Statement of Cash Flows

Statement of Cash FlowsStatement of Cash Flows

FIN 591: Financial Fundamentals/Valuation 2

EBITDAEBITDA

Many people define cash flow as EBITDAMany people define cash flow as EBITDA– What is its relevance?What is its relevance?– What is it missing?What is it missing?– Do it do a reasonably good job?Do it do a reasonably good job?

Why not use the statement of cash flows?Why not use the statement of cash flows?


Importance of Importance of the Statement of Cash Flowsthe Statement of Cash Flows

Combines balance sheet & income statement Combines balance sheet & income statement analysisanalysis

Eliminates differences in accountingEliminates differences in accounting Directly assesses Directly assesses “quality of earnings” “quality of earnings” — or — or

“How to go broke while making a profit...”“How to go broke while making a profit...” Components:Components:

– Operating activities (cash profits)Operating activities (cash profits)– Investing activitiesInvesting activities– Financing activities.Financing activities.


Articulation of Financial StatementsArticulation of Financial Statements

Revenues

Expenses

Net income

Income StatementIncome Statement

Investment and disinvestment

by owners

Net income and other earnings

Net change in owners’ equity

Statement of Shareholders’ EquityStatement of Shareholders’ Equity

Cash from operations

Cash from investing

Cash from financing

Net change in cash

Cash Flow StatementCash Flow Statement

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Beginning Balance SheetBeginning Balance Sheet

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Ending Balance SheetEnding Balance Sheet


W. T. GrantW. T. Grant

Accounting profits versus cash operating Accounting profits versus cash operating profitsprofits

Cash flow frequently defined as:Cash flow frequently defined as:Net income + depreciationNet income + depreciation

» Poor definition.Poor definition.

Look at W. T. Grant’s trend...Look at W. T. Grant’s trend... And then at Salton…And then at Salton…


What Happened to W. T. Grant?What Happened to W. T. Grant?

'66 '67 '68 '69 '70 '71 '72 '73 '74 '75-200

-150

-100

-50

0

50

100

'66 '67 '68 '69 '70 '71 '72 '73 '74 '75

NI + depr.

NICFFO


What Happened to Salton?What Happened to Salton?

-60

-40

-20

0

20

40

60

80

'93 '94 '95 '96 '97 '98 '99

EBITDACFFO


Accounting Methods for Measuring Accounting Methods for Measuring PerformancePerformance

Strict cash basis of accounting.Strict cash basis of accounting.– Revenues are recorded when cash is received Revenues are recorded when cash is received

and expenses are recorded when cash is paidand expenses are recorded when cash is paid

Accrual basis of accountingAccrual basis of accounting– Revenues and expenses are recorded on an Revenues and expenses are recorded on an

economic basis independently of the actual economic basis independently of the actual flow of cash.flow of cash.


Cash vs. Accrual AccountingCash vs. Accrual Accounting

Cash BasisCash Basis Accrual BasisAccrual BasisEasy to understand.Easy to understand. Theoretically difficult.Theoretically difficult.

Provides a reliable picture of the the Provides a reliable picture of the the change in cash and the firm’s change in cash and the firm’s liquidity.liquidity.

Provides a more reliable picture of Provides a more reliable picture of the economic changes in wealth.the economic changes in wealth.

Revenues and expenses are Revenues and expenses are recorded according to cash inflows recorded according to cash inflows and outflows.and outflows.

Revenues and expenses are Revenues and expenses are recorded according to economic recorded according to economic change in wealth (the rules are change in wealth (the rules are discussed later on in this clinic).discussed later on in this clinic).

Can be manipulated by changing Can be manipulated by changing the cash flows timing.the cash flows timing.

Can be manipulated by the Can be manipulated by the changing the recognition rules.changing the recognition rules.


Accrual Accounting: The QuestionAccrual Accounting: The Question

At what point of the operating cycle of the At what point of the operating cycle of the firm should revenues and their related firm should revenues and their related expenses be recognized?expenses be recognized?


Accrual Accounting: Basic RulesAccrual Accounting: Basic Rules

Revenue and expense should be Revenue and expense should be recognized at the first point at which both recognized at the first point at which both of the following criteria are met:of the following criteria are met:

1.1. Revenue is Revenue is earnedearned• Revenue-producing activity has been performedRevenue-producing activity has been performed

2.2. Revenue is either Revenue is either realized realized or or realizablerealizable• Amount of cash to be collected can be Amount of cash to be collected can be estimated estimated

with reasonable accuracy.with reasonable accuracy.


Revenue RecognitionRevenue Recognition

For product sale transactions, revenue is typically For product sale transactions, revenue is typically recognized when when title passes to the recognized when when title passes to the customercustomer

For service transactions, revenue is typically For service transactions, revenue is typically recognized when therecognized when the substantial performance substantial performance occurredoccurred– Because of the intangibility of services, it is often Because of the intangibility of services, it is often

difficult to ascertain when a service consisting of more difficult to ascertain when a service consisting of more than a single act has been satisfactorily performed so than a single act has been satisfactorily performed so as to warrant recognition of revenue.as to warrant recognition of revenue.


Expense recognitionExpense recognition

According to the According to the matching matching principle, selecting a principle, selecting a revenue-recognition basis also determines revenue-recognition basis also determines whether related costs are expensed immediately or whether related costs are expensed immediately or capitalized and expensed subsequentlycapitalized and expensed subsequently

Generally, expenses and losses are recognized Generally, expenses and losses are recognized when an entity's economic benefits are used up in when an entity's economic benefits are used up in the process of generating revenues. the process of generating revenues.


Earnings and Cash FlowsEarnings and Cash Flows

Rather than matching cash inflows and Rather than matching cash inflows and outflows, earnings match revenues and outflows, earnings match revenues and expensesexpenses

RevenuesRevenues = cash receipts + revenue accruals = cash receipts + revenue accruals

ExpensesExpenses = cash disbursements – cash investments = cash disbursements – cash investments + expense accruals + expense accruals

EarningsEarnings


Revenue and Expense AccrualsRevenue and Expense Accruals

Revenue AccrualsRevenue Accruals

Value added that is not cash flow

Adjustments to cash inflows that are not value added

Expense AccrualsExpense Accruals

Value decreases that are not cash flow

Adjustments to cash outflows that are not value decreases


The Revenue CalculationThe Revenue Calculation

Revenue = Cash receipts from salesRevenue = Cash receipts from sales

+ New sales on credit+ New sales on credit

Cash received for previous periods' salesCash received for previous periods' sales

Estimates of credit sales not collectibleEstimates of credit sales not collectible

Estimated sales returns and rebatesEstimated sales returns and rebates

Deferred revenue for cash received in advance of saleDeferred revenue for cash received in advance of sale

+ Revenue previously deferred.+ Revenue previously deferred.


The Expense CalculationThe Expense Calculation

Expense = Cash paid for expensesExpense = Cash paid for expenses

+ Amounts incurred in generating revenue but not yet paid+ Amounts incurred in generating revenue but not yet paid

Cash paid for generating revenues in future periodsCash paid for generating revenues in future periods

+ Amounts paid in the past for generating revenues in the current + Amounts paid in the past for generating revenues in the current period.period.


Rules for Identifying Cash FlowsRules for Identifying Cash Flows

Assets increase Use

Assets decrease Source

Financing increases Source

Financing decreases Use

Balance Sheet

Revenues = SourceExpenses = Use


Sources = UsesSources = Uses

Construct two columns for balance sheet Construct two columns for balance sheet changeschanges– Sources = decreases in assets & increases in Sources = decreases in assets & increases in

financingfinancing– Uses = increases in assets & decreases in Uses = increases in assets & decreases in

financing financing

Sources must equal usesSources must equal uses Construct the SCF.Construct the SCF.


Example: Construct a SCFExample: Construct a SCF

Beginning Balance SheetBeginning Balance SheetCash 100 Payables 50Cash 100 Payables 50AR 150 Accruals 75AR 150 Accruals 75Invent 200 Equity Invent 200 Equity 475475Fixed Fixed 150 150 Total 600 600Total 600 600Income StatementIncome StatementSalesSales 500500COSCOS 300300Expenses Expenses (Deprec. = 5)(Deprec. = 5) 170170ProfitProfit 30 30

Ending Balance SheetEnding Balance Sheet

Cash 120 Payables 125Cash 120 Payables 125

AR 100 Accruals 50AR 100 Accruals 50

Invent 250 Equity Invent 250 Equity 495495

Fixed Fixed 200 200

Total 670 670Total 670 670

Statement of Cash FlowsStatement of Cash Flows


WorksheetWorksheet


On to Free Cash FlowOn to Free Cash Flow

Definition of free cash flow:Definition of free cash flow:– After-tax operating earnings + non-cash After-tax operating earnings + non-cash

charges - investments in operating working charges - investments in operating working capital, PP&E and other assets.capital, PP&E and other assets.

» It doesn’t incorporate financing related cash flowsIt doesn’t incorporate financing related cash flows

Operating free cash flow = Cash flow to Operating free cash flow = Cash flow to debt holders + cash flow to equity ownersdebt holders + cash flow to equity owners

» In other words, the sum of operating flows = sum of In other words, the sum of operating flows = sum of financing flows.financing flows.


Free Cash FlowFree Cash Flow

Normal approach is to use the SCFNormal approach is to use the SCF– Operating cash flows less investing activityOperating cash flows less investing activity

Problems:Problems:– Not all investments are necessaryNot all investments are necessary

» Eliminate discretionary investmentsEliminate discretionary investments

– Operating cash flows includes interest expenseOperating cash flows includes interest expense» Eliminate it and put in financing categoryEliminate it and put in financing category

– Operating cash flows exclude all cashOperating cash flows exclude all cash» Add necessary transaction balances.Add necessary transaction balances.


FCF Per the Valuation TextFCF Per the Valuation Text

FCF = NOPLAT - net operating investmentFCF = NOPLAT - net operating investment What is NOPLAT?What is NOPLAT?

– NOPLAT means “net operating profit less adjusted NOPLAT means “net operating profit less adjusted taxes”taxes”

– See Exhibit 7.3 of See Exhibit 7.3 of ValuationValuation text for an example text for an example– Comparable to EBIT * (1 - Comparable to EBIT * (1 - ))

» Tax expense adjustedTax expense adjusted• Change in deferred taxesChange in deferred taxes• Tax shield provided by interest expense & other non-operating Tax shield provided by interest expense & other non-operating

expenses.expenses.


Questions Raised by the SCF...Questions Raised by the SCF...

How strong is internal cash flow How strong is internal cash flow generation?generation?

Is cash flow from operations positive? Is cash flow from operations positive? Why? If negative, why?Why? If negative, why?

Is the company growing? Too quickly?Is the company growing? Too quickly? Are operations profitable?Are operations profitable? Are there problems managing working Are there problems managing working

capital?capital?


Questions...Questions...

Can the company meet short-term Can the company meet short-term obligations from operating cash flows?obligations from operating cash flows?

Can it continue to meet these obligations Can it continue to meet these obligations without reducing operating flexibility?without reducing operating flexibility?

How much is invested in growth?How much is invested in growth? Are these investments consistent with the Are these investments consistent with the

business strategy?business strategy? Was internal cash used to finance growth?Was internal cash used to finance growth?



Does free cash flow exist? Is this a long-Does free cash flow exist? Is this a long-term trend?term trend?

What plan does management have to deploy What plan does management have to deploy free cash flow?free cash flow?

Were dividends paid from free cash flow? Were dividends paid from free cash flow? Or was external financing used?Or was external financing used?

If external financing is used for dividends, If external financing is used for dividends, is the dividend policy sustainable?is the dividend policy sustainable?



What type of external financing does the What type of external financing does the company rely on?company rely on?– EquityEquity– Short-term debtShort-term debt– Long-term debtLong-term debt

Is the financing consistent with the Is the financing consistent with the company’s overall business risk?company’s overall business risk?



Are there significant differences between a Are there significant differences between a firm’s net income and its operating cash firm’s net income and its operating cash flow?flow?

Is it possible to identify the sources of this Is it possible to identify the sources of this difference?difference?

Which accounting policies contribute to it?Which accounting policies contribute to it? Do one-time events contribute to the Do one-time events contribute to the

difference?difference?



Is the relationship between operating cash flow Is the relationship between operating cash flow and net income changing over time? Why?and net income changing over time? Why?

Is it because of changes in business conditions or Is it because of changes in business conditions or accounting policies and estimates?accounting policies and estimates?

What is the time lag between the recognition of What is the time lag between the recognition of revenue and expenses and the receipt and revenue and expenses and the receipt and disbursement of cash flows?disbursement of cash flows?


QuestionsQuestions

Are the changes in receivables, inventories, Are the changes in receivables, inventories, and payables normal?and payables normal?

If not, is there adequate explanation for the If not, is there adequate explanation for the changes?changes?


The EndThe End

Statement of Cash Flows

Business

Transcript of Statement of Cash Flows