Financial Accounting 003: Cash Flow Statement

What is Cash Flow Statement

The Cash Flow Statement reports changes in cash due to operating, investing and financing activities over a period of time.

Cash Flow Statement Format

  • Net cash from operating activities +
  • Net cash from investing activities +
  • Net cash from financing activities =
  • Net change in cash balance

Business Activities

Operating activities create transactions related to providing goods and services to customers and to paying expenses to generating revenue.

Investing activities create transactions related to acquisition or disposal of long-term assets, which includes PP&E and intangibles.

Financing activities create transactions related to owners or creditors, such as issuing new stock, payment of dividends and taxes etc.

Receipt of interest or interest payment may be classified in either of the 3 activities, depending on regulations.


Growth Stages of a Company

  1. At the Start-Up stage of a company, operating cash flow is likely to be negative as the company is attempting to gain market share. Outflow of cash for investing will be high to build up capabilities. Inflow of cash from financing will be high in order to keep the business running when the company has yet to become profitable.
  2. If the company is able to move past the Start-Up stage, it will enter the Early Growth stage, where the company will start to make profit, hence it will start to see positive operating cash flow. Investing cash flow will remain negative as the company expands the business. Inflow of cash from financing may not be as high, but the company will likely to continue to borrow money for expansion.
  3. When the company reaches the Mature stage, operating cash inflow will be huge. It will gradually reduce investment spending as the business has already reached optimal scale. This is the stage where the company starts paying back the debts and give dividends to the stockholders. Financing cash will see a net outflow.
  4. Finally at the Decline stage of a company, there will still be cash inflow from operating activities, although not as much as compared to the previous stage. Investing cash outflow will be minimal, just sufficient to maintain the business. Financing cash outflow will be mainly dividend payouts as the company do not need to borrow money for expansion.

Statement of Cash Flow Complications

The change in balance sheet numbers is often not equal to the number on the cash flow statement. This is due to a number of reasons:

  • Non-cash investing and financing activities.
  • Acquisitions and divestitures of business.
  • Foreign currency translation adjustments.
  • Subsidiaries in different industries.

EBITDA

EBITDA is Earnings before Interest, Taxes, Depreciation and Amortisation, is often used as a proxy for cash flow that excludes interest and taxes, but note that it is ultimately an income concept.

Earnings and current cash flow from Operations are good predictor of future cash flow.

Free Cash Flow

FCF is the operating cash flow less cash for long-term investments. There is no standard measure for operating cash flow, and companies may use their custom definitions which include:

  • Cash from operations before interest expense
  • NOPLAT (Net operating profits less adjusted taxes)
    (EBITDA – Cash taxes on EBITDA)
  • NOPAT – increase in working capital
    (Net Income + After-tax net interest expense)
  • Net income adjusted for depreciation and other non-cash items – increase in working capital
  • EBIT + Depreciation
  • EBITDA

 

(Reference: Coursera Wharton Online Introduction to Financial Accounting)

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Corporate Finance 001: Time Value of Money

Definition

Simply put, corporate finance is the study of how corporations make decision, any kinds of decision from investment, purchasing, operations and marketing. It provides a framework to quantify the costs and benefits of any endeavours, so that corporation, or even individuals at a personal level, can make financially sound decisions.


Time Value of Money

This is an intuition, fundamental to any finance course, that money obtained or expended (Cash Flows) at different time period has a different value with respect to a chosen point in time. The value is calculated based on a Rate of Return offered by investment alternatives in the capital markets of equivalent risk.

Here are some examples from the lesson of the next best alternative investment in the capital markets and the rate of return. Therefore, depending on the alternatives chosen for comparison, the rate used in valuing money will differ. This also interestingly point out that with higher risk of investment, rate of return will also be higher.


Discounting and Compounding

If we are interested in finding the Present Value of a series of future cash flows, we would discount the cash flows with a selected rate of return.

Discounting

If we are interested in finding the Future Value of a series of cash flows that occured before the chosen point in time, we would compound the cash flows with a selected rate of return.

Compounding


Annuity and Perpetuity

Instead of discounting or compounding the cash flows, there are simple formulas to calculate the value of common cash flow streams. Here are some examples:

Annuity

  • A finite stream of cash flows
  • Cash flows of identical magnitude
  • Cash flows are spaced out equally in time

To find the present value of annuity, simply use:

PV of Annuity = [CF / R] * [1 – (1+R)^-T]

When dealing with Growing Annuity, which is annuity with cash flows that grow at a constant rate, the formula is as follows:

PV of Growing Annuity = [CF / (R-g)] * (1 – [ (1+R) / (1+g) ]^-T )

Perpetuity

Perpetuity is very similar to annuity. A perpetuity does not have an expiry for the stream of cash flows. Some coupon bonds, company stocks that give dividends, or insurance with payouts, are assumed to be perpetuity as the stream of cash flows is theoretically infinite.

To find the present value of perpetuity, simple use:

PV of Perpetuity = CF / R

For Growing Perpetuity, which has cash flows that grow at a constant rate, the formula is:

PV of Growing Perpetuity = CF / (R-g)

These concepts of present values of cash flows intuitively explain why the stock prices of dividend stocks rise or fall when there are changes in the amount of dividend payout.

 

(Reference: Coursera Wharton Online Introduction to Corporate Finance)