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Analyzing Statements of Cash Flows II

Financial Statement Analysis

Evaluating Sources and Uses of Cash

Learning Outcome Statement:

analyze and interpret both reported and common-size cash flow statements

Summary:

This LOS focuses on evaluating the sources and uses of cash by analyzing cash flow statements, both reported and common-size. It involves assessing cash flows from operating, investing, and financing activities, and understanding the primary determinants within each category. The evaluation includes analyzing the relationship between net income and operating cash flow, the sustainability of cash flows, and the implications of cash flow patterns on a company's financial health and strategic decisions.

Key Concepts:

Major Sources and Uses of Cash Flow

Identifying the primary sources (like operating activities) and uses (such as investing and financing activities) of cash. For mature companies, operating activities should ideally be the main source, whereas growth-stage companies might rely on financing activities initially.

Determinants of Operating Cash Flow

Analyzing factors that affect cash from operations, such as changes in working capital components like receivables, inventory, and payables, and comparing operating cash flow to net income to assess earnings quality.

Determinants of Investing Cash Flow

Evaluating each line item in the investing section to understand cash spent on long-term assets like property, plant, and equipment, or cash received from selling such assets.

Determinants of Financing Cash Flow

Reviewing each component in the financing section to determine whether the company is raising new capital or repaying existing obligations, and assessing the nature of these capital transactions.

Formulas:

Free Cash Flow to the Firm (FCFF)

FCFF=EBIT×(1−TaxRate)+Depreciation−CapitalExpenditures−ChangeinWorkingCapitalFCFF = EBIT \times (1 - Tax Rate) + Depreciation - Capital Expenditures - Change in Working Capital

FCFF represents the cash flow available to all capital providers, both debt and equity holders, after the company has met all operating expenses and investments.

Variables:
EBITEBIT:
Earnings Before Interest and Taxes
TaxRateTax Rate:
Applicable tax rate
DepreciationDepreciation:
Depreciation expense
CapitalExpendituresCapital Expenditures:
Investments in long-term assets
ChangeinWorkingCapitalChange in Working Capital:
Net change in working capital components
Units: currency units

Free Cash Flow to Equity (FCFE)

FCFE=FCFF−NetInterestExpense×(1−TaxRate)+NetBorrowingFCFE = FCFF - Net Interest Expense \times (1 - Tax Rate) + Net Borrowing

FCFE represents the cash flow available to equity holders after all expenses, taxes, and operational cash needs are met, and after accounting for cash flows to and from debt holders.

Variables:
FCFFFCFF:
Free Cash Flow to the Firm
NetInterestExpenseNet Interest Expense:
Interest expenses minus interest income
TaxRateTax Rate:
Applicable tax rate
NetBorrowingNet Borrowing:
Difference between new debt raised and debt repayments
Units: currency units

Ratios and Common-Size Analysis

Learning Outcome Statement:

calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios

Summary:

This LOS focuses on understanding and applying the concepts of free cash flow to the firm (FCFF) and free cash flow to equity (FCFE), as well as analyzing performance and coverage cash flow ratios. It also covers the methodology of common-size analysis for financial statements, which involves expressing each line item as a percentage of a relevant total, facilitating trend analysis and comparison across periods or companies.

Key Concepts:

Free Cash Flow to the Firm (FCFF)

FCFF represents the cash flow available to both debt and equity investors after all operating expenses, taxes, and investments in working and fixed capital.

Free Cash Flow to Equity (FCFE)

FCFE is the cash flow available to equity shareholders after all operating expenses, taxes, investments in working and fixed capital, and after meeting all debt financing costs including net debt issuance.

Common-Size Analysis

In common-size analysis, each line item on the financial statement is expressed as a percentage of a total (e.g., total assets, total sales), which helps in comparing financial statements of different-sized companies or of the same company over different periods.

Performance and Coverage Cash Flow Ratios

These ratios assess the efficiency and effectiveness of a company's cash flow management, indicating how well the company generates cash to meet its debt obligations, pay dividends, and fund operations.

Formulas:

Free Cash Flow to the Firm (FCFF)

FCFF=NI+NCC+Int(1−Tax rate)−FCInv−WCInvFCFF = NI + NCC + Int(1 - \text{Tax rate}) - FCInv - WCInv

This formula calculates the free cash flow available to all investors (both equity and debt holders) after the company has paid for its operating expenses, taxes, and necessary capital investments.

Variables:
NINI:
Net Income
NCCNCC:
Non-Cash Charges
IntInt:
Interest Expense
TaxrateTax rate:
Tax Rate
FCInvFCInv:
Fixed Capital Investment
WCInvWCInv:
Working Capital Investment
Units: currency units (e.g., USD, EUR)

Free Cash Flow Measures

Learning Outcome Statement:

calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios

Summary:

This LOS focuses on understanding and calculating different measures of free cash flow (FCF), specifically Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE), as well as analyzing various cash flow performance and coverage ratios. These measures and ratios are crucial for assessing a company's financial health, efficiency in generating cash, and its ability to meet financial obligations.

Key Concepts:

Free Cash Flow to the Firm (FCFF)

FCFF represents the cash flow available to both debt and equity investors after all operating expenses, taxes, and investments in working and fixed capital have been accounted for. It starts with net income and adjusts for non-cash charges, interest (net of tax), and capital expenditures.

Free Cash Flow to Equity (FCFE)

FCFE is the cash flow available to equity shareholders after all operating expenses, interest, and principal payments, as well as necessary investments in working and fixed capital. It starts with cash flow from operations and adjusts for net borrowing and capital expenditures.

Cash Flow Performance Ratios

These ratios, such as cash flow to revenue, cash return on assets, and cash return on equity, measure the efficiency of a company in generating cash relative to its revenue, assets, and equity respectively.

Cash Flow Coverage Ratios

Coverage ratios like debt coverage, interest coverage, reinvestment, and debt payment ratios assess a company's ability to meet its financial obligations and reinvest in its operations using the cash generated from its activities.

Formulas:

Free Cash Flow to the Firm (FCFF)

FCFF=NI+NCC+Int(1−Tax rate)−FCInv−WCInvFCFF = NI + NCC + Int(1 - \text{Tax rate}) - FCInv - WCInv

This formula calculates the cash available to all suppliers of capital (debt and equity holders) after all expenses and necessary investments.

Variables:
NINI:
Net Income
NCCNCC:
Non-cash Charges
IntInt:
Interest Expense
TaxrateTax rate:
Applicable Tax Rate
FCInvFCInv:
Fixed Capital Investments
WCInvWCInv:
Working Capital Investments
Units: currency (e.g., USD)

Free Cash Flow to Equity (FCFE)

FCFE=CFO−FCInv+Net borrowingFCFE = CFO - FCInv + \text{Net borrowing}

This formula calculates the cash flow available to equity holders after all expenses, debt payments, and necessary investments.

Variables:
CFOCFO:
Cash Flow from Operations
FCInvFCInv:
Fixed Capital Investments
NetborrowingNet borrowing:
Net Increase or Decrease in Debt
Units: currency (e.g., USD)

Cash Flow Statement Analysis: Cash Flow Ratios

Learning Outcome Statement:

calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios

Summary:

This LOS focuses on understanding and applying various cash flow ratios to analyze the financial health and performance of a company. These ratios are divided into performance ratios, which assess profitability, and coverage ratios, which evaluate solvency. The ability to calculate and interpret these ratios helps in comparing companies within the same industry or across different industries.

Key Concepts:

Free Cash Flow to Equity (FCFE)

FCFE is the amount of cash available to the company's equity shareholders after all expenses, reinvestment, and debt repayments have been accounted for. It is a measure of equity capital usage.

Performance Ratios

These ratios, such as cash flow to revenue and cash return on assets, measure how effectively a company generates cash flow relative to its revenue, assets, and equity.

Coverage Ratios

Coverage ratios, including debt coverage and interest coverage, assess a company's ability to meet its financial obligations with its operating cash flow, thus indicating its solvency.

Formulas:

Cash Flow to Revenue

CFONet Revenue\frac{\text{CFO}}{\text{Net Revenue}}

This ratio measures the operating cash generated per dollar of revenue.

Variables:
CFOCFO:
Cash Flow from Operations
NetRevenueNet Revenue:
Total Net Revenue
Units: ratio

Cash Return on Assets

CFOAverage Total Assets\frac{\text{CFO}}{\text{Average Total Assets}}

This ratio measures the operating cash generated per dollar of asset investment.

Variables:
CFOCFO:
Cash Flow from Operations
AverageTotalAssetsAverage Total Assets:
Average value of total assets over the period
Units: ratio

Interest Coverage

CFO+Interest Paid+Taxes PaidInterest Paid\frac{\text{CFO} + \text{Interest Paid} + \text{Taxes Paid}}{\text{Interest Paid}}

This ratio measures the company's ability to meet its interest obligations from its operating cash flow.

Variables:
CFOCFO:
Cash Flow from Operations
InterestPaidInterest Paid:
Total interest payments
TaxesPaidTaxes Paid:
Total tax payments
Units: ratio
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