Handout 3

CASH FLOW ANALYSIS

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Learning Objectives

explain the meaning, usefulness and purpose of cash flow statement

identify cash flow from three different activities

understand two different methods of preparing cash flow statement

understand free cash flow

study various types of cash flow ratios

test solvency by calculating cash flow ratios2

CASH FLOW ANALYSIS

•The income statement is based on the accrual method, and net income may not represent cash generated from operations.

•Net income, based on accrual accounting, is not the same thing as cash earnings.

•When the timing of revenue or expense recognition differs from the receipt or payment of cash, it is reflected in changes in balance sheet accounts.

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• A company may be generating positive and growing net income but ………………….

• may be headed for insolvency because insufficient cash is being generated from operating activities.

• Therefore constructing a statement of cash flows is very important in an analysis of a firm’s activities and its prospects.

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THE CASH FLOW STATEMENT

•The cash flow statement provides information about…………….a company’s cash receipts and cash payments during an accounting period.

•showing how these cash flows link the ending cash balance to the beginning balance shown on the company ’ s balance sheet.

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• The cash flow statement reconciles the beginning and ending balances of cash over an accounting period.

• The change in cash is a result of the firm’s operating, investing, and financing activities.

+ Operating Activities

+ Investing Activities

+ Financing Activities

= Change in cash balance

+ Beginning Cash Balance

- Ending Cash Balance.

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The cash flow statement provides information beyond that available from the income statement, which is based on

accrual, rather than cash accounting.

The cash flow statement provides the following.

—provide information on cash inflows, outflows for a period.

—Information about a company’s cash receipts and cash payments during an accounting period.

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—Information about a company’s operating, investing and financing activities.

—An understanding of the impact of accrual accounting events on cash flows.

—provides information to assess the firm’s liquidity, solvency, and financial flexibility.

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An analyst can use the statement of cash flows to determine whether;

Regular operation generate enough cash to sustain the business

Enough cash is generated to pay off existing debts as they mature.

The firm is likely to need additional financing

Unexpected obligations can be met.

The firm can take advantage of new business opportunities as they arise.

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A firm’s cash receipts and cash payments are classified on the cash flow statement as operating, investing, or financing activities.

Cash flow from operating activities

Cash flow from financing activities

Cash flow from investing activities

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CASH FLOW FROM OPERATING ACTIVITIES

•Sometimes it is referred to as “cash flow from operations/operating cash flow.

•Operating activities include the company’s day-to-day activities that create revenues, such as selling inventory and providing services.

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• Cash inflows result from cash sales and from collection of accounts receivable.

Examples……………………..

• cash receipts from the provision of services and royalties, commissions, and other revenue.

• To generate revenue, companies undertake activities such as manufacturing inventory, purchasing inventory from suppliers, and paying employees.

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Cash outflows result from cash payments……………………

•for inventory, salaries, taxes, and other operating-related expenses and from paying accounts payable.

•Additionally, operating activities include cash receipts and payments related to securities held for dealing or trading purposes (as opposed to being held for investment).

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CASH FLOW FROM INVESTING ACTIVITES

•Investing activities include purchasing and selling investments. …………….

•Investments include property, plant, and equipment; other long-term assets; and

•both long-term and short-term investments in the equity and debt (bonds and loans) issued by other companies.

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Cash inflows in the investing category include……….

•cash receipts from the sale of non-trading securities; property, plant, and equipment; or

•other long-term assets.

Cash outflows include …………………………•cash payments for the purchase of these assets.

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CASH FLOW FROM FINANCING ACTIVITIES

•Financing activities include obtaining or repaying capital, such as equity and long-term debt.

•Cash inflows in this category include…………….

cash receipts from issuing stock (common or preferred) or bonds and cash receipts from borrowing.

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Cash outflows include …………………

•cash payments to repurchase stock (e.g., treasury stock),

•to pay dividends, and

•to repay bonds and other borrowings.

Note that indirect borrowing using accounts payable is not considered a financing activity—such borrowing would be classified as an operating activity.

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NON CASH INVESTING/FINANCING ACTIVITIES

—These activities are not reported in the cash flow statement since they do not result in flows or outflows of cash.

—These are significant investing and financing activities that do not directly affect cash.

—These activities involve only on long-term assets, long-term liabilities and stock holder’s equity.

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• These transactions must be disclosed in either footnote or supplement schedule to the cash flow statement.

• Analyst should incorporate these transactions into analysis of past and current performance, and include their effects in estimating future cash flows.

EXAMPLE:• Issuance of common stock to retire long-term debt• Purchase of equipment with a note payable• Issuance of stock to acquire land

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MAJOR SOURCES AND USES OF CASH

•Cash flow analysis begins with an evaluation of the firm’s sources and uses of cash from operating, investing, and financing activities.

•Sources and uses of cash change as the firm moves through its life cycle.

For example:In the early stage of growth…………………•Experience negative operating cash flow

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• Negative operating cash flow usually financed externally by issuing debt or equity securities

• Over the long term firm must be able to generate operating cash flows that exceed capital expenditure and provide a return to debt and equity holders.

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CASH FLOWS FROM INVESTING ACTIVITIES

Cash flows are related to an entity’s life cycle stage

– Significant cash outflows in the emerging and growth stages of business

– They become positive and peak during business maturity

– CFIs trend toward zero as a firm declines and ceases operations

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CASH FLOWS FROM FINANCING ACTIVITIES

CFFs are related to an entity’s life cycle stage – Significant cash inflows in the emerging and growth

stages of business – They decline during business maturity

– CFFs negative as a firm declines and ceases operations (return of investment)

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OPERATING CASH FLOW & ANALYST•An analyst should identify the major determinants of operating cash flow.

•Positive operating cash flow can be generated by the firm’s earnings related activities.

•Positive operating cash flow can also be generated by decreasing non-cash working capital, such as liquidating inventory and receivables or increasing payables.

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• Operating cash flow also provides a check of the quality of a firm’s earnings.

• A stable relationship of operating cash flow and net income is an indication of quality earnings

• Earnings that significantly exceed operating cash flow may be an indication of aggressive accounting choices. Ex: recognizing revenues too soon or delaying the recognition of expenses.

• The variability of net income and operating cash flow should also be considered.

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INVESTING CASH FLOW

—The sources and uses of cash from investing activities should be examined.

—A firm may reduce capital expenditure or sell capital assets in order to save or generate cash.

—Increasing capital expenditure is usually an indication of growth.

—Generating operating cash flow that exceeds capital expenditures is a desirable trait.

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FINANCING CASH FLOW

•This cash flow reveals information about whether the firm is generating cash flow by issuing debt or equity.

•This also provides information about whether the firm is using cash to repay debts, re acquire stock or pay dividends.

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LINKAGES OF THE CASH FLOW STATEMENT WITH THE INCOME STATEMENT AND BALANCE SHEET

•Cash is an asset. The statement of cash flows ultimately shows the change in cash during an accounting period.

•The beginning and ending balances of cash are shown on the company’s balance sheets for the previous and current years,

•and the bottom of the cash flow statement reconciles beginning cash with ending cash.

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The beginning and ending balance sheet values of The beginning and ending balance sheet values of cash and cash equivalents are linked through the cash and cash equivalents are linked through the cash flow statementcash flow statement..

Beginning Balance + - E n d in g Balance B eg in n in g cash Cash receipts (from

operating, in v e s tin g , and fin an c in g activities)

Cash payments (for operating, in v e s tin g , and fin an c in g activities)

Ending cash

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Retained Earnings

Beginning Balance + - E n d in g Balance B eg in n in g retained earnings

Net income or minus net loss from the income statement for year

Dividends Ending retained earnings

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• A company’s operating activities are reported on an accrual basis in the income statement……………..

• Any differences between the accrual basis and the cash basis of accounting for an operating transaction result in an increase or decrease in some (usually) short-term asset or liability on the balance sheet.

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For example

if revenue reported using accrual accounting is higher than the cash actually collected, the result will be an increase in accounts receivable.

•If expenses reported using accrual accounting are lower than cash actually paid, the result will be a decrease in accounts payable

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• A company’s investing activities typically relate to the long-term asset section of the balance sheet, and

• its financing activities typically relate to the equity and long-term debt sections of the balance sheet.

• Each item on the balance sheet is also related to the income statement and/or cash flow statement through the change in the beginning and ending balance.

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Knowing any three of these four items makes it easy to compute the fourth.

Understanding these interrelationships between the balance sheet, income statement, and cash flow statement is useful in not only understanding the company’s financial health but also in detecting accounting irregularities.

Beginning Balance + - E n d in g Balance B eg in n in g A c c o u n ts R e c e iv a b le

Income Statement Revenue

Cash Collected from Customers

Ending Accounts Receivables

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METHODS OF PRESENTING CASH FLOW STATEMENT

There are two acceptable formats for reporting cash flow from operations.

1.Direct method

2.Indirect method

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DIRECT METHOD

•This method converts an accrual –basis income statement into cash-basis income statement.

•That is, the direct method reports gross cash receipts and cash disbursements related to operations.

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DIRECT METHOD……………Cont/………….

•Creditors preferred the direct method. The direct method reports total amounts of cash flowing in and out of a company from operating activities.

•This offers most analysts a better format to readily assess the amount of cash inflows and outflow.

• When companies report using the direct method, they must disclose a reconciliation of net income to cash flows from operations (the indirect method) in a separate schedule

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INDIRECT METHODINDIRECT METHOD•Under this method net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions.

These adjustments includesThese adjustments includes

•Eliminating non-cash expenses [depreciation/amortization]•Non-operating items [gain/losses]•Changes in balance sheet accounts [resulting from accrual accounting events]

Total cash flow from operating activities is exactly the same under both methods, only the presentation method is different.

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Statement of Cash Flows

• Consider first the net cash from operations.

Indirect method

Statement of Cash Flows

• Depreciation and amortization add-back.

Preparation of the Statement of Cash Flows

Statement of Cash Flows

• Adjustments for changes in balance sheet accounts can be summarized as follows:

Preparation of the Statement of Cash Flows

STEPS IN PREPARING THE CASH FLOW STATEMENT

•The preparation of the cash flow statement uses data from both the income statement and the comparative balance sheets.

•As noted earlier, companies often only disclose indirect operating cash flow information, whereas analysts prefer direct-format information.

•Operating Activities: Direct Method•Investing Activities: Direct Method•Financing Activities: Direct Method

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OPERATING ACTIVITIES: DIRECT METHOD

•First determine how much cash received from its customers

•how much cash was paid to suppliers and to employees as well as

•how much cash was paid for other operating expenses, interest, and income taxes.

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Cash Received from Customers

•To determine the cash receipts from its customers, it is necessary to adjust this revenue amount by the net change in accounts receivable for the year.

•If accounts receivable increase If accounts receivable increase during the year,

revenue on an accrual basis is higher than cash revenue on an accrual basis is higher than cash

receipts from customersreceipts from customers, and vice versa.

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Revenue $23,598

L ess: In c rea se in a c c o u n ts re c e iv a b le (55) Cash re c e iv e d from customers $ 2 3 ,5 4 3

Cash re c e iv e d from c u s to m e r s a f f e c ts the a c c o u n ts re c e iv a b le account a s follows:

B eg in n in g ac c o u n ts receivable $957

P lu s revenue 23,598 Minus ca sh c o l le c te d from customers (2 3 ,5 4 3 ) Ending ac c o u n ts receivable $1,012

The a c c o u n ts re c e iv a b le account information can a ls o be p re s e n te d a s follows:

B eg in n in g ac c o u n ts receivable $957

P lu s re v e n u e 23,598 Minus ending accounts receivable (1,012) Cash co llec ted from customers $ 2 3 ,5 4 3

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Cash Paid to Suppliers

To determine purchases from suppliers, cost of goods sold is adjusted for the change in inventory.

If inventory increased during the year, then purchases during the year exceeded cost of goods sold, and vice versa.

If accounts payable increased during the year, then purchases on an accrual basis are higher than they are on a cash basis, and vice versa.

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Cost of goods sold $11,456

Plus: Increase in inventory 707

Equals purchases from suppliers $12,163

Less: Increase in accounts payable (263)

Cash paid to suppliers $11,900

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Once purchases have been determined, cash paid to suppliers can be calculated by adjusting purchases for the change in accounts payable.

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Purchases from suppliers affect the inventory account, as shown below

The cash paid to suppliers was $11,900, determined as follows:

Beginning inventory $3,277Plus purchases 12,163Minus cost of goods sold (11,456)Ending inventory $3,984

Purchases from suppliers $12,163

Less: Increase in accounts payable (263)

Cash paid to suppliers $11,90050

Cash Paid to Employees

To determine the cash paid to employees, it is necessary to adjust salary and wage expense by the net change in salary and wage payable for the year.

If salary and wage payable increased during the year, If salary and wage payable increased during the year, then salary and wage expense on an accrual basis is then salary and wage expense on an accrual basis is higher than the amount of cash paidhigher than the amount of cash paid for this expense, and vice versa.

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The amount of cash paid to employees is reflected in the salary and wage payable account, as shown below:

Salary and wage expense $4,123Less: Increase in salary and wage payable (10)Cash paid to employees $4,113

Beginning salary and wages payable $75Plus salary and wage expense 4,123Minus cash paid to employees (4,113)Ending salary and wages payable $85 52

Cash Paid for Other Operating Expenses

•To determine the cash paid for other operating expenses, it is necessary to adjust the other operating expenses amount on the income other operating expenses amount on the income

statement by the net changes in prepaid expenses and accrued expense statement by the net changes in prepaid expenses and accrued expense

liabilities for the yearliabilities for the year.

•If prepaid expenses increasedprepaid expenses increased during the year, other operating other operating

expenses on a cash basis were higher than on an accrual basisexpenses on a cash basis were higher than on an accrual basis, and vice versa.

• Likewise, if accrued expense liabilities increased if accrued expense liabilities increased during the year, other operating expenses on a cash basis were lower than on an operating expenses on a cash basis were lower than on an

accrual basisaccrual basis, and vice versa.

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Cash Paid for Other Operating Expenses………….

Other operating expenses $3,577

Less: Decrease in prepaid expenses (23)

Less: Increase in other accrued liabilities

(22)

Cash paid for other operating expenses

$3,532

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Cash Paid for Interest……………….•To determine the cash paid for interest, it is necessary to adjust interest expense by the net change in interest payable for the year. •If interest payable increases If interest payable increases during the year, then interest interest expense on an accrual basis is higher than the amount of expense on an accrual basis is higher than the amount of cash paid for interestcash paid for interest, and vice versa.

Interest expense $246

Plus: Decrease in interest payable 12

Cash paid for interest $258

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Alternatively, cash paid for interest may also be determined by an analysis of the interest payable account, as shown below:

Beginning interest payable $74Plus interest expense 246Minus cash paid for interest (258)Ending interest payable $62

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Cash Paid for Income Taxes……………………………. •To determine the cash paid for income taxes, it is necessary to adjust the income tax expense amount on the income statement by the net changes in taxes receivable, taxes payable, and deferred income taxes for the year.

•If taxes receivable or deferred tax assets increase during the year, income taxes on a cash basis will be higher than on an accrual basis, and vice versa.

•Likewise, if taxes payable or deferred tax liabilities increase during the year, income tax expense on a cash basis will be lower than on an accrual basis, and vice versa.

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Cash Paid for Income Taxes…………………………….

Income tax expense $1,139

Less: Increase in income tax payable (5)

Cash paid for income taxes $1,134

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INVESTING ACTIVITIES: DIRECT METHOD***

•The second and third steps in preparing the cash flow statement are to determine the total cash flows from investing activities and from financing activities.

•The presentation of this information is identical, regardless of whether the direct or indirect method is used for operating cash flows. Investing cash flows are always presented using the direct method.

FINANCING ACTIVITIES: DIRECT METHOD***

•As with investing activities, financing activities are always presented using the direct method

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• Total Liabilities = Total liabilities - Par value of preferred stock

• The higher ratio indicates that the company has lost some ground with respect to covering all its debts with net tangible assets.

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COMMON SIZE CASH FLOW STATEMENT

• In common-size analysis of a company’s income statement, each income and expense line item is expressed as a percentage of net revenues (net sales).

• For the common-size balance sheet, each asset, liability, and equity line item is expressed as a percentage of total assets.

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• For the common-size cash flow statement, there are two alternative approaches.

• • The first approach is to express each line item of cash

inflow (outflow) as a percentage of total inflows (outflows) of cash.

• second approach is to express each line item as a percentage of net revenue.

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FREE CASH FLOWFREE CASH FLOW

The excess of operating cash flow over capital expenditures is known generically as free cash flow.

For purposes of valuing a company or its equity securities, an analyst may want to determine a more precise free cash flow measure.

Methods of Measure of Free cash flowMethods of Measure of Free cash flow

1. free cash flow to the firm (FCFF) free cash flow to the firm (FCFF) 2.2.free cash flow to equity (FCFE).free cash flow to equity (FCFE).

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FREE CASH FLOW TO THE FIRM FREE CASH FLOW TO THE FIRM

• Free cash flow to the firm [FCFF] is the cash available to all investors, both equity owners and debt holders.

• FCFF can be calculated by starting with either net income or operating cash flow.

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FREE CASH FLOW TO EQUITYFree cash flow to equity [FCFE] is the cash flow that would be available for distribution to common shareholders.

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CASH FLOW RATIOSCASH FLOW RATIOS• The cash flow statement can be analysed by comparing the

cash flows either over time or to those of other firmseither over time or to those of other firms.

• profits are very important for a company. companies that companies that appear very profitable can actually be at a financial risk if appear very profitable can actually be at a financial risk if they are generating little cash from these profitsthey are generating little cash from these profits

• For example, if a company makes a ton of sales on credit, they will look profitable but haven't actually received cash for the sales, which can hurt their financial health since they have obligations to pay.

• Cash flow ratios can be categorizedCash flow ratios can be categorized Performance ratioPerformance ratio Coverage ratioCoverage ratio 66

Performance ratioPerformance ratio

• Cash flow-to-revenue• Cash return-on-asset ratio• Cash return-on-equity ratio• Cash flow per share

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Cash flow-to-revenue

The cash flow-to-revenue ratio, also known as the operating cash flow-to-sales ratio or the cash flow-to-sales ratio, is the ratio of operating cash flow to revenue.

It indicates management's ability to turn revenue management's ability to turn revenue into profits and net cash flowinto profits and net cash flow.

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•Management, investors and other stakeholders can use the cash flow-to-revenue ratio to evaluate the effectiveness of internal cost controls.

•A high ratio usually means the company is able to turn able to turn a higher percentage of its revenue into profits and net a higher percentage of its revenue into profits and net cash flow. cash flow.

•A flat or increasing trend line is generally an indication indication of consistent sales growth and effective expense of consistent sales growth and effective expense management. management.

•Poor receivables collection and higher expenses Poor receivables collection and higher expenses are some of the reasons for a declining trend line.

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Operating cash flow depends on net income, which is revenue minus expenses. Therefore, if a company generates higher revenue, it must keep expenses steady relative to revenue to drive operating cash flow and the cash flow-to-revenue ratio higher.

If revenue declines, the company must make a corresponding reduction in expenses to maintain the same cash flow-to-revenue ratio. Other strategies to increase the ratio include using credit instead of cash for purchases, tightening credit requirements and following up on overdue accounts.

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Cash return-on-asset ratiocash return on assets is designed to measure management’s success in making operating decisions

Cash return on assets measures management’s success in generating cash from operating activities.

Because CFO is available to pay dividends and to finance investments, a high ratio is desirable.

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• This ratio used to compare a businesses performance among other industry members.

• The ratio can be used internally by the company's analysts, or by potential and current investors.

• When a high cash return on assets ratio is listed, it can indicate to investors that a higher return is anticipated.

• This is due to the theory that the higher the ratio, the more cash the company has made available for reinvestment in the company either through replacements.

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Cash Return On Equity Ratio

The cash return on equity ratio is the ratio of cash flow from operations to average shareholders' equity.

This ratio measures the amount of cash generated from operations per one dollar of average shareholders' equity.

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Cash flow per shareCash flow per shareA measure of a firm's financial strength

•Many analysts and investors place more weight on cash flow per share than earnings per share.

•Because EPS is more easily manipulated, its reliability can at times be questionable. Cash, on the other hand, is difficult to fake. •Therefore, cash flow per share is a useful measure for the strength of a firm and the measure for the strength of a firm and the sustainability of its business model.sustainability of its business model.

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Cash flow per share...........................Cash flow per share...........................

•cash flow per share takes into consideration a company's ability to generate cash.

•it is regarded by some analysts as a more accurate measure of a company's financial situation than the earnings per share metric.

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COVERAGE RATIO

i.Debt coverage ratioii.Cash flow interest coverage ratio/Interest coverage Ratioiii.Reinvestment ratioiv.Dividend payment ratiov.Free Cash Flow to Operating Cash Flow Ratio

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Debt-Coverage Ratio/Debt-Coverage Ratio/Cash Flow Coverage RatioCash Flow Coverage Ratio•The cash flow coverage ratio is an indicator of the ability of a company to pay interest and principal amount.

•This ratio tells the number of times the financial obligations of a company are covered by its earnings.

•A ratio equal to 1 or more than 1 means

- good financial health – meet its financial obligations through the cash generated by operating activities.

•A ratio of less than one is an indicator of bankruptcy of the company within two years if it fails to improve its financial position.

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Debt-Coverage Ratio/Cash Flow Coverage Ratio…………..cont/……

―It is an important indicator of the liquidity position of a company.

Cash Flow Coverage Ratio = Operating Cash Flows / Total Debt

Cash Flow Coverage Ratio = (Net Earnings + Depreciation + Amortization) / Total Debt

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Cash flow interest coverage ratio/Interest Cash flow interest coverage ratio/Interest coverage Ratiocoverage Ratio

• This ratio measures the firm’s ability to meet its firm’s ability to meet its interest obligationsinterest obligations

• Interest coverage is regarded as a measure of a company’s creditworthiness

• Banks and financial analysts also rely on this ratio as

a rule of thumb to measure the fundamental fundamental strength of a business.strength of a business.

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Reinvestment RatioReinvestment Ratio• This measures the firm’s ability to acquire long-

term assets with operating cash flow

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Dividend Payment Ratio Dividend Payment Ratio

This ratio measures the firm’s ability to make dividend payments from operating cash flow.

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Free Cash Flow to Operating Cash Flow RatioFree Cash Flow to Operating Cash Flow Ratio

• Ratio measures the relationship between free cash flow and operating cash flow.

• FCF considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency.

• FCF available to a company to use for expansion, acquisitions, and/or financial stability .

• The higher the percentage of this ratio indicates that company is in the greater financial strength.

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HOW TO TEST SOLVENCY WITH CASH FLOW HOW TO TEST SOLVENCY WITH CASH FLOW RATIOSRATIOS

• Creditors and lenders began using cash flow ratios because

• those ratios give more information about a company's ability to meet its payment commitments than traditional balance sheet working capital ratios.

• Traditional working capital ratios indicate how much cash the company had available on a single date in the past.

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HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS…………………………………………………………………………..HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS…………………………………………………………………………..

Cash flow ratios, on the other hand, test

how much cash was generated over a period of time and compare that to near-term obligations,

giving a dynamic picture of what resources the company must have to meet its commitments.

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Operating cash flow (OCF/CFO) RatioOperating cash flow (OCF/CFO) Ratio[Company's ability to generate resources to meet current liabilities]

• The numerator of the OCF ratio consists of net cash provided by operating activities.

• The denominator is all current liabilities, taken from the balance sheet.

Operating cash flow (OCF) = sLiabilitieCurrent

Operations from FlowCash

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Operating Cash MarginOperating Cash Margin

• Thus, the operating cash margin ratio indicates performance based on cash generating ability –as opposed to a profit margin ratio with its focus on accrual based accounting income.

• This ratio is useful to evaluate cash management cash management performanceperformance, as well as, credit granting policies credit granting policies and receivable collections.

• it is more effective to focus a comparative analysis on companies within the same industry

Sales

Operation from FlowCash MarginCash Operating

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Cash Generating PowerCash Generating Power

The ratio demonstrates a company’s ability to generate cash and the proportion of the cash generated solely by

operations compared to the total cash inflow

Year to year comparisons of the cash generating power for a company should be evaluated, as well as, comparisons with industry competitors.

Significant decreases in the ratio over time would be a source of concern that merits investigation.

FlowCash FinancingFlowCash InvestingCFO

Operation from FlowCash Power GeneratingCash

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External Financing IndexExternal Financing Index

This ratio compares cash flows provided by financing activities with cash generated from operations.

The ratio indicates the extent of dependenceextent of dependence on external sources as a means of financing.

The larger the ratio, the more dependent a company is on external funding and this can lead to higher level of

financial risk.

Operations from FlowCash

Activities Financing from FlowCash Index Financing External

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Capital Asset RatioCapital Asset Ratio

• The capital asset ratio shows a company’s ability to meet its The capital asset ratio shows a company’s ability to meet its capital expenditure needs from cash generated by capital expenditure needs from cash generated by operating activities rather than from financing activitiesoperating activities rather than from financing activities

• A ratio of 1.0 or greater means that debt financing is not necessary for capital expenditures.

nsAcquisitioAsset Capitalfor OutflowsCash

Dividendsfor PaidCash - DisposalAsset Capital from InflowsCash CFORatioAsset Capital

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Earnings QualityEarnings Quality

In the earnings quality ratio both CFO and net income are adjusted for the effects of interest and income taxes that result from differences between cash payments versus accruals and deferrals.

This provides the extent of deviation between operating cash flows and reported earnings.

Non-cash items such as depreciation, amortization, losses

and gains, are a typical cause for normal deviation of CFO from earnings.

ExpenseTax IncomeExpenseInterest IncomeNet

Taxes Income &Interest for PaymentsCash CFO RatioQuality Earnings

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• However, the underlying cause of any potentially abnormal or substantial deviations needs to be investigated.

• Therefore, during the evaluation process it is important to not only understand that a difference exists and to monitor its direction and size, it is equally important to identify the underlying cause.

• For example, based on comparisons over time, an earnings quality ratio that is falling increasingly further below 1.0 could indicate a possible problem such as fictitious receivables or unrecorded payables.

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Accounting Shenanigans on the Cash Flow Statement

– Investors’ increased Investors’ increased focus on the cash flow statement is beneficial.

– Analysing the cash flow statement is integral integral part part to understanding a company’s financial performance and position

– because it often provides a check to the quality provides a check to the quality of the earningsof the earnings shown in the income statement.

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CASH FLOW MANIPULATION

Accrual accounting is easily manipulated because of the many estimates and judgements involvedmany estimates and judgements involved. Management has several ways to manipulate operating cash flow, including

• deciding how to allocate cash flow between categories• changing the timing of receipts of cash flows.

•A financial analyst should investigate the quality of a company’s cash flows and determine whether increases in operating cash flow are sustainable.

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METHODS OF MANIPULATING CASH FLOW

•Stretching Accounts payables•Financing Accounts payables•Securitizing Accounts Receivables•Repurchasing Stock to Offset Dilution

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Stretching Accounts payablesStretching Accounts payables•Transaction with suppliers is usually reported as operating activities in the cash flow statement.

•A firm can temporarily increase operating cash flow by simply stretching accounts payable[delaying payments]

• delaying payment is no-cost financing.

•stretching payables is not a sustainable source of increased cash flows, since suppliers may refuse to extend credit.

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Stretching Accounts payables...................../cont....

One way to determine whether a firm is stretching its payable is to examine the number of days in accounts payable./days accounts payable (Days A/P)

As a rule of thumb, a well managed company's days accounts payable do not exceed 40 to 50 days.

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Financing Accounts payables

By entering into a financial agreement with 3rd party[financial institution] can delaying cash payment.

Financing accounts payable allows the firm to manage the timing of the reporting operating cash flow.

When accounts payable due---------------financial institutor makes the payment to suppliers on behalf of firm-----then firm reclassifies the A/C payable to short-term financing.

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• So firm might time the arrangement. By doing so, lower CFO is offset by higher operating cash flow from other sources

Ex: 1. seasonal cash flow2. Cash flow from receivables sales/ securitization

When the firm repays to the financial institution, report the cash outflow as financing activity not an operating activity.

That means the firm has delayed the out flow of cash.

Financial institution will charge a fee to handle this arrangements.

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Borrowing against receivables/Securitizing Accounts Receivables

• A firm can convert A/C receivables into cash by

• Borrowing against the receivables[collateral]• Selling securitizing the receivables

• When borrowing [use receivables as collateral] the inflow of cash is reported as financing activity

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Securitizing Accounts Receivables

• Companies will securitize illiquid assets into liquid assets in order to increase their overall liquidity.

• Accounts receivable securitization is the process of bundling together the accounts receivables asset and selling that to investors as a security.

The inflow of cash is reported as an operating activity in the cash flow statement -------- since transaction is reported as a sale.

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Securitizing Accounts Receivables....................

• Securitising may affect earnings ----- securitizing of receivables may give gain in some cases.

— At the time of securitization gain is the result of difference between book value and fair value.

— Through number of estimates Expected default rate Expected payment rate Discount rate.

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Benefits of Securitizing

1. Securitized debt has a lower interest cost than corporate debt2. Securitization can increase a companies total liquidity3. Securitization can enhance the enterprise value

AR securitization is only available to large companies having broad customer base.

When the firm has limited amounts of AR, increasing/ accelerating CFO is not suitable.

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Repurchasing Stock to Offset Dilution

When a firm’s stock options are exercised, shares must be Issued

When stock price[mkt] > Exercise price, then more shares will be issued.....EPS will be diluted as shares are issued.

Firms often repurchase stock to offset the dilutive effects of stock option exercise

Cash received from option[inflow] cash outflow[repurchase]...both reported as financing activities. Since there is tax benefit when options are exercised.

For analytical purpose, net cash outflow for share repurchase[to avoid dilution] should be reclassified from financing activities to operating activities.

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"Stock options are contracts; they don't represent ownership in anything. They are merely contracts that grant you certain rights".

Option that gives its holder the right to buy or sell a firm's common stock (ordinary shares) at a specified price and by a specified date.

call option - an option to buyput option - an option to sell

The "Call" option gives its buyer the right to "buy" shares of a stock at a specified price on or before a given date.

The "Put" option gives its buyer the right to "sell" shares of a stock at a specified price on or before a given date.

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Definition of 'Exercise Price

The price at which the underlying security can be purchased (call option) or sold (put option)

The exercise price is determined at the time the option contract is

formed.

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An employee stock option (ESO)

It is a call option on the common stock of a company, granted by the company to an employee as part of the employee's remuneration package.

The objective is to give employees an incentive to behave in ways that will boost the company's stock price.

If the company's stock market price rises above the call price, the employee could exercise the option, pay the exercise price and

would be issued with ordinary shares in the company.

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An employee stock option (ESO) …………………………

The employee would experience a direct financial benefit of the difference between the market and the exercise prices.

Another substantial reason that companies issue employee stock options as compensation is to preserve and generate cash flow.