FSA 5 Analyzing Statements of Cash Flows II
Reading a statement of cash flows well is central to judging where a company stands today and to projecting the cash it will generate later, which is what ultimately supports the value of its debt and its shares. A disciplined review works through the three activity categories (operating, investing, and financing) and then digs into what drives the movement inside each one. A convenient way to organize the work is four steps.
- Weigh the major sources and uses of cash across operating, investing, and financing activities.
- Examine what is driving operating cash flow.
- Examine what is driving investing cash flow.
- Examine what is driving financing cash flow.
Step 1: The big picture across the three categories
Which category supplies most of the cash tends to shift with where a company sits in its life cycle. For an established business, the healthy pattern is for operations to be the main wellspring of cash. Over any extended horizon a firm has to fund itself from what it earns; persistently negative operating cash flow forces it to lean on borrowing or share issuance to plug the gap, and lenders and shareholders will eventually want repayment out of operations or they will stop supplying funds. Cash thrown off by operations can then be redeployed. When genuinely value-adding projects exist, putting that cash into investing activities makes sense; when they do not, the better use is to return it to the providers of capital, which is a financing activity.
Younger or fast-expanding companies often show the reverse for a while. Building inventory and extending credit to win customers can hold operating cash flow below zero as the business scales. That cannot last: cash must in time flow mainly from operations so that capital can be handed back to those who supplied it. The ideal is for operating cash flow to be large enough to fund the company’s capital spending on its own, which is the essence of free cash flow. The two questions to settle at this step are what the principal sources and uses are, and whether operating cash flow is both positive and enough to cover capital expenditures.
Step 2: What drives operating cash flow
Inside the operating section, the task is to find the line items that move the number most. A company consumes cash to carry receivables and inventory and to pay staff and suppliers, and it collects cash as customers pay. Tracking the swings in receivables, inventory, payables, and similar accounts shows whether operations are releasing cash or absorbing it, and why.
It also pays to set operating cash flow beside net income. For a mature firm, net income carries non-cash charges such as depreciation and amortization, so operating cash flow would normally be expected to run above net income. That comparison doubles as a read on earnings quality. Strong reported earnings paired with weak operating cash flow is a warning sign: the company may be leaning on aggressive accounting to lift income without actually converting it into cash. How much earnings and cash flow swing from period to period matters too, since it feeds into the risk assessment and into how confidently future cash flows can be projected. So the analyst asks what the main determinants are, whether operating cash flow sits above or below net income and for what reason, and how steady the operating cash flows have been.
Step 3: What drives investing cash flow
Here each line is worth reading on its own, because every one is either a source or a use of cash. This is where you see how much is being sunk into property, plant, and equipment for the future, how much is going to buy whole businesses, and how much is being parked in liquid holdings such as stocks and bonds, as well as how much is coming back in from selling such assets. If capital outlays are large, ask where the money is coming from, whether surplus operating cash flow or the financing activities covered in Step 4. When assets are being sold off, it is worth learning why and weighing what that means for the company.
Step 4: What drives financing cash flow
The financing lines reveal whether the company is taking in capital or paying it back, and what kind of capital is involved. Steady annual borrowing prompts the question of when repayment falls due. This section also carries dividends and share repurchases, the two routes for handing capital back to owners. The point of the step is to understand why capital is being raised or returned.
Derek Yee, CFA, is building a valuation model for Groupe Danone and needs to forecast its cash flow. Danone prepares its statements under IFRS. Condensing the consolidated statement of cash flows into the main categories gives the following (in EUR millions).
| 2016 | 2017 | |
|---|---|---|
| Cash flows from operating activities | 2,652 | 2,958 |
| Cash flows from (used in) investing activities | (848) | (11,437) |
| Cash flows from (used in) financing activities | (1,616) | 8,289 |
| Exchange rate effects on cash | (151) | 272 |
| Increase in cash | 38 | 81 |
Net income was 1,827 in 2016 and 2,563 in 2017. Capital expenditure was (925) and (969). Sub-totals may not sum exactly because the company rounds.
Common-size work restates statement lines as percentages so that patterns stand out and companies of different sizes become comparable. On the income statement each line is scaled by net revenue; on the balance sheet each line is scaled by total assets. The cash flow statement offers two routes rather than one.
- Scale every cash inflow by total inflows and every cash outflow by total outflows.
- Scale every line by net revenue.
Either way the percentages make cash flow trends easier to read than raw totals do. To see both methods at work, take Acme Corporation, whose direct-method statement for the year ended 31 December 2018 is below.
| Amount | |
|---|---|
| Cash received from customers | 23,543 |
| Cash paid to suppliers | (11,900) |
| Cash paid to employees | (4,113) |
| Cash paid for other operating expenses | (3,532) |
| Cash paid for interest | (258) |
| Cash paid for income tax | (1,134) |
| Net cash provided by operating activities | 2,606 |
| Cash received from sale of equipment | 762 |
| Cash paid for purchase of equipment | (1,300) |
| Net cash used for investing activities | (538) |
| Cash paid to retire long-term debt | (500) |
| Cash paid to retire common stock | (600) |
| Cash paid for dividends | (1,120) |
| Net cash used for financing activities | (2,220) |
| Net increase (decrease) in cash | (152) |
Cash balance moved from 1,163 at 31 December 2017 to 1,011 at 31 December 2018, a fall of 152.
The percentage-of-inflows and outflows method
Under the first route, each inflow is divided by total inflows and each outflow by total outflows. The presentation of operating cash flow decides how much detail survives. With the direct method, individual operating receipts and payments are listed, so each can be shown against the relevant total. With the indirect method, operating inflows and outflows are netted, so only the single net operating figure appears, expressed against total inflows when it is positive (as it is here) or against total outflows when it is negative.
Prepare the percentage-of-inflows and outflows common-size statement for Acme, first from the direct-method presentation, then from the indirect-method presentation.
| Inflows | Amount | % of inflows |
|---|---|---|
| Receipts from customers | 23,543 | 96.86% |
| Sale of equipment | 762 | 3.14% |
| Total | 24,305 | 100.00% |
| Outflows | Amount | % of outflows |
|---|---|---|
| Payments to suppliers | 11,900 | 48.66% |
| Payments to employees | 4,113 | 16.82% |
| Other operating expenses | 3,532 | 14.44% |
| Interest | 258 | 1.05% |
| Income tax | 1,134 | 4.64% |
| Purchase of equipment | 1,300 | 5.32% |
| Retirement of long-term debt | 500 | 2.04% |
| Retirement of common stock | 600 | 2.45% |
| Dividend payments | 1,120 | 4.58% |
| Total | 24,457 | 100.00% |
| Inflows | Amount | % of inflows |
|---|---|---|
| Net cash from operating activities | 2,606 | 77.38% |
| Sale of equipment | 762 | 22.62% |
| Total | 3,368 | 100.00% |
| Outflows | Amount | % of outflows |
|---|---|---|
| Purchase of equipment | 1,300 | 36.93% |
| Retirement of long-term debt | 500 | 14.20% |
| Retirement of common stock | 600 | 17.05% |
| Dividend payments | 1,120 | 31.82% |
| Total | 3,520 | 100.00% |
The net-revenue method
The second route scales every line by net revenue, taken here as the 23,543 of cash received from customers in 2018. Its practical strength is forecasting: once revenue has been projected, any item that moves with revenue (depreciation, capital spending, debt drawdowns and repayments, and so on) can be estimated from its historical percentage. The restatement below uses Acme’s indirect-method operating section.
| Amount | % of revenue | |
|---|---|---|
| Net income | 2,210 | 9.37% |
| Depreciation expense | 1,052 | 4.46% |
| Gain on sale of equipment | (205) | (0.87)% |
| Increase in accounts receivable | (55) | (0.23)% |
| Increase in inventory | (707) | (3.00)% |
| Decrease in prepaid expenses | 23 | 0.10% |
| Increase in accounts payable | 263 | 1.11% |
| Increase in salary and wage payable | 10 | 0.04% |
| Decrease in interest payable | (12) | (0.05)% |
| Increase in income tax payable | 5 | 0.02% |
| Increase in other accrued liabilities | 22 | 0.09% |
| Net cash from operating activities | 2,606 | 11.04% |
| Sale of equipment | 762 | 3.23% |
| Purchase of equipment | (1,300) | (5.51)% |
| Net cash used for investing | (538) | (2.28)% |
| Retire long-term debt | (500) | (2.12)% |
| Retire common stock | (600) | (2.54)% |
| Dividends | (1,120) | (4.75)% |
| Net cash used for financing | (2,220) | (9.41)% |
| Net decrease in cash | (152) | (0.64)% |
Andrew Potter reviews an abbreviated common-size statement for Apple Inc., where each line is divided by total net sales for the year. Selected figures are below.
| 2017 | 2016 | 2015 | |
|---|---|---|---|
| Net income | 21.1% | 21.2% | 22.8% |
| Depreciation and amortization | 4.4% | 4.9% | 4.8% |
| Cash generated by operating activities | 27.7% | 30.5% | 34.8% |
| Purchases of marketable securities | (69.6)% | (66.0)% | (71.2)% |
| Acquisition of property, plant and equipment | (5.4)% | (5.9)% | (4.8)% |
| Cash used in investing activities | (20.3)% | (21.3)% | (24.1)% |
| Payments for dividends | (5.6)% | (5.6)% | (4.9)% |
| Repurchases of common stock | (14.4)% | (13.8)% | (15.1)% |
| Cash used in financing activities | (7.6)% | (9.5)% | (7.6)% |
Free cash flow, in its plainest form, is the operating cash flow left over after capital expenditures. For valuing a company or its shares, analysts usually work with two sharper measures: free cash flow to the firm and free cash flow to equity.
Free cash flow to the firm
Free cash flow to the firm (FCFF) is the cash left for every provider of capital, debt holders and equity holders alike, once all operating costs (income taxes included) are settled and the necessary investment in working capital and fixed capital is made. Starting from net income, it is built up as follows.
Here NI is net income, NCC is non-cash charges such as depreciation and amortization, Int is interest expense, t is the tax rate, FCInv is fixed capital investment (capital expenditures such as equipment), and WCInv is working capital investment. Interest is added back, net of its tax shield, because FCFF belongs to lenders as well as owners, so it is measured before interest leaves the firm. The same figure can be reached starting from operating cash flow.
CFO is cash flow from operating activities. This assumes interest paid sits in the operating section, as it does under US GAAP and often under IFRS; if interest paid were reported in financing instead, no Int(1 minus t) adjustment is needed. Under IFRS, interest and dividends received that were placed in investing should be added back to CFO, and any dividends paid that were subtracted in operating should also be added back.
Compute FCFF for Acme Corporation for 2018 from the direct-method statement, using a marginal tax rate of 34 percent. Interest paid was 258, and the effective rate of 0.34 comes from tax expense over pretax income (1,139 / 3,349).
| Amount | |
|---|---|
| CFO | 2,606 |
| Plus: interest paid times (1 − 0.34) | 170 |
| Less: net investment in fixed capital | (538) |
| FCFF | 2,238 |
Free cash flow to equity
Free cash flow to equity (FCFE) is the cash available to common shareholders once all operating costs and all borrowing costs (both principal and interest) are met and the needed working capital and fixed capital investment is made. It is computed directly from operating cash flow.
When net borrowing is negative, repayments outweigh new borrowing, and the term becomes a subtraction of net debt repayment.
Compute FCFE for Acme Corporation for 2018 from the same statement. During the year Acme repaid 500 of long-term debt and did not take on new borrowing.
| Amount | |
|---|---|
| CFO | 2,606 |
| Less: net investment in fixed capital | (538) |
| Less: debt repayment | (500) |
| FCFE | 1,568 |
FCFF measures cash for all capital providers, so it is taken before any payment to lenders; interest is added back, net of its tax benefit, so the debt claim is not double counted. FCFE, by contrast, is what remains for shareholders only, so borrowing costs stay deducted and the effect of net borrowing (a source when positive, a use when negative) is carried through. The two measures answer different valuation questions: FCFF supports enterprise value, FCFE supports equity value.
Ratios drawn from the cash flow statement let an analyst compare firms within an industry and across industries, and track one firm over time. They divide into performance (profitability) ratios and coverage (solvency) ratios. The tables below list the common ones and what each conveys.
| Ratio | Calculation | What it measures |
|---|---|---|
| Cash flow to revenue | CFO / Net revenue | Operating cash per unit of revenue |
| Cash return on assets | CFO / Average total assets | Operating cash per unit of asset investment |
| Cash return on equity | CFO / Average shareholders’ equity | Operating cash per unit of owner investment |
| Cash to income | CFO / Operating income | Cash-generating power of operations |
| Cash flow per share | (CFO − Preferred dividends) / Common shares outstanding | Operating cash on a per-share basis |
| Ratio | Calculation | What it measures |
|---|---|---|
| Debt coverage | CFO / Total debt | Financial risk and leverage |
| Interest coverage | (CFO + Interest paid + Taxes paid) / Interest paid | Capacity to service interest due |
| Reinvestment | CFO / Cash paid for long-term assets | Whether operating cash can buy long-term assets |
| Debt payment | CFO / Cash paid for long-term debt repayment | Whether operating cash can repay debt |
| Dividend payment | CFO / Dividends paid | Whether operating cash can fund dividends |
| Investing and financing | CFO / Cash outflows for investing and financing | Capacity to buy assets, repay debt, and pay owners |
Two reporting notes matter. If a company reports under IFRS and records the full dividends paid within operating outflows, add those dividends back to reported CFO before subtracting preferred dividends in cash flow per share, since CFO under US GAAP and IFRS can differ with the treatment of interest and dividends. And if interest paid was placed in the financing section under IFRS, do not add it back in the interest coverage numerator.
Using Acme Corporation’s 2018 figures, compute the interest coverage, reinvestment, debt payment, and dividend payment ratios. Recall CFO of 2,606, interest paid of 258, taxes paid of 1,134, equipment purchase of 1,300, long-term debt repayment of 500, and dividends of 1,120.
Andrew Potter lines up the operating cash flow record of Microsoft against that of Apple.
| 2017 | 2016 | 2015 | |
|---|---|---|---|
| Microsoft | 43.9% | 39.1% | 31.7% |
| Apple Inc. | 27.7% | 30.5% | 34.8% |
| 2017 | 2016 | 2015 | |
|---|---|---|---|
| Microsoft | 18.2% | 18.1% | 17.1% |
| Apple Inc. | 18.2% | 21.5% | 31.1% |