Financial Statement Analysis — Cash Flow Analysis: Operating Cash Flow, Free Cash Flow and Activity Patterns
Profit is a number shaped by estimates and judgement, but cash is hard to manipulate. Cash flow analysis asks whether profit is backed by real cash and whether the company can fund its investment and dividends on its own. How the statement of cash flows is prepared was covered in Intermediate Accounting chapter 18 (unit: ₩100 million).
1. FA’s statement of cash flows
FA’s depreciation for 20X2 is 60, there were no disposals of property, plant and equipment, and the only changes in equity are net profit and dividends.
| Section | Item | Amount |
|---|---|---|
| Operating activities | Net profit | 96 |
| Depreciation | +60 | |
| Increase in receivables | −30 | |
| Increase in inventories | −40 | |
| Increase in payables | +20 | |
| Cash flow from operating activities | 106 | |
| Investing activities | Purchase of PP&E (600 − 580 + 60) | −80 |
| Financing activities | Short-term borrowing +10, long-term borrowing +20 | +30 |
| Dividends paid (450 + 96 − 500) | −46 | |
| Cash flow from financing activities | −16 | |
| Increase in cash | +10 |
Opening cash of 40 rises by 10 to closing cash of 50. Purchases of PP&E and dividends were worked back from account analysis.
2. Operating cash flow and net profit
Operating cash flow of ₩10.6 billion is a little larger than net profit of ₩9.6 billion, about 110% of it, and equals 53% of current liabilities of ₩20 billion. Depreciation of ₩6 billion was added back, but ₩5 billion went into working capital. A company whose sales are growing fast tends to see operating cash flow fall below net profit as working capital builds up. If the ratio of operating cash flow to net profit falls well below 1 year after year, question the quality of earnings (chapter 6).
3. Free cash flow
FA paid dividends of ₩4.6 billion, more than its FCF of ₩2.6 billion, and covered the ₩2 billion shortfall with ₩3 billion of borrowing, so cash rose by ₩1 billion. It is increasing debt to keep paying dividends while continuing growth investment. If such years continue, the debt ratio will rise.
In valuation, free cash flow to the firm (FCFF), before interest and borrowing, is distinguished from free cash flow to equity (FCFE), after the creditors’ share. FCFE is roughly FCF + net borrowing = (interest is already reflected in operating cash flow).
4. Sign patterns of the three activities
| Operating | Investing | Financing | Interpretation |
|---|---|---|---|
| + | − | − | Mature: invests with money earned from operations and repays debt or pays dividends |
| + | − | + | Growth: raises outside funds on top of operating cash to invest |
| − | − | + | Start-up or crisis: covers operating losses and investment with outside funds |
| − | + | +/− | Decline or restructuring: sells assets to cover operating losses |
FA shows the mature pattern — operating +, investing −, financing − — but within financing activities, borrowing rose while dividends went out. Look at the composition, not just the signs.
Check your understanding
FE’s net profit is ₩20 billion and depreciation ₩12 billion. Receivables rose by ₩8 billion and inventories by ₩6 billion, and payables fell by ₩1 billion. Capital expenditure is ₩25 billion, dividends ₩5 billion and the net increase in borrowing ₩6 billion. What are operating cash flow, FCF and the change in cash?
Operating cash flow is (₩17 billion). FCF is (−₩8 billion). The change in cash is (−₩7 billion). Profit is ₩20 billion, but FCF is negative, and dividends and investment are being funded by borrowing and existing cash.
References
- Krishna Palepu, Paul Healy and Erik Peek, Business Analysis and Valuation: IFRS Edition, ch. 5
- Stephen Penman, Financial Statement Analysis and Security Valuation, ch. 10
- Korea Accounting Standards Board, K-IFRS 1007 Statement of Cash Flows
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