Analyzing Statements of Cash Flows I

Profit is an opinion built on accrual estimates; cash is a fact. The statement of cash flows shows where a company's cash actually came from and went, and it is the analyst's best check on the quality of reported earnings. This module covers how cash flows are classified under IFRS and US GAAP, how the cash flow statement links to the income statement and balance sheet, and how to prepare operating, investing and financing cash flows using both the direct and the indirect method, including converting one into the other.

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What you will learn

1. Classify cash flows as operating, investing or financing activities, identify non-cash transactions, and contrast the classification rules of IFRS and US GAAP.

CFO: cash effects of income-statement transactions; CFI: long-term assets and non-trading investments; CFF: debt principal, equity and dividends.
Non-cash investing and financing activities are disclosed separately, not shown in the statement.
US GAAP: interest paid and received and dividends received are operating; dividends paid are financing.
IAS 7 allows choices: interest and dividends paid (operating or financing); interest and dividends received (operating or investing).
Restate IFRS and US GAAP companies onto one basis before comparing CFO.

2. Explain how the cash flow statement links to the income statement and balance sheet, and calculate operating cash flows using the direct method.

Each direct-method line = income statement amount adjusted for the change in its related working capital account.
Increase in an operating asset reduces cash flow; increase in an operating liability increases it.
Depreciation and other non-cash items never appear in the direct method.
IFRS and US GAAP encourage the direct method; total CFO is identical under both methods.

3. Calculate cash flow from operating activities using the indirect method and interpret the reconciling items between net income and operating cash flow.

Indirect method: net income + non-cash charges - gains + losses - increases in operating assets + increases in operating liabilities.
Gains on asset sales are deducted because the full proceeds appear in investing activities.
Notes payable to banks and dividends payable are financing items, not working capital adjustments.
CFO persistently below net income is a classic earnings-quality warning.
Working-capital-driven boosts to CFO (stretched payables, sold receivables) tend to reverse.

4. Calculate investing and financing cash flows from balance sheet and income statement data, and explain how capitalization choices shift cash flows between categories.

Capex = ending gross PP&E - beginning gross PP&E + historical cost of assets sold.
Proceeds from sale = historical cost - accumulated depreciation + gain (or - loss).
Dividends paid = beginning RE + net income - ending RE - increase in dividends payable.
Debt issued and repaid can be inferred from the change in the debt balance.
Capitalizing costs raises CFO and lowers CFI; free cash flow neutralizes the choice.

5. Convert an indirect-method statement of cash flows to the direct method and verify that both give the same operating cash flow.

Convert line by line: income statement amount plus or minus its related working capital change.
Drop depreciation, amortization, impairments and gains or losses on asset sales.
Revenue: subtract increases in receivables, add increases in unearned revenue.
Expenses: add increases in related assets, subtract increases in related liabilities.
The direct-method total must equal the indirect-method CFO.

Module at a glance

CFO covers income-statement transactions, CFI long-term assets and investments, CFF debt principal, equity and dividends.
US GAAP: interest paid and received and dividends received are operating; dividends paid are financing. IAS 7 offers choices.
Direct method: each income statement line adjusted for its working capital account; depreciation never appears.
Indirect method: net income + non-cash charges - gains + losses - increases in operating assets + increases in operating liabilities.
Proceeds from asset sales = carrying amount + gain (or - loss); dividends paid = declared - increase in dividends payable.
Capitalizing costs raises CFO and lowers CFI; free cash flow neutralizes the choice.
Converting indirect to direct reveals whether collections and supplier payments track revenue and costs.

This free module has 5 lessons, 14 practice questions with full explanations.

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