Monday, May 11, 2009

Cash Flow Analysis, pt 1 - CFO

[Cash Flow Analysis Series 1 CFO - 2 CFI - 3 CFF - 4 FCFF - 5 FCFE]

After my post about using cash flow as a valuation tool, I thought it would be prudent to review how to calculate cash flows using the direct and indirect method.

The most intuitive method is the direct method. This is by taking items from the income statement and understanding how they affect the cash account.
  • Cash from sales is usually the largest component of CFO and a good starting point.
  • Not all sales are paid for in cash as some are accrued. Therefore a change in accounts receivables reflects sales on account and therefore have to be accounted for (an increase in AR implies less cash from sales).
  • Also, cash on hand is affected by other current assets such as inventory and accounts payable (cash owed to suppliers). If inventory increases this implies that cash was used to buy more inventory. If AP decreases that means cash was used to pay off suppliers.
For each of these relationships, the reverse is also true
  • lower AR means more collections from customers and higher cash flow
  • lower inventory means COGS liquidated for cash
  • higher AP means longer payment terms from suppliers (less cash out)
Using the indirect method, we work our way backwards from net income:
  1. Take net income
  2. subtract cash flows from financing or investing (CFF and CFI respectively)
  3. Add back non-cash charges (such as depreciation)
  4. Subtract decreases in operating asset accounts (decreases of Inv, AP are cash flows out)
  5. Add increases in operating asset liabilities (decreases of AR is cash flow in)
Regardless of the method, the result for cash flow from operations, CFO, should be the same.

[Cash Flow Analysis Series 1 CFO - 2 CFI - 3 CFF - 4 FCFF - 5 FCFE]

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