FINANCIAL MANAGEMENT

Cash-Flow Analysis
Module 6

LEARNING OBJECTIVES

After studying module, you should be able to:

 Understand the usefulness of the statement of cash flows for decision making.
 Know the classifications of the cash flow activities
 Identify the various sources and applications of cash according to the firm’s Operating
activities, financing activities and investing activities
 Be familiar with the content and form of the Statement of Cash flows

The statement of cash flows is a financial statement that shows the firm’s cash flows over a
given period of time. This reports the amount of cash the firm generated and distributed
during a particular period of time.

Uses of statement of Cash Flows

Creditors examine cash flow statements carefully because they are concerned about
being paid. They begin their examination by finding net cash provided by operating activities.
Consequently, creditors look for answers to the following questions in the company’s cash
flows

1. Is the company generating sufficient positive cash flows from the ongoing
operations to remain viable?
2. Will the company be able to meet its financial obligations to creditors?
3. What expansion activities took pace and how are those financed?
4. Will the company be able to pay its customary dividends?
5. Why did cash decrease even though a net income was reported
6. To what extent will the company have to borrow money in order to make needed
investment?
7. What happened to the proceeds received from the issuance of capital stock?

The primary purpose of cash flow statement is to provide relevant information about a
company’s cash receipts and cash payments during an accounting period that is useful in
evaluating the preceding items.

Statement of Cash flows provides the means of measuring ta business firms

a. Financial Liquidity – which refer to the “measures to cash” of assets and liabilities
b. Financial flexibility – which refers to a company’s ability to respond and adapt to
financial adversary and unexpected needs and opportunities.
Financial Liquidity

Readers of financial statements often assess liquidity by using the current cash debt
coverage ratio. It indicates whether the company can pay off its current liabilities from its
operations in a given year. The formula for this ratio is:

Net Cash Provided by Operatng Actities Current Cash

¿
Average Current Liabilities Debt Coverage Ratio

The higher the current cash debt coverage ratio, the less likely a company will have liquidity
problems. For example a ratio of 1:11 is good, it indicates that the company can meet all of
its current obligation from internally generated cash flow

For example, ABC Company had the following balances at the end of the year 2018:

Particulars Php

Cash flow from operating activities 300,000

Current liabilities at the beginning of the year 150,000

Current liabilities at the end of the year 250,000

Step 1 Calculate average current liabilities: Php 200,000

Step 2Apply the given figures to the current cash debt coverage ratio

Current cash debt coverage ratio: 1.5

The above example indicates that company ABC is liquid enough to cover its current
debts conveniently with the annual cash generation from operating activities. The company
does not need to acquire loans or apply for other forms of credit to clear its debts on time.

A cash debt coverage ratio of 1 or higher implies that the business is liquid enough to
clear its debts on time.

Financial Flexibility

The Cash Debt Coverage Ratio provides information on the financial flexibility. It
indicates a companny’s ability to repay its liabilities from net cash provided by operating
activities, without having to liquidate the assets employed to its operations.

Cash debt coverage ratio is calculated by dividing net cash provided by operating activities
by the average total liabilities (i.e., current liabilities plus long-term liabilities):
 Net Cash Provided by Operating Activities
Cash Debt Coverage Ratio =
Average Total Liabilities

Cash Debt Coverage Ratio Example

4,870
Cash Debt Coverage Ratio =  = 0 .52
[(4,200 + 6,000) + (5,300 + 3,220)]   2

Cash debt coverage ratio of 0.52 indicates that for every dollar of total liabilities there were
52 cents of net cash provided by operating activities. In other words, Friends Company can
meet (or cover) 52% of its liability obligations with net cash provided by operating activities.

Basic Approach to a cash flow statement / funds flow statement

In preparing statement of cash flows, the term cash is broadly defined to include both cash
and cash equivalents.

Cash equivalents consist of short-term, highly liquid investments such as treasury bills, SEC
registered commercial papers an money market funds. Such investments are made solely for
the purpose of generating return on funds that are temporarily idle.

What Are Sources? Uses?

We prepare a basic, bare-bones funds statement by
(1) determining the amount and direction of net balance sheet changes that occur between
two balance sheet dates
 we simply place one balance sheet beside the other
 compute the changes in the various accounts and note the direction of change
– an increase (+) or decrease (−) in amount
(2) classifying net balance sheet changes as either sources or uses of funds,
 Each balance sheet item change is classified as either a source or use of funds,
as follows

For example, a reduction in inventory (an asset) would be a source of funds, as would
an increase in short-term loans (a claim). An increase in accounts receivable (assets) would
be a use of funds, and a reduction in shareholders’ equity (claims) – through, for example, a
share
repurchase – would also be a use of funds.
 Below table walks us through the first two steps necessary to produce a funds
statement for the Aldine Manufacturing Company, our example in the preceding chapter. The
amount and direction of balance sheet changes are determined. Notice that total sources of
funds ($263,000) equals total uses of funds ($263,000). Because total sources must always
equal total uses, it provides a check on our work.

Once all sources and uses are computed, they may be arranged in statement form so
that we can analyze them better. Table below shows a “basic” sources and uses of funds
statement for the Aldine Manufacturing Company for the fiscal year ended March 31, 20X2.
 (3) consolidating this information in a sources and uses of funds statement format.
Once all sources and uses are computed, they may be arranged in statement form so that
we can analyze them better

Classification of Cash Flow activities

Operating Activities

Cash flows from operating activities is a section of a company's cash flow statement
that explains the sources and uses of cash from ongoing regular business activities in a given
period. This typically includes net income from the income statement, adjustments to net
income, and changes in working capital.

Operating activities include delivering or producing goods for sale and providing
services, and the cash effects of transactions and other events rather than enter into the
determination of income.

Examples are:

Inflows
Sales of goods
Revenue from services
Return on interest earnings assets (Interest)
Return from contracts held for dealing and trading purposes
Receipts from contracts held for dealing and trading purposes
Tax refunds unless identified with financing and investing activities
Outflows
Payments for purchases of inventories
Payments for operating expenses (salaries, rent, insurance, etc.)
Payment for purchases from suppliers other than inventory
Payment for lenders (Interest)
Payment for taxes unless identified with financial an investing
activies.

Investing Activities

Cash flow from investing activities is the cash that has been generated (or spent) on
non-current assets that are intended to produce a profit in the future. Types of activities that
this may include are capital expenditures, lending money, and sale of investment securities.
Along with this, expenditures in property, plant and equipment fall within this category as
they are a long-term investment. Cash flow from investing activities is stated on the cash
flow statement
Investing activities also include acquiring and selling, or otherwise disposing of
securities that are not cash equivalent and productive asses that are expected to benefit the
firm for long periods of time.

Examples are:

Inflows
Sale of long-lived assets such property, plant and equipment,
intangibles and other long-term assets.
Sale of debt or equity securities of other entities
Collection of loans (principal) to others (other than advances and
loans made by financial institution)

Outflows
Acquisitions of long-lived assets such as property, plant and
equipment, intangibles and other long-term assets.
Purchases of debt or equity securities for other entities.
Loans (principal) to others (other than advances and loan made by a
financial institution)

Financing Activities

Cash flow from financing activities (CFF) is a section of a company’s cash flow
statement, which shows the net flows of cash that are used to fund the company. Financing
activities include transactions involving debt, equity, and dividends.

Cash flow from financing activities provides investors with insight into a company’s
financial strength and how well a company's capital structure is managed.

Financing activities include borrowing from creditors and repaying the principal, and
obtaining resources from owners and providing them with a return on the investment.

Examples are:

Inflows
Proceeds from borrowing (short-term and long-term)
Proceeds from issuing the firm’s own equity securities
Outlflows
Repayment of debt principal
Repurchase of a firm’s own shares
Payment of dividends
Acquisition of the enterprise’s own share

Structure of the Cash Flow Statement

The main components of the cash flow statement are:

Cash from operating activities (provided or used by operating activities)

Cash from investing activities (provided or used by investing activities
Cash from financing activities (provided or used by financing activities)
Disclosure of non-cash activities, which is sometimes included when prepared under generally
accepted accounting principles (GAAP)

Illustrative Statement of Cash Flows

Statement of Cash Flows
For the year ended Dec 31, 2015
Cash flow from operating activities  
  Net Income Php 14,000.00
Ass ( Deduct) Adjustment for differences between
  net income  
  and cash flows from operating activities  
  Depreciation Expense 8,000.00
  Increase in salaries payable 800.00
  Increase in accounts payable 2,600.00
  Increase in accounts receivable
  Net cash provided by operating activities Php 18,400.00
Cash flows from investing activities  
  Payment for purchase of building
  Payment for purchase of equipment (4,000.00)
  Proceeds from sal of land, at cost 10,000.00
   
  Net cash used for investing activities Php (24,000.00)
Cash flows from financing activities  
  Proceeds from issuance of ordinary shares 18,000.00
  Proceeds from issuance of bonds 12,000.00
  Payment of dividends (9,000.00)
  Payment of notes payable (13,000.00)
  Net cash provided by financing activities Php 8,000.00
Net increase in Cash 2,400.00
Cash balance, Januaryry 1, 2015 10,900.00
Cash balance, December 31, 2015 Php 13,300.00
Investing and Financing Activities not affecting cash  
  Issuance of ordinary shares for land Php 6,000.00
Acquisition of land by issuance of ordinary
  shares. Php (6,000.00)
Calculating cash flow from Operating Activities

The cash flow statement may be presented using either a “direct method” (which is
encouraged by the Financial Accounting Standards Board because it is easier to understand)
or an “indirect method” (which is likely to be the method followed by a good majority of
firms because it is easier to prepare).

Direct Method

The direct method adds up all of the various types of cash payments and receipts,
including cash paid to suppliers, cash receipts from customers, and cash paid out in salaries.
This method of CFS is easier for very small businesses that use the cash basis accounting
method. These figures can also be calculated by using the beginning and ending balances of
a variety of asset and liability accounts and examining the net decrease or increase in the
accounts. It is presented in a straightforward manner.

At minimum, the following classes of operating cash receipts and payments should
be separately reported:
1. Cash collected from customers including lessees, licensees and the like
2. Interest, fees , royalties and dividends received
3. Other operating cash receipt, if any
4. Cash paid to employees and other supplies of goods and services
5. Interest paid
6. Income taxes paid
7. Other operating payments , if any
8. Contracts held for dealing or trading purposes

Indirect Method

Indirect Cash Flow Method. Most companies use the accrual basis accounting

method, where revenue is recognized when it is earned rather than when it is received. This
causes a disconnect between net income and actual cash flow because not all transactions in
net income on the income statement involve actual cash items. Therefore, certain items must
be reevaluated when calculating cash flow from operations.

With the indirect method, cash flow is calculated by adjusting net income by adding
or subtracting differences resulting from non-cash transactions. Non-cash items show up in
the changes to a company’s assets and liabilities on the balance sheet from one period to the
next. Therefore, a company’s accountant will identify the increases and decreases to asset
and liability accounts that need to be added back to or removed from the net income figure,
in order to identify an accurate cash inflow or outflow.

The indirect cash flow method allows for a reconciliation between two other financial
statements: the income statement and balance sheet.

The only difference between the direct and indirect methods of presentation concerns
the reporting of operating activities; the investing and financing activity sections would be
identical under either method. Under the direct method, operating cash flows are reported
(directly) by major classes of operating cash receipts (from customers) and payments (to
suppliers and employees). A separate (indirect) reconciliation of net income to net cash flow
from operating activities must be provided.
 Under the indirect method shown in Frame B of Table 7.5, the reconciliation of net
income to net cash flow from operating activities moves up to replace the direct method’s
operating activity cash-flow section. In effect, then, the indirect method is just a reduced
version of the direct method of presentation.
 Adjustments to Convert Income Statement Amounts to Operating Cash Flows (Direct Method)
Income Statement Cash Flow from Net Operating
Accounts Adjustments Operating Activities Cash flows
+ Decrease in accounts receivable or
-Increase in account receivable = Collection from customers
Sales Revenue + Increase in deferred revenue or
- Decrease in deferred revenue

+ Decrease in interest receivable or

= Interest and dividends
Interest revenue and -Increase in interest receivable collected Cash inflows from
+Amortization of premium on investment
Dividend revenue in bonds or Operating Activities
-Amortization of discount on investment
in bonds

+ Increase in unearned revenue or

Other Revenues -Decrease in unearned revenues or = Other operating receipts
-Gains on disposal of assets and liabilities
or
-Investment income ( equity method)

+ Increase in Inventory or
Cost of Goods Sold -Decrease in inventory or = Payment to Suppliers
+ Decrease in accounts payable or
-Increase in accounts payable

- Depreciation, depletion and amortization

expense
Selling and + Decrease in accrued expenses or
Administrative = Payment to Operating
Expenses - Increase in accrued expenses Expenses
+ Increase in prepaid expenses or
- Decrease in prepaid expenses

+ Decrease in interest payable or Cash inflows from

Insurance Expense - Increase in interest payable = Payment to Interest Operating Activities
+ Amortization of premium on bonds
payable or
- Amortization of discount on bonds
payable

Other Expenses - Loss on disposal of assets and liabilities = Other operating payments
- Investment Loss ( Equity method)

+ Decrease in income tax payable or

Income tax expense - Increase in income taxes payable = Payment of Income taxes
+ Decease in deferred income taxes
payable or
-Increase in deferred income taxes
payable
 Net Income after taxes

PLUS
Decreases in current assets (except cash, marketable securities and non- trade accounts)
Increases in current liabilities (except financing or non-operating accounts e.g. bank loan,
current maturities of long term debt)
Depreciation, depletion and amortization expense
Amortization of discount on bonds payable
Amortization of premium on investment in bonds
Increase in deferred income taxes
Loss (net) on disposal of assets or liabilities
Subsidiary loss under the equity method
Interest Expense
Income taxes

MINUS
Increases in current assets (except cash, marketable securities and non- trade accounts)
Decreases in current liabilities (except financing or non-operating accounts e.g. bank loan,
current maturities of long term debt)
Amortization of premium on bonds payable
Amortization of discount on investment in bonds
Decrease in deferred income taxes
Gain (net) on disposal of assets or liabilities
Subsidiary gain under the equity method

EQUALS
Net Cash Flow From Operations

Interest Paid
Income taxes paid

Net Cash from Operating Activities

 Adjustments to Convert Net Income to Net Cash Flow from Operating Activities
(INDIRECT METHOD)

Example 1.

Dana-Stallings, Inc., had the following financial statements for 20X1 and 20X2. Prepare
a sources and uses of funds statement, and evaluate your findings.

Using the information provided plus your sources and uses of funds statement from Part (a),
prepare a statement of cash flows using the indirect method and evaluate your findings. (Was
your analysis based on the cash flow statement much different from that based on the flow of
funds statement?

Solution:

The company has had substantial capital expenditures and increases in current assets. This growth has
far outstripped the growth in retained earnings. To finance this growth, the company has reduced its marketable
securities to zero, has leaned heavily on trade credit (accounts payable), and has increased its accrued expenses
and bank borrowings. All of this is short-term financing of mostly long-term buildups in assets.
 In addition to the same points raised by an analysis of the sources and uses of funds
statement, we see that all of the firm’s cash flow from operating activities (and then some)
went toward additions to fixed assets. By and large, the cash flow statement prepared using
the indirect method gives you much the same information gathered from an analysis of the
sources and uses of funds statement.