1 Security Analysis The Role of the Cash Flow Statement

2 Balance Sheet Review Identify Financial Risk (Leverage) Identify Value in Distressed Situations (Stocks Near or Below Net Cash) Confirm Quality of EPS Growth (EPS vs BV Growth) Identify Competitive Advantage (Asset Turnover and Cash Conversion Cycle)

3 Cash Flow Statement What Does It Do? Why Do We Care?

4 What does it Do? Provides Info As To Differences in Timing Between Revenue and Expense Recognition Under GAAP and the Associated Cash Inflows and Outflows Shows If and How Company Generated or Consumed Cash – and serves as the basis for estimating FCFE

5 Why Else Do We Care? Depicts Ability of a Company to Pay Bills Shows Ability to Self Finance Growth Provides Clues to Future EPS Surprises Shows Changes in Operating Efficiency

6 Krispy Kreme Statement of Cash Flows as Reported Sales 665,592491,549394,354 35% PERIOD ENDING 1-Feb-042-Feb-033-Feb-02 Net Income 57,087 33,478 26,378 70% Operating Activities, Cash Flows Provided By or Used In Depreciation 19,723 12,271 7,959 Adjustments To Net Incom 49,363 20,723 14,361 Changes In Accounts Receivable (17,629)(7,390)(13,317) 238% Changes In Liabilities (2,130)(420)5,488 Changes In Inventories (3,804)(7,866)(3,977) 16% Changes In Other Operating Activities (7,057)240 (682) Total Cash Flow From Operating Activities95,553 51,036 36,210 87% Investing Activities, Cash Flows Provided By or Used In Capital Expenditures (79,649)(83,196)(37,310) Investments 21, ,877 Other Cash flows from Investing Activities(128,262)(11,736)(22,830) Total Cash Flows From Investing Activities(186,241)(94,574)(52,263) Financing Activities, Cash Flows Provided By or Used In Dividends Paid Sale Purchase of Stock 19,518 6,708 21,335 Net Borrowings 64,458 44,861 5,636 Other Cash Flows from Financing Activities (4,462)2,268 3,960 Total Cash Flows From Financing Activities79,514 53,837 30,931 Effect Of Exchange Rate Changes Change In Cash and Cash Equivalents ($11,174)$10,299 $14,878

7 Krispy Kreme Cash Flow Without Financing Activities

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9 Lucent Technologies 1999 Income Statement Reported Net Income$4,766 Less: Sale of Juniper Stock (167) Pension Accounting Change (1,308) Plus: Restructuring Costs 270 Acquisition Related Charges 272 Operating Income Highlighted in 1999 Annual Report $3,833 Excluded Item: Effect of Pension Accounting Change $260 Reversal of Prior Restruct. Charge $93

10 Lucent Cash Flow Statement 1998/1999 Net Income$1035 $4,766 Cum. Effect of Acct. Change 0(1308) Depreciation and Amortization 1,4111,806 Change in Inventory(403)(1,612) Change in Receivables(2,161)(3,183) Change in Other Assets/Liabs 155(2,320) Other Items 1,823 1,575 Operating Cash Flow$1,860(276) Adjust. for Receivables Sale 0(600) Adjusted Operating OCF$1,860$(876)

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12 Cash From Operations Shows Good if Concern ifQuestions If Company generates enough Cash from Operations to Continue w/o External Financing Positive OK if Negative and seeing Revenue Growth w/modest burn Negative Especially w/absence of Revenue Growth Major sources of In and Out flow Need External Financing

13 CFO to Earnings Ratio ShowsGood ifConcern ifQuestions Proportion of Earnings Yielding Cash Conservatism of Accounting High relative to Industry Low and High Growth and R&D Low Relative to Industry or Trend falling Why is it Changing Is Source of Gap Sustainable

14 Operating Margins ShowsGood ifConcern ifQuestions Extent that Revenue Growth can Sustain Profit High or Improving Low or Declining. Watch for High Margins and Declining Revenue Are Changes Consistent with State of Competition New Management?

15 Operating Asset Turnover ShowsGood ifConcern ifQuestions If Revenue Growth is Created by Operations or Asset Growth Efficiency Growing or Sector High Level Declining can Indicate Capitalizing Excess Costs Recent Restructur- ing Change in Expensing Policy?

16 Days Sales Outstanding ShowsGood ifConcern if Questions Customer Credit Terms Channel Stuffing Reduced or Low. Shows efficient capital management Sudden Rise Any Receivables discount? Terms in Line with Competitors? Acquisitions?

17 Inventory Turnover ShowsGood ifConcern ifQuestions Expected Change in Pace of Sales Efficiency Write Down Potential Sustainable increase Short Term Increase or Concurrent with Increase in DSO Any potential Supplier Shortages Does Company Bill and Hold Sales

18 Capital Expenditures to Depreciation Ratio ShowsGood ifConcern ifQuestions If Depreciation is Reasonable Anticipated Growth Conservative? Stable between 1 and 2 High especially if Slow Revenue Growth Consistent Less than 1 Does Capex include M&A Outsourcing Excess Sector Capacity?

19 Loan Loss Reserves ShowsGood ifConcern ifQuestions Proportion of Loans that won’t be Realized with Cash Low or decreasing Low (eps may have been overstated) Compare to Sector Norms DSO and LLR send same message?

20 Cash Flow Statement Conclusions: Shows Ability to Pay Bills Shows Ability to Self Finance Shows FCF available to Shareholder Provides Clues to Future EPS Surprise Shows Changes in Operational Efficiency

21 Stock Selection Diligence Process No One Route to the Truth Takes Time…But It Accelerates with Experience Two Decisions: Do I Like This Company and Do I Like this Price

22 Investment Process Sources of Ideas: Companies, Peers, Technical Personnel, Publications, New Low List Examine Company Financials and Management Discussion of Results Assess Return on Capital versus Cost of Capital

23 Diligence Process Look at Company Growth and Margin Prospects By Business Line Evaluate Competitive Advantage and its Trajectory Quick Valuation Check Look for “Scuttlebutt” (Suppliers, Competitors, Employees, Customers)

24 Due Diligence Articulate Key Investment Controversies More Extensive Valuation Analysis Meet Management If You Can’t Understand an Issue at any Point, Move On