Statement of Cash Flows
EBITDA
 Many people define cash flow as EBITDA
– What is its relevance?
– What is it missing?
– Do it do a reasonably good job?
 Why not use the statement of cash flows?
FIN 591: Financial Fundamentals/Valuation
2
Importance of
the Statement of Cash Flows
 Combines balance sheet & income statement
analysis
 Eliminates differences in accounting
 Directly assesses “quality of earnings” — or
“How to go broke while making a profit...”
 Components:
– Operating activities (cash profits)
– Investing activities
– Financing activities.
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Articulation of Financial Statements
Cash Flow Statement
Cash from operations
Cash from investing
Beginning Balance Sheet
Ending Balance Sheet
Cash from financing
Net change in cash
Cash
+ Other Assets
Cash
+ Other Assets
Statement of Shareholders’ Equity
Total Assets
Total Assets
Investment and
- Liabilities
disinvestment
by owners
- Liabilities
Net income and other earnings
Owners’ equity
Net change in owners’ equity
Owners’ equity
Income Statement
Revenues
Expenses
FIN 591: Financial
Fundamentals/Valuation
Net income
4
W. T. Grant
 Accounting profits versus cash operating
profits
 Cash flow frequently defined as:
Net income + depreciation
» Poor definition.
 Look at W. T. Grant’s trend...
 And then at Salton…
FIN 591: Financial Fundamentals/Valuation
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What Happened to W. T. Grant?
100
50
0
-50
NI + depr.
NI
CFFO
-100
-150
-200
'66
'67
'68
'69
'70
'71
'72
FIN 591: Financial Fundamentals/Valuation
'73
'74
'75
6
What Happened to Salton?
80
60
40
20
0
EBITDA
CFFO
-20
-40
-60
'93
'94
'95
'96
'97
FIN 591: Financial Fundamentals/Valuation
'98
'99
7
Accounting Methods for Measuring
Performance
 Strict cash basis of accounting.
– Revenues are recorded when cash is received
and expenses are recorded when cash is paid
 Accrual basis of accounting
– Revenues and expenses are recorded on an
economic basis independently of the actual
flow of cash.
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Cash vs. Accrual Accounting
Cash Basis
Accrual Basis
Easy to understand.
Theoretically difficult.
Provides a reliable picture of the the
change in cash and the firm’s
liquidity.
Revenues and expenses are
recorded according to cash inflows
and outflows.
Provides a more reliable picture of
the economic changes in wealth.
Can be manipulated by changing
the cash flows timing.
Revenues and expenses are
recorded according to economic
change in wealth (the rules are
discussed later on in this clinic).
Can be manipulated by the
changing the recognition rules.
FIN 591: Financial Fundamentals/Valuation
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Accrual Accounting: The Question
 At what point of the operating cycle of the
firm should revenues and their related
expenses be recognized?
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Accrual Accounting: Basic Rules

Revenue and expense should be
recognized at the first point at which both
of the following criteria are met:
1. Revenue is earned
•
Revenue-producing activity has been performed
2. Revenue is either realized or realizable
•
Amount of cash to be collected can be estimated
with reasonable accuracy.
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Revenue Recognition
 For product sale transactions, revenue is typically
recognized when when title passes to the
customer
 For service transactions, revenue is typically
recognized when the substantial performance
occurred
– Because of the intangibility of services, it is often
difficult to ascertain when a service consisting of more
than a single act has been satisfactorily performed so as
to warrant recognition of revenue.
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Expense recognition
 According to the matching principle, selecting a
revenue-recognition basis also determines
whether related costs are expensed immediately or
capitalized and expensed subsequently
 Generally, expenses and losses are recognized
when an entity's economic benefits are used up in
the process of generating revenues.
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Earnings and Cash Flows
 Rather than matching cash inflows and
outflows, earnings match revenues and
expenses
Revenues = cash receipts + revenue accruals
Expenses = cash disbursements – cash investments
+ expense accruals
Earnings
FIN 591: Financial Fundamentals/Valuation
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Revenue and Expense Accruals
Revenue Accruals
Value added that is not
cash flow
Adjustments to cash inflows
that are not value added
Expense Accruals
Value decreases that are
not cash flow
Adjustments to cash outflows
that are not value decreases
FIN 591: Financial Fundamentals/Valuation
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The Revenue Calculation
Revenue = Cash receipts from sales
+ New sales on credit
 Cash received for previous periods' sales
 Estimates of credit sales not collectible
 Estimated sales returns and rebates
 Deferred revenue for cash received in advance of sale
+ Revenue previously deferred.
FIN 591: Financial Fundamentals/Valuation
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The Expense Calculation
Expense = Cash paid for expenses
+ Amounts incurred in generating revenue but not yet paid
 Cash paid for generating revenues in future periods
+ Amounts paid in the past for generating revenues in the current
period.
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Rules for Identifying Cash Flows
Balance Sheet
Assets increase Use
Financing increases Source
Assets decrease Source
Financing decreases Use
Revenues = Source
Expenses = Use
FIN 591: Financial Fundamentals/Valuation
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Sources = Uses
 Construct two columns for balance sheet
changes
– Sources = decreases in assets & increases in
financing
– Uses = increases in assets & decreases in
financing
 Sources must equal uses
 Construct the SCF.
FIN 591: Financial Fundamentals/Valuation
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Example: Construct a SCF
Beginning Balance Sheet
Cash 100 Payables 50
AR
150 Accruals 75
Invent 200 Equity 475
Fixed 150
Total 600
600
Income Statement
Sales
500
COS
300
Expenses (Deprec. = 5) 170
Profit
30
Ending Balance Sheet
Cash 120 Payables 125
AR
100 Accruals 50
Invent 250 Equity 495
Fixed 200
Total 670
670
Statement of Cash Flows
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Worksheet
FIN 591: Financial Fundamentals/Valuation
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On to Free Cash Flow
 Definition of free cash flow:
–
After-tax operating earnings + non-cash
charges - investments in operating working
capital, PP&E and other assets.
»
It doesn’t incorporate financing related cash flows
 Operating free cash flow = Cash flow to
debt holders + cash flow to equity owners
» In other words, the sum of operating flows = sum of
financing flows.
FIN 591: Financial Fundamentals/Valuation
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Free Cash Flow
 Normal approach is to use the SCF
–
Operating cash flows less investing activity
 Problems:
–
Not all investments are necessary
» Eliminate discretionary investments
–
Operating cash flows includes interest expense
» Eliminate it and put in financing category
–
Operating cash flows exclude all cash
» Add necessary transaction balances.
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FCF Per the Valuation Text
 FCF = NOPLAT - net operating investment
 What is NOPLAT?
–
–
–
NOPLAT means “net operating profit less adjusted
taxes”
See Exhibit 7.3 of Valuation text for an example
Comparable to EBIT * (1 - t)
» Tax expense adjusted
•
•
Change in deferred taxes
Tax shield provided by interest expense & other non-operating
expenses.
FIN 591: Financial Fundamentals/Valuation
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Questions Raised by the SCF...
 How strong is internal cash flow
generation?
 Is cash flow from operations positive?
Why? If negative, why?
 Is the company growing? Too quickly?
 Are operations profitable?
 Are there problems managing working
capital?
FIN 591: Financial Fundamentals/Valuation
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Questions...
 Can the company meet short-term
obligations from operating cash flows?
 Can it continue to meet these obligations
without reducing operating flexibility?
 How much is invested in growth?
 Are these investments consistent with the
business strategy?
 Was internal cash used to finance growth?
FIN 591: Financial Fundamentals/Valuation
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Questions...
 Does free cash flow exist? Is this a longterm trend?
 What plan does management have to deploy
free cash flow?
 Were dividends paid from free cash flow?
Or was external financing used?
 If external financing is used for dividends,
is the dividend policy sustainable?
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Questions...
 What type of external financing does the
company rely on?
–
–
–
Equity
Short-term debt
Long-term debt
 Is the financing consistent with the
company’s overall business risk?
FIN 591: Financial Fundamentals/Valuation
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Questions...
 Are there significant differences between a
firm’s net income and its operating cash
flow?
 Is it possible to identify the sources of this
difference?
 Which accounting policies contribute to it?
 Do one-time events contribute to the
difference?
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Questions...
 Is the relationship between operating cash flow
and net income changing over time? Why?
 Is it because of changes in business conditions or
accounting policies and estimates?
 What is the time lag between the recognition of
revenue and expenses and the receipt and
disbursement of cash flows?
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Questions
 Are the changes in receivables, inventories,
and payables normal?
 If not, is there adequate explanation for the
changes?
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The End
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