Statement of Cash Flow Corporate Finance: MBAC 6060 Spring 2003 Professor Jaime Zender

SCF Basics SCF is a summary of a company’s transactions for a given period that involve the cash account. The statement provides information about the firm’s ability to generate cash and the effectiveness of its cash management. Derived from the income statement for this period and (at least) the two balance sheets surrounding the period. Cash is the “life blood” of the firm so the SCF can be an important diagnostic tool and provide insight into which financial ratios should be calculated to assess the strengths and weaknesses of the firm.

SCF Basics The questions that can be addressed are: Why is our cash balance increasing or decreasing? Where are we getting our cash? Where is our cash going? It is increasingly viewed as a (the) crucial piece of information for assessing the firm and its financial health by outside audiences: Investors, creditors, analysts, etc.

SCF The generic structure of the SCF is: Cash provided (used) by operating activities. Basic running of the business, how fast cash comes in versus how fast it goes out. Tells us about how past investments are generating cash. Cash provided (used) by investing activities. Acquisition/sale of new fixed assets. Cash provided (used) by financing activities. Raising new capital/retiring old, significant sources/uses of cash. Increase (decrease) in cash. Cash – beginning of the period. Cash – end of the period. Let’s look at each category in a bit more detail.

SCF Operating Activities: Start with:Net Income (from Operations) Add:Depreciation & Amortization Add:Change in Tax Accruals Subtract:Change in NWC (exclude Cash and current portion of long term debt) Total to find:Total Cash from Operations

SCF Investing Activities: Acquisitions of fixed assets are (generally) cash outflows. Sales of fixed assets are (generally) cash inflows. The net is Cash from Investing Activities.

SCF Financing Activities: Subtract the amount of long-term or short-term debt retired. Add the amounts of newly issued long-term or short- term debt. Subtract total amount of dividends paid. Subtract the amount of stock repurchases. Add the amount of new stock issues. Total is cash flow from financing activities.

Valuation Cash Flow While the SCF is a good diagnostic tool, it still does not present cash flow information in a form useful for valuation purposes. This is where we step away from your accounting class and strike out on our own (finally). Recall our basic valuation equation. We need forecasts of all future cash flow generated by ownership of the asset/firm. We want to introduce Free Cash Flow (FCF). The first thing we want to do is realize that for this purpose there is no reason to focus on the change in the cash account. This is really just another asset account. Now reconsider the section on financing cash flows. Some parts are cash that goes to “owners” others are changes in the ownership of the cash flow.

FCF The most correct cash flow figure to use in most DCF valuation is Free Cash Flow. FCF: Start with:Net Income (from Operations) Add back:Depreciation & Amortization Subtract:Change in NWC * Subtract:Net Capital Expenditures Add:After tax interest – (1-T c )Interest

FCF Alternatively, FCF can be estimated as: EBIT less T c EBIT = EBIT(1-T c ) Add Depreciation & Amortization Subtract Change in NWC * Subtract Net Capital Expenditures What crap! You haven’t started from the same figure, you haven’t added back interest, how can this be the same? Be sure you fully understand why. Think of alternative ways of finding FCF, it is instructive.

Financial Ratios

Ratios – Basics 5 Categories Liquidity Ratios Current and Quick Ratio – How do the current liabilities compare to the current assets? Is the firm a candidate for a liquidity problem? Leverage Ratios Debt to Assets, Debt to Equity, Interest Coverage Ratios, etc. – Measures of financial leverage and firm’s ability to meet its obligations. Have we raised capital in a sensible way?

Ratios – Basics 5 Categories… Activity or Turnover Ratios Asset Turnover Ratios – How efficiently is the firm using its assets? What kind of sales are we generating with each dollar spent on assets? Profitability Ratios ROE, ROA, etc. – Measures of total performance. Market Value Ratios Ratios using market values intended to give a view of expectations rather than refer to historical costs.

Ratio Analysis The idea is to develop information that allows you to evaluate the performance of a firm over a given period. ROE is, perhaps, the most widely used measure of overall performance. “Pieces” of ROE can tell us about specific aspects of the firm’s performance. (See the Higgins chapters.) The profit margin for example gives an idea of how well we are controlling our costs. They can also be very useful in forecasting.

Limitations Blind (mindless) calculation and application of ratio analysis is not only stupid but dangerous. Does a high profitability ratio necessarily indicate a good firm? To what do you compare a given ratio? Consider the current ratio. What should it be? Is a high current ratio good? Is a low current ratio good? Is a firm with a high asset turnover (sales/assets) better than a firm with a low one? Can you trust leverage ratios? Are coverage ratios calculated correctly?

Case of the Unidentified Industries

Data Airline, Ad Agency, Bank, Software Developer, Department Store, Utility, HMO, Meat Packer, Pharmaceutical Manufacturer, Retail Drug, Retail Grocery