Financial Analysis Project

M Hannan Siddiqui

L1F17BSAF0067

Section: B

Financial Analysis

Submitted to: Sir Abid Noor

CASH FLOW ANALYSIS

Cash is the gasoline that makes your business run. Basically Cash Flow Analysis shows how a
company spends its money (cash outflows) and from where a company receives its money (cash
inflows). The cash flow statement includes all cash inflows a company receives from its ongoing
operations and external investment sources, as well as all cash outflows that pay for business
activities and investments during a given quarter.

Different types of Ratios:

Ratio analysis is a cornerstone form of financial statement analysis that is used to obtain a
quick indication of a company’s performance in some areas such as liquidity, profitability,
operating activities, stock market performance or debt and asset management. It is a
quantitative method to gain some insights about a firm’s financial performance to
compare either with the previous years or with the firms in the same industry

 Current Liability Coverage Ratio

 Price to Cash Flow Ratio
 Cash Flow Margin Ratio
 Cash Flow Coverage Ratio
 Viability

Current Liability Coverage Ratio:

Net Cash from Operating Activities ÷ Average Current Liabilities

This is a measurement of cash from operating activities to average current liabilities. This ratio
demonstrates the ability for operations to generate cash that can be used to cover debts that need
to be paid within a years' time.

Significance and interpretation:

A higher current cash debt coverage ratio indicates a better liquidity position. Generally a ratio of
1 : 1 is considered very comfortable because having a ratio of 1 : 1 means the business is able to
pay all of its current liabilities from the cash flow of its own operations.

Example:

Suppose a company generated $55,000 cash from operations during the last year. The current
liabilities at the beginning and at the end of the year were $45,000 and $60,000 respectively. The
current cash debt coverage ratio would be computed as follows:

$55,000 / $52,500*
1.05

or

1.05 : 1

*($45,000 + $60,000)/2

Price to Cash Flow Ratio:

Share Price ÷ Operating Cash Flow per Share

The price to cash flow ratio is an appraisal of a company's share price to its cash flow. This ratio
is generally accepted as being more reliable than the price per earnings ratio, as it is harder for
false internal adjustments to be made. The share price is usually the closing price of the stock on
a particular day and operating cash flow is taken from the statement of cash flows.

Calculating the Price-to-Cash-Flow Ratio

The price-to-cash-flow ratio is a simple calculation. All you have to do is take the current share
price and divide it by the total cash flow from operations found on the cash flow statement.123

Some investors prefer to use a modified price-to-cash-flow ratio that uses free cash flow instead
of total cash flow from operations. Free cash flow adjusts for expenses such as amortization and
depreciation, changes in working capital, and capital

Analysis and Interpretation

P/CF is one of the most used multiples in the investment industry. Analysts often need to know
the valuation of a company with respect to the cash it generates from the underlying operations.
Cash flows analysis with respect to price also helps us compare different companies in the same
industry irrespective of certain accounting differences.

In the Example of the steel companies presented above, we see that ArcelorMittal has a large
P/CF compared to ThyssenKrupp. Intuitively, it might mean that the Arcelor is costlier than
Thyssen. While, that might be the case, an analyst needs to look at it from an overall business
point of view. It is possible that the cash flows of Arcelor have been very weak while the share
price has not corrected to the same extent. On the other hand, investors might pay a premium for
the company given it is one of the largest steel producers in the world, so they expect strong
turnaround in the company. Again, if the excitement is unfounded, it is advisable to stay away
from such companies. Valuation is also dependent on perception and risk appetite of investors.
Analysts should always compare the multiple against the market expectations. They should also
explore the drivers of a ratio. Detailed financial analysis is required to determine if the
management is not doing any creative business practices to boost cash flows for a short period, at
the expense of long-term value erosion.

Cash Flow Margin Ratio:

Cash Flow from Operating Cash Flows ÷ Net Sales

The cash flow margin ratio is a key ratio for business owners and managers as it expresses the
relationship between cash generated from operations and sales. This ratio is specific in that it
indicates the amount of cash generated per dollar of net sales. Cash flow from operating cash
comes from the firm's statement of cash flows. Net sales are taken from the income statement.
The larger the percentage, the better the firm is at converting sales to cash flow.

How Is Cash Flow Margin Calculated?

The cash flow margin is a measure of how efficiently a company converts its sales dollars to
cash. Because expenses and purchases of assets are paid from cash, this is an extremely useful
and important profitability ratio. It's also a margin ratio.

The cash flow margin is calculated as:

Cash flows from operating activities/net sales = _______ percent

The higher the percentage, the more cash is available from sales. If cash flows were $500,000
divided by net sales of $800,000, this would work out to 62.5 percent—very good, indicating
strong profitability. It would drop to a 55.5 percent cash margin with an additional $100,000 in
net sales.

Keep in mind that this is not the same as the net income margin, which includes non-cash
transactions such as bad debt expenses and depreciation. And although higher is better, there is
no "perfect" percentage to aim for because all companies are different. But a company that
shows an increasing cash flow margin from year-to-year is certainly getting stronger with time,
and this is a good indicator of its probability for long-term success.

Cash Flow Coverage Ratio:

Cash Flow from Operations ÷ Total Debt

The cash flow coverage ratio measures the solvency of a company. This is the ability to pay
long-term debts. Cash flow from operations is taken from the statement of cash flows. Total debt
is total liabilities, both short and long term. This ratio demonstrates the ability of the company to
use its operating cash flows to pay off its debt.

A higher ratio reflects the firm's financial flexibility, and its ability to pay its debts. A ratio of
more than 1 is desired. For example, if the cash flow coverage ratio were 1.5, the company could
pay it’s debts 1.5 times with operating cash flows. The higher this ratio, the more cash you have
leftover from operations after paying debts.

Explanation
Cash flow measures allow the investor-analyst to understand if the company is generating
enough cash flow from ongoing operations to keep the company in a financially sound position
over the long term. One of the ways to understand the ability of a company to meet its non-
expense-related financial obligations is to calculate their cash flow coverage ratio.

The investor-analyst can calculate a company's cash flow coverage ratio if they wish to
understand if a company's is generating enough cash to pay for non-expense costs. This measure
supplements metrics such as fixed charge coverage and is of particular interest when examining
companies that are rapidly expanding in terms of capital projects and / or companies that are
already heavily in debt.

The metric takes the sum of non-expense costs such as the repayment of debt, stock dividends,
and capital expenditures and divides it by the cash flow generated in the same period. Cash flow
for the period would be equal to the company's net income plus non-cash expenses (such as
depreciation and amortization), minus non-cash sales. Ideally, a company's ratio would be in
excess of 1.0; however, the investor-analyst must carefully consider the nature of debt payments
used in the calculation. This is especially true if the company has an unusually large debt
payment due in the period examined.

Cash Flow Coverage Example

American Glass is a company that produces glass panels for windows and vehicles. They are
heavily indebted, yet the Chief Financial Officer claims they are in a good position to cover for
all the company’s financial commitments. Yet, the CEO wanted to corroborate this information
and he decided to run some calculations himself with the following information:

Information from last year’s annual report:

Cash Flow from Operations: $12,563,000

Capital Expenditures: $1,340,000

Total Long Term Debt: $76,000,000

By using this information, the CEO can calculate the Cash Flow Coverage Ratio:

CFCR = $12,563,000 / $76,000,000 = 16.5%

He can also estimate the number of years it will take the business to cover for its entire debt:

Years to Cover = 1 / 0.165 = 6 years

A 16.5% is not necessarily a positive or negative figure. Instead, the number of years it takes for
the cash flow to cover the entire principal of the outstanding debt does give some insights on the
business’ capacity to fulfill its financial commitments. For example, if the business currently has
loans that are due in less than 5 years, the CEO should review the past 5 years of cash flows at
least to determine if the cash flow generated by the business during those periods of time
combined is healthy enough to fulfill these commitments.

Viability:

Net assets/long-term debt = Viability

The four ratios discussed are methods behind determining a firm's financial viability. Viability is
the ability for a firm to continue generating income to meet all of its financial obligations while
allowing for growth at the same time. Combined, these ratios communicate the effectiveness of a
business' operations and demonstrate solvency (paying off long-term debts) and liquidity (paying
off short-term debts).

The viability ratio indicates the relative liquidity of the organization in measuring the availability
of sufficient cash, or other convertible assets, to pay institutional obligations as of the date of the
Statement of Net Assets,

There are no absolute thresholds for this ratio in that long-term debt need not be paid off at once.
Of more importance are long-term trends in direction. Long-term declines would limit the
ability to deal with adverse impacts or to take on new projects.