# Understanding and Analyzing Cash Flow Statements | CFA Level I FSA

In this comprehensive guide, we will delve into the analysis of cash flow statements. Our focus will be on:

## Sources and Uses of Cash

As a company progresses through its life cycle, its cash flow patterns change. Let’s break down how cash flow behaves in different stages of a company’s growth:

A. Early Growth Stage

During the early stages, a firm may experience:

• Negative operating cash flow due to cash used for purchasing inventory and developing capabilities.
• Negative investing cash flow as the company acquires long-term assets.
• External financing through issuing debt or equity securities to cover negative cash flows.

B. Sustainable Stage

A sustainable company has the following cash flow characteristics:

Key aspects to analyze in cash flow statements:

## Calculating and Analyzing Free Cash Flow (FCF)

Free cash flow (FCF) is the excess of net cash flow from operations (CFO) over capital expenditures, indicating a company’s ability to generate cash after accounting for the investments required to maintain or expand its asset base. A consistently positive FCF is indicative of a more sustainable company.

Calculate Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE):

Formula for FCFF:

FCFF = CFOFixed Capital Investments + After-tax Interest

Formula for FCFE:

FCFE = CFOFixed Capital Investments + Net Borrowing

A positive FCFE means that the company has enough cash flow to cover capital expenditures and debt repayment, with surplus cash available for distribution to shareholders.

## Cash Flow Ratios

Cash flow ratios can be divided into performance ratios and coverage ratios, providing insights into a company’s profitability and solvency.

Performance Ratios:

Coverage Ratios:

## Common-Size Analysis on Cash Flow Statements

Common-size cash flow statements can be expressed as a percentage of net revenue or total assets, facilitating comparisons of relative cash flows across periods or different firms.

EXAMPLE

Analyzing common-size cash flow statements for a firm over three years, we can observe the following:

• CFO has been increasing as a percentage of revenues.
• Upon further inspection, the increase can be attributed to decreasing cash paid to suppliers over the years.

This peculiar change could be due to a significant drop in the cost of inventory or aggressive accounting tactics, such as accruing large amounts under accounts payable. The analyst should investigate by examining the balance sheets and income statements for these years.

## Conclusion

Understanding and analyzing cash flow statements are crucial for assessing a company’s financial health and sustainability. By evaluating sources and uses of cash, calculating free cash flow, analyzing cash flow ratios, and performing common-size analysis, you can gain valuable insights into a company’s performance, solvency, and growth prospects. Remember to always dig deeper and investigate any unusual patterns or discrepancies to make informed decisions.

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