6. cash flow analysis

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Cash Flow Analysis

Financial Statement Analysis

Lecture 6


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Statement of Cash Flows

Cashflow refers to the current period cash inflows less cashoutflows

Cashflows are different from accrual income measures

Cashflow recognizes inflows when cash is received but notnecessarily earned

And recognizes outflows when cash is paid but expenses notnecessarily incurred

Statement of cashflows reports cashflow for three businessactivities

Information on cashflows helps us a companys ability to

Meet its obligations

Pay dividends

Incur capital expenditure

Raise financing

It also helps us to assess the quality of earnings


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Net cashflow is the end measure of profitability It is cash, not income, that ultimately repays loans,

replaces equipment, and pays dividends Analysis of cashflows helps in assessing

liquidity, solvency and financial flexibility Liquidity is the convertibility of assets into cash

Solvency is the ability to pay liabilities when theybecome due

Financial flexibility is the ability to react and adjust toopportunities and adversities

Relevance of Cash


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Statement of cash flows (SCF) helps addressquestions such as: How much cash is generated from or used in operations?What expenditures are made with cash from operations?

How are dividends paid when confronting an operating loss?

What is the source of cash for debt payments?

How is the increase in investments financed?

What is the source of cash for new plant assets?

Why is cash lower when income increased?

What is the use of cash received from new financing?

Relevance of Cash


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The SCF reports cash receipts and cash payments byoperating, financing, and investing activities:

Operating activities are the earning-related activities ofa company.

Operating activities relate to income statement items(with minor exceptions) and to balance sheet items

relating to operations usually working capital accounts Receivables, inventories, prepayments, payables and accruedexpenses

Reporting by Activities


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Investing activities are means of acquiring and disposingof noncash assets.

Involve assets expected to generate income; lending funds andcollecting the principal on these loans.

Financing activities are means of contributing,withdrawing, and servicing funds to support business

activities. Include borrowing and repaying funds with bonds and otherloans; contributions and withdrawals by owners and their returnon investment.

Reporting by Activities


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The cashflow statement is a blend of incomestatement and balance sheet

Indirect Method Net income is adjusted for non-cash income and

expense items to yield cash profits which are thenfurther adjusted for cash generated and used by

balance sheet transactions to yield cashflow fromoperations

Most commonly used method

Constructing the Cash Flow Statement


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Consider first the net cash from operations

Preparation of the SCF (Indirect method)


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Because the statement of cashflows focus oncashflows, we need to eliminate non-cash expensesthat are recognized in the computation of net

income

Preparation of the Statement of Cash Flows


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We also adjust net income for gains/losses on thesale of assets

The purpose of the adjustment is not to eliminatethese investment gains, but to move them out of theoperating section of the statement of cashflows

The cash inflows from the sale of assets are

reflected in net cashflow from investing activities



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The final adjustments involve analysis of cashgenerated and used by changes in current assets

and liabilities Adjustments for changes in balance sheet accounts

can be summarized as follows:



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Constructing the Statement

1. The company purchased a truck during

the year. Out of the total cost of thetruck, $30,000 was financed by themanufacturer.

2. A truck with a cost of $10,000 and a netbook value of $2,000 was sold duringthe year for $7,000. There were noother sales of depreciable assets.

3. Dividends paid during Year 2 are $51,000

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Steps in Constructing the Statement

(1) Start with Net Income

(2) Adjust Net Income for non-cash expenses and gains

(3) Recognize cash inflows (outflows) from changes in current assetsand liabilities

(4) Sum to yield net cash flows from operations

(5) Changes in long-term assets yield net cash flows from investingactivities

(6) Changes in long-term liabilities and equity accounts yield net cashflows from financing activities

(7) Sum cash flows from operations, investing, and financing activities toyield net change in cash

(8) Add net change in cash to the beginning cash balance to yieldending cash

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Analysis Implications of Cash Flows

Some limitations of the current reporting of cash flow: Practice does not require separate disclosure of cash flows

pertaining to either extraordinary items or discontinuedoperations.

Interest and dividends received and interest paid are classifiedas operating cash flows. Many users consider interest paid asfinancing outflow, and interest and dividends received as cash

inflows from investing activities

Limitations in Cash Flow Reporting

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Interpreting Cash Flows and Net Income

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An income statement records revenues when earned andexpenses when incurred.

It does not show the timing of cash inflows and outflows, northe effect of operations on liquidity and solvency.

This information is available in the SCF.

Cash flows from operations (CFO) is a broader view of operatingactivities than is net income. It encompasses not only revenuesand expenses but also the cash demands of these earning-relatedactivities

It is not a measure of profitability but focuses on the liquidityaspect of operations


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Accounting accruals determining net income rely onestimates, deferrals, allocations, and valuations

Element of subjectivity involved For this reason, we relate cashflows from operations to netincome in assessing its quality

Note: CFO effectively serve as a check on net income, but nota substitute for net income


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Analysis of Cash Flows

Our analysis of cashflows must establish the major pastsources of cash and their uses

In evaluating sources and uses of cash, the analystshould focus on questions like:Are asset replacements financed from internal or external

funds?

What are the financing sources of expansion and businessacquisitions?

Is the company dependent on external financing?What are the companys investing demands and opportunities?

What are the requirements and types of financing?

Are managerial policies (such as dividends) highly sensitive tocash flows?

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Analysis of Cash Flows of Campbell Soup

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Inferences from analysis of cash flows include:

Where management committed its resources

Where it reduced investments

Where additional cash was derived from

Where claims against the company were reduced

Disposition of earnings and the investment of discretionary cash flows

The size, composition, pattern, and stability of operating cash flows

Allows us to appraise the quality of managements decisions over time andtheir impact on the companys results and financial position

It can also yield insight into managements success in responding tochanging business conditions and their ability to seize opportunities andovercome adversities

Inferences from Analysis of Cash Flows

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We must also examine the components of operating cashflows,components often hold clues about the stability of cash sources

For example, increases in operating cashflows that result from the

securitization of accounts receivable or the reduction in inventories are notusually a reliable source of cash

Cash inflows from the continued reduction in receivables is limited

Similarly, reductions in inventory will adversely impact sales at somepoint

Increases in operating cashflows that arise from increases in currentliabilities also are not usually a sustainable source of cash inflow

For example, companies can defer the payments to suppliers(increase payables) to increase operating cashflow, but at some pointin time suppliers will respond by charging higher costs ordiscontinuing shipments

Inferences from Analysis of Cash Flows

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Net income plus depreciation and amortization is often

used as a crude proxy for operating cashflow EBITDA (earnings before interest, taxes, depreciation, andamortization)

The main issue with this measure is that ignoreschanges in working capital accounts that comprise the

remainder of net cash flows from operating activities. Yetchanges in working capital accounts often comprise alarge portion of cash flows from operating activities

Alternative Cash Flow Measures

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While both successful and unsuccessful companies can experienceproblems with cash flows from operations, the reasons are markedlydifferent

A successful company requiring increasing investments in receivablesand inventories to meet expanding customer demand often find itsgrowing profitability useful in obtaining additional financing from bothdebt and equity suppliers. This profitability ultimately yields positivecashflows

An unsuccessful company experiences cash shortages fromslowdown in receiavable and inventory turnover, or losses inoperations. The unsuccessful company can increase cashflows byreducing receivables and inventories but it wuill ultimately furtherdepress profits. Even if it borrows moneey to offset the decline inoperating cashflows, the costs of borrowing will only magnify the

ultimate losses

Company and Economic Conditions

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Therefore, we must interpret changes in operatingworking capital items in light of economic circumstances

For example, an increase in receivables can implyexpandding customer demand or it can signal aninability to collect amounts due in a timely fashion

Similarly, an increase in inventories can imply

anticipation of increase in customer demand or it cansignal an inability to sell products

Company and Economic Conditions

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Free Cash Flow

Cash available to the firm to distribute tocreditors and shareholders because it is not

needed for working capital or fixed assetinvestment

FCF = CFO CAPEX

FCF = NOPAT Change in NOA The increase in NOA includes the change in

working capital and the increase in long-termoperating assets

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Growth and financial flexibility depend on adequate free cash flow.

Recognize that the amount of capital expendituresneeded to maintain productive capacity is generallynot disclosedinstead, most use total capitalexpenditures, which is disclosed, but can includeoutlays for expansion of productive capacity.

Free Cash Flow

Positive free cash flow reflects the amount available for businessactivities after allowances for investing requirements to maintainproductive capacity at current levels.

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Specialized Cash Flow Ratios

Cash Flow Adequacy Ratio Measure of a companys ability togenerate sufficient cash from operations to cover capital expenditures,investments in inventories, and cash dividends:

Three-year sum of cash from operations

Three-year sum of expenditures, inventory additions, and cash dividends

Investment in receivables is omitted because they are financed primarily byshort-term credit (such as growth in accounts payable)

Also, in years where inventories decline, the downward change is treated aszero change in computing the ratio

A ratio of 1 indicates that the company exactly covered these cash needswithout a need for external financing

A ratio below 1 suggests internal cash sources were insufficient to maintaindividends and current operating growth levels

Cash Flow Adequacy Ratio Measure of a companys ability togenerate sufficient cash from operations to cover capital expenditures,investments in inventories, and cash dividends:

Three-year sum of cash from operations

Three-year sum of expenditures, inventory additions, and cash dividends

Investment in receivables is omitted because they are financed primarily byshort-term credit (such as growth in accounts payable)

Also, in years where inventories decline, the downward change is treated as

zero change in computing the ratio

A ratio of 1 indicates that the company exactly covered these cash needswithout a need for external financing

A ratio below 1 suggests internal cash sources were insufficient to maintaindividends and current operating growth levels

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Specialized Cash Flow Ratios

Cash Reinvestment Ratio Measure of the percentage of investmentin assets representing operating cash retained and reinvested in thecompany for both replacing assets and growth in operations:

Operating cash flow Dividends

Gross fixed assets + Investments + Other assets + Working capital

A reinvestment ratio of 7% to 11% is generally considered satisfactory

Cash Reinvestment Ratio Measure of the percentage of investmentin assets representing operating cash retained and reinvested in thecompany for both replacing assets and growth in operations:

Operating cash flow Dividends

Gross fixed assets + Investments + Other assets + Working capital

A reinvestment ratio of 7% to 11% is generally considered satisfactory

6. cash flow analysis

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