CHAPTER (4): Cash Flows Statement Analysis

INTRODUCTION
Cash flows is the inflow and outflow of cash. It is cash, which a firm can invest, or pay to
creditors to discharge its obligations, or distribute to shareholders as dividends. Cash flow is a
simple and objectively defined concept. It is simply the difference between dollars received and
dollars paid out. Information about the sources and uses of cash helps creditors, investors, and
other statement users to evaluate the company’s liquidity, solvency, and financial flexibility.

1. CASH FLOWS or PROFIT

Cash flow should not be confused with profit. Changes in profits do not necessarily mean
changes in cash flows. It is not difficult to find examples of firms in practice that experience
cash shortages in spite of increasing profits.

Data from the annual reports for 2001 ($ in millions) of retail merchandising companies
Company Net income Net cash provided by operations
Kmart corporation 2 418 997
Wal-Mart Stores, Inc 6 671 10 260
JCPenney Company, Inc 98 987
Sears, Roebuck & Co 735 2 262
May Department Stores Company 703 1 644

Cash flows is not the same thing as profit, at least, for two reasons:

• First, profit, as measured by an accountant, is recognized when it is earned, rather than

when cash is received, and expense is recognized when it is incurred rather than when
cash is paid. In other words, profit includes cash revenues as well as receivables and
excludes cash expenses as well as payable.
• Second, for computing profit, expenditures are arbitrarily divided into revenue and
capital expenditures. Revenue expenditures are entirely charged to profits while capital
expenditures are not. Capital expenditures are capitalized as assets (investments), and
depreciated over their economic life. Only annual depreciation that does not involve any
cash flows, is charged to profit. Thus, the measurement of profit excludes some cash
flows such as capital expenditures and includes some non-cash items
such as depreciation

Assuming a firm is entirely equity-financed, and that taxes do not exist:

Cash flows = profit + depreciation – capital expenditure

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Financial managers will be making incorrect decisions if they put emphasis on profits or
earnings per share. The objective of a firm is not to maximize profits or earnings per share,
rather it is to maximize the shareholders’ wealth, which depends on the present value of cash
flows available to them. Profits fail to provide meaningful guidance for making financial
decisions. Profits can be changed by affecting changes in the firm’s accounting policy without
any effect on cash flows. For example, a change in the method of inventory valuation will
change the accounting profit without a corresponding change in cash flows.

2. CLASSIFICATION OF CASH FLOWS

The cash flow statement classifies all cash receipts and cash payments of the company into
three categories: operating, investing, and financing.
• Cash flows from operating activities include the cash effects of transactions that create
revenues and expenses. They thus enter into the determination of net income.
• Cash flows from investing activities are associated with the (a) acquisition and disposal
of long-term assets, such as property and equipment, and (b) lending money and
collecting loans.
• Cash flows from financing activities include (a) obtaining cash from issuing debt and
repaying the amount borrowed, and (b) obtaining cash from stockholders and paying
them dividends
➔ The operating activities category is the most important because it shows the cash provided
or used by company operations. Ultimately, a company must generate cash from its
operating activities in order to continue as a going concern to expand.

Activity: Indicate the classification in the cash flows statement for each of the following (see
chapter 0)
Cash Cash Operating Investing Financing
inflows outflows activity activity activity
Cash from sale of goods or
services
Cash from returns on loans
(inters received) and on
equity securities (dividends
received)
Cash from sale of property,
plant and equipment
Cash from sale of debt or
equity securities of other
entities

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 Cash to supplier to
inventory
Cash to employees for
services
Cash to purchase property,
plant and equipment
Cash to make loans to other
entities
Cash from sale of equity
securities (company’s own
stock)
Cash to lenders for interest
Cash to government for
taxes
Cash from issuance of debt
(bonds and notes)
Cash to stockholders as
dividends
Cash to redeem long term
debt
Cash from collection of
principal on loans to other
entities
Cash to purchase bonds or
stocks of other entities

3. CASH FLOWS STATEMENT

Obviously, the primary purpose of the cash flows statement is to provide information about cash
receipts, cash payments and net change in cash resulting from the operating, investing and financing
activities of a company during a period. It provides answers to many important questions such as:
❖ Where did the cash come from during the period?
❖ What was the cash used for during the period?
❖ Does the company generate enough cash from its operations to pay for its new
investments, or is the company relying on new debt issuance to finance them?
❖ Does the company pay its dividends to common stockholders using cash
generated from operations, from selling assets, or from issuing debt?
Answers to these questions are important because, in theory, generating cash from operations
can continue indefinitely, but generating cash from selling assets, for example, is possible only
as long as there are assets to sell. Similarly, generating cash from debt financing is possible
only as long as lenders are willing to lend, and the lending decision depends on expectations
that the company will ultimately have adequate cash to repay its obligations.

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The general format of the cash flow statement consists of the three activities discussed above

Company name
Cash flows statement
Period Covered
Cash flows from operating activities
List of individual items cash inflows A
List of individual items cash outflows B
Net Cash provided (used) by operating activities (I) (A-B)
Cash flows from investing activities
List of individual items cash inflows C
List of individual items cash outflows D
Net Cash provided (used) by investing activities (II) (C-D)
Cash flows from financing activities
List of individual items cash inflows E
List of individual items cash outflows F
Net Cash provided (used) by financing activities (III) (E-F)

Net increase (decrease) in cash (IV) I +II +III

Cash at beginning of period (V) V
Cash at end of period V +IV

The statement of cash flows is prepared in general using two different methods of presentation:
direct and indirect method:
➢ The direct method shows the specific cash inflows and outflows that result in reported
cash flow from operating activities. It shows each cash inflow and outflow related to a
company’s cash receipts and disbursements. (Appendix 1)
➢ The indirect method shows how cash flow from operations can be obtained from
reported net income as the result of a series of adjustments. The indirect format begins
with net income. To reconcile net income with operating cash flow, adjustments are
made for non-cash items, for non-operating items, and for the net changes in operating
accruals. (Appendix 2)
In practice the indirect method is used extensively in practice by about 99% of companies for
three reasons: (1) it is easier to prepare, (2) it focuses on the differences between net income
and operating cash flow, and (3) it tends to reveal less company information to competitors.

4. CASH FLOW ANALYSIS

In chapter 3 (ratio analysis) we introduced net income based ratios that are gaining increased
acceptance among analysts. In this section we review those ratios and introduce new ones.

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 Old ratios New ratios
Current ratio = Current cash debt coverage ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑪𝒂𝒔𝒉 𝒑𝒓𝒐𝒗𝒊𝒅𝒆𝒅 𝒃𝒚 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒊𝒆𝒔
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Liquidity
Its disadvantage is that
position: It
it uses year end balances It is assumed to correct the problem because cash
refers to the
of current assets and provided by operating activities involves the
firm’s ability
current liability entire year rather than a balance at one point in
to meet its
accounts. These year time
immediate
end balances may not be
obligations
representative of the
company’s position
during most of the year
Cash debt coverage ratio =
𝑪𝒂𝒔𝒉 𝒑𝒓𝒐𝒗𝒊𝒅𝒆𝒅 𝒃𝒚 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒊𝒆𝒔
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Solvency position:
The ratio indicates a company’s ability to repay
It refers to the firm’s ability to survive
its liabilities from cash generated from
over the long term
operations, that is without having to liquidate
productive assets such as property, plant and
equipment
Free Cash flows describes the cash remaining
from operations after adjustment for capital
expenditures and dividends
Free Cash flows Free Cash flows =
𝑪𝒂𝒔𝒉 𝒑𝒓𝒐𝒗𝒊𝒅𝒆𝒅 𝒃𝒚 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒊𝒆𝒔 −
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 − 𝑪𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔

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 5. APPENDIX
Appendix 1: DIRECT METHOD

Tech Data Corporation is a leading distributor of information technology products. Appendix

1 presents comparative cash flow statements from the company’s annual report for the fiscal
years ended December 31st, 2018

Appendix 2: INDIRECT METHOD

Walmart is a global retailer that conducts business under the names of Walmart and Sam’s
Club. Appendix 2 presents the comparative cash flow statements from the company’s annual
report for the fiscal years ended December 31st, 2018,

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