Learning Outcome Map

1. Analyze reported cash flow statements: identify where cash came from and where it went.
2. Analyze common-size cash flow statements: convert cash flow lines into percentages so trends are easier to see.
3. Calculate and interpret free cash flow to the firm: cash available to all capital providers after operating needs and capital investment.
4. Calculate and interpret free cash flow to equity: cash available to common shareholders after operating needs, capital investment, and debt flows.
5. Calculate and interpret cash flow ratios: performance ratios show cash productivity; coverage ratios show ability to meet obligations.

The Four-Step Cash Flow Analysis

1. First, find the major sources and uses of cash.

What is a source of cash: money coming into the company.

What is a use of cash: money leaving the company.

Do not begin with ratios. First ask whether cash mainly came from customers, asset sales, new debt, or new share issues. A mature company should usually be funded by operating cash flow. If a mature company keeps surviving only because banks and shareholders keep sending money, that is not a normal long-term story.

1. Second, inspect operating cash flow.

What is operating cash flow: cash generated by the normal business, such as collecting from customers and paying suppliers, employees, interest, and taxes depending on the accounting classification.

Why is operating cash flow used: it tells you whether the business engine itself is producing cash.

Look at receivables, inventory, payables, and other working-capital accounts. If receivables jump, the company may have booked sales but not collected cash. If inventory jumps, cash may be stuck in unsold goods. If payables jump, the company may be preserving cash by delaying payments to suppliers.

1. Third, compare operating cash flow with net income.

What is net income: accounting profit after recognizing revenues, expenses, gains, losses, and taxes.

For a mature business, operating cash flow being higher than net income is usually healthy because depreciation and amortization reduce accounting profit without using cash in the current period. If net income is high but operating cash flow is poor, the business may be showing accounting profit before the cash has truly arrived.

Think of a company selling phones on credit. It can report revenue today, but if customers have not paid yet, the cash flow statement exposes the lag. That is why cash flow is a quality check on earnings.

1. Fourth, inspect investing and financing cash flow.

Investing cash flow shows whether the company is buying assets for the future, buying other companies, buying financial investments, or selling assets. Financing cash flow shows whether the company is borrowing, repaying debt, issuing shares, buying back shares, or paying dividends.

A growth company can have negative investing cash flow because it is building capacity. That is not automatically bad. The exam question is: where did the cash come from? If operating cash flow funded the investment, that is stronger than funding every expansion with new debt or new equity.

Common-Size Cash Flow Statements

1. Common-size cash flow analysis makes cash flow lines comparable.

What is common-size analysis: rewriting each line as a percentage of a base number.

Why is common-size analysis used: it turns raw cash amounts into proportions, so you can compare years or companies of different sizes.

A USD 10 billion operating cash flow sounds huge, but it means different things for a mega-cap technology company than for a small retailer. Percentages tell you the shape of the cash flow statement.

1. Method 1: percentage of total cash inflows and total cash outflows.

Each cash inflow is divided by total cash inflows. Each cash outflow is divided by total cash outflows.

For example, if total cash inflows are USD 1,000 and cash received from customers is USD 960, then:

$$ \frac{960}{1,000} = 96.00\% $$

This tells you that almost all cash coming in came from customers, not from selling assets.

1. Direct method versus indirect method matters here.

What is direct method: the operating section lists operating cash receipts and operating cash payments separately.

What is indirect method: the operating section starts with net income and adjusts it to operating cash flow.

If the operating section uses the direct method, you can show customer receipts, supplier payments, employee payments, interest payments, and tax payments separately as percentages. If it uses the indirect method, you usually only show net operating cash flow as a percentage of total inflows or outflows because individual operating receipts and payments are not shown.

1. Method 2: percentage of net revenue.

Each cash flow line is divided by net revenue. This is useful for forecasting because many cash flow items naturally move with sales.

For example, if net revenue is USD 1,000 and operating cash flow is USD 110, then:

$$ \frac{110}{1,000} = 11.00\% $$

If an analyst forecasts next year's revenue, this percentage gives a starting point for forecasting operating cash flow. It is not a magic rule, but it is a disciplined anchor.

1. How to read common-size trends.

If capital expenditures rise from 4.8% of sales to 5.9% of sales, the company is likely investing more heavily in property, plant, and equipment relative to sales. If operating cash flow falls from 34.8% of sales to 27.7% of sales, cash generation is weakening relative to sales even if the company still looks profitable.

A common-size trend has exactly this flavor: operating cash flow can still be positive, but the percentage of sales can decline if receivables and inventory start using more cash. The point is not whether one year looks good in isolation. The point is that cash-flow percentages make the trend visible.

3. Free Cash Flow Measures

CRITICAL_MODULE

Free Cash Flow to the Firm

1. Free cash flow to the firm is cash available to both debt and equity investors.

What is debt investor: a lender or bondholder who has supplied borrowed money to the company.

What is equity investor: an owner of the company, usually a common shareholder.

Free cash flow to the firm is measured after operating expenses, taxes, working-capital investment, and fixed-capital investment. It is before deciding how much cash finally belongs to lenders versus owners.

1. Formula from net income:

$$ FCFF = \underbrace{NI + NCC - \text{WCInv}}_\text{CFO} + \text{Int}(1 - \text{Tax rate}) - \text{FCInv} $$

Notation in simple language:

• FCFF: free cash flow to the firm.
• NI: net income.
• NCC: non-cash charges such as depreciation and amortization.
• Int: interest expense.
• Tax rate: marginal tax rate used for the after-tax interest adjustment.
• FCInv: fixed capital investment, such as net investment in equipment.

• WCInv: working capital investment, such as extra cash tied up in receivables and inventory.

• Formula from operating cash flow:

$$ FCFF = CFO + Int(1 - \text{Tax rate}) - FCInv $$

What is operating cash flow: cash flow from operating activities.

Why is this formula simpler: operating cash flow already captures net income, non-cash charges, and working-capital changes, so you do not add them again.

1. Why after-tax interest is added back.

Interest is a payment to lenders. But free cash flow to the firm is for lenders and owners together. So if operating cash flow has already subtracted interest, you add back the after-tax cost of that interest.

Suppose a company paid USD 100 of interest and the tax rate is 10%. Interest is tax-deductible, so paying interest saved USD 10 of tax. The real after-tax cash cost is USD 90. $$ USD\ 100 \times (1 - 0.10) = USD\ 90 $$

That USD 90 is the amount added back when interest was included in operating cash flow.

1. IFRS classification trap.

Under IFRS, interest paid may be classified as operating or financing. If interest paid is already in operating cash flow, add back after-tax interest for free cash flow to the firm. If interest paid is in financing, operating cash flow did not subtract it, so do not add it back again.

Under IFRS, interest received and dividends received may be classified as investing. If they are in investing but you need operating cash flow for free cash flow to the firm, add them back to operating cash flow. If dividends paid were classified as operating, add them back too when computing free cash flow to the firm.

Free Cash Flow to Equity

1. Free cash flow to equity is cash available to common shareholders.

What is common shareholder: the ordinary owner who receives residual cash after operating costs, lenders, and preferred shareholders have been handled. Free cash flow to equity is after operating expenses, borrowing costs, fixed-capital investment, working-capital investment, and debt principal flows.

1. Formula from operating cash flow:

$$ FCFE = CFO - FCInv + \text{Net borrowing} $$

Intuition: imagine the company as a shop owned by common shareholders. The shop first generates cash from normal business. That is operating cash flow. Then the shop must spend some cash to keep its shelves, machines, stores, and systems alive. That is fixed capital investment, so subtract it. After that, check what happened with lenders. If the shop borrowed fresh money, that cash is now inside the business and can support common shareholders, so add net borrowing. If the shop repaid debt, cash left the business to lenders, so net borrowing becomes negative.

Tiny numerical: the shop generates USD 100 of operating cash flow, spends USD 30 on fixed capital investment, and borrows USD 10 more than it repays. Common shareholders have USD 80 of free cash flow to equity.

$$ USD\ 100 - USD\ 30 + USD\ 10 = USD\ 80 $$

The formula is not saying borrowing is profit. It is saying borrowing changes the cash left for common shareholders after the business has funded its assets. New borrowing increases free cash flow to equity; debt repayment decreases it.

If debt repayments are larger than new borrowing, net borrowing is negative. Then the formula is easier to read as:

$$ FCFE = CFO - FCInv + \text{Net Borrowing} $$

1. Relationship between free cash flow to the firm and free cash flow to equity:

$$ FCFE = FCFF + \text{Net borrowing} - Int(1 - \text{Tax rate}) $$

Free cash flow to equity adds net borrowing because new debt brings cash into the company that can support common shareholders after required investments. It subtracts after-tax interest because interest is cash paid to lenders, not cash left for common shareholders.

Cash Flow Performance Ratios

1. Performance ratios ask: how efficiently does the company turn business resources into operating cash?

What is performance ratio: a ratio that measures cash productivity or profitability.

These ratios are not about whether debt can be paid tomorrow. They are about whether sales, assets, and equity are producing operating cash.

1. Cash flow to revenue:

$$ Cash\ flow\ to\ revenue = \frac{CFO}{\text{Net revenue}} $$

This measures operating cash generated per dollar of revenue. If two companies both report USD 100 of revenue, but one generates USD 30 of operating cash and the other generates USD 5, the first company has cleaner cash conversion.

1. Cash return on assets:

$$ Cash\ return\ on\ assets = \frac{CFO}{\text{Average total assets}} $$

This measures operating cash generated per dollar of asset investment. It is useful when comparing asset-heavy businesses. A factory company needs lots of assets; a software company may not. The ratio shows how much cash the asset base is actually producing.

1. Cash return on equity:

$$ Cash\ return\ on\ equity = \frac{CFO}{\text{Average shareholders equity}} $$

This measures operating cash generated per dollar of owners' capital.

1. Cash to income:

$$ Cash\ to\ income = \frac{CFO}{\text{Operating income}} $$

This measures how well operating income converts into operating cash. A low ratio can mean profit is stuck in receivables, inventory, or other accruals.

1. Cash flow per share:

$$ Cash\ flow\ per\ share = \frac{CFO - \text{Preferred dividends}}{\text{Number of common shares outstanding}} $$

What is preferred dividend: a dividend paid to preferred shareholders before common shareholders get residual cash.

If IFRS reporting puts total dividends paid inside operating cash flow, add total dividends back to operating cash flow first, then subtract preferred dividends. The goal is cash flow available per common share, not cash flow after all dividends.

5. Cash Flow Coverage Ratios

1. Coverage ratios ask: can operating cash cover obligations and strategic cash needs?

What is coverage ratio: a ratio that compares operating cash flow with debt, interest, reinvestment, dividends, or total investing and financing outflows.

These ratios are solvency-flavored. They are about staying power.

1. Debt coverage:

$$ Debt\ coverage = \frac{CFO}{\text{Total debt}} $$

This measures financial risk and leverage. Higher means operating cash flow is larger relative to total debt.

1. Interest coverage, cash-based:

$$ Interest\ coverage = \frac{CFO + \text{Interest paid} + \text{Taxes paid}}{\text{Interest paid}} $$

This measures ability to meet interest obligations. If IFRS reporting placed interest paid in financing, do not add interest paid back to the numerator, because operating cash flow did not subtract it.

1. Reinvestment ratio:

$$ Reinvestment = \frac{CFO}{\text{Cash paid for long-term assets}} $$

This measures ability to acquire assets with operating cash flows. If the ratio is above 1, operating cash flow covers the cash paid for long-term assets.

1. Debt payment ratio:

$$ Debt\ payment = \frac{CFO}{\text{Cash paid for long-term debt repayment}} $$

This measures ability to pay debt principal with operating cash flows.

1. Dividend payment ratio:

$$ Dividend\ payment = \frac{CFO}{\text{Dividends paid}} $$

This measures ability to pay dividends with operating cash flows. If the ratio is weak, dividends may be funded by borrowing, selling assets, or using old cash balances.

1. Investing and financing coverage:

$$ Investing\ and\ financing\ coverage = \frac{CFO}{\text{Cash outflows for investing and financing activities}} $$

This measures ability to acquire assets, pay debts, and make distributions to owners from operating cash flow.

6. Tiny Practice Blocks

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