Chapter 3

The statement of cash flows reports all the cash inflows and outflows classified among operating, investing and financing activities for a specified period.

Cash flow from operating activities

Measures the amount of cash generated from the production and sales of goods and services. May be negative (rapid growth or a troubled firm), but long-term is required to be positive for a firm to survive.

Investing cash flow

Cash used to acquire assets
Acquire PP&E, investments and other businesses Sale or disposal of assets or business segments. Some investment is necessary to maintain current operating capacity (M&M) or for future growth.

Financing cash flow

Cash flows from issuance and repurchases of equity Payment of dividends Cash flows from proceeds and repayment of debt.

Effect of exchange rate changes on cash

A fourth category applicable to firms needing to accumulate changes in exchange rates when translating foreign currencies

SFAS 95
Direct method and indirect method Investing and financing cash flow sections tend to be the same Indirect method more common, may be from similarity to the old statement of changes in working capital.

Transactional analysis
Method to convert indirect statements to direct statements of cash flows. See page 78, 79 and 80 of text A key point to remember is that income statement items tend to have an associated balance sheet account(s). Examples: Accounts receivable and sales PP&E and depreciation Interest payable and interest expense

 Discrepancies between the changes in accounts reported on the balance sheet and those reported in the cash flow statement are primarily due to two factors: 1. Acquisitions and divestitures tend to distort trends in cash flows from operations and investing cash flows. Cash outflows for the acquisition of operating assets and liabilities of the acquired firm are excluded from operating cash flows and included in investing cash flows. Upon subsequent collection or payment, the cash flows are included in operating cash flows.

 2. Foreign subsidiaries the assets and liabilities of the foreign subsidiary must be translated from the foreign currency to the reporting currency. The translated amount then has two components (a) a real cash flow effect and (b) and exchange rate effect that has no current cash flow effect. This translation gain or loss are excluded from cash flows from operating, investing and financing activities.

Free cash flow

FCF is the cash flow left after funding all positive net present value projects and has associated agency cost issues. Our focus now is the measurement of FCF as a basis for valuing the company. There is no one definition

 A basic definition is the cash flows from operations less the amount of capital expenditures required to maintain the firms present productive capacity. Alternative 1:Operating cash flows plus depreciation has the problem of using historical cost rather than replacement cost which may be quite different for longlived assets. Alternative 2:Operating cash flows less capex required to maintain current operations has the difficulty of separating replacement and expansion capex and whether capex is sufficient to maintain current operations (consider a distressed firm). Alternative 3:Operating cash flows less capex.

Relationship between cashflows and net income

See exhibit 3-5 Note that cashflows from operations is the same for each method of accounting, but that net income differs. Income taxes would differ based on method of accounting. Also note that a firms method of accounting for income tax purposes usually differs from its method of accounting for financial statement purposes. AMT

Other obfuscating issues

Capitalization of overhead into fixed assets (selfconstructed asset for instance) moves the cash outflow to investing from operations. Interest and dividends received from investments from other firms are operating cash flows. The return ON capital is separated from the return OF capital. Interest paid is an operating cash outflow, but it reflects a financing decision not an operating decision. Noncash transactions example purchasing a building by assuming the mortgage does not require a direct outlay of cash. Disclosure is by footnote even though the transaction is equivalent to issuing debt and purchasing the building.