Analyzing Statements of Cash Flows II

Once a cash flow statement is prepared, the real work is interpreting it: is operating cash flow driven by the business or by timing, how much cash is genuinely free for investors, and can the company meet its obligations from its own operations? This module shows how to evaluate sources and uses of cash, build common-size cash flow statements, calculate free cash flow to the firm and to equity, and use cash flow performance and coverage ratios.

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What you will learn

1. Evaluate a company's major sources and uses of cash, including the quality and sustainability of its operating cash flow.

Identify the main sources (operations, asset sales, borrowing, equity) and uses (capex, acquisitions, repayments, distributions) of cash.
Expected cash patterns differ by life-cycle stage: start-up, growth, maturity, decline.
CFO driven by working capital changes is less sustainable than CFO driven by profit.
CFO persistently below net income is a warning sign; capex persistently below depreciation may mean under-investment.
Supplier finance and receivable sales can flatter CFO; read the notes.

2. Prepare and interpret common-size cash flow statements using both the revenue-based and the inflows-and-outflows approaches.

Approach 1: every line as a percentage of net revenue.
Approach 2: each inflow as a percentage of total inflows; each outflow as a percentage of total outflows.
Trends in CFO and capex as a share of revenue reveal working capital and investment needs.
Common-size percentages can anchor cash flow forecasts.
Align IFRS classification choices and consider the business model before comparing.

3. Calculate and interpret free cash flow to the firm and free cash flow to equity, adjusting for IFRS classification choices.

FCFF = CFO + Int(1 - t) - FCInv (US GAAP, interest deducted in CFO).
FCFE = CFO - FCInv + net borrowing = FCFF - Int(1 - t) + net borrowing.
FCInv = capital expenditure - proceeds from asset sales.
IFRS: no interest add-back if interest paid is in financing; add back dividends paid if classified in operating.
Company-reported free cash flow is non-GAAP; check the definition.

4. Calculate and interpret cash flow performance ratios and cash flow coverage ratios.

Performance: cash flow to revenue, cash ROA, cash ROE, cash to income, cash flow per share.
Coverage: debt, interest, reinvestment, debt payment, dividend payment, investing and financing.
Interest coverage adds interest paid and taxes paid back to CFO before dividing by interest paid.
Ratios above 1 for reinvestment or investing-and-financing mean operations fund those needs internally.
Interpret against history and peers; one year's CFO can be distorted by timing.

Module at a glance

Start with sources and uses of cash, and judge them against the company's life-cycle stage.
CFO driven by working capital, supplier finance or receivable sales is less sustainable than CFO driven by profit.
Common-size cash flows use revenue, or total inflows and total outflows, as denominators.
FCFF = CFO + Int(1 - t) - FCInv; FCFE = CFO - FCInv + net borrowing.
Under IFRS, add back dividends paid that were classified as operating, and adjust interest according to where it was classified.
Cash flow performance ratios: cash flow to revenue, cash ROA and ROE, cash to income, cash flow per share.
Coverage ratios: debt, interest ((CFO + interest + taxes) / interest), reinvestment, debt payment, dividend payment, investing and financing.

This free module has 4 lessons, 14 practice questions with full explanations.

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