Page 101 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2
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LOS 18.i: Describe indicators of cash flow quality –
READING 18: EVALUATING QUALITY OF FINANCIAL REPORTS
Operating cash flow (OCF) has the most direct impact on the
valuation of a company: MODULE 18.4: EVALUATING CASH FLOW QUALITY
• Early-stage startups have negative OCF and investing cash
flows, financed by cash flow from financing activities (e.g.,
equity issuance).
• For a mature firm, negative OCF coupled with positive
financing cash flow is usually problematic.
High-quality cash flow is positive OCF derived from sustainable sources and is adequate to cover: Capital expenditures, dividends, and debt repayments.
It is lower volatility than that of the firm’s peers. Significant differences between OCF and earnings can be an indicator of earnings manipulation.
Management can affect cash flows via strategic decisions (timing issues) (Slowing payments to suppliers, selling receivables, shift positive cash flows from
investing or financing activities into operating activities to boost OCF (classification issues).
LOS 18.j: Evaluate the cash flow quality of a company –Key steps!
1. Checking for any unusual items or items that have not shown up in prior years.
2. Checking revenue quality (Aggressive revenue recognition practices -increase in receivables, increase in inventories (and hence a cash
outflow) when sham sales are reversed (i.e., treated as returns from customers).
3. Checking for strategic provisioning: Provisions for restructuring charges show up as an inflow (i.e., a non-cash expense) in the year of the
provision and then as an outflow when ordinary operating expenses are channeled through such reserves.
Accounting standards afford some flexibility in the treatment of certain items in the statement of cash flows:
• Interest paid, interest received, and dividends received are treated as OCF under U.S. GAAP, but interest paid interest/dividend received can be
classified as either operating or financing cash flow under IFRS.
• Also, interest/dividend received can be classified as either operating or investing cash flow under IFRS.
LOS 18.k: Describe indicators of balance sheet quality.
LOS18.l: Evaluate the balance sheet quality of a company.
High-quality financial balance sheet reporting is evidenced by
• Completeness,
• unbiased measurement, and
• clarity of presentation.
