Financial Analysis & Valuation

Cash Flow Analysis

 Analysis of the Statement of Cash Flows
 Measuring Free Cash Flows

FBE 421 – Scott Abrams – Spring 2023

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Techniques for Financial Analysis

 Financial health
 Common size financial statements
 Ratio Analysis
 Analysis of the statement of cash flows
 Off balance-sheet exposure
 Performance Evaluation
 ROE and the DuPont analysis
 ROIC
 FCF vs. Earnings
 Analysis of revenue growth
 Risk analysis
 Quality of management

FBE 421 – Scott Abrams – Spring 2023

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Balancing Cash Sources & Needs
Describes how the firm generated and used cash during the period.
Cash flows are divided into 3 types in the statement:

Sources of Cash: Cash Needs:

Operating: Sustain existing

generated Cash from Operations
from selling
products net Operations (working capital
of cash & plant capacity)
Investing:
cash spent on
Growth from
purchasing Cash from Pool of new products
assets less
cash received
Asset Sales cash and services
from selling or plant &
assets
market expansion
Financing:
Cash
Cash from Buyback stock or
transactions Financial Pay dividends,
with claimants
Markets debt principal
or interest
FBE 421 – Scott Abrams – Spring 2023
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Statement of Cash Flow

Cash flow from operating activities
Net income $                 86
Depreciation               90
Deferred taxes               13
Changes in assets and liabilities
Accounts receivable              (24)
Inventories               11
Accounts payable               16
Accrued expenses               18
Other                (8)
Total cash flow from operations $              202
Cash flow from investing activities
Acquisition of fixed assets $             (198)
Sale of fixed assets               25
Total cash flow from investing activities $             (173)
Cash flow from financing activities
Retirement of long‐term debt $               (73)
Proceeds from issualnce of long‐term debt               86
Change in notes payable                (3)
Dividends              (43)
Repurchase of stock                (6)
Proceeds from new stock issue               43
Total cash flow from financing activities $                   4
Change in cash (on the balance sheet) $                 33
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Statement of Cash Flow
 The statement of cash flow summarizes the firm’s sources and uses of cash
 The statement combines information from the income statement (revenues and
expenses) with information from the balance sheet (working capital accounts,
capex)
 Cash flows are divided into three types of activities:
 Operating – cash generated from the primary activities of the company

 Investing – cash spent on purchasing fixed assets less cash received from selling
fixed assets
 Financing – cash transactions with stakeholders (financial markets)

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Cash Flow Intuition

 Increase in an asset
 Decrease in an asset
 Increase in a liability
 Decrease in a liability

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Cash Flow is King
 Relationship between Earnings and Operating Cash Flow:
Net income
+/- Deprecation and similar adjustments
+/- working capital changes (1)
= Cash flow from operations (CFO) (levered)


(1)working capital changes are the changes in all operating current assets (other than cash)
and operating current liabilities over the period. Some working capital accounts on the
balance sheet are non-operating and should not be included here (the most common of
these are the current portion of long term debt, interest bearing short term debt such as
notes payable and dividends payable ~ all are considered financing items. Marketable
securities are considered investments, not operating items.

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Cash Flow is King

Cash flow from operations (CFO)
+/- Cash flow from investing activities
+/- Cash flow from financing activities
= Net change in cash over the period

 Firms with positive earnings have gone bankrupt

 CFO reflects the hard reality of how much cold currency is
flowing in and out of a company

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Operating Activities
 The results of cash inflows and outflows related to the fundamental
operations of the basic line or lines of business in which the company
engages.
 Direct vs. Indirect methods
 IFRS strongly recommends the direct method while US GAAP encourages it

 However the indirect method is overwhelmingly more popular worldwide

 Working capital accounts

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Investing Activities
 Cash flows associated with the purchase and sale of
non-current assets (fixed assets)
 Largely capex

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Financing Activities
 Cash flows associated with financing the firm; flows associated with the non-
current liabilities and equity accounts (cash transactions with stakeholders)

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Exceptions
 Two ‘working capital’ accounts:
 Short-term marketable securities are treated as long-term investments and

appear in the investing activities section

 Short-term debt (largely notes payable) is treated as long-term debt and

appears in cash flow from financing activities

 Interest and dividends
 Although dividends are treated as a cash outflow in the financing section,

interest payments are considered an operating activity (US GAAP), despite the
fact that both are payments to outsiders for using their money
 IFRS allows interest payments to be included in any of the three sections provided
that the classification is consist across time

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Statement of Cash Flow
By analyzing operating,
investing, and financing
activities, we can see if a
firm is financing its capex
with internally generated
cash flow or financing
through the capital
markets
The Financial Life Cycle and Cash Flows
Cash Flows from
Operations
Investing
Financing
Net Change
Cash flow from operating activities
Net income $                 86
Depreciation               90
Deferred taxes               13
Changes in assets and liabilities
Accounts receivable              (24)
Inventories               11
              16
Accounts payable
Accrued expenses               18
Other                (8)
Total cash flow from operations $              202
Cash flow from investing activities
Acquisition of fixed assets $             (198)
Sale of fixed assets               25
Total cash flow from investing activities $             (173)
Cash flow from financing activities
Retirement of long‐term debt $               (73)
Proceeds from issualnce of long‐term debt               86
Change in notes payable                (3)
Dividends              (43)
Repurchase of stock                (6)
Proceeds from new stock issue               43
Total cash flow from financing activities $                   4
Change in cash (on the balance sheet) $                 33
FBE 421 – Scott Abrams – Spring 2023
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A B C D
$(5) 5 15 0
(20) (15) (5) (5)
25 10 (10) 5
0 0 0 0
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Steps in Reviewing the Statement of Cash Flows
 Scan the big picture
 Check the power of the cash flow engine
 Pinpoint the good and bad news
 Major sources and uses of cash
 Put the puzzle together
 Is the firm facing BK? Is it in the best position?

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Step 1: Scan the Big Picture

 Lifecycle – growing or mature company?
 Trend in net income and CFO

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Step 2: Check the Power of the Cash Flow Engine
 Major sources and uses of cash
 CFO > 0?
 CFO vs. Net Income
 Was the firm able to generate enough CFO to pay for all if its capex?
 Did the firm’s CFO cover both capex and dividends?
 If yes, what did the firm do with the excess cash?

 If not, what were the sources of cash the firm used to pay for the capex and/or

dividends?
 Were working capital accounts other than cash and cash equivalents primarily
sources or users of cash?
 What other major items affected cash flows?

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Step 2: Check the Power of the Cash Flow Engine

 What was the trend in:
 Net income?

 CFO?

 Capex?

 Dividends?

 Net borrowing (proceeds less payments of ST and LT debt)

 Working capital accounts?

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Step 3: Pinpoint the Good News and the Bad News
 Cash Flow from Investing Activities
 Generating or using cash?

 Steadily growing company?

 If positive, is this due to selling assets or a portion of business simply to generate

cash? Watch for companies that are beginning to shrink.

 Cash Flow from Financing Activities
 View in conjunction with other information

 Carefully analyze its leverage and cost of capital and chose to finance itself with

debt/equity rather than internally

 IPO

 Low CFO ~ forced to generate funds through financing

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Step 4: Putting the Puzzle Together

 Investigate any unusual line items
 If a company is restructuring, there is good news and bad news
 Bad ~ some problem occurred that requires the restructuring

 Good ~ the company recognized the problem and took action

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Company 1

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Company 2

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Company 3

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Free Cash Flow

Tesla Posts Loss as Output Climbs

Tesla’s shares fell 12%... The

Company said it had adjusted
income of $16 million.

The company said it generated

record free cash flow of $26m
and ended the quarter with
$796m in cash.

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Free Cash Flow
 FCF is the cash that a company is able to generate after laying out the
money required to maintain or expand its asset base
 The cash that the company is free to distribute to its investors (creditors and
stockholders) because it is not needed for working capital or fixed asset investments
(capex)

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Free Cash Flow

 Unlevered Free Cash Flows or Free Cash Flow to the Firm
 Cash flows generated by the company after

 Collection of its revenues

 Payment of its expenses, and

 After making its investments, including investments in working capital

 The cash flows the company would generate if it was entirely financed with

equity
 They are “free” because the company is “free” to distribute these flows to its

investors without interfering with the execution of its strategy

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Free Cash Flow

Tesla, which has dwindling cash

Reserves and continues to generate
negative free cash flow hasn’t given
Any detail on how it would fund a
Buyout.

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Cash Flow vs. Free Cash Flow

$ million

Accountant's cash flow statement Free cash flow

Current Current
year year
Free cash flow is Net income 198 NOPLAT 210
the after-tax cash Depreciation 20 Depreciation 20
flow available to all Decrease (increase) in inventory (25) Gross cash flow 230

investors: debt
holders and equity
Increase (decrease) in accounts payable 25 Decrease (increase) in operating cash (10) Subtract investments  in
Cash flow from operations 218 Decrease (increase) in inventory (25) operating items
holders. Unlike Increase (decrease) in accounts payable 25 from gross cash flow
“cash flow from Capital expenditures (70) Capital expenditures (70)
operations” and the Decrease (increase) in equity investments (10) Free cash flow 150
total change in Cash flow from investing (80) Evaluate cash flow from

cash reported in a Nonoperating income 4 nonoperating assets

company’s annual Increase (decrease) in interest‐bearing debt (25) Nonoperating taxes 4 separately

report, free cash

Dividends (103) Decrease (increase) in equity investments (10) from core operations
Cash flow from financing (128) Cash flow available to investors 148
flow is independent
of financing and Starting cash 5
nonoperating Change in cash 10 Reconciliation of cash flow available to investors Treat interest as a

items. Ending cash 15 Interest expense 20 financial payout to

Increase (decrease) in interest‐bearing debt 25 investors, not an expense
Dividends 103
Cash flow available to investors 148

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Is FCF Superior to Earnings?
 Wall Street tends to put too much focus on earnings
 It can be manipulated much more than FCF
 Reserves, estimates, deferrals, depreciation methods, asset impairments,
accruals, change in accounting principal
“Cash is king”
 Many profitable companies have gone bankrupt because they failed to
generate sufficient cash flow

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Is FCF Immune from Manipulation?

 Delaying payment to suppliers

 Reducing Capex
 Selling Receivables
 Selling Securities

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Measuring Cash Flow to the Firm
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= EBIT * ( 1 - tax rate)

+ Depreciation/Amortization (any noncash operating expense)

- Capex (Any investment

- Investment in NWC in operating
invested capital)
-/+ Incr. in other operating assets/liabilities
= Free Cash Flow to the firm

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Measuring Cash Flow to the Firm

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= EBIT * ( 1 - tax rate)

+ Depreciation/Amortization (any noncash operating expense)

- Capex (Any investment

- Investment in NWC in operating
invested capital)
-/+ Incr. in other operating assets/liabilities
= Free Cash Flow to the firm
- Interest payments * (1-t) & principal payments
= Levered FCF (to equity holders)

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Reorganizing the Financial Statements
Tax & Pension Accounts ~ Invested Capital

If using the ‘financing approach’ for invested capital, how do we treat unfunded or
overfunded pension liabilities? Deferred tax assets and liabilities?

 Unfunded pension liability (debt equivalent) – include

 Overfunded pension asset (non-operating asset) – subtract
 Deferred tax liability (equity equivalent) – include
 Deferred tax asset (negative equity equivalent) – subtract (in other words, include the
negative number)

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Reorganizing the Financial Statements

Other Items

 Operating working capital / excess cash

 Other assets and liabilities
 Goodwill
 Nonconsolidated subsidiaries and equity investments
 Noncontrolling (Minority) interest

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How Much Cash Is Excess Cash?
 Method 1 – excess of 2% of revenues
 Method 2 – excess of historical average
 Method 3 – excess of industry median or average

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Free Cash Flow: An Example

The EBS Company
Income Statement and Balance Sheet
($ in millions) 2017
Year -1 2018
Year 0 2017
Year -1 2018
Year 0

Balance Sheet - Assets: Balance Sheet - Liabilities & Equity:

Cash Balance (Required) $ 4.5 $ 6.5 Accounts Payable $ 1.8 $ 2.0
Accounts Receivable 2.0 2.2 Other Current Operating Liabilities 3.6 4.0
Inventory 4.0 4.4 Total Current Liabilities $ 5.4 $ 5.9
Total Current Assets $ 10.5 $ 13.1 Debt 10.0 10.0
Net Property, Plant and Equipment 10.0 11.0 Total Liabilities $ 15.4 $ 15.9
Total Assets $ 20.5 $ 24.1 Common Stock 2.0 2.0
Retained Earnings 3.1 6.2
Income Statement: Total Shareholders Equity $ 5.1 $ 8.2
Revenue $ 26.7 $ 31.8 Total Liabilities and Equities $ 20.5 $ 24.1
Cost of Goods Sold -16.0 -19.1
Gross Margin $ 10.7 $ 12.7
Selling, General & Administrative -3.2 -3.8
Operating Income $ 7.5 $ 8.9
Interest Expense -0.8 -0.8
Income Before Taxes $ 6.7 $ 8.1
Income Tax Expense (37.5%) -2.5 -3.1
Net Income $ 4.1 $ 5.0

Depreciation in Cost of Goods Sold $2.0 $4.0

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Free Cash Flow: An Example

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How has AT&T performed?

Unlevered Free Cash Flow
 Which items are included in the calculation of free cash flow?
 NOPLAT

 Noncash expenses

 Investments in invested capital:

 Net Capex

 Change in operating net working capital

 Investment in goodwill and acquired intangibles

 Change in other long-term operating assets, net of long-

term operating liabilities

 Change in capitalized operating leases

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How has AT&T performed?
Unlevered Free Cash Flow

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Summary: FCF & The Statement of Cash Flows

 The accounting statement of cash flows is a powerful financial statement – we can
quickly see the lifecycle of the firm and how it relates to the financial markets.
 By comparing cash flow to free cash flow, investors can gain a better understanding of
where cash is coming from and how the company is spending their cash.
 Looking at FCF in conjunction with the statement of cash flows gives us a better view
on how much liquidity a company is left with after maintaining or spending on its
asset base.

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