The Statement of Cash Flows is essential for understanding a company's financial health, forecasting performance, and valuing debt and equity. The core of analysis is identifying where cash comes from and where it goes.
PURPOSE OF CASH FLOW ANALYSIS
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Forecast future cash flows based on business operations
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Assess ability to meet obligations (debt, dividends)
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Determine need for external financing
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Evaluate financial strategy effectiveness
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Analyze consistency and quality of operating cash flow
CASH FLOW BY BUSINESS LIFECYCLE
Growth Companies
- Operating cash flow (CFO) may be negative initially due to heavy reinvestment
- Sustained positive CFO is key to long-term viability
Mature Companies
- Operating activities should be the primary source of cash
- Negative CFO may signal strategic payouts (dividends, buybacks)
WHY POSITIVE OPERATING CASH FLOW MATTERS
Consistently positive CFO indicates financial strength:
Covers capital expenditures (CapEx)
Supports debt servicing
Improves financing terms with lenders
Signals a sustainable business model
NET INCOME VS. OPERATING CASH FLOW
A large gap between net income and CFO can be a red flag:
Low-quality earnings
Aggressive accounting
Poor operational cash generation
Working capital issues
Analyst assessment needed
Earnings quality analysis
COMMON-SIZE ANALYSIS
Standardizes the cash flow statement for trend analysis and comparison:
As % of total inflows/outflows
Shows proportion of each activity
As % of Net Revenue
Assesses cash efficiency relative to sales
FREE CASH FLOW (FCF)
Free cash flow is the cash available after essential reinvestment. It's crucial for valuation.
Free Cash Flow to the Firm (FCFF)
The cash available to all investors (debt and equity holders).
FCFF = CFO + Interest × (1 Tax Rate) FCInv
Or from Net Income:
FCFF = NI + NCC + Interest × (1 Tax Rate) FCInv WCInv
Where: NI = Net Income, NCC = Non-Cash Charges, FCInv = Fixed Capital Investment, WCInv = Working Capital Investment.
FCFF Calculation
CFO = $500K, Interest = $50K, Tax Rate = 30%, FCInv = $120K
After-tax interest = $50K × (1 0.30) = $35K
FCFF = $500K + $35K $120K = $415K
Free Cash Flow to Equity (FCFE)
The cash available to common shareholders after all obligations.
FCFE = CFO FCInv + Net Borrowing
Or from Net Income:
FCFE = NI + NCC FCInv WCInv + Net Borrowing
Net Borrowing = New Debt Issued Debt Repaid
FCFE Calculation
CFO = $500K, FCInv = $120K, New Debt = $80K, Debt Repaid = $50K
Net Borrowing = $80K $50K = $30K
FCFE = $500K $120K + $30K = $410K
Converting Between FCFF and FCFE
FCFE = FCFF Interest × (1 Tax Rate) + Net Borrowing
Exam tip: Remember to use after-tax interest when converting between FCFF and FCFE
Ratios help assess performance, risk, and sustainability.
PERFORMANCE RATIOS
Cash Flow to Revenue
CFO / Net Revenue
Purpose: Measures how much operating cash is generated per dollar of sales.
Higher ratio indicates better cash conversion from sales
Cash Return on Assets (CROA)
CFO / Average Total Assets
Purpose: Measures cash efficiency of asset investment.
Use average assets (Beginning + Ending) / 2
Cash Return on Equity (CROE)
CFO / Average Shareholders' Equity
Purpose: Measures cash return to owners.
Cash to Income
CFO / Operating Income
Purpose: Assesses quality of earnings.
Ratio near or above 1.0 indicates high-quality earnings
Cash Flow per Share
(CFO Preferred Dividends) / Weighted Avg Shares Outstanding
Purpose: Operating cash flow on a per-share basis.
COVERAGE RATIOS
Debt Coverage
CFO / Total Debt
Purpose: Ability to cover total debt with operating cash.
Higher ratios indicate better debt servicing capacity
Interest Coverage
(CFO + Interest Paid + Taxes Paid) / Interest Paid
Purpose: Ability to meet interest obligations.
Reinvestment Ratio
CFO / Cash Paid for Long-Term Assets
Purpose: Can operations fund asset purchases?
Ratio > 1.0 means CFO covers CapEx without external financing
Debt Payment Coverage
CFO / Cash for Debt Repayment
Purpose: Ability to pay down debt from operations.
Dividend Payment Coverage
CFO / Dividends Paid
Purpose: Sustainability of dividend payouts.
Coverage > 1.5x generally indicates sustainable dividends
Investing & Financing Coverage
CFO / Cash Outflows from Investing and Financing Activities
Purpose: Can operations fund all external cash requirements?
High-Yield Topics
Focus your study time on these key areas:
- Free Cash Flow calculations (FCFF vs. FCFE) - expect 2-3 questions
- Cash flow quality assessment and red flags
- Converting between different FCF formulas
- Coverage ratio interpretations
- Common-size analysis applications
ESSENTIAL FORMULAS
1. FCFF (Free Cash Flow to the Firm)
FCFF = CFO + Interest × (1 Tax Rate) FCInv
Alternative: FCFF = NI + NCC + Interest × (1 T) FCInv WCInv
2. FCFE (Free Cash Flow to Equity)
FCFE = CFO FCInv + Net Borrowing
Alternative: FCFE = NI + NCC FCInv WCInv + Net Borrowing
3. Converting FCFF to FCFE
FCFE = FCFF Interest × (1 Tax Rate) + Net Borrowing
4. Cash Flow to Revenue Ratio
CFO / Net Revenue
Higher is better; consistent ratios indicate quality earnings
5. Cash Return on Assets
CFO / Average Total Assets
6. Debt Coverage Ratio
CFO / Total Debt
Higher ratios indicate better debt servicing ability
COMMON EXAM PITFALLS
Pitfall 1: Forgetting After-Tax Interest
When calculating FCFF from CFO, add back after-tax interest: Interest × (1 Tax Rate). Don't use gross interest.
Pitfall 2: Confusing Net Borrowing with Total Debt
Net Borrowing = New Debt Issued Debt Repaid. This is the change in debt, not the total outstanding balance.
Pitfall 3: Working Capital Sign Errors
Increase in working capital = USE of cash (negative). Decrease in working capital = SOURCE of cash (positive).
Pitfall 4: Using Ending Instead of Average Balances
For CROA and CROE, use average balances: (Beginning + Ending) / 2. Don't use just ending balance.
Pitfall 5: Missing Cash Flow Quality Signals
Red flags: High net income but low CFO, declining CFO/Revenue ratio, CFO consistently < Net Income, negative CFO in mature companies.
Exam Success Tips
- Master Formula Variations: Practice calculating FCFF and FCFE from both CFO and Net Income. Exam questions mix these approaches.
- Speed and Accuracy: Set a 2-minute timer for FCF calculation problems. You need both speed AND precision.
- Understand the Why: Know WHY we add back after-tax interest for FCFF (cash available to all investors) and WHY net borrowing increases FCFE.
- Watch Units: Pay attention to thousands vs. millions. A decimal error costs points.
- Link to Valuation: FCF is used in DCF models (equity valuation) and in credit analysis (coverage ratios assess default risk).