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Subject 3. Cash Flow Statement Analysis PDF Download
Evaluation of the Sources and Uses of Cash

Analysts should assess the sources and uses of cash between the three main categories and investigate what factors drive the change of cash flow within each category. For example, if operating cash flow is growing, does that indicate success as the result of increasing sales or expense reductions? Are working capital investments increasing or decreasing? Is the company dependent on external financing? Answers to questions like these are critical for analysts and can help form a foundation for evaluating the financial health of an industry or company.

Please refer to the textbook for specific examples.

Common-Size Analysis of the Statement of Cash Flows

This topic will be discussed in detail in Reading 26 [Financial Analysis Techniques].

Free Cash Flow to the Firm and Free Cash Flow to Equity

From an analyst's point of view, cash flows from operation activities have two major drawbacks:

  • CFO does not include charges for the use of long-lived assets. Recall that depreciation is added back to net income in arriving at CFO.
  • CFO does not include cash outlays for replacing old equipment.

Free Cash Flow (FCF) is intended to measure the cash available to a company for discretionary uses after making all required cash outlays. It accounts for capital expenditures and dividend payments, which are essential to the ongoing nature of the business.

The basic definition is cash from operations less the amount of capital expenditures required to maintain the company's present productive capacity.

Free cash flow = CFO - capital expenditure

Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

  • NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends.
  • NCC: Net non-cash charges. These represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies.
  • Int (1 - Tax rate): After-tax interest expense. Add this back to net income because:

    • FCFF is the cash flow available for distribution among all suppliers of capital, including debt-holders, and
    • Interest expense net of the related tax savings was deducted in arriving at net income.

    The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis.
  • FCInv: Investment in fixed capital. It equals capital expenditures for PP&E minus sales of fixed assets.
  • WCInv: Investment in working capital. It equals the increase in short-term operating assets net of operating liabilities.


Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):

  • Net income: $250
  • Interest expense: $50
  • Depreciation: $130
  • Investment in working capital: $20
  • Investment in fixed capital: $100
  • Tax rate: 30%
  • Net borrowing: $180
  • Proust has launched a new product in the market. It has capitalized $200 as an intangible asset out of a product launch expense of $240.
  • During the year, Proust has written down restructuring non-cash charges amounting to $30.
  • The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.


NCC = Depreciation + non-cash restructuring charges - Cash expenses during the year in which they are capitalized = 130 + 30 - 200 = -$40 million

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv = 250 + (-40) + 50 (1 - 0.3) - 20 - 100 = $125 million

FCFF can also be computed from cash flow from operating activities (CFO).

FCFF = CFO + Int (1 - Tax rate) - FCInv

The convenience of this approach to calculation of FCFF is that CFO is already adjusted for non-cash charges and changes in working capital accounts.


Uwe is doing a valuation of TechnoSchaft for fiscal year 2004, using the following information (in millions).

  • CFO: $250
  • Depreciation: $80
  • Interest expense: $50
  • Tax rate: 30%
  • Investment in working capital: $60
  • Investment in fixed capital: $240
  • Net borrowing: $180

Calculate the FCFF for the company for the year.


FCFF = CFO + Int (1 - tax rate) - Investment in fixed capital = 250 + 50 (1 - 0.3) - 240 = $45 million

As CFO is given, information on WCInv and non-cash charges is not required.

Free Cash Flow to Equity (FCFE): Cash available to stockholders after payments to and inflows from bondholders. This is the cash flow from operations net of capital expenditures and debt payments (including both interest and repayment of principal).

FCFE = FCFF + Net borrowing - Int ( 1- Tax rate)

FCFE can be calculated from net income. Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv. Then:

FCFE = NI + NCC + Net borrowing - FCInv - WCInv

FCFE can be calculated from CFO.

FCFE = CFO + Net borrowing - FCInv

This is different from the formula given in the textbook since net debt repayment should be included in net borrowing!

Cash Flow Ratios

The cash flow statement may also be used in financial ratios measuring a company's profitability, performance, and financial strength.

Performance Ratios

  • Cash flow to revenue = CFO / Net revenue: cash generated per dollar of revenue.
  • Cash return on assets = CFO / Average total assets: cash generated from all resources.
  • Cash return on equity = CFO / average shareholders' equity: cash generated from owner resources.
  • Cash to income = CFO / Operating income: cash-generating ability of operations.
  • Cash flow per share = (CFO - Preferred dividends) / number of common shares outstanding: operating cash flow on a per-share basis.

Coverage Ratios

  • Debt coverage = CFO / Total debt: financial risk and financial leverage.
  • Interest coverage = (CFO + Interest Paid + Taxes paid) / Interest paid: ability to meet interest obligations.
  • Reinvestment = CFO / Cash paid for long-term assets: ability to acquire assets with operating cash flows.
  • Debt payment = CFO / Cash paid for long-term debt repayment: ability to pay debt with operating cash flows.
  • Dividend payment: CFO / Dividends paid: ability to pay dividends with operating cash flows.
  • Investing and financing: CFO / Cash outflows for investing and financing activities: ability to acquire assets, pay debts, and make distributions to owners.

Learning Outcome Statements

h. analyze and interpret both reported and common-size cash flow statements;

i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

CFA® Level I Curriculum, 2020, Volume 3, Reading 23

User Contributed Comments 19

User Comment
wundac CFO is already adjusted for non-cash charges and changes in working capital accounts: CFO = NI + NCC - WCInv
uformula how does CFO not measure equipment replacement? Wouldn't it count as an investment activity as a purchase? or an operating activity for COGS as a labor cost?
thammy Precisely what u said (uformula), investment cost for the new equipment goes under CFI not CFO.
nayagan do we really need to know all these formulas?
soorajiyer @nayagan - Yes, according to some folks, this is heavily tested.
omya Free Cash Flows = CFO - Capital Expenditure.
Free Cash Flow to firm (Equity and Bondholders) = NI + Non cash expenses + Interest(1-t) - WC Exp - FC exp.
FCFF = CFO + Interest(1-t) - FC Exp.
Free Cash Flow to Equity = FCFF + Net borrowing - Interest(1-t).
Free Cash Flow to Equity = NI + NCC - WC -FC +Net Borrowings.
Saxonomy LOL @ these formulas. These people think I have all day???
leloupsolitaire I hate the idea of memorizing all these formula
oneashok Interest Coverage=CFO+Interest Paid+Tax Paid/Interest Outflow.
CFO already has accounted for Interest and Tax paid. Why do we add it again in numerator.?
majesty The formulas are easy as they are pretty logical.
ybavly @oneashok - we are looking for the percentage of operating income that will go to cover interest.
Excluding interest from the equation will show how much of income after interest will cover interest... this is incorrect.
--we want to know how much of total income will cover interest--
moneyguy The memorization part of studying for this exam is very frustrating. In the real world we will have access to these. Even if all equations were provided, it would still be a scary test. Knowing how to use them is really the important part in my opinion.
johntan1979 Just for fun:
FCFF = CFO + Int(1-t) - InvFC
and InvFC = CAPEX - sale of fixed asset

FCFF = FCF + Int(1-t) + sale of fixed asset
Shaan23 John -- Was that fun?
something Interest Coverage = EBIT/Interest paid. So how come EBIT translates to CFO + Interest paid + Taxes Paid? I thought EBIT is NI + int paid + T paid... Where am I missing..
fobucina Can't FCFF also be stated as --> NOPAT (EBIT * 1-T) + NCC - Net CAPEX - WCInv ??
etrefemme I think practicing with problems helps memorize the formula. The real challenge is "storing" in all this info as you progress into the curriculum. How much "going back to previous readings" can we do as the test nears. Any suggestions?
khalifa92 the treatment of working capital in both direct and indirect are typically the same which makes the rest of the work easier.
pigletin there will only be one question on this section, if any. not worth my time.
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