1. Explain why investors should use the statement of cash flows.
Cash flow is one of the most important measurements used by investors in valuing a company. You will hear the term used in the context of understanding how much a company is really growing (or not) after accounting conventions are stripped out of the income statement.
Cash flow measures the amount of cash that a company brings in and uses during the course of an accounting period (quarter or year) after all fixed expenses are eliminated.
This number is frequently called earnings before interest, taxes, depreciation and amortization (EBITDA).
The reason investors are interested in cash flow is that it gives them a clearer ...view middle of the document...
* Amortization – Amortization is the same as depreciation except for intangibles such as goodwill from the acquisition of a company. In this case, if the company paid more than the shareholder equity (a premium) the excess is goodwill and the company would amortize the cost.
It is important to note that both depreciation and amortization are non-cash items, that is they are expenses on paper only and do not involve any cash, yet they reduce the company’s net income on the books.
Companies that make heavy investments in capital equipment or buildings and real estate may have so much depreciation that they show very little if any in the way of earnings, yet may be generating strong cash flows.
How to Use
Cash flow is an important measurement and is best understood when you compare a company to its peers and to the market.
Fortunately, a number of Web sites make the calculations for you. One of the best is Reuters.com.
Enter the symbol of the company and go to the quote page. On the left side navigation, click on “ratios.” This will take you to a page of valuation ratios where you will find the cash flow ratio among others.
The company is compared to the industry as a whole, its particular sector and the S&P 500. You can readily see if where the market is pricing the stock.
Cash flow is just one measurement for evaluating a company, but it is important because it focuses on actual operations and eliminates one-time expenses and non-cash charges.
2. Distinguish among operating activities, investing activities, and financing activities?
The statement of cash flows classifies cash receipts and cash payments into operating, investing, and financing activities. Transactions within each activity are as follows:
* Operating activities include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. There are 2 types of flows inflows and outflows, cash inflows are from sales of goods or services, and from returns on loans (interest) and on equity securities (dividends), whereas cash outflows are to suppliers for inventories, to employees for services, to government for taxes, to lenders for interest, to others for expenses.
* Investing activities include (a) purchasing and disposing of investments and productive long-lived assets using cash and (b) lending money and collecting the loans. Cash inflows of investing activities are from sale of property, plant, and equipment, from sale of debt or equity securities of other entities, from collection of principal on loans to other entities. Cash outflows are to purchase property, plant and equipment, to purchase debt or equity securities of other entities, to make loans to other entities.
* Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from stockholders and paying those dividends. Cash inflows...