Financial Statement Analysis Cash Flow Statement 1
The Articulation of the Financial Statements Beginning stocks Flows Ending stocks Cash Flow Statement Beginning Balance Sheet Cash Cash from operations Cash from investing Cash from financing Net change in cash Ending Balance Sheet Cash + Other Assets Total Assets - Liabilities Owners equity Statement of Shareholders Equity Investment and disinvestment by owners Net income and other earnings Net change in owners equity + Other Assets Total Assets - Liabilities Owners equity Income Statement Revenues Expenses Net income
Cash Flow Statement The statement of cash flows explains the change in cash during the period in terms of cash provided by or used for operating, investing and financing activities. 3
Analyzing the Statement of Cash Flows The statement of cash flows is an important analytical tool for creditors, investors, and other users of financial statement data. 4-4
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Analyzing the Statement of Cash Flows Statement of cash flows helps to determine a firm s ability to generate cash flows in the future capacity to meet cash obligations future external financing needs success in productively managing investing activities effectiveness in implementing financing and investing strategies 4-7
Cash Flow It is possible for a firm to be highly profitable and not be able to pay dividends not be able to invest in new equipment not be able to service debt go bankrupt How? The problem is cash. 4-8
Statement of Cash Flows Positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash 4-9
Cash Flow from Operations Ongoing operation depends upon its success in generating cash from operations. Firms need cash to satisfy creditors and investors. Temporary shortfalls of cash can be satisfied by borrowing or other means, but ultimately a firm must generate cash. 4-10
Nocash Corporation The Nocash Corporation had sales of $100,000 in its second year of operations, up from $50,000 in the first year. Expenses, including taxes, amounted to $70,000 in year 2, compared with $40,000 in year 1. 4-11
Nocash Corporation Nocash Corporation Income Statement for Year 1 and Year 2 Year 1 Year 2 Sales $50,000 $100,000 Expenses 40,000 70,000 Net income $10,000 $30,000 The comparative income statements for the two years indicate substantial growth. 4-12
Nocash Corporation Other relevant facts that do not appear on income statement. Nocash eased credit policies in year 2, attracting customers of lower quality. purchased a new line of inventory near the end of year 1 and had to sell it below cost. had problems with accounts receivable causing suppliers to refuse the sale of goods on credit. The effect of these factors can be found on Nocash s balance sheet. 4-13
Nocash Corporation Balance Sheet at December 31 Year 1 Year 2 $Change Cash $2,000 $2,000 0 Accounts Receivable 10,000 30,000 +20,000 Inventories 10,000 25,000 +15,000 Total Assets $22,000 $57,000 +35,000 Accounts payable 7,000 2,000-5,000 Notes payable to banks 0 10,000 +10,000 Equity 15,000 45,000 +30,000 Total liabilities and equity $22,000 $57,000 +35,000 4-14
Nocash Corporation If Nocash s net income is recalculated on a cash basis, the following adjustments would be made: Net income $30,000 Accounts receivable (20,000) Inventories (15,000) Accounts payable (5,000) Cash Income ($10,000) 4-15
Nocash Corporation Increase in accounts receivable is subtracted, because more sales revenue was recognized in computing net income than was collected in cash. Increase in inventory is deducted, reflecting the cash outflow for inventory purchases in excess of the expense recognized through cost of goods sold. 4-16
Nocash Corporation Decrease in accounts payable is deducted, because the cash payments to suppliers in year 2 were greater than the amount of expense recorded. Appearance of a $10,000 note payable indicates that borrowing has enable Nocash to operate, but unless it can generate cash, its problems will compound. 4-17
Statement of Cash Flows Provides information about cash inflows and outflows during an accounting period Extremely important as an analytical tool Only source in financial statement data for learning about the generation of cash from operations 4-18
Four Parts of a Statement of Cash Flows Cash Operating activities Investing activities Financing activities 4-19
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Four Parts of a Statement of Cash Flows Cash Cash and highly liquid short-term marketable securities Also called cash equivalents If a company separates marketable securities into two accounts (cash and cash equivalents and short-term investments), the short-term investments are classified as investing activities. 4-21
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Four Parts of a Statement of Cash Flows Operating activities Delivering or producing goods for sale and providing services Cash effects of transactions and other events 4-24
Four Parts of a Statement of Cash Flows Investing activities Acquiring and selling or otherwise disposing of securities that are not cash equivalents productive assets that are expected to benefit the firm for long periods of time Lending money and collecting on loans 4-25
Four Parts of a Statement of Cash Flows Financing activities Borrowing from creditors and repaying the principal Obtaining resources from owners and providing them with a return on the investment 4-26
GAAP Differences can matter 27
Direct and Indirect methods of calculating operating cash flow Direct and indirect methods yield identical figures for net cash flow from operating activities, because the underlying accounting concepts are the same. 594 firms out of 600 used the indirect method in 2007 according to Accounting Trends and Techniques. Chinese accounting standards require use of direct method with reconciliation using indirect method in the footnotes. 4-28
Direct Method Shows cash collections from customers interest and dividends collected other operating cash receipts cash paid to suppliers and employees interest paid taxes paid other operating cash payments 4-29
Cash Flow Statement Direct Method 30
Reconciliation to Indirect method 31
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Indirect Method Starts with net income and adjusts for deferrals accruals noncash items, such as depreciation and amortization nonoperating items, such as gains and losses on asset sales 4-33
Indirect Method 34
Net Cash Flow from Operating Activities Indirect Method Depreciation and amortization are added to net income. Increase in deferred tax liability is added. Decrease in deferred tax liability is deducted. Increase in deferred tax asset is deducted. Decrease in deferred tax asset is added. 4-35
Net Cash Flow from Operating Activities Indirect Method Increase in investment account from equity income is deducted. Decrease in investment account from equity income is added. Gain on sale of assets is deducted. Loss on sale of assets is added. 4-36
Net Cash Flow from Operating Activities Indirect Method Increase in accounts receivable is deducted. Decrease in accounts receivable is added. Increase in inventory is deducted. Decrease in inventory is added. Increase in prepaid expenses is deducted. Decrease in prepaid expenses is added. 4-37
Net Cash Flow from Operating Activities Indirect Method Increase in interest receivable is deducted. Decrease in interest receivable is added. Increase in accounts payable is added. Decrease in accounts payable is deducted. 4-38
Net Cash Flow from Operating Activities Indirect Method Increase in accrued liabilities is added. Decrease in accrued liabilities is deducted. Increase in deferred revenue is added. Decrease in deferred revenue is deducted. 4-39
Analysis of the Statement of Cash Flows Should, at a minimum, cover the following areas: Cash flow from operating activities Cash inflows Cash outflows 4-40
Analysis of the Statement of Cash Flows Analyst Concerns Success or failure of the firm in generating cash from operations Underlying causes of the positive or negative operating cash flow Magnitude of positive or negative operating cash flow Fluctuations in cash flow from operations over time 4-41
Analysis of Cash Inflows Generating cash from operations is the preferred method for obtaining excess cash to finance capital expenditures and expansion repayment of debt payment of dividends 4-42
Analysis of Cash Outflows When analyzing the cash outflows, the analyst should consider the necessity of the outflow how the outflow was financed Generally, it is best to finance short-term assets with short-term debt long-term assets with long-term debt or issuance of stock 4-43
Analysis of Cash Outflows Repayment of debt is a necessary outflow. Notes reveal future debt repayments and are useful in assessing how much cash will be needed in upcoming years to repay outstanding debt. 4-44
Free Cash Flow Cash basis net income less capital expenditures Some argue it is a better measure than net income. No estimates! You cannot calculate either cash basis net income or capital expenditures from an income statement or balance sheet (but you can make a pretty good guess) The cash flow statement supplies the missing information. 45
Free Cash Flow Cash flow operations 1,891 Capex (15,981) Free Cash Flow (14,090) 46
Altman s Z 2017 47
Evergrande Altman s Z 2018 48
Piotroski s F Score 1. Return on assets is positive (1 point) 2. Positive operating cash flow in the current year (1 point) 3. Higher return on assets (ROA) in the current period compared to the ROA in the previous year (1 point). 4. Cash flow from operations is greater than net income (1 point). 5. Lower ratio of long term debt to in the current period compared value in the previous year (1 point). 6. Higher current ratio this year compared to the previous year (1 point). 7. No new shares were issued in the last year (1 point). 8. A higher gross margin compared to the previous year (1 point). 9. A higher asset turnover ratio compared to the previous year (1 pt). If a company scores 8 or 9, it is considered to have strong and improving financials, whereas a score between 0-2 points suggests a company has weak and deteriorating financials. 49