Operating Cash Flow
Direct method: In the direct method, we take each item from the income statement and convert it to its cash equivalent by removing the impact of accrual accounting. The rules to adjust are:
Cash collected from customers: Adjust sales for changes in accounts receivables and unearned revenue.
Cash for inputs: Adjust COGS for changes in inventory and accounts payable.
Cash operating expenses: Adjust SG&A for changes in related accrued liabilities or prepaid expenses.
Cash interest paid: Adjust interest expense for change in interest payable.
Cash taxes paid: Adjust tax expense for changes in tax payable and changes in deferred tax assets and liabilities.
Consider a company which reported sales of $10 million. Accounts receivable for the year went up from $2 million to $4 million. Unearned revenue went up from $1 million to $2 million. Calculate cash collected from customers.
Δ Accounts receivable = $2 million. This is an asset and increase in asset is use of cash so –ve adjustment.
Δ Unearned revenue = $1million. This is a liability and increase in liability is source of cash so +ve adjustment.
Cash collected from customers = + $10 million – $2million + $1million = $9 million
Consider a company with COGS of $20 million for a particular period. During this period, inventory increased by $4 million and accounts payable went up by $2 million. Calculate the cash paid to suppliers.
Δ Inventory = $4 million. This is an asset and increase in asset is use of cash so –ve adjustment.
Δ Accounts payable = $2 million. This is a liability and increase in liability is source of cash so +ve adjustment.
Cash paid to suppliers = – $20 million – $4 million + $2 million = – $22 million
Indirect method shows how cash flow from operations can be obtained from reported net income as a result of a series of adjustments. The steps are:
Decrease in operating assets (source of cash) should be added and increase in operating assets (use of cash) should be subtracted.
Similarly, increase in current liabilities (source of cash) should be added and decrease in current liabilities (use of cash) should be subtracted.
Consider a company with net income of $100 million in 2001. Depreciation expense is $10 million. Gain on sale of equipment is $4 million. Increase in A/R is $8 million. Increase in A/P is $4 million. Increase in inventory is $10 million. Calculate CFO using the indirect method.
|Add non-cash charges (depreciation)||+ 10|
|Less gain on sale of equipment||– 4|
|Less increase in A/R||-8|
|Add increase in A/P||+4|
|Less increase in inventory||-10|
|CFO = $92 million|
Investing cash flows: CFI is calculated by determining changes in the gross asset account that result from the purchase or sale of equipment. It can be calculated by using the following formulae:
Financing cash flows: CFF is the sum of net cash flows from creditors and net cash flows from shareholders. It can be calculated using the following formulae:
(1) CFF = net cash flow from creditors + net cash flow from shareholders
(2) Net cash flow from creditors = new borrowings – principal repaid
(3) Net cash flow from shareholders = new equity issued – shares repurchased – cash dividends
The following information is available about company ABC for 2001.
New borrowings $10 million
Principal repaid $5 million
New equity issued $5 million
Shares repurchased –
Dividends paid $2 million
Net cash flow from creditors = new borrowings – principal repaid = 10 – 5 = $5 million
Net cash flow from shareholders = new equity issued – shares repurchased – cash dividends = 5 – 0 – 2 = $3 million.
CFF = net cash flow from creditors + net cash flow from shareholders = 5 + 3 = $8 million