Sessions 7, 8 and 9

You will never reach your destination if you
stop and throw stones at every dog that

barks at you.
.
1
Cash Flow Analysis
• Objectives
– Understand the relation between profits
flows and cash flows
– Understand the Statement of Cash Flows
– Understand the relation between cash flow
from operating, investing and financing
activities of entities in the various stage of
the business cycle
– Understand the implication for the analyst
based on the type of audit report issued
PROFIT VS CASH FLOWS
A entity’s cash flow will be different from its net profit
each period because ;
(1) cash receipts from customers do not necessarily
occur in the same period in which a entity recognizes
revenues;
(2) cash expenditures to employees, suppliers, and
governments do not necessarily occur in the same
period in which a entity recognizes expenses; and
(3) cash inflows and outflows that pertain to investing
and financing activities do not immediately flow through
the income statement.
3
Cash Flow Analysis
Concerns of the Analyst

• How much cash is needed to run the
firm?
• When will the cash flow, into or out of
the firm?
• What is the probability of future cash
inflows and outflows?
Cash Flow Analysis Questions
• How much cash came in and left the
entity?
• What were the primary sources and
uses?
• Were the cash flow patterns consistent?
Cash Flow Analysis Questions
Continued
• Will the firm take in more cash than it pays

out?
• Will cash from operations cause the firm to
expand and grow?
• How much cash will the entity need to
acquire long term productive assets and to
pay long-term creditors and owners?
Statement of Cash Flows Formats
• Cash flow Statement (Indirect) • Cash flow Statement (direct)

– Cash from operations – Cash From operations
• Net Profit • Sales
– Items not requiring cash • Purchases
– Gains / Losses • Other revenues
• Movements in working
• Expenses
capital items
– Cash from investing – Cash from investing
• Purchase/sale of non-
• Purchase/sale of non-
current assets
current assets
– Cash from financing – Cash from financing
• Share/long term loans
• Share/long term loans
• Dividends/loan payments
• Dividends/loan payments
Interpreting Operating Cash Flows
Operations
– Trends
– Benchmark with other companies / industry
– Relate cash flows to liquidity
Tools
• Establish relationship of direct cash flows
to revenues
• Alternately ‘common size’ cash from
operations with sales/revenues as the
base
Cash Flows from Investing & Financing
Activities
Investing
– Property, plant and equipment make up the
tangible productive base of an entity
– Surplus funds are invested
Financing
– cash generated from debt and equity
issues, while the outflows are debt
reduction and dividends paid
Cash Flow Measures
– Cash sufficiency measures
• Cash flow adequacy = Cash flow from operations
(PPE purchased +long term debt paid + cash dividends
paid )
Can the cash flow from operations cover the acquisition
of PPE, the repayment of long term debt and pay
dividends to shareholders.
• Reinvestment ratio = PPE purchased

cash flow from operations
What percentage of cash from operations is invested in

PPE
• Long term debt repayment ratio long-term debt paid

The percentage of cash from operations used to pay long

term debt
• Dividend payout ratio = cash dividends paid

The percentage of cash from operations used to pay

dividends
• Free cash flows = Cash flows from operations - (capital
expenditures for capital maintenance + dividends)
• A positive free cash flow indicates that the business is able

to meet all of its cash commitments and has cash available
to expand current operations and, or reduce loan capital.
• A negative free cash flow indicates that the business will
have to borrow funds and, or issue share capital and, or sell
investments in order to maintain its planned operating
activity level.
Cash Flow Analysis
impact on efficiency
• Measure Stable Ops Efficient Ops Inefficient Ops
• Cash to sales None Increasing Decreasing
• A/c Rec turn. None Increasing Decreasing
• Days rec. None Decreasing Increasing
• Cash - Payable None Decreasing Increasing
• Stock turn. None Increasing Decreasing
• Days stock None Decreasing Increasing
• payables turn. None Decreasing Increasing
• Conversion Cycle None Decreasing Increasing
Financial Statement Influences
• The Analyst’s reliance on Financial statements
– Assess the judgment and integrity of
management
– Consider the financial reporting history of the
company
– Investigate large and unusual changes in
reported items
– Determine if any unusual pressure exist for
management to attain a certain level of
performance
• Verify auditor independence
– Constantly monitor media reports
Audit Opinion
– What message does it convey?
• Many persons are of the view that the opinion
–communicates compliance with legal and
professional requirements
–communicates the responsibility of the
directors and management
–communicates that it is an independent
examination of the financial statement
• The Audit report is not saying that the
financial statements are free from bias
Audit Opinion
– Expectation Gap
• fraud detection responsibilities / absolute
accuracy
• Others see gap as
–a reasonableness gap, what society
expects vs auditor’s achievement
–a performance gap, deficient standards
gap vs deficient performance
You will never reach your destination if you
stop and throw stones at every dog that
barks at you.
.
17

Sessions 7, 8 and 9

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Sessions 7, 8 and 9

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You will never reach your destination if you

stop and throw stones at every dog that

Concerns of the Analyst

• Will the firm take in more cash than it pays

• Cash flow Statement (Indirect) • Cash flow Statement (direct)

• Reinvestment ratio = PPE purchased

What percentage of cash from operations is invested in

• Long term debt repayment ratio long-term debt paid

The percentage of cash from operations used to pay long

• Dividend payout ratio = cash dividends paid

The percentage of cash from operations used to pay

• A positive free cash flow indicates that the business is able

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