introduction to cash flow analysis chapter 10. chapter 10 objectives explain the relationships...

INTRODUCTION INTRODUCTION TO CASH FLOW TO CASH FLOW ANALYSISANALYSIS

Chapter 10Chapter 10

CHAPTER 10 OBJECTIVESCHAPTER 10 OBJECTIVES

Explain the relationships between Explain the relationships between operating, investing, and financing cash operating, investing, and financing cash flows and stages in the business life flows and stages in the business life cycle.cycle.

Convert indirect CFOs to direct CFOs.Convert indirect CFOs to direct CFOs. Describe the significance of cash Describe the significance of cash

received as a percentage of revenues received as a percentage of revenues and paid as percentage of cost of goods and paid as percentage of cost of goods sold to business operations.sold to business operations.

CHAPTER 10 OBJECTIVES CHAPTER 10 OBJECTIVES (CONT.)(CONT.)

Discern stability, efficiency, and Discern stability, efficiency, and inefficiency in an entity’s operating inefficiency in an entity’s operating cash flows and liquidity measures.cash flows and liquidity measures.

Analyze a company or industry’s Analyze a company or industry’s CFOs.CFOs.

THE OBJECTIVE OF CASH THE OBJECTIVE OF CASH FLOW ANALYSISFLOW ANALYSIS

An evaluation of past events and An evaluation of past events and present conditions so that the amount, present conditions so that the amount, timing, and probability of future cash timing, and probability of future cash flows can be forecast flows can be forecast

Analyst seek to understandAnalyst seek to understand Cash flows into and out of an entityCash flows into and out of an entity The primary sources and uses of cashThe primary sources and uses of cash Relative consistency of cash flows over timeRelative consistency of cash flows over time

BUSINESS DECISIONS AND BUSINESS DECISIONS AND CASH FLOWSCASH FLOWS

Business success depends on an Business success depends on an entity taking in more cash in its life entity taking in more cash in its life than it pays out over timethan it pays out over time

Initial cash flowsInitial cash flows Provided by debt and equity investorsProvided by debt and equity investors Used to acquire productive assetsUsed to acquire productive assets Reflect managerial decisions about Reflect managerial decisions about

how to maximize wealthhow to maximize wealth

BUSINESS DECISIONS AND BUSINESS DECISIONS AND CASH FLOWS (CONT.)CASH FLOWS (CONT.)

The Financial Accounting Standards The Financial Accounting Standards Board’s perspectiveBoard’s perspective

Requires that companies disclose a Requires that companies disclose a statement of cash flowsstatement of cash flows

The cash flow statement should provide The cash flow statement should provide equity investors and creditors with equity investors and creditors with information to make judgments about the information to make judgments about the Amount of future cash flowsAmount of future cash flows Timing of future cash flowsTiming of future cash flows Uncertainty of future cash flowsUncertainty of future cash flows


Cash flows and corporate lifeCash flows and corporate life An entity’s life cycle stage affects An entity’s life cycle stage affects

cash acquisitions and disbursementscash acquisitions and disbursements The life cycle stages are (Exhibit 10-1)The life cycle stages are (Exhibit 10-1)

EmergenceEmergence GrowthGrowth Maturity Maturity DeclineDecline


Cash flow relationships to life cycle Cash flow relationships to life cycle stages (Exhibit 10-2)stages (Exhibit 10-2)

Operating activitiesOperating activities Outflows during emergence and early Outflows during emergence and early

growthgrowth Inflows peak during maturityInflows peak during maturity Inflows decrease (trending toward Inflows decrease (trending toward

zero) in declinezero) in decline


Financing activitiesFinancing activities Inflows during emergence and growthInflows during emergence and growth Outflows during late maturity and decline Outflows during late maturity and decline

(i.e., the return of investment)(i.e., the return of investment) Investing activitiesInvesting activities

Outflows during emergence and early growthOutflows during emergence and early growth Inflows during late maturity Inflows during late maturity Decreasing cash inflows during business Decreasing cash inflows during business

declinedecline

CASH FLOWS FROM CASH FLOWS FROM OPERATING ACTIVITIESOPERATING ACTIVITIES

The most important part of cash The most important part of cash flow statementflow statement Reports the difference between cash Reports the difference between cash

received and paid for conducting core received and paid for conducting core business activitiesbusiness activities

Less subjective than accrual-based Less subjective than accrual-based disclosuresdisclosures

Analyst must determine the Analyst must determine the sustainability of operating cash flowssustainability of operating cash flows

CASH FLOWS FROM CASH FLOWS FROM OPERATING ACTIVITIES OPERATING ACTIVITIES (CONT.)(CONT.)

Direct methodDirect method The superior method of reporting The superior method of reporting Reports cash collected from revenues Reports cash collected from revenues

and cash paid for operating expensesand cash paid for operating expenses Easy for financial statement users to Easy for financial statement users to

understandunderstand Companies do not disclose CFOs on a Companies do not disclose CFOs on a

direct basisdirect basis


Indirect methodIndirect method The inferior method of reportingThe inferior method of reporting Reconciles net income to operating Reconciles net income to operating

cash flowscash flows Hard for financial statement users to Hard for financial statement users to

understandunderstand Companies disclose CFOs on an Companies disclose CFOs on an

indirect basisindirect basis


Converting indirect operating cash flows Converting indirect operating cash flows to direct operating cash flowsto direct operating cash flows Procedure for producing direct CFOs from Procedure for producing direct CFOs from

the indirect ones reported by companiesthe indirect ones reported by companies An analyst lists each revenue and operating An analyst lists each revenue and operating

expense categoryexpense category Each income statement account is adjusted Each income statement account is adjusted

for changes in balance sheet accounts (e.g., for changes in balance sheet accounts (e.g., accounts receivable changes affect cash accounts receivable changes affect cash collected from sales)collected from sales)


Converting indirect operating cash Converting indirect operating cash flows to direct operating cash flows flows to direct operating cash flows (cont.)(cont.) Certain operating expense categories Certain operating expense categories

are adjusted for non-cash expenses are adjusted for non-cash expenses (e.g., deprecation)(e.g., deprecation)

Cash collected from sales minus cash Cash collected from sales minus cash paid for each expense category paid for each expense category determines direct cash flowsdetermines direct cash flows


Direct CFOs are more informative Direct CFOs are more informative than indirect CFOsthan indirect CFOs Analyst can directly see how much Analyst can directly see how much

cash was received from continual cash was received from continual activities in a reporting periodactivities in a reporting period

Analyst can directly see how much Analyst can directly see how much cash was paid for continual activities cash was paid for continual activities in a reporting periodin a reporting period

eSTUFF’S DIRECT CASH eSTUFF’S DIRECT CASH FLOWSFLOWSeSTUFF's Direct Cash Flows 2003 2002 2001 2000Sales revenue $1,310 $1,240 $1,200 $1,000Change in accounts receivable 15 (35) (20) (120) Cash received from customers 1,325 1,205 1,180 880

Cost of goods sold 800 719 660 600 Change in inventory 65 20 50 200 Change in accounts payable (30) (30) 110 (160) Cash paid to suppliers 835 709 820 640

eSTUFF’S DIRECT CASH eSTUFF’S DIRECT CASH FLOWSFLOWS

eSTUFF's Direct Cash Flows 2003 2002 2001 2000Selling and administrative expenses 505 462 485 335 Change in prepaid expenses (4) 7 (5) 10 Change in accrued liabilities 3 (22) 29 (50) Less: depreciation and amortization (141) (125) (125) (105) Cash paid for operating expenses 363 322 384 190

Tax expense (6) 16 14 22 Change in taxes payable 6 (6) 5 (5) Cash paid for taxes - 10 19 17

Financial expense 20 20 20 10 Change in interest expense - - - - Cash paid for interest 20$ 20$ 20$ 10$

eSTUFF’S CFO eSTUFF’S CFO RECONCILIATIONRECONCILIATION

eSTUFF's CFO Reconciliation 2003 2002 2001 2001

CFOs--Indirect Method (as reported) $107 $144 ($63) $23CFOs--Direct Method (as computed)Cash received from customers $1,325 $1,205 $1,180 $880Cash paid: To suppliers (835) (709) (820) (640) For operations (363) (322) (384) (190) For taxes - (10) (19) (17) For interest (20) (20) (20) (10) Net cash provided by operating act. $107 $144 ($63) $23


Drawbacks of direct CFOsDrawbacks of direct CFOs Conversion process takes timeConversion process takes time Judgment is often required in Judgment is often required in

classifying and adjusting accounts classifying and adjusting accounts

INTERPRETING CFOsINTERPRETING CFOs

Analysts judge how well an entity Analysts judge how well an entity performs its core business activitiesperforms its core business activities

Cash flows from operating activities Cash flows from operating activities provide numerous insightsprovide numerous insights

The focal point is operating cycle The focal point is operating cycle activityactivity Cash collected on salesCash collected on sales Cash paid for inventoryCash paid for inventory

INTERPRETING CFOs INTERPRETING CFOs (CONT.)(CONT.)

Operating cycle cash flows are Operating cycle cash flows are classified in three categories classified in three categories (Exhibit 10-4)(Exhibit 10-4)

Stable operationsStable operations Cash collected from customers as a Cash collected from customers as a

percentage of sales remains constant percentage of sales remains constant over timeover time

Cash paid to vendors as a percentage Cash paid to vendors as a percentage of cost of goods sold remains constant of cost of goods sold remains constant over timeover time


Efficient operationsEfficient operations Cash collected from customers as a Cash collected from customers as a

percentage of sales increases over timepercentage of sales increases over time Cash paid to vendors as a percentage of Cash paid to vendors as a percentage of

cost of goods sold decreases over timecost of goods sold decreases over time Inefficient operationsInefficient operations

Cash collected from customers as a Cash collected from customers as a percentage of sales decreases over timepercentage of sales decreases over time

Cash paid to vendors as a percentage of Cash paid to vendors as a percentage of cost of goods increases over timecost of goods increases over time


Operating cash flow and trendsOperating cash flow and trends Trend data increases insights about Trend data increases insights about

operating cycle cash flows (Exhibit operating cycle cash flows (Exhibit 10-5)10-5)

Trends are sometimes difficult to Trends are sometimes difficult to deduce for existing companiesdeduce for existing companies


Relationships between operating Relationships between operating cycle cash flow and short-term cycle cash flow and short-term liquidity measures (Exhibit 10-6)liquidity measures (Exhibit 10-6) Reports the direction of change Reports the direction of change

(increase or decrease) for (increase or decrease) for Inventory activity measuresInventory activity measures Accounts receivable activity measuresAccounts receivable activity measures Accounts payable activity measuresAccounts payable activity measures


Changes in these activity Changes in these activity measures can be applied tomeasures can be applied to Stable operationsStable operations Efficient operationsEfficient operations Inefficient operations Inefficient operations


Forecasting operating cash flowsForecasting operating cash flows Uses operating cash flow history and Uses operating cash flow history and

trends to predict the futuretrends to predict the future Incorporates short-term liquidity Incorporates short-term liquidity

analysis into the assessmentanalysis into the assessment Knowledge of other areas of analysis Knowledge of other areas of analysis

(e.g., operating performance) assists (e.g., operating performance) assists in cash flow forecastsin cash flow forecasts

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRYTHE PC INDUSTRY

Company is in its late growth or Company is in its late growth or early maturity life cycle stage early maturity life cycle stage

Focus of the operating cash flow Focus of the operating cash flow analysis is on the cash provided by analysis is on the cash provided by and used for making and selling and used for making and selling PCsPCs

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRY (CONT.)THE PC INDUSTRY (CONT.)

Industry cash flowsIndustry cash flows Industry demonstrated strong Industry demonstrated strong

operating cash flows from 1993 to operating cash flows from 1993 to 1998 (Exhibit 10-7A)1998 (Exhibit 10-7A)

Industry’s cash flows were less than Industry’s cash flows were less than stable over timestable over time

Compaq’s poor performance reduced Compaq’s poor performance reduced operating and net cash flows in 1998 operating and net cash flows in 1998 (Exhibit 10-7B) (Exhibit 10-7B)

Exhibit 10-7Composite Cash Flows

1993-1998(in millions of dollars)

-5000

-4000

-3000

-2000

-1000

0

1000

2000

3000

4000

5000

6000

1993 1994 1995 1996 1997 1998

(A)

Ca

sh F

low

Acti

vit

es

CFO CFI CFF


Apple Computer’s direct operating Apple Computer’s direct operating cash flowscash flows Apple’s indirect operating cash flows Apple’s indirect operating cash flows

were converted to a direct basis to were converted to a direct basis to improve interpretation (Exhibit 10-8)improve interpretation (Exhibit 10-8)

The company reported positive CFOs The company reported positive CFOs during the period analyzedduring the period analyzed


Cash flows were positive because Cash flows were positive because of Apple’sof Apple’s Return to profitabilityReturn to profitability Continued reductions of inventoryContinued reductions of inventory Favorable changes in the account Favorable changes in the account

balances of current assets and balances of current assets and restructuring costsrestructuring costs

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRY(CONT.)THE PC INDUSTRY(CONT.)

Operating cycle cash flowsOperating cycle cash flows Industry data was analyzed from 1994 to 1998 Industry data was analyzed from 1994 to 1998

(Exhibit 10-9)(Exhibit 10-9) Dell and Gateway demonstrated stable Dell and Gateway demonstrated stable

operating cash flows during that time periodoperating cash flows during that time period Apple and Compaq’s collection on sales and Apple and Compaq’s collection on sales and

payments to vendors were erraticpayments to vendors were erratic Compaq’s paid a higher percentage on its cost Compaq’s paid a higher percentage on its cost

of goods sold than it collected on its salesof goods sold than it collected on its sales Apple collected more than 100% of revenues Apple collected more than 100% of revenues

in cash (a trend that cannot continue)in cash (a trend that cannot continue)

Exhibit 10-9bCash Received as a Percentage of Revenues

1994-1998

80.00%

90.00%

100.00%

110.00%

1994 1995 1996 1997 1998

Apple Compaq Dell Gateway

Exhibit 10-9cCash Paid as a Percentage of Cost of Goods Sold

1994-1998

80%

85%

90%

95%

100%

105%

110%

1994 1995 1996 1997 1998

Apple Compaq Dell Gateway

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRY(CONT.)THE PC INDUSTRY(CONT.)

Operating cash flow data support Operating cash flow data support the analysis of short-term liquiditythe analysis of short-term liquidity Dell and Gateway are more liquid than Dell and Gateway are more liquid than

Apple and CompaqApple and Compaq Dell’s and Gateway’s operations are Dell’s and Gateway’s operations are

more stable than those of Apple and more stable than those of Apple and CompaqCompaq

Apple’s inability to sell computers Apple’s inability to sell computers profitability results in its lagging the profitability results in its lagging the industryindustry

introduction to cash flow analysis chapter 10. chapter 10 objectives explain the relationships...

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