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CFA Level I · CFA Level I Exam

Analyzing Statements of Cash Flows II: CFA Level I Chapter Guide

Analyzing Statements of Cash Flows II teaches you to judge cash flow quality, not just build the statement. You link cash flows to the income statement and balance sheet, run common-size analysis, compute FCFF and FCFE, and use coverage and performance ratios. Solve questions by identifying the starting number, adjusting step by step, and checking the sign.

What this chapter covers

This chapter picks up after you learn how to prepare the cash flow statement. Here you use it as an analytical tool. You ask where cash came from, whether it is sustainable, and what it says about earnings quality and solvency.

The chapter has four parts. First, you see how operating, investing and financing cash flows link to the income statement and balance sheet, and how to judge sources of cash. Second, you apply common-size analysis, both as a percentage of revenue and as a percentage of total cash inflows or outflows. Third, you compute free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) from net income, EBIT, EBITDA or cash flow from operations. Fourth, you use performance and coverage ratios such as cash flow to revenue, cash return on assets, debt coverage and reinvestment ratios.

The content connects to much of the rest of Level I. FCFF and FCFE return in Equities as inputs to discounted cash flow valuation and in Corporate Finance for capital budgeting and capital structure. Earnings quality links to the other Financial Statement Analysis chapters, including income statements, balance sheets and financial reporting quality. Coverage ratios also support credit analysis in Fixed Income. Financial reporting questions use IFRS unless the question says US GAAP, so remember that IFRS allows more choice in classifying interest and dividends.

Financial Statement Analysis carries a topic weight of 11-14% at Level I, and this chapter is one of its most calculation-friendly parts. Questions are standalone three-option MCQs, so a clear method for FCFF, FCFE and ratios turns into reliable marks. The ideas also repeat in Equities and Corporate Finance, so time spent here pays back in several topics. With no penalty for wrong answers, knowing the logic also helps you eliminate two options even when the arithmetic is long.

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

  1. 1Cash Flow Statement Linkages and Evaluating SourcesStart here because it builds the logic of how cash flows tie to the other statements and what a healthy mix of sources looks like.
  2. 2Common-Size Analysis of Cash Flow StatementsIt comes next because it applies that logic with simple percentages and trains you to read trends before you compute anything complex.
  3. 3Free Cash Flow to the Firm and to EquityThis is the main calculation topic, and it needs the linkages and the idea of sources of cash clear first.
  4. 4Cash Flow Performance and Coverage RatiosStudy it last because ratios reuse CFO and free cash flow, and you can then compare ratios against what you already know about quality.

How to prepare Analyzing Statements of Cash Flows II

Aim for a method you can run quickly under time pressure, about 90 seconds per question. Build understanding first, then speed.

  1. Read the linkages topic and write a one-page map showing how net income, working capital changes, capex and debt issuance move between statements.
  2. Practise common-size analysis on one real company's cash flow statement. Compute each line as a percentage of revenue and as a percentage of total inflows, then write one sentence on what changed.
  3. Practise computing FCFF and FCFE from net income, EBIT, EBITDA and CFO, and make sure you understand why the routes reconcile. Check that each route gives the same answer when you use the same data.
  4. Do 10 to 15 numerical FCFF and FCFE questions with a calculator. Keep every intermediate figure and write the sign beside each item before you add.
  5. Learn each coverage and performance ratio by its numerator and denominator. Then explain in words what a rising or falling value tells you.
  6. Finish with mixed standalone MCQs. For each, eliminate two options by checking sign, direction and whether interest is already after tax.
  7. Revise the IFRS versus US GAAP classification differences for interest and dividends, paid and received, on a single sheet the day before the exam. Note that taxes are generally operating under both frameworks unless they are specifically identified with investing or financing.

Common mistakes in Analyzing Statements of Cash Flows II

  • Adding back interest without adjusting for tax in FCFF.

    Fix: Add back after-tax interest, interest × (1 − t), and only if interest was deducted in the starting figure. Net income always is after interest. CFO is after interest under US GAAP or when IFRS classifies interest as operating, but not when IFRS classifies interest paid as financing.

  • Subtracting working capital changes with the wrong sign.

    Fix: Write whether each item is a source or use of cash before you add, and check the result against the direction of the business.

  • Mixing FCFF and FCFE net borrowing.

    Fix: Net borrowing belongs in FCFE only. FCFF is before payments to all capital providers.

  • Using the wrong denominator in coverage and performance ratios.

    Fix: Learn each ratio by name, numerator and denominator, and say what question it answers.

  • Treating all positive cash flow as high quality.

    Fix: Check whether CFO is recurring and large enough to fund capex and debt service, or whether it relies on asset sales and borrowing.

  • Ignoring IFRS versus US GAAP classification.

    Fix: Read the question for the framework. Default to IFRS unless it says US GAAP, and adjust CFO for interest and dividends where needed.

Last-day revision: Analyzing Statements of Cash Flows II

  • FCFF = CFO + interest paid × (1 − t) − FCInv, where interest is added back only if it was deducted in CFO (US GAAP, or IFRS if classified as operating). If IFRS interest paid is classified as financing, CFO is already before interest and FCFF = CFO − FCInv.
  • FCFE = CFO − FCInv + net borrowing, with CFO after interest paid (US GAAP, or IFRS if interest is classified as operating). If IFRS interest paid is classified as financing, CFO is before interest, so FCFE = CFO − interest paid × (1 − t) − FCInv + net borrowing.
  • FCFE = FCFF − interest × (1 − t) + net borrowing, which holds for FCFF defined as before-interest cash flow to all capital providers.
  • FCFF from net income = NI + non-cash charges + interest × (1 − t) − FC investment − WC investment.
  • FCFF from EBIT = EBIT × (1 − t) + depreciation − capex − increase in working capital.
  • FCFF from EBITDA = EBITDA × (1 − t) + depreciation × t − capex − increase in working capital.
  • Common-size cash flow can be shown as a percentage of revenue or of total cash inflows and outflows.
  • Cash flow to revenue = CFO ÷ net revenue; cash return on assets = CFO ÷ average total assets.
  • Debt coverage = CFO ÷ total debt; interest coverage on a cash basis = (CFO + interest paid + taxes paid) ÷ interest paid, where interest paid is added back only if it was deducted in CFO. If IFRS interest paid is classified as financing, the numerator is CFO + taxes paid.
  • Reinvestment ratio = CFO ÷ cash paid for long-term assets; a higher figure means more internal funding.
  • Strong operating cash flow that is sustainable is a better source than asset sales or new borrowing.
  • Under IFRS, interest and dividends received can be operating or investing, and interest and dividends paid can be operating or financing.

Analyzing Statements of Cash Flows II practice questions

Analyzing Statements of Cash Flows II in other exams

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

Analyzing Statements of Cash Flows II: frequently asked questions

Is Analyzing Statements of Cash Flows II calculation-heavy?

Partly. FCFF and FCFE need careful arithmetic and sign handling. Linkages, common-size and ratio interpretation are mostly conceptual, so you can answer many of those questions quickly.

Do I need to memorise all four FCFF routes?

Not by rote. You should be able to compute FCFF from any of these starting points: net income, EBIT, EBITDA or CFO. You should also understand why they reconcile. They give the same result with consistent data, so you can pick whichever fits the information in the question.

How does this chapter connect to valuation topics?

FCFF and FCFE are the cash flows discounted in equity valuation, and they are used in corporate finance analysis too. If you understand how they are built here, those later topics become easier.

Which calculator steps help most in this chapter?

Most questions need only basic arithmetic, so use the memory keys to hold running totals. On the TI BA II Plus, store a result with STO and a digit, then recall it with RCL and the same digit. Practise this so you do not retype figures.