Library/CFA (Chartered Financial Analyst)/SchweserNotes 2022 Level I CFA Book 2: Financial Statement Analysis/Reading 19: Understanding Cash Flow Statements

Reading 19: Understanding Cash Flow Statements

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Cash Flow Classifications and Standards10 min

The cash flow statement classifies flows into Operating (CFO), Investing (CFI), and Financing (CFF). CFO reflects transactions affecting net income, CFI reflects long-term asset transactions, and CFF reflects capital structure changes. A significant portion of the analysis involves understanding the differences between US GAAP and IFRS. Under US GAAP, interest paid, interest received, and dividends received are operating cash flows, whereas dividends paid are financing. IFRS allows interest and dividends paid to be classified as operating or financing, and interest and dividends received to be classified as operating or investing. Taxes paid are generally operating under US GAAP, but under IFRS, they are split based on the underlying transaction if possible.

Key Points

CFO: Day-to-day operations, working capital changes.
CFI: Long-term assets, buying/selling securities (unless trading).
CFF: Equity and debt transactions, dividends paid (US GAAP).
US GAAP: Interest/Dividends received = Operating; Interest paid = Operating; Dividends paid = Financing.
IFRS: More flexibility; Interest/Dividends paid can be Operating or Financing; Received can be Operating or Investing.

Direct and Indirect Methods15 min

There are two formats for presenting CFO. The Direct Method shows actual cash inflows (e.g., collections from customers) and outflows (e.g., payments to suppliers). The Indirect Method derives CFO by adjusting Net Income for non-cash charges (depreciation, amortization), non-operating items (gains/losses on asset sales), and changes in working capital accounts (receivables, inventory, payables). An increase in an asset is a use of cash (subtracted), while a decrease is a source (added). An increase in a liability is a source of cash (added), while a decrease is a use (subtracted). Investing and Financing sections are presented identically under both methods.

Key Points

Direct Method: Shows gross cash receipts and payments.
Indirect Method: Reconciles Net Income to CFO.
Adjustments: Add back non-cash expenses (depreciation); subtract gains/add losses on sales.
Asset Rule: Increase in asset = Use of cash (-); Decrease = Source (+).
Liability Rule: Increase in liability = Source (+); Decrease = Use (-).

Free Cash Flow and Ratios10 min

Free Cash Flow (FCF) measures cash available for discretionary use. FCFF (Firm) is available to debt and equity holders: FCFF = CFO + Interest(1 - Tax Rate) - Fixed Capital Investment (CapEx). FCFE (Equity) is available to shareholders: FCFE = CFO - CapEx + Net Borrowing. Analysts use ratios to compare companies. Performance ratios include Cash Flow per Share and Cash Return on Equity. Coverage ratios include Debt Coverage (CFO / Total Debt) and Interest Coverage ((CFO + Interest Paid + Taxes Paid) / Interest Paid).

Key Points

FCFF = CFO + Int(1-t) - CapEx.
FCFE = CFO - CapEx + Net Borrowing.
Ratios assess liquidity, solvency, and profitability.
Reinvestment Ratio measures ability to acquire assets with operating cash.

Questions

Question 1

Which of the following best describes the primary purpose of the statement of cash flows?

Reading 19: Understanding Cash Flow Statements

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