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LM05 Analyzing Statements of Cash Flows II 2025 Level I Notes © IFT. All rights reserved 1 LM05 Analyzing Statements of Cash Flows II 1. Introduction ........................................................................................................................................................... 2 2. Evaluating Sources and Uses of Cash ........................................................................................................... 2 3. Ratios and Common-Size Analysis ................................................................................................................ 2 4. Free Cash Flow Measures ................................................................................................................................. 3 5. Cash Flow Statement Analysis: Cash Flow Ratios ................................................................................... 4 Summary ...................................................................................................................................................................... 6 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM05 Analyzing Statements of Cash Flows II 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers the tools and techniques for analyzing the statement of cash flows such as:  Evaluating the sources and uses of cash  Common size analysis  Calculation of free cash flow measures  Cash flow ratios 2. Evaluating Sources and Uses of Cash Evaluation of the cash flow statement should involve the following:  Evaluate where the major sources and uses of cash flow are between operating, investing, and financing activities. Major sources of cash for a company can vary with its stage of growth. For example, for a mature company it is expected that operating activities are the primary source of cash flows. However, analysts must analyze whether operating cash flows are positive and cover capital expenditures for all companies.  Evaluate the primary determinants of operating cash flow. Analysts should compare operating cash flow with net income. If a company has large net income but poor operating cash flow, it may be a sign of poor earnings quality. In addition, analysts need to look at consistency of operating cash flows.  Evaluate the primary determinants of investing cash flow. This is useful for letting the analyst know how much is being invested for the future in property, plant, and equipment and how much is put aside in liquid investments.  Evaluate the primary determinants of financing cash flow. This helps understand if the company is raising capital or repaying capital and which capital sources are being used. 3. Ratios and Common-Size Analysis In common-size analysis of a company’s cash flow statement, there are two alternative approaches. In the first approach, we express each line item of cash inflow (outflow) as a percentage of total inflows (outflows). An example of a common-size cash flow statement using this approach is shown below for a fictitious company - K2 Corp. Inflows Actual % of Total Inflow Net cash provided by operating activities 3,200 80 % Sale of Equipment 800 20% Total 4,000 100% Outflows Actual % of Total Outflow
LM05 Analyzing Statements of Cash Flows II 2025 Level I Notes © IFT. All rights reserved 3 Purchase of equipment 1,500 36.58% Retirement of long-term debt 500 12.19% Retirement of common stock 325 7.9% Dividend payments 1,775 43.29% Total 4,100 100% Net increase (decrease) in cash (100) In the second approach, we express each line item as a percentage of revenue. An example of such a statement is shown below for K2 Corp. In this example, we have assumed total revenue is 10,000. Cash flow Actual % of Total Revenue Cash flow from operating activities Net Income 4,000 40% Depreciation expense 500 5% Increase in accounts receivable (500) (5%) Increase in inventory (1,000) (10%) Decrease in prepaid expenses 1,000 10% Increases in accounts payable 500 5% Increases in accrued liabilities 500 5% Net cash provided by operating activities 5,000 50% Cash flow from investing activities Cash received from sale of equipment 2,000 20% Cash paid for purchase of equipment (5,000) (50%) Net cash used for investing activities (3,000) (30%) Cash flow from financing activities Sale of bonds 1,000 10% Cash dividends (2,000) (20%) Net cash used for financing activities (1,000) (10%) Net increase in cash 1,000 10% The common-size cash flow statement makes it easier to see trends in cash flow rather than just looking at the total amount. The second approach is useful for the analyst in forecasting future cash flows. 4. Free Cash Flow Measures Free cash flow to firm (FCFF) is the cash flow available to all the suppliers of capital to a company after all operating expenses have been paid and necessary investments in working