26 Understanding Cash Flow Statements

cash flow statements

two sources: income statement items & changes in balance sheet accounts
cash flow from operating activities (CFO): from transactions that affect a firm's net income
cash flow from investing activities (CFI): from the acquisition or disposal of long-term assets and certain investments
cash flow from financing activities (CFF): from transactions affecting a firm's capital structure
nocash investing and financing activities are not reported

change in cash balance = CFO + CFI + CFF
change in cash balance + beginning cash balance = ending cash balance
beginning accounts receivable + sales - cash collections = ending accounts receivable

an increase in an asset, a decrease in a liability → a use of cash
an increase in a liability, a decrease in an asset → a source of cash

acquisition of debt and equity investments and loans made to others: CFI
income from these investments: CFO
principal amounts borrowed from others: CFF
interest paid: CFO
dividends paid to shareholders: CFF
all taxes: CFO
payments for interest and taxes can be reported in the cash flow statement or disclosed in the footnotes

interest and dividends received: CFO or CFI
dividends paid to shareholders, interest paid on the company's debt: CFO or CFF
tax expense associated with an investing or financing transaction: CFI or CFF
payments for interest and taxes must be disclosed separately in the cash flow statement

direct method

present clearly the firm's operating cash receipts and payments
encouraged by both standard setters
under U.S. GAAP, must include footnote disclosure of the indirect method


  • cash collected from customers, typically the main component of CFO
  • cash used in the production of goods and services (cash inputs)
  • cash operating expenses
  • cash paid for interest
  • cash paid for taxes

indirect method

focus on the differences between net income and operating cash flow
most firms use


  • begin with net income
  • + losses or - gains that resulted from investing or financing cash flows
  • + all noncash charges to income and - all noncash components of revenue
  • adjust changes to balance sheet operating accounts
    • - increase (+ decrease) in the operating asset accounts
    • + increase (- decrease) in the operating liability accounts

the changes in asset accounts that result from investing activities
related accumulated depreciation or amortization are ignored (no cash expenses)
cash paid for new asset = ending gross assets + gross cost of old assets sold - beginning gross assets
cash from asset sold = book value of the asset + gain ( - loss) on sale

the sum of net cash flows from creditors and net cash flows from shareholders
net cash flows from creditors = new borrowings - principal amounts repaid
net cash flows from shareholders = new equity issued - share repurchases - cash dividends paid

convert from indirect to direct method

cash collection from customers:

  • begin with net sales from the income statement
  • - increase (+ decrease) in the accounts receivable balance
  • + increase (- decrease) in unearned revenue

cash payments to suppliers

  • begin with COGS as reported in the income statement
  • add back depreciation and amortization have been included in COGS
  • - increase (+ decrease) in the accounts payable balance
  • + increase (- decrease) in the inventory balance
  • - inventory write-off

common-size cash flow statement

express each line item as a percentage of revenue

free cash flow

free cash flow to the firm FCFF
FCFF = net income + noncash charges + interest expense (1- tax rate) - fixed capital investment - working capital investment
FCFF = CFO + interest expense (1- tax rate) - fixed capital investment

free cash flow to the equity FCFE
FCFE = CFO - fixed capital investment + net borrowing
FCFE = CFO - fixed capital investment + net borrowing + dividends (IFRS have subtracted dividends paid in calculating CFO)

cash flow ratios

performance ratios
cash flow-to-revenue = CFO / net revenue
cash return-on-assets = CFO / average total assets
cash return-on-equity = CFO / average total equity
cash-to-income = CFO / operating income
cash flow per share = (CFO - preferred dividends) / weighted average number of common shares
if common dividends were classified as CFO under IFRS, it should be added back

coverage ratios
debt coverage = CFO / total debt
interest coverage = (CFO + interest paid + taxes paid) / interest paid
if interest paid was classified as CFF under IFRS, no interest adjustment
reinvestment = CFO / cash paid for long-term assets
debt payment = CFO / cash long-term debt repayment
dividend payment = CFO / dividends paid
investing and financing = CFO / cash outflows from investing and financing activities