Cash Flow Analysis.pdf

Advanced Commercial Lending

Cash Flow Analysis

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© Omega Performance Corporation. All rights reserved. Table of Contents iii

TTaabbllee ooff CCoonntteennttss Start -------------------------------------------------------------- 1

Unit 1: Principles of Cash Flow Analysis ------------------- 9 Section 1: What Is Cash Flow? --------------------------- 11

Section 2: A Three-Layer Approach to Cash Flow Analysis --------------------------------------------------- 21

Unit 2: Three Cash Flow Formats -------------------------- 31 Section 1: Quick Cash Flow ------------------------------- 33

Section 2: Cash Flow Statement------------------------- 47

Unit 3: Financial Drivers of Cash Flow ------------------- 53 Section 1: Change in Sales ------------------------------- 55

Section 2: Changes in Days on Hand ------------------- 71

Section 3: Change in Margins ---------------------------- 91

Section 4: Investment in Non-current Assets and Other Significant Uses of Cash Flow ---------------- 109

Unit 4: Nonfinancial Drivers of Cash Flow ------------- 129 Section 1: Four Critical Management Areas --------- 131

Section 2: An Example of Layer Three Analysis ----- 135

Cases -------------------------------------------------------- 159 Shepherd Ltd ---------------------------------------------- 160

Karr Photo Equipment & Supplies Ltd ---------------- 170

Appendix ---------------------------------------------------- 183 Direct Cash Flow ------------------------------------------ 183

Job Aids ----------------------------------------------------- 205 The Decision Strategy ------------------------------------ 206

Job Aid: IFRS Statement of Cash Flows -------------- 207

Job Aid: Financial Drivers of Cash Flow --------------- 209

Job Aid: Four Critical Management Areas ------------ 213

Job Aid: Direct Cash Flow Constructions ------------- 214

Job Aid: Cash Flow Summary Tips --------------------- 217

Job Aid: Target Cash Flow Analysis -------------------- 218

Quick Cash Flow Worksheet ---------------------------- 219

Financial Drivers Worksheet ---------------------------- 220

Cash Flow Summary Worksheet ----------------------- 221

Glossary ------------------------------------------------------ 223

© Omega Performance Corporation. All rights reserved. Start 1

SSttaarrtt WWhen Alpha Ltd developed several new products, its

sales grew 30% in one year. After years of stability, Alpha

suddenly needed more space, more equipment, more

employees, better invoicing and financial information,

and more cash. All of Alpha’s banks were eager to

finance the growth, but only one anticipated that Alpha

would need more financing and a longer repayment

period than the company thought. Alpha now has a new

lead financing relationship.

CCaasshh FFllooww AAnnaallyyssiiss

Builds on your understanding of a company’s asset conversion cycle.

Tests your preliminary assessments of its financial strength.

Provides a foundation for your projections of borrowing need and repayment ability.

CCaasshh FFllooww AAnnaallyyssiiss aanndd tthhee DDeecciissiioonn SSttrraatteeggyy Before continuing, review the Decision Strategy job aid on the following page to see where cash flow analysis fits into the lending process. The job aid also appears in the Job Aids section of this module.

Cash flow analysis is an important component of repayment source analysis because it yields answers to the following questions:

Has the borrower’s historical cash flow from internally generated sources been sufficient to meet its cash flow requirements?

How much annual debt service would the borrower’s cash flow support if future cash flow amounts were consistent with historical cash flow amounts?

How much could future cash flow shrink and still be sufficient, or how much will cash flow need to increase over historical levels in order to meet needs including debt repayment?

What financial and non-financial risks have had the greatest impact on the customer’s need to borrow and ability to repay?

2 Cash Flow Analysis © Omega Performance Corporation. All rights reserved.

The Decision Strategy

Opportunity assessment

Prospecting Does the prospect match the institution’s profiles?

If the prospect is a current customer, can the relationship be expanded?

Identify opportunities Review the prospect’s strategic objectives and financial structure.

What immediate and long-term needs exist for lending or non-lending services?

Preliminary analysis

Preliminary assessment What is the specific opportunity? Is the opportunity legal and within your institution’s policy?

Are the terms logically related? Do the risks appear to be acceptable?

Identify borrowing cause What caused the need to borrow? How long will the borrowed funds be needed?

Repayment source analysis

Industry and business risk analysis What trends and risks affect all companies in the borrower’s industry?

What risks must the borrower manage successfully in order to repay the lending facility?

Financial statement analysis What do the financial statement trends show about the borrower's management of the business?

What trends will influence the ability to repay?

Facility packaging

Summary and recommendation What are the major strengths and weaknesses of the lending situation? Should a lending facility be

granted?

Facility structuring and negotiation What are the appropriate facility, security, pricing, advance method, documentation, and covenants?

Facility management

Facility monitoring Is the borrower performing as expected? What caused variations?

What are the risks to repayment? How can you protect the institution’s position?

Cash flow analysis and projections Will the business have sufficient cash to repay the lending facility in the proposed

manner? Which risks will have the greatest impact on its ability to repay?


Armed with these insights, you will be able to proceed in the lending process:

To perform sensitivity analysis on important components of cash flow.

To project cash flow and repayment ability more reliably.

To anticipate risks you will want to manage in your loan structure and covenants.

YYoouu WWiillll BBee AAbbllee ttoo .. .. ..

Evaluate the sufficiency of a borrower’s historical internally generated cash flow to meet its future cash flow needs, using various formats for cash flow, including:

Quick cash flow (an indirect method consistent with traditional cash flow and EBITDA approaches)

Indirect Statement of Cash Flows (one of the formats provided when statements are prepared under IFRS)

Apply a deliberate, three-layer approach to cash flow analysis:

Identify the cash flow formats that will be used for your analysis. Determine the significance of four financial drivers to each

borrower. Analyse critical management areas that affect cash flow.

Unit 1, Principles of Cash Flow Analysis, covers the cash flow basics, including the distinctions between net profit and cash flow and the types of cash flow. The unit also introduces the three-layer approach to cash flow that will be explained in detail throughout this module.

Unit 2, Cash Flow Formats, discusses Layer One analysis, including quick cash flow and the statement of cash flows. Various job aids and worksheets will help you understand how to construct and interpret these cash flow formats to help you determine financing requirement and repayment ability.

Unit 3, Financial Drivers of Cash Flow, describes how to uncover the four financial drivers in a borrower’s financial statements, as well as how to measure and evaluate the effect of the drivers on cash flow. This unit introduces the Financial Drivers of Cash Flow job aid and the Financial Drivers worksheet to help you perform a Layer Two analysis.

Unit 4, Nonfinancial Drivers of Cash Flow, teaches Layer Three analysis. It explains how management decisions in the four critical areas of a company’s financial performance – sales, operating cycle, expenses, and capital investment cycle – affect cash flow, and describes an analytical process for evaluating the nonfinancial drivers of cash flow – economic factors, industry factors, business strategy, and management actions.


Appendix, which presents the Direct Statement of Cash Flows. IFRS and UK GAAP have two acceptable formats, the indirect and direct methods. The majority of accountants use the indirect method. This appendix explains how the Direct Statement of Cash Flows is calculated and how to analyse the Direct Statement of Cash Flows. The appendix is for your reference and will not be part of the assessment.

UUsseeffuull PPrriioorr LLeeaarrnniinngg Each module has been designed so that it can be undertaken on a standalone basis. Nevertheless it is recognised that for anyone new to a lending role there is a preferred order of study. In this respect you may find it useful, before beginning this module, to have covered the following skills or knowledge:

Understanding of the basic principles of accrual accounting, including an understanding of the connections between the income statement (profit and loss accounts) and the statement of financial position (balance sheet).

Knowledge of the meaning and implications of the following terms:

Asset conversion cycle Operating cycle Capital investment cycle Trading assets and trading activities Trading asset financing need Industry risk factors Business strategy

These subjects are covered in the following modules: Opportunity Assessment, Borrowing Causes, Industry Risk Analysis, Business Risk Analysis, and Financial Statement Analysis.

BBee AAwwaarree TThhaatt .. .. .. The following conventions are used in this module:

Practise opportunities: Some paragraphs are marked with a question icon (Q) and followed by questions and blank spaces. These are learning and practise opportunities to help you understand and apply the material in this module. Please write your answers in the spaces below the questions, and then compare your responses to the answers that follow the spaces, which are marked with an answer icon (A).

Sidebars: Special boxes offer additional details, background information, and focused examples for those who want more detail than is available in the mainstream content.


Formulas: All formulas are set apart with a calculator icon. This will make it easy for you to find and review formulas when you need to use them.

Points of emphasis: Essential information is emphasised with the arrow icon.

Dates: In financial statements, historical years are presented with “Y dates”: 20Y1, 20Y2, 20Y3 and so on. The first year of the financial statement is represented as 20Y1, year two as 20Y2 and so on. Future years and projected financial statements use “P dates”; 20P1 represents future year or projected year one, 20P2 indicates projection year two, etc., in the future. These dates do not correlate to actual years, but to the specific sequence of years in the example or case. Think of 20Y1 as “year one”, 20Y2 as “year two” of the case, and so on.

Numbers in brackets: Brackets around a figure generally indicate a negative number. On cash flow formats, brackets around a figure indicate a use of cash.

Financial statement presentation: Financial statement data are generally presented in order of descending dates, from left to right, with the most current year at the left. International Financial Reporting Standards (IFRS) allow a variety of financial statement presentation formats; we have selected a single format for this programme for consistency. While you may see a variety of formats in practise, the content of the accounts will comply with the applicable accounting standard, so the format selected by the borrower for its financial statements should not affect your analysis results. Always read the notes to the financial statements to understand the accounting standards which have been applied.

Worksheet presentation: Most lending organsations use computer-based statement spreading systems that reorganize the accountant’s financial statements for analysis, and in most cases these programs will show the financial statement spreads, ratios, and cash flow in ascending order, with the earliest date at the left and the most recent year at the right—the opposite of the original financial statement. The worksheets used in this program present information in the order in which you would see it in a spread—earliest year at the left, most recent year and projected years ascending to the right.

Financial terminology: As new terms are introduced and defined, the term used in IFRS appears first, in boldface, and other terms commonly used to mean the same thing are also presented. From that point forward in the module, only the preferred IFRS term is used.. The table that follows shows some of the differences in terminology you may encounter.


Previous terminology IFRS terminology used here

Balance sheet Statement of financial position

Profit and loss accounts Income statement, or statement of comprehensive income

Cash flow statement Statement of cash flows

Debtors Trade debtors or trade accounts receivable

Creditors Trade creditors or trade accounts payable

Turnover Sales, revenue, or sales revenue

Rounding: When calculations are performed in this module, numbers are rounded to the nearest significant digit. For example, if a calculation yields a value of 95.4567:

Round the value at two decimal places to show pounds and pence. Since the third decimal place is greater than or equal to 5, you would round the second decimal place up to 6, yielding a value of £95.46.

Round the value at no decimal places to show whole pounds. Since the first decimal place is less than 5, ignore everything to the right of the decimal and round down to £95.

On the job, you will use your judgment or your organisation’s policy to guide you in determining the significant digit for rounding purposes. Significance depends on what you are calculating and how you will use the number. In this module, we will use the following rounding convention:

Pounds are rounded to the nearest whole pound. If the amounts are expressed in £000s, figures are rounded to the nearest thousand.

Accounting Standards: Reference in these materials to any accounting standard is to International Financial Reporting Standards (IFRS) as implemented in an International Accounting Standard (IAS) as of December 2010, unless the materials, either directly or implied, indicate otherwise. Accounting standards are studied in order to introduce you to the foundations upon which accounting practises and procedures are built. Standards are not studied in detail but rather at a level that allows you to see, in reasonably simple terms, why and how accountants treat various accounting matters as they do. Since any reference in these materials to an accounting standard is to an international standard, the materials can be used in any jurisdiction that has harmonised its accounting standards with international standards.


GGlloossssaarryy A glossary of terms is provided at the end of this module explaining terminology used in this programme that may be unfamiliar to you. Refer to this glossary as needed during your study.

BBee SSuurree ttoo HHaavvee .. .. .. Before you begin this module, be sure to have the following items on hand:

Pencil

Calculator

© Omega Performance Corporation. All rights reserved. Principles of Cash Flow Analysis 9

1 U

N I

T

PPrriinncciipplleess ooff CCaasshh FFllooww AAnnaallyyssiiss

When you have completed Unit 1, you will be able to:

Distinguish between net profit and cash flow

Distinguish between cash flow that is the result of profit and cash flow that is the result of changes in accounts on the statement of financial position, independent of profit or loss

Describe a three-layer approach to cash flow analysis that frees the analyst from dependence on a particular format of cash flow

Describe four financial drivers of cash flow

Cash flow is what repays loans. The concepts in this unit will provide you with an essential foundation on which to analyse cash flow, regardless of whether or not you are expected to actually construct a cash flow statement.

This unit contains two sections that will help you understand the importance of cash flow.

Section 1 defines cash flow and discusses how knowing the two types of cash flow can help you to make better decisions about borrowing and loan repayment.

Section 2 explains the three-layer approach to cash flow analysis, which includes exposing cash flows, analysing the financial drivers, and recognising qualitative factors affecting cash flow.


SSSeeeccctttiiiooonnn 111 WWhhaatt IIss CCaasshh FFllooww?? CCaasshh FFllooww IIss aa MMeeaassuurree ooff CCaasshh IInnffllooww aanndd OOuuttffllooww iinn aannyy PPeerriioodd Cash flow does not equal net income, since there are timing differences between cash receipt and disbursements and accrual accounting recognition of income and expenses. In addition, there are cash outlays and receipts – such as capital expenditures, dividends, and asset sales – that are not reported as income or expenses. Cash flow statements must combine cash flows recognised on the income statement with those on the statement of financial position.

CCaasshh FFllooww IIss tthhee CChhaannggee iinn CCaasshh Cash flow is the term lenders use to identify the increases and decreases in a borrower’s cash and cash equivalents. The key is to understand the receipts and disbursements of cash that occur beneath the surface of accrual accounting. The actual net change in cash and cash equivalent (such as marketable securities) balances from one financial statement date to the next is the sum of all the increases and decreases, and is less revealing than the various increases and decreases and what caused them.

Remember the basic equation of financial accounting:

AAsssseettss == LLiiaabbiilliittiieess ++ SShhaarreehhoollddeerrss’’ FFuunnddss

According to the principle of double entry accounting, when one part of the basic accounting equation changes, one or more of the other elements must automatically change so that the equation will remain, always, in balance. Cash flow analysis regards this process as occurring through changes in the cash account. In real life this will frequently not be the case (a purchase of stock may be financed, for an example, by an increase in creditors with no direct impact on the cash balance), but even transactions which have no immediate effect on cash will have a potential impact. By concentrating on this potential change in cash, our attention can more easily be focused on the underlying cash impact of accounting and management actions.

We can restate the basic equation above as:

CCaasshh ++ OOtthheerr AAsssseettss == LLiiaabbiilliittiieess ++ SShhaarreehhoollddeerrss’’ FFuunnddss


And, isolating the cash account, this becomes:

CCaasshh == LLiiaabbiilliittiieess ++ SShhaarreehhoollddeerrss’’ FFuunnddss –– OOtthheerr AAsssseettss

Let’s look at an example of using the cash account to balance the basic accounting equation:

Cash = Liabilities (Creditors)

+ Shareholders’

Funds –

Other Assets (Stock)

Cash Flow Impact

Sources of cash

Uses of cash Net change in cash account

1. A company begins operations with an initial shareholder investment of £50 deposited in the bank.

50 = 0 + 50 – 0 50 0 0

2. It purchases £60 of stock from suppliers, using £10 in cash from the deposited shareholders’ funds; the remaining £50 is purchased on credit.

40 = 50 + 50 – 60 0 (10) (10)

3. Work costing £15 is carried out on the stock, so its value increases by the same amount. The work has not yet been paid for, and so increases accrued expenses (for example, wages payable). It is a potential (but not yet an actual) use of cash.

40 = 65 + 50 – 75 15 accrued

wages (15) increase in

stock 0

4. The company pays its workers their accrued wages of £15 and also pays other suppliers £15. This is now a real (and no longer a potential) use of cash. The cash balance declines by £30.

10 = 35 + 50 – 75 0 (30)

(15) wages (15) suppliers

(30)

5. Stock, valued at £50 is sold for £60. Cash sources therefore total £60, comprising £50 from the reduction in stock (stock is reduced by £50) and £10 profit (shareholders’ funds increase by £10). The cash flow impact is therefore:

70 = 35 + 60 – 25 60

50 stock 10 profit

0 60


When creditors (a current liability) increase, those creditors are, in effect, lending money to the company. If the ‘loan’ is to finance (as in the above example) the purchase of stock, the cash account (in terms of cash held at the bank etc.) will not change at this time, BUT the ‘loan’ will have to be repaid in the future, and the creditor will normally expect to receive payment in cash. The cash flow analysis therefore shows the increase in creditors as a source of cash and the corresponding increase in the asset (in this case, stock) as a use of cash. Thus an increase in a liability account is a source of cash (think of it as somebody lending money to the company), and an increase in an asset account is a use of cash (think of it as the company using ‘cash’, potential or actual, to convert it into another type of asset).

Using the same logic you will see that a reduction in a liability is therefore a use of cash, equivalent to the company repaying a loan – the creditor receives cash in settlement of the debt. A reduction in an asset is also a source – the company is converting the materials and services it has used to make the asset into cash received (or to be received) from its customers.

When these two events or transactions occur in the same period and in the same amount, the cash account balance will not change. The increase in stock, a use of cash, is offset by the increase in creditors, a source of cash. On the surface, it appears that nothing has affected the cash balance; underneath the surface, cash flows. The purpose of cash flow analysis is to uncover these ‘hidden’ changes, to show which items and transactions have the biggest impact on the cash flow of the company.

Use this chart to help you remember sources and uses of cash:

Increase Decrease

Assets (Use) Source

Liabilities and Equity Source (Use)


Try applying the chart to the following events. For each one, decide what cash flow change is necessary to keep the basic accounting equation in balance, if nothing else happens

1. The borrower makes a sale on credit so that debtors increase.

2. The borrower repays a short-term loan from the bank.

3. The borrower’s stock level falls to a seasonal low point.

4. The borrower makes a profit after taxes during the period.

1. An increase in an overall debtor balance over a period means cash is being used by the company to make a ‘loan’ to the debtors. Instead of receiving cash in exchange for its sales, it agrees to be paid later, so an increase in debtors is a negative cash flow or a use of cash. However, from a standing start (as indicated in this question), a sale on credit to a customer is cash neutral, it has neither an outflow nor an inflow of cash.

2. A decrease in a loan means cash would go down to keep the accounting equation in balance, so a decrease in loans is a negative cash flow or a use of cash.

3. A decrease in stock means cash would go up (stock is being sold to customers) to keep the accounting equation in balance, so a decrease in stock is a positive cash flow or a source of cash.

4. An increase in retained earnings means cash would go up (profits have been made on the sale of products) to keep the accounting equation in balance, so the increase in retained earnings is a positive cash flow or a source of cash.


OOnnllyy CCaasshh RReeppaayyss LLooaannss When evaluating a borrower’s repayment ability, the lender must answer these questions:

When will the borrower generate enough cash to repay the loan?

How will the borrower generate that cash – what combination of positive and negative cash flows will result in the required amount of cash?

Can you be sure the cash will not be needed in the business for something other than loan repayment?

You will be able to answer these questions reliably by carefully identifying the underlying cash flows and analysing what causes them. During the process, avoid three common mistakes or myths that can mislead lenders.

Myth No. 1: Net profit will find its way into the cash account and be available to repay your loan. After all, net profit is a positive cash flow and a source of cash, and a very encouraging one at that since it signifies the economic viability of the company.

Reality: Some or all of the positive cash flow from net profit is usually offset by negative cash flows such as increases in debtors, stock, or long-term assets, especially when the borrower’s sales are growing either year on year or seasonally; most businesses require more assets to support more sales. In addition, some debtors may not pay as promised.

Myth No. 2: Loans can be repaid when debtors are collected. After all, a decrease in debtors is a positive cash flow and a source of cash.

Reality: Many times when debtors are collected, new credit sales immediately result in new debtors, so the debtors balance does not decrease. The cash collected is immediately reinvested in more debtors or more stock and is not available to repay your loan. Only when the debtors balance decreases is cash available to repay debt.

Myth No. 3: Depreciation and amortisation expense results in cash that is available for loan repayment. After all, depreciation and amortisation expense is a positive cash flow and a source of cash from two perspectives:


Depreciation and amortisation is a noncash expense, so the positive cash flow represented by net profit is actually greater than the net profit on the accrual basis income statement. Hence, it is correct to add the depreciation and amortisation expense for that period back to the net profit for the period to identify the potential cash flow from profitability.

Depreciation and amortisation expense for the period is carried to the statement of financial position and added to the accumulated depreciation and amortisation account, a contra account that reduces the balance of net long-term assets. This reduces the asset balance and is a positive cash flow.

Reality: This positive cash flow is often offset by the need to acquire replacement long-term (or short-term) assets. As a result, net total assets don’t necessarily decrease, and the cash flow from depreciation and amortisation is not necessarily available for debt repayment.

Remember:

Net profits don’t repay loans because the potential cash flow often is used in increasing assets.

Debtor collection repays loans only if the balance of debtors decreases.

Depreciation and amortisation expense repays loans only when the balance of net long-term assets decreases.

Does an increase in depreciation expense increase a borrower’s cash flow (exclude the impact on taxes)?

No. The increase in depreciation expense reduces profit, so when you add the two, you have the same amount of cash flow you had before, except for a possible reduction in income taxes. Depreciation is not a receipt of cash.


TTwwoo TTyyppeess ooff CCaasshh FFllooww Your evaluation of a company’s repayment ability will be more reliable if you understand that there are two types of cash flow, and that each type is best suited for repaying a different kind of loan.

Type A: Cash flow from profit is the best source of repayment for long-term loans. This is often more broadly described as net income plus depreciation or as EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) minus actual payments of interest and taxes.

Type B: Cash flow from (temporary) shrinkage of assets is the best source of repayment for seasonal, short-term loans. Even if a company is breaking even, it can still release Type B cash flow. If it is loss-making, those losses may absorb some (or all) of the cash released by asset shrinkage.

Financing Need Best Type of Cash Flow

When you consider financing for: Long-term assets Permanently higher levels of

core current assets Replacement of equity or other

long-term liabilities

Your borrower will only be able to repay if: Cash flow from profits plus

depreciation and amortisation consistently exceeds the amounts needed for long-term assets and to support permanent growth in trading assets (debtors and stock)

You need Type A cash flow.

When you consider financing for: A temporary or seasonal

increase in debtors or stock Any other short-term timing

difference in cash inflows and cash outflows

Your borrower will be able to repay you when: Trading assets shrink back to a

base level Short-term timing differences

reverse You can be repaid from Type B cash flow, even if the borrower is not making a profit, provided it is not losing money or spending the borrowed funds for other things.


OOvveerrttrraaddiinngg

A company that is growing rapidly will typically need to finance higher levels of assets. If its profitability is weak or marginal, however, it may not be able to generate sufficient Type A cash flow (cash flow from profit) to support such financing, making it difficult to justify granting a lending facility. This condition is often referred to as overtrading. These situations are usually best supported with additional equity investments.

Try matching the type of cash flow best suited to repay loans that have the following borrowing causes:

1. Financing an increase in debtors due to the borrower offering all its customers longer sales terms from this day forward.

2. Financing a large stock purchase to take advantage of a one-time discount offered by the supplier.

3. Financing the acquisition of equipment to replace worn out, obsolete equipment.

1. Type A cash flow will be needed. Because the new sales terms will be offered permanently, debtors are not likely to shrink. As a result, there may not be any Type B cash flow.

2. Type B cash flow, from the shrinkage of the stock to its normal level, will be able to repay this loan, even if the borrower only breaks even on the sales. No Type A cash flow is needed to repay this loan.

3. Type A cash flow will be required to repay this loan. Type B cash flow may provide a secondary source of repayment, but expenditures in the capital investment cycle are expected to be repaid from profit over several operating cycles.

SSuummmmaarryy


Cash flow is the activity that occurs beneath the surface of the actual change in cash and beneath the surface of accrual accounting.

Cash flow from profit is desirable, but the total is not necessarily the capacity of the company to pay debt because other cash flow sources and uses intervene.

Increases in assets are negative cash flows (uses of cash), and increases in liabilities and equity accounts are positive cash flows (sources of cash).

Identifying those underlying positive and negative cash flows, as well as what causes them, will help you make decisions about how much and when a company will need to borrow and how and when it will be able to pay you back.

When considering the most desirable repayment sources for loans, look for the two types of cash flow:

Type A cash flow is from profits plus depreciation and amortisation that exceed intervening uses of cash. Some lenders define this more broadly as EBITDA (Earnings Before Interest and Taxes plus Depreciation and Amortisation). Look for Type A cash flow to repay loans for long-lived assets and permanent increases in core trading assets.

Type B cash flow is from temporary or seasonal shrinkage of assets, such as stock or debtors. Look for Type B cash flow to repay seasonal or short-term loans, even when the borrower might only be breaking even.

NNeett PPrrooffiittss DDoo NNoott NNoorrmmaallllyy EEqquuaall CCaasshh FFllooww


SSSeeeccctttiiiooonnn 222 AA TThhrreeee--LLaayyeerr AApppprrooaacchh ttoo CCaasshh FFllooww AAnnaallyyssiiss

PPeeeelliinngg tthhee OOnniioonn Getting beneath the change in cash from one statement of financial position to the next is like peeling the layers of an onion, always asking ‘Why?’ until you’ve reached the core.

Peeling the onion deliberately each time you need to thoroughly understand a borrower’s current and future repayment ability will:

Help you focus on the most important components of each borrower’s cash flow.

Help you to discover the most significant causes of positive and negative cash flows.

Provide insights you need to anticipate future cash flows.

LLaayyeerr OOnnee:: EExxppoossee CCaasshh FFlloowwss The first layer in an effective cash flow analysis is to peel away the effects of accrual accounting and expose all material positive and negative cash flows.

Accrual basis financial statements match revenues and expenses but obscure cash flows.

The accrual-based statement of financial position, income statement, and statement of changes in equity prepared in accordance with International Financial Reporting Standards (IFRS) are intended to match revenues and expenses, not cash receipts and disbursements. Here are some examples: Income statement accounts report revenue when it has been earned,

not when customers pay; they report expenses when incurred, not when bills are paid.

For some kinds of expenses, such as cost of goods sold, ‘incurred’ means in the period when the associated revenues are recognised, not necessarily when the expense activity, such as production, took place.

Production costs are accumulated in the stock account until the goods are sold, which may be long after they were produced and suppliers and workers were paid.

Although matching of revenue and expense is very important to a lender’s understanding of the accumulated performance and future economic potential of the company, it does obscure the amount and timing of cash inflows and outflows that determine loan repayment ability.

Lenders and accountants have developed a variety of methods and formats for reporting cash inflows and outflows so that lenders and other users of financial statements can more efficiently and reliably measure the amounts of cash flows and analyse their components and causes.


In this module, you will learn to identify and analyse various cash flow formats.

You will not usually need to construct cash flow statements; borrowers will provide them. Nor will you have to perform Layer One calculations; software packages are available to perform these calculations when the information is not provided. However, in order to analyse cash flow, you will need to understand how a cash flow report is derived from the statement of financial position, income statement, and statement of changes in equity. So, we will explain and show you how the Layer One formats are put together, even if you won’t ever have to calculate them yourself.

CCaasshh FFllooww RReeppoorrttiinngg

11.. Following are some of the more common formats used in presenting cash flows: Quick cash flow, also known as indirect or traditional cash flow, is the easiest to construct, if you do not receive a cash flow statement from the borrower. It starts with the sources of cash flow from net profits and depreciation and amortisation on the income statement, and then adjusts for the major categories of cash flow use that show up on the statement of financial position: change in trading asset financing need, fixed assets, dividends, and debt service. Quick cash flow is an example of an indirect or ‘bottom-up’ approach, so called because it starts at the bottom of the income statement with net profit. Unit 2, Section 1, of this module demonstrates how to analyse quick cash flow with a simple worksheet.

22.. Statement of cash flows is the format provided by a company when its financial statements are prepared in accordance with IFRS. It typically organises sources and uses of cash flow into three categories: operating, investing, and financing activities. Its chief advantage is that the borrower provides it for you. It can be done in either a direct or indirect format. Unit 2, Section 2, of this module will show you how to use the indirect statement of cash flows to identify financing requirements or repayment capacity.

Another format, known as “direct cash flow,” is also used on occasion. This format starts with sales as the primary cash inflow and adjusts specific cash and non-cash accounts, including expenses and changes in assets and liabilities. It exposes more detail on the changes to various accounts than other methods. This method is not typically used by accountants; therefore this format is discussed in an appendix to this module, which you have the option of studying. Of note, in the future, IFRS may move to the direct method for completion of the Statement of Cash Flows.


All cash flow formats:

Combine information from the accrual statement of financial position, income statement, and statement of changes in equity.

Remove the effects of accrual accounting.

Show you how cash has flowed into, and out of, the business.

Can be the basis of effective cash flow analysis.

Regardless of the format you use for the Layer One calculation of cash flow, remember that it is only the first step in cash flow analysis. Understanding the Layer One format makes your subsequent analysis easier. You must peel away more layers of the onion to understand what financial and nonfinancial factors are causing the cash flows.

LLaayyeerr TTwwoo:: AAnnaallyyssee FFiinnaanncciiaall DDrriivveerrss Layer Two of cash flow analysis quantifies the effects of major financial factors on cash flow. Four of these are so important to understanding past and future cash flows that we call them the financial drivers.

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The percentage increase or decrease in sales from one period to the next. If a company’s sales in year 1 are £100,000,000 and in year 2 are £120,000,000, the company’s change in sales has been an increase of 20%. Increases in sales tend to drive similar percentage increases in stock, debtors, and creditors. Over time, increases in sales may also drive increases in spending on non-current assets (also known as fixed assets).

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The increase or decrease in the number of days in the stock holding period, the debtors collection period, and the creditors payment period from one accounting period to the next. For example, if a company’s debtor days on hand (DDOH) in year 1 are 60 days and in year 2 are 65 days, the number of days in the collection period has increased 5 days. Additional days in the collection period represent a slowdown in collection, and would indicate an increase in actual debtors (unless sales are decreasing) and drive a decrease in cash flow. It is important to consider the sales value and the actual debtors balance movement in such analysis as an increase in the DDOH does not automatically mean a decrease in cash.

Similar analysis techniques can be applied to the stock holding period by calculating change in stock days on hand (SDOH) and to the creditors payment period by calculating creditors days on hand (CDOH).


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The increase or decrease in expenses as a percent of sales. This can be further broken down into cash cost of goods sold and cash selling, general, and administrative expense (cash means excluding non-cash expenses such as depreciation and amortization). If a company’s cash cost of goods sold as a percent of sales in year 1 is 60% and in year 2 is 57%, the cash expenses have decreased and the gross profit margin has increased by 3% of sales. If that 3% carries to the bottom line net profit, the improved margin drives an increase in cash flow, just as a reduced profit margin drives a decrease in cash flow. The combined effect of changes in cash COGS and cash SG&A expense is often measured by calculating the cash operating profit margin – the percentage of sales that remains after subtracting both cash COGS and cash SG&A. This is sometimes referred to as the cash cushion because it provides a cushion for increases in production or operating expenses and a cushion for interest expense.

Another refinement is to measure EBITDA as a percent of sales, called the EBITDA margin, and then to assess the impact that each expense category has had on the EBITDA margin.

Cash COGS and Cash SG&A

Lenders can focus more closely on the cash required to meet production and other operating costs by considering cash cost of goods sold (cash COGS) and cash selling, general, and administrative expenses (cash SG&A). These terms indicate that non cash expenses for depreciation and amortisation have been excluded.

To calculate cash COGS and cash SG&A, subtract any included depreciation and amortisation from the total. To find the amount of depreciation and amortisation, look on the income statement, or look in schedules that break down cost of goods sold and operating expenses, or check for footnotes. For example, a printing company is likely to classify the depreciation of its printing presses as a cost of goods sold.

Cash COGS is important because when lenders use it to calculate stock and creditor days on hand, they obtain more precise measures of the cash required to support each day in the stock holding period and the cash provided by each day in the creditors payment period. Unit 2 has more about this technique.

Of course, in using EBITDA margin, depreciation and amortisation have already been segregated.

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The spending for replacement and expansion of fixed assets, net of any proceeds from the sale or disposal of fixed assets. Spending for fixed assets is an application or use of cash. When spending on fixed assets in a period exceeds the depreciation and amortisation expense in that period, we can imagine the use of cash as competing with other potential uses, such as stock increases or loan repayment. Investment in fixed assets drives an immediate decrease in cash flow – although its ultimate intention is clearly to increase cash flow in the longer term.


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The first three of these changes (sales, days on hand, and margins) are the only areas of a borrower’s financial performance that produce (or fail to produce) ‘internally’ generated cash flow. Internally generated cash flow is important to the lender because reliable loan repayment depends more on it than on external sources of cash flow such as new debt or equity investments.

Cash flow from sales is determined, in part, by internal production and marketing decisions, days on hand are the result of management responses to purchasing, manufacturing and marketing factors, and margins reflect the management of the cost/revenue mix of the company. All are, therefore, in principle, internally controlled rather than reliant upon intervention from new external sources, or uses, of cash.

Contrasted to this, investment in fixed assets is, by its nature, designed to extend the activities of the company beyond their present level – even if it is a replacement of old equipment by new. In other words the management have decided that to realise opportunities or solve problems, they must expand or replace fixed assets.

The distinction is made to enable the lender to evaluate the ability of the company ‘as is’ to meet its obligations, and/or the need to find a solution to its problems outside the current scope of activities – for example, by buying (or selling) production assets. Identifying the amount, consistency, and trend of the impact that each of the four financial drivers is having sets you up to ask the next round of ‘Why?’ questions, ones that will get you to the heart of cash flow issues: what is causing the changes in sales, days on hands, margins, and capital spending?

LLaayyeerr TThhrreeee:: AAnnaallyyssee QQuuaalliittaattiivvee FFaaccttoorrss Layer Three of an effective cash flow analysis asks those questions that will provide cash flow insights that will tell you what is driving cash flow and what combination of external and management factors is at work.

In this third and deepest layer of analysis, you will answer these questions:

How have economic and industry factors affected the borrower’s cash flow?

Which of the factors that are influencing the financial drivers are within management’s control, and which are not?

How well has management been controlling the financial drivers?

Uncovering the qualitative issues behind the financial drivers is necessary in estimating the amount of cash flow available for future debt service and the sustainability of that cash flow.


Critical Management Area Financial Driver Analytical Approach

Sales Percentage change in sales How have external factors such as economic trends affected each financial driver?

Which factors are within management’s control, and which are not?

How effective are management’s strategies and actions in managing each driver?

What are the implications for future cash flows?

Operating cycle Change in DDOH, SDOH, and CDOH

Expenses Change in cash COGS and cash SG&A expenses as a percent of sales

Capital investment cycle Spending for fixed assets, net of any proceeds from sale of fixed assets

SSuummmmaarryy A deliberate, three-layer cash flow analysis will improve your ability to identify a borrower’s current capacity to repay debt because the approach will lead you steadily deeper into the reasons for positive and negative cash flows.

Layer One merely exposes or calculates cash flows; this is often done for you in the Statement of Cash Flows included in the financial statements.

Layer Two identifies the cash impact of each of four financial drivers:

Percentage change in sales

Change in days in the holding, collection, and payment periods

Change in margins

Spending for fixed assets

Layer Three goes deeper to analyse the external economic and industry factors and management actions that have influenced the financial drivers.


PPrraaccttiissee EExxeerrcciissee 1. Which of the following most accurately describes the relationship of

cash flow and net profit reported in accrual accounting?

a. Net profit and cash flow are the same b. Net profit is one source of cash flow c. Net profit is always greater than cash flow d. Net profit is always less than cash flow e. None of the above

2. Which of the following are accurate statements about sources and uses of cash flow? 1. An increase in debtors is a positive cash flow 2. An increase in creditors is a positive cash flow 3. Depreciation and amortisation expense do not use cash 4. An increase in net fixed assets is a negative cash flow

a. 1, 2, and 3 b. 1, 2, 3, and 4 c. 2 and 3 d. 2, 3, and 4

3. Which of the following is an objective of accurate and thorough cash flow analysis?

a. To cancel some effects of accrual accounting and expose actual cash inflows and outflows

b. To identify financial results that have influenced cash flow c. To analyse how management decisions have influenced cash flow d. To understand how conditions beyond management’s control

may have influenced cash flow e. All of the above

4. Which of the following is the measurement for change in sales as a financial driver of cash flow?

a. Returns and allowances as a percentage of sales in the most recent period

b. The cash amount of the sales increase or decrease from one period to the next

c. The percentage increase or decrease in sales from one period to the next


5. Why is the change in sales a significant driver of cash flow?

a. Because all sales result in payments from customers in the same accounting period in which the sale is made

b. Because an increase in sales usually results in a similar cash amount increase in debtors and stock

c. Because an increase in sales tends to cause a similar increase in debtors and stock

6. Which of the following is a way to organise your thinking about management decisions that affect cash flow?

a. Identify the ages of key members of the management team b. Analyse how management decisions have affected sales, the

operating cycle, expenses, and the capital investment cycle c. Find out whether a plan of management succession exists d. Calculate the change in cash and marketable securities from the

beginning to the end of the period of the cash flow e. All of the above

7. Which of the following are accurate statements about Type A and Type B cash flows? (Circle as many as you think are accurate.)

a. Type A cash flow is never used to repay seasonal or short-term debt

b. Type B cash flow, from shrinkage of assets, is always used to repay seasonal or short-term debt

c. Type A cash flow is the best source of repayment for financing of long-lived assets and permanent increases in core trading assets

d. Type B cash flow, from shrinkage of assets, is a good source of repayment for seasonal short-term loans


AAnnsswweerrss 1. b. Net profit is not the same as cash flow and might be more or less

than cash flow in any period, depending on the amount of noncash expense reported in the income statement and the degree of changes in statement of financial position accounts.

2. d. Increasing a liability (creditors) is a source of cash; increasing an asset (net fixed assets) is a use of cash; and a noncash expense (depreciation and amortisation) is not a use of cash. Only statement 1 is not accurate, because an increase in an asset (debtors) is a use of cash and a negative cash flow.

3. e. All choices are objectives of cash flow analysis. Option a is part of Layer One, option b is part of the quantitative analysis in Layer Two; options c and d are part of the qualitative analysis in Layer Three.

4. c. Analysts use the percentage increase or decrease so that they can apply the same percentage increase or decrease to assets such as debtors and stock and to liabilities such as creditors to isolate how the change in sales affects those statement of financial position accounts.

5. c. When sales increase, higher levels of debtors and stock are typically required. Unless the company changes the average length of its collection period and holding period, the two current asset accounts will increase at the same rate as sales.

6. b. Age of managers and existence of a management succession plan might be important to know, but are not likely to help you organise your analysis of how management decisions affect cash flow. Calculating the change in cash is not very analytical, and can be performed simply by looking at the two statements of financial position without performing a cash flow summary.

7. c and d. Statements a and b are not accurate because Type A cash flow can be used to repay seasonal or short-term debt when profits are strong even when the seasonal cycle is extended and the low point comes later than or is not as low as expected.

© Omega Performance Corporation. All rights reserved. Cash Flow Formats 31

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Identify the amount of the financing requirement or cash flow available for debt service as measured by different cash flow formats:

Quick cash flow (also called indirect or traditional cash flow)

Statement of cash flows prepared according to IFRS

Recognise the benefits of each format to the analysis you are performing.

Recognise the limitations of Layer One analysis and the importance of going on to perform Layer Two and Layer Three analyses before drawing conclusions about repayment ability.

This unit introduces some common formats for measuring and

presenting cash flows and contains the following:

Section 1 presents a simple, indirect method of measuring cash flow and illustrates its use to identify cash flow available for debt repayment and the major categories of cash sources and uses when you have not been provided with a cash flow statement.

Section 2 illustrates the indirect cash flow format, which is the most common option used by accountants for the cash flow presentation required under International Financial Reporting Standards (IFRS), and explains how to use the statements to measure the financing surplus or requirement.


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WWhhaatt IIss QQuuiicckk CCaasshh FFllooww??

Quick cash flow (also known as traditional cash flow) is a simple Layer

One format that is quick and easy and doesn’t require a computer. Use

quick cash flow as your foundation for Layer Two and Layer Three cash

flow analyses when you:

Are pressed for time

Have not received a statement of cash flows from the borrower

Want to focus on Type A cash flows

Want to focus on the impact of trading asset financing need

If you need to construct a quick cash flow, you can do it on a napkin –

it’s that easy. If you prefer, you can use a worksheet, an example of which

appears on the following page. Take a look at it now.

The quick cash flow worksheet has the following significant features:

It begins with Type A cash flow, which is cash flow from profits, adjusted for non-cash expenses.

It isolates the combined cash flow impact of all changes in trading asset financing need.

It imposes a hierarchy of cash flow uses that puts debt repayment last.

You will notice that the quick cash flow worksheet has columns for multiple years and these years are listed in ascending order from left to right—earliest year on the left, and most recent year on the right—the opposite of the original financial statements. We use this presentation because most lending institutions use statement spreading software that produces reports, ratios, and cash flow information, and most of this software presents the years in ascending order from left to right. This also facilitates adding projected years to the quick cash flow.

Trading Asset Financing Need

Trading asset financing need is the net balance of those current assets and liabilities that change as a

result of business activity and business decisions – rather than as a result of financial decisions. Trading asset

financing need is generally calculated as debtors plus stock, less creditors and accrued expense. Other current

items, such as prepaid expenses or deferred liabilities, may be included if appropriate, but this decision will

depend upon the analyst’s opinion as to whether this will give a more informative and accurate picture of the

factors affecting the company’s behaviour. Debtors and stock may change because of changes in days on hand

or changes in sales. Large increases in stock and/or debtors resulting from overtrading increase risk.


Quick Cash Flow (in £s) Company Name:

+ -

TAFN (U) S

GFA (U) S

Year 1 Year 2 Year 3

Net profit

Plus: Depreciation, amortisation expense

Plus: Inte est expense

Plus decrease (or less increase): Trading asset financing need

Equals: Cash after operating c cle

Plus (or less): Gross non-current assets

Equals: Cash after capital investment cycle

Less: Dividend declared

Equals: Cash available for all debt repayment

Less: Current portion long-term debt (prior year)

Less: Interest expense

Equals: Cash available for other debt repayment

Change in trading asset financing need OPENING CLOSING

Debtors

Plus: Stock

Less: Creditors

Less: Accrued expenses

Equals: Trading asset financing need

Closing trading asset financing need

Less: Opening trading asset financing need

Equals: Trading asset financing need Year 1


Debtors

Plus: Stock

Less: Creditors







Debtors

Plus: Stock

Less: Creditors






Are any changes in income taxes payable, interest payable, prepaid expenses, investments, or

miscellaneous other accounts large enough to distort quick cash flow?


Quick cash flow is conservative because it shows the effect on debt

repayment capacity if increases in stock and debtors, non-current assets,

and dividends are allowed to absorb internally generated cash flows.

Debts will only be repaid from internally generated cash flows after those

other uses have been satisfied. With that clarity, lenders and borrowers

can decide if some uses of cash flow will be financed, or if some uses of

cash flow can safely be deferred or reduced.

Let’s look at some examples:

An overdraft facility may be available to provide cash needed for growth in trading asset financing needs. If so, the borrower’s internally generated cash flow may be sufficient to pay for non-current assets and dividends, and to make payments on a scheduled long-term loan.

Lenders may be willing to finance investments in non-current assets, with the result that internally generated cash flow may be sufficient to fund growth in stock and debtors and payment of dividends.

The borrower may be able to reduce expenditures on non-current assets, perhaps by establishing operating leases, or some expenditures may be deferred a year or two without damaging productivity. If so, more internally generated cash flow will be available for debt repayment and other uses.

Sales and Days on Hand Drive Trading Asset

Financing Need

A company’s need to finance trading assets grows for two reasons: the amount of financing required each day

on average and the time for which it is needed.

Amount: If sales grow, either permanently or seasonally, the amount required to finance trading

assets each day increases by the same percentage that sales grew.

Timing: If the operating cycle gets longer or the payment period gets shorter, either permanently or

temporarily, the number of days for which financing for trading assets is required gets longer. This

number of days is the cash flow timing difference.

Cash flow timing difference is the length of the operating cycle less the number of days of spontaneous

financing provided by creditors and accruals. If sales for a company grow 10%, the company’s need for

financing trading assets will also grow 10%, unless there is a change in the cash flow timing difference.

If the cash flow timing difference Then the company’s need for financing trading assets

Gets longer… Will grow by more than the percentage increase in sales

Gets shorter… Will grow by less than the percentage increase in sales


AAnnaallyyssiinngg QQuuiicckk CCaasshh FFllooww

Study the background information, statement of financial position, and

income statement in Shepherd Ltd, Part I, in the Cases section of this

module, and the Shepherd Quick Cash Flow worksheet that follows.

Then answer the following questions to confirm your understanding of

how to analyse quick cash flow.


Quick Cash Flow (in £s) Company Name: Shepherd Ltd

+ -

TAFN (U) S

GFA (U) S

20Y2 20Y3

Net profit 285 1,792

Plus: Depreciation, amortisation expense 1,765 1,744

Plus: Interest expense 1,430 1,271

Plus decrease (or less increase): Trading asset financing need 11,304 (8,633)

Equals: Cash after operating cycle 14,784 (3,826)

Plus (or less): Gross non-current assets (2,944) (71)

Equals: Cash after capital investment cycle 11,840 (3,897)

Less: Dividend declared (1,068) (1,222)

Equals: Cash available for all debt repayment 10,772 (5,119)

Less: Current portion long-term debt (prior year) (1,374) (1,734)

Less: Interest expense (1,430) (1,271)

Equals: Cash available for other debt repayment 7,968 (8,124)


Debtors 24,549 17,469

Plus: Stock 25,743 20,519

Less: Creditors 6,937 6,410

Less: Accrued expenses 3,615 3,142

Equals: Trading asset financing need 39,740 28,436

Closing trading asset financing need 28,436

Less: Opening trading asset financing need 39,740

Equals: Trading asset financing need (11,304) 20Y2


Debtors 17,469 22,233

Plus: Stock 20,519 27,865

Less: Creditors 6,410 8,810


Equals: Trading asset financing need 28,436 37,069

Closing trading asset financing need 37,069

Less: Opening trading asset financing need 28,436

Equals: Trading asset financing need 8,633 20Y3


Debtors

Plus: Stock

Less: Creditors









1. How much were Shepherd’s Type A cash flows in 20Y2? Where do

you find them in the company’s financial statements, and where do

they show up on the quick cash flow worksheet?

2. Why is the change in trading asset financing need in 20Y2,

£11,304,000, added to the Type A cash flows?

3. Why is the change in trading asset financing need in 20Y3,

£8,633,000, subtracted from the Type A cash flows?

4. Why do you think quick cash flow uses the change in gross non-

current assets when computing cash after capital investment cycle?

5. Why does the quick cash flow use £1,734,000 and £1,374,000 for

current portion long-term debt in 20Y3 and 20Y2, respectively?


1. Shepherd’s Type A cash flows in 20Y2 were £2,050,000. You find

them on the company’s income statement for 20Y2, being careful to

pick up all three amounts for depreciation and amortisation. Profits

are on the first line of Quick Cash Flow worksheet and the sum of

depreciation and amortisation are on the second line. Notice that we

have rounded to the nearest thousand on the worksheet.

2. Shepherd’s trading asset financing need actually decreased

£11,304,000 in the year ending 31/12/Y2. Since a decrease in trading

asset financing need is a source of cash flow, the amount is added on

the worksheet rather than subtracted.

3. In 20Y3, Shepherd’s trading asset financing need increased by

£8,633,000. The increase in trading asset financing need is a use of

cash flow, so the amount is subtracted from Type A cash flows in the

computation of cash after operating cycle.

4. Because quick cash flow specifically includes depreciation and

amortisation expense as a source of Type A cash flow. Using net fixed

assets could overstate the impact of depreciation and amortisation on

cash flow.

5. Because they each represent the amount that was scheduled to be

repaid during the period of the quick cash flow statement. £1,374,000

showed on the notes to the financial statements for 20Y1 as the

amount due to be paid within the next 12 months, which is the period

of the 20X2 quick cash flow.

IInntteerrpprreettiinngg QQuuiicckk CCaasshh FFllooww

Even before going on to Layer Two and Layer Three cash flow analysis, a

lender is able to make some useful interpretations from quick cash flow.

You can:

Compare the amount of cash available for all debt repayment to the principal amortisation and interest for any existing and proposed additional debt.

Consider whether any of the cash uses, such as increases in trading asset financing need or increases in non-current assets, were financed with debt.

Compare the amount of Type A cash flow to each category of cash use.

Compare each line item of use or source to the total of cash flow available for all debt repayment.

Anticipate how future cash flows may be like, or unlike, the historical cash flows.


These interpretations are components of answering the key Layer One

question: Is cash flow sufficient to repay debt?

Quick cash flow is especially helpful in answering another Layer One

question: What is the impact of the change in trading asset financing

needs? Growth in stock and debtors is what causes overtrading risk. Be

careful not to overlook or underestimate its impact in the evaluation of

debt repayment capacity.

Which of the following interpretations can you reliably make from the

Shepherd Ltd. Quick Cash Flow worksheet? Making some notes of your

calculations will help you see the significance of each interpretation.

1. Without the substantial decrease in trading asset financing need in

20Y2, Shepherd would have been unable to make scheduled debt

payments from internally generated cash flow.

2. Shepherd in 20Y3 was unable to finance its growth in trading asset

financing need with internally generated funds.

3. If Shepherd’s lenders were willing to finance 75% of the growth in

trading asset financing need in 20Y3, Shepherd still would have been

unable to make scheduled payments on long-term debt without

further borrowing.

4. If Shepherd’s increase in gross fixed assets in 20Y3 had been a more

typical £2,000,000, instead of the atypical £71,000, the company’s

cash available for all debt repayment would have been an even larger

negative number, necessitating more new debt.


You can reliably make all four interpretations based on the quick cash

flows for 20Y2 and 20Y3. Here is why:

1. The 20Y2 decrease in trading asset financing need generated

£11,304,000 and cash available for all debt repayment was positive

£10,772,000. Without the cash flow from the lower trading asset

financing need, cash available for all debt repayment would have been

negative £532,000.

2. Internally generated funds were only £3,536,000, which was not

enough to fund the growth in trading asset financing need of

£8,633,000.

3. If lenders have financed 75% of the £8,633,000 growth in trading

asset financing need (perhaps secured by the debtors and stock), that

would bring in £6,474,750 of loan proceeds. However, cash available

for all debt repayment was negative £5,119,000 and scheduled debt

payments were £1,734,000, plus interest expense of £1,271,000.

Shepherd would still have been short by £1,649,250 in making the

debt payments. More borrowing would have been needed.

4. Shepherd’s very low expenditures for non-current assets in 20Y3

minimised the strain on cash flow. If spending had been £2,000,000

instead of the insignificant £71,000, cash available for all debt

repayment would have been negative £7,048,000 (worse by

£1,929,000).

So now we come to the key Layer One question: Is Shepherd’s cash flow

in 20Y2 and 20Y3 sufficient to repay its debt?

We have to say ‘no’, not as the debts are presently structured. Quick cash

flow shows us that Shepherd has insufficient Type A cash flows to pay

dividends and current portion of long-term debt plus interest. Positive

cash flows in 20Y2 are misleading, because they were due almost entirely

to shrinking trading asset financing needs and were therefore not

repeatable in 20Y3.

We can’t be so sure of the answer if we modify the question to ask, ‘Will

Shepherd’s cash flow in the future be sufficient to repay its debt?’

Certainly if cash flow amounts are the same in the future as in the past,

they will be insufficient. However, we can’t reliably anticipate cash flow

without a thorough understanding of Layer Two drivers and Layer Three

issues. We must remember that with all the measuring and thinking about

quick cash flow so far, we are just in Layer One of our analysis.


SSuummmmaarryy

Quick cash flow is a simple, indirect, Layer One format for cash flow

analysis. Its chief advantages are its:

Simplicity

Focus on Type A cash flow

Focus on trading asset financing need

It is conservative because it imposes a hierarchy of thinking about uses of

cash flow that assumes all uses are satisfied before any cash flow is

available to repay any debt.


PPrraaccttiissee EExxeerrcciissee

Directions: Use the background information, financial statements and

Quick Cash Flow Worksheet in Karr Photo, Part I, in the Cases section

of this module to complete the following exercise.


Quick Cash Flow (in £s) Company Name: Karr Photo Equipment and Supplies

+ -

TAFN (U) S

GFA (U) S

20Y2 20Y3

Net profit 246,500 226,630

Plus: Depreciation, amortisation expense 57,250 167,200

Plus: Interest expense 83,210 199,150

Plus decrease (or less increase): Trading asset financing need (1,205,370) (446,930)

Equals: Cash after operating cycle (818,410) 146,050

Plus (or less): Gross non-current assets (568,100) (750,750)

Equals: Cash after capital investment cycle (1,386,510) (604,700)

Less: Dividends declared 0 0

Equals: Cash available for all debt repayment (1,386,510) (604,700)

Less: Current portion long-term debt (prior year) (300,000) (300,000)

Less: Interest expense (83,210) (199,150)

Equals: Cash available for other debt repayment (1,769,720) (1,103,850)


Debtors 1,613,580 2,471,350

Plus: Stock 3,633,700 7,078,700

Less: Creditors 1,665,620 4,521,630


Equals: Trading asset financing need 3,254,830 4,460,200

Closing trading asset financing need 4,460,200

Less: Opening trading asset financing need 3,254,830

Equals: Trading asset financing need 1,205,370 20Y2


Debtors 2,471,350 3,449,770

Plus: Stock 7,078,700 9,364,910

Less: Creditors 4,521,630 7,573,850


Equals: Trading asset financing need 4,460,200 4,907,130

Closing trading asset financing need 4,907,130

Less: Opening trading asset financing need 4,460,200

Equals: Trading asset financing need 446,930 20Y3


Debtors

Plus: Stock

Less: Creditors









1. Which major category of cash use or source had the largest impact on

Karr’s cash flow available for all debt repayment in 20Y2? In 20Y3?

2. Based only on the quick cash flow, is Karr’s cash flow sufficient to

repay its debt?

3. If lenders were willing to finance 75% of Karr’s non-current asset

expenditures in 20Y3, how much cash would Karr have raised from

that source, and how would that change your assessment of Karr’s

cash flow?


AAnnsswweerrss

1. 20Y2: Change in trading asset financing need, a cash use of

£1,205,370

20Y3: Change in gross long-term investments, a cash use of £750,750

2. No. Cash available for all debt repayment is negative in both years.

3. Using the change in gross non-current assets as the amount of non-

current asset expenditures, Karr Photo would generate £563,063 if

lenders advanced 75% of the expenditure. Cash available for all debt

repayment would still be negative by £41,637 (£604,700 - £563,063 =

£41,637). In order to have positive cash flow to make its £300,000

payment of current portion long-term debt, Karr would need an

additional cash inflow of at least £341,637 (£41,637 + £300,000 =

£341,637). Karr might be able to raise that amount by financing some

of the increase in debtors or stock that drove the growth in trading

asset financing need.


SSSeeeccctttiiiooonnn 222

SSttaatteemmeenntt ooff CCaasshh FFlloowwss

WWhhaatt IIss tthhee SSttaatteemmeenntt ooff CCaasshh FFlloowwss??

The statement of cash flows (also known as the cash flow statement) is

one of the basic financial statements required when financial statements

are prepared in accordance with International Financial Reporting

Standards (IFRS). This statement strips away the effects of accrual

accounting in the income statement and statement of financial position,

and reconciles cash inflows and outflows to the actual change in cash

balances from one statement date to the next.

Some UK limited companies preparing accounts under UK GAAP or

using a small companies reporting exemption do not have to prepare a

statement of cash flows and in smaller entities it is often not immediately

available; however, you should request it in these circumstances as most

accountants can easily prepare one.

Because it is intended not only for lenders but for any user of external

financial reports, it does not impose a lender’s perspective or hierarchy on

the cash flows of the business. Instead, it organises various cash inflows

and outflows as:

Cash flows from operating activities

Cash flows from investing activities

Cash flows from financing activities

IFRS allow companies to choose methods or formats that correspond to

the direct or indirect approaches when presenting the statement of cash

flows. Indirect statements start with net income and add back non-cash

expenses. Direct statements begin with cash collected from sales and

subtract expenses. Both statements take into account changes in accounts

on the statement of financial position, and end with the actual change in

cash, and both use the same three basic categories (operating, investing,

and financing). Although IFRS allow the use of either method, it advises

the use of the direct method on the basis that it provides better

information to estimate future cash flow.

Examples of a direct format and an indirect format for the statement of

cash flows for Shepherd Ltd. appear in Shepherd, Part II, in the Cases

section. Take a look at them now. Then come back to this page.


What was Shepherd’s net cash provided by or used in operating activities

for the years ended 31/12/Y2 and 31/12/Y3?

Net cash provided by (used in) operating activities was £11,834 in 20Y2

and a negative £3,764 in 20Y3. Notice that the answers are the same on

the direct and the indirect statements of cash flows.

Most companies provide the indirect format because it is somewhat

easier to prepare. We will focus our discussion and examples on the

indirect format, but you can perform exactly the same analysis using

direct statements of cash flow. For more information on the direct

format, refer to the Appendix to this module.

WWhhyy UUssee tthhee SSttaatteemmeenntt ooff CCaasshh FFlloowwss??

Because it strips away the effects of accrual accounting and shows you

actual cash in and cash out. If your borrower prepares its financial

statements in accordance with IFRS, you will receive a statement of cash

flows. Quick insights from it will be helpful, even if you choose to

calculate another format of cash flow as well.

The portion of the IFRS Statement of Cash Flows job aid that

summarises key features of the statement and its use in estimating a

financing surplus or requirement is displayed on the following page. The

entire job aid, which also provides detailed guidance for conducting Layer

Two and Layer Three analyses using the statement, is included in the Job

Aids section of the module.

Here is what you can gain from just a quick look at the statement of cash

flows:

The total financing needs the company had during the period covered by the statement.

The total purchases of non-current assets and the total proceeds from any disposals of non-current assets.

The total cash paid for interest expense and for income taxes.

Exactly how the company raised cash to meet any shortfalls.


TToottaall ffiinnaanncciinngg nneeeeddss

To calculate financing need, the formula is:

Total net cash provided by or used in

operating activities +


investing activities

Add the total net cash provided by or used in operating activities and the

total net cash provided by or used in investing activities. If the sum is

negative, then this is the company’s financing need. To meet that need,

the company must have borrowed from a lender, raised equity capital, or

drawn down its own cash balances, which will be evident in the financing

activities shown on the statement.

Job Aid: IFRS Statement of Cash Flows

Features Categorises activities as operating, investing, or financing

Reconciles cash flow to the actual change in cash and equivalents or to net debt

Operating activities may be direct or indirect:

Direct: Begins with cash received from customers, subtracts noncash revenue items, subtracts

cash expenses, and adjusts for other cash received

Indirect: Begins with net income, adds noncash expenses, adjusts for changes in certain

accounts on the statement of financial position, especially current assets and current liabilities

Both methods will provide the same information either in the statement of cash flows itself or in the

notes to the accounts – the method chosen by the company affects the presentation of information

rather than its content

Financing need or repayment capacity

Is cash flow sufficient without additional debt or equity or reducing cash?

Net cash provided by (used in) operating activities

Plus: Net cash provided by (used in) investing activities

Equals: (Financing need) or debt reduction capacity

Here is an example using Shepherd. Refer to the statements of cash flows

for Shepherd in the Cases section.

20Y3 20Y2

Net cash used in operating activities (3,764) 11,834

Net cash used in investing activities (1,048) (3,899)

Subtotal (4,812) 7,935

Notice that the shortfall in 20Y3 and the surplus in 20Y2 are before any

payments of dividends or purchase of treasury stock.


TToottaall ppuurrcchhaasseess aanndd pprroocceeeeddss ffrroomm ssaallee ooff nnoonn--

ccuurrrreenntt aasssseettss

The statement of cash flows and its accompanying notes disclose

proceeds from the sale of non-current assets. Without the statement of

cash flows, the only way a lender can discover that information is by

asking management.

Shepherd’s statement of financial position indicates that the combined

effect of any purchases plus proceeds of any sales was a use of £371,000,

but that net figure might be the result of purchasing £471,000 and selling

£100,000, or any other combination that nets to £371,000. The best clue

that there was some disposal or sale of non-current assets is that

accumulated depreciation increased only £1,262,000 during 20Y3, but

depreciation expense was £1,562,000. Assets that had accumulated

depreciation of £300,000 were removed from the statement of financial

position. If Shepherd had a loss on the disposal, meaning any proceeds

were less than the net book value of the assets removed, the loss is

included in Shepherd’s other expenses.

Refer to the Shepherd indirect statement of cash flows, and find the

amounts of total purchases and total proceeds from the sale of non-

current assets for 20Y3.

Total purchases were £396,000 and total proceeds were £25,000. Both

amounts are disclosed in the investing activities section of the statement

of cash flows.

TToottaall ccaasshh ppaaiidd ffoorr iinntteerreesstt aanndd iinnccoommee ttaaxxeess

Only the statement of cash flows calculates cash paid for interest and

taxes. Without the statement of cash flows, you might have difficulty

identifying cash interest paid because the interest payable might be

included in accrued expenses.

How much interest did Shepherd actually pay during the year ended

31/12/Y3?


£1,255,000. This is included in operating activities in the direct method

and reported as a memo item at the bottom of the indirect statement of

cash flows.

FFiinnaanncciinngg ttoo mmeeeett sshhoorrttffaallllss

When the combination of net cash from operating activities and net cash

from investing activities is negative, the company must raise cash to meet

the shortfall. The cash can come from external financing sources, either

debt or equity, or it can come from drawing down the company’s cash

balances.

Under IFRS, non-cash activities related to investing or financing must be

disclosed in the notes to financial statements.

How much of Shepherd’s shortfall of £4,812,000 did it raise from

external financing in 20Y3?

£4,376,000. Notice that this is net of payments for dividends and

purchase of treasury shares; the total net increase in short- and long-term

debt was £5,922,000.

How much of Shepherd’s shortfall did the company ‘raise’ by drawing

down its cash balance in 20Y3?

£436,000.


Comparing Quick Cash Flow and the

Statement of Cash Flows

The two statements are organised similarly, with the result that both statements help

the lender focus on Type A cash flows and the effect of changes in trading asset

financing needs:

Statement of Cash Flows Quick Cash Flow

Net cash provided by (used in) operating activities Cash after operating cycle

Net cash provided by (used in) investing activities Change in gross non-current assets

Combine net cash provided by (used in) operating

activities and investing activities

Cash after capital investment cycle

SSuummmmaarryy

The statement of cash flows is a workable format for Layer One cash

flow and has the advantage of being provided with a borrower’s financial

statements prepared in accordance with IFRS.

Because the statement is for general-purpose users of financial

statements, it does not provide either the lender perspective or the

hierarchy of uses of cash flow that the quick cash flow provides. Instead,

the statement of cash flows is organised into operating, investing, and

financing activities.

Use the statement of cash flows to calculate the total financing need or capacity to

repay debt:



Equals: (Financing need) or debt repayment capacity

© Omega Performance Corporation. All rights reserved. Financial Drivers of Cash Flow 53

3 U

N I

T

FFiinnaanncciiaall DDrriivveerrss ooff CCaasshh FFllooww


Identify in financial statements the four financial drivers of cash flow:

Percentage of increase or decrease in sales Changes in number of days in the collection period, holding

period, and payment period Changes in cash cost of goods sold and cash selling, general, and

administrative expense as percentages of sales Investment in non-current assets

Measure the effect each of the four drivers has had on cash flow

Evaluate the importance of each driver to the cash flow of a particular borrower

Use the Financial Drivers of Cash Flow job aid and the Financial Drivers worksheet to perform a Layer Two analysis

This unit contains four sections, each exploring a particular financial driver of cash flow.

Section 1 discusses the impact that a change in sales has on debtors, creditors, and stock.

Section 2 discusses the impact that a change in days on hand of debtors, creditors, and stock has on cash flow.

Section 3 discusses the impact that a change in profit margins has on cash flow.

Section 4 discusses the impact that an investment in non-current assets has on capital spending as well as other sources and uses of cash flow.



SSttaatteemmeenntt ooff CCaasshh FFlloowwss

WWhhaatt IIss tthhee SSttaatteemmeenntt ooff CCaasshh FFlloowwss??

The statement of cash flows (also known as the cash flow statement) is

one of the basic financial statements required when financial statements

are prepared in accordance with International Financial Reporting

Standards (IFRS). This statement strips away the effects of accrual

accounting in the income statement and statement of financial position,

and reconciles cash inflows and outflows to the actual change in cash

balances from one statement date to the next.

Some UK limited companies preparing accounts under UK GAAP or

using a small companies reporting exemption do not have to prepare a

statement of cash flows and in smaller entities it is often not immediately

available; however, you should request it in these circumstances as most

accountants can easily prepare one.

Because it is intended not only for lenders but for any user of external

financial reports, it does not impose a lender’s perspective or hierarchy on

the cash flows of the business. Instead, it organises various cash inflows

and outflows as:

Cash flows from operating activities

Cash flows from investing activities

Cash flows from financing activities

IFRS allow companies to choose methods or formats that correspond to

the direct or indirect approaches when presenting the statement of cash

flows. Indirect statements start with net income and add back non-cash

expenses. Direct statements begin with cash collected from sales and

subtract expenses. Both statements take into account changes in accounts

on the statement of financial position, and end with the actual change in

cash, and both use the same three basic categories (operating, investing,

and financing). Although IFRS allow the use of either method, it advises

the use of the direct method on the basis that it provides better

information to estimate future cash flow.

Examples of a direct format and an indirect format for the statement of

cash flows for Shepherd Ltd. appear in Shepherd, Part II, in the Cases

section. Take a look at them now. Then come back to this page.


What was Shepherd’s net cash provided by or used in operating activities

for the years ended 31/12/Y2 and 31/12/Y3?

Net cash provided by (used in) operating activities was £11,834 in 20Y2

and a negative £3,764 in 20Y3. Notice that the answers are the same on

the direct and the indirect statements of cash flows.

Most companies provide the indirect format because it is somewhat

easier to prepare. We will focus our discussion and examples on the

indirect format, but you can perform exactly the same analysis using

direct statements of cash flow. For more information on the direct

format, refer to the Appendix to this module.

WWhhyy UUssee tthhee SSttaatteemmeenntt ooff CCaasshh FFlloowwss??

Because it strips away the effects of accrual accounting and shows you

actual cash in and cash out. If your borrower prepares its financial

statements in accordance with IFRS, you will receive a statement of cash

flows. Quick insights from it will be helpful, even if you choose to

calculate another format of cash flow as well.

The portion of the IFRS Statement of Cash Flows job aid that

summarises key features of the statement and its use in estimating a

financing surplus or requirement is displayed on the following page. The

entire job aid, which also provides detailed guidance for conducting Layer

Two and Layer Three analyses using the statement, is included in the Job

Aids section of the module.

Here is what you can gain from just a quick look at the statement of cash

flows:

The total financing needs the company had during the period covered by the statement.

The total purchases of non-current assets and the total proceeds from any disposals of non-current assets.

The total cash paid for interest expense and for income taxes.

Exactly how the company raised cash to meet any shortfalls.


TToottaall ffiinnaanncciinngg nneeeeddss

To calculate financing need, the formula is:


operating activities +


investing activities

Add the total net cash provided by or used in operating activities and the

total net cash provided by or used in investing activities. If the sum is

negative, then this is the company’s financing need. To meet that need,

the company must have borrowed from a lender, raised equity capital, or

drawn down its own cash balances, which will be evident in the financing

activities shown on the statement.

Job Aid: IFRS Statement of Cash Flows

Features Categorises activities as operating, investing, or financing



Direct: Begins with cash received from customers, subtracts noncash revenue items, subtracts

cash expenses, and adjusts for other cash received

Indirect: Begins with net income, adds noncash expenses, adjusts for changes in certain

accounts on the statement of financial position, especially current assets and current liabilities

Both methods will provide the same information either in the statement of cash flows itself or in the

notes to the accounts – the method chosen by the company affects the presentation of information

rather than its content






Here is an example using Shepherd. Refer to the statements of cash flows

for Shepherd in the Cases section.

20Y3 20Y2

Net cash used in operating activities (3,764) 11,834

Net cash used in investing activities (1,048) (3,899)

Subtotal (4,812) 7,935

Notice that the shortfall in 20Y3 and the surplus in 20Y2 are before any

payments of dividends or purchase of treasury stock.


TToottaall ppuurrcchhaasseess aanndd pprroocceeeeddss ffrroomm ssaallee ooff nnoonn--

ccuurrrreenntt aasssseettss

The statement of cash flows and its accompanying notes disclose

proceeds from the sale of non-current assets. Without the statement of

cash flows, the only way a lender can discover that information is by

asking management.

Shepherd’s statement of financial position indicates that the combined

effect of any purchases plus proceeds of any sales was a use of £371,000,

but that net figure might be the result of purchasing £471,000 and selling

£100,000, or any other combination that nets to £371,000. The best clue

that there was some disposal or sale of non-current assets is that

accumulated depreciation increased only £1,262,000 during 20Y3, but

depreciation expense was £1,562,000. Assets that had accumulated

depreciation of £300,000 were removed from the statement of financial

position. If Shepherd had a loss on the disposal, meaning any proceeds

were less than the net book value of the assets removed, the loss is

included in Shepherd’s other expenses.

Refer to the Shepherd indirect statement of cash flows, and find the

amounts of total purchases and total proceeds from the sale of non-

current assets for 20Y3.

Total purchases were £396,000 and total proceeds were £25,000. Both

amounts are disclosed in the investing activities section of the statement

of cash flows.

TToottaall ccaasshh ppaaiidd ffoorr iinntteerreesstt aanndd iinnccoommee ttaaxxeess

Only the statement of cash flows calculates cash paid for interest and

taxes. Without the statement of cash flows, you might have difficulty

identifying cash interest paid because the interest payable might be

included in accrued expenses.

How much interest did Shepherd actually pay during the year ended

31/12/Y3?


£1,255,000. This is included in operating activities in the direct method

and reported as a memo item at the bottom of the indirect statement of

cash flows.

FFiinnaanncciinngg ttoo mmeeeett sshhoorrttffaallllss

When the combination of net cash from operating activities and net cash

from investing activities is negative, the company must raise cash to meet

the shortfall. The cash can come from external financing sources, either

debt or equity, or it can come from drawing down the company’s cash

balances.

Under IFRS, non-cash activities related to investing or financing must be

disclosed in the notes to financial statements.

How much of Shepherd’s shortfall of £4,812,000 did it raise from

external financing in 20Y3?

£4,376,000. Notice that this is net of payments for dividends and

purchase of treasury shares; the total net increase in short- and long-term

debt was £5,922,000.

How much of Shepherd’s shortfall did the company ‘raise’ by drawing

down its cash balance in 20Y3?

£436,000.


Comparing Quick Cash Flow and the

Statement of Cash Flows

The two statements are organised similarly, with the result that both statements help

the lender focus on Type A cash flows and the effect of changes in trading asset

financing needs:

Statement of Cash Flows Quick Cash Flow

Net cash provided by (used in) operating activities Cash after operating cycle

Net cash provided by (used in) investing activities Change in gross non-current assets

Combine net cash provided by (used in) operating

activities and investing activities

Cash after capital investment cycle

SSuummmmaarryy

The statement of cash flows is a workable format for Layer One cash

flow and has the advantage of being provided with a borrower’s financial

statements prepared in accordance with IFRS.

Because the statement is for general-purpose users of financial

statements, it does not provide either the lender perspective or the

hierarchy of uses of cash flow that the quick cash flow provides. Instead,

the statement of cash flows is organised into operating, investing, and

financing activities.

Use the statement of cash flows to calculate the total financing need or capacity to

repay debt:



Equals: (Financing need) or debt repayment capacity


SSSeeeccctttiiiooonnn 111 CChhaannggee iinn SSaalleess

SSaalleess DDrriivveess CCaasshh FFllooww Sales have a larger impact on cash flow than any other aspect of financial performance. A change in sales, whether an increase or decrease, is usually the largest driver of changes in cash flow.

Generally, businesses need more assets and incur more expenses when their sales become higher. When sale grow too fast, overtrading can occur.

Growth or decline in sales from one period to the next impacts cash because:

Debtors will increase by the same percentage that sales grew or decrease by the same percentage that sales declined, if there is no change in DDOH.

Stock and creditors will each increase by the same percentage that cash COGS grew or decrease by the same percentage that cash COGS declined, if there are no changes in SDOH or CDOH.

Other accounts in the statement of financial position may also rise and fall roughly in proportion to sales although their combined cash impact is seldom material.

Variable expenses may rise and fall with the level of sales activity.

If profit margins are stable and sales increase, the amount of profit increases, and so does cash flow.


Closer Look at Sales Impacting Cash Flow

–

Sales Increase, A Decrease in Cash Flow

+ Sales Decrease,

An Increase in Cash Flow

+ Debtors –

As sales increase, the debtors increase and may stay at the higher level unless sales decline. The growth in debtors is a use or application of cash flow.

When sales decline, the company may gradually collect the debtors from earlier sales; the new debtors are not as large, so total debtors shrink and are therefore a source of cash flow.

+ Stock –

More units of stock are usually required to support higher levels of customer demand, so that orders can be filled promptly and sales can be recognised. This is a use or application of cash flow.

If customer demand falls, less stock is normally needed. If management is able to reduce purchasing and labour costs, stock will decline, a source of cash flow.

+ Expenses –

If sales increase and the company is producing more goods and services, it incurs higher expenses and more bills, including wages and sales and administrative labour costs; this is a use of cash flow.

If sales decrease, some variable expenses (sales commissions and delivery costs) will fall. Other variable expenses will fall when expenses that go into COGS decline. These are sources of cash flow.

+ Non-current assets –

Periodically, as sales increase, the borrower will need to increase plant, equipment, or other productive assets, a use of cash flow.

If sales decline over a prolonged period of time, the borrower may be able to sell excess capacity and generate cash flow.

Creditors follow a slightly different rule:

+

Sales Increase, An Increase in Cash Flow

- Sales Decrease,

A Decrease in Cash Flow

If stock requirements increase due to growth in customer demand, management purchases more materials or merchandise. This leads to an increase in creditors, a source of cash flow.

If management reduces purchases when stock requirements fall with customer demand, the amounts owed to suppliers will fall, a use of cash flow.

Measuring the impact that a change in sales has had on debtors, stock, and creditors is important because:

The measures tell you how much cash flow is being absorbed or released by these balances as a result of the company’s sales growth. (Other events can cause changes in the balances, so it is important to separate the amount of change that is due to sales growth or decline.)

The bigger the impact on cash flow, the more important it is to understand when considering lending facility structure, especially repayment plans.

Unless the growth rate is low and the net profit margin very high, the cash required to fund growth in debtors and stock often uses up all the increased cash flow from the increase in profit.


MMeeaassuurriinngg tthhee CCaasshh IImmppaacctt oonn DDeebbttoorrss WWhheenn SSaalleess CChhaannggee

This measurement is easy. First, calculate the percentage of increase or decrease in sales for the period you are analysing.

Here is an example if you are analysing cash flow in year 2:

Sales in year 2 £55,000,000

Less: Sales in year 1 £50,000,000

Equals: £ Change in sales £5,000,000

Divided by: Sales in year 1 £50,000,000

Equals: Percentage of change in sales 10%

Sales in year 2 increased 10% over sales in year 1.

Next, multiply the opening debtors balance by that percentage. The result is the amount you would expect debtors to increase during the year, based only on the sales growth that occurred during the year.

Next, add that increase to the opening amount, and you have the amount you expect debtors to be at the end of the year, based only on the sales growth.

Continuing with our example:

Debtors at the beginning of year 2 (Use amount on statement of financial position at end of year 1)

£9,000,000

Times: Percentage of change in sales 10%

Equals: Change in debtors due to sales growth £900,000

Plus: Opening debtors £9,000,000

Equals: Expected balance of debtors based on sales growth

£9,900,000

SSoo WWhhaatt??

You know the company will need positive cash flows of at least £900,000 to offset this negative cash flow. This is before any consideration of possible changes in sales terms that could stretch out collections, expenditures for non-current assets, stock needs, or repayment of lending facilities.

You know that if sales were to grow another 10% next year, an additional £990,000 in positive cash flows would be needed. Will the company generate the cash internally, or will it need to borrow? A lender who can anticipate these needs has a competitive advantage, either to shore up a risky situation (overtrading) before it gets worse, or to expand the relationship if the risk is satisfactory.


MMeeaassuurriinngg tthhee CCaasshh IImmppaacctt oonn SSttoocckk WWhheenn SSaalleess CChhaannggee

This one is easy, too, but there is one twist: we use the percentage of change in cash COGS instead of the percentage of change in sales because:

Stock is the accumulated cost of goods purchased or produced that have not yet been sold.

Therefore, stock does not have the ‘mark-up to selling price’ that debtors have.

Use cash COGS to eliminate any distortion if depreciation or amortisation expenses are reported in total COGS. You are trying to focus on the cash flow at this point, not the accrual profitability. To calculate cash COGS, look for any depreciation or amortisation expense reported in COGS on the income statement, in schedules, or in the footnotes. Subtract those noncash expenses from the total COGS before beginning this calculation.

Note: You may not find the depreciation or amortisation expense reported in COGS from the statutory accounts and may need to review the notes to the financial statements or ask for further information from your customer to establish this.

First, calculate the percentage of increase or decrease in cash COGS for the period you are analysing.

Here is an example if you are analysing cash flow in year 2:

Cash COGS in year 2 £33,500,000

Less: Cash COGS in year 1 £30,000,000

Equals: £ Change in cash COGS £3,500,000

Divided by: Cash COGS in year 1 £30,000,000

Equals: Percentage of change in cash COGS 11.67%

Cash COGS in year 2 increased 11.67% over cash COGS in year 1.

Next, multiply the opening stock balance by that percentage. The result is the amount you would expect stock to increase during the year, based only on the cash COGS growth that occurred during the year.

Next, add that increase to the beginning amount, and you have the amount you expect stock to be at the end of the year, based only on the growth in sales and production activities.


Continuing with our example:

Stock at the beginning of year 2 (From statement of financial position at end of year 1)

£7,000,000

Times: Percentage of change in cash COGS 11.67%

Equals: Change in stock due to cash COGS growth £816,900

Plus: Opening stock £7,000,000

Equals: Expected balance of stock based on cash COGS growth

£7,816,900

AAggaaiinn,, ssoo wwhhaatt??

You know that the increased sales and production levels, measured by the change in cash COGS, is driving stock levels up by £816,900. This negative cash flow must be offset by positive cash flows before the company will be able to repay any debt. If internally generated cash flows are less than £816,900, the company will need to borrow.

The problem is actually worse, because this cash flow need for stock is in addition to the cash flow need for debtors.

In our example, the combined cash flow need for increases in trading assets is now £1,716,900, all due to sales growth. (Brackets indicate negative cash flow, uses of cash.)

Cash impact of sales growth on debtors £(900,000)

Cash impact of cash COGS growth on stock £(816,900)

Subtotal cash impact of growth on trading assets £(1,716,900)

MMeeaassuurriinngg tthhee CCaasshh IImmppaacctt oonn CCrreeddiittoorrss WWhheenn SSaalleess CChhaannggee

This one calculates exactly like the measurement for the impact of sales change on stock: use the percentage of change in cash COGS as a yardstick surrogate for sales growth.

The twist with this measure is that growth in cash COGS drives an increase in creditors, but this increase is a positive cash flow because creditors is a liability.


Continuing with the same example:

Creditors at beginning of year 2 (From statement of financial position at end of year 1)

£4,000,000

Times: Percentage of change in cash COGS 11.67%

Equals: Change in creditors due to cash COGS growth

£466,800

Plus: Opening creditors £4,000,000

Equals: Expected balance of creditors based on cash COGS growth

£4,466,800

At last we have a positive cash flow to help offset the negative cash flows.

Cash impact of sales growth on debtors £(900,000)

Cash impact of cash COGS growth on stock £(816,900)

Subtotal cash impact of growth on trading assets £(1,716,900)

Cash impact of growth on creditors £466,800

Total impact of sales growth on trading assets and creditors

£(1,250,100)

NNooww wwhhaatt??

You know the size of the combined impact of sales growth on debtors, stock and creditor accounts.

You can assess its importance relative to other historical sources and uses of cash flow, and aim your analysis of the external and management factors according to what seems most important.

You can assume that if sales growth next year is comparable to the growth this year, the company will need to generate that same amount of cash flow to support the growth, even if nothing else changes. If other things also change, such as a need to replace or expand non-current assets, cash flow requirements will be even higher.

On the other hand, if it happens that the company’s other sources of internally generated cash flow this year have been sufficient to offset the needs, you can shift your analysis to the:

External and management factors influencing those other cash flows Evaluation of how likely those other positive cash flows are to occur

again next year

TToooollss ttoo GGuuiiddee YYoouu tthhrroouugghh TThhiiss AAnnaallyyssiiss The Financial Drivers of the Cash Flow job aid captures the step-by-step process for measuring and analysing the cash impact of a change in sales.


It also provides tips and analytical insights that go beyond the example you have just worked through. You can use this job aid to analyse more complex borrowers. While the complete job aid is located in the Job Aids section of this module, the portion of the job aid that deals with change in sales is reproduced on the following page. Take a brief look at it now.

Job Aid: Financial Drivers of Cash Flow

Change in sales STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure sales and cash COGS growth (or decline) 1. Calculate the %

increase or decrease in sales from one period to the next

Current period’s sales Less: Prior period’s sales Divided by: Prior period’s sales Equals: % change (up or down) in sales

• The total cash impact of sales and cash COGS growth (or decline) is cash flow absorbed (used) in or released (provided) from the operating cycle as a result of the change in sales and cash cost of goods sold.

• It includes the amounts by which debtors and stock would have increased (a cash use) or decreased (a cash source), and the amount by which creditors would have increased (a cash source) or decreased (a cash use) due only to the change in sales and cash COGS.

• If debtors, stock, or creditors changed by more or less than this amount, the remainder of the change (and the cash flow) can be due only to a change in days on hand.

2. Calculate the % increase or decrease in cash COGS from one period to the next

Current period’s cash COGS Less: Prior period’s cash COGS Divided by: Prior period’s cash COGS Equals: % change (up or down) in cash COGS

B. Measure the impact on: 1. Debtors

Opening debtors Times: % change in sales Equals: Change in debtors due to change in sales

2. Stock Opening stock Times: % change in cash COGS Equals: Change in stock due to change in cash COGS

3. Creditors Opening creditors Times: % change in cash COGS Equals: Change in creditors due to change in cash COGS

C. Measure the combined impact of sales and cash COGS growth (or decline) on trading asset financing need

Change in debtors due to change in sales Plus: Change in stock due to change in cash COGS Plus: Change in creditors due to change in cash COGS Equals: Total impact of sales and cash COGS growth (or decline)

Increases in debtors or stock are uses of cash. An increase in creditors is a source of cash.


The financial drivers worksheet is a format for performing and recording your calculations as you analyse the financial drivers of cash flow. You can use the worksheet during this module and also on the job when you are analysing the cash flow of real borrowers. The change in sales portion of the worksheet appears below. Take a look at it now.

Financial Drivers Worksheet Borrower: ( ) = use of cash

Cash Impact of Change in Sales (£000s etc.) Year 1 Year 2 Year 3 Sales Sales change % Times: Opening debtors Equals: Impact on debtors

Cash COGS Cash COGS change % Times: Opening stock Equals: Impact on stock

Cash COGS change % Times: Opening creditors Equals: Impact on creditors

TOTAL OPERATING CYCLE IMPACT OF CHANGE IN SALES

AA MMoorree CCoommpplleexx EExxaammppllee ooff tthhee IImmppaacctt ooff CChhaannggee iinn SSaalleess We have completed the change in sales portion of the Financial Drivers worksheet for Karr Photo Equipment & Supplies Ltd as an example of a Layer Two analysis of the cash impact of the change in sales. Karr Photo is a medium-sized, middle market company with several lines of business and relatively complex financial statements.

To become more familiar with the analytical steps and insights and the use of the worksheet:

Study the partially completed Karr Photo Financial Drivers worksheet which follows.

Refer to the Financial Drivers of Cash Flow job aid in this section or in the Job Aids section of the module.

Refer to the financial statements and worksheets in Karr Photo, Parts I and II in the Cases section of the module.

Then, answer the questions that follow the worksheet about how the Karr Photo cash flow has been affected by the change in sales. Understanding the answers to these questions will help prepare you for cash flow analysis on the job.


Financial Drivers Worksheet Borrower: Karr Photo ( ) = use of cash

Cash Impact of Change in Sales (£s) 20Y1 20Y2 20Y3 Sales 22,110,280 36,786,130 Sales change % 66.38% Times: Opening debtors 1,613,580 Equals: Impact on debtors (1,071,025)

Cash COGS 17,296,520 29,412,810 Cash COGS change % 70.05% Times: Opening stock 3,633,700 Equals: Impact on stock (2,545,423)

Cash COGS change % 70.05% Times: Opening creditors 1,665,620 Equals: Impact on creditors 1,166,774

TOTAL OPERATING CYCLE IMPACT OF CHANGE IN SALES (2,449,674)

Answer these questions about the ways that Karr’s cash flow has been affected by the change in sales:

1. On which of the three accounts (debtors, stock, and creditors) did the change in sales for Karr Photo from 20Y1 to 20Y2 have the largest cash flow impact? How much was the change-in-sales driver effect on this account?

2. Based on what you know about the business of Karr Photo, did you expect this result, or was it a surprise? Why?

3. Was the impact of the change in cash COGS on creditors a source of cash flow or a use of cash flow?


4. Place the following questions in order of their importance, based on the cash flow impact of sales on Karr Photo during 20Y2 as shown in the partially completed Financial Drivers Worksheet. Assume that you have the opportunity to ask these questions early in 20Y3.

a. How are debtors affected when sales increase?

b. How do you manage the stock in the face of rapid sales growth?

c. What is the outlook for sales growth next year?

d. How much of your growth in core trading assets have you financed from creditors growth?

5. Advanced: If the cash flow impact of the 70.05% growth in cash COGS was to increase stock £2,545,423, why did stock actually increase £3,445,000, almost a million pounds more than the cash COGS growth impact?


1. The largest cash flow impact of the 66.38% growth in sales and 70.05% growth in cash COGS was on Karr’s stock. The 70.05% growth in cash COGS drove an increase of £2,545,423 in Karr’s stock from 31/10/Y1 to 31/10/Y2.

2. This is not a surprise for Karr because we know that Karr carries a large amount of stock for each £ of sales, while it has a low level of debtors for each £ of sales because most sales are cash or credit card transactions. The cash flow of companies that sell mostly on credit, with longer settlement terms than retail credit cards, typically experience greater growth in debtors due to sales growth than they experience in stock growth. But for Karr, we should not be surprised.

3. The cash COGS growth drove an increase in creditors of £1,166,774, a source of cash.

4. Based on these measurements of the cash flow impact of the very strong sales growth, it is most important (of the four choices given) to find out what Ron Karr thinks is the proper relationship of sales and stock and how he manages the stock levels. A companion question that is equally important is to ask about Ron’s outlook for sales growth. The other two questions, a and d, aren’t very useful. They don’t get you beyond what you already know from the quantitative measurements you have in front of you, and they aren’t focused on the largest cash flow impact of the change in sales for Karr, stock growth.

5. Experienced lenders will notice that the actual increase in stock from 31/10/Y1 to 31/10/Y2 was quite a bit more than the growth that was driven or predicted by the increase in cash COGS. They know that something else is at work to cause the stock to grow even more. That something else is an increase in SDOH, the subject of Section 2. SDOH increased from 76.7 in 20Y1 to 87.8 in 20Y2, and that increase of about 11 days is a big user of cash flow.

SSuummmmaarryy Sales growth is a substantial driver of cash flow because the increase in sales triggers these uses of cash flow:

Proportionate increases in debtors and stock

Higher levels of expense

Periodically, the need to expand non-current assets

Sales growth also triggers an immediate source of cash flow: growth in spontaneous financing from creditors.


When sales decline rather than grow, the effects are reversed:

We expect debtors and stock to decrease proportionately.

Variable expenses are lower, and management may be able to curtail other expenses.

There is no need to expand non-current assets and less wear and tear on existing non-current assets.

We expect creditors to decrease proportionately, using up cash flow.

Measuring the cash impact of changes in sales is important, for it tells us how big the impact is relative to other cash flow sources and uses, and therefore helps prioritise and focus our analysis of the external and management factors that influence sales.

To measure the cash impact of sales growth or decline on debtors:

Calculate the percentage of change in sales

Multiply the beginning debtors by the percentage of change in sales

To measure the cash impact of sales growth or decline on stock and creditors:

Calculate the percentage of change in cash COGS

Multiply the beginning stock by the percentage of change in cash COGS

Multiply the beginning creditors by the percentage of change in cash COGS


PPrraaccttiissee EExxeerrcciissee Directions: Use the financial statements and worksheets in Karr Photo, Parts I and II in the Cases section of this module, the Financial Drivers of Cash Flow job aid, and the Financial Drivers Worksheet below to answer the following questions.


Cash Impact of Change in Sales (£s) 20Y1 20Y2 20Y3 Sales 22,110,280 36,786,130 47,374,050 Sales change % 66.38% 28.78% Times: Opening debtors 1,613,580 2,471,350 Equals: Impact on debtors (1,071,025) (711,313)

Cash COGS 17,296,520 29,412,810 36,951,760 Cash COGS change % 70.05% 25.63% Times: Opening stock 3,633,700 7,078,700 Equals: Impact on stock (2,545,423) (1,814,378)

Cash COGS change % 70.05% 25.63% Times: Opening creditors 1,665,620 4,521,630 Equals: Impact on creditors 1,166,774 1,158,962

TOTAL OPERATING CYCLE IMPACT OF CHANGE IN SALES (2,449,674) (1,366,729)

1. Based on the partial worksheet, answer the following questions:

a. What is the largest cash flow impact of the change in sales during 20Y3?

b. How does your answer to 1a confirm or change your insight about the most important area for further questioning about sales change and cash flow for Karr?


c. What, if anything, is different about the impact of sales and cash COGS growth in this year than in the prior year?

d. Why is the total cash flow impact of the change in sales only half as much this year as it was last year, even though sales were up almost £11,000,000 this year compared to being up about £15,000,000 last year?

2. Advanced: Why is the cash flow impact of the change in cash COGS on creditors so close in amount in 20Y3 to the impact in 20Y2, even though the percentage of increase in cash COGS was much less in 20Y3?


AAnnsswweerrss 1. a. The largest cash flow impact of the change in sales during 20Y3

was to drive an increase of £1,814,378 in stock.

b. This finding confirms that the most important area for further investigation of cash flow impact from sales growth is the relationship between sales and stock and how, if at all, the company can manage stock levels to reduce cash flow requirements. For two consecutive years, the sales growth has driven an increase in stock that far exceeds the source of cash from increased creditors, and is 7 to 8 times the amount of potential Type A cash flow.

c. The most obvious differences between the cash impact of sales growth this year and the impact last year are:

The overall amount of the impact is less because the percentage of growth in sales and cash COGS was less in 20Y3 than in 20Y2.

The increase in cash COGS drove an increase of £1,158,962 in creditors this year, almost as much as the £1,166,774 the growth in cash COGS drove last year, in spite of the lower rate of growth this year (25.63% compared to 70.05% last year).

d. Because the change in sales (and the impact on statement of financial position accounts) is calculated using a percentage. While the change in the amount of sales this year (an increase of £11,000,000) is more than half the change in sales last year (almost £15,000,000), the percentage of change in sales this year was only 28.78% and the percentage of change in sales last year was 66.38%.

2. Because the monetary impact is the result of multiplying two numbers: beginning creditors and the percentage of increase in cash COGS. Although the percentage of increase in cash COGS was less in the second year than it was in the prior year (25.63% versus 70.05%), the beginning creditors for the second year was larger than it was at the beginning of the first year (£4,521,630 vs. £1,665,620).


SSSeeeccctttiiiooonnn 222 CChhaannggeess iinn DDaayyss oonn HHaanndd Changes in debtor, stock and creditor days on hand impact cash flow because:

Each additional day in the collection period (DDOH) uses cash.

Each additional day in the holding period (SDOH) uses cash.

Each additional day in the payment period (CDOH) provides cash.

When DDOH or SDOH decreases, the decrease is a positive cash flow, a source of cash. When CDOH decreases, the decrease is a negative cash flow, a use of cash. These principles apply in all circumstances: whether sales are increasing, decreasing, or flat; whether the change in days on hand is temporary or permanent; and whether the change is the result of a deliberate strategy and management action, something unplanned but controllable, or something beyond management’s control.

The amount of the cash impact of changes in days on hand is important for the lender to identify because:

Knowing the size helps the lender understand the importance of investigating and evaluating the factors that influence the changes in days on hand.

Knowing the factors influencing the changes helps the lender evaluate how well management is responding to and controlling those factors.

Knowing what to expect of management helps the lender anticipate what the cash flow impacts are likely to be in the future.

MMeeaassuurriinngg tthhee CCaasshh IImmppaacctt WWhheenn DDDDOOHH CChhaannggeess

To measure the amount of cash flow absorbed when DDOH increases, or the amount of cash flow released when DDOH decreases:

1. Calculate the change in DDOH

2. Calculate the amount of one day’s sales (average daily sales)

3. Multiply the number of days change in DDOH times the average daily sales


Refer to the changes in days on hands portion of the Financial Drivers of Cash Flow job aid for detailed guidance in performing those calculations and for the insights the numbers provide.

Here is an example when DDOH is increasing:

DDOH, year 1 54 DDOH, year 2 59 Change in DDOH 5, an increase in days

Sales in year 1 £38,000,000 Sales in year 2 £38,000,000 Average daily sales £104,110

(£38,000,000 annual sales 365 days in the year = £104,109.59 average sales each day)

Cash impact of change in DDOH (£520,550) (5 days x £104,110 for each day = £520,550)

The increase of 5 days DDOH, which measures a lengthening in the average collection period, has absorbed £520,550 in cash flow. This cash flow is ‘tied up’ in the debtors and is unavailable for other things. Only when the cash is collected and debtors shrink will the cash be available to meet other needs such as repaying debt.

Shortening the average collection period will release the cash that was absorbed when the days on hand slowed down.

In our example:

Shortening the collection period from 59 days back to an average of 54 days would release the entire £520,550.

Each one-day reduction in DDOH would release £104,110.

Improving the collection period to 50 days, a total reduction of 9 days, would release a total of 9 times £104,110 or £936,990.

SSoo wwhhaatt??

Because the level of DDOH and any change in DDOH from one period to the next has an impact on cash flow, the lender needs to understand what factors influence turnover and how well management is controlling it.


Brainteaser

What is really happening when a borrower repays your short-term loan on time but comes back a week later to borrow again?

Very likely, the borrower paid you with cash collected from customers, but new sales were generating new receivables, and the amount of debtors did not shrink. So, the borrower delayed paying some of its creditors, to pay you instead. This delay didn’t sit well with suppliers or jeopardised some discounts, so the borrower came back to you for another loan. Your loan is supporting a permanently higher level of debtors. Unless debtors shrink back to earlier levels, either because sales fall or because DDOH falls, the borrower will have to generate Type A cash flow to pay you.

MMeeaassuurriinngg tthhee CCaasshh IImmppaacctt WWhheenn SSDDOOHH CChhaannggeess

To measure the cash impact when SDOH increases and absorbs cash or decreases and releases cash:

1. Calculate the change in SDOH

2. Calculate the amount of one day’s cash COGS (average daily cash COGS)

3. Multiply the number of days change in SDOH times the average daily cash COGS

Refer to the changes in days on hands portion of the Financial Drivers of Cash Flow job aid, for detailed guidance in performing those calculations and for more of the analytical insights the numbers yield.

Here is an example when SDOH is increasing:

SDOH, year 1 96.4 SDOH, year 2 100.0 Change in SDOH 3.6, an increase in days

Cash COGS in year 1 £30,000,000 Cash COGS in year 2 £30,000,000 Average daily cash COGS £82,192

(£30,000,000 annual cash COGS 365 days in the year = £82,191.79 average cash COGS each day)

Cash impact of change in SDOH £(295,891) (3.6 days x £82,192 for each day = £295,891)


The increase of 3.6 days SDOH, which measures a lengthening or slowdown in the average holding period, has absorbed £295,891 in cash flow. This cash flow is ‘tied up’ in the stock and is not available to be spent for other things. Only when the stock is sold, if it is not immediately replaced with other stock, will the stock shrink so that the cash is available to meet other needs such as repaying debt. If the SDOH does not go back down to 96.4 days, the permanent or base level of stock has permanently increased and requires that cash be invested there permanently.

SSoo wwhhaatt??

Measuring the impact on cash when stock days on hand changes is important because:

Knowing the size of the impact helps the lender decide how important it is to investigate the underlying economic, industry, and management

factors that are influencing the days on hand.

Knowing what is actually influencing the days on hand and how well management is controlling it helps the lender anticipate what days on hand is likely to be in the future, and what the cash flow consequence is likely to be.

The causes of change in stock days on hand are diverse. Just measuring the change in stock tells you nothing about the causes. Isolating the amount of change due to change in sales (as measured by cash COGS) and the amount of change due to days on hand will help you focus your questions to get at the real underlying causes.

Seasonal Purchases and Collections Affect Cash Flow

Feed and grain merchants have silos full after the harvest. Sales of grain to feed livestock are steady year round. The SDOH is very high in the first months after the big purchase but declines as stock on hand gradually falls in relation to the stable level of sales.

Now imagine that the merchant’s customers are able to pay for grain purchases only at the end of a livestock growing cycle. The merchant’s cash flow is dominated by the bunched-up purchases and collections, even though its sales are about the same each month.


MMeeaassuurriinngg tthhee IImmppaacctt oonn CCaasshh WWhheenn CCDDOOHH CChhaannggeess

To measure the amount of cash flow provided when CDOH increases and the cash absorbed when CDOH decreases:

1. Calculate the change in CDOH

2. Calculate the amount of one day’s cash COGS (average daily cash COGS)

3. Multiply the number of days change in CDOH times the average daily cash COGS

Remember, each additional day in the creditors payment period provides cash that the company has not yet paid suppliers and can use for other needs in the business. For each day that the payment period shortens, that cash (the amount of one day of cash COGS) is required to pay suppliers and is not available for other uses.

Refer to the changes in days on hand portion of the Financial Drivers of Cash Flow job aid, for detailed guidance in performing those calculations and for the analytical insights they provide.

Here is an example when CDOH is increasing:

CDOH, year 1 27 CDOH, year 2 33 Change in CDOH 6, an increase in days

Cash COGS in year 1 £30,000,000 Cash COGS in year 2 £30,000,000 Average daily cash COGS £82,192

(£30,000,000 annual cash COGS 365 days in the year = £82,191.78 average cash COGS each day)

Cash impact of change in CDOH £493,152 (6 days x £82,192 for each day = £493,152)

The increase of 6 days CDOH, which measures a lengthening in the average payment period, has provided £493,152 in cash flow. For each additional day that the company could stretch its payables, it would have another £82,192 in positive cash flow.

If CDOH must shrink, perhaps because suppliers don’t want to wait so long to be paid, each day that the payment period shrinks requires a use of £82,192.


SSoo wwhhaatt??

Measuring the amount of the effect of change in CDOH on cash flow is important because:

Knowing the amount helps the lender set priorities for analysis and decide how important it is to understand the underlying factors

influencing the payment period.

Knowing the underlying factors that influence the borrower’s CDOH helps the lender evaluate how effective management is in controlling

the payment period.

Knowing both the causes and what to expect from management helps the lender anticipate what will happen with CDOH in the future and how that will

affect repayment ability.

Shortcuts

Use these shortcuts to spot a change in DDOH, SDOH, or CDOH when you already know the percentage of change in sales or cash COGS from one period to the next:

11.. Multiply the beginning amount by the % of change in sales or cash COGS to calculate the amount of the total change (debtors, stock, or creditors) that is due to the change in sales or cash COGS.

22.. From the total cash change in the account on the statement of financial position, subtract the amount that is due to the change in sales or cash COGS.

33.. The answer is the amount of the change in the account that is due to DDOH, SDOH, or CDOH.

Example: Sales are up from £30,000,000 to

£33,000,000, so you expect debtors to be up 10%. But when you look at the two statements of financial position, you see that debtors actually went up from £3,000,000 to £4,000,000. That is quite a bit more than 10%, so you know DDOH must have gone up.

Example: If cash COGS are up from £40,000,000 to £42,000,000, you would expect both stock and creditors to be up 5%. If stock is up from £10,000,000 to £11,000,000, that is more than 5%, so you know SDOH must have gone up. If creditors are up from £6,000,000 to £6,150,000, they are up only 2.5%, so you know CDOH must have gone down.


AA MMoorree CCoommpplleexx EExxaammppllee ooff tthhee IImmppaacctt ooff CChhaannggeess iinn DDaayyss oonn HHaanndd We have completed the change in days on hand portion of the financial drivers worksheet for the Karr Photo company as an example of this approach to analysing the cash impact when days on hand of debtors, stock, or creditors change. Karr Photo is a medium-sized, middle market company with several lines of business and relatively complex financial statements.

To become more familiar with the analytical steps and insights for changes in days on hand and the use of the worksheet:

Study the partially completed Karr Photo Financial Drivers worksheet which follows.

Refer to the Financial Drivers of Cash Flow job aid which follows.


Then answer the questions about the Karr Photo days on hands and cash flow that follow the job aid. Understanding the answers to these questions will help prepare you for cash flow analysis on the job.






Cash Impact of Change in Days on Hand 20Y1 20Y2 20Y3 Average daily sales 60,576 100,784 Times: Change in DDOH 2.1 Equals: Cash impact of change in DDOH 211,646

Average daily cash COGS 47,388 80,583 Times: Change in SDOH 11.1 Equals: Cash impact of change in SDOH (894,472)

Average daily cash COGS 47,388 80,583 Times: Change in CDOH 21 Equals: Cash impact of change in CDOH 1,692,244

TOTAL IMPACT OF CHANGE IN DAYS ON HAND 1,009,418



Changes in days on hand STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure days on hand and change in days

1. Change in DDOH Opening debtors Divided by: Sales first (prior) year Times: 365 Equals: Opening DDOH

Closing debtors Divided by: Sales second year Times: 365 Equals: Closing DDOH Closing DDOH Less: Opening DDOH Equals: Change in DDOH

2. Change in SDOH Opening stock Divided by: Cash COGS (prior) year Times: 365 Equals: Opening SDOH

Closing stock Divided by: Cash COGS (second) year Times: 365 Equals: Closing SDOH Closing SDOH Less: Opening SDOH Equals: Change in SDOH

3. Change in CDOH Opening creditors Divided by: Cash COGS (prior) year Times: 365 Equals: Opening CDOH

Closing creditors Divided by: Cash COGS (second) year Times: 365 Equals: Closing CDOH Closing CDOH Less: Opening CDOH Equals: Change in CDOH

B. Measure the cash impact of one day

• One day of sales is the amount of cash required for each day in the collection period.

• One day of cash COGS is the amount of cash required for each day in the holding period.

• One day of cash COGS is the amount of cash provided by each day in the payment period.

1. Calculate the amount of one day of sales

Annual sales Divided by: 365 Equals: Average daily sales

2. Calculate the amount of one day of cash COGS

Annual cash COGS Divided by: 365 Equals: Average daily cash COGS

C. Measure the cash impact of the changes in days on hand

1. DDOH Change in DDOH Times: Average daily sales Equals: Cash impact of change in DDOH

• Cash flow impact of borrower’s management of days on hand is independent of the cash flow impact a change in sales has on the same accounts: debtors, stock, and creditors.

2. SDOH Change in SDOH Times: Average daily cash COGS Equals: Cash impact of change in SDOH

3. CDOH Change in CDOH Times: Average daily cash COGS Equals: Cash impact of change in CDOH

Measure total cash impact of changes in asset days on hand

Cash impact of change in DDOH Plus: Cash impact of change in SDOH Plus: Cash impact of change in CDOH Equals: Total cash impact of changes in days on hand


Part A

1. Of the three changes in days on hand Karr experienced in 20Y2 (DDOH, SDOH, and CDOH), which ones are increases in the requirement for cash and which ones are decreases in the requirement for cash?

a. DDOH

b. SDOH

c. CDOH

2. How much was the total impact on cash that was driven by changes in turnover for all three accounts combined?

3. Did this combined impact increase or decrease the requirement for cash?

Part B

4. Which of the following questions seems most important to ask at this point about the cash impact of days on hand? If more than one is important, rank them.

a. What is influencing the faster turnover of debtors?

b. Can you continue to pay creditors as you have been without harming supplier relations?

c. What is influencing the slower turnover of stock?

d. Why are customers taking longer, on average, to pay you?


Part C

Show your calculations for the next two questions. Showing the calculations will help you master this concept.

1. What was the total change in creditors from 31/10/Y1 to 31/10/Y2?

2. How much of that total change in creditors was driven by the change in CDOH, and how much was driven by the change in cash COGS?

a. Change in creditors due to change in CDOH

b. Change in creditors due to change in cash COGS

c. Total ‘driven’ change in creditors

3. Is any part of the total change not accounted for by the combination of the change in CDOH and the change in cash COGS?

Part D

1. What would have been the impact on cash flow if Karr’s DDOH in 20Y2 had increased by 5.1 days over 20Y1, rather than decreasing by 2.1 days?

2. What would have been the impact on cash flow if Karr’s CDOH had changed by 25 days in 20Y2 instead of 21 days (but the change was in the same direction)?


Part A

1. The change in stock turnover drove a need for increased cash; the changes in debtors and creditors drove a reduction in the need for cash.

Debtors DDOH down by 2.1 days Positive cash flow

Reducing cash tied up in debtors

Stock SDOH up by 11.1 days Negative cash flow

Increasing cash tied up in stock

Creditors CDOH up by 21.0 days Positive cash flow

Increasing cash provided by the liability account

2. The combined impact on cash that was driven by changes in days on hand for all three accounts was £1,009,418. Debtors + £211,646 Reduced cash requirement

Stock + £(894,472) Increased cash requirement

Creditors – £1,692,244 Increased cash available

Combined impact = £1,009,418 Reduced cash requirement

3. The combined impact reduced the cash requirement by £1,009,418 compared to what the cash requirement would have been if days on hand had not changed.

Part B

1. Three of the following questions are important to ask at this point about the cash impact of change in days on hand: a, b, and c. Question d is not a good question, because the Layer Two analysis has already told you that customers on average are paying faster, not slower.

In order of importance, the three good questions are:

b. Can you continue to pay creditors as you have been without harming supplier relations?

c. What is influencing the slower turnover of stock?

a. What is influencing the faster turnover of debtors?

The ranking here is determined by the magnitude of the monetary impact of the change in days on hand for the particular account.


When you have more data, such as trends over several years, you can use

factors other than size to set priorities for analysis. For example, it’s important to investigate a change in the direction of the turnover for an account, such as an increase in DDOH one year and a decrease in DDOH the next year, particularly if the changes also have material monetary impacts on cash flow.

Part C

1. The total change in creditors from 31/10/Y1 to 31/10/Y2 was £2,856,010.

Closing creditors (at 31/10/Y2) £4,521,630 Less: Opening creditors (at 31/10/Y1) £1,665,620 Equals: Total change in creditors £2,856,010

2. The total change in creditors was driven £1,692,244 by the increase in CDOH, and driven to increase £1,166,774 by the growth in cash COGS.

Change in creditors due to change in CDOH £1,692,244 Plus: Change in creditors due to change in cash COGS £1,166,774 Equals: Total ‘driven’ change in creditors £2,859,018 Less: Total actual change in creditors £2,856,010 Equals: Difference due to rounding £3,008

3. No. The entire change in creditors from 31/10/Y1 to 31/10/Y2 is accounted for by the two cash flow drivers: change in turnover (measured by change in CDOH) and change in sales (measured for creditors by change in cash COGS). The small difference of £3,008 between these changes and the sum of the ‘driven’ changes is due only to rounding days on hand and average daily sales.

Part D

1. Karr’s 20Y2 cash flow would have been decreased by £513,998 due to the increase in debtors driven by the lengthening of the collection period.

2. Karr’s 20Y2 cash flow would have been increased by £2,014,575 due to the increase in creditors driven by the lengthening of the payment period.


SSuummmmaarryy Turnover affects cash flow:

Each additional day in the collection period, measured by a change in DDOH, uses up cash flow in the amount of one average day’s sales.

Each additional day in the holding period, measured by a change in SDOH, uses up cash flow in the amount of one average day’s cash COGS.

Each additional day in the payment period, measured by a change in CDOH, provides cash flow in the amount of one average day’s cash COGS.

When DDOH or SDOH declines rather than increases, the change releases cash flow.

When CDOH declines rather than increases, the change uses up cash flow.

Identifying the amounts of the cash impact when turnover changes is important to the lender:

The amounts of the impact help the lender decide how important it is to understand the underlying causes

Understanding the underlying causes helps the lender evaluate management and anticipate future cash flows.


PPrraaccttiissee EExxeerrcciissee Directions: Use the financial statements and worksheets in Karr Photo, Parts I and II in the Cases section of this module, the Financial Drivers of Cash Flow job aid, and the partial Financial Drivers Worksheet below to complete this exercise.






Cash Impact of Change in Days on Hand 20Y1 20Y2 20Y3 Average daily sales 60,576 100,784 129,792 Times: Change in DDOH 2.1 2.1 Equals: Cash impact of change in DDOH 211,646 (272,563)

Average daily cash COGS 47,388 80,583 101,238 Times: Change in SDOH 11.1 4.7 Equals: Cash impact of change in SDOH (894,472) (475,817)

Average daily cash COGS 47,388 80,583 101,238 Times: Change in CDOH 21 18.7 Equals: Cash impact of change in CDOH 1,692,244 1,893,145

TOTAL IMPACT OF CHANGE IN DAYS ON HAND 1,009,418 1,144,765

1. Based on the information provided on the worksheet for 20Y3, answer the following questions.

a. Does the combined cash impact of all three changes in turnover drive an increase or a decrease in the cash required for the three accounts altogether?


b. Why is the cash flow impact on debtors more in 20Y3 than it was in 20Y2, even though the change in DDOH was 2.1 days in both years?

c. Why is the cash flow impact on creditors more in 20Y3 than it was in 20Y2, even though the change in CDOH was less in 20Y3 than it was in 20Y2? (CDOH increased 21 days in 20Y2 but increased only 18.7 days in 20Y3.)

d. Show the amount that each of the two cash flow drivers (change in sales and change in days on hand) drove the total change in each account in 20Y3 by filling in the following table: (Note that £ Total will not exactly equal the actual total change in each account because of the rounding of the percentages and DOH figures.)

Debtors Stock Creditors

£ due to sales (cash COGS)

£ due to turnover (DOH)

£ Total from 31/10/Y2 to 31/10/Y3*

2. Which question in each set of questions seems the most important to ask at this point, based on your Layer Two analysis thus far?

a. About the factors influencing turnover of debtors:

1. Why are customers paying 2.1 days slower than last year?

2. Why did DDOH deteriorate last year, then improve this year?

3. What is influencing the overall stability of the average collection period in the past two years?

4. How much cash could you free up if you could speed up your average collections by one day?


b. About the factors influencing turnover of stock:

1. How were you able to turn your stock faster, on average, in 20Y3 than in 20Y2?

2. Why did your stock increase during 20Y3?

3. What influenced the continued slowdown in your stock turnover?

4. What changed in your stock mix that caused a slower turnover?

c. About the factors influencing turnover of creditors:

1. Why did you pay your suppliers faster, on average in 20Y3 than in 20Y2?

2. How much cash did you generate by extending your average payment period?

3. How are your suppliers reacting to your taking longer to pay them?

4. What special terms did you negotiate with suppliers?

d. About all three:

1. How are your suppliers reacting to your taking longer to pay them?

2. What influenced the continued slowdown in your stock turnover?

3. What is influencing the overall stability of the average collection period in the past two years?

4. What was the combined cash flow effect of the changes in turnover?

3. Which cash flow driver, change in sales or change in days on hand, has had the most significant (biggest) effect on cash flow over the past two years?


AAnnsswweerrss 1. a. The combined cash impact of all three changes in days on hand

drove a decrease of £1,144,765 in the cash required to be invested in the three accounts.

b. The cash flow impact on debtors was more in 20Y3 than it was in 20Y2, even though the change in DDOH was 2.1 days in both years, because the average daily sales were higher in 20Y3 than they were in 20Y2. So, each day in the collection period in 20Y3 used up more cash than each day in the collection period used up in 20Y2.

c. For the same reason as b, the cash flow impact on creditors was more in 20Y3 than it was in 20Y2, even though the change in CDOH was less in 20Y3 than it was in 20Y2. (CDOH increased 21 days in 20Y2 but increased only 18.7 days in 20Y3.)

Average daily cash COGS was higher in 20Y3 than in 20Y2, so each day in the payment period in 20Y3 provided more cash than each day in the payment period provided in 20Y2.

d. Show the amount that each of the two cash flow drivers (change in sales and change in days on hand) drove the total change in each account by filling in the following table:

Debtors Stock Creditors

£ due to sales (cash COGS)

(711,313) (1,814,378) 1,158,962

£ due to turnover

(272,563) (475,817) 1,893,145

Total driven £ from 31/10/Y2 to 31/10/Y3

Total actual £ from 31/10/Y2 to 31/10/Y3

Difference due to rounding

(983,876)

(978,420)

5,456

(2,290,195)

(2,286,210)

3,985

3,052,107

3,052,220

113

2. a. Question 3 accurately applies what you already know from your Layer Two analysis and opens up further exploration of the underlying causes. It recognises that a movement of 2.1 days in either direction is more a sign of stability than of significant change.


Question 2 is based on an incorrect assumption because DDOH did not deteriorate. And question 4 is a waste of your customer’s time because you already know the answer from your Layer Two analysis.

Question 1 is technically accurate but places too much emphasis on a small change in DDOH, which might be the result of a single payment received, or not received, or invoice sent, or not sent, at the financial statement dates. Rather than signalling an important change, the slight variation in DDOH is either not worth mentioning or it suggests stability.

b. Question 3 accurately builds on your Layer Two analysis and opens up the exploration of the underlying causes of the slowdown, which has continued for two years.

Question 1 is based on an inaccurate assumption; stock did not turn faster in 20Y3.

Question 2 is a waste of your customer’s time since you already have insight about why stock increased, based on your Layer Two analysis. Now you need to ask a question that goes in the direction the Layer Two analysis has pointed you.

Question 4 might be a good question if you know that the stock mix has changed. Otherwise, the question might be based on a faulty assumption.

c. Question 3 builds on an important insight from your Layer Two analysis and focuses on the serious consequences to future cash flows and the future health of the business.

Question 1 is based on a misstatement of fact; Karr did not pay suppliers faster in 20Y3.

Question 2 is a waste of the customer’s time since you know already from your Layer Two analysis how much cash was generated by extending the payment period.

Question 4 might be a good question if you know that Karr has negotiated special terms or was trying to negotiate special terms. Unless you know that, the question makes a faulty assumption.

d. Question 1 is the most important to ask, because it focuses on a cash flow that is:

Very large

Probably not repeatable next year (it seems very unlikely that Karr could extend the payment period another 18 or 20 days for a third year in a row)


Might reverse directions next year, if Karr has to begin paying suppliers faster so that the average payment period gets shorter

Might indicate an impending problem in keeping the business running, if suppliers stop shipping or become willing to ship only C.O.D.

3. Change in sales has had the most significant (biggest) effect on cash flow over the past two years.

20Y2 20Y3 Two-Year Total

Cash impact of sales £(2,449,674) £(1,366,729) £(3,816,403)

Cash impact of days on hand £1,009,418 £1,144,765 £2,154,183


SSSeeeccctttiiiooonnn 333 CChhaannggee iinn MMaarrggiinnss

TTwwoo CCaatteeggoorriieess ooff EExxppeennssee MMaannaaggeemmeenntt DDrriivvee CCaasshh FFllooww Expenses reported as cost of goods sold (COGS) and as selling, general, and administrative expenses (SG&A) make up most or all of operating expenses. These expenses are large users of a company’s cash flow.

Expense management improves profit margins when management is successful in:

Reducing COGS expense as a percentage of sales, which improves the gross profit margin

Reducing SG&A expense as a percentage of sales, which improves the operating profit margin

Improvement in one area can be cancelled by deterioration in the other area, but the combined effect of the two can increase or decrease a company’s Type A cash flow significantly.

Earnings before interest, taxes, depreciation and amortisation (EBITDA) is a measure of cash flow that encourages lenders to focus on the combined effect of production and operating expense management, excluding noncash expenses from depreciation and amortisation. It represents the cash generated by operations without regard to financial strategy and tax management and without regard to cash flows from changes in assets and liabilities. When measured as a percentage of sales, it is called EBITDA margin.

‘Cash cushion’ is the term used by some lenders and in some analysis software to express EBITDA. Cash cushion can also be expressed as a percentage of sales by subtracting cash SG&A as a percentage of sales from the cash gross margin.

EBITDA, or cash cushion, is driven by the two categories of expense management. Therefore, understanding the sustainability of EBITDA or cash cushion requires analysis of both expense categories.

MMeeaassuurree CCaasshh CCOOGGSS aanndd SSGG&&AA EExxppeennsseess aass aa PPeerrcceennttaaggee ooff SSaalleess The best way to understand the impact expense management and the resulting profit margins are having on cash flow is to think of the expenses as a percentage of sales.


Expressing the expense categories as a percentage of sales allows the lender to:

Separate the rise (or fall) in expenses that were just the normal result of the change in the level of sales.

Concentrate on the change that is due to improved expense management.

Understanding that the cost of goods sold increased from 80% of sales to 81% of sales is more useful than just knowing the amount that cost of goods sold went up, because it prepares you to measure the cash flow effect of that 1% change and its direct impact on borrowing needs and repayment ability.

By performing some ratio analysis on income statements, the analysis is made much easier.

To calculate the percentages for yourself:

1. Divide cash COGS by sales for the same period, and express the answer as a percentage

2. From the percentage for year 2, subtract the percentage for year 1

The answer is the change in cash COGS as a percentage of sales.

MMeeaassuurree tthhee CCaasshh IImmppaacctt ooff tthhee CChhaannggee iinn PPeerrcceennttaaggeess

To identify the cash impact of the changes in cash COGS and cash SG&A as a percentage of sales:

1. Multiply the changes in cash COGS and cash SG&A as a percentage of sales by the £ sales for year 2

2. The answers are the cash impact of each change on the operating profit margin

In this example, the management of cash COGS expense is improving, so the improved gross margin (and operating profit margin) is a source of cash flow:

Year 1 £000 Year 1 % Year 2 £000 Year 2 %

Sales £60,000 100% £70,000 100.00% Cash COGS 45,000 75% 51,499 73.57% Depreciation and amortisation 1,200 2% 1,400 2.00% Total COGS 46,200 77% 52,899 75.57% Gross profit £13,800 23% £17,101 24.43%


Cash COGS as a percentage of sales changed from 75% of sales to 73.57% of sales, or 1.43% of sales. Notice that the gross profit as a percentage of sales (which is commonly called the gross margin) also changed (increased) 1.43% of sales. You could use either one, but we use cash COGS to be sure of eliminating the effects of depreciation and amortisation, which might also change as a percentage of sales.

Continue with the example and identify the cash impact of that improvement in the cash COGS as a percentage of sales:

Sales for year 2 £70,000,000 Times: Change in % 1.43% Equals: Cash impact £1,001,000

Because the change of 1.43% was a decline in expenses, the company has £1,001,000 in positive cash flows; management was able to reduce cash cost of goods sold by 1.43% of sales. Without that improvement in the management of cost of goods sold expense, the company would not have that £1,001,000 in cash flow.

This positive cash flow occurs even though the £ amount of cash COGS went up by £6,500,000 because the £ increase is affected by the rise in sales. In fact, if the expenses as a percentage of sales had not improved, the cash COGS £s would have gone up even more.

Here is a challenge for you: Can you figure what the cash COGS would have been if the expense management improvement had not occurred?

If the improvement from 75% to 73.57% of sales in cash COGS had not taken place, the cash COGS would have gone up to £52,500,000. (That is £70,000,000 x .75). The potential increase in cash flow would be lost because cash COGS would be exactly £1,001,000 higher without the expense improvement.

AAnnaallyyssee WWhhyy tthhee EExxppeennsseess aass aa PPeerrcceennttaaggee ooff SSaalleess CChhaannggeedd Consider all the things you have learned about analysing the income statement and borrower profitability. They all apply to this part of cash flow analysis. But now you understand how the expense management and the resulting increase or decrease in profitability directly affects cash flow.


You will have more information about, and practise analysing, the external and management factors influencing expenses as a percentage of sales in Unit 4 of this module. Knowing what factors influence expense and what to expect from management is important in estimating future cash flows.

TThhee PPoowweerr ooff 11%% You can perform a simple sensitivity analysis by calculating 1% of sales. For every 1% of sales that management is able to improve either cash COGS or cash SG&A, there is a measurable cash impact apart from any other cash flows that result from changes in the amount of sales or changes in days on hand.

Here is an example, with £ amounts in thousands:

Year 1 Actual Year 2 Actual Next Year Projected

Sales £ 60,000 70,000 80,000 Cash COGS £ 45,000 51,499 Cash COGS % 75 73.57 76 Cash SG&A £ 12,600 14,700 Cash SG&A % 21 21 19 1% of Sales 600 700 800

If the company had been able to reduce its SG&A as a percentage of sales to 19% in year 2, an improvement of 2%, it would have had £1,400,000 more in positive cash flows (2 x £700,000).

If the company’s cash COGS as a percentage of sales next year (projected) increases to 76%, a deterioration of 2.43%, its cash flow will be £1,944,000 less as a result (2.43 x £800,000).

This type of sensitivity analysis can help you quickly estimate the cash impact of changes in profit margins.

Here is one for you to try: How much more cash flow would the company have in the next year (projected) if it is able to improve the cash SG&A to 19% of sales, an improvement of 2%?

With just 19% of sales going out in cash SG&A, the improvement in cash flow would be £1,600,000 over what cash flow would be if the SG&A as a percentage of sales stayed at 21% of sales (2 x £800,000).


MMoorree CCoommpplleexx EExxaammppllee ooff tthhee CCaasshh IImmppaacctt ooff CChhaannggeess iinn MMaarrggiinnss We have completed the change in margins portion of the Financial Drivers worksheet for the Karr Photo company as an example of this approach to analysing the cash impact when the two major expense categories (cash COGS and cash SG&A) change as a percentage of sales. Karr Photo is a medium-sized, middle market company with several lines of business and relatively complex financial statements.

To become more familiar with the analytical steps and insights for change in margins and the use of the worksheet:

Study the partially completed Karr Photo Financial Drivers Worksheet, which follows.

Refer to the change in margins portion of the Financial Drivers of Cash Flow job aid that follows.


Then answer these questions about the Karr Photo profit margins and cash flow. Understanding the answers to the questions will help prepare you for cash flow analysis on the job.











Cash Impact of Change in Margins 20Y1 20Y2 20Y3 Cash COGS as % sales in prior year 78.23% Cash COGS as % sales in this year 79.96% Change in cash COGS as % sales 1.73% Times: Sales this year 36,786,130 Equals: Cash impact of change in cash COGS as % sales (635,606)

Cash SG&A 4,281,410 6,824,130 Cash SG&A as % sales in prior year 19.36% Cash SG&A as % sales in this year 18.55% Change in cash SG&A as % sales 0.81% Times: Sales this year 36,786,130 Equals: Cash impact of change in cash SG&A as % sales 299,095

TOTAL IMPACT OF CHANGE IN MARGINS (336,511)



Change in margins STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure the change in margins

1. Calculate the cash COGS as a % of sales

Cash COGS for first (prior) period Divided by: Sales for the same (first) period Equals: Cash COGS as % of sales, first period Cash COGS for second period Divided by: Sales for the same (second) period Equals: Cash COGS as % of sales, second period Cash COGS as % of sales, second period Less: Cash COGS as % of sales, first period Equals: cash COGS as % of sales

Reduce cash COGS as % of sales Improve gross profit margin Increase cash flow Reduce cash SG&A as % of sales Improve operating profit margin Increase cash flow

2. Calculate the cash SG&A as a % of sales

Cash SG&A for first (prior) period Divided by: Sales for the same (first) period Equals: Cash SG&A as % of sales, first period Cash SG&A for second period Divided by: Sales for the same (second) period Equals: Cash SG&A as % of sales, second period Cash SG&A as % of sales, second period Less: Cash SG&A as % of sales, first period Equals: cash SG&A as % of sales

B. Measure the £ cash impacts

1. Calculate £ cash impact of cash COGS as % of sales

cash COGS as a % of sales Times: Sales for the second period Equals: £ impact of cash COGS as a % of sales

• This cash flow is independent of any changes in the amount of expense that are the result of a change in the amount of sales.

• This isolation of the cash impact of the change in margins allows the lender to focus on the importance of expense management to the borrower’s cash flow.

2. Calculate £ cash impact of cash SG&A as % of sales

cash SG&A as a % of sales Times: Sales for the second period Equals: £ impact of cash SG&A as a % of sales

3. Calculate combined impact of cash COGS as a % of sales and changes in cash SG&A as a % of sales

£ impact of cash COGS as a % of sales Plus: £ impact of cash SG&A as a % of sales Equals: Combined impact of cash COGS as % of sales and cash SG&A as a % of sales


1. What was the change in cash COGS as a percentage of sales from 20Y1 to 20Y2?

2. Did that change drive cash flow positively or negatively?

3. Which categories of expense as reported by Karr must be combined to identify total SG&A expense?

4. What was the change in cash SG&A as a percentage of sales from 20Y1 to 20Y2?

5. Did that change drive cash flow positively or negatively?

6. Assume you are standing in front of Ron Karr in early 20Y3 and he tells you,

‘Sales this year should be £50,000,000, and I will be able to reduce my cost of goods sold to 77% and hold my [cash] operating expense to the same percentage of sales as in 20Y2.’

What is the cash flow effect if those assumptions are reliable? (Calculate the changes in expense as a percentage of sales and multiply the percentage by the second year’s sales.)


7. What would be the impact on cash flow if Karr’s cash COGS in 20Y2 were £28,000,000 (76.12% of sales rather than 79.96% of sales) compared to 78.23% of sales in 20Y1?

8. What would be the impact on cash flow if Karr’s cash SG&A in 20Y2 were £7,000,000 (19.03% of sales rather than 18.55% of sales) compared to 19.36% of sales in 20Y1?


1. The change in cash COGS as a percentage of sales from 20Y1 to 20Y2 was 1.73%.

Cash COGS as % of sales in 20Y1 78.23% Less: Cash COGS as % of sales in 20Y2 79.96% Equals: Change in cash COGS as % of sales 1.73%

2. The increase in cash COGS as a percentage of sales negatively drove cash flow. The higher cash COGS expenses as a percentage of sales was a use of cash flow. Karr Photo had £635,606 less cash flow because the cash COGS as a percentage of sales went up 1.73%.

3. Combine expenses categorised as direct costs and operating expenses to arrive at total SG&A expense for Karr.

20Y1 20Y2 Direct costs £3,449,190 £5,945,050 Operating expenses £867,260 £936,330 Total SG&A expense £4,316,450 £6,881,380

4. The change in cash SG&A as a percentage of sales from 20Y1 to 20Y2 was .81% of sales.

Cash SG&A as a % of sales in 20Y1 19.36% Less: Cash SG&A as a % of sales in 20Y2 18.55% Equals: Change in () cash SG&A as a % of sales .81%

5. The change in cash SG&A as a percentage of sales drove cash flow positively. The decrease in cash SG&A by .81% of sales decreased the amount of cash needed to be spent for those expenses by £299,095 and increased the cash flow Karr Photo had available in 20Y2 by the same amount.

6. Ron expects to reduce his cash COGS from 79.96% in 20Y2 to 77% of sales in 20Y3 (i.e. a saving of 2.96%) and for sales to be £50,000,000 – generating extra cash flow of £50,000,000 x 0.0296 = £1,480,000. In more general terms, you can quickly estimate the cash flow impact of each 1% in cash cost savings as follows. If sales are £50,000,000 and the cash COGS improves by 1% of sales, that will positively drive cash flow by £500,000.

£50,000,000 x .01 £500,000

7. 76.12% cash COGS as a % of sales is a substantial improvement over the 78.23% Karr achieved in 20Y1, so cash flow would increase by £776,187.

8. 19.03% cash SG&A expenses would still be an improvement over the 19.36% Karr achieved in 20Y1, so the cash flow would be increased by £121,394 over 20Y1.


SSuummmmaarryy Expense management, especially management of cash cost of goods sold and cash selling, general, and administrative expenses, directly affects cash flow.

When management is able to reduce expenses as a percentage of sales, the resulting improvement in profit margin generates cash flow.

When management is unable to control expenses and expenses increase as a percentage of sales, the resulting deterioration in profit margin reduces cash flow.

Measuring the change in cash COGS and cash SG&A as a percentage of sales allows the lender to separate the effect of the expense management from the effect of changes in the level of sales.

Isolating the cash impact of expense management helps focus the lender on the underlying causes, including external factors and deliberate strategy and management actions. In turn, those insights about the underlying causes are essential to anticipate reliably the future cash flows and repayment ability.

Calculating 1% of sales for each year you are analysing allows you to perform a quick sensitivity analysis of the magnitude of:

Positive cash flow if profit margins improve by 1% (or multiples of 1)

Negative cash flow if profit margins decline by 1% (or multiples of 1)


PPrraaccttiissee EExxeerrcciissee Directions: Use the financial statements and worksheets in Karr Photo, Parts I and II in the Cases section of this module, the Financial Drivers of Cash Flow job aid, and the Financial Drivers worksheet that follows to complete this exercise.






Cash Impact of Change in Days on hand 20Y1 20Y2 20Y3 Average daily sales 60,576 100,784 129,792 Times: Change in DDOH 2.1 2.1 Equals: Cash impact of change in DDOH 211,646 (272,563)




Cash Impact of Change in Margins 20Y1 20Y2 20Y3 Cash COGS as % sales in prior year 78.23% 79.96% Cash COGS as % sales in this year 79.96% 78.00% Change in cash COGS as % sales 1.73% 1.96% Times: Sales this year 36,786,130 47,374,050 Equals: Cash impact of change in cash COGS as % sales (635,606) 926,754

Cash SG&A 4,281,410 6,824,130 9,764,310 Cash SG&A as % sales in prior year 19.36% 18.55% Cash SG&A as % sales in this year 18.55% 20.61% Change in cash SG&A as % sales 0.81% 2.06% Times: Sales this year 36,786,130 47,374,050 Equals: Cash impact of change in cash SG&A as % sales 299,095 (976,034)

TOTAL IMPACT OF CHANGE IN MARGINS (336,511) (49,280)


1. Based on the worksheet provided, answer the following questions.

a. How did the change in cash COGS as a percentage of sales from 20Y2 to 20Y3 affect cash flow?

b. How did the change in cash SG&A as a percentage of sales from 20Y2 to 20Y3 affect cash flow?

c. Why is the total impact of change in margins (from the worksheet) an increase in expense £s of £49,280, but the actual cash operating profit (from the income statement) went up by more that £100,000? (Cash operating profit 20Y3 = £657,980; cash operating profit 20Y2 = £549,190)

d. Which of the following questions seems most important to ask?

1. How do you expect SG&A expense to perform as a percentage of sales as sales grow?

2. Why has SG&A expense increased?

3. What influences the variation in the gross margin?

4. How much cash flow could you have saved or provided in 20Y3 if you cut SG&A expense in 20Y3 to the 20Y2 level as a percentage of sales?


AAnnsswweerrss 1. a. The decrease in cash COGS from 79.96% of sales in 20Y2 to

78% of sales in 20Y3 positively affected cash flow. Karr’s cash required for cost of goods sold expenses was £926,754 less than it would have been if the cash COGS had not declined 1.96% of sales.

b. The increase in SG&A as a percentage of sales from 18.55% in 20Y2 to 20.61% in 20Y3 negatively drove cash flow. Karr required £976,034 more in cash for selling, general, and administrative expenses because the cash SG&A increased 2.06% of sales.

c. The two amounts are not the same because:

The £49,280 on the worksheet is the negative cash flow or loss of cash flow driven by the overall decline in the cash operating profit margin (due to the combined effects of changes in cash COGS and cash SG&A expenses as a percentage of sales).

While the actual total change in cash operating profit on the income statement is the result not only of the change in margins, but also the result of the higher sales in 20Y3.

Actual change in cash operating profit £108,790

Less: Measured change due to change in margins £(49,280)

Equals: Change due to higher sales £158,070

If not for the deteriorating profit margin, operating profit would have been up £158,070 in 20Y3 compared to 20Y2, based only on the higher level of sales in 20Y3.

d. Question 1 is the most important because not only is the increase in SG&A expense as a percentage of sales a material drain on cash flow, but also the increased percentage is not what we expect to see when sales grow. We normally expect that when sales grow, SG&A as a percentage of sales will decline, because some expense items included in SG&A tend to be fixed expenses. If Karr is increasing fixed expenses faster than sales, that bodes ill for future cash flow. Or, if Karr’s SG&A expenses are mostly variable, it will be harder for the company to achieve substantial payoff from its growth strategy.

Question 3 is the next best, because it does build on what you have learned in your Layer Two analysis, and the impact of changes in cash COGS as a percentage of sales in the past two years has been significant. Most well-run businesses have a cash COGS percentage that is more stable than is the case for Karr Photo.


Question 2 is not very good because it doesn’t use the insight from Layer Two analysis that the £ increase in SG&A expense is not only due to higher sales but is also due to some deterioration in expense management.

Question 4 is a waste of the customer’s time, because you already know the answer from your Layer Two analysis. Karr would have generated £976,034 more cash flow in 20Y3 if they could have held SG&A expenses to 18.55% of sales instead of allowing them to swell to 20.61% of sales.


SSSeeeccctttiiiooonnn 444 IInnvveessttmmeenntt iinn NNoonn--ccuurrrreenntt AAsssseettss aanndd OOtthheerr SSiiggnniiffiiccaanntt UUsseess ooff CCaasshh FFllooww

IInnvveessttmmeenntt iinn NNoonn--ccuurrrreenntt AAsssseettss HHaass AA SSiiggnniiffiiccaanntt IImmppaacctt oonn CCaasshh FFllooww Outlays of cash to acquire, lease, or maintain non-current assets such as land, buildings, and equipment used in the business are a substantial negative cash flow for many companies. Lease payments and maintenance cash flows are expenses that can be significant components of cash COGS and cash SG&A.

Cash outflows to acquire non-current assets (also known as fixed assets) have a significant impact on cash flow because payments typically:

Are large.

May exceed the internally generated cash flow of the business.

Require positive Type A cash flows over several years to offset the initial negative cash flow.

Result in a financing requirement to meet that relatively long cash flow timing difference.

Investment in fixed assets differs from the other influences on cash flow because it is not usually a major influence on the level of internally generated cash flow (see Unit 1, Section 2). Also, seldom can the lender look to changes in fixed asset levels as a source of repayment for loans.

The impact of cash flows for investment in fixed assets is significant in these kinds of businesses:

Manufacturing companies that require plant and equipment to produce products.

Service companies that generate revenues from fixed assets such as printing presses, hospital or hotel facilities, and fleets of aircraft or trucks.

Retailing companies that own the land or buildings for their own stores.


Fixed asset expenditures can have a significant influence on companies that have moderate to low need for fixed assets, such as many wholesalers and people-intensive service companies, when they experience:

Rapid sales growth that absorbs cash flow as debtors and stock increase.

Low profit margins that provide small cash flows relative to cash needs.

Long operating cycles that require substantial investment in stock even when sales growth is moderate.

Be Aware of Fair Value Measurement

Under IFRS, businesses have the option to reflect all or a portion of their fixed assets at market value rather than historical cost. When fixed assets are reflected at market (or fair) value, this can distort your perception of fixed assets. Review the cash flow and disclosures carefully to make sure that you understand how fixed assets are being valued. Few businesses use this methodology, but you need to be aware of it as it can impact your analysis.

MMeeaassuurriinngg tthhee CCaasshh IImmppaacctt ooff FFiixxeedd AAsssseett IInnvveessttmmeenntt

To measure the amount of impact that fixed asset investments have on cash flow:

Opening net fixed assets Less: Depreciation charge Equals: Expected closing net fixed assets

Actual closing net fixed assets Less: Expected closing net fixed assets Equals: Spending for fixed assets

Net referred to above is Net Book Value.

Any amount of spending for fixed assets is a use of cash flow. That use is partially, and sometimes completely, offset by the positive cash flow from the noncash expense depreciation.

Here is an example of a company spending more for fixed assets than its annual depreciation charge:


31/12/Y1 31/12/Y2

Cost of plant and equipment £ 12,000,000 £ 14,000,000 Less: Accumulated depreciation £ 5,000,000 £ 6,200,000 Net book value of plant and equipment £ 7,000,000 £ 7,800,000

Depreciation charge for year ended £ 1,000,000 £ 1,200,000

Spending for fixed assets during the year ended 31/12/Y2:

Opening net book value fixed assets £7,000,000 Less: Depreciation charge £1,200,000 Equals: Expected net fixed assets £5,800,000 Actual closing net fixed assets £7,800,000 Less: Expected closing net fixed assets £5,800,000 Equals: Spending on fixed assets £2,000,000

Notice that the £2,000,000 spending for fixed assets is NOT the amount of the change in net book value of fixed assets (which is only £800,000) because the fixed assets net book value has also been reduced by the annual depreciation charge that was added to the accumulated depreciation.

The reliable measure of spending for fixed assets provides these benefits:

Puts historical spending accurately in perspective relative to total plant and equipment as well as other cash flows.

Sets realistic expectations for future spending requirements and the potential amount of borrowing.

What If the Borrower Also Sells Fixed Assets?

The measurement of spending for fixed assets is understated by the amount of the net book value of assets sold or disposed of. The measurement is never overstated. The true level of acquisitions and disposals of fixed assets is set out in the statement of cash flows and/or the notes to the accounts. If you do not have these (e.g., if you have only interim or unaudited statements) and if you are concerned that the actual spending might be more than you have measured or is evident from the figures you have been given, ask the borrower about any fixed assets sales or disposals. The best clues that fixed assets have been sold or disposed of are a reported gain or loss on the transaction, and an increase in the accumulated depreciation account that is less than the depreciation charge.

It is unusual for the understatement to be significant. However, most businesses are routinely retiring old assets and replacing them with new. Here is what happens when they retire an asset:

They remove its original cost from gross fixed assets.

They remove its accumulated depreciation.

If the asset had any net book value, they write off that amount as a noncash expense reported as a gain or loss on disposal of assets.

If the company sells the old asset instead of just mothballing or scrapping it:

The difference between any proceeds from the sale and the net book value is a gain or loss.

The gain or loss is not likely to be exactly the same as the cash received.


AAnnaallyyssiinngg CCaappiittaall SSppeennddiinngg To analyse capital spending:

Compare the spending amount to the depreciation charge.

Compare the beginning and ending ratio of sales to net fixed assets, and compare the borrower’s ratio and trend to the industry ratio and trend.

Calculate the percentage of gross fixed assets that has already been expensed through depreciation.

Evaluate the indirect impacts on cash flow.

Those financial or quantitative analyses will set you up to ask the most important questions about economic and industry conditions affecting the need for fixed assets, and about the plausibility of management’s plan for future fixed asset spending.

SSppeennddiinngg aanndd tthhee ddeepprreecciiaattiioonn cchhaarrggee

Spending more for fixed assets than the amount of depreciation charge:

Increases net fixed assets.

Is the typical pattern for a growing or stable company.

Can mean that the company is expanding its productive capacity.

Spending less for fixed assets than the amount of depreciation charge:

Is unusual for a stable or growing company.

Can mean:

The company is deferring needed expenditures.

The company is downsizing its business deliberately.

The business is declining.

The business is reverting to operating leases to acquire assets or is outsourcing and as such the fixed assets do not appear on the statement of financial position but there will be an additional expense shown through the profit and loss account/cash flow.


SSaalleess ttoo nneett ffiixxeedd aasssseettss rraattiioo

To calculate the ratio of sales to net fixed assets:

Net sales for the period Divided by: Net fixed assets at the end of the period Equals: Ratio of sales to net fixed assets

Changes in this ratio suggest some things that will help guide your questions about and your analysis of the factors that influence fixed asset spending:

An increase in the ratio suggests:

A decrease in the ratio suggests:

The company has become more efficient in the use of its fixed assets, getting more sales for its investment in fixed assets.

The company may need to increase its spending for fixed assets to expand productive capacity.

The company may have deliberately expanded capacity in expectation of sales growth that has not yet occurred.

Sales may have declined while net fixed assets were stable, either because assets have become less able to produce what the market needs or because sales have fallen for other reasons.

If your borrower’s sales to net fixed assets ratio is higher than the industry average:

If your borrower’s sales to net fixed assets ratio is lower than the industry average:

Your borrower may have a competitive advantage in more modern equipment or more efficient production methods.

Your borrower may need to increase spending to add capacity.

Your borrower’s product mix or production methods may be somewhat different from others in the industry.

Your borrower is at a disadvantage by carrying higher depreciation charge and other costs for each unit of sales.

Your borrower may have overspent for capacity that its sales have not yet ‘grown into’.

Your borrower’s business may be somewhat different from others in the industry.

This ratio will be distorted if fair value accounting for fixed assets is being used. However, so long as your analysis is consistent year on year and when comparing to industry standards this variation will be removed.


PPeerrcceennttaaggee ooff oorriiggiinnaall ccoosstt aallrreeaaddyy ddeepprreecciiaatteedd Accumulated depreciation that exceeds a range of about 60–65% of the original cost of its fixed assets suggests future cash flow may need to be used to replace worn out or obsolete assets. In order to evaluate past and future cash flows for replacing fixed assets, you must understand what the assets are, how well they are maintained, and whether they are subject to obsolescence because of evolving technology.

IInnddiirreecctt iimmppaaccttss

Indirect impacts are important for the lender to explore, beyond the direct cash impact of spending. Ask these questions to uncover indirect impacts:

Will increased spending on fixed assets lead to higher sales and therefore higher levels of core trading assets?

Will new (or deferred) spending improve (or weaken) production efficiencies and profit margins that in turn drive cash flows?

Will an increase in plant capacity result in a longer stock holding period?

Will deferred spending this year result in higher spending needs in the future or the risk of obsolescence?

AA MMoorree CCoommpplleexx EExxaammppllee ooff tthhee CCaasshh IImmppaacctt ooff IInnvveessttmmeenntt iinn FFiixxeedd AAsssseettss We have completed the investment in fixed assets portion of the Financial Drivers Worksheet for Karr Photo as an example of this approach to analysing the cash impact of capital spending. Karr Photo is a medium-sized, middle market company with several lines of business and relatively complex financial statements.

To become more familiar with the analytical steps and insights for investment in fixed assets and the use of the worksheet:

Study the partially completed Financial Drivers worksheet for Karr Photo on the following page.

Refer to the investment in fixed assets portion of the Financial Drivers of Cash Flow job aid, either in this section or in the Job Aids section of the module.


Then answer the questions that follow the job aid about the Karr Photo spending for fixed assets and its impact on cash flow. Understanding the answers to those questions will help prepare you for cash flow analysis on the job.














Cash Impact of Change in Fixed Assets 20Y1 20Y2 20Y3 Opening net fixed assets 154,590 Less: Depreciation charge for this year 57,250 Equals: Expected closing net fixed assets 97,340

Actual closing net fixed assets 665,440 Less: Expected closing net fixed assets 97,340 Equals: Cash impact of change in fixed assets (568,100)

TOTAL IMPACT OF CHANGE IN FIXED ASSETS (568,100)



Investment in fixed assets STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure the amount spent to acquire fixed assets

Opening net fixed assets

Less: Depreciation charge for the period

Equals: Expected closing net fixed assets

Actual closing net fixed assets

Less: Expected closing net fixed assets

Equals: Amount spent to acquire fixed assets

B. Calculate indicators of the reason for spending

When the amount spent is greater than the depreciation charge:

• Internally generated cash flow is less likely to be sufficient to meet other cash needs

• Company is more likely to need to borrow

When the ratio is increasing, the company may:

• Be using its fixed assets more efficiently, or

• Soon need to use cash flow to expand productive capacity, or

• Both

The greater the accumulated depreciation as % of gross book value of fixed assets, the more likely:

• Assets may show signs of ageing

• Expenses for maintenance and repair may increase

• Borrower may suffer from obsolescence and other inefficiencies

• Cash flow may be required to replace existing productive capacity

1. Compare the amount spent to the annual depreciation charge

Amount spent to acquire fixed assets

Less: Depreciation charge for the same period

Equals: Difference between amount spent and depreciation charge.

2. Calculate the ratio of sales to net fixed assets

Sales

Divided by: Closing net fixed assets

Equals: Ratio of sales to net fixed assets

3. Calculate the % of original costs that have been expensed

Accumulated depreciation

Divided by: Gross fixed assets

Equals: % of original costs that have been expensed


1. Where in Karr’s financial statements do you find the information to fill in the worksheet for each of the following:

a. The ‘opening net fixed assets’ for 20Y2?

b. The ‘depreciation charge’ for 20Y2?

c. The ‘actual closing net fixed assets’ for 20Y2?

2. How much cash did Karr spend for fixed asset acquisitions during 20Y2?

3. Perform the following Layer Two analysis of Karr’s cash flow for fixed asset investment during 20Y2:

a. Calculate the ratio of sales to net fixed assets for 20Y1 and 20Y2:

b. Calculate the extent to which Karr’s fixed assets are already depreciated as of the end of each year:

31/10/Y2 31/10/Y1

Accumulated depreciation

Divided by: Gross fixed assets

Equals: % of GFA already depreciated


c. Based on your analysis in 3.a. and 3.b., which of the following is the most likely hypothesis about Karr’s capital expenditures in 20Y2?

i. Karr’s fixed assets were worn out from use and needed to be replaced.

ii. Karr’s spending for fixed assets appears to be routine replacement of existing assets and existing capacity.

iii. Karr’s business has changed, and we can expect higher levels of capital spending in future years.

iv. Karr spent an above average amount of its cash flow for fixed asset acquisitions.

d. Based on your analysis in 3.a. and 3.b. and your answer to 3.c., which of the following is the most important question to ask Ron Karr about future capital spending?

i. Why are the company’s needs for fixed assets changing?

ii. How will you finance future capital expenditures?

iii. What will your cash flow from depreciation be next year?

iv. Are you going to buy more store locations?


1. a. Statement of financial position as at 31/10/Y1

b. Income statement for 20Y2

c. Statement of financial position as at 31/10/Y2

2. Karr spent £568,100 for fixed asset acquisitions during 20Y2.

3. a. 20Y1 143.0 (£22,110,280 £154,590 = 143) 20Y2 55.3 (£36,786,130 £665,440 = 55.3)

b. 31/10/Y1 31/10/Y2

Accumulated depreciation £ 83,600 £ 140,850 Divided by: Gross fixed assets £ 238,190 £ 806,290 Equals: % of GFA already depreciated 35.1% 17.5%

c. The most likely hypothesis about Karr’s capital expenditures in 20Y2 is option iv. Options i – iii are not correct for the reasons that follow:

i. Not indicated by the Layer Two analysis, which showed assets were only 35% depreciated at the end of 20Y1. If Karr were a photo-finishing lab or a photography studio, we might think that technological advances had made fixed assets obsolete before they were more fully depreciated. Their obsolescence risk is in their stock, not in fixed assets.

ii. Implausible because the amount spent is substantially more than the annual depreciation, and is more than total gross fixed assets were at the beginning of the year. So, it does not seem like a routine level of spending.

iii. Tempting, but we can’t really say at this point that the spending level will be repeated next year because we don’t know yet what caused it.

d. The best question is i because it builds on your Layer Two analysis

and opens up the exploration of what factors are and will be influencing the need to spend cash flow for fixed assets.

Questions ii and iii are too narrowly focused at this point. They address only the numbers and will fail to find out why things are happening.

Question iv might be a good one if you know that Karr is moving from operating leases for its store locations to buying the properties or acquiring them under capital leases. But you don’t know that yet, so it might be a false assumption.


OOtthheerr SSiiggnniiffiiccaanntt SSoouurrcceess aanndd UUsseess ooff CCaasshh FFllooww Several other potentially large cash flows are important to keep in mind, although we do not consider them among the financial drivers of cash flow, because they are relatively straight forward uses of cash flow and because when they are sources, they are not usually primary repayment sources.

The other sources of cash flow are:

Additional equity investments in the company.

Reductions in other assets such as sale of fixed investments.

These other uses of cash flow are:

Reductions in net worth through capital redemptions (e.g., purchase of own shares), payment of dividends, or other distributions to owners.

Increases in other assets such as purchase of fixed investments.

Layer Two analysis is not normally needed for these categories because these sources and uses are so straightforward. The lender can go directly from the Layer One cash flow format that exposes these particular cash flows to the Layer Three analysis of underlying external factors, business strategy, and management actions that have influenced these flows.

SSuummmmaarryy Fixed asset expenditures are for many businesses a significant use of cash flow. This is especially true for businesses that:

Are manufacturers, capital intensive service companies, and retailers that own their stores.

Have rapid sales growth, low profit margins, or long operating cycles.

The amount of the spending is shown in the cash flow statement and the notes; however, not all companies are required to prepare a cash flow statement (smaller companies are exempt). If it is not readily apparent from the financial statements, it is important to calculate it carefully.

After you know the actual amount of historical spending, you can focus the questions you will want to ask management by performing the following additional quantitative analyses:

Compare spending amount with depreciation charge amount.

Compare opening and closing ratios of sales to net fixed assets, and compare the borrower’s ratio to the industry’s ratio.


Identify how fully depreciated the fixed assets already are.

Other sources and uses of cash flow can be important to analyse, but they are straightforward and require no Layer Two analysis before going into Layer Three analysis:

New equity investments and equity reductions through share repurchase or distributions to owners.

Sale or purchase of other assets such as fixed investments.


PPrraaccttiissee EExxeerrcciissee Directions: Use the financial statements and worksheets in Karr Photo, Parts I and II, in the Cases section of this module, the Financial Drivers of Cash Flow job aid, and the Financial Drivers Worksheet provided below to complete this exercise.







Cash Impact of Change in Days on hand 20Y1 20Y2 20Y3 Average daily sales 60,576 100,784 129,792 Times: Change in DDOH 2.1 2.1 Equals: Cash impact of change in DDOH 211,646 (272,563)







Cash Impact of Change in Fixed Assets 20Y1 20Y2 20Y3 Opening net fixed assets 154,590 665,440 Less: Depreciation charge for this year 57,250 167,200 Equals: Expected closing net fixed assets 97,340 498,240

Actual closing net fixed assets 665,440 1,248,990 Less: Expected closing net fixed assets 97,340 498,240 Equals: Cash impact of change in fixed assets (568,100) (750,750)

TOTAL IMPACT OF CHANGE IN FIXED ASSETS (568,100) (750,750)


1. Perform the following Layer Two analysis of the capital spending for Karr in 20Y3.

a. Ratio of sales to net fixed assets

20Y1 143 20Y2 55.3 20Y3 ____

b. Extent to which gross fixed assets are already depreciated

31/10/Y1 35% 31/10/Y2 17% 31/10/Y3 ____

2. Based on your measurement of cash flow spent for fixed assets and your Layer Two analysis in question 2, which, if any, of the following assumptions about the capital spending and its impact on cash flow can you make?

1. Karr is using straight-line depreciation for financial reporting purposes, while most companies in the retail camera and photo equipment business use accelerated depreciation.

2. Future capital spending will increase to almost £1,000,000 since that would be about the same increase that occurred this past year.

3. Future spending will drop to about the amount of annual depreciation since Karr can’t keep using so much cash flow for another year.

4. Karr has slightly more than tripled its capacity as a result of the spending over the past two years.

5. Karr’s spending for fixed assets has used up all Type A cash flow in the past two years, forcing the company to borrow to support growth in core current assets.


3. Which of the following is a likely indirect impact on cash flow that is driven by Karr’s capital spending in the past two years?

1. If the increased fixed assets have increased sales capacity, Karr may also experience an increase in stock, even before sales grow.

2. If the increased fixed assets represent store locations that are now owned instead of leased, Karr’s cash SG&A expense for rent will decrease although the rent expense reduction may be partially or completely offset by higher interest expense.

3. If the fixed assets represent a change in the kind of business Karr is doing, such as a venture into photo finishing, profit margins and the operating cycle are likely to change.

4. If the fixed assets represent a change in the kind of business Karr is doing, the new line of business may require different management experience and skills than Ron and his old management team have.


AAnnsswweerrss 1. Layer Two analysis of the capital spending for Karr in 20Y3.

a. Ratio of sales to net fixed assets

20Y1 143 20Y2 55.3 20Y3 37.9

Generally a downward trend in the ratio of sales to net fixed assets suggests there is not a need to expand fixed assets. When the ratio is as extreme as Karr’s is, and when the trend is so steep (in either direction), it suggests a change in the way of doing business or a change in the fixed asset investment strategy. The astute lender would have a discussion with Ron Karr about his intentions to expand with purchased property or to replace operating leases with capital leases or outright purchases.

b. Extent to which gross fixed assets are already depreciated

31/10/Y1 35% 31/10/Y2 17% 31/10/Y3 20%

When the trend is down and the percentage depreciated is in the range of 60–65%, it suggests that there is no imminent need to replace fixed assets.

2. Choice 5 is the most certain judgement you can make from the information you have. It is tempting to select 3 also, since Karr has no capacity for further expenditures, but that is something the lender will have to confirm with Ron Karr. Choice 4 looks technically correct, but is not because some locations are under operating leases and some are owned. Adding an owned location appears to increase capacity because it reduces the sales to net fixed assets ratio, but the appearance is misleading. Converting from an operating lease to ownership does not increase capacity.

3. All four choices are plausible indirect impacts that capital spending can have on cash flow.

© Omega Performance Corporation. All rights reserved. Nonfinancial Drivers of Cash Flow 129

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NNoonnffiinnaanncciiaall DDrriivveerrss ooff CCaasshh FFllooww


Analyse how management decisions in these critical areas affect cash flow:

Sales Operating cycle Expenses Capital investment cycle

Analyse the following nonfinancial drivers of cash flow to determine how they influence cash flow:

Economic factors Industry factors Business strategy Management actions

This unit has two sections:

Section 1, Four Critical Management Areas, explains the four critical areas of a company’s financial performance – sales, operating cycle, expenses, and capital investment cycle.

Section 2, An Example of Layer Three Analysis, provides an opportunity for you to follow along as we perform a Layer Three Analysis and then provides an opportunity for you to do the same.


SSSeeeccctttiiiooonnn 111 FFoouurr CCrriittiiccaall MMaannaaggeemmeenntt AArreeaass Informed and guided by your Layer Two information, you are now ready to investigate and evaluate the Layer Three issues: ‘What forces are driving the drivers?’ This layer focuses on the four critical areas of a company’s financial performance that must be managed. These four critical management areas are the organising principle for a Layer Three analysis:

Sales

Operating cycle

Expenses

Capital investment cycle

The Four Critical Management Areas job aid on the following page distils the analytical approach and highlights the link between each of the four critical management areas and the four financial drivers. Take a look at the job aid now, and then return to this page.

Which of the financial drivers measures management of the operating cycle?

The effectiveness of management’s business strategy and day-to-day actions in dealing with economic and industry factors that influence a company’s operating cycle is measured by changes in asset turnover.

Success in a critical management area requires that managers:

Understand how economic conditions affect the performance of the industry or industries in which they operate.

Anticipate the effects of those conditions and have plans for coping with them.

Understand how the behaviour of competitors, suppliers, and customers within the industry is likely to affect their own performance.

Anticipate the effects of that behaviour and have plans for coping with them.


Job Aid: Four Critical Management Areas

Sales

How have economic and industry conditions, trends, or events influenced the level of or change in sales?

What has the company’s management done or not done to influence sales, and how effective has that action been?

How has a change in sales affected profitability, asset structure, and gearing?

What are the implications for the future?

Operating cycle

How have economic and industry conditions or events influenced the level of debtors and stock?

How have economic and industry conditions influenced the level of financing from creditors?

What has the company’s management done or not done to influence the level of trading asset financing need, and how effective has that action been?

How has management financed trading asset financing need, and does the financing seem appropriate?

How has a change in needed trading asset financing affected the company’s profitability and gearing?


Expenses

How have economic and industry conditions and events influenced production, SG&A, interest, and Corporation Tax?

What has the company’s management done or not done to influence and control expenses, and how successful have those actions been?

How has a change in expenses affected the company’s asset turnover and gearing?



How have economic and industry conditions affected the need for plant, equipment, and other non-current assets?

How well has the company’s management planned and directed investments for adequate capacity and capability?

How has management financed the capital investments, and does the financing seem appropriate?

How have capital investments affected profitability and gearing?



‘Plans for coping’ are a part of a company’s business strategy. A good business strategy considers not only the factors that management can control, such as paying suppliers on time or having a strong training programme for employees, but also factors that management cannot control, such as the weather, a dock strike in the home country of an important supplier, or a computer virus.

No matter how good a business strategy may be, cash flow depends on managers being able to carry it out each day. Let’s look at some examples:

As you perform this Layer Three cash flow analysis you will:

Revisit your insights about the borrower’s industry risk and business risk.

Re-examine some of your analysis of the borrower’s statements of financial position and income statements, especially profitability and financial efficiency.

Link those insights to the direction and priorities you have identified in Layer Two.

An effective Layer Three analysis of cash flow allows you to:

Understand not only the amount of cash flow, but the reasons behind it.

Evaluate how well management is performing in each of the four critical management areas.

Understand how management’s performance in each area is affecting cash flow.

Anticipate and project future cash flows.

A strategy of focusing on a particular market segment and really knowing the needs of that segment may be a very good strategy to compete with companies that try to be all things to all people. But the strategy depends on day-to-day action to capture customer information in a database, make it available to customer contact staff in a useable form, and ensure that staff know how to make appropriate decisions using the data.

A strategy to reduce production costs by using lower-cost suppliers may be a very good strategy to compete against companies that have high-cost labour and raw materials. But the strategy depends on management’s ability to screen or monitor suppliers for suitable quality and reliability.

A strategy to cut stock levels when sales forecasts fall may be a very good strategy for a business in a cyclical industry. But the strategy still requires a manager to notice the forecast and call for a cut-back in the amount of purchases.



AAnn EExxaammppllee ooff LLaayyeerr TThhrreeee AAnnaallyyssiiss

AAnnaallyyssee CCrriittiiccaall MMaannaaggeemmeenntt AArreeaass BBaasseedd oonn LLaayyeerr TTwwoo PPrriioorriittiieess In the Layer Two analysis of Karr Photo’s cash flow for 20Y2 (Unit 3 of this module), you saw that the biggest drivers of cash flow that year were:

The 66% increase in sales.

The changes in turnover, especially the increase in SDOH and CDOH.

Therefore, it’s appropriate to focus your Layer Three analysis on the critical management areas behind those drivers. Review your industry, business, and financial analysis to be sure you understand the factors influencing the percentage change in sales and changes in days on hand, and collect all your insights in order to evaluate management.

Review the following information about Karr Photo in the Cases section: the Financial Drivers worksheet that appears in Part III, and the background information that appears in Part I. Have a copy of the Four Critical Management Areas job aid available for reference. Then follow along in the discussion of the critical management areas. For each question prompted by the job aid (indicated by large question marks in the left margin), we will:

Provide guidance on the process that will help you answer the question reliably and efficiently.

Offer an analysis for Karr Photo using:

Information provided in the case. New questions that an expert lender would ask when more

information is needed. Answers you might get from Ron Karr. Conclusions you could logically draw.


MMaannaaggeemmeenntt ooff SSaalleess Karr Photo’s 66% increase in sales had a material impact on cash flow, which is why we select management of sales as the priority area for Layer Three. Karr’s growth required £2,449,674 in cash, just considering the impact on debtors, stock, and creditors (before any consideration of fixed asset requirements, and before any impact of changes in the length of the operating cycle or payment period).

?? HHooww hhaavvee eeccoonnoommiicc aanndd iinndduussttrryy ccoonnddiittiioonnss,, ttrreennddss,, oorr

eevveennttss iinnfflluueenncceedd tthhee lleevveell ooff oorr tthhee cchhaannggee iinn ssaalleess??

Process: In answering this question, you are trying to evaluate whether management deserves ‘extra points’ for achieving this rate of sales growth, or whether they should have been able to do even better, and why. The expert lender revisits and thinks systematically about how all firms in the industry are affected by:

Economic conditions, trends, and events.

Industry conditions, trends, and events.

Consider your past discussions with management as well as research you have performed or obtained from others.

Analysis:

Economic Conditions, Trends, Events

Sales are affected by economic conditions – people spend less on photography when they have less disposable income because cameras are a moderately expensive luxury item. But the economy nationally, and in the regions where Karr operates, has been strong and has created an opportunity for growth in sales.

But how much growth? Population in Karr’s main markets is more or less static. Karr’s growth of 66% seems to be due to something other than just ‘more opportunity for growth’.

Industry Conditions, Trends, Events

There have been new product introductions and a flood of advertising, and industry leaders such as Kodak, Nikon, and Minolta, are all reporting sales up 5% to 15%, with triple-digit growth in some hot product areas. No retailers have exited; on the contrary, chains such as Dixons, Curry’s, Argos, and PC World are increasingly carrying a range of photo equipment and are willing to discount prices heavily for special promotions.

It seems that Karr has ridden a wave of new sales, but it may also deserve some points for stock selection and fending off competition from other


retailers. An expert lender would confirm this by inquiring further about the stock mix and competitive tactics.

?? WWhhaatt hhaass tthhee ccoommppaannyy’’ss mmaannaaggeemmeenntt ddoonnee oorr nnoott ddoonnee

ttoo iinnfflluueennccee ssaalleess,, aanndd hhooww eeffffeeccttiivvee hhaass tthhaatt aaccttiioonn bbeeeenn??

Process: To answer this broad question, you must think:

How have the borrower’s particular business strategies affected sales?

What has management actually done (or not done) in such areas as product-market match, distribution, and sales?

How effective have strategies and actions been?

Analysis: Ron Karr and his management team have done something to grow sales faster than could have been predicted from economic and industry factors alone. So we have some more hypotheses, and some questions for testing them:

Business Strategy in Sales: ProductMarket Match

Hypothesis Suggested by

Management’s Information

Questions to Test the Hypothesis

Possible Response from Ron Karr

Ron has filled his stores with the items customers really want to buy.

What is the breakdown of sales and stock by major brands and product lines?

The breakdowns of sales and stock don’t match as well as we had expected. Karr had plenty of the items customers really wanted, but it also looks like they have on hand some slow-moving items. Apparently Karr bought more of several lines; some sold well, and some did not.


Business Strategy in Sales: Distribution





Ron has well-located stores. OR Ron’s growth comes from new store openings.

What is the growth per store, year over year? What new stores were opened in 20Y2?

Here the evidence is better. Karr opened only 1 store in 20Y2, and year over year growth is solidly up in all the other 14 stores. Growth, even in the oldest stores, was more than 15% last year. Stores that are 2 to 5 years old are still rapidly outpacing the market, taking market share from local competitors.


Business Strategy in Sales: Sales





Ron’s approach to sales within each store is effective. AND the Sales Centre has boosted sales.

What is the growth per store, year over year?

What is the trend in repeat business from the same customers?

What is the amount and trend in sales that can be attributed to the Sales Centre?

How much growth is due to price, and how much to unit volume?

Year-over-year growth per store helps to confirm the effectiveness of Karr’s sales approach. Ron’s new customer data system tells him that 60% of first time customers purchase again within 12 months. Based on the percentage of customers who are tourists or who move out of the area, Ron considers this to be very good. He is anxious for the system to be in place long enough to help him track customer patterns over a longer period of time.

Sales booked directly in the Sales Centre were 11% of total sales in 20Y2, more than the average for a store. And the selling, general, and administrative costs of the Sales Centre are less than the cost of a store.

At this point, we would have to rate Ron as very effective in sales and distribution. And the product–market match worked (he didn’t run out of high demand products), but at a high cost of carrying a significant amount of slower moving stock.

?? HHooww hhaass aa cchhaannggee iinn ssaalleess aaffffeecctteedd pprrooffiittaabbiilliittyy,, aasssseett

ssttrruuccttuurree,, aanndd ggeeaarriinngg??

Process: Here, an expert lender deals with ‘crossover’ issues that demonstrate how the areas of a company’s financial performance and the management of those areas are interconnected. Often, you will address these interconnections during financial statement analysis. If so, you need only review them during cash flow analysis to be sure you understand the impact on cash flow. If not, cash flow analysis is your opportunity to investigate and get behind those numbers.


Here are some classic crossover patterns and how they affect cash flow:

Analysis: Two crossovers are especially important for Karr Photo:

Sales growth and prices.

Sales growth and trading assets.

Karr’s sales growth may be partly the result of lowering prices because cash COGS increased 1.73% of sales in 20Y2. It is important for Ron to understand that the slippage in gross margin cost him £635,606 in cash flow.

(We didn’t target expense management for priority analysis because the combined impact of changes in cash COGS and cash SG&A as a percentage of sales was much smaller than the impact of sales and days on hand. But Karr’s net profit margin is so thin that any change is significant.)

Ron’s costs also went up because some of the new merchandise items cost more than the older models. He marked them up by the same percentage he always marks up merchandise. Older items did not sell as well as Ron had hoped, so his sales mix changed and his overall gross margin was less than he expected.

Crossover Pattern Effect on Cash Flow

Sales growth is achieved partly by lowering prices. This will show up in higher COGS as a % of sales.

Less Type A cash flow is available to support sales growth. This results in a greater need to borrow from trade suppliers or lenders.

Sales growth causes a change in the operating cycleoffering different sales terms, entering a new market, or beginning to sell new products. This will show up as a change in DDOH or SDOH.

If the length of the operating cycle (either DDOH or SDOH) changes, a longer operating cycle will use cash flow and a shorter operating cycle will provide cash flow.

Sales growth causes growth in trading assets. Debtors grow by the same % as sales; stock grows by the same % as cash COGS.

Average daily sales and average daily cash COGS increase, requiring more cash even with no lengthening of the operating cycle.

Sales growth results in more borrowing to finance increased debtors and stock or fixed assets or both. This will show up in gearing ratios and in higher interest expense.

If the net effect of the higher sales and higher interest expense is lower profit as a % of sales, there is less Type A cash flow to support further growth or repay debt.


So now you have more questions for Ron:

How do you plan to sell that stock of older models next year? How much might you need to lower the price?

How would you adjust your purchasing based on this year’s sales experience?

What are your thoughts about raising the price of the newer items?

How much longer can you delay payment?

If Ron has to cut prices to unload the older stock, or borrow from the bank to pay suppliers, the impact on profitability will be severe. Ron’s net profit margin is already very thin.

??

WWhhaatt aarree tthhee iimmpplliiccaattiioonnss ffoorr tthhee ffuuttuurree??

Process: This does not mean that you know which conditions or events will occur; it means that you have a good grasp of how management will perform and how cash flow will be affected IF they occur.

Analysis: For Karr Photo, you can reliably anticipate that:

You might reasonably ask Ron to discuss with you two growth scenarios:

Sales will grow primarily in stores, with commensurate pressure on stock, or

Sales will grow most significantly in the Sales Centre, with less stock but a different mix of SG&A expenses.

You might even have a strong opinion of which scenario is more likely. But, in either case, you can reliably estimate the impact on cash flow and then assess the degree of risk or comfort those cash flow levels give you as a lender.

Layer Three Insight Future Outcome

IF regional economic conditions continue to be favourable

THEN Karr’s sales will continue to grow due to per store increases, Sales Centre increases, and new store openings

IF sales through the Sales Centre continue to increase as a percentage of total sales

THEN Karr may need to carry less stock for each unit of sales, but shipping and delivery may become a bigger expense


MMaannaaggeemmeenntt ooff tthhee OOppeerraattiinngg CCyyccllee In Layer Two analysis, we identified Karr’s management of the operating cycle as the second priority area for a Layer Three analysis. Again, we will follow the questions in the Four Critical Management Areas job aid, indicated below by large question marks.

Karr’s trading asset financing need increased £1,205,370 during 20Y2. This increase was driven entirely by the extreme sales growth, and the impact of sales growth was only partially offset by reduced DDOH and extended CDOH.

Summary of Layer Two Trading Asset Financing Need

Cash Use 20Y1 20Y2 Change Due to Sales

Change Due to Days on

hand

Debtors £1,613,580 £2,471,350 £ (1,071,025) £211,646

Plus: Stock 3,633,700 7,078,700 (2,545,423) (894,472)

Less: Creditors 1,665,620 4,521,630 1,166,774 1,692,244

Less: Accruals 326,830 568,220 228,946 12,450

Equals: Trading asset financing need 3,254,830 4,460,200 (2, 220,728) 1,021,868

Change in Trading asset financing need 1,205,370 (2,220,728) 1,021,868

Because you have already focused on sales as a priority driver of cash flow, you can narrow your analysis of Karr’s operating cycle to the management of days on hand, which reduced the increase in trading asset financing need by £1,021,868.

?? HHooww hhaavvee eeccoonnoommiicc aanndd iinndduussttrryy ccoonnddiittiioonnss oorr eevveennttss

iinnfflluueenncceedd tthhee lleevveell ooff ddeebbttoorrss aanndd ssttoocckk??

Process: Review insights about what is influencing how long customers take to pay and how long the borrower must hold stock.

Analysis:

Debtors

There do not seem to be any economic or industry issues tending to increase the average collection period for companies like Karr. If anything, the rising use of small business credit cards and competitive pressures on credit card lenders to settle more quickly with their


merchants might tend to decrease average collection periods. So, for Karr, a decrease of 2.1 DDOH is probably either an accident of timing or to be expected, rather than heroic effort on Ron’s part.

Stock

Economic factors don’t seem at work here, but industry issues are active. Large suppliers of photographic equipment, which have considerable influence over smaller retailers like Karr Photo, have brought desirable new products to market at the same time they are requiring retailers to take quota-like quantities of older models.

Ron says the practise is already fading as output of the newer products has grown and manufacturers have worked off their supplies of older items. Ron also says the larger retailers were immune, but he doesn’t worry as long as he can get a sufficient supply of items that are selling well.

??

HHooww hhaavvee eeccoonnoommiicc aanndd iinndduussttrryy ccoonnddiittiioonnss iinnfflluueenncceedd tthhee lleevveell ooff ffiinnaanncciinngg ffrroomm ccrreeddiittoorrss aanndd aaccccrruuaallss??

Process: Check with the borrower and other sources to uncover industry reasons for changes in the payment period.

Analysis: Karr’s suppliers were generally willing to provide free financing to enable retailers to make larger purchases, especially of older items the suppliers wanted to get rid of.

It seems Ron was caught by industry forces he could not control. That is a risk to keep in mind for the future. Evaluating how well he coped can help you evaluate Ron’s ability to deal with other risks and issues that may arise in the future.

Accruals for Karr are not as large, so it is less important to dig for what is influencing them.

Can you think of a different scenario that suppliers might have adopted to get rid of their unwanted production? What impact would that other scenario have had on retailer financial statements like Karr Photo’s?


Suppliers might have discounted the older items to encourage retailers to take them. If this worked for the manufacturers, the retailers would have shown longer holding periods for a time, without the corresponding extended payment terms. But the retailers might have been more inclined to offer promotional pricing to sell the ends of ranges. However, that might have dampened the sales of new items, which the suppliers would not want to see.

??

WWhhaatt hhaass tthhee ccoommppaannyy’’ss mmaannaaggeemmeenntt ddoonnee oorr nnoott ddoonnee ttoo iinnfflluueennccee tthhee lleevveell ooff ttrraaddiinngg aasssseett ffiinnaanncciinngg nneeeedd,, aanndd hhooww eeffffeeccttiivvee hhaass tthhaatt aaccttiioonn bbeeeenn??

Process: When you are evaluating management’s effectiveness in controlling trading asset financing need, it helps to visualise the actions that managers, suppliers, and customers can take that result in the numbers we see for receivables, stock, and payables or accruals.

Analysis: Ron Karr is quick to assert that he did well, since he ended up with less excess stock than he obtained in extra supplier financing.

Your evaluation of Karr Photo in this area hinges on the answers to these questions:

How will you reduce stock levels?

When do the extended terms expire?

Here are some responses Ron might have, and a suggestion about how they would affect your assessment of Ron and the risk of future cash flows:


?? HHooww hhaass mmaannaaggeemmeenntt ffiinnaanncceedd ttrraaddiinngg aasssseett ffiinnaanncciinngg

nneeeedd,, aanndd ddooeess tthhee ffiinnaanncciinngg sseeeemm aapppprroopprriiaattee??

Process: To answer this broad question, you must understand:

Whether the increased trading asset financing need is permanent or temporary.

Whether the company’s Type A cash flow is likely to be sufficient to amortise term debt.

You will also want to look behind the numbers and assess the quality of the company’s trading assets. Is the liquidity, measured by current ratio or working capital, reliable? Would the assets make suitable collateral for a loan?

Possible Answer Scenarios Assessment of Ron and Risk

Suppliers will take back certain items if not sold within 12 months of purchase.

You would feel much better about what Ron was thinking when he agreed to take so much excess stock. However, there still might be a timing difference if supplier payments must be made before the end of the 12 months.

Ron has studied purchasing patterns at his various stores and will move older items to stores where they are selling faster and without large discounts.

This is encouraging. The utility of the customer data system bodes well for sales. But could Ron have implemented the system more quickly?

Ron plans a January and February sale of the older items, heavily discounted if necessary. He is required to pay suppliers in full on 1 March.

This might impact sales of other items and could hurt profitability for the year, but it shows Ron has a plausible plan to eliminate the cash requirement.

Ron is indecisive. He must pay suppliers by 31/12 but does not want to promote the slow moving items during the peak Christmas season, a prime selling season for new products. If he does not offer new products, he risks losing customers to other retailers.

This is disturbing. Not only is raising the cash to pay suppliers a problem, but your confidence in Ron is shaken. Action taken earlier in the year would not have jeopardised Christmas sales. If he loses customers who buy new equipment elsewhere, he may have lost them for years.


Here are three financing profiles:

If the need for increased trading asset financing is permanent AND the company’s Type A cash flow is (and is expected to be) sufficient to meet various needs and repay new long-term debt, then a term loan is a suitable way to finance the trading asset financing need. Quality of trading assets is important because it will heavily influence sales and profits over the long-term, but you are not looking to a shrinkage of trading assets as a primary source of repayment.

If the need for increased trading asset financing is permanent BUT the company’s Type A cash flow is not or is not expected to be sufficient to meet various needs and repay new long-term debt, then a revolving line of credit is a more suitable way to finance trading asset financing need. In this situation, you might depend on the quality of trading assets as your primary source of repayment should you decide not to renew the line of credit.

If the need for increased trading asset financing is temporary or seasonal, whether due to temporary fluctuations in sales, in the operating cycle, or in the payment period, a short-term line of credit is a suitable way to finance the trading asset financing need. Because Type B cash flow, from shrinkage of assets, is the most likely source of repayment, you are concerned about the quality of debtors and stock.

Analysis: Karr Photo seems to fit the second profile: permanent increase in trading asset financing need driven by long-term sales growth, with insufficient Type A cash flow to repay new (or existing) long-term debt. Therefore, a line of credit is the most suitable way to finance the trading asset financing need. As the potential lender, you need to be very comfortable with the quality and amount of current assets. And given Karr’s thin profit margin, you will need to be sure the company can earn enough to pay your interest.

?? HHooww hhaass aa cchhaannggee iinn ttrraaddiinngg aasssseett ffiinnaanncciinngg nneeeedd

aaffffeecctteedd tthhee ccoommppaannyy’’ss pprrooffiittaabbiilliittyy aanndd lleevveerraaggee ggeeaarriinngg??

Process: Here are the crossover issues again. You already considered the interaction of sales and days on hand with trading asset financing need. Now consider profitability and gearing.


Analysis:

Trading Asset Financing Need and Gearing

In Karr Photo, the increase in trading asset financing need has definitely increased gearing, as the entire increase during 20Y2 was financed with the increase in short-term loans and overdrafts. If Karr has to pay suppliers before it shrinks stock levels, the trading asset financing need will increase further, and interest-bearing debt seems to be Karr’s only source since profits are low.

Trading Asset Financing Need and Profitability

Karr’s profitability has not yet been significantly affected by the increased trading asset financing need, but the combined effect of higher year-round levels of debt and pressure to cut prices to reduce stock can reasonably be expected to impact profitability in 20Y3.

?? WWhhaatt aarree tthhee iimmpplliiccaattiioonnss ffoorr tthhee ffuuttuurree??

Process: Now consider how your insights about what is influencing turnover might play out in the future. Then test specific assumptions about how the conditions would affect financial performance and cash flow.

The more the future is likely to be similar to the past, the more confident you can be in your assessments. However, even when you are not confident of what will happen, you can rely on your understanding of how each scenario would affect cash flow. Then you can assess your comfort with each amount of cash flow.

Analysis: You could reliably anticipate the following for Karr Photo:

Specific assumptions to test for Karr:

The gross margin will fall slightly if Ron is able to shorten his stock holding period.

If the gross margin holds up, interest expense will rise because ‘old products’ are still on hand in stock, and this will force Ron to borrow.

Layer Three Insight Future Outcome

IF manufacturers come out with more new products

THEN Ron will face continued pressure to carry high levels of stock and the continuing challenge of selling old products that are not competitive with his new products

IF new product introductions are fewer, and competition among suppliers increases

THEN Ron will have an easier time controlling his stock mix and should be able to do a better job of matching stock to sales, thus reducing his holding period


SSuummmmaarryy The most effective Layer Three analysis focuses on the management areas that are responsible for the financial drivers that have the largest impact on a company’s cash flow. Each financial driver is the product of one or more critical management areas:

Financial Driver Management Area

Change in sales Sales, including business strategy for product–market match, distribution, and sales

Change in days on hand

Operating cycle, including supply

Change in margins Expense management, including production

Fixed asset investment Capital investment cycle, including expansion and replacement

Within each critical management area, expert lenders follow a deliberate process to move from the financial drivers of cash flow into the economic, industry, and management factors that are driving the drivers. The Four Critical Management Areas job aid summarises this disciplined approach. In each area, revisit your insights and ask new questions if they are needed to help you answer the following:

What economic and industry conditions, trends, or events are driving the driver?

What has management done or not done to anticipate or react to the economic and industry conditions, and how effective has management action been?

How have the drivers and external and management factors interacted to shape cash flow?

What does this suggest for the future cash flow?


PPrraaccttiissee EExxeerrcciissee Directions: Study Parts I, II, and III of the Karr Photo case, which appear in the Cases section. Use those insights about Karr’s industry risk, business strategy, and financial drivers to answer the following questions about Karr’s cash flow in 20Y3, and the trend for 20Y2 and 20Y3.

1. Which critical management area is the most important to analyse in order to understand Karr’s cash flow in 20Y3 and the two-year trend? Why?

2. To practise using the Four Critical Management Areas job aid to analyse another area, perform a Layer Three analysis of Karr’s management of expenses (regardless of your answer to question 1).

Answer each question posed by the job aid. If answers are not available in the case, be sure to identify the key questions an expert lender would ask. (In the answer section, we will suggest questions and offer several plausible answers Ron might provide, along with the assessment an expert lender would make based on such answers.)

a. How have changes in expenses for production, operations, interest, and Corporation Tax affected the company’s cash requirements?


b. How have economic and industry conditions and events influenced production, SG&A, interest, and Corporation Tax?

c. What has the company’s management done or not done to influence and control expenses, and how successful have those actions been?

d. How has a change in expenses affected the company’s financial efficiency and gearing?

e. What are the implications for the future?


AAnnsswweerrss 1. Most important is management of sales; it is the biggest influence on

cash flow for 20Y3 and for the two-year period. Although sales growth slowed to 28.78%, sales were up about £11,000,000. With the relatively long operating cycle due to the holding period, such high rate of sales growth will absorb large amounts of cash (even if turnover does not change).

We must also re-examine management of the operating cycle, especially Karr’s use of creditors to finance the operating cycle. For both years, Karr raised large sums by extending the payment period. Is this really a permanent change, or will it swing back, forcing Karr to come up with cash from other sources?

Expense management also needs to be examined because:

Karr Photo badly needs to improve profitability; its margins remain perilously thin.

Much needed improvement in cash COGS as a percentage of sales in 20Y3 was wiped out by deterioration in cash SG&A as a percentage of sales, when we should expect SG&A expense as a percentage of sales to be falling as sales rise.

Management of the capital investment cycle is also important. Although it has the smallest impact on Karr’s cash flow, spending in this area is increasing, and is substantially higher than the sum of net profit plus depreciation and amortisation. Understanding it is key to evaluating Ron Karr’s management.

2. a. Despite the improvement in the gross margin, which increased cash flow in 20Y3 by £926,754, the rise in SG&A expenses by 2.06% of sales denied the company £976,034 in cash flow. Expense management deterioration in those two areas combined reduced cash flow by £49,280 compared to what cash flow would have been if margins had remained at 20Y2 percentages.

Interest expense more than doubled in amount in 20Y3, as it rose from £83,210, (.23% of sales) to £199,150 (.42% of sales), due to the increase of about £900,000 in Karr Photo’s interest-bearing debt. Interest expense was almost as much as total net profit.

Karr’s effective Corporation Tax rate is relatively low, which makes the low net profit after tax even more unfavourable in comparison to other firms that might pay higher taxes.

Given this trend, the expert lender would focus on why cash COGS as a percentage of sales has changed in the past two years and why SG&A expenses, which normally have a substantial fixed


component, have increased as a percentage of sales in the past year even as sales rose.

b. Production expenses, cash COGS

An expert lender would compare Karr Photo’s gross margin with industry averages, and would ask Ron:

How are competitors pricing their merchandise?

Has an excess supply produced by manufacturers in any product lines lowered costs?

Has customer demand driven prices up?

The answers to those questions would tell you much more about the risk in lending to Karr Photo than the numbers alone tell you:

If you learned . . . You could reasonably judge . . .

Competitors have consistently cut prices 5% to 10% under Karr’s prices, but Karr has maintained its prices on most lines.

Karr Photo’s strategy of selling on knowledge and service rather than price is viable and paying off.

Competitors have generally held or raised prices, and Karr has been able to follow them.

Karr has been able to compete successfully against chain retailers using that strategy.

Pricing in the industry is not predatory.

It is not clear how effective the Karr strategy of expert sales and service is.

Competition among manufacturers has intensified this year as more have come out with attractive competing products to some of the hot new items introduced last year. This has enabled retailers like Karr to have more control over purchasing prices and selection.

This is good news for all companies like Karr, but probably means Ron was taking advantage of the industry-wide phenomenon rather than taking heroic individual measures to reduce COGS.

Customer demand has been relatively flat with last year, so prices have not risen.

Ron’s growth is from selling more items, not just from higher prices per item.

Ron’s improved gross margin is more from lower costs than from higher sales prices.

This may raise questions about the amount of consumer demand for more and new photo equipment.


Operating expenses (SG&A expenses)

Be sure to study the category of ‘total direct costs’ as well as the category of ‘operating expenses’. Look for expenses that are large in amount and are up more than the 28.78% by which sales increased. For each large amount that has increased more than sales have increased, think about what could be happening in the economy or industry that could be driving the cost up.

Salaries, National Insurance, and employee benefits are the largest expense for Ron (other than COGS), and they increased almost 46% during 20Y3. Why?

If you asked . . . Suppose Ron answered . . .

Is there a scarcity of knowledgeable workers for Ron to hire, so he has to pay higher wages to get and retain good people?

‘Yes. While my type of worker has not been in the same demand as lawyers and highly technical workers, the areas in which I operate have boomed in media production and entertainment jobs, drawing some from my traditional pool.

‘I probably have to pay at least 15% more today than I did two years ago for someone who knows about photography or camcorders and can talk to customers.’

Are there union negotiations or other factors that are escalating wages?

No, although I do have bonus plans for my sales managers and store managers.

That line of inquiry would pave the way to explore Ron’s hiring and compensation strategies, since his employee compensation costs have ballooned over what might be expected in a time of low unemployment.

Rental expense and utilities, although much smaller than salaries, have also increased disproportionately. The lender would inquire about rental terms and rates since only one new store was opened during 20Y3.

Let’s say that Ron tells you that indeed an unusual number of his store leases renewed at higher rates during 20Y3, and that he took additional space in 3 of the 15 locations.


The rent and utility increases may be beyond Ron’s control. However, you would want to be sure you think his store locations are desirable for the long-term.

Interest expense

You could say that Ron has done a good job managing interest expense since he has borrowed most heavily from his trade suppliers, interest free. Nevertheless, his interest-bearing debt has increased about £900,000 during 20Y3, and his interest expense is very high relative to his profits.

The burning question here is how would the company be able to pay interest if Karr wants to borrow to pay down suppliers? It would take over £4,500,000 to reduce creditors to 30 days. At 10%, that is £450,000 in interest expense – substantially more than Karr could pay.

Corporation Tax

Karr’s effective tax rate has been just 21%, 40%, and 22% in the past three years. The expert lender would first check that the Corporation Taxes are consistent with Karr Photo’s likely tax obligations – and that there are, for example, no disputed tax claims. Then the lender would ask:

What has lowered your effective tax rate?

Do you have any deferred tax liabilities other than shown in the financial statements, and what is it based on?

Let’s say Ron tells you that there are no undisclosed tax liabilities. Deferred taxes are payable, but are mistakenly reported in with other taxes payable, including VAT and National Insurance due but not yet remitted. The deferred taxes arise from the accelerated depreciation and amortisation Karr Photo is taking on the fixed assets acquired during 20Y2 and 20Y3, while using straight line depreciation and amortisation for financial reporting purposes.

You would be encouraged about Karr’s management of taxes, but discouraged about the quality of financial statements (and the auditor), since the deferred taxes should be reported separately.

c. Production expenses

An expert lender would ask Ron:

What strategies for purchasing and pricing merchandise produced the improved gross margin?

How did the product mix affect the margin?


Some plausible answers and their implication for risk are:

If you learned . . . You could reasonably judge . . .

Karr monitors competitor prices and is careful not to let his prices be more than 7% higher, unless the complexity and sophistication of the product favour the ‘expert sales’ in which Karr specialises.

Ron is astute about pricing and competitor practises.

His ‘expert sales’ strategy has a high likelihood of success within the parameters he has established.

Karr did promote the sale of older items in January and February by offering large discounts. Throughout the spring and summer, he regularly offered limited promotions each month. He has cleared out most of the older items and has been selling newer, higher margin items almost exclusively since August.

Ron seems to have done a good job balancing stock issues with margin issues.

Operating expenses (SG&A expenses)

Since you found that economic and industry conditions accounted for only a small part of the increase in compensation expense, you need to explore Ron’s strategy and actions that have allowed this expense to rise almost 46% while sales were up just under 29%. This has driven the 2.06% increase in all SG&A as a percentage of sales.

The expert lender would follow up on Ron’s mention of a bonus plan for his sales managers and store managers by asking:

Why has compensation risen so much more than sales?

What is the sales bonus plan, and how has that affected compensation expense in 20Y3?

Let’s say Ron admits that his area sales managers and best store managers were not happy with their compensation after the explosive growth in 20Y2. So Ron implemented a bonus plan that is earned on increased sales. To reward long-term growth and repeat business with existing customers, the bonus is paid on a 2-year average, which for 20Y3 included that explosive growth of 20Y2.

That would be discouraging, since Ron apparently failed to think about the impact on profitability and cash flow. Now suppose he tells you that he has implemented a revision to the policy such that bonuses are paid only to the extent that Karr Photo’s pre-tax


profitability is at least 1% of sales, with increases of .3% in that floor each year.

You would raise your rating of Ron’s expense management, but you would also realise that the cash flow demands of sales growth for Karr are even higher now. A substantial expense is now more variable than it was two years ago.

d. For Karr, the key crossover issue is the connection between changes in the gross margin and the amount and type of stock the company has on hand. Ron’s stock turnover has deteriorated further as of 31/10/Y3, and he has higher gearing as a result.

Has Karr held onto unwanted stock while selling the more desirable, higher margin items? That does not bode well for future cash flow from profits, and it might mean Ron has no plan to liquidate the stock. Or, has Karr been able to off-load less desirable stock while increasing its margin? That would be quite an accomplishment and would boost your rating of Ron as a manager and your outlook for future cash flow from profits.

e. IF Karr has already unloaded most of the less desirable stock it purchased last year (during 20Y2), THEN Karr’s expense management in cost of goods sold is encouraging. There is reason to think the Karr Photo strategy of expert selling is paying off and can continue to pay off. Industry pricing is not predatory, and suppliers are fiercely competitive so that their influence over retailers like Karr is weakened.

The outlook for SG&A expense is less encouraging since a large portion of it is now more variable than it was, as a result of the sales bonus plans. However, Ron has recognised the need for higher pre-tax profit as a percentage of sales and is beginning to focus his management team on that.

A stable gross margin and stable SG&A as a percentage of sales seems a reasonable assumption of most likely performance. But the expert lender would also test for the effect of higher interest expense as well as some deterioration in the gross margin.

IF Karr still has substantial amounts of the older stock items AND IF suppliers don’t want to keep financing it, THEN there will be pressure on the gross margin if discounting is needed to reduce the stock. Because the company cannot afford to borrow much money to continue to carry the stock, Karr could be forced to liquidate it regardless of the impact on profitability. Fortunately, the cash inflow from the stock reduction will far outweigh the cash outflow from pre-tax losses.


Because Ron is so far ‘out on a limb’ with the excess stock, extreme dependence on supplier financing, and inability to borrow the money if needed to pay suppliers (because he cannot pay the higher interest), it is critical that Ron has a credible plan for liquidating the stock.

© Omega Performance Corporation. All rights reserved. Cases 159

CCaasseess This section contains the following cases:

Shepherd Ltd

Karr Photo Equipment & Supplies

160 Cash Flow Analysis CFA.CS.000.0113.CSD.IFRS.UK.doc © Omega Performance Corporation. All rights reserved.

C A S E

S T U D Y

SShheepphheerrdd LLttdd

This case contains:

Part I

Background Statements of Financial Position, 20Y1-20Y3 Income Statements, 20Y2-20Y3

Part II

Quick Cash Flow, 20Y2-20Y3 Direct Statement of Cash Flows, 20Y2-20Y3 Indirect Statement of Cash Flows, 20Y2-20Y3

© Omega Performance Corporation. All rights reserved. Shepherd: Part I 161

PPPaaarrrttt III SShheepphheerrdd LLttdd

This section contains the following materials:

Background Statements of Financial Position, 20Y1-20Y3 Income Statements, 20Y2-20Y3


BBaacckkggrroouunndd Shepherd Ltd is a multinational company that provides aviation services and products. Services include engine maintenance, general aircraft maintenance, tie-downs, and fuelling services. Shepherd also manufactures a small line of specialty tools used in aircraft maintenance. The company has operations at 25 airports in the United Kingdom and continental Europe.

Shepherd grew primarily by acquiring other companies in the same business. Its goal was to achieve revenues of £500 million by the year 20Y7. In 20Y1, sales reached £149 million, a decrease from the previous year which had sales of £150 million. Sales continued to decrease to £137 million in 20Y2. In a cost-cutting move, the company closed one unprofitable operation in 20Y2.

Sales volume and profit margins improved in 20Y3. The company expects steady but not spectacular growth in the next few years as the economy continues to grow.


Shepherd Ltd Statements of Financial Position

Years Ended 31 December:

(in £000s) 20Y3 20Y2 20Y1

ASSETS Property, plant, and equipment (net) (Note 1) £ 11,246 £ 12,437 £ 11,138 Goodwill 2,066 1,571 736 Total non-current assets 13,312 14,008 11,874

Current assets Stock 27,865 20,519 25,743 Debtors 22,233 17,469 24,549 Prepaid expenses 923 900 909 Cash 2,312 2,748 671 Other current assets 447 1,236 0 Total current assets 53,780 42,872 51,872

Total Assets £67,092 £ 56,880 £ 63,746 EQUITY AND LIABILITIES Capital and reserves Ordinary share capital £ 3,149 £ 3,149 £ 3,069 Other reserves 15,702 15,702 15,772 Retained earnings 15,596 15,026 15,809 Purchase of own shares (1,145) (821) 0 Capital and reserves 33,302 33,056 34,650 Non-Current Liabilities Deferred taxes 2,304 2,298 2,580 Long-term debt 15,391 9,384 10,949 Accrued pensions 448 227 13 18,143 11,909 13,542 Current liabilities Creditors 8,810 6,410 6,937 Accrued expenses 4,219 3,142 3,615 Taxes payable 935 595 820 Loans and overdrafts (Note 2) 1,683 1,768 4,182 Total current liabilities 15,647 11,915 15,554

Total equity and liabilities £ 67,092 £ 56,880 £ 63,746


Shepherd Ltd Income Statements and Statements of Retained Earnings


(in £000s) 20Y3 20Y2

Sales £ 144,902 £ 137,460 Cash cost of goods sold 110,905 106,531 Depreciation expense 342 510 Total cost of sales 111,247 107,041

Gross profit 33,655 30,419

Interest income 258 40 Selling, general, and administrative expenses Selling expenses 10,313 9,763 Salaries 6,018 6,120 General expenses 9,476 9,695 Depreciation 1,220 1,135 Amortisation 182 120 Total SG&A expenses 27,209 26,833

Other expense 2,060 1,873 Operating profit 4,644 1,753

Interest expense 1,271 1,430 Net profit before tax 3,373 323

Taxes 1,581 38

Net profit after tax £ 1,792 £ 285

Retained earnings, 1 January £ 15,026 £ 15,809 Net income 1,792 285 Dividends 1,222 1,068

Retained earnings, 31 December £ 15,596 £ 15,026


Note 1) Property, plant, and equipment

20Y3 20Y2 20Y1

Buildings 4,813 3,987 3,534 Equipment 4,992 5,553 5,236 Property 9,794 9,988 7,814 Less: Accumulated depreciation (8,353) (7,091) (5,446)

Net property, plant, and equipment 11,246 12,437 11,138

Note 2) Loans and overdrafts due within one year

Current portion—long-term loans 1,679 1,734 1,374 Short-term bank loans and overdrafts 4 34 2,808

Total 1,683 1,768 4,182


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Quick Cash Flow, 20Y2-20Y3 Direct Statement of Cash Flows, 20Y2-20Y3 Indirect Statement of Cash Flows, 20Y2-20Y3

© Omega Performance Corporation. All rights reserved. Shepard: Part II 167

Quick Cash Flow (in £s) Company Name: Shepherd Ltd

+ -

TAFN (U) S

GFA (U) S

20Y2 20Y3

Net profit 285 1,792 Plus: Depreciation, amortisation expense 1,765 1,744 Plus: Interest expense 1,430 1,271 Plus decrease (or less increase): Tradi g asset financing need 11,304 (8,633) Equals: Cash after operating cycle 14,784 (3,826) Plus (or less): Gross non-current assets (2,944) (71) Equals: Cash after capital investment cycle 11,840 (3,897) Less: Dividend declared 1,068) (1,222) Equals: Cash available for all debt repayment 10,772 (5,119) Less: Current portion long-term debt (prior year) (1,374) (1,734) Less: Interest expense (1,430) (1,271) Equals: Cash available for other debt repayment 7,968 (8,124) Change in trading asset financing need OPENING CLOSING Debtors 24,549 17,469 Plus: Stock 25,743 20,519 Less: Creditors 6,937 6,410 Less: Accrued expenses 3,615 3,142 Equals: Trading asset financing need 39,740 28,436 Closing trading asset financing need 28,436 Less: Opening trading asset financing need 39,740 Equals: Trading asset financing need (11,304) 20Y2 Change in trading asset financing need OPENING CLOSING ebtors 17,469 22,233 Plus: Stock 20,519 27,865 Less: Creditors 6,410 8,810 Less: Accrued expenses 3,142 4,219 Equals: Trading asset financing need 28,436 37,069 Closing trading asset financing need 37,069 Less: Opening trading asset financing need 28,436 Equals: Trading asset financing need 8,633 20Y3 Change in trading asset financing need OPENING CLOSING Debtors Plus: Stock Less: Creditors Less: Accrued expenses Equals: Trading asset financing need Closing trading asset financing need Less: Opening trading asset financing need Equals: Trading asset financing need Are any changes in income taxes payable, interest payable, prepaid expenses, investments, or



Shepherd Ltd Statement of Cash Flows (Direct)

(in £000s)


OPERATING ACTIVITIES 20Y3 20Y2 Cash received from customers £ 140,138 £ 144,540 Cash (paid) to suppliers and employees (115,851) (101,834) Cash (paid) to employees and others (23,736) (27,002) Other income 258 40 Other (expense) (2,083) (1,864) Interest (paid) (1,255) (1,501) Income taxes (paid) (1,235) (545)

Net cash provided (used) in operating activities £ (3,764) £ 11,834

INVESTING ACTIVITIES (Purchases) of fixed assets £ (396) £ (2,944) Proceeds from sale of fixed assets 25 0 (Purchases) of goodwill (677) (955)

Net cash provided (used) in investing activities £ (1,048) £ (3,899)

FINANCING ACTIVITIES Proceeds from short-term borrowings £ 400 £ 200 (Payments) to reduce short-term borrowings (430) (2,974) Proceeds from long-term borrowings 7,686 169 (Payments) to reduce long-term borrowings (1,734) (1,374) Proceeds from sale of shares 0 10 (Purchase) of own shares (324) (821) (Payment) of dividends (1,222) (1,068)

Net cash provided (used) by financing activities £ 4,376 £ (5,858)

Increase (Decrease) in cash and cash equivalents £ (436) £ (2077) Beginning cash and cash equivalents £ 2,748 £ 671

Ending cash and cash equivalents £ 2,312 £ 2,748

© Omega Performance Corporation. All rights reserved. Shepard: Part II 169

Shepherd Ltd Statement of Cash Flows (Indirect)

(in £000s)


20Y3 20Y2

OPERATING ACTIVITIES Net income 1,792 285 Adjustments to reconcile net income to net cash provided (used)

by operating activities Depreciation 1,744 1,765 Changes in operating assets and liabilities (Increase) Decrease in debtors (4,764) 7,080 (Increase) Decrease in stock (7,346) 5,224 (Increase) Decrease in prepaid expenses and other current assets 766 (1,227) Increase (Decrease) in creditors 2,400 (527) Increase (Decrease) in accrued expenses 1,077 (473) Increase (Decrease) in taxes payable 340 (225) Increase (Decrease) in deferred taxes 6 (282) Increase (Decrease) in accrued pensions 221 214

Net cash provided (used) in operating activities (3,764) 11,834

INVESTING ACTIVITIES (Purchases) of fixed assets (396) (2,944) Proceeds from sale of fixed assets 25 0 (Increase) Decrease in goodwill (677) (955) Net cash provided (used) in investing activities (1,048) (3,899)

FINANCING ACTIVITIES Proceeds from short-term borrowings 400 200 (Payments) to reduce short-term borrowings (430) (2,974) Proceeds from long-term borrowings 7,686 169 (Payments) to reduce long-term borrowings (1,734) (1,374) Proceeds from issue of shares 0 10 (Purchase) of own shares (324) (821) (Payment) of dividends (1,222) (1,068) Net cash provided (used) by financing activities 4,376 (5,858)

Increase (Decrease) in cash and cash equivalents (436) 2,077 Opening cash and cash equivalents 2,748 671 Closing cash and cash equivalents 2,312 2,748

Memo items Cash paid for interest 1,255 1,501 Cash paid for taxes 1,235 545 Cash paid for leases 3,211 3,241


C A S E

S T U D Y

KKaarrrr PPhhoottoo EEqquuiippmmeenntt && SSuupppplliieess LLttdd

This case contains:

Part I

Background Statements of Financial Position and Income Statements, 20Y1-

20Y3 Ratios, 20Y1-20Y3

Part II

Quick Cash Flow, 20Y2-20Y3 Part III

Financial Drivers Worksheet, 20Y2-20Y3

© Omega Performance Corporation. All rights reserved. Karr Photo: Part I 171

PPPaaarrrttt III KKaarrrr PPhhoottoo EEqquuiippmmeenntt && SSuupppplliieess LLttdd


Background Statements of Financial Position and Income Statements, 20Y1-

20Y3 Ratios, 20Y1-20Y3


BBuussiinneessss BBaacckkggrroouunndd aanndd SSttrraatteeggyy The Karr family has been in the retail camera equipment business for more than 25 years since Herbert Karr, a professional photographer, first opened a store in Manchester. The company now has 15 stores, mostly in northern UK, with, in addition, one store each in Birmingham, Cambridge, and Bristol.

Ron Karr became Chairman 10 years ago when his father Herbert died. Ron continued the growth pattern established earlier, opening a new store about every two years. He also focused the company on retail exclusively, closing the photography studios that had been in about half of the stores and getting out of the film developing and photo finishing business. Ron moved most of Karr Photo’s banking relationship to you when he took over.

Two and half years later, the national economy went into recession and the North was particularly hard hit. Sales dropped for Karr Photo because as Ron says, ‘Nobody even thinks about buying a camera in a recession’. Still, Ron is proud of how he managed through the downturn, trimming stock and closing one store that had not been profitable.

Today, Karr Photo carries a full line of cameras, lenses, printing supplies, even some lighting and studio equipment. Popular items include the latest video cameras, digital cameras, and water-resistant cameras. Brands such as Nikon, Kodak, Polaroid, Minolta, Pentax, and Canon offer price points from very high-end to mid-range. Karr Photo avoids the low end, where customers are more price-sensitive and tend to buy from chain and discount department stores like Comet and Argos.

Having higher-end equipment on hand is important to making the sale. ‘If I have to order it,’ Ron explains, ‘I’m going to lose some customers who just won’t wait, or if they’ve got to wait, they will go online and find a better price. I need to be able to let them touch and feel the cameras. We sell online through our web site (cameras-karr.com), but we’d rather keep the customers coming into our stores.’

Most customers are experienced photographers or videographers, or ‘they want to think they are,’ says Ron. Most of the store locations tend to sell to most of the professional photographers in their areas. Your own discussions with a few professional photographers in the Greater Manchester area confirm this. The word from them is that you might not get the lowest price at Karr Photo, but the price will be fair and Karr Photo will never sell you something you do not need.


The sales approach is very low key, and the staff is generally very knowledgeable about their products and how customers will use them. Ron is proud of this, too, and quick to point out that he does all the hiring of store managers and is often involved in the hiring of other store sales staff as well. He looks for budding professional photographers who have to make a living while they pursue their art. Some (even store managers) work three or four days a week and do their own photography the rest of the time. Ron has confided that the main problem with this approach is that store managers aren’t always attuned to the financial aspects of the business, and sometimes the sales staff is impatient with customers who are novice photographers.

‘Some of the store managers and sales staff are not comfortable with the growth of our online sales,’ Ron has told you. He thinks they may see it as a threat, but he is trying to get them to think of the online activity as ‘lead development.’ Ron has invested fairly heavily in the technology to track and evaluate activity on the web site and to build a database of information about customers and visitors (to the stores and to the web site). He believes that investment, together with an internal Sales Centre he started three years ago, has contributed solidly to the sales growth in the past few years.

The Sales Centre employs two people who respond to inquiries from the web and take inbound calls. About 40% of their time is available for outbound calls and for writing messages for postcard promotions and email messages. The mail and electronic outbound efforts are tailored to the customer profile. Ron is very pleased and congratulates himself for having had the foresight to staff the Sales Centre with experienced, knowledgeable people who don’t have to work from a script. Their expertise extends the overall image of Karr Photo as a source of expertise as well as quality product.

MMaannaaggeemmeenntt

Ron has expanded the management of Karr Photo as it has grown, and he now feels the company pretty much runs itself. He has two area sales managers reporting to him; the store managers report to the area sales managers. Also reporting directly to Ron are a purchasing manager, a marketing manager, and a chief accountant.

The chief accountant manages billings, payroll and other payables, and prepares monthly financial statements. Most sales are through credit cards with some cash, so billing and collection efforts are not time consuming.

The marketing manager has a technical background and is able to work not only with the store managers on merchandising ideas, but also with the firm Karr uses to design and maintain the web site. The Sales Centre reports to the marketing manager.


The purchasing manager is a graduate student in media arts at Manchester who has been working full time for Ron for two years now. He works largely under Ron’s supervision, although he also has access to stock reports and sales pattern data.

Ron travels to equipment shows and makes the overall decisions about what items to carry. The two area sales managers sometimes attend shows also, and they participate in evaluating the particular trends in their markets.

FFiinnaanncciiaall RReeppoorrttiinngg aanndd PPeerrffoorrmmaannccee A reliable local firm of accountants audits Karr Photo’s annual report and accounts.

The company now owns a warehouse in Leeds, which is becoming the primary distribution centre for Karr. They also rent warehouse space on the southwest side of Manchester, not far from the airport.

Twelve of the fifteen stores are leased under operating leases that are renewed every three years. This flexibility has been good, but Karr’s locations have been so popular that rental expense has risen steadily. A few years ago, Ron became frustrated and decided to control his facilities expenses by purchasing some of his store sites. Stores in Leeds, York, and Newcastle are now owned rather than leased. All are in upscale commercial condominium developments where the mix of businesses is boutique retail, restaurants, and lodging.

The company has two credit facilities from you, a £2,000,000 short-term facility and a term loan with a balance of £1,200,000 with repayments of £75,000 quarterly. The short-term line is used to finance stock and store expansion and is renewed annually. The term loan was made to finance growth in core trading assets and capital expenditures.

Lately Ron has been thinking that the short-term facility may need to be increased.

Financial statements for Karr Photo appear on the following pages.


Karr Photo Equipment & Supplies Ltd Statements of Financial Position

31 October:

20Y3 20Y2 20Y1 ASSETS (%) (%) (%) Non-current assets Property, plant and equipment £ 1,557,040 10.8 £ 806,290 7.7 £ 238,190 4.2 Accumulated depreciation (308,050) (2.1) (140,850) (1.3) (83,600) (1.5)

Net property, plant and equipment 1,248,990 8.7 665,440 6.3 154,590 2.7

Investments 45,840 0.3 0 0.0 0 0.0

Total non-current assets 1,294,830 9.0 665,440 6.3 154,590 2.7 Current assets Stock 9,364,910 64.9 7,078,700 67.5 3,633,700 64.5 Debtors 3,449,770 23.9 2,471,350 23.5 1,613,580 28.6 Employee loans 36,240 0.3 14,420 0.1 7,500 0.1 Prepaid expenses 89,130 0.6 102,240 1.0 42,470 0.8 Other current assets 177,020 1.2 152,020 1.4 80,000 1.4 Cash 17,670 0.1 10,100 0.1 105,750 1.9

Total current assets 13,134,740 91.0 9,828,830 93.7 5,483,000 97.

3

TOTAL ASSETS £ 14,429,570 100.0 £ 10,494,270 100.0 £ 5,637,590 100.0

EQUITY AND LIABILITIES Shareholders’ funds Share capital £ 200,000 1.4 £ 200,000 1.9 £ 200,000 3.5 Retained earnings 2,867,010 19.9 2,640,380 25.2 2,393,880 42.5

Total shareholders’ funds 3,067,010 21.3 2,840,380 27.1 2,593,880 46.

0

Long-term debt 900,000 6.2 673,960 6.4 612,230 10.9

Current liabilities Creditors 7,573,850 52.5 4,521,630 43.1 1,665,620 29.5 Overdraft 2,000,000 13.9 1,397,020 13.3 0 0.0 Current portion—long-term debt 300,000 2.1 300,000 2.9 300,000 5.3 Other accruals 333,700 2.3 568,220 5.4 326,830 5.8 Income taxes payable 50,190 0.3 0 0.0 9,520 0.2 Other taxes payable 204,820 1.4 193,060 1.8 129,510 2.3

Total current liabilities 10,462,560 72.5 6,979,930 66.5 2,431,480 43.

1 TOTAL EQUITY AND LIABILITIES £ 14,429,570 100.0 £ 10,494,270 100.0 £ 5,637,590 100.0


Karr Photo Equipment & Supplies Ltd Income Statements

Years Ended 31 October:

20Y3 20Y2 20Y1 (%) (%) (%)

Sales £ 47,374,050 100.0 £ 36,786,130 100.0 £ 22,110,280 100.0 Cost of goods sold 36,951,760 29,412,810 17,296,520

Gross profit 10,422,290 22.0 7,373,320 20.0 4,813,760 21.8

Direct costs

Salaries 7,727,880 5,297,200 3,073,320 National Insurance 667,150 457,310 265,320 Employee benefits 277,930 190,540 110,550

Total direct costs 8,672,960 18.3 5,945,050 16.2 3,449,190 15.6

Operating expenses

Rent 362,070 241,100 191,930 Telephone 96,320 79,990 81,210 Utilities 62,120 39,410 32,020 Insurance 186,630 172,120 136,390 Taxes and licences 110,280 95,340 81,440 Advertising 86,270 41,170 95,410 Travel and entertainment 46,630 52,670 40,070 Other transport 47,370 42,140 34,880 Depreciation 167,200 57,250 35,040 Services and supplies 73,650 54,140 56,620 Other operating expenses 20,010 61,000 82,250

Total operating expenses 1,258,550 2.7 936,330 2.5 867,260 3.9 Operating profit 490,780 1.0 491,940 1.3 497,310 2.2 Interest expense 199,150 83,210 89,940

Net profit before tax 291,630 0.6

408,730 1.1

407,370 1.8

Tax on profit 65,000 0.1

162,230 0.4

84,350 0.4

Net profit after tax £ 226,630 0.5

£ 246,500 0.7

£ 323,020 1.5


Karr Photo Equipment & Supplies Ltd Ratios

Years Ended 31 October:

20Y1 20Y2 20Y3 Profitability Gross margin 21.8 20.0 22.0 Operating profit margin 2.2 1.3 1.0 Pretax profit margin 1.8 1.1 0.6 Net profit margin 1.5 0.7 0.5 Contribution margin* 21.80 % 20.00 % 22.00 %Breakeven sales point £20,212,752 £34,822,950 46,048,455 Liquidity Current ratio 2.3 1.4 1.3 Quick ratio 0.7 0.4 0.4 Working capital £3,051,520 £2,848,900 £2,672,180 Working investment £3,254,830 £4,460,200 £4,907,130 Leverage Debt to assets 0.5 0.7 0.8 Net worthactual £2,593,880 £2,840,380 £3,067,010 Debt to net worth 1.2 2.7 3.7 Debt to tangible net worth** N/A N/A N/A Adjusted debt to adjusted tangible net worth** N/A N/A N/A EBITDA £532,350 £549,190 £657,980 EBITDA to senior debt ***N/A 1.43 1.32 EBITDA to total debt ***N/A 1.43 1.32 Efficiency Sales to assets 3.9 3.5 3.3 Cost of goods sold to stock (SDOH) 76.7 87.8 92.5 Sales to debtors (DDOH) 26.6 24.5 26.6 Cost of goods sold to creditors (CDOH) 35.1 56.1 74.8 Sales to net fixed assets 143 55 38 Return on assets (pretax) 7.2 3.9 2.0 Return on equity (pretax) 15.7 14.4 9.5 * Calculated using the pure field method ** These ratios are not applicable because there are no intangibles and no adjustments to net

worth ***You cannot calculate 20Y1 without knowing the current portion of LTD that was shown as due

in the previous year’s accounts.


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Quick Cash Flow, 20Y2-20Y3

© Omega Performance Corporation. All rights reserved. Karr Photo: Part II 179

Quick Cash Flow (in £s) Company Name: Karr Photo Equipment & Supplies Ltd

+ -

TAFN (U) S

GFA (U) S

20Y2 20Y3 20Y4

Net profit 246,500 226,630 Plus: Depreciation, amortisation expense 57,250 167,200 Plus: Interest expense 83,210 199,150 Plus decrease (or less increase): Trading asset financing need (1,205,370) (446,930) Equals: Cash after operating cycle (818,410) 146,050 Plus (or less): Gross non-current assets (568,100) (750,750) Equals: Cash after capital investment cycle (1,386,510) (604,700) Less: Dividends declared 0 0 quals: Cash available for all debt repayment (1,386,510) (604,700) Less: Current portion long-term debt (prior year) (300,000) (300,000) Less: Interest expense (83,210) (199,150) Equals: Cash available for other debt repayment (1,769,720) (1,103,850) Change in trading asset financing need OPENING CLOSING Debtors 1,613,580 2,471,350 Plus: Stock 3,633,700 7,078,700 Less: Creditors 1,665,620 4,521,630 Less: Accrued expenses 326,830 568,220 Equals: Trading asset financing need 3,254,830 4,460,200 Closing trading asset financing need 4,460,200 Less: Opening trading asset financing need 3,254,830 Equals: Trading asset financing need 1,205,370 20Y2 Change in trading asset financing need OPENING CLOSING Debtors 2,471,350 3,449,770 Plus: Stock 7,078,700 9,364,910 Less: Creditors 4,521,630 7,573,850 Less: Accrued expenses 568,220 333,700 Equals: Trading asset financing need 4,460,200 4,907,130 Closing trading asset financing need 4,907,130 Less: Opening trading asset financing need 4,460,200 Equals: Trading asset financing need 446,930 20Y3 Change in trading asset financing need OPENING CLOSING Debtors Plus: Stock Less: Creditors Less: Accrued expenses Equals: Trading asset financing need Closing trading asset financing need Less: Opening trading asset financing need Equals: Trading asset financing need 20Y4 Are any changes in income taxes payable, interest payable, prepaid expenses, investments, or



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Financial Drivers Worksheet, 20Y2-20Y3

© Omega Performance Corporation. All rights reserved. Karr Photo: Part III 181






Cash Impact of Change in Turnovers 20Y1 20Y2 20Y3 Average daily sales 60,576 100,784 129,792 Times: Change in DDOH 2.1 2.1 Equals: Cash impact of change in DDOH 211,646 (272,563)



TOTAL IMPACT OF CHANGE IN TURNOVERS 1,009,418 1,144,765




Cash Impact of Change in Fixed Assets 20Y1 20Y2 20Y3 Opening net fixed assets 154,590 665,440 Less: Depreciation expense for this year 57,250 167,200 Equals: Expected closing net fixed assets 97,340 498,240

Actual closing net fixed assets 665,440 1,248,990 Less: Expected closing net fixed assets 97,340 498,240 Equals: Cash impact of change in fixed assets (568,100) (750,750)

TOTAL IMPACT OF CHANGE IN FIXED ASSETS (568,100) (750,750)

© Omega Performance Corporation. All rights reserved. Appendix 183

AAAppppppeeennndddiiixxx DDiirreecctt CCaasshh FFllooww

WWhhaatt IIss DDiirreecctt CCaasshh FFllooww?? Direct cash flow, or ‘top down’, formats begin with sales (like the top of the income statement) and then subtract only cash expenses and make two kinds of adjustments:

Add statement of financial position changes that are sources of cash flow, such as a decrease in debtors

Subtract statement of financial position changes that are uses of cash flow, such as an increase in long-term assets or reduction of bank loans and overdrafts

An explanation of the direct cash flow format, which we call the cash flow summary, appears on the following page. Take a look at it now, and then return to this page.

BBeenneeffiittss ooff DDiirreecctt CCaasshh FFllooww

It focuses the lender immediately on sales (the first line of a direct cash flow), which keeps the lender aware of the impact of the change in sales on statement of financial position accounts and on expenses.

It provides a high level of detail about statement of financial position changes that have affected cash flows. This enables the lender to identify the cash impact of changes in debtors, stock, creditors, accruals, and interest and taxes paid, which don’t show up individually on the quick cash flow format.

It imposes a hierarchy of cash flow uses that allows the lender to spot when and why the cash flow has turned negative, and to consider if the lender is willing to finance any of the uses that caused the cash flow to turn negative. Quick cash flow or other indirect cash flow formats can do that also, but the added detail of the direct cash flow facilitates that kind of thinking.

184 Cash Flow Analysis CFA.APP.000.0113.CSD.IFRS.UK.doc © Omega Performance Corporation. All rights reserved.

Cash Flow Summary (in £000s etc.)

Company Name:

+ – A (U) S

L/E S (U)

Target

Sales revenue (net) (1)

Debtors (2) Sometimes called ‘cash

Cash collected rom sales (3) from sales’. Shows cash effect of Cash cost of goods sold (4) transactions with customers. Stock (5) Creditors (6)

Cash paid for production (7) Sometimes called ‘gross

Cash from trading activities (3) + (7 = (8) cash profits’. Indicates effect of buying Cash SG&A expense (9) or producing and selling Prepaid expenses (10) goods and services. Accrued expenses (11)

Cash paid for operating costs (12)

Cash after operations (8) + (12) = (13) Cash after operations. Shows cash effect of Other income (expense) (14) operating cycle after Other current and non-current accounts (15) overhead and other Income tax expense (16) expenses. Deferred income t xes (17) Income taxes payable (18)

Taxes paid and other income (expense) (19) Net cash after operations.

Net cash after operations (13) + (19) = (20) Shows net cash effect of operating cycles after Interest expense (21 income taxes Interest payable (22) Dividends declared or other reductions in capital (23) Dividends payable (24) Sometimes called ‘net cash

Cash paid for dividends and interest (25) income’.

Cash after financing costs (20 + (25) = (26) Shows cash effect of operating cycle after

Current portion long-term debt (prior year) (27) interest and dividends,

Cash after debt amortisation (26) + (27) = 28) payments over which management may have Property, plant and equipment (29) little discretion. Investments (30) Intangibles (31) Financing surplus or

Cash paid for non-current assets (32) (requirement).

Financing surplus (requirement) (28) + (32) = (33) Shows total cash impact of all activities, Short-term debt and overdraft facilities (34) including ‘discretionary’ Long-term debt (35) outlays for non-current Preference shares (36) assets. Ordinary shares (37) Total external financing (3 ) Sometimes called

Financing surplus (requirement) + ‘cash after financing’. Total external financing (33) + (38) = (39) Indicates how management financed requirements PROOF: Cash and marketable securities (40) or applied surplus.


Direct cash flow has these limitations:

It is very long and can therefore be confusing. Learning to focus on key lines, which we call targets, can reduce the confusion.

It is time-consuming to construct manually. Fortunately, the direct cash flow format is most often prepared by a software program. The purpose of learning to construct the statement manually is to ensure understanding of the computer-generated statement, not to rely on manual constructions on the job.

It obscures the amount of net profit plus depreciation; therefore it does not help the lender focus on Type A cash flow. Careful analysis of Layer Two financial drivers, especially changes in margins, helps to offset that limitation.

It is usually best to use direct cash flow when:

Financial statements are complex and the amounts are large, and so greater detail is important.

Computer software is used for the historical cash flow calculations.

Most widely used software programmes for direct cash flow analysis follow the same rules and steps to calculate cash flows although they may label lines in the cash flow statement differently.

To associate common titles or labels that you may encounter in computer generated cash flow statements with the particular format you will work with in this module, look again at the Cash Flow Summary worksheet on the previous page and use it to answer the following questions:

1. What is the first target that shows cash flow after payment of interest?

2. What is the first target that shows cash flow after payment of income taxes?

3. What potentially large cash outflows are still to be addressed after CADA (cash after debt amortisation)?

4. What is the first target that shows cash flow after inflows and outflows of the operating cycle?


1. Cash after financing costs, often called net cash income

2. Net cash after operations

3. Expenditures for long-term assets or other long-term investments

4. Cash after operations

CCoonnssttrruuccttiinngg DDiirreecctt CCaasshh FFllooww MMaannuuaallllyy Being able to construct direct cash flow manually is the best way to be sure you understand what the numbers on a computer-generated direct cash flow represent. You will be able to spot inconsistencies due to errors in input or faulty assumptions about future financial performance and cash flow. It is important to be sure you understand the accuracy of the numbers before you begin to interpret them.

Two job aids will provide you with guidance as you construct cash flow summaries:

The Direct Cash Flow Construction job aid is a line-by-line guide for constructing a direct cash flow in the format of the cash flow summary.

The Cash Flow Summary Tips job aid provides general guidance for the cash flow summary worksheet.

You will notice that the Cash Flow Summary has columns for multiple years and, unlike the actual financial statements, these years are listed in ascending order from left to right—earliest year on the left, and most recent year on the right—the opposite of the original financial statements. We use this presentation because most lending institutions use some form of statement spreading software that produces reports, ratios, and cash flow information, and most of this software presents the years in ascending order from left to right. This also facilitates adding projected years to the Cash Flow Summary.

The Direct Cash Flow Construction job aid begins on the following page. Look at it now and return to this page. The Cash Flow Summary Tips job aid is on the back of the Cash Flow Summary worksheet for Shepherd Ltd., which follows the job aid. You will be referring to this Shepherd Cash Flow Summary worksheet throughout this section.

Use the worksheet and job aids that follow and the Shepherd Ltd. financial statements (in Shepherd, Part I, in the Cases section) to answer questions about how Shepherd’s 20Y3 direct cash flow was calculated. These questions follow the Shepherd Cash Flow Summary worksheet.


Job Aid: Direct Cash Flow Construction Page 1

Target 1: Cash collected from sales Line: 1 Record net sales (total revenues less returns and allowances). 2 Record the change in debtors. 3 Combine lines 1 and 2. This is cash collected from sales.

Target 2: Cash from trading activities Line: 4 Record cash cost of goods sold (cash COGS), calculated as follows: COGS from accrual income statement Less: Noncash expenses in COGS, such as depreciation Equals: Cash COGS 5 Record the change in stock. 6 Record the change in creditors. 7 Combine lines 4, 5, and 6. This is cash paid for production. 8 Combine lines 3 and 7. This is cash from trading activities

Target 3: Cash after operations Line: 9 Record cash SG&A expense, calculated as follows: SG&A from accrual income statement Less: Interest expense, if reported in SG&A Less: Depreciation and amortisation Equals: Cash SG&A expense Do not subtract from SG&A the provision for losses on receivables, if any, because net debtors

is used to calculate line 2, Debtors. 10 Record the change in current prepaid expenses. 11 Record the change in accrued expenses. 12 Combine lines 9, 10, and 11. The result is cash paid for operating costs. 13 Combine lines 8 and 12. The result is cash after operations.

Target 4: Net cash after operations Line: 14 Record the sum of other income and expense from the accrual income statement. Do not

include interest expense.

15 Record the change in other current and non-current assets and liabilities. ‘Other’ means all miscellaneous statement of financial position accounts not accounted for elsewhere in the cash flow summary. Do not include the following accounts: interest, dividends, or income taxes payable; interest-bearing debts; property, plant and equipment; investments, or intangibles; or any equity accounts.

Calculate the change in current and non-current accounts as follows: Opening other current assets Less: Closing other current assets Plus: Opening other non-current assets Less: Closing other non-current assets Less: Opening other current liabilities Plus: Closing other current liabilities Less: Opening other long-term liabilities Plus: Closing other long-term liabilities Equals: Change in other current and non-current accounts A positive result is a source of cash. A negative result is a use of cash. Record in ( ). 16 Record total income tax expense from accrual income statement. 17 Record the change in deferred income taxes, including current portions, if any. 18 Record the change in income taxes payable. 19 Combine lines 14, 15, 16, 17, and 18. The result is taxes paid and other income (expense). 20 Combine lines 13 and 19. The result is net cash after operations.



Target 5: Cash after financing costs Line: 21 Record interest expense from accrual income statement. Do not net interest income. 22 Record the change in interest payable. 23 Record, in ( ), dividends declared, shares repurchased, or other equity distributions from the statement reconciling changes in shareholders’ funds. Opening retained earnings Plus: Net profit after taxes Less: Closing retained earnings Equals: Dividends declared or other distributions of capital 24 Record the change in dividends payable. 25 Combine lines 21, 22, 23, and 24. The result is cash paid for dividends and interest (financing costs). 26 Combine lines 20 and 25. The result is cash after financing costs, also called net cash income.

Target 6: Cash after debt amortisation Line: 27 Record, in ( ), the current portion of long-term debt from the prior year (the statement of financial position for the beginning of the period). Assume the amount that was due to be paid during the period of the cash flow summary was, in fact, paid. Prepayments or payments not made will be accounted for on line 35. If the cash flow summary is for a period of less than 12 months, record on line 27 the portion of opening current maturities of long-term debt that were scheduled to be paid during the period. If unknown, prorate and be aware that you might overstate or understate the financing surplus (requirement) on line 33 and the change in long-term debt on line 35. 28 Combine lines 26 and 27. The result is cash after debt amortisation, often called CADA.

Target 7: Financing surplus (requirement) Line: 29 Record the change in property, plant and equipment after adjusting for depreciation, as follows: Opening net property, plant and equipment Less: Depreciation expense (from COGS, SG&A, or both) Equals: Expected closing net property, plant and equipment Closing net property, plant and equipment Less: Expected closing net property, plant and equipment Equals: Change in net property, plant and equipment Do not adjust for disposals of property, plant and equipment if you included the gain or loss on sale of these assets when calculating line 14, other income and expense. If you did not include the gain or loss on sale of property, plant and equipment when calculating line 14, adjust opening property, plant and equipment by adding the gain or subtracting the loss before performing the calculation shown above. 30 Record the change in investments after adjusting for amortisation, as follows: Opening investments Less: Amortisation expense (if any) Equals: Expected closing investments Closing investments Less: Expected closing investments Equals: Change in investments 31 Record the change in intangibles after adjusting for amortisation, as follows: Opening intangibles Less: Amortisation expense (if any) Equals: Expected closing intangibles Closing intangibles Less: Expected closing intangibles Equals: Change in intangibles 32 Combine lines 29, 30, and 31. 33 Combine lines 28 and 32. The result is financing surplus (requirement).



Target 8: Financing surplus (requirement) + Total external financing Line: 34 Record the change in short-term debt and overdrafts. 35 Record the change in long-term debt, calculated as follows: Closing long-term debt Plus: Closing current portion of long-term debt (CPLTD) Less: Opening long-term debt (long-term portion only) Equals: Change in long-term debt Note: The CPLTD for the opening period was already accounted for on line 27. 36 Record the change in preference shares. 37 Record the change in ordinary shares. Note: Calculate only changes to equity accounts other than retained earnings. The change in retained earnings is automatically accounted for in the cash flow construction. 38 Combine lines 34, 35, 36, and 37. The result is total external financing. 39 Combine lines 33 and 38. The result is the calculated change in cash.

Proof: To prove the accuracy of your calculations Line: 40 Record the actual change in cash between the beginning and ending statements of financial position. Your calculations are accurate if the amounts on lines 39 and 40 are the same. Note: Accuracy in a manual cash flow is secondary to identification of key variables influencing cash flow and analysis of the ‘Why?’ behind the numbers.


Cash Flow Summary (in £000s) Company Name: Shepherd Ltd

+ –

A (U) S

L/E S (U)

Target Line Number 20Y2 20Y3 20Y4

Sales revenue (net) (1) 137,460 144,902

Debtors (2) 7,080 (4,764) Cash collected from sales (3) 144,540 140,138

Cash cost of goods sold (4) (106,531) (110,905) Stock (5) 5,224 (7,346) Creditors (6) (527) 2,400

Cash paid for production (7) (101,834) (115,851) Cash from trading activities (3) + (7) = (8) 42,706 4,287

Cash SG&A expense (9) (25,578) (25,807) Prepaid expenses (10) 9 (23) Accrued expenses (11) (473) 1,077

Cash paid for operating cost (12) (26,042) (24,753) Cash after operations (8) + (12) = (13) 16,664 466)

Other income (expense) (14) (1,833) (1,802) Other current and non-current accounts (15) (1,022) 1,010 Income tax expense (16) (38) (1,581) Deferred income taxes (17) (282) 6 Income taxes payable (18) (225) 340

Taxes paid and other income (expense) (19) (3,400) (2,027) Net cash after operations (13) + (19) = (20) 13,264 (2,493)

Interest expense (21) (1,430) (1,271) Interest payable (22) 0 0 Dividends declared or ot er reductions in

capital (23)

(1,068)

(1,222)

Dividends payable (24) 0 0

Cash paid for dividends and interest (25) (2,498) (2,493) Cash after financing costs (20) + (25) = (26) 10,766 (4,986)

Current portion long-t rm debt (prior year) (27) (1,374) (1,734) Cash after debt amortisation (26) + (27) = (28) 9,392 (6,720)

Property, plant and equipment (29) (2,944) (371) Investments (30) 0 0 Intangibles (31) (955) (677)

Cash paid for non-current assets (32) (3,899) (1,048) Financing surplus (requirement) (28) + (32) = (33) 5,493 (7,768)

Short-term debt and overdrafts (34) (2,774) (30) Long-term debt (35) 169 7,686 Preference shares ( 6) 0 0 Ordinary shares (37) (811) (324) Total external financing (38) (3,416) 7,332

Financing surplus (requirement) + Total external financing (33) + (38) = (39) 2,077 (436) PROOF: Cash and marketable se urities (40) 2,077 (436)

© Omega Performance Corporation. All rights reserved. Three Cash Flow Formats 191

Job Aid: Cash Flow Summary Tips

Getting started

Be sure to use the income statement and statements of financial position (opening and closing) for the same period of time.

• If statements are company-prepared, be sure the statement of financial position balances and the income statement have been totalled properly.

• Begin with line 1 of the cash flow summary and work down to line 2, then line 3, and so on, analysing as you go.

• Place a mark () on the statement of financial position and income statement next to each account as you use it on the cash flow summary. Circle any noncash items that you have deducted from COGS or SG&A.

Recording income statement information

Lines of the cash flow summary in boldface type call for information from the income statement.

• Record revenues, sources of cash flow, as positive numbers.

• Record expenses, uses of cash flow, as negative numbers, in brackets ( ).

Recording statement of financial position information

• Lines of the cash flow summary that include the symbol (change in) call for information calculated from the statements of financial position for the beginning and end of the period of the cash flow.

• Calculate changes in statement of financial position accounts using the following formula:

Closing balance Less: Opening balance Equals: Change in () the account

• Classify changes as sources or uses of cash according to the following rules and table:

- Record an increase in an asset or a decrease in a liability in ( ) as a use of cash. - Record a decrease in an asset or an increase in a liability as a source of cash.

A+ –

S

(U)

(U)

S

L/E

• Line 27 calls for the CPLTD from the opening statement of financial position (or a prorated amount if the cash flow is for an interim period).

Troubleshooting

If lines 39 and 40 are unequal, be sure you have:

• Accounted for (placed a mark [] beside) all income statement and statement of financial position accounts.

• Transferred figures properly from the income statement to the cash flow summary, and enclosed all expense items in ( ).

• Calculated the amount of each source or use correctly, and enclosed each use in ( ).

• Used the net, not gross, amounts to calculate the change in such accounts as debtors and non-current assets.

• Checked your addition and subtraction for each target.

• Checked your calculation of the change in other accounts (line 15) by following these steps:

- For each category of other accounts (current and non-current assets and liabilities), calculate the change and classify each result as a source or a use of cash.

- Combine the sources and uses. For example, an increase in other current assets is a use of cash; a decrease in other non-current liabilities is also a use of cash.


1. Why is the amount for 20Y3 on line 4 of the cash flow summary NOT £111,247,000?

2. For 20Y3 what is the correct calculation of cash SG&A expense for line 9 of the cash flow summary?

3. Suppose a footnote disclosed the following additional information about debtors:

31/12/Y2 31/12/Y3

Gross debtors £18,469,511 £23,533,755 Less: Provision for bad debts 1,000,511 1,300,755 Net debtors £17,469,000 £22,233,000

Would the amount on line 2 of the cash flow summary for 20Y3 change? Why or why not?

4. For 20Y3, why is the amount for 20Y3 on line 27, current portion long-term debt, £1,734,000? Why not £1,679,000?

5. For 20Y3, why is the amount on line 35, change in long-term debt, a positive £7,686,000? Show your calculation.

6. Show your calculation for the amount on line 29, change in long-term assets.

7. Which line on the cash flow summary shows the change in retained earnings from 31/12/Y2 to 31/12/Y3?


1. £111,247,000 is the total amount of cost of goods sold, including depreciation and amortisation expense of £342,000. Shepherd has disclosed the amount of cash COGS as £110,905,000, so you simply put that amount on line 4. Some financial statements report only total cost of goods sold, and you must look for a footnote or other schedule of expenses to identify any noncash component of the total expense.

2. Total SG&A expenses £27,209,000 Less: Depreciation 1,220,000 Less: Amortisation expense 182,000 Equals: Cash SG&A £25,807,000

3. The amount would not change, because the cash flow summary calls for the change in net debtors, which remains an increase of £4,764,000 even with the additional disclosure of gross debtors and provision for bad debts.

4. It is £1,734,000 because that was the amount on the statement of financial position at 31/12/Y2 as the amount due to be paid during the next 12 months, which are the 12 months covered by the 20Y3 cash flow summary. When preparing a cash flow summary for 20Y4, you would use £1,679,000 as the current portion on line 27.

5. Ending long-term debt £17,070,000 (current and long-term portions) Less: Beginning long-term debt 9,384,000 (long-term portion only)

Equals: 7,686,000

Do not include the current portion in the beginning long-term debt because it is already accounted for on line 27.

6. Beginning net long-term assets £12,437,000 Less: Depreciation and amortisation expense 1,562,000 Equals: Expected ending net long-term assets 10,875,000

Actual ending net long-term assets £11,246,000 Less: Expected ending net long-term assets 10,875,000 Equals: Spending for long-term assets 371,000

Use only the depreciation and amortisation expense on long-term assets in the calculation. Do not use the amortisation expense, which applies to intangibles rather than to long-term assets.

7. None. The change in retained earnings is not expressly stated on the direct cash flow summary. It is accounted for by the combined effect of items from the income statement for revenues and expenses and by the dividends declared, if any.


IInnssiigghhttss aanndd QQuueessttiioonnss ffrroomm tthhee EEiigghhtt TTaarrggeettss HHiieerraarrcchhyy The hierarchy imposed by the order in which cash flows are listed in the cash flow summary helps the lender focus on the company’s capacity to fund various activities and expenditures with internally generated cash flows.

Cash requirements that are met ‘above’ the point on the cash flow summary when cash flow becomes negative are thought of as having been funded with internally generated cash.

Cash requirements that fall ‘below’ the point on the cash flow summary when cash flow becomes negative are thought of as requiring external financing (or a reduction in the company’s cash balance).

For example, if cash after operations is positive, the company has been able to fund any increases in debtors and stock as well as to pay cost of goods sold and selling, general and administrative expenses with internally generated cash flows. The company has not had to increase interest-bearing debt, raise new equity, or draw down its cash balance to meet those needs.

If net cash after operations is also positive, the company has been able to pay income taxes without borrowing. If net cash after operations is negative, the company has had to borrow to pay income taxes.

It is as if the lender looks down the cash flow summary and says ‘so far, so good’ for each target that remains positive. In reality, a company might borrow to finance an increase in debtors so that it would have enough remaining internally generated cash flow to pay taxes, dividends, or other expenditures. Therefore, it is also wise to ask at each target that is negative if any of the cash outflows above this point are financeable.

In that way, the hierarchy provides a useful discipline for thinking about:

Why the company has needed to borrow (or has generated a surplus).

How well the financing sources and their maturities meet the borrowing needs.

Whether a lender might be willing to finance any of the significant cash outflows if they recur in the future.

Using the hierarchy this way is helpful for measuring and isolating borrowing needs and repayment capacity. We have put together a job aid to help you think clearly about each target as you work down through a cash flow summary. Study the Targeted Cash Flow Analysis job aid on the following page.


Job Aid: Targeted Cash Flow Analysis

Cash Collected from Sales (line 3)

How has cash collected from sales been affected by:

Change in average daily sales?

Change in debtors DOH?

What industry and business conditions and management action or

inaction influenced those changes?

What are the implications for future cash flow?

Cash from Trading Activities (line 8)

How has cash from trading activities been affected by:

Change in average daily cash COGS?

Change in stock DOH?

Change in creditors DOH?




Cash after Operations (line 13)

How has cash after operations been affected by:

Change in trading asset financing need?

Change in cash expenses for SG&A?


inaction influenced the change in cash SG&A expenses?


Net Cash after Operations (line 20)

Has the company been able to meet all the cash requirements of its

operating cycle and pay income taxes with internally generated cash?

If so (line 20 positive), how?

If not (line 20 negative), why not?

Cash after Financing Costs (line 26)

Has the company been able to pay interest expense with internally

generated cash?

If yes (line 26 positive), is the cash after financing costs sufficient to pay

existing and proposed principal debt service?

If no (line 26 negative), will loan proceeds be used to pay interest?

Cash after Debt Amortisation (line 28)

Has the company been able to meet both interest and principal debt

service with internally generated cash?

If yes (line 28 positive), is all debt fully amortised, and is CADA sufficient

to make needed capital investments?

If no (line 28 negative), how can debts be restructured or reduced?

Financing Surplus (Requirement) (line 33)

If negative, what is the company’s total need for external cash?

If positive, were long-term investments sufficient to maintain capacity and

capability, and what cash flow is available to make further reductions in

short- or long-term debt or to reduce equity?

Financing Surplus (Requirement) + Total External Financing (line 39)

How has the company financed its need for external cash?

Is the structure of new financing appropriate?


Answer the following questions about the Cash Flow Summary worksheet of Shepherd Ltd., which appears earlier in this section. Refer to the Targeted Cash Flow job aid on the previous page to answer these questions.

1. In 20Y3, was Shepherd able to fund its increases in debtors and stock from internally generated funds?

2. What was Shepherd’s capacity to repay long-term debt with internally generated cash flow during 20Y2? During 20Y3?

3. Based on the structure of the debt financing Shepherd obtained in 20Y3, do you assume that the increases in debtors and stock are probably permanent or probably temporary?

4. If Shepherd’s cash after financing costs is the same next year as it was in 20Y3, how do you evaluate the company’s ability to repay long-term debt?


1. Yes, cash from trading activities (Target 2, line 8 of the cash flow summary) is positive £24,287,000. This means that, according to the hierarchy imposed by the direct cash flow summary, Shepherd collected enough cash from customers during 20Y3 to be able to pay all cash expenses of cost of goods sold as well as selling, general, and administrative expenses, and to support the increase in stock. Cash from trading activities does include the effect of an increase in creditors, but for Shepherd the amount is very small compared to the positive cash from trading activities.

2. In 20Y2, Shepherd was able to pay its current portion of long-term debt with internally generated cash flow, and still have £9,392,000 positive cash after debt amortisation (Target 6, line 28). However, in 20Y3, Shepherd was not able to pay current portion of long-term debt with internally generated cash flow; cash after financing costs (Target 5, line 26) was already negative £4,986,000.

3. Shepherd obtained additional long-term debt financing during 20Y3 in the amount of £7,686,000 (line 35). This debt was needed almost entirely to finance the growth in debtors and stock, since we know from the income statement (and from quick cash flow) that Type A cash flows were sufficient in 20Y3 to pay for dividends and current portion long-term debt and the very low expenditures for property, plant and equipment that year. If Shepherd and its lender are appropriately matching the repayment term to the borrowing cause, they must think the increase in trading asset financing need is permanent.

4. Insufficient. Cash after financing costs is negative £4,986,000. In order to be able to amortise long-term debt, Shepherd needs lower cash cost of goods sold expenses or lower selling, general, and administrative expenses, less growth in debtors and stock, lower dividend payments – or, a combination of those things that would increase net cash after financing costs to at least the amount of the current portion of long-term debt. Without that, Shepherd will have to borrow short-term to repay long-term debt.

The difficulty of answering question No. 4 reliably based only on Layer One information suggests that further analysis is needed at this point: a Layer Two analysis to understand the financial drivers of cash flow and a Layer Three analysis to understand the economic, industry, and management factors that are ‘driving the drivers’.


SSuummmmaarryy Being able to construct a cash flow summary helps you spot inaccurate inputs and faulty assumptions that make the Layer One cash flow data unreliable.

The tips on the back of the Cash Flow Summary worksheet and the Constructing Direct Cash Flow job aid are helpful tools for accurately constructing a cash flow summary.

The direct cash flow summary is a good Layer One foundation for cash flow analysis because:

It provides useful detail that is helpful when analysing the cash flow of large companies.

It begins with sales, which helps the lender to focus on the impact of change in sales.

It provides a hierarchy for thinking about cash flow sources and uses.

When analysis of Type A cash flows is important, supplement the direct cash flow statement with a review of the income statement.


PPrraaccttiissee EExxeerrcciissee Directions: Use the background information and financial statements in Karr Photo, Part I in the Cases section of this module to answer the following questions.

1. Calculate direct cash flow for Karr Photo for 20Y3. Write your answers on the Cash Flow Summary worksheet that follows. We have calculated the 20Y2 direct cash flow for you.


Cash Flow Summary (in £s) Company Name: Karr Photo Equipment & Supplies Ltd

+ –

A (U) S

L/E S (U)


Sales revenue (net) (1) 36,786,130

Debtors (2) (857,770) Cash collected from sales (3) 35,928,360

Cash cost of goods sold (4) (29,412,810) Stock (5) (3,445,000) Creditors (6) 2,856,010

Cash paid for production (7) (30,001,800) Cash from trading activities (3) + (7) = (8) 5,926,560

Cash SG&A expense (9) (6,824,130) repaid expenses, advances, other current

operating assets (10)

(59,770) Accrued expenses (11) 241,390

Cash paid for operating costs (12) (6,642,510) Cash after operations (8) + (12) = (13) (715,950)

Other income (expense) (14) 0 Other current and non-current accounts (15) (78,940) Income tax expense (16) (162,230) Deferred income taxes (17) 0 Income taxes payable (18) 54,030

Taxes paid and other income (expense) (19) (18 ,140) Net cash after operations (13) + (19) = (20) (903,090)

Interest expense (21) (83,210) Interest payable (22) 0 Dividends declared or owners’ withdrawals (23) 0 Dividends payable (24) 0

Cash pa d for dividends and interest (25) (83,210) Cash after financing costs (20) + (25) = (26) (986,300)

Current portion long-term debt (prior year) (27) (300,000) Cash after debt amortisation (26) + (27) = (28) (1,286,300)

Property, plant and equipment (29) (568,100) Investments (30) 0 Intangibles (31) 0

Cash paid for non-current assets (32) (568,100) Financing surplus (requirement) (28) + (32) = (33) (1,854,400)

Short term debt and overdrafts (34) 1,397,020 Long-term debt (35) 361,730 Preference shares (36) 0 Ordinary shares (37) 0 Total external financing (38) 1,758,750

Financing surplus (requirement) + Total exte nal financing (33) + (38) = (39) (95,650) PROOF: Cash and marketable securities (40) (95,650)


When you have completed your direct cash flow, you may compare it to the correct one which appears in the Answers for this exercise. Then base your answers to the following questions on the correct direct cash flow.

2. In 20Y3, was Karr able to fund its increases in debtors and stock from internally generated funds? What was the largest source of those internally generated funds?

3. What was Karr’s capacity to repay long-term debt with internally generated cash flow during 20Y2? During 20Y3?

4. Based on your judgement of whether the increases in debtors and stock are permanent or temporary, how appropriate is the debt financing Karr Photo obtained in 20Y3?

5. If Karr’s cash after financing costs is the same next year as it was in 20Y3, how do you evaluate the company’s ability to repay long-term debt?

6. What areas of cash flow seem most important to subject to a thorough Layer Two and Layer Three analysis before drawing conclusions about the sufficiency of cash flow?


AAnnsswweerrss 1.

Cash Flow Summary (in £s) Company Name: Karr Photo Equipment & Supplies LTD

+ – A (U) S

L/E S (U)


Sales revenue (net) (1) 36,786,130 47,374,050

Debtors (2) (857,770) (978,420) Cash collected from sales (3) 35,928,360 46,395,630

Cash cost of goods sold (4) (29,412,810) (36,951,760) Stock (5) (3,445,000) (2,286,210) Creditors (6) 2 856,010 3,052,220

Cash paid for production (7) (30,001,800) (36,185,750) Cash from trading activities (3) + (7) = (8) 5,926,560 10,209,880

Cash SG&A expense (9) (6,824,130) (9,764,310) Prepaid expenses, advances, othe

current operating assets (10)

(59,770) 13,110 Accrued expenses (11) 241,390 (234,520)

Cash paid for operating costs (12) (6,642,510) (9,985,720) Cash after operations (8) + (12) = (13) (715,950) 224,160

Other income (expense) (14) 0 0 Other current and non-current accounts (15) (78,940) (46,820) Income tax expense (16) (162,230) (65,000) Deferred income taxes (17) 0 0 Income taxes payable (18) 54,030 61,950

Taxes paid and other i come (expense) (19)

(187,140) (49,870)

Net cash after operations (13) + (19) = (20) (903,090) 174,290 Interest expense (21) (83,210) (199,150) Interest payable (22) 0 0 Dividends declared or owners’ withdrawals (23) 0 0 Dividends payable (24) 0 0

Cash paid for dividends and interest (25) (83,210) (199,150) Cash after financing costs (20) + (25) = (26) (986,300) (24,860)

Current portion long-term debt (prior year) (27) (300,000) 300,000) Cash after debt amortisation (26) + (27) = (28) (1,286,300) (324,860)

Property, plant and equipment (29) (568,100) (750,750) Investments (30) 0 (45,840) Intangibles (31) 0 0

Cash paid for non-current assets (32) (568,100) (796,590) Financing surplus (requirement) (28) + (32) = (33) (1,854,400) (1,121,450)

Short-term debt and overdrafts (34) 1,397,020 602,980 Long-term debt (35) 361,730 526,040 Preference shares (36) 0 0 Ordinary shares (37) 0 0 Total external financing (38) 1,758,750 1,129,020

Financing surplus (requirement) + Total external financing (33) + (38) = (39) (95,650) 7,570 PROOF: Cash and marketable ecurities (40)

(95,650) 7,570


2. Yes. Cash from trading activities (Target 2, line 8 of the cash flow summary) is positive £10,209,880. The largest source of funds to support Karr’s 20Y3 increases in debtors and stock is the increase in creditors, which was £3,052,220. (The top line sales revenue is also a source for funding the asset increases. However, it must also fund the increases in both cash cost of goods sold (accounted for on line 4) and the cash SG&A expense (to be accounted for on line 9). When evaluating the cash flow impact of the sales revenue on line 1, subtract lines 4 and 9 from line 1. For Karr in 20Y3, this is £657,980, so the increased revenue did help to fund the increase in assets, but less so than the increase in creditors.)

3. Karr had no capacity to pay long-term debt with internally generated funds in either year. Cash after financing costs, Target 5, line 26 was already negative £986,300 in 20Y2 and negative £24,860 in 20Y3. Karr had to borrow money from lenders to make its payments on long-term debt in both years.

4. Based only on the expected duration of the increase in Karr’s debtors and stock, the split between short-term and long-term financing seems reasonable, with perhaps a little bit too much short-term and not quite enough long-term. This judgement assumes that sales increases are permanent but that the lengthening of the holding period and the collection period are temporary. If those assumptions are proven wrong, a different blend of short- and long-term financing would be best.

Don’t worry if this relationship of asset growth and debt maturity is not yet clear. You will have more chance to work with it in Unit 3 of this module.

Because Karr Photo’s sales were up 28.78% in 20Y3 over 20Y2, similar percentage increases in debtors and stock are likely. However, Karr’s debtors increased about £275,000 more and its stock increased about £250,000 more than would be expected by the sales increase alone. So some of the increases are due to an increase in the collection period and an increase in the holding period, which might be permanent or temporary.

If increases in assets are permanent, it is best to finance them with long-term debt (or equity) or with revolving short-term debt that does not require a seasonal payout. When increases in assets are temporary, it is most reasonable to finance them with short-term debt that is scheduled to be repaid when the assets shrink to their earlier levels.


5. If Karr’s cash after financing costs is negative again in 20Y4, it will not have the cash flow from internally generated funds to repay long-term debt. Lenders would need to be willing to lend Karr the cash, perhaps short-term secured by current assets, to make long-term debt payments. Or, Karr would need to do a better job of managing the turnover of debtors and stock, so that the operating cycle would not absorb so much cash. As a lender, if you can see now in 20Y3 that you would not be likely to make such loans or do not think Karr could shorten its operating cycle, you would be concerned about the repayment of any long-term debt to Karr.

6. Based on Karr’s direct cash flow summary, two of the four financial drivers show up as very significant: change in sales and change in turnovers. The most obvious from the cash flow summary is the change in turnovers, which shows up as large cash uses on lines 2 and 5. The cash flow summary does not neatly compute for you the impact of change in sales, but you can quickly see on line 1 that sales have increased substantially.

You can also see from lines 29 to 32 in Target 7 that expenditures for long-term assets are significant, but not as large as the increases in trading assets.

It is much harder to tell from a direct cash flow summary whether a change in margins is having a substantial impact on cash flow. Most lenders would return to a common-size income statement or to a worksheet for examining the financial drivers (which is introduced in Unit 3 of this module) to assess the cash impact of changes in profitability.

206 Cash Flow Analysis CFA.JA.000.0113.CSD.IFRS.UK.doc © Omega Performance Corporation. All rights reserved.

The Decision Strategy

Opportunity assessment

Prospecting Does the prospect match the lending institution’s profiles?

If the prospect is a current customer, can the relationship be expanded?

Identify opportunities Review the prospect’s strategic objectives and financial structure.

What immediate and long-term needs exist for credit or non-credit services?

Preliminary analysis

Preliminary assessment What is the specific opportunity? Is the request legal and within your institution’s policy?

Are the terms logically related? Do the risks appear to be acceptable?

Identify borrowing cause What caused the need to borrow? How long will the borrowed funds be needed?

Repayment source analysis

Industry and business risk analysis What trends and risks affect all companies in the borrower’s industry?

What risks must the borrower manage successfully in order to repay the loan?

Financial statement analysis

What do the financial statement trends show about the borrower’s management of the business? What trends will influence the ability to repay?

Loan packaging

Summary and recommendation What are the major strengths and weaknesses of the loan situation? Should a loan be granted?

Loan structuring and negotiation What are the appropriate facility, security, pricing, disbursement method, documentation, and covenants?

Loan management

Loan monitoring Is the borrower performing as expected? What caused variations?

What are the risks to repayment? How can you protect the institution’s position?

Cash flow analysis and projections Will the business have sufficient cash to repay the loan in the proposed manner?

Which risks will have the greatest impact on its ability to repay?


Job Aid: IFRS Statement of Cash Flows Page 1

Features

Categorises activities as operating, investing, or financing



Direct: Begins with cash received from customers, subtracts noncash revenue items, subtracts cash expenses, and adjusts for other cash received

Indirect: Begins with net income, adds noncash expenses, adjusts for changes in certain accounts on the statement of financial position, especially current assets and current liabilities

Both methods will provide the same information either in the statement of cash flows itself or in the notes to the accounts – the method chosen by the company affects the presentation of information rather than its content






Layers Two and Three analyses OPERATING ACTIVITIES Critical management areas: Sales, operating cycle, expenses

Is net cash provided by operating activities positive and greater than the current portion of long-term debt (CPLTD)?

If yes, the company is more likely to pay CPLTD without additional borrowing, unless fixed-asset expenditures exceed depreciation expense or dividends are significant.

If no, the company cannot pay CPLTD without additional borrowing, new equity, or sale of assets. Which components had a material effect on cash flow?

If net profit: Can management maintain or improve the trend? How has management controlled expenses and profit margins? Was other income (expense) material, and is it repeatable?

If change in debtors or stock: Was change due to change in average daily sales or cash COGS? Was change due to change in DDOH or SDOH?

If change in creditors: Was change due to change in average daily cash COGS, driven by sales? Was change due to change in CDOH?

What industry conditions, business strategies, or management decisions influenced the changes in sales, turnover, or profitability?

Are significant changes repeatable? What are the implications for future cash flow from operating activities?


Job Aid: IFRS Statement of Cash Flows Page 2

Layers Two and Three analyses

INVESTING ACTIVITIES Critical management areas: Capital investment cycle

How does net cash provided by (used in) investing activities compare to net profit plus depreciation?

• If net cash used in investing activities is less than net profit plus depreciation, the company has less need to borrow·

• If net cash used in investing activities is more than net profit plus depreciation, the company has more need to borrow.

If net cash from investing activities is positive, are sales declining, or is the company deferring important expenditures?

FINANCING ACTIVITIES Critical management areas: Cumulative effects of all

• How did the company apply cash provided by operating and investing activities?·

• How did the company raise cash externally to supply cash used in operating and investing activities?

• Is the long- or short-term structure of liabilities appropriate to the borrowing causes?

• What are the implications for future cash flow, including interest expense, required principal payments, and dividends?


Job Aid: Financial Drivers of Cash Flow Page 1

Change in sales STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure sales and cash COGS growth (or decline) 1. Calculate the %

increase or decrease in sales from one period to the next

Current period’s sales Less: Prior period’s sales Divided by: Prior period’s sales Equals: % change (up or down) in sales

• The total cash impact of sales and cash COGS growth (or decline) is cash flow absorbed (used) in or released (provided) from the operating cycle as a result of the change in sales and cash cost of goods sold.

• It includes the amounts by which debtors and stock would have increased (a cash use) or decreased (a cash source), and the amount by which creditors would have increased (a cash source) or decreased (a cash use) due only to the change in sales and cash COGS.

• If debtors, stock, or creditors changed by more or less than this amount, the remainder of the change (and the cash flow) can be due only to a change in days on hand.

2. Calculate the % increase or decrease in cash COGS from one period to the next

Current period’s cash COGS Less: Prior period’s cash COGS Divided by: Prior period’s cash COGS Equals: % change (up or down) in cash COGS

B. Measure the impact on: 1. Debtors

Opening debtors Times: % change in sales Equals: Change in debtors due to change in sales

2. Stock Beginning stock Times: % change in cash COGS Equals: Change in stock due to change in cash COGS

3. Creditors Opening creditors Times: % change in cash COGS Equals: Change in creditors due to change in cash COGS

C. Measure the combined impact of sales and cash COGS growth (or decline) on trading asset financing need

Change in debtors due to change in sales Plus: Change in stock due to change in cash COGS Plus: Change in creditors due to change in cash COGS Equals: Total impact of sales and cash COGS growth (or decline)

Increases in debtors or stock are uses of cash. An increase in creditors is a source of cash.



Changes in days on hand STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure days on hand and change in days

1. Change in DDOH Opening debtors Divided by: Sales first (prior) year Times: 365 Equals: Opening DDOH

Closing debtors Divided by: Sales second year Times: 365 Equals: Closing DDOH Closing DDOH Less: Opening DDOH Equals: Change in DDOH

2. Change in SDOH Opening stock Divided by: Cash COGS (prior) year Times: 365 Equals: Opening SDOH

Closing stock Divided by: Cash COGS (second) year Times: 365 Equals: Closing SDOH Closing SDOH Less: Opening SDOH Equals: Change in SDOH

3. Change in CDOH Opening creditors Divided by: Cash COGS (prior) year Times: 365 Equals: Opening CDOH

Closing creditors Divided by: Cash COGS (second) year Times: 365 Equals: Closing CDOH Closing CDOH Less: Opening CDOH Equals: Change in CDOH

B. Measure the cash impact of one day

• One day of sales is the amount of cash required for each day in the collection period.

• One day of cash COGS is the amount of cash required for each day in the holding period.

• One day of cash COGS is the amount of cash provided by each day in the payment period.

1. Calculate the amount of one day of sales

Annual sales Divided by: 365 Equals: Average daily sales

2. Calculate the amount of one day of cash COGS

Annual cash COGS Divided by: 365 Equals: Average daily cash COGS

C. Measure the cash impact of the changes in asset days on hand

1. DDOH Change in DDOH Times: Average daily sales Equals: Cash impact of change in DDOH

• Cash flow impact of borrower’s management of days on hand is independent of the cash flow impact a change in sales has on the same accounts: debtors, stock, and creditors.

2. SDOH Change in SDOH Times: Average daily cash COGS Equals: Cash impact of change in SDOH

3. CDOH Change in CDOH Times: Average daily cash COGS Equals: Cash impact of change in CDOH

Measure total cash impact of changes in days on hand

Cash impact of change in DDOH Plus: Cash impact of change in SDOH Plus: Cash impact of change in CDOH Equals: Total cash impact of changes in days on hand



Change in margins STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure the change in margins

1. Calculate the cash COGS as a % of sales

Cash COGS for first (prior) period Divided by: Sales for the same (first) period Equals: Cash COGS as % of sales, first period Cash COGS for second period Divided by: Sales for the same (second) period Equals: Cash COGS as % of sales, second period Cash COGS as % of sales, second period Less: Cash COGS as % of sales, first period Equals: cash COGS as % of sales

Reduce cash COGS as % of sales Improve gross profit margin Increase cash flow Reduce cash SG&A as % of sales Improve operating profit margin Increase cash flow

2. Calculate the cash SG&A as a % of sales

Cash SG&A for first (prior) period Divided by: Sales for the same (first) period Equals: Cash SG&A as % of sales, first period Cash SG&A for second period Divided by: Sales for the same (second) period Equals: Cash SG&A as % of sales, second period Cash SG&A as % of sales, second period Less: Cash SG&A as % of sales, first period Equals: cash SG&A as % of sales

B. Measure the £ cash impacts

1. Calculate £ cash impact of cash COGS as % of sales

cash COGS as a % of sales Times: Sales for the second period Equals: £ impact of cash COGS as a % of sales

• This cash flow is independent of any changes in the amount of expense that are the result of a change in the amount of sales.

• This isolation of the cash impact of the change in margins allows the lender to focus on the importance of expense management to the borrower’s cash flow.

2. Calculate £ cash impact of cash SG&A as % of sales

cash SG&A as a % of sales Times: Sales for the second period Equals: £ impact of cash SG&A as a % of sales

3. Calculate combined impact of cash COGS as a % of sales and changes in cash SG&A as a % of sales

£ impact of cash COGS as a % of sales Plus: £ impact of cash SG&A as a % of sales Equals: Combined impact of cash COGS as % of sales and cash SG&A as a % of sales



Investment in fixed assets STEP CALCULATION ANALYTICAL INSIGHTS

A. Measure the amount spent to acquire fixed assets

Opening net fixed assets Less: Depreciation expense for the period Equals: Expected closing net fixed assets

Actual closing net fixed assets Less: Expected closing net fixed assets Equals: Amount spent to acquire fixed assets

B. Calculate indicators of the reason for spending

When the amount spent is greater than the depreciation expense: • Internally generated cash

flow is less likely to be sufficient to meet other cash needs

• Company is more likely to need to borrow

When the ratio is increasing, the company may: • Be using its fixed assets

more efficiently, or • Soon need to use cash

flow to expand productive capacity, or

• Both The greater the accumulated depreciation as % of gross book value of fixed assets, the more likely: • Assets may show signs of

ageing • Expenses for maintenance

and repair may increase • Borrower may suffer from

obsolescence and other inefficiencies

• Cash flow may be required to replace existing productive capacity

1. Compare the amount spent to the annual depreciation expense

Amount spent to acquire fixed assets Less: Depreciation expense for the same period Equals: Difference between amount spent and depreciation expense

2. Calculate the ratio of sales to net fixed assets

Sales Divided by: Closing net fixed assets Equals: Ratio of sales to net fixed assets

3. Calculate the % of original costs that have been expensed

Accumulated depreciation Divided by: Gross fixed assets Equals: % of original costs that have been expensed


Job Aid: Four Critical Management Areas

Sales

How have economic and industry conditions, trends, or events influenced the level of or change in sales?

What has the company’s management done or not done to influence sales, and how effective has that action been?

How has a change in sales affected profitability, asset structure, and gearing?


Operating cycle

How have economic and industry conditions or events influenced the level of debtors and stock?

How have economic and industry conditions influenced the level of spontaneous financing from creditors?

What has the company’s management done or not done to influence the level of needed trading asset financing need, and how effective has that action been?

How has management financed trading asset financing need, and does the financing seem appropriate?

How has a change in needed trading asset financing affected the company’s profitability and gearing?


Expenses

How have economic and industry conditions and events influenced production, SG&A, interest, and Corporation Tax?

What has the company’s management done or not done to influence and control expenses, and how successful have those actions been?

How has a change in expenses affected the company’s days on hand and gearing?



How have economic and industry conditions affected the need for plant, equipment, and other non-current assets?

How well has the company’s management planned and directed investments for adequate capacity and capability?

How has management financed the capital investments, and does the financing seem appropriate?

How have capital investments affected profitability and gearing?




Target 1: Cash collected from sales Line : 1 Record net sales (total revenues less returns and allowances). 2 Record the change in debtors. 3 Combine lines 1 and 2. This is cash collected from sales.

Target 2: Cash from trading activities Line: 4 Record cash cost of goods sold (cash COGS), calculated as follows: COGS from accrual income statement Less: Noncash expenses in COGS, such as depreciation Equals: Cash COGS 5 Record the change in stock. 6 Record the change in creditors. 7 Combine lines 4, 5, and 6. This is cash paid for production. 8 Combine lines 3 and 7. This is cash from trading activities.

Target 3: Cash after operations Line: 9 Record cash SG&A expense, calculated as follows: SG&A from accrual income statement Less: Interest expense, if reported in SG&A Less: Depreciation and amortisation Equals: Cash SG&A expense Do not subtract from SG&A the provision for losses on receivables, if any, because net debtors is used to calculate line 2, Debtors. 10 Record the change in current prepaid expenses. 11 Record the change in accrued expenses. 12 Combine lines 9, 10, and 11. The result is cash paid for operating costs. 13 Combine lines 8 and 12. The result is cash after operations.

Target 4: Net cash after operations Line: 14 Record the sum of other income and expense from the accrual income statement. Do not include interest expense. 15 Record the change in other current and non-current assets and liabilities. ‘Other’ means all miscellaneous accounts on the statement of financial position not accounted for elsewhere in the cash flow summary. Do not include the following accounts: interest, dividends, or Corporation Taxes payable; interest-bearing debts; property, plant and equipment, investments, or intangibles; or any equity accounts. Calculate the change in current and non-current accounts as follows: Opening other current assets Less: Closing other current assets Plus: Opening other non-current assets Less: Closing other non-current assets Less: Opening other current liabilities Plus: Closing other current liabilities Less: Opening other long-term liabilities Plus: Closing other long-term liabilities Equals: Change in other current and non-current accounts A positive result is a source of cash. A negative result is a use of cash. Record in ( ). 16 Record total Corporation Tax from accrual income statement. 17 Record the change in deferred Corporation Taxes, including current portions, if any. 18 Record the change in Corporation Taxes payable. 19 Combine lines 14, 15, 16, 17, and 18. The result is taxes paid and other income (expense). 20 Combine lines 13 and 19. The result is net cash after operations.



Target 5: Cash after financing costs

Line: 21 Record interest expense from accrual income statement. Do not net interest income. 22 Record the change in interest payable. 23 Record, in ( ), dividends declared, shares repurchased, or other equity distributions from the statement reconciling changes in shareholders’ funds. Opening retained earnings Plus: Net profit after taxes Less: Closing retained earnings Equals: Dividends declared or other distributions of capital 24 Record the change in dividends payable. 25 Combine lines 21, 22, 23, and 24. The result is cash paid for dividends and interest (financing costs). 26 Combine lines 20 and 25. The result is cash after financing costs, also called net cash income.

Target 6: Cash after debt amortisation Line: 27 Record, in ( ), the current portion of long-term debt from the prior year (the statement of financial position for the beginning of the period). Assume the amount that was due to be paid during the period of the cash flow summary was, in fact, paid. Prepayments or payments not made will be accounted for on line 35. If the cash flow summary is for a period of less than 12 months, record on line 27 the portion of opening current maturities of long-term debt that were scheduled to be paid during the period. If unknown, prorate and be aware that you might overstate or understate the financing surplus (requirement) on line 33 and the change in long-term debt on line 35. 28 Combine lines 26 and 27. The result is cash after debt amortisation, often called CADA.

Target 7: Financing surplus (requirement) Line: 29 Record the change in property, plant and equipment after adjusting for depreciation, as follows: Opening net property, plant and equipment Less: Depreciation expense (from COGS, SG&A, or both) Equals: Expected closing net property, plant and equipment Closing net property, plant and equipment Less: Expected closing net property, plant and equipment Equals: Change in net property, plant and equipment Do not adjust for disposals of property, plant and equipment if you included the gain or loss on sale of these assets when calculating line 14, other income and expense. If you did not include the gain or loss on sale of property, plant and equipment when calculating line 14, adjust opening property, plant and equipment by adding the gain or subtracting the loss before performing the calculation shown above. 30 Record the change in investments after adjusting for amortisation, as follows: Opening investments Less: Amortisation expense (if any) Equals: Expected closing investments Closing investments Less: Expected closing investments Equals: Change in investments 31 Record the change in intangibles after adjusting for amortisation, as follows: Opening intangibles Less: Amortisation expense (if any) Equals: Expected closing intangibles Closing intangibles Less: Expected closing intangibles Equals: Change in intangibles 32 Combine lines 29, 30, and 31. 33 Combine lines 28 and 32. The result is financing surplus (requirement).



Target 8: Financing surplus (requirement) + Total external financing Line: 34 Record the change in short-term debt and overdrafts. 35 Record the change in long-term debt, calculated as follows: Closing long-term debt Plus: Closing current portion of long-term debt (CPLTD) Less: Opening long-term debt (long-term portion only) Equals: Change in long-term debt Note: The CPLTD for the opening period was already accounted for on line 27. 36 Record the change in preference shares. 37 Record the change in ordinary shares. Note: Calculate only changes to equity accounts other than retained earnings. The change in retained earnings figure is automatically accounted for in the cash flow construction. 38 Combine lines 34, 35, 36, and 37. The result is total external financing. 39 Combine lines 33 and 38. The result is the calculated change in cash.

Proof: To prove the accuracy of your calculations Line: 40 Record the actual change in cash between the beginning and ending statements of financial position. Your calculations are accurate if the amounts on lines 39 and 40 are the same. Note: Accuracy in a manual cash flow is secondary to identification of key variables influencing cash flow and analysis of the ‘Why?’ behind the numbers.


Job Aid: Cash Flow Summary Tips

Getting started Be sure to use the income statement and statement of financial position (opening and closing) for the same period of time. • If statements are company-prepared, be sure the statement of financial position balances

and the income statement has been totalled properly. • Begin with line 1 of the cash flow summary and work down to line 2, then line 3, and so on,

analysing as you go. • Place a mark () on the statement of financial position and income statement next to each

account as you use it on the cash flow summary. Circle any noncash items that you have deducted from COGS or SG&A.

Recording income statement information Lines of the cash flow summary in boldface type call for information from the income statement. • Record revenues, sources of cash flow, as positive numbers. • Record expenses, uses of cash flow, as negative numbers, in brackets ( ).

Recording information from the statement of financial position • Lines of the cash flow summary that include the symbol (change in) call for information

calculated from the statements of financial position for the beginning and end of the period of the cash flow.

• Calculate changes in accounts using the following formula: Closing balance Less: Opening balance Equals: Change in () the account • Classify changes as sources or uses of cash according to the following rules and table: - Record an increase in an asset or a decrease in a liability in ( ) as a use of cash. - Record a decrease in an asset or an increase in a liability as a source of cash.

A+ –

S

(U)

(U)

S

L/E

• Line 27 calls for the CPLTD from the opening statement of financial position (or a prorated amount if the cash flow is for an interim period).

Troubleshooting If lines 39 and 40 are unequal, be sure you have: • Accounted for (placed a mark [] beside) all accounts on the income statement and

statement of financial position. • Transferred figures properly from the income statement to the cash flow summary, and

enclosed all expense items in ( ). • Calculated the amount of each source or use correctly, and enclosed each use in ( ). • Used the net, not gross, amounts to calculate the change in such accounts as debtors and

non-current assets. • Checked your addition and subtraction for each target. • Checked your calculation of the change in other accounts (line 15) by following these steps: - For each category of other accounts (current and non-current assets and liabilities),

calculate the change and classify each result as a source or a use of cash. - Combine the sources and uses. For example, an increase in other current assets is a

use of cash; a decrease in other non-current liabilities is also a use of cash.


Job Aid: Targeted Cash Flow Analysis

Cash Collected from Sales (line 3)

How has cash collected from sales been affected by:

Change in average daily sales?

Change in debtors DOH?




Cash from Trading Activities (line 8)

How has cash from trading activities been affected by:

Change in average daily cash COGS?

Change in stock DOH?

Change in creditors DOH?




Cash after Operations (line 13)

How has cash after operations been affected by:

Change in trading asset financing need?

Change in cash expenses for SG&A?


inaction influenced the change in cash SG&A expenses?


Net Cash after Operations (line 20)

Has the company been able to meet all the cash requirements of its

operating cycle and pay Corporation Taxes with internally generated

cash?

If so (line 20 positive), how?

If not (line 20 negative), why not?

Cash after Financing Costs

(line 26)

Has the company been able to pay interest expense with internally

generated cash?

If yes (line 26 positive), is the cash after financing costs sufficient to pay

existing and proposed principal debt service?

If no (line 26 negative), will loan proceeds be used to pay interest?

Cash after Debt Amortisation (line 28)

Has the company been able to meet both interest and principal debt

service with internally generated cash?

If yes (line 28 positive), is all debt fully amortised, and is CADA sufficient

to make needed capital investments?

If no (line 28 negative), how can debts be restructured or reduced?

Financing Surplus (Requirement) (line 33)

If negative, what is the company’s total need for external cash?

If positive, were long-term investments sufficient to maintain capacity and capability, and what cash flow is available to make further reductions in short- or long-term debt or to reduce equity?

Financing Surplus (Requirement) + Total External Financing (line 39)

How has the company financed its need for external cash?

Is the structure of new financing appropriate?


Quick Cash Flow (in £s) Company Name:

+ -

TAFN (U) S

GFA (U) S

Year 1 Year 2 Year 3

Net profit

Plus: Depreciation, amortisation expense

Plus: Interest expense Plus decrease (or less increase): Trading asset financing need

Equals: Cash after operating cycle

Plus (or less): Gross non-current assets

Equals: Cash after capital investment cycle

Less: Dividends declared

Equals: Cash available or all debt repayment

Less: Current portion long-term debt (prior year) Less: Interest expense

Equals: Cash available for other debt repayment


Debtors Plus: Stock Less: Creditors Less: Accrued expenses


Closing trading asset financing need Less: Opening trading asset financing need















Financial Drivers Worksheet Borrower: ( ) = use of cash

Cash Impact of Change in Sales (£000s) Year 1 Year 2 Year 3 Sales Sales change % Times: Opening debtors Equals: Impact on debtors

Cash COGS Cash COGS change % Times: Opening stock Equals: Impact on stock

Cash COGS change % Times: Opening creditors Equals: Impact on creditors

TOTAL OPERATING CYCLE IMPACT OF CHANGE IN SALES

Cash Impact of Change in Days on Hand Year 1 Year 2 Year 3 Average daily sales Times: Change in DDOH Equals: Cash impact of change in DDOH

Average daily cash COGS Times: Change in SDOH Equals: Cash impact of change in SDOH

Average daily cash COGS Times: Change in CDOH Equals: Cash impact of change in CDOH

TOTAL IMPACT OF CHANGE IN DAYS ON HAND

Cash Impact of Change in Margins Year 1 Year 2 Year 3 Cash COGS as % sales in prior year Cash COGS as % sales in this year Change in cash COGS as % sales Times: Sales this year Equals: Cash impact of change in cash COGS as % sales

Cash SG&A Cash SG&A as % sales in prior year Cash SG&A as % sales in this year Change in cash SG&A as % sales Times: Sales this year Equals: Cash impact of change in cash SG&A as % sales

TOTAL IMPACT OF CHANGE IN MARGINS

Cash Impact of Change in Fixed Assets Year 1 Year 2 Year 3 Opening net fixed assets Less: Depreciation expense for this year Equals: Expected closing net fixed assets

Actual closing net fixed assets Less: Expected closing net fixed assets Equals: Cash impact of change in fixed assets

TOTAL IMPACT OF CHANGE IN FIXED ASSETS


Cash Flow Summary (in £000s) Company Name:

+ –

A (U) S

L/E S (U)

Target Line Number Year 1 Year 2 Year 3

Sales revenue (net) (1)

Debtors (2) Cash collected from sales (3)

Cash cost of goods sold (4)

Stock (5)

Creditors (6)

Cash paid for production (7) Cash from trading activities (3) + (7) = (8)

Cash SG&A expense (9)

Prepaid expenses (10)

Accrued expenses (11)

Cash paid for operating cost (12) Cash after operations (8) + (12) = (13)

Other income (expense) (14)

Other current and non-current accounts (15)

Income tax expense (16)

Deferred income taxes (17)

Income taxes payable (18)

Taxes paid and other income (expense) (19) Net cash after operations (13) + (19) = (20)

Interest expense (21)

Interest payable (22)

Dividends declared or other reductions in capital (23)

Dividends payable (24)

Cash paid for dividends and interest (25) Cash after financing costs (20) + (25) = (26)

Current portion long-term debt (prior year) (27) Cash after debt amortisation (26) + (27) = (28)

Property, plant and equipment (29)

Inve tments (30)

Intangibles (31)

Cash paid for non-current assets (32) Financing surplus (requirement) (28) + (32) = (33)

Short-term debt and overdrafts (34)

Long-term debt (35)

Preference s ares (36)

Ordinary shares (37)

Total external financing (38)

Financing surplus (requirement) + Total external financing (33) + (38) = (39)

PROOF: Cash and marketable securities (40)


GGlloossssaarryy

This glossary is an alphabetical cross-reference of the IFRS terminology and other terms used throughout the Credit Skills Development programme to the alternate terminology with which you may be more familiar.

IFRS or standard term

Alternate term(s) Definition or explanation (if required)

Accounts payable Creditors* Amounts owed to suppliers

Accounts receivable Debtors* Amounts due from customers

Aged debtors list Ageing, debtors ageing, accounts receivable ageing

A listing of debtors and invoices outstanding, usually sorted by days from date of invoice

Borrowing request Credit application

Business Firm, Company, etc. In CSD, the term “business” is used generally for all types of business without regard to legal structure.

Cash cost of goods sold (Cash COGS, CCOGS)

Cash cost of sales Cost of goods sold, less any depreciation or amortisation that is included in the account.

Collection period Debtors days on hand The average number of days to collect debtors accounts

Company Corporation, Limited Company, Firm (Partnership)

IFRS often uses “company” as a synonym for “business”, including all legal forms of business.




Core current assets Permanent current assets

Current asset amounts at the low point in the business’s operating cycle

Core trading assets Permanent trading assets

Trading asset amounts at the low point in the business’s operating cycle

Cost of goods sold (COGS)

Cost of sales Total cost of all stock sold during the period

Creditors days on hand (CDOH)

Payment period The average number of days between the purchase of stock and the sale of that stock. Calculated as follows using annual financial statments: creditors divided by cost of goods sold, times 365 days.

Current portion of long-term debt (CPLTD)

Current maturities of long-term debt

The amount of long-term debt that is due within the 12 months following the statement date

Debtors days on hand (DDOH)

Collection period The average number of days between a sale on credit and collection of cash from that sale. Calculated as follows using annual financial statements: debtors divided by net sales, times 365 days

Facility, lending Credit facility, offering, loan type

Encompasses all types of lending: loan, overdraft, revolver, etc.




Financial statement Statement of accounts Group of statements designed for the use of interested parties outside the business, such as lenders and investors. In IFRS, a complete set of financial statements includes:

Statement of financial position

Statement of comprehensive income

Statement of cash flows

Statement of changes in equity

Notes

Financing need A requirement for financing over and above what is provided by the spontaneous financing sources, creditors and accrued expenses.

Fixed assets Non-current assets Assets with an expected useful life or term of more than one year. In UK, synonymous with non-current assets; in other countries, the term fixed assets may apply only to tangible non-current assets used in operation of the business.

Holding period Stock days on hand, inventory days on hand

The average number of days between the purchase of stock and its sale to customers




Income statement Profit and loss accounts, P&L

See also: Statement of comprehensive income

Inventory See: Stock*

Lending Credit

Lending facility See: Facility

Loan term The length of time between the provision of financing and the date on which the financing must be repaid.

Non-current assets Fixed assets, long-term assets

Assets that have a useful life of more than one year. Includes land, buildings, equipment, machinery, vehicles, intangible assets, and financial assets. Also the name of the category in the balance sheet or statement of financial position in which are lists assets that do not qualify as current assets.

See Fixed assets for additional information

Non-current liabilities

Long-term liabilities

Payment period Creditors days on hand, accounts payable days on hand

The average number of days taken to pay creditors

Profits Income, net income

Relationship manager

Credit officer, loan officer, lender

Sales Turnover, revenue, sales revenue




Sole trader Sole proprietor A business with one owner who is legally indistinguishable from the business

Spontaneous financing

Creditors and accrued expenses

Forms of financing that occur spontaneously in the course of doing business, as distinguished from more formal debts such as overdrafts or long-term lending

Statement of cash flows

Cash flow statement

Statement of comprehensive income

Income statement, profit and loss accounts, P&L

Income statement plus a statement of comprehensive income other than operating income

Statement of financial position

Balance sheet Statement of the business’s assets, liabilities, and equity at a specific point in time

Stock days on hand (SDOH)

Holding period The average number of days between the purchase of stock and the sale of that stock. Calculated as follows using annual financial statements: Stock divided by cost of goods sold, times 365 days.

Stock slowdown Increase in stock days on hand

A lengthening of the time between the purchase of stock and its sale

Trade debtors Debtors

Trade creditors Creditors




Trading asset financing need

Working investment The amount of trading assets (debtors and stock) that is in excess of the amount of spontaneous financing provided by creditors and accrued expenses; a need for financing of trading assets

Trading assets Debtors and stock Debtors and stock are considered to be trading assets because they are an integral part of a business’s trading (sales) activities

* This term is used throughout the programme instead of the preferred

IFRS terminology.

Cash Flow Analysis.pdf

Documents

Transcript of Cash Flow Analysis.pdf