Measuring Cash Flows

Earnings
• Updated earnings
• Correcting Earnings Misclassification
• Operating Expenses
• Capital Expenses
• Neither financial nor capital expenses should be included in operating
expenses
• Capital expenses may be depreciated or amortized over the period
that the firm obtains benefits from the expenses
• NI is revenues less both operating and financial expenses and should
not deduct capital expenses
Can accounting measures be misleading?
• Yes because operating, capital and financial expenses are
misclassified
• One major misclassification till last year
• Inclusion of financial expenses like operating leases in operating
expenses
• This affected only operating income but not net income.
Operating Leases
• Operating leases till recently were not required to be shown as an asset or
liability on the balance sheet
• Lease are recorded as an expense on Income statement and future lease
commitments are recorded in notes to the financial statements
• The Ministry of Corporate Affairs (MCA) has announced that a new lease
accounting standard, IndAS 116 has been implemented from 1st April
2019.
• The new Standard, globally implemented in several countries from 1st Jan
2019, is called IFRS 16.
• The Standard eliminates the 6-decade old distinction between financial and
operating leases, from lessee accounting perspective, thereby putting all
leases on the balance sheet.
Example

• If A takes Aircraft-1 on lease and owns Aircraft-2, A can either include

both of them in PPE or can show Aircraft-2 in PPE and Aircraft-1 just
below PPE under the head Right of Use (ROU)
• Correspondingly, a lease liability will be disclosed separately,
• Or disclose in item which includes lease liability.
Implementation of Standard Ind AS 116
• Currently, there are two accounting standards for lease transactions, first, Ind AS 17, which is applicable to
the Ind AS compliant companies and second, AS 19, which is applicable to the remaining classes of
companies.
• Ind AS 116 will replace Ind AS 17, therefore, the companies which are not covered by Ind AS will continue to
follow old accounting standard.
• The applicability of this standard will be examined separately for the lessor and the lessee, that is, if the
lessor is Ind AS compliant and lessee is not Ind AS compliant, then lessor will follow Ind AS 116 whereas
lessee will follow AS 19.
• The new standard changes treatment of operating leases in the books of the lessees significantly. Earlier,
operating leases remained completely off the balance sheet of the lessee, however, vide this standard,
lessees will have to recognise a right-to-use asset on their balance sheet and correspondingly a lease liability
will be created in the liability side.
• Lease of low value assets and short tenure leases (up to 12 months) have been carved out from the
requirement of recognition of RTU asset in the books of the lessee.

• No change in the accounting treatment in case of financial leases.

• No change in the lessor’s accounting.
• Major impact on lessee
• Eliminates the classification of financial and operating leases as
required by Ind AS 17
• Introduction of single on balance sheet accounting model that is
similar to current finance lease accounting model
• Operating leases on balance sheet as if entity has borrowed funds to
purchase an asset
• Lessee will create a ROU asset and a lease liablility representing its
obligation to make lease payment
Impact on Financial Statements
Balance sheet
Will be more asset rich
And
More heavily indebted
Income Statement
Lease expense = Depreciation + Interest
Will affect key financial metrics such as EBIT, Tax, EBITDA, asset
turnover ratio, interest coverage ratio,
Dealing with operating leases
• As leasing are alternative to borrowing and present value of operating
leases should be included in the firm’s total outstanding debt
• Future lease payments should be discounted to the present at the firm’s
pre-tax cost of debt
• Operating lease expense must be added to EBIT as now it is a financial
expense rather than operating expense and EBIT represents only operating
income
• Lease expense has two components- interest and depreciation
• An estimate of depreciation of lease asset must be subtracted from EBIT
• EBIT ADJ = EBIT + OLE – DEPOL
Operating Leases
• As a speciality retailer, Target leases a substantial number of its stores, with the
leases being treated as operating leases. For the most recent financial year, Target
had operating lease expenses of $240 million. Target has pretax cost of debt of
5.5%. Target has conventional interest bearing debt of $9,538 million and
operating income of $3,601 million. Calculate adjusted debt and operating
income for the firm. The following table presents the operating lease
commitments beyond that point in time
Year Commitment
($miilion)
1 146
2 142
3 137
4 117
5 102
6 and beyond 2,405
Adjustments to income
• Operating income should reflect continuing operations and should
not include any item that are one time or extraordinary
Extraordinary, Recurring and Unusual Items
• One-time expenses or income that is truly one-time
• Expenses and income that do not occur every year but seem to recur
at regular intervals
• Expenses and income that recur every year but with considerable
volatility
• Items that recur every year that changes sign
Tax rate
• Blended Tax rates
Reinvestment Needs
• Capex
• Normalize
• Acquisitions
• Normalize
 Investment in Working Capital
• Calculate investment in Working capital
20X1 20X0s
Cash 2,245 708
Accounts receivable 5,069 4,621
Inventory 5,384 4,531
Other Current Assets 1,224 1,000
Current Assets of Discontinued Operations 0 2,092
Total Current Assets 13,922 12,952
Accounts Payable 5,779 4,596
Accrued Liabilities 1,633 1,288
Income Taxes Payable 304 382
Current Portion of Long term Debt 504 863
Current Liabilities of Discontinued Operations 0 825
Total Current Liabilities 8,220 8,314
Working Capital 5,702 4,638
Investment in Working Capital
• What all should be included?
• Cash should not be included as it earns lower than ROE/ROC
• Interest bearing dent should be excluded as it is part of WACC
Working Capital Investments
• We generally compute , the working capital by subtracting current
liabilities ( accounts payables, short term debt and debt due with in
one year) from current assets (inventory, cash and accounts
receivables)
• From cash flow perspective it is the difference between non cash
current assets (inventory and accounts receivable) and non debt
current liabilities (accounts payable)
• Any investment in this measure of Working capital ties up cash.
Therefore, any increases (decreases) in working capital will reduce
(increase) cash flows in that period
Leverage, FCFE and Value
In a discounted cash flow model, increasing the debt/equity ratio will
generally increase the expected free cash flows to equity investors over
future time periods and also the cost of equity applied in discounting these
cash flows. Which of the following statements relating leverage to value
would you subscribe to?
• Increasing leverage will increase value because the cash flow effects will
dominate the discount rate effects
• Increasing leverage will decrease value because the risk effect will be
greater than the cash flow effects
• Increasing leverage will not affect value because the risk effect will exactly
offset the cash flow effect
• Any of the above, depending upon what company you are looking at and
where it is in terms of current leverage