – Preferred dividends}}{\text{Number of common shares outstanding}}$$

Debt coverage

$$\frac{\text{CFO }}{\text{Total debt}}$$

Financial risk and leverage

Interest coverage

$$\frac{\text{CFO+ Interest paid + Taxes paid }}{\text{Interest paid}}$$

Reinvestment

$$\frac{\text{CFO }}{\text{Cash paid for long-term assets}}$$

Ability to acquire assets with operating cash flows

Debt payment

$$\frac{\text{CFO }}{\text{Cash paid for long-term debt repayment}}$$

Dividend payment

$$\frac{\text{CFO }}{\text{Dividends paid}}$$

Investing and financing

$$\frac{\text{CFO }}{\text{Cash outflows for investing and financing activities}}$$

Ability to acquire assets, pay debts, and make distributions to owners