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:
- Understanding sources and uses of cash
- Calculating and analyzing free cash flow (FCF)
- Exploring various cash flow ratios
- Performing common-size analysis on cash flow statements
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:
- Positive operating cash flow that exceeds capital expenditures.
- Provides returns to debt and equity holders.
Key aspects to analyze in cash flow statements:
- Operating cash flow: Determine the major factors affecting operating cash flow and examine the quality of the firm’s earnings.
- Investing cash flow: Analyze capital expenditures and their implications on the company’s growth prospects.
- Financing cash flow: Evaluate the firm’s financing activities to understand its reliance on debt or equity and its use of cash for debt repayment, stock repurchase, or dividend payments.
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 = CFO – Fixed Capital Investments + After-tax Interest
Formula for FCFE:
FCFE = CFO – Fixed 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.
- Cash Flow to Revenue Ratio: Measures the amount of operating cash flow generated for each dollar of sales (CFO / Net Revenue).
- Cash Return on Assets Ratio: Calculates the return of operating cash flow attributed to all providers of capital (CFO / Average Total Assets).
- Cash Return on Equity Ratio: Determines the return of operating cash flow attributed to shareholders (CFO / Average Shareholders’ Equity).
- Cash to Income Ratio: Evaluates the ability to generate cash from firm operations (CFO / Operating Income).
- Cash Flow per Share: Measures operating cash flow on a per-share basis, similar to Earnings per Share (EPS), using CFO instead of net income. Preferred dividends should be excluded from the calculation.
- Debt Coverage Ratio: Assesses financial risk and leverage by dividing the CFO by total debt. A low debt coverage ratio means the firm is not generating enough cash to pay off its debt.
- Interest Coverage Ratio: Measures the firm’s ability to meet its interest obligations by adjusting the amount available to cover interest payments (adding back interest paid and taxes paid). Note that if interest paid was classified as a financing activity under IFRS, the interest adjustment is not necessary.
- Reinvestment Ratio: Calculates the firm’s ability to acquire long-term assets with operating cash flow (CFO / Cash Paid for Long-term Assets).
- Debt Payment Ratio: Determines the firm’s ability to satisfy long-term debt with operating cash flow (CFO / Cash Paid for Long-term Debt Repayment).
- Dividend Payment Ratio: Evaluates the firm’s ability to make dividend payments from operating cash flow (CFO / Dividends Paid).
- Investing and Financing Ratio: Measures the firm’s ability to purchase assets, satisfy debts, and pay dividends (CFO / Cash Outflows for Investing and Financing Activities).
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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