Cash Flow Analysis

Lecture- 8&9
 Algebraic Formulation

■ Assets = Liabilities + Shareholders’ Equity

 Analyzing Cash Flow
Information
Cash flow analysis can be used to address a variety of questions regarding a
firm's cash flow dynamics:
■ How strong is the firm's internal cash flow generation?
■ Is the cash flow from operations positive or negative?
■ If it is negative, why?
■ Is it because the company is growing?
■ Is it because its operations are unprofitable?
■ Or is it having difficulty managing its working capital properly?
■ Does the company have the ability to meet its short-term financial obligations,
such as interest payments, from its operating cash flow?
■ Can it continue to meet these obligations without reducing its operating flexibility?
 Analyzing Cash Flow
Information
■ How much cash did the company invest in growth?
■ Are these investments consistent with its business strategy?
■ Did the company use internal cash flow to finance growth, or did it rely on external
financing?
■ Did the company pay dividends from internal free cash flow, or did it have
to rely on external financing?
■ If the company had to fund its dividends from external sources, is the company's
dividend policy sustainable?
■ What type of external financing does the company rely on?
■ Equity, short-term debt, or long-term debt?
■ Is the financing consistent with the company's overall business risk?
■ Does the company have excess cash flow after making capital investments?
■ Is it a long-term trend?
■ What plans does management have to deploy the free cash flow?
Recasting the SCF
 Traditional SCF Format
Net Income
+ Depreciation and Amortization
± Deferred Taxes
± Gains/Losses
± Changes in Working Capital
= Cash Flow from Operating Activities
- Purchases of Long Term Assets
+ Sales of Long Term Assets
= Cash Flow from Investing Activities
+ Sale of Stock
+ New Borrowing
- Debt Payments
- Dividends
- Stock Repurchases
= Cash Flow from Financing Activities
Cash Flow from Operating Activities
+ Cash Flow from Investing Activities
+ Cash Flow from Financing Activities
= Net Change in Cash
Recast SCF Format
Net Income
+ Interest Expense (Net of Tax)
+ Depreciation and Amortization
± Deferred Taxes
± Gains/Losses
= OCF before Working Capital Investments
± Changes in Working Capital
= OCF before Investment in Long Term Assets
- Purchases of Long Term Assets
+ Sales of Long Term Assets
= FCF Available to Debt and Equity
- Interest Expense (Net of Tax)
- Debt Payments
+ New Borrowing
= FCF Available to Equity
+ Sale of Stock
- Dividends
- Stock Repurchases
= Net Change in Cash
OCF = Operating Cash Flow
FCF = Free Cash Flow
 Operating Cash Flow
■ Operating Cash Flow is broken up into two components, OCF
before working capital investments and OCF before investments
in long term assets.
■ Over the long run OCF must be positive, but firms in the early
stages of development, growing rapidly, or investing heavily in
research and development, marketing and advertising, and other
future growth opportunities will have negative OCF.
 Free Cash Flow
■ If cash flow after investing in long term assets is not positive
then the firm did not generate enough cash from operations to
pursue long-term growth opportunities and must rely on external
financing.
■ These firms have less flexibility than firms that can generate the
necessary funds internally.
■ Cash flow after long term investments is cash flow available to
both debt and equity holders.
 Free Cash Flow
■ Payments to debt holders include interest and principal
payments.
■ Firms with negative free cash flow after investments in long
term assets must borrow additional funds to meet their interest
and principal payments.
■ They can also reduce their investments in working capital, long
term investments, or issue additional equity.
 Free Cash Flow
■ Cash flow after payments to creditors is free cash flow
available to owners.
■ Payments to equity holders include dividends and stock
repurchases.
■ If firms pay dividends despite negative cash flows available to
equity holders then they are borrowing to pay dividends. This
is not sustainable in the long term.
 Summary
■ Examine cash flow from operations before investment in working
capital to verify the company is able to generate a cash surplus
from its operations.
■ Examine cash flow from operations before investment in long
term assets to how the firms working capital is being managed
and to see if the company can invest in long-term assets for
future growth.
 Summary
■ Examine free cash flow to debt and equity
holders to asses a firm’s ability to meet its
principal and interest payments.
■ Examine free cash flow to equity holders to
asses a firm’s ability to sustain its dividend
policy.
■ All cash flow analysis must be done taking
into consideration the company’s business, its
growth strategy, and its financial policies.
 Analysis of Cash Flows
Case Analysis of Cash Flows of Campbell Soup
 CASH FLOW MEASURES
(CONT.)
■ Cash flow adequacy is computed as: cash flows from operations / (fixed
assets purchased + long-term debt paid + cash dividends distributed)
■ General interpretation: a ratio of one or more indicates an entity’s operations
produce sufficient cash to meet necessary business obligations
■ A ratio of less than one indicates potential liquidity problems
■ Discretionary cash flows exist if the ratio exceeds one
 CASH FLOW MEASURES
(CONT.)
■ Depreciation impact ratio
■ Computed as: (depreciation + amortization expenses) / cash flows
from operations
■ Interpretation: small ratio indicates financial strength as the non-cash
addition to income isn’t the driving force behind operating cash flows
■ A large ratio (approaching one) indicates insufficient cash flow from
core activities
 CASH FLOW MEASURES
(CONT.)
■ Cash efficiency measures
■ A company must invest wisely in productive resources
■ Measure the relationship between operating cash flows and assets and
revenues
■ Determine if an enterprise’s investments produced enough operating cash
flows
 CASH FLOW MEASURES
(CONT.)
■ Three measures of cash efficiency
■ Cash flow return on assets: cash flow from operations / total assets
■ Cash flow return on sales: cash flow from operations / revenues
■ Operations index: cash flow from operations / operating income
 CASH FLOW MEASURES
(CONT.)
■ Signs of cash efficiency
■ Large rates of cash returns on assets and revenues
■ Strong correlation between operating cash flows and operating
income
 CASH FLOW MEASURES
(CONT.)
■ Cash sufficiency versus cash efficiency
■ An entity must produce sufficient cash to prosper
■ They should do in an efficient manner (i.e., generating maximum
revenues from its productive base.)
■ Cash flow sufficiency is a necessary component of cash flow
efficiency
 Analyzing Quality of Income
■ The Quality of Income Ratio is calculated as
Cash Flow from Operations
Net Income

This ratio should be > 1 for a healthy firm.

 Analyzing Quality of Income
■ If there are significant differences between net
income and operating cash flow ask the
following questions:
■ What are the sources of the difference?
■ Is it due to accounting policy?
■ Is it due to one-time events or on-going activities?
■ Is the relationship changing over time?
■ If so, why?
■ Is it because of changes in business conditions or
accounting policies and estimates?
 Analyzing Quality of Income
■ What is the time lag between recognition of
revenues and expenses and the receipt or
payment of cash?
■ What uncertainties are there regarding cash
collection or cash payments (e.g. bad debts,
contingent liabilities, etc.)
■ Are the changes in working capital accounts
normal?
■ If not, is there an adequate explanation for the
changes?
 Analyzing Quality of Income
■ Looking at earnings results is the most popular method most investors use
to judge business success. But looking beyond earnings to see information
about cash flow analysis adds a lot of color to an earnings report, exposing
where money is flowing into and out of a certain business.
■ Cash flow analysis answers two of the most frequently asked questions I
hear from businesses with money problems: “How could I have made a
profit and have no cash?” and “Where did all the money go?” The answers
to these two questions are easily answered through an analysis of the
company’s cash flow statement, a much needed and less used financial
statement of the big three: profit and loss statement, balance sheet, and
statement of cash flow