Chapter 4

MEASURING CASH
FLOWS

Hawawini & Viallet Chapter 4 1

Background
 Management’s ability to make decisions
that generate cash over time is essential
to a firm’s long-term survival
 Because the firm’s suppliers, bankers, and
the tax authorities require payments in cash,
not profits
 This chapter presents a framework for
analyzing cash flows and their relation to
business decisions

Hawawini & Viallet Chapter 4

2
Background
 After reading this chapter, students should
understand:
 The relationship between cash and cash flows
 The relationship between profit and cash flows
 How business decisions affect cash flows
 How to use a firm’s balance sheets and income
statements to calculate the cash flows generated by
the firm’s operating, investing and financing activities
 How to prepare and interpret a cash flow statement

Hawawini & Viallet Chapter 4

3
Cash Flows And Their Sources
 Total net cash flow
 Difference between the firm’s cash inflows
and outflows
• Equal to the change in the firm’s cash position
during a period of time
 A firm’s cash position changes as a result
of decisions related to its operating,
investment, and financing activities

Hawawini & Viallet Chapter 4

4
 EXHIBIT 4.1a:
OS Distributors’ Balance Sheets.
Figures in millions of dollars

DEC. 31, 1998 DEC. 31, 1999 DEC. 31, 2000

ASSETS
CURRENT ASSETS $104.0 $119.0 $137.0
Cash $6.0 $12.0 $8.0
Accounts receivable 44.0 48.0 56.0
Inventories 52.0 57.0 72.0
Prepaid expenses 2.0 2.0 1.0

NONCURRENT ASSETS 56.0 51.0 53.0

Financial assets & intangibles 0.0 0.0 0.0
Property, plant, & equip. (net) 56.0 51.0 53.0
Gross value $90.0 $90.0 $93.0
Accumulated depreciation (34.0) (39.0) (40.0)

TOTAL ASSETS $160.0 $170.0 $190.0

Hawawini & Viallet Chapter 4
5
 EXHIBIT 4.1b:
OS Distributors’ Balance Sheets.
Figures in millions of dollars

DEC. 31, 1998 DEC. 31, 1999 DEC. 31, 2000

LIABILITIES AND
OWNERS’ EQUITY
CURRENT LIABILITIES $54.0 $66.0 $75.0
Short-term debt $15.0 $22.0 $23.0
Owed to banks $7.0 $14.0 $15.0
Current portion of 8.0 8.0 8.0
long-term debt
Accounts payable 37.0 40.0 48.0
Accrued expenses 2.0 4.0 4.0
NONCURRENT LIABILITIES 42.0 34.0 38.0
Long-term debt 42.0 34.0 38.0
Owners’ equity 64.0 64.0 70.0 70.0 77.0 77.0
TOTAL LIABILITIES AND
$160.0 $170.0 $190.0
OWNERS’ EQUITY

Hawawini & Viallet Chapter 4

6
EXHIBIT 4.2:
Sources of Cash Inflow and Cash Outflow.
Amounts are OS Distributors’ cash flows in millions of dollars in 2000

Exhibit 4.2 shows typical

transactions associated with each of
these activities for the case of OS
Distributors during 2000.

Hawawini & Viallet Chapter 4

7
EXHIBIT 4.3:
OS Distributors’ Preliminary Cash Flow
Statement for 2000.
Figures in millions of dollars

 CASH ON JANUARY 1, 2000 $12

Net operating cash flow (NOCF) $11.2

+ Net cash flow from investment decisions ($10.0)
+ Net cash flow from financing decisions ($5.2)
Total net cash flow for year 2000 ($4)

CASH ON DECEMBER 31, 2000 $8

1Cash on January 1, 2000, is the same as cash on December 31, 1999. See balance sheets in
Exhibit 4.1.

Exhibit 4.3 contains a preliminary

cash flow statement for OS
Distributors for 1997 using the
information in Exhibit 4.2.
Hawawini & Viallet Chapter 4
8
EXHIBIT 4.4:
OS Distributors’ Income Statements.
Figures in millions of dollars

1998 1999 2000

Net Sales $390.0 $420.0 $480.0
Cost of goods sold ($328.0) ($353.0) ($400.0)
Gross profit 62.0 67.0 80.0
Selling, general, & administrative expenses (39.8) (43.7) (48.0)
Depreciation expenses (5.0) (5.0) (8.0)
Operating profit 17.2 18.3 24.0
Extraordinary items 0 0 0
Earnings before interest & tax (EBIT) 17.2 18.3 24.0
Net interest expenses (5.5) (5.0) (7.0)
Earnings before tax (EBT) 11.7 13.3 17.0
Income tax expense (4.7) (5.3) (6.8)
Earnings after tax (EAT) $7.0 $8.0 $10.2
Dividends $2.0 $2.0 $3.2
Retained earnings $5.0 $6.0 $7.0
Hawawini & Viallet Chapter 4
9
Preparing a Detailed Cash Flow
Statement
 Net cash flow from operating activities
 Sources of operating cash flows
• Operating revenues
• However, an increase in revenues does not necessarily
imply a corresponding cash inflow because cash comes
in only when the customer pays
• Expenses
• Likewise, an increase in expenses does not necessarily
imply a corresponding cash outflow because expenses
are recorded only when they generate revenues, not
when they are paid

Hawawini & Viallet Chapter 4

10
 Preparing a Detailed Cash Flow
Statement
 Procedure for estimating operating cash flows
consists of reconciling the dollar amount of an
income statement account with the change in the
corresponding balance sheet account
• Balance sheet accounts used for the adjustments are
exclusively those related to the firm’s operating cycle (i.e.,
comprising the firm’s working capital requirement)
Increases in
WCR  Formulas required to calculate net operating cash
represent
amounts of
flow (NOCF)
cash the firm • NOCF = Sales – COGS – SG&A expenses – Tax expenses
has used to
finance the
- WCR
growth of its • EBIT + Depreciation expenses = Sales – COGS – SG&A
investment
in expenses
operations.

Hawawini & Viallet Chapter 4

11
Preparing a Detailed Cash Flow
Statement
 Net cash flow from investing activities
 Net cash flow from Assets
 Sum of the net cash flows from operating and
investment activities (AKA: free cash flow)
• Measure of the net cash flow generated by the firm’s
invested capital or net assets
• Remaining portion of a firm’s net cash flow is the cash flow
from its financing activities
 Net cash flow from financing activities
 Net cash flow from financing activities corresponds
to the capital employed shown in the managerial
balance sheet (See Exhibit 4.6)
Hawawini & Viallet Chapter 4
12
EXHIBIT 4.5a:
OS Distributors’ Cash Flow Statements.
Figures in millions of dollars

1999 2000
CASH FLOWS FROM OPERATING ACTIVITIES

(+) Net sales $420.0 $480.0

(–) Cost of goods sold (353.0) (400.0)
(–) Selling, general, & administrative expenses1 (43.7) (48.0)
(–) Tax expenses (5.3) (6.8)
(–) Change in working capital requirement (4.0) (14.0)
A. NET OPERATING CASH FLOW (NOCF) $14.0 $11.2

• CASH FLOWS FROM INVESTING ACTIVITIES

(–) Sale of fixed assets 0 2.0

(–) Capital expenditures and acquisitions 0 (12.0)
B. NET CASH FLOW FROM INVESTING ACTIVITIES $0 ($10.0)
1 Excluding depreciation expenses

Hawawini & Viallet Chapter 4

13
EXHIBIT 4.5b:
OS Distributors’ Cash Flow Statements.
Figures in millions of dollars

1999 2000
CASH FLOWS FROM FINANCING ACTIVITIES

(+) Increase in long-term borrowings 0 12.0

(+) Increase in short-term borrowings 7.0 1.0
(–) Long-term debt repaid (8.0) (8.0)
(–) Interest payment (5.0) (7.0)
(–) Dividend payment (2.0) (3.2)
C. NET CASH FLOW FROM FINANCING ACTIVITIES ($8.0) ($5.2)

D. TOTAL NET CASH FLOW (A + B + C) $6.0 ($4.0)

E. OPENING CASH $6.0 $12.0
F. CLOSING CASH (E + D) $12.0 $8.0

Hawawini & Viallet Chapter 4

14
The Cash Flow Statement
 Firm’s total net cash flow must be equal to
the firm’s change in its cash position
during the period
 Cash flow statement reconciles the firm’s
cash flows with the change in the cash
position and tells how and why the firm’s
cash position has changed

Hawawini & Viallet Chapter 4

15
Two Variations Of The Cash
Flow Statement
 Nondiscretionary versus discretionary cash flows
 For internal purposes, some firms prefer to classify the cash
flows from investing and financing activities as cash flows they
cannot control and cash flows they can control
 Nondiscretionary cash flows
 Cash outflows that the firm is legally obligated to meet
 Discretionary cash flows
 Cash flow available for strategic investment decisions and
strategic financing decisions after the firm’s financial obligations
are met

Hawawini & Viallet Chapter 4

16
EXHIBIT 4.7a:
OS Distributors’ Cash Flow Statements:
Nondiscretionary Versus Discretionary Cash Flows.
Figures in millions of dollars

1999 2000
CASH FLOWS FROM OPERATING ACTIVITIES
(–) Net sales $420.0 $480.0
(–) Cost of goods sold (353.0) (400.0)
(–) Selling, general, & administrative expenses1 (43.7) (48.0)
(–) Tax expenses (5.3) (6.8)
(–) Change in working capital requirement (4.0) (14.0)
A. NET OPERATING CASH FLOW (NOCF) $14.0 $11.2
NONDISCRETIONARY CASH FLOWS
(–) Long-term debt repaid (8.0) (8.0)
(–) Interest payment (5.0) (7.0)
B. NONDISCRETIONARY NET CASH FLOW ($13.0) ($15.0)
C. CASH FLOW AVAILABLE FOR
STRATEGIC DECSIONS (A + B) $1.0 ($3.8)
1 Excluding depreciation expenses
Hawawini & Viallet Chapter 4
17
EXHIBIT 4.7b:
OS Distributors’ Cash Flow Statements:
Nondiscretionary Versus Discretionary Cash Flows.
Figures in millions of dollars

1999 2000
DISCRETIONARY CASH FLOWS
(+) Increase in long-term borrowings 0 12.0
(+) Increase in short-term borrowings 7.0 1.0
(+) Sale of fixed assets 0 2.0
(–) Capital expenditures and acquisitions 0 (12.0)
(–) Dividend payment (2.0) (3.2)
D. DISCRETIONARY NET CASH FLOW $5.0 ($0.2)

E. TOTAL NET CASH FLOW (C + D) $6.0 ($4.0)

E. OPENING CASH $6.0 $12.0
F. CLOSING CASH (E + F) $12.0 $8.0

Hawawini & Viallet Chapter 4

18
The Statement Of Cash Flows
 Firms are required by the FASB to issue a
statement of cash flows
 However, the way cash flows are calculated
and the allocation of cash flows to the three
activities is somewhat different from those
reflected earlier in Exhibit 4.5
• Exhibit 4.8 provides OS Distributors’ statements
of cash flows for 1999 and 2000 prepared in
accordance with FASB 95

Hawawini & Viallet Chapter 4

19
The Statement Of Cash Flows
 Cash flows from operating activities
 The net cash flow from operating activities in the statement of
cash flows (Exhibit 4.8) is different from the net operating cash
flow (NOCF) in Exhibit 4.5 in that
• The statement of cash flows is created using the indirect method
• The firm’s interest expenses are part of operating, not financing,
activities according to the statement of cash flows
 Cash flows from investing and financing activities
 Differ from Exhibit 4.5 in that interest payments and interest
and dividends received from financial investments are included
by default in earnings after tax
• Thus are automatically included in the cash flows from operating
activities

Hawawini & Viallet Chapter 4

20
EXHIBIT 4.8a:
OS Distributors’ Statements of Cash Flow:
Financial Accounting Standards Board (FASB) 95.
Figures in millions of dollars

1999 2000
CASH FLOWS FROM OPERATING ACTIVITIES

(+) Earnings after tax $8.0 10.2

(+) Depreciation expenses 5.0 8.0
(–) Change in working capital requirement (4.0) (14.0)
A. NET CASH PROVIDED BY OPERATING ACTIVITIES $9.0 $4.2

CASH FLOWS FROM INVESTING ACTIVITIES

(+) Sale of fixed assets 0 2.0

(–) Capital expenditures and acquisitions 0 (12.0)
B. NET CASH FLOW FROM INVESTING ACTIVITIES $0 ($10.0)

Hawawini & Viallet Chapter 4

21
EXHIBIT 4.8b:
OS Distributors’ Statements of Cash Flow:
Financial Accounting Standards Board (FASB) 95.
Figures in millions of dollars

1999 2000
CASH FLOWS FROM FINANCING ACTIVITIES

(+) Increase in long-term borrowings 0 12.0

(+) Increase in short-term borrowings 7.0 1.0
(–) Long-term debt repaid (8.0) (8.0)
(–) Dividend payment (2.0) (3.2)
C. NET CASH FLOW FROM FINANCING ACTIVITIES ($3.0) $1.8

D. TOTAL NET CASH FLOW (A + B + C) $6.0 ($4.0)

E. OPENING POSITION $6.0 $12.0
F. CLOSING POSITION (E + D) $12.0 $8.0

Hawawini & Viallet Chapter 4

22
Bankers’ Cash Flow Versus Net
Operating Cash Flow
 Bankers’ cash flow or cash earnings
 Bankers’ cash flow = Earnings after tax (EAT) + Depreciation
expense
• Derived exclusively from income statement accounts ignoring any
balance sheet adjustments—is not really a measure of cash flow
 Bankers’ cash flow and net operating cash flow are
equivalent only when
 There is no variation in the firm’s WCR and
 Net interest expenses are zero
• The chance of both of these occurring is quite unlikely
 Bankers’ cash flow behaves like a profit measure
 Because it ignores changes in WCR

Hawawini & Viallet Chapter 4

23
Managerial Implications
 Net operating cash flow can be looked at as a
 Margin component less an investment component
• Where the margin component is sales minus the sum of
COGS, SG&A, and tax expenses and the investment
component is the change in WCR
 Firms should run and monitor their operating
activities on the basis of net operating cash flow
rather than margin
 Will encourage managers to widen the firm’s margin
without letting investment in operations grow too fast

Hawawini & Viallet Chapter 4

24
EXHIBIT 4.9:
Margin and Investment Components for OS
Distributors’ Net Operating Cash Flow.
PERCENT
1999 2000 CHANGE
Sales $420.0 $480.0 14.3%
less COGS (353.0) (400.0)
less SG&A expenses (43.7) (48.0)
less tax expenses (5.3) (6.8)
= margin component $18.0 $24.2 40%
Working capital requirement at
the beginning of the year $59.0 $63.0
less working capital requirement
at the end of the year 63.0 77.0
= investment component ($4.0) ($14.0) 250%

NOCF = Margin – Investment $14.0 $11.2 –20%

Exhibit 4.9 shows the two components of net operating cash flow for OS
Distributors and demonstrates that although the firm’s margin component increased
by 40 percent in 2000, its investment component grew much faster (by 250
percent) over the same period, which resulted in a decline in the firm’s net
operating cash flow of 20 percent.
Hawawini & Viallet Chapter 4
25