Reconciling Net Income to Cash Flow from Operating Activities, by adding Noncash charges, NWC... ? what about Indirect method?

CFA Level I FRA
#1

the Free Cash Flow to the Firm (FCFF) formulas are: (Schweser Book 3 LOS 27, or Curriculum Reading 27) FCFF = Net Income + Noncash Charges - Addition in Net Working Capital + Interest(1-tax) - Fixed capital investment or FCFF = OCF + Interest(1-tax) - Fixed capital investment which implies that OCF = Net Income + Noncash Charges - Addition in Net Working Capital (*) Meanwhile, the Indirect Method is like: OCF = Net Income - Gains from sale of fixed assets + Noncash charges - Increase in Account Receivables/Inventory… + Increase in Account Payable/Tax Payable/Wage Payable… How to reconcile

OCF = Net Income + Noncash Charges - Addition in Net Working Capital

= Net Income - Gains from sale of fixed assets + Noncash charges - Increase in Account Receivables/Inventory… + Increase in Account Payable/Tax Payable/Wage Payable…

#2

Dividends Payable is not a Working Captial account.

#3

Dividends Payable is under Current Liabilities. Changes in Net Working Capital will take this into account

#4

Let’s try this again: Dividends Payable is not a Working Capital account. It may be a current liability, but it is not part of working capital. Period.

Changes in Net Working Capital _ will not _ take it into account.

#5

Working Capital is Current Assets - Current Liabilities. That’s why I think changes in Dividend Payables will come into calculation. How could it not affect Changes to Net Working Capital?

#6

I’ll try this another way: if you include changes in Dividends Payable in your calculation of changes in Working Capital to compute CFO using the indirect method, you will get the wrong answer. If you get enough wrong answers – whether through ignorance, error, stubbornness, or whatever – you will fail the Level I CFA exam.

So, ask yourself whether it’s worth arguing about this at the risk of failing the exam.

No. When you use the indirect method to compute CFO you start with net income and reverse all non-cash items on the income statement, and all non-operations items on the income statement. The formula you gave above is simplified: it assumes that there are no non-operations items on the income statement.

#7

OK someone just told me gains/losses from sale of land falls under noncash charges, that is something I didn’t know.

No I don’t use Dividends Payable to calculate CFO if I use the Indirect Method, because I know paying dividends falls under Financing activities. I’m talking about the formula:

OCF = Net Income + Noncash Charges - Addition in Net Working Capital

I’m not arguing. I don’t understand a point in the book, which is most likely correct and credible. All I’m doing here is seeking an explanation why they put “Net Working Capital” when I think it is not because “Working Capital” automatically includes the cash and dividends payable account.

If, as you say, the formula above assumes that there’s no non-operating activities, meaning no dividends paid, then still, the cash account is there.

I have always calculating Changes in NWC by using a formula:

(Current Assets in current year - Current Liabilities in current year) - (Current Assets in previous year - Current Liabilities in previous year)

This formula is found in basically any source that shows how to calculate Changes in NWC.

#8

That someone is wrong. If you receive cash when you sell the land, then it is not a noncash charge. It is, however, a _ nonoperating transaction _, so the gain/loss must be removed from net income when computing CFO.

Once again, the simplified formula:

OCF = Net Income + Noncash Charges – Addition in Net Working Capital

assumes that there are no nonoperating items (e.g., gain/loss on sale of land, equipment, whatever) on the income statement.

One more time: Working Capital does not include Dividends Payable. It simply doesn’t. It doesn’t matter if it’s classified as a current liability, it isn’t part of Working Capital. You need to understand that. I keep telling you that it’s not part of Working Capital and you keep saying that it’s a current liability: that’s arguing.

#9

OK. I wish I had read a source that said Working Capital does not include Dividends Payable. But I did not see that anywhere, that’s why I posed the question.

It has always been this one single formula: Working Capital = Current Assets - Current Liabilities

http://www.investopedia.com/terms/w/workingcapital.asp

How do you define Working Capital by the way?

Anyway, assuming that there’s no dividends paid. Then there’s still the cash account, which is definitely a current asset and working capital. How could it get cancelled out from

OCF = Net Income + Noncash Charges – Addition in Net Working Capital?

Please stop trying to explain the Indirect method to me. I’m basically trying to reconcile

CFO = Net Income + Noncash Charges – Addition in Net Working Capital

to Net Income - Gains from sale of land + Noncash Charges – Increases in (Operating) assets accounts + Dncreases in (Operating) assets accounts

Since gains from sale also involves cash, if possible please help explain where has it gone under Net Income + Noncash Charges – Addition in Net Working Capital?

#10

You do have: I have written it several times in this very thread. That’s your source.

And that’s why I have answered that very question several times.

The usual way.

You’re not asking the correct question. How I define it doesn’t matter. What matters is how it is defined for the purposes of the formulae you’re using. I’ve tried to tell you how to define it for those formulae; you keep arguing with me.

The Net Working Capital to which this formula refers excludes Cash. Just as the formula for . . .

I’m just trying to help. If you’d rather just muddle through on your own, you’re welcome to do so.

You cannot reconcile those two, which is what I have been telling you. If you understand getting CFO using the indirect method – and you pointedly claim that you do – then you know that you have to remove nonoperating items from net income.

The formula:

CFO = Net Income + Noncash Charges – Addition in Net Working Capital

assumes that there are no nonoperating items in net income. (I’d swear that I’ve already said this somewhere.) If there are nonoperating items in net income – gains from the sale of land, losses from the sale of trucks, gains from the sale of a business segment, whatever – then this formula isn’t sufficient, because (pay attention here): it assumes that net income has none of these items.

It isn’t in there anywhere, because that formula assumes that there are no gains from sales of PP&E, no losses from sales of PP&E, no gains/losses from sales of business segments . . . in short, no nonoperating gains/losses included in Net Income.

#11

All you do in your first replies were just insisting that Dividends Payable is not a working capital, with no explanation at all. “That’s your source.”?? What is it? Because you - some strange person a forum, keep insisting that Dividends Payable is not working capital, which is the opposite to what professors and books mentioned… then I should believe it? That simply wasn’t any helpful or convincing so I kept asking Why…

You did not mention that you think this formula is insufficient/it assumes no operating activities… /Working Capital in this formula particularly excludes cash/

Then instead of keep saying Dividends Payable is not a working capital, you just should have said that you believe this formula assumes that there’s no dividends paid.

#12

I’ll leave it to you to figure out who I am.

Do whatever you like. I’ve tried to help you and you’re unwilling to accept it. Best of luck. It appears that you’re going to need it.

#13

Okay I’ll admit I didn’t read this whole thread, but Cara, take a step back and really understand what “working capital” is. NET WC does not include cash or dividends payable as S2000 stated in any formula. Why is that? Well, ask yourself what is the purpose of FCFF? Then think about net working capital as related to only the operations of a company. Is cash or dividends accounts part of the “operations” of a company? Investopedia is not the best source for information…

Search is your friend

http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91320951

I think a related question to S2000 would be: for calculating BS ratios such as current ratio, I believe you can just take CA/CL as given without having to worry about the line items (at least that’s what I did for L1)

Also, Cara, S2000 is THE man for help on this forum. So I’d read and understand before posting. Stay in his good graces. It’ll help you along the way!

#14

Hi callmenoobie, thanks for the link. The comments in the thread you posted do help a lot, at least for reference. If I had found and read through that thread, I probably wouldn’t have posted this enquiry. I do know that Investopedia and any online source are not always credible, but professors and all what I have learned in school have also never noted that Net WC may or may not include cash and dividends accounts.

And obviously I made an account here to post the question and seek help, but I meant to look for opinions that are explanative and convincing, not intrusive.

#15

There’s a reason you’re pursuing the charter, buddy – to hand it to your college professors who ignore the finer things in life :).

In all seriousness, you have to be careful about which dividend accounts are being talked about. Transactions between the company and its shareholders (through cash dividends) do not affect free cash flow. However, for e.g., dividends received from investments do impact FCF.

Taking it a step further, there are differences in how certain items are categorized under GAAP vs. IFRS. Based on the categorization, you have to adjust FCF accordingly. Dividends received from investments can be deemed an investing activity under IFRS (GAAP always deems it an operating activity). In this case, you’d have to explicitly add the dividends to your FCF calculation for IFRS. GAAP already accounted for this activity through NI since it says that dividends received are an operating activity.

Also, this is not required at L1, but preferred dividends issued** /redeemed** also impact FCF (more on this at L2). Overall, understand the I/S and then try to tie things to the CF/S. Maybe start with GAAP first and then think about some of the differences between IFRS/GAAP. I don’t think they would be evil enough to include such analysis on the L1 exam, but 20-30% of the exam is “very hard,” so you never know.

To keep things legible, digest what S2000 said earlier - dividends payable are not part of WC. It may be counterintuitive to what you learned elsewhere, but the CFA curriculum is the shit when it comes to the exams (and life in general).

If it helps, imagine S2000 in a teddy bear suit when reading his posts, and you won’t feel so violated. Doesn’t mean he’s always right, but he’s right 99.999999% of the time.

#16

That’s a good start; you’ll get a lot of good help here. But you’ll get it only if people want to help you; the way to get them to want to help you is to be polite, attentive, unargumentative, and, frankly, humble. Arrogance will get you no help from anyone here.

Ask yourself some questions:

  1. How many CFA exam have I (cara) passed?
  2. How many CFA exams has S2000magician passed?
  3. How many accounting degrees do I have?
  4. How many accounting degrees does S2000magician have?
  5. How many other degrees do I have?
  6. How many other degrees does S2000magician have?
  7. How many years have I taught review courses for the CFA exams?
  8. How many years has S2000magician taught review courses for the CFA exams?
  9. How many candidates have passed CFA exams because of my knowledge of the curriculum?
  10. How many candidates have passed CFA exams because of S2000magician’s knowledge of the curriculum?

You probably know the answers to half those questions. You can find the answers to the other half by following callmenoobie’s advice: Search is your friend.

You shouldn’t be looking for opinions; you should be looking for correct answers. If you want answers that are explanative, then you have to ask questions with explainable answers.

My first answer to you was: Dividends Payable is not a Working Captial account.

You didn’t seek an explanation for that answer. Your reply was an argument: Dividends Payable is under Current Liabilities. Changes in Net Working Capital will take this into account

I said that it isn’t; your reply was, “Yes, it is.” That’s argumentative.

The reason I didn’t explain further in my initial answer why Dividends Payable isn’t a Working Capital account is that there is no explanation; it’s simply a fact.

As for convincing . . . well . . . read the CFA curriculum. It is the final authority on everything. If your professors told you something that differs from the CFA curriculum, they’re wrong (as far as these exams go). If you’re unconvinced by an answer here, check it against the CFA curriculum, not your old professors, not wikipedia, not investopedia, not E-Trade’s glossary; the CFA curriculum is the only thing that matters.

If your feelings are so easily hurt, this isn’t the exam for you. But I guaranty you that you will find answers less intrusive (whatever that means) if you take to heart the first three sentences in this post.

#17

@carameow

i think ur from a non finance background and self study? i was from engineering & self study as well, and believe me FRA is the worst topic IMO for non finance/accounting people. its a topic that is not easy to understand and u just have to follow the rules, then out of nowhere, something new pops up and u have to make an exception. IFRS and GPRS, some european and US convention makes it worst. im so glad L3 has no FRA! anyhow, self study makes it worst, u do not have anyone on hand to ask. u just have to listen, read textbooks on ur own, come up with ur own reasoning and hope that is correct so that u can do the qn on exam day.

just take what S2000 said over here and learn to get the correct answers first - reason being ur exam is in 90 days or less, FRA is book 2 in Schweser(?), u got a lot of ground to cover. then u can talk about what accounts belong to what category when u know the material better. u cannot expect to be an accounting expert in just a few study sessions.

to add on and try to help, i remembered vaguely that

Current Liabilities (CL) is anything that is to be paid off in short term (a few months - <1yr),

and the accounts in that CL group is related to CFO, activities that relate to the operation of the company. Working Capital (WC) is related to how much nett assets is availiable currently. similarly Current Assets (CA) is stuff that can be liquidated quickly. u do not see buildings branded as CA, right?

perhaps the misleading part is naming it _ Dividends Payable _, u see PAYABLE --> its a liability --> need to pay off soon --> lets use it in the CA-CL = WC equation… [–> means leads to]. BIG DISCLAIMER: I AM/MAY BE WRONG! i already forgot my L3 stuff!

the common enemy is the CFA exam, lets not lose sight of that. people in AF are here to help, sometimes people may be wrong, u need to learn how to sieve through the info at times but there are a few regulars like S2000, jans, cpk123, etc that really know their stuff and helps out everyone around here. S2000 is a dick nice guy (hahaha, its a joke! im kidding!) he helped many of us in this pursuit of the CFA charter ( not joking, serious ). in level 1-3 forums in AF, u find him there. his turn around time of answering questions really helped me in L3. just let him help u and try not to get too irritated. i know for sure the studying for the exam made me very irritable, lets try to keep our cool =)

fight hard!

#18

…i was clicking around and got here…its a month long thread…guess im late…shucks