Analyzing Statements of Cash Flows I: CFA Level I Guide

What this chapter covers

Analyzing Statements of Cash Flows I: topics in the order to study them

1. 1Cash Flow Statement Classification: CFO, CFI, CFFEverything else depends on knowing where an item sits, including IFRS choices for interest and dividends versus US GAAP.
2. 2Direct vs Indirect Method of Cash Flow StatementOnce you can classify, learn the two ways of presenting CFO and what each one shows.
3. 3Linking Cash Flow Statement to Balance Sheet and Income StatementThis explains why working capital changes and non-cash items adjust net income, and it prepares you for the conversion work.
4. 4Converting Between Methods and Preparing the StatementYou apply the links to build the statement and move between direct and indirect figures, which is the calculation-heavy part.
5. 5Free Cash Flow and Cash Flow Analysis RatiosThese use the finished statement, so you study them last, when CFO, capex and interest are clear.

How to prepare Analyzing Statements of Cash Flows I

1. Learn the classification table first: write down where interest paid, interest received, dividends paid, dividends received and taxes go under IFRS and under US GAAP.
2. Memorise the direction of working capital adjustments in the indirect method: an increase in an operating asset reduces CFO, an increase in an operating liability raises CFO.
3. Practise tracing each balance sheet change to its cash flow line, for example a change in net PP&E, accumulated depreciation, debt and equity accounts.
4. Work through conversions both ways: cash collected from customers, cash paid to suppliers, and indirect CFO from direct data. Always check that the totals match.
5. Write out the FCFF and FCFE formulas from memory, then solve them from net income, CFO and EBIT versions. Add the cash flow ratios with their definitions.
6. Finish with timed standalone three-option questions. For each one, eliminate the two options that break a sign or classification rule before you calculate.

Common mistakes in Analyzing Statements of Cash Flows I

• Treating interest and dividends as fixed in one section under every standard

  Fix: Read the question for the standard named. IFRS is the default; apply its options and note any stated policy.

• Getting the sign wrong on working capital changes

  Fix: Ask whether cash was tied up or released. A rise in an operating asset ties up cash, so subtract it; a rise in an operating liability releases cash, so add it.

• Leaving a gain or loss on sale in CFO

  Fix: Subtract gains and add back losses in the indirect reconciliation, and put the full sale proceeds in CFI.

• Including non-cash transactions in the statement

  Fix: Remember that only cash movements enter the statement. Non-cash deals are disclosed in notes.

• Mixing up FCFF and FCFE adjustments

  Fix: FCFF is cash available to all capital providers, so add back after-tax interest only if interest paid was deducted in CFO. If interest paid is in CFF under IFRS, CFO already excludes it and you add nothing back. FCFE is cash for shareholders, so include net borrowing instead of an interest add-back. If interest paid is in CFF, subtract the full interest paid, not an after-tax amount, because the tax saving is already in CFO's taxes paid.

• Using the wrong balance sheet change in conversions

  Fix: Rebuild the account: ending balance = beginning balance + additions − disposals − depreciation, then solve for the missing item.

Last-day revision: Analyzing Statements of Cash Flows I

• ✓CFO, CFI and CFF together explain the change in cash and cash equivalents.
• ✓Under IFRS, interest paid and dividends paid can be CFO or CFF; interest and dividends received can be CFO or CFI. US GAAP puts interest and dividends received and interest paid in CFO, and dividends paid in CFF.
• ✓Income taxes paid are generally in CFO.
• ✓Direct method shows cash receipts and payments; indirect starts with net income. CFO is the same under both.
• ✓Indirect method: add back non-cash charges such as depreciation, and remove gains on asset sales from CFO.
• ✓Increase in accounts receivable or inventory lowers CFO; increase in accounts payable raises CFO.
• ✓Proceeds from asset sales are CFI; the gain itself is removed from CFO.
• ✓Non-cash investing and financing transactions are disclosed separately, not included in the three sections.
• ✓FCFF: add back after-tax interest only if interest paid was deducted in CFO. If interest paid is in CFO (US GAAP, or an IFRS choice), FCFF = CFO + interest paid × (1 − t) − capex. Under IFRS, if interest paid is classified in CFF, CFO already excludes it, so do not add it back: FCFF = CFO − capex.
• ✓Interest or dividends received that are classified in CFI under IFRS are excluded from CFO, so an FCFF built from CFO also excludes them. Add them separately only if the analyst wants them included.
• ✓FCFE = CFO − capex + net borrowing. Here CFO is after interest paid, so no interest add-back is made. If interest paid is classified in CFF under IFRS, CFO excludes the interest outflow, so subtract the full interest paid: FCFE = CFO − interest paid − capex + net borrowing. Do not use interest paid × (1 − t). The tax saving on interest is already in the income taxes paid inside CFO, so deducting the full interest once gives the correct result. Using an after-tax amount would count the tax saving twice.
• ✓Cash flow ratios compare CFO or FCF with sales, assets, equity, net income or debt to judge performance and coverage.
• ✓Check your answer: the three sections must sum to the change in cash.

Analyzing Statements of Cash Flows I practice questions

• Harlow Ltd reported cost of goods sold of 600. Inventory increased from 80 to 110, and accounts payable increased from 50 to 65. Cash paid t…
• Under IFRS, a company sells a machine for more than its carrying amount and reports a gain in net income. When preparing operating cash flow…
• Under IFRS, a company reports profit before tax of 500,000, interest expense of 40,000, and income tax expense of 150,000. Income taxes paya…
• Under IFRS, a company reports cash paid for income taxes of 30,000, of which 6,000 relates to a gain on the sale of a factory that is report…
• During the year, an IFRS reporter acquired equipment by issuing a long-term note payable directly to the seller, with no cash exchanged. Thi…
• A company reports revenue of 840,000, and accounts receivable rose from 120,000 to 150,000 during the year. Cost of goods sold was 500,000, …
• Under US GAAP, which of the following items is most likely classified as a financing cash flow?
• Dalton Corp reported revenue of 900 for the year. Accounts receivable rose from 120 to 150, and unearned revenue (a liability for cash recei…

Analyzing Statements of Cash Flows I in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• CMA IntermediateCash Flow Statement - Preparation and Analysis
• CA IntermediateAS 3 Cash Flow Statement
• CA FinalInd AS 7 Statement of Cash Flows
• NISM CertificationsCompany Analysis - Financial Analysis