Module 5: Analyzing Statements of Cash Flows II

What are the four steps for analyzing a cash flow statement?

1) Evaluate major sources and uses of cash; 2) Evaluate primary determinants of CFO; 3) Evaluate primary determinants of CFI; 4) Evaluate primary determinants of CFF.

What is the key question when evaluating major sources and uses of cash?

Determine which of CFO, CFI, and CFF are the major sources and uses of cash, examine the pattern over time, and assess whether CFO is sufficient to fund capital expenditure.

What should an analyst examine when evaluating CFO?

Working-capital movements such as receivables, inventory, payables, and accruals; also compare CFO with net income.

What should an analyst examine when evaluating CFI?

Capital expenditure, asset disposals, acquisitions, and financial investments; then determine how these investments are being funded.

What should an analyst examine when evaluating CFF?

Debt issuance and repayment, equity issuance and repurchases, and dividends to determine whether the firm is raising or returning capital.

What is the typical cash flow pattern of a start-up or early-growth firm?

CFO is negative or small; CFI is strongly negative due to investment; CFF is strongly positive because external financing is required.

What is the typical cash flow pattern of a mature healthy firm?

Large positive CFO, moderately negative CFI, and negative CFF. Operations generate cash, investment uses some cash, and excess cash is returned to capital providers.

Why is persistent reliance on CFF to fund operations or capex concerning?

External financing is not indefinitely sustainable. Ultimately, operations must generate sufficient cash to support the business and provide returns to capital providers.

For a mature firm, how should CFO generally compare with net income?

CFO should normally exceed net income because non-cash expenses such as depreciation reduce net income but do not reduce CFO.

What may persistent CFO below net income indicate?

Potentially poor earnings quality, aggressive revenue recognition, expense deferral, or excessive working-capital investment.

Why can positive CFO still be unsustainable?

CFO can temporarily be increased by reducing receivables or inventory or stretching payables. These working-capital sources cannot continue indefinitely.

What does capex consistently above depreciation generally suggest?

The firm is investing beyond replacement requirements and may be expanding productive capacity.

What does capex consistently below depreciation potentially suggest?

The firm may be harvesting its existing asset base rather than fully replacing productive capacity, potentially reducing future capacity.

What does borrowing to fund dividends or share repurchases potentially indicate?

It may be a warning sign because the firm is increasing financial leverage to return capital rather than funding distributions from internally generated cash.

What is a particularly useful cash flow comparison for analysts?

Compare CFO with capital expenditure. CFO comfortably above capex indicates internally generated cash remains after reinvestment.

What are the two methods for constructing a common-size cash flow statement?

1) Total inflows/total outflows method; 2) Net-revenue method.

How does the total inflows/outflows common-size method work?

Each cash inflow is expressed as a percentage of total cash inflows, while each cash outflow is expressed as a percentage of total cash outflows.

Why is the total inflows/outflows method easiest with direct-method CFO?

The direct method reports gross operating cash receipts and payments, allowing individual operating inflows and outflows to be expressed as percentages of their respective totals.

How does the net-revenue common-size method work?

Every cash flow statement line is divided by net revenue: Common-size cash flow item = Cash flow item ÷ Net revenue.

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

If a cash flow item maintains a relatively stable relationship with revenue, forecasting revenue can help forecast the corresponding cash flow.

What does declining CFO as a percentage of revenue indicate?

The firm is converting a smaller proportion of revenue into operating cash; the analyst should investigate margins and working-capital movements.

Why should multi-year cash flow statements be analyzed together?

A single period can be distorted by major acquisitions, financing transactions, asset sales, or timing effects. Multi-year analysis helps reveal the underlying pattern.

What is free cash flow to the firm (FCFF)?

Cash available to all providers of capital—both debt and equity—after operating requirements and necessary fixed-capital investment.

What is free cash flow to equity (FCFE)?

Cash available to common shareholders after operating requirements, fixed-capital investment, and debt-holder claims/net debt financing.

Who are the recipients of FCFF?

Both debt holders and equity holders.

Who are the recipients of FCFE?

Common equity holders.

What discount rate is conceptually associated with FCFF valuation?

The weighted average cost of capital (WACC), because FCFF belongs to all providers of capital.

What discount rate is conceptually associated with FCFE valuation?

The cost of equity, because FCFE belongs only to equity holders.

What is the FCFF formula starting from net income?

FCFF = NI + NCC + Interest × (1 − t) − FCInv − WCInv.

What does NCC represent in the FCFF formula?

Non-cash charges such as depreciation, amortisation, impairment, and other qualifying non-cash adjustments.

Why are non-cash charges added back when calculating FCFF from net income?

They reduced accounting net income without representing a current-period cash outflow.

Why is after-tax interest added back when calculating FCFF from net income?

Interest reduced net income, but FCFF measures cash available to both debt and equity providers. Only after-tax interest is added because interest provides a tax shield.

How is after-tax interest calculated?

After-tax interest = Interest × (1 − marginal tax rate).

What is FCInv?

Net investment in fixed capital: cash paid to acquire fixed assets minus cash received from fixed-asset disposals.

How is FCInv calculated?

FCInv = Cash paid for fixed assets − Cash proceeds from fixed-asset disposals.

Why is FCInv subtracted when calculating free cash flow?

Cash reinvested in long-term operating assets is not currently available for distribution to capital providers.

What is WCInv?

Investment in operating working capital: the net increase in operating current assets less the net increase in operating current liabilities, excluding financing items and cash-type items specified by the curriculum.

What is the general cash effect of an increase in an operating current asset?

It represents an investment of cash in working capital and therefore increases WCInv/reduces free cash flow.

What is the general cash effect of an increase in an operating current liability?

It provides a source of operating financing and therefore reduces WCInv/increases free cash flow.

What is the FCFF formula starting from CFO under the standard CFO treatment?

FCFF = CFO + Interest × (1 − t) − FCInv.

Why does the CFO-based FCFF formula not separately adjust for NCC and WCInv?

CFO has already incorporated non-cash adjustments and changes in operating working capital.

Why is after-tax interest added to CFO when calculating FCFF under US GAAP?

CFO is already after interest paid, but FCFF represents cash available to debt and equity holders, so after-tax interest is restored.

When starting FCFF from CFO, which interest figure do the supplied notes emphasize using?

Cash interest paid rather than income-statement interest expense.

If interest paid is classified as CFF under IFRS, what is the simplified FCFF formula from CFO?

FCFF = CFO − FCInv because CFO has not been reduced by the interest payment, so no interest add-back is required.

What is the FCFE formula starting from FCFF?

FCFE = FCFF − Interest × (1 − t) + Net borrowing.

What is net borrowing?

Net borrowing = New debt issued − Debt principal repaid.

Why is after-tax interest subtracted when moving from FCFF to FCFE?

FCFF belongs to both debt and equity providers; FCFE belongs only to equity holders, so the cash claim attributable to debt holders must be removed.

Why is net borrowing added when calculating FCFE?

New net debt financing provides additional cash available to equity holders; net debt repayment reduces cash available to equity holders.

What is the FCFE formula starting directly from CFO?

FCFE = CFO − FCInv + Net borrowing.

Why is there normally no interest adjustment in the CFO-based FCFE formula?

CFO has already been calculated after interest paid, and FCFE is the cash flow remaining for equity holders after servicing debt.

What happens to FCFE if debt repayment exceeds new borrowing?

Net borrowing is negative, reducing FCFE.

What is the fastest FCFF/FCFE route when both CFO and net income are given?

Usually start from CFO because it already incorporates non-cash charges and working-capital adjustments.

What is the key difference between FCFF and FCFE?

FCFF is cash available to debt and equity providers; FCFE is cash available only to common equity holders after accounting for debt claims and net borrowing.

What are the five cash flow performance ratios in the notes?

Cash flow to revenue, cash return on assets, cash return on equity, cash to income, and cash flow per share.

What is the cash flow to revenue ratio?

Cash flow to revenue = CFO ÷ Net revenue.

How is cash flow to revenue interpreted?

It measures operating cash generated per unit of revenue; higher generally indicates stronger cash conversion.

What is cash return on assets?

Cash return on assets = CFO ÷ Average total assets.

How is cash return on assets interpreted?

It measures operating cash generated per unit of asset investment.

What is cash return on equity?

Cash return on equity = CFO ÷ Average shareholders' equity.

How is cash return on equity interpreted?

It measures operating cash generated relative to owners' equity.

What is the cash-to-income ratio?

Cash to income = CFO ÷ Operating income.

What does cash to income indicate?

It measures how much operating income is reflected in operating cash flow and can provide information about accrual quality and cash-generating ability.

What is cash flow per share?

Cash flow per share = (CFO − Preferred dividends) ÷ Weighted average common shares outstanding.

Why are preferred dividends deducted when calculating cash flow per share?

Preferred shareholders have a senior claim, so that cash does not belong to common shareholders.

What are the six cash flow coverage ratios in the notes?

Debt coverage, cash interest coverage, reinvestment, debt payment, dividend payment, and investing-and-financing coverage.

What is the debt coverage ratio?

Debt coverage = CFO ÷ Total debt.

How is debt coverage interpreted?

It measures the firm's ability to cover total debt using operating cash flow. Higher is stronger.

What does the reciprocal of debt coverage approximately indicate?

The approximate number of years of current CFO required to repay total debt, assuming CFO remains constant.

What is the cash interest coverage ratio under the standard treatment?

Cash interest coverage = (CFO + Interest paid + Taxes paid) ÷ Interest paid.

Why are interest and taxes added back in the cash interest coverage numerator?

The ratio measures cash available before those payments relative to the interest obligation.

What is the reinvestment ratio?

Reinvestment = CFO ÷ Cash paid for long-term assets.

How is the reinvestment ratio interpreted?

It measures the firm's ability to fund long-term asset purchases from operating cash. A ratio above 1 indicates CFO exceeds the cash spent on those assets.

What is the debt payment ratio?

Debt payment = CFO ÷ Cash paid for long-term debt repayment.

What does the debt payment ratio measure?

The firm's ability to meet long-term debt repayments using operating cash flow.

What is the dividend payment ratio?

Dividend payment = CFO ÷ Dividends paid.

What does the dividend payment ratio measure?

The firm's ability to fund dividends from operating cash flow.

What is the investing-and-financing coverage ratio?

Investing and financing coverage = CFO ÷ (Cash outflows for investing + Cash outflows for financing).

What does an investing-and-financing coverage ratio above 1 indicate?

CFO is sufficient to cover the firm's total investing and financing cash outflows.

What is a common FCFF exam trap involving fixed-capital investment?

Using gross capex instead of net FCInv. FCInv subtracts cash proceeds from fixed-asset disposals from cash paid for fixed assets.

What is a common FCFF exam trap involving gains on asset sales when starting from NI?

A gain on disposal increased NI but is not an operating cash flow; it must be removed when constructing FCFF from NI because the disposal cash flow is reflected through FCInv.

What is the key FCFF memory formula from net income?

NI + Non-cash charges + After-tax interest − Fixed-capital investment − Working-capital investment.

What is the key FCFF memory formula from CFO?

CFO + After-tax interest − Fixed-capital investment.

What is the key FCFE memory formula from CFO?

CFO − Fixed-capital investment + Net borrowing.

What is the key FCFE memory formula from FCFF?

FCFF − After-tax interest + Net borrowing.

What is the quickest conceptual way to distinguish FCFF from FCFE?

FCFF = cash for the whole firm; FCFE = cash left for equity.

What is the main exam interpretation when CFO consistently covers capex?

The firm is capable of funding its fixed-capital investment internally and has cash remaining for other uses.

What is the main concern when CFO repeatedly fails to cover capex?

The firm must fund the shortfall through external financing or reductions in cash, raising questions about sustainability.

What should you look for if a firm has a very large CFI outflow together with a very large financing inflow?

Investigate whether a major acquisition or investment has been financed through new debt or equity rather than assuming the pattern reflects normal operations.

What is the central earnings-quality signal from cash flow analysis?

Compare reported earnings with operating cash generation over time. Persistent divergence, particularly CFO below earnings, warrants further investigation.