Session 10

 The Analysis of Cash Flow Statement (CFS): A

Strategic perspective.
 Analyst’s point
2

a. How safe is the company’s dividend?

b. Could the company fund its needs internally if external
sources of capital suddenly become scarce or
prohibitively expensive?
c. Can the company be able to continue meeting its
obligation if its business turned down sharply?
 Analyst’s point
3

a. Firm’s ability to generate cash flows from operation

b. Trends in cash flow components and cash consequences of
investing and financing decisions.
c. Management’s decision regarding such critical areas as
financial policy (leverage), dividend policy, and investment
for growth
Note:
1. Cash Flow Statement provides essential information about a firm’s
financial flexibility.
2. Income statement and Balance sheet data must be combined with cash
flows for insights into the firm’s ability to turn its assets into cash flows,
repay its liabilities, and generate positive returns to shareholders. All three
financial statements are needed to value the firm appropriately.
 Relevance of Cash
4

 Cash is the most liquid asset and offers a company

both liquidity and flexibility. It is the beginning and
end of a company’s operating cycle.
 Problem of accrual basis of accounting principle.
 Analysis of Liquidity, Solvency and Flexibility.

Note: It can illuminate a treasure trove of clues as to how a company

is balancing its receivables, and payables, paying for its growth,
and otherwise managing its flow of funds.
 Application of Cash Flow Analysis
5

 Particularly useful when net income does not

accurately reflect the economic performance of a
business:
 Noncash expenses are high
 Growth companies use more cash than expenses
 Accrual basis accounting assumptions are stretched to
the limit
 Cash Flow Analysis
6

1. Cash flow statement (CFS) presents summary of investment ,

dividend and financing decisions with a focus on movements
in cash and cash equivalents during the period.
2. Funds flow statement explains changes in working capital,
while CFS explains changes in cash balance.
3. CFS is considered superior to funds flow statement in terms of
decision usefulness.
 Valuation insights:
7

Concerned parties Insights

1. Executives Whether Cash generated by the company is sufficient to fund their
expansion strategy.

2. Stockholders Is it enough to pay dividends

3. Suppliers Customers will be able to pay if offered credit

4. Investors Evaluate future growth potential

5. Employees Interested in to know the overall viability of their employer as

indicated by its ability to fund its operations.
 8

PRESENTATION OF CFS
CFS Elements
 Summary : Classification of activities
9

Activity title Description

1. Operating activities Principal revenue producing activities of an enterprise.
Generally include the day to day (mostly recurring) business
transactions . Receipt of interest, dividend, and payment of
interest are excluded from operating activities.
2. Investing activities Activities related to capital expenditure, inter corporate
investments and acquisitions. Receipt of interest, dividend are
investment activities. Disposal of non-current assets is included in
investment activities.
3. Financing activities Relate to transactions and activities that change the capital
structure. They are transactions with financiers. Payment of
interest and dividend are financing activities.
• These involve obtaining resources from owners and providing
them with return.
• Obtaining and repaying borrowings and paying for their
borrowings.
Cash Flow Pattern

Net Cash flow is typically

Net Cash Inflow Outflow
from... (positive) (negative)
Operations 
Investing 
 
or
Financing
10
 Analyst’s point
11

 A company’s cash flow pattern is a general

reflection of where the company is in its life cycle ...
 Cash Flow Pattern
12

Start-Up, High Growth Company

Investing

Financing

Operating
 Cash Flow Pattern
13

Start-Up, High Growth Company

Investing

Financing

Operating
 Cash Flow Pattern
14

Steady-State Company

Investing

Financing

Operating
 Cash Flow Pattern
15

Steady-State Company

Investing

Dividends
Financing

Operating
 Cash Flow Pattern
16

Cash Cow

Investing

Financing

Operating

Established Growth Oriented firm

 Cash Flow Pattern
17

Cash Cow

Investing

Loan Repayment

Share Repurchases
Financing
Dividend-paid

Operating

Established Growth Oriented firm

 Cash Flow Pattern
18

Decline Firm

Investing

Financing

Operating
 Cash Flow Pattern
19

Decline Firm:
Net cash user but for a different reason.
Investing

Financing

Operating
 Cash provided (used)
by operating activities
20

 Rationality: income statement is prepared on accrual basis-

i.e. revenues are recorded when earned and expenses are
recorded when incurred. In most cases earned revenues include
credit sales at the end of the period, and some expenses which
have been incurred but have not yet been paid for.
 Thus net profit disclosed by the income statement does not
indicate the net cash provided by the operating activities.
 Implication
21

 Hence to calculate the net cash provided by (used

in) operating activities , revenues and expenses are
replaced by actual receipts and payments in cash.
 Methods of converting net income into net cash
flows from operating activities :
a. Direct method
b. Indirect method
 a. Direct method
22

 Under the direct method, cash receipts from

operating revenues and cash payments for
operating expenses are calculated and shown in the
CFS in a summarized form.
 The difference between total cash receipts and
total cash payments is shown as the net cash
provided (or used in) operating activities.
 b. Indirect method
23

 Under the indirect method necessary adjustments

are made to the figure net profit (loss) as disclosed
by the profit and loss account to arrive at the figure
of net cash flow from operating activities.
 It involves the reconciliation of the net profit with net
cash flow from operating activities. Hence this
method is also called as reconciliation method.
 Implication
24

1. Users prefer indirect method, because it

establishes linkage between the cash flow
statement , the balance sheet and the profit and
loss account.
2. SEBI requires indirect method to present the CFS.
3. Any firms uses direct method needs to provide the
reconciliation between the reported net profit and
the change in cash balance during the reporting
period.
 A: Cash Flows From Operation: Implication
25

 Cash flow from operations focuses on the liquidity aspect of

operations. It is not a measure of profitability.
 Cash flow analysis provides valuable information about the
quality of earnings. The higher the correlation between income
and cash flow, the higher the earnings quality.
 Some users consider earnings of higher quality, when the ratio
of cash flows from operations divided by net income is greater
than one.
 Cash Flow Yield =
CFFO
NI
Example: Dell Inc.
 Cash flow yield-Dell
26

 For most companies, the cash flow yield should exceed 1.0. In
2011, Dell performed much better than this minimum. With a
cash flow yield of 1.51 times, Dell generated about $1.51 of
cash for every $ of net income.
 Analyst point
27

 The cash flow yield needs to be examined carefully. Keep in

mind, for instance, that a firm with significant depreciable
assets should have a cash flow yield greater than 1.0 because
depreciation expense is added back to net income to arrive at
cash flows from operating activities.
 If special items, such as discontinued operations, appear on the
income statement and are material, income from continuing
operations should be used as the denominator. Also, an
artificially high cash flow yield may result because a firm has
very low net income, which is the denominator in the ratio.
 Analyst’s point
28

 Look into the size, composition, pattern, and stability of

operating cash flows.
 Examine the components of operating cash flows. Key is
the stability of cash resources.
1. For example: increase in operating cash flows resulting
from securitization of accounts receivables or reduction
in inventories are not a reliable source of cash.
2. Increase in operating cash flows that arise from
increase in current liabilities are not usually a
sustainable source of cash inflow.
 Cash flows to sales
29

DELL
6.45

6.45
 Cash flows to assets
30

10.28 DELL

10

10.28
1.59 6.45
 B: Cash provided (used)
by Investing activities
31

 Is the cash flow related to capital expenditure, inter –corporate

investment and acquisitions.
 Also include cash received from the sale of non-current assets.
 Cash receipts or payments to acquire shares, warrants or debt
instruments of other enterprises and interest in joint ventures (other
than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes)
 Note: Think of B/S -If you assume current assets are associated with
operations, then the activities associated with all the rest of the assets
are in this section.
 Investing activities include lending money and collecting interest on
those loans, buying and selling securities not classified as cash
equivalents (i.e. these securities not related to financing activities).
 C: Cash provided (used)
by Financing activities
32

 Cash flow from financing activities relates to change in

the capital structure of the firm.
 Examples of cash flows arising from financing activities
are:
 Cash proceeds from issue of shares or other similar instruments.
 Cash proceeds from issue of debenture, loans, notes, bonds, and
other short or long term borrowings.
 Cash repayments of amounts borrowed.

Note: payments of interest and dividend are included in cash flow from
financing activities. Because interest expenses is a function of financial
leverage and does not relate to firm’s operations.
 Analyst Point
33

 Think of B/S: if you eliminate the current liabilities

associated with operations , then the activities of
all rest of the liabilities and the stockholders equity
accounts are summarized in cash flow from financing
activities.
 Some anomaly:
34

1. Short-term marketable securities:

2. Short-term Debt:
3. Dividend paid: Cash outflow in financing activity
section
4. Interest payments: considered an operating outflow.
Note: In some countries like UK Interest payments are
included in financing activity section. But in USA
(FASB) voted that interest payments should be in the
operating activities section .
In India interest paid is a part of financing activity.
 Some Anomaly
35

5. Foreign currency cash flows:

 Using exchange rate at the date of cash flow or at a rate i.e.
weighted average rate for the period that approximates the
actual rate.
 The cash flow of a foreign subsidiary is translated using the
exchange rate at the date of cash flows.
 Unrealized gains and losses arising from changes in foreign
exchange rates are not cash flows.
1. In calculating cash flows from operating activities exchange
difference , if reported as gain should be deducted from the net
profit.
2. If the exchange difference is recognized as a loss, it should be
added to the net profit.
 Implication
36

 Effect of exchange rate changes on cash and cash

equivalents held or due in a foreign currency is
reported in the CFS in order to reconcile cash and
cash equivalents at the beginning and the end of
the period.
 This amount is presented separately from cash flows
from operating, investing, and financing activities
(applicable exchange rate- end of period
exchange rate).
 37

CASE- COLGATE PALMOLIVE.

For Practice:
 Analytical Evaluation of CFS
38

Step-1: Scanning the big picture:

A. The first place your company in context in terms of its
age, industry, and size.
a) Matured firm Vs. Start-ups
b) Service industries Vis-à-vis Manufacturing industries
c) Big corporations Vs. small firms

B. What is the bottom-line? Does it show income or losses over the

past few years? Is income (loss) growing or shrinking?.

Example: Suzlon Energy Ltd.

 Scanning the big picture
39

C. Note any line items that are vastly different from

year to year.
COLPAL has few:
a) Changes in working capital accounts
b) Proceeds from issue of debt
 Step-2: Checking the power
of the cash flow engine.
40

The cash flow from operating activities section is the cash flow
engine of the company. On an average we should expect cash
flow from operations should be positive.
a. We do expect the operations of a matured company to
generate enough cash to ‘keep the company whole’ i.e.
replacement of worn-out equipments, and the payment of
dividends.

b. Net cash provided by operations must greater than sum

total of depreciation and capital expenditure outflow
(purchase of fixed asset)
 Implication
41

c. Annual depreciation amount provides a very rough

surrogate for the amount of fixed assets that need to be
replaced each year.
d. To ensure that the firm is kept whole and is not shrinking
, we should expect the portion of the investing activities
related to purchase of fixed assets to exceed depreciation.
e. In a healthy growing company, we should expect growth
in operating working capital accounts i.e. receivables,
payables, and inventory.
f. Streamlining a collection policy or implementing a JIT
inventory system could shrink accounts receivable or
inventory in a growing company.
 Implication
42

 But on an average , inventory, receivables and accounts

payables usually grow in expanding companies.

 Beware of situations in which all working capital

accounts increase net cash from operating activities. It
normally results from deliberate management actions
and could indicate a company in such a cash flow crisis
that managers have been forced to raid the working
capital accounts to survive.
 Step 3: Pinpointing the good news
and the bad news
43

What we must look into is the story that the cash flow
statement trying to reveal.
a. Whether the company is generating or using cash in its
investment activities.
b. Whereas, we expect positive cash flow from
operating activities, we also expect a healthy
company to invest continually in more plant,
equipment, land, and other fixed assets to replace
existing assets as well as to expand and grow.
 3.1 Investing Activities
44

1. Compare capital expenditure (CE) If CE>DEP , Required to keep the

with depreciation (DEP)amount company whole.

2. Expenditure on acquisition (EOA) (last Growth indicator

3 to 5 year trend)

3. Compare the cash flow from operating CFFO must be sufficient to cover CE and
(CFFO) activities with CE and EOA EOA.
 3.2: Cash flow from Financing (CFFF) activities
45

1. It requires viewing CFFF in conjunction with other information on

the cash flow statement .
2. One good news- scenario might be that the company has
carefully analyzed its leverage and cost of capital and chosen
to finance from debt or equity rather than cash from operations
(when substantial amount of CFFO is available).
____________________________________________
1. One start-up is doing well enough to issue an IPO.
2. One bad news: The company has low or negative CFFO and is
being forced to generate funds from other sources.
(Example: Suzlon Energy Ltd.)
 Analyst’s point
46

1. Compare borrowings and payments on debt with each other

across the years and note the trends.
(Conscious management decision to borrow or the company is
desperately borrowing to survive.)
2. Uncovering the news in financing section regarding the stock
(shares outstanding and further transaction) accounts.

3. Note: If we have incredible amount of cash being thrown off from

operations (CFFO)- hence an increase in debt financing is
probably the conscious management decision rather a company
desperately borrow to survive.
 Analyst’s point
47

1. Nevertheless, it might be worth another more detailed look if

we wanted to consider whether continued borrowing provides
a likely source of funds for future growth, or whether the firm
is nearing its debt capacity.
2. Check the foot note, calculate percentage of leverage
including debt service ratio. Industry standard for leverage
might be another indicator.

Note: investigate through reformulated income statement and BS

Cash and cash equivalent/long term debt.
 Analyst’s point: Share repurchase
48

1. Luminous is not issuing stock; instead, it seems to be repaying

debt.
2. In fact, that is the single largest use of cash outside of capital
expenditure.
3. This is probably a “good news” scenario, because the
company may be cashing in on what it considers:
(a) low interest rate in future
(b) or perhaps internal generation is self sufficient and existing cost
of debt is high.
Note:
i. In either event, Luminous appears to have sufficient cash
available to make this large, non-routine investment.
ii. Future EPS will be magnified
 Step 4: Putting the puzzle together
49

Identify the unusual line items: No unusual items in case of MSIL

Examples of unusual items:
1. Example: Hyper inflationary transition charge
2. Example: Restructured operations

the company had more cash inflows for restructuring than it

expensed in the income statement.
 Example
50

1. Example: Hyper inflationary transition charge in 2010

When the company made this accounting change all of its effects
were charged to income in 2010.

2. Example: Restructured operations ,

Subtracted from net income while computing CFO. This means that the cash
flows associated with restructuring operations occurred in a different year
from when those costs were expensed on the income statement. In all three
years the company had more cash outflows for restructuring than it expensed
in the income statement. Whether the restructuring cash costs are more or less
than the restructuring expense is simply a timing issue.
 Summary
51

1. Net income has been positive for all three years

and if we eliminate the effects of accounting
change, has been steadily increasing.
2. Operating cash flows have been positive for all
years and have been steadily increasing.
3. Operating cash flows have significantly exceeded
the sum of depreciation and dividends.
4. Working capital accounts are growing, consistent
with the expectations for a growing business.
 Summary
52

1. Capital expenditure significantly exceed depreciation

and making fairly large acquisitions- indicates the
company grooming the business for the future.
2. There are no large scale sales of fixed assets or
divestitures that indicate any downsizing or shrinking of
the business.
3. The company has increased its dividend payments
annually- an expression of managements confidence in
the firm’s future cash generating capability.
4. The company has sufficient excess cash to repurchase
large amounts of its stock.
 53

SOME IMPLICATION
Cash flow Analysis
 Analyst point-1
54

 Enquire whether the firm has generated positive

cash flows from operating activities.
 Usually a healthy firm in a steady state and
operating in a mature industry generates positive
cash flows.
 On the other hand, a growing firm that invests
significantly in fixed assets, R&D, advertising,
training and working capital to support its future
growth may not be able to generate positive cash
flows from operations.
 Analyst point-2
55

 Reconciliation of net profits and cash flow from

operating activities helps understand the quality of
net profit reported in the profit and loss account.
 Examination of gap between the two provides an
understanding of the accounting policy of the firm
regarding non-current amortizations.
 Analyst-point-3
56

 Analysts analyze the financing policy of the firm by

examining the different sources that the firm has
used to mobilize additional resources.
 Cash flow is analyzed from investing activities to
understand the firm’s strategy for long term growth.
 Some facts
57

1. Asset replacements are financed from internal or

external funds.
2. Financing sources of expansion and business
acquisitions.
3. Whether the company is depended on external
financing.
4. What are the company’s investing demands and
opportunities.
5. What are the requirements and types of financing.
6. Are managerial policies (such as dividends) highly
sensitive to cash flows, i.e. PSUs (Coal India Ltd.)
 Some facts
58

 Analysis period- should be as large as possible

(Generally more than 5 years)
 Estimate the trends in major cash inflows and
outflows over a period of time.
 Evaluate the common size analysis for the cash flow
statement to understand the relative importance of
the individual component of the CFS.
 Analyst’s Point
59

 Cash flow statement should be analyzed in the

context of corporate strategy and likely changes in
the business environment.
 Cash flow ratios
60

1. Cash flow adequacy ratio

2. Cash reinvestment ratio
 1. Cash flow adequacy ratio (CFAR)
61

1. Measure of company’s ability to generate sufficient cash from

operations to cover capital expenditures , investment in
inventories and cash dividends.
2. CFAR = 3 year sum of cash from operation/ three year sum
of capital expenditures , inventory additions and cash
dividends
3. CFAR of 1.00 indicates that the company exactly covered these
cash needs without a need for external financing. A ratio of less
than 1.00 suggests that internal cash resources are insufficient to
maintain dividends and current operating growth levels.
4. Note: Why 3 year periods.?
 2. Cash reinvestment ratio (CRIR)
62

1. CRIR is a measure of the percentage of investment in assets

representing operating cash retained and reinvested in the
company for both replacing assets and growth in operations.
2. CRIR = (Gross plant +Investment +Other assets + Working
capital)/ (Operating cash flow- Dividend)
3. A reinvestment ratio of 7% to 11% is generally considered
satisfactory.