Introductory Corporate Finance: Financial Statement Analysis - Statement of Cash, Flows Operating Investing Financing Activities Free Cash Flow

What This Is

The Statement of Cash Flows (SCF) is a financial statement that reports a company's inflows and outflows of cash over a specific period. It's essential in corporate finance as it helps investors, creditors, and analysts assess a company's liquidity, solvency, and ability to generate cash. For instance, Tesla's SCF for 2022 shows a net cash inflow of $11.4 billion, primarily driven by its operating activities.

Key Formulas & Models

• Operating Cash Flow (OCF) = EBIT + Depreciation - Taxes - Change in Working Capital: OCF measures a company's ability to generate cash from its core operations. EBIT is earnings before interest and taxes, depreciation is non-cash expense, taxes are cash outflows, and change in working capital represents the difference between cash inflows and outflows from accounts receivable, inventory, and accounts payable.
• Investing Cash Flow (ICF) = Capital Expenditures - Proceeds from Sale of Assets: ICF measures a company's investment in assets, such as property, plant, and equipment (PP&E). Capital expenditures are cash outflows, while proceeds from sale of assets are cash inflows.
• Financing Cash Flow (FCF) = Net Borrowings - Dividends - Repurchase of Shares: FCF measures a company's financing activities, including borrowing, dividend payments, and share repurchases.
• Free Cash Flow (FCF) = OCF - Capital Expenditures: FCF measures a company's ability to generate cash after investing in its assets.
• Sustainable Growth Rate (SGR) = ROE x (1 - Retention Ratio): SGR measures a company's ability to sustain its growth rate over time. ROE is return on equity, and retention ratio is the percentage of earnings retained by the company.
• Degree of Operating Leverage (DOL) = (Q(P - V) / (Q(P - V) - F)): DOL measures a company's sensitivity to changes in sales. Q is quantity sold, P is price per unit, V is variable cost per unit, and F is fixed cost.
• Weighted Average Cost of Capital (WACC) = wd × rd(1 - T) + wps × rps + we × re: WACC is the discount rate used to evaluate investment opportunities. wd is the weight of debt, rd is the cost of debt, T is the tax rate, wps is the weight of preferred stock, rps is the cost of preferred stock, and we is the weight of equity, re is the cost of equity.

Step-by-Step Calculation

1. Calculate Operating Cash Flow (OCF):
   • Start with EBIT
   • Add depreciation
   • Subtract taxes
   • Subtract change in working capital
2. Calculate Investing Cash Flow (ICF):
   • Calculate capital expenditures
   • Subtract proceeds from sale of assets
3. Calculate Financing Cash Flow (FCF):
   • Calculate net borrowings
   • Subtract dividends
   • Subtract repurchase of shares
4. Calculate Free Cash Flow (FCF):
   • Calculate OCF
   • Subtract capital expenditures
5. Calculate Sustainable Growth Rate (SGR):
   • Calculate ROE
   • Calculate retention ratio
   • Multiply ROE by (1 - retention ratio)

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC, as it reflects the current market price of the company's securities.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the WACC calculation, as they represent the costs of issuing new securities.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Sunk cost is a cost that has already been incurred, while opportunity cost is the cost of choosing one option over another.

Exam / CFA Tips

• Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
• Tip: Understand the difference between IRR and NPV ranking.
• Tip: Be able to explain the concept of dividend irrelevance and bird-in-hand.

Quick Practice Problem

A company has EBIT of $10M, interest of $2M, tax rate of 25%, and change in working capital of $3M. Calculate Operating Cash Flow (OCF).

Answer: $10M + $0 (depreciation) - $2.5M (taxes) - $3M (change in working capital) = $4.5M

Last-Minute Cram Sheet

• Operating Cash Flow (OCF) = EBIT + Depreciation - Taxes - Change in Working Capital
• Investing Cash Flow (ICF) = Capital Expenditures - Proceeds from Sale of Assets
• Financing Cash Flow (FCF) = Net Borrowings - Dividends - Repurchase of Shares
• Free Cash Flow (FCF) = OCF - Capital Expenditures
• Sustainable Growth Rate (SGR) = ROE x (1 - Retention Ratio)
• Weighted Average Cost of Capital (WACC) = wd × rd(1 - T) + wps × rps + we × re
• Degree of Operating Leverage (DOL) = (Q(P - V) / (Q(P - V) - F))
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield
• WACC is the discount rate used to evaluate investment opportunities
• SGR measures a company's ability to sustain its growth rate over time