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Eduzan / MODULE 04 — Financial Statement Analysis

FSA 5 Analyzing Statements of Cash Flows II

Turning the cash flow statement into analysis: sources and uses, common-size views, free cash flow, and cash flow ratios. Check-yourself items are study aids.

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.

Example 1 · Worked

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).

Groupe Danone: cash flows by category (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.

1. Where does Danone’s cash mainly come from, and where does it go?

Solution. In 2016 the leading source was operations, at 2,652. Most of that year’s 848 investing outflow was capital expenditure of 925. In 2017 the picture flips: financing became the main source, at 8,289, while investing consumed a large 11,437, driven by the purchase of subsidiaries.

2. Was operating cash flow large enough for the year’s capital spending?

Solution. It was, in both years. Operating cash flow of 2,652 and 2,958 comfortably exceeded routine capital expenditure of 925 and 969.

3. How did net income compare with operating cash flow?

Solution. Operating cash flow topped net income in each year (2,652 against 1,827, and 2,958 against 2,563). Operating cash flow running ahead of reported profit is a favorable indicator.

4. What kind of financing cash flows appear?

Solution. Danone’s footnotes describe a large acquisition (WhiteWave, at USD 56.25 per share, an enterprise value near USD 12.5 billion), part of which was funded from an earlier bond issuance that shows up as a financing inflow in 2016.

Check yourself

For a mature company, why is it expected that operating cash flow exceeds net income?

Net income is charged with non-cash items such as depreciation and amortization, which reduce reported profit but do not drain cash. Adding them back tends to lift operating cash flow above net income.

A company reports high net income but weak operating cash flow. What might this signal?

Poor earnings quality. The company may be using aggressive accounting to boost reported income without generating the matching cash from its operations.

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.

Acme Corporation: cash flow statement, direct method (USD)

	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.

Example 2 · Worked

Prepare the percentage-of-inflows and outflows common-size statement for Acme, first from the direct-method presentation, then from the indirect-method presentation.

1. Direct method.

Solution. Total inflows are the two positive lines, cash from customers plus the equipment sale: 23,543 + 762 = 24,305. Total outflows are the nine payment lines, which sum to 24,457. Each item is then divided by its own total. Cash from customers is 23,543 / 24,305 = 96.86 percent of inflows; the equipment sale is 3.14 percent. On the outflow side, payments to suppliers are 11,900 / 24,457 = 48.66 percent, and so on down the list. The gap between the two totals, 24,305 minus 24,457, is the 152 net decrease in cash.

Panel A: direct format, percentage of total

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%

2. Indirect method.

Solution. Now the operating detail collapses into one net figure of 2,606. Total inflows become 2,606 + 762 = 3,368, and total outflows become 3,520. Net operating cash flow is 2,606 / 3,368 = 77.38 percent of inflows, the equipment sale is 22.62 percent, and purchase of equipment is 1,300 / 3,520 = 36.93 percent of outflows. The 3,368 minus 3,520 difference is again the 152 net decrease.

Panel B: indirect format, percentage of total

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.

Acme Corporation: common-size cash flow, percentage of net revenue

	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)%

Example 3 · Worked

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.

Apple Inc.: selected common-size cash flow lines (% of net sales)

	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)%

1. Describe the trend in depreciation and amortization and in capital expenditure.

Solution. Depreciation and amortization held just under 5 percent of net revenue in 2015 and 2016, then eased to 4.4 percent in 2017. Capital expenditure ran above depreciation and amortization in both 2016 and 2017, whereas in 2015 the two were roughly level; by 2017 capital spending neared 6 percent. That points to Apple adding to its property, plant, and equipment rather than merely replacing it. With operating cash flow above 27 percent of sales every year, the company had ample means to fund the spending.

2. How does operating cash flow as a share of revenue compare with net profit margin?

Solution. Operating cash flow ran well above net profit margin in each year, though the gap narrowed. In 2015 the margin was 22.8 percent against operating cash flow of 34.8 percent of sales; by 2017 the margin had slipped to 21.1 percent while operating cash flow fell further, to 27.7 percent. The main cause was a build-up of receivables and inventory, partly cushioned by higher accounts payable.

3. What does Apple do with its operating cash flow?

Solution. Apple produced large operating cash flow above net income each year, and directed it to relatively modest property, plant, and equipment purchases, sizeable purchases of marketable securities, dividends, and repurchases of its own shares.

Check yourself

Under the percentage-of-inflows method, why does an indirect-method statement show fewer operating lines than a direct-method one?

The indirect method nets operating inflows and outflows into a single figure, so only that net operating cash flow can be shown as a percentage, whereas the direct method lists each receipt and payment separately.

Why is the net-revenue method especially useful for forecasting?

Once revenue is projected, any line that bears a stable relationship to revenue can be estimated by applying its historical percentage, giving a direct basis for forecasting those cash flows.

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.

Example 4 · Worked

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).

1. Apply the operating-cash-flow formula.

Solution. Begin with CFO of 2,606. Add back after-tax interest: 258 times (1 minus 0.34) = 258 times 0.66 = 170. Subtract net fixed capital investment, which is the equipment purchase less the equipment sale: 1,300 minus 762 = 538. So FCFF = 2,606 + 170 minus 538 = 2,238.

FCFF for Acme Corporation (USD)

	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.

Example 5 · Worked

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.

1. Apply the formula.

Solution. Start with CFO of 2,606. Subtract net fixed capital investment of 538 (1,300 minus 762). Because borrowing was purely a repayment, subtract the 500 of net debt repayment. FCFE = 2,606 minus 538 minus 500 = 1,568.

FCFE for Acme Corporation (USD)

	Amount
CFO	2,606
Less: net investment in fixed capital	(538)
Less: debt repayment	(500)
FCFE	1,568

Positive FCFE means operating cash flow more than covers capital spending and debt repayment, leaving cash that could be distributed to owners.

Why FCFF adds back interest but FCFE does not

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.

Check yourself

Starting from CFO, how do you get to FCFF when interest paid is in the operating section?

Add after-tax interest, Int times (1 minus t), and subtract fixed capital investment: FCFF = CFO + Int(1 minus t) minus FCInv.

A company’s net borrowing for the year is negative. How does that enter the FCFE calculation?

Negative net borrowing means repayments exceed new borrowing, so it reduces FCFE: FCFE = CFO minus FCInv minus net debt repayment.

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.

Performance (profitability) ratios

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

Coverage (solvency) ratios

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.

Example 6 · Worked

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.

1. Interest coverage.

Solution. (CFO + interest paid + taxes paid) / interest paid = (2,606 + 258 + 1,134) / 258 = 3,998 / 258 = 15.5 times. Operating cash before interest and tax covers the interest bill about fifteen and a half times over.

2. Reinvestment, debt payment, and dividend payment.

Solution. Reinvestment = CFO / cash paid for long-term assets = 2,606 / 1,300 = 2.0 times. Debt payment = CFO / long-term debt repayment = 2,606 / 500 = 5.2 times. Dividend payment = CFO / dividends paid = 2,606 / 1,120 = 2.3 times. Each ratio above one shows that operating cash flow alone could fund that specific use.

Example 7 · Worked

Andrew Potter lines up the operating cash flow record of Microsoft against that of Apple.

Operating cash flow as a percentage of total net revenue

	2017	2016	2015
Microsoft	43.9%	39.1%	31.7%
Apple Inc.	27.7%	30.5%	34.8%

Operating cash flow as a percentage of average total assets

	2017	2016	2015
Microsoft	18.2%	18.1%	17.1%
Apple Inc.	18.2%	21.5%	31.1%

1. What can Potter conclude about their relative ability to generate operating cash?

Solution. Both look strong on either measure. On cash flow to revenue, Microsoft led in 2016 and 2017 and was rising, while Apple, ahead in 2015, was on a declining path and fell below Microsoft in the two later years. On cash flow to average assets, Microsoft was steady with a slight climb from 2015, and matched Apple in 2017; Apple opened much higher but drifted down to Microsoft’s level. Apple’s asset ratio is heavily shaped by its large holdings of financial instruments, funded by its strong past cash flow.

Check yourself

An analyst takes operating cash flow plus interest plus taxes, then divides by interest paid. Which ratio is this, and what does it indicate?

It is the interest coverage ratio. It measures the ability to meet interest obligations and speaks to the company’s solvency.

Which two cash flow ratios would you use to gauge whether operating cash flow can fund asset purchases and debt repayment?

The reinvestment ratio (CFO over cash paid for long-term assets) and the debt payment ratio (CFO over cash paid for long-term debt repayment). Values above one mean operating cash flow could cover each use on its own.

End of lesson.

Back to MODULE 04 — Financial Statement Analysis

FSA 5 Analyzing Statements of Cash Flows II

Overview

Evaluating the Sources and Uses of Cash

Step 1: The big picture across the three categories

Step 2: What drives operating cash flow

Step 3: What drives investing cash flow

Step 4: What drives financing cash flow

Common-Size Analysis of Cash Flows

The percentage-of-inflows and outflows method

The net-revenue method

Free Cash Flow Measures

Free cash flow to the firm

Free cash flow to equity

Cash Flow Ratios