Principal Finance 235 Chapter 2 (part 3 (cash flow identity…))

Introduction

This tutorial focuses on the cash flow identity discussed in Chapter 2 of Principal Finance 235. Understanding cash flow identities is crucial for financial analysis, helping you assess a company's financial health by analyzing how cash is generated and used.

Step 1: Understand the Cash Flow Identity

The cash flow identity is a fundamental concept in finance that states:

• Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash

Key Components:

• Cash Flow from Operations: Money generated from normal business operations.
• Cash Flow from Investing: Cash spent on or received from long-term assets (like equipment or investments).
• Cash Flow from Financing: Cash flows related to borrowing or repaying debt and equity financing.

Step 2: Calculate Each Component

To effectively use the cash flow identity, you must calculate each component accurately.

A. Calculate Cash Flow from Operations

1. Start with net income.
2. Adjust for non-cash items (such as depreciation).
3. Include changes in working capital (current assets - current liabilities).

Practical Tip:

• Use the indirect method for calculating cash flow from operations for simplicity.

B. Calculate Cash Flow from Investing

1. Identify cash spent on purchasing long-term assets.
2. Include cash received from the sale of assets.

Common Pitfall:

• Be careful not to mix operational cash flows with investing cash flows.

C. Calculate Cash Flow from Financing

1. Include cash received from issuing stocks or bonds.
2. Account for cash paid in dividends or loan repayments.

Step 3: Analyze Changes in Cash

After calculating all three components, sum them up to find the change in cash.

A. Review the Cash Flow Statement

• Ensure that the total change in cash from your calculations matches the change reported in the cash flow statement.

B. Assess Financial Health

• A positive cash flow indicates good financial health, while negative cash flow may signal potential issues.

Conclusion

Understanding and calculating the cash flow identity is essential for evaluating a company’s financial performance. By following these steps, you can effectively analyze how cash is generated and utilized within a business. For further learning, consider reviewing examples of cash flow statements from real companies to see these calculations in practice.