Statement of Cash Flows and Financial Statement Analysis
What this domain tests
This domain tests cash flow classification and preparation, direct and indirect methods, free cash flow, ratio analysis, DuPont decomposition, and earnings quality under ASC 230 and IAS 7.
Cash flow statement
Operating activities include cash from revenue and expenses. Investing activities include acquisitions and disposals of long-term assets and investments. Financing activities include debt, equity, and dividends. Under US GAAP, interest paid is operating and dividends paid are financing; IFRS permits interest and dividends to be classified as operating or financing.
The indirect method starts with net income, adds noncash expenses such as depreciation, amortization, and stock compensation, removes gains and adds back losses on investing or financing activities, and adjusts for working capital changes. An increase in a current asset is subtracted; an increase in a current liability is added. The direct method discloses gross receipts and payments and reconciles to operating cash flow. Free cash flow is operating cash flow minus capital expenditures, a non-GAAP measure that should be used cautiously.
Analysis
Liquidity ratios include the current, quick, and cash ratios. Solvency ratios include debt-to-equity and times interest earned. Profitability ratios include gross margin, net margin, return on assets, and return on equity. Activity ratios include receivables turnover, inventory turnover, and asset turnover. DuPont analysis decomposes return on equity into net profit margin times asset turnover times the equity multiplier.
Worked example
Net income is $200,000; depreciation is $40,000; a gain on sale is $10,000; accounts receivable increased $15,000; inventory decreased $5,000; accounts payable increased $8,000. CFO is $200,000 + $40,000 - $10,000 - $15,000 + $5,000 + $8,000 = $228,000. Proceeds from the sale are $30,000 and are investing cash flow; the $10,000 gain is removed from operating. Dividends paid of $20,000 and borrowing of $50,000 are financing cash flows.
Traps
Leaving a gain on sale in operating cash flow; treating an increase in receivables as a source of cash; classifying interest paid as financing under US GAAP; equating net income with cash flow; and comparing ratios without adjusting for LIFO versus FIFO or lease accounting differences.