Reading: The Cash Flow Statement

Let us now turn to the firm's financing activities, that is, all the cash flows that go to and come from the providers of debt and equity. 

Debtholders have a contractual claim on regular interest payments as well as the repayment of the notional amount. Equityholders, in contrast, have a so-called residual claim, which means that they are only entitled to compensation after all other stakeholders have received their fair compensation. Because debt claims are senior to equity claims, it makes sense to first consider all cash flows related to debt financing.

Cash flows from debt financing

As we have just mentioned, there are typically two types of cash flows associated with debt: Interest payments and changes in the notional amount.

• Interest payments: Clearly, interest expenses reflect a cash outflow. Therefore, we have to subtract them from the free cash flow.  However, remember from before that the cash implications of interest expenses are two-fold: the actual interest payments to the bank and the tax savings the firm makes because interest expenses lower taxable income. To account for these two cash implications of interest expenses, we deduct the after-tax interest expenses from the free cash flow.

• Changes in the notional amount: A repayment of debt constitutes a cash outflow to the firm whereas additional borrowing is a cash inflow for the firm. The financial liabilities in the balance sheet tell us how much debt is outstanding. If financial liabilities decrease from one period to the next, this means that the firm pays back some of its debt (a cash outflow), whereas an increase in financial liabilities implies additional borrowing (a cash inflow).

In the case of firm X, the two components of debt financing are as follows:

• After-tax interest expenses of 400 (see our discussion of the income statement)

• Moreover, the balance sheet indicates that the firm's financial liabilities drop by 1'000 from 10'000 to 9'000. This implies that the firm repays 1'000 of its debt outstanding.

Therefore, the total cash outflow from debt financing is1'400.  Based on this information, we can now compute the so-called Residual cash flow. This is the amount of money which is available for distribution to the firm's equityholders:

The table shows a residual cash flow of 1'600 for Year 1. This is the amount of cash the firm has generated after all stakeholders except for the shareholders have received their fair compensation. In principle, this money could be paid out to the shareholders without affecting the firm's operating activities, investment policy, or debt financing policy.