Cash Flow Analysis

Lindsay Dastrup

Overview• Direct method• Indirect method• Cash flow patterns• Cash flow ratios• Free cash flow

Categories of Cash Flow• Operating Activities

– transactions that affect the determination of net income

• Investing Activities– sale and purchase of property, buildings, and equipment

• Financing Activities– transactions whereby cash is obtained from or repaid to

owners

Cash Flow from Operations

• Direct method – the reporting of the

cash received or disbursed of each income statement item

• Indirect method– the adjustment of the

net income for items that do not affect cash flow

TWO METHODS

Orchard Blossom CompanyEnd of the

Year

Beginning of

year

Balance Sheet Cash $25 15 Accounts receivable 60 40 Inventory 75 100 Wages payble 10 7Income Statement Sales 150 Cost of goods sold -80 Wages expenses -25 Depreciation expense -30 Net income 15

Direct MethodSales and cash collected from customers

Beginning accounts receivables $ 40

+sales 150

=cash available for collection $ 190

-ending accounts receivable 60

=cash collected from customers $ 130

Direct Method

Cost of goods sold and cash paid for inventory

Ending inventory $ 75+cost of goods sold 80=required inventory $ 155-beginning inventory 100=inventory purchased $ 55

Direct Method

Wages expense and cash paid for wages

Beginning wages payable $ 7+wage expense 25=total wages payable $ 32-ending wages payable 10=cash paid for wages $ 22

Cash from Operating Activities: Direct Method

Cash collected from customers $ 130

Cash paid for inventory -55

Cash paid for wages -22

Cash paid for depreciation 0

Net cash from operating activities $ 53

Indirect method

Net income $ 15+depreciation 30-increase in accounts receivables -20+decrease in inventory 25+increase in wages payable 3= net cash from operating activities $ 53

Cash from InvestingLong-term investments

Book value of long term investments sold

+gain (loss) on sale

=cash proceeds

Cash from InvestingBuildings and Equipment

Beginning buildings and equipment balance-original cost of buildings and equipment sold=ending balance

Cash from FinancingDividends paid

Beginning balance of retained earnings

-dividends declared

+net income

=ending balance of retained earnings

Cash from Financing

Dividends paid

Dividends declared

-increase in dividends payable

=cash paid for dividends

Cash from FinancingIssued common stock+borrowed short term debt+borrowed long term debt-dividends paid-treasury stock purchases=cash from financing activities

Analysis of Cash flows

• Cash flow patterns

• Cash flow ratios

Cash Flow PatternsStart-up, high growth company

Large cash inflows from financing pays for• capital expansion• subsidized negative cash flow from operations

Cash flow patternsSteady-state company

Cash flow from operation is sufficient to• replenish long term assets• pay dividends

Cash flow pattern

Cash cow

Large cash inflow from operations• capital expansion• repay loans• pay cash dividends• repurchase of company stock

Cash flow ratios

Cash flow–to-net income

Cash from operationsNet income

• Measure of earnings quality• Tends to be greater than 1• Should remain fairly stable for the years for a specific

company

Cash flow ratiosCash flow adequacy

Cash from operations

Cash required for investing activities

• Measures relationship between investment spending and cash generated by operations

• Indicate a company’s attitude towards reinvestment in long-lived production assets

• When ratio is small it indicates that cash flows from operations fall short of funding growth

Cash flow ratios

Cash times interest earned

(Cash from operations + Interest paid + Taxes paid)Interest expense

• Measures ability to service debt• Generally, a higher ratio indicates more solvency

Free cash flow

Profit after tax+depreciation+investment in fixed assets+investment in working capital=free cash flow

Tire City Corporation1. Given the income statement and balance sheet,

determine the operating cash flows, the investment cash flows, and the financing cash flows

2. Determine the value of the firm using the following assumptions:

WACC (discount rate)= 15.06%

Growth rate= 5.0%

1998 FCF= $759.24

Tire City Corporation

For years ending 12/31 1993 1994 1995 1996 1997

INCOME STATEMENT

Net Sales 16,230.00 20,355.00 23,505.00 28,206.00 33,847.20 Cost of sales 9,430.00 11,898.00 13,612.00 16,334.40 19,601.28

Gross profit 6,800.00 8,457.00 9,893.00 11,871.60 14,245.92 Selling, general, and administrative expenses 5,195.00 6,352.00 7,471.00 8,965.20 10,758.24 Depreciation 160.00 180.00 213.00 313.00 313.00

EBIT 1,445.00 1,925.00 2,209.00 2,593.40 3,174.68 Net interest expense 119.00 106.00 94.00 87.50 104.72

Pre-tax income (EBT) 1,326.00 1,819.00 2,115.00 2,505.90 3,069.96 Income taxes 546.00 822.00 925.00 1,002.36 1,227.99

Net income 780.00 997.00 1,190.00 1,503.54 1,841.98

Dividends 155.00 200.00 240.00 300.71 368.40

Tire City CorporationBALANCE SHEET

AssetsCash 508.00 609.00 706.00 847.20 1,016.64 Accounts receivable 2,545.00 3,095.00 3,652.00 4,382.40 5,258.88 Inventories 1,630.00 1,838.00 2,190.00 1,625.00 3,153.60

Total current assets 4,683.00 5,542.00 6,548.00 6,854.60 9,429.12

CapEx 563.00 368.00 2,000.00 400.00 Gross plant & equipment 3,232.00 3,795.00 4,163.00 6,163.00 6,563.00 Accumulated depreciation 1,335.00 1,515.00 1,728.00 2,041.00 2,354.00

Net plant & equipment 1,897.00 2,280.00 2,435.00 4,122.00 4,209.00

Total assets 6,580.00 7,822.00 8,983.00 10,976.60 13,638.12

Liabilities

Current Debt 125.00 125.00 125.00 125.00 125.00 Bank debt - - - 297.17 867.79 Accounts payable 1,042.00 1,325.00 1,440.00 1,728.00 2,073.60 Accrued expenses 1,145.00 1,432.00 1,653.00 1,983.60 2,380.32

Total current liabilities 2,312.00 2,882.00 3,218.00 4,133.77 5,446.71

Long-term debt 1,000.00 875.00 750.00 625.00 500.00

Common stock 1,135.00 1,135.00 1,135.00 1,135.00 1,135.00 Accumulated retained earnings 2,133.00 2,930.00 3,880.00 5,082.83 6,556.41

Total shareholders' equity 3,268.00 4,065.00 5,015.00 6,217.83 7,691.41

Total liabilities and equity 6,580.00 7,822.00 8,983.00 10,976.60 13,638.12

Tire City Corporation

1993 1994 1995 1996 1997

Operating Cash flows 1,335.00 1,538.40 1,869.04 2,217.81 ONWC 2,496.00 2,785.00 3,455.00 3,143.00 4,975.20 Change in ONWC 289.00 670.00 (312.00) 1,832.20 CAPEX 563.00 368.00 2,000.00 400.00

UFCF 483.00 500.40 181.04 (14.39)

Tire City Corporation

1995 1996 1997 1998Year 0 1 2 3UFCF 181.04 (14.39) 759.2424

Discounted CF years 1-2 157.34 (10.87) SUM years 1-2) 146.47

Terminal Cash Flow 7,547.14Discounted terminal value 5,700.77

Firm Value 5,847.25

Summary• Operating

– Income statement and current assets and liabilities• Investing

– Long-term assets• Financing

– Long-term liabilities and owner’s equity

Summary• Ratios

– Cash flow to net income– Cash flow adequacy– Cash times interest earned

Reading List• Intermediate Accounting by Stice, Stice, Skousen; 15th

edition• Principles of Corporate Finance by Brealey, Myers,

Allen; 8th edition