Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws Chapter 4

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Chapter 4: Explains what’s on a statement of cash flows Discusses how to interpret the information presented Emphasizes: cash flow from operations as an analytical tool

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Company Success Depends on firm’s ability to generate cash from operations Where to find this information? On the statement of cash flows

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Statement of Cash Flows Provides information about cash inflows & outflows Prepared for three-year period Cash flows separated by types of activities –Operating –Investing –Financing

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing The Difference Between Cash Inflows & Cash Outflows Equals change in cash (or cash plus cash equivalents) for period

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Operating Activities Involve production & delivery of goods & services

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cash Flows from Operating Activities The cash effects of transactions & events related to the firm’s operations Amount of cash generated internally

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Financing & Investing Activities Are external sources of cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cash Flow Statement Begins with adjustments to net income Converts net income (accrual basis) to cash flow from operating activities

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Two Methods to Make Adjustments 1.Indirect: Begins with net income Adjusts for: –accruals –deferrals –non-cash items –non-operating items

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Two Methods to Make Adjustments Continued: 2.Direct: Separately converts each item of revenue & expense on earnings statement Almost all companies use the indirect method

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Investing Activities The acquisition/disposition of: Securities that are not cash equivalents Productive, long-lived assets, e.g. machinery & equipment Includes lending money & collecting on loans

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Financing Activities Include: Borrowing from creditors & repaying the principal Obtaining resources from owners Providing owners with a return on investment, e.g. dividends

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cash Flow from Operations Important for analysis Use in context of other performance measures Evaluate trend over time

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Analyzing Cash Flow from Operations Look at trends over time, not just one period Compare with net income: Should track closely Consider underlying causes of changes in cash flow operations Be aware that companies can manipulate this number too

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Statement of Cash Flows also provides information about... Cash needs from external sources Ability to meet obligations Effectiveness of asset management Ability to satisfy owners through dividend payments & healthy growth

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Free Cash Flow Widely used in analysis Considers firm’s ability to provide cash for current operations & for expansion No standardized measure

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Some Measures of Free Cash Flow Cash flow from operations less capital expenditures Cash flow from operations less capital expenditures & dividends Always look behind number to see how it is calculated

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing When evaluating Cash Flow from Operations... Consider firm’s success in generating cash internally over time Determine underlying causes for trends & fluctuations Look at relationship between cash flow from operations & net income over time

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Do firms on the brink of bankruptcy have negative cash flow from operations? Not always You need to look behind the numbers

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Enron... Had positive cash flow from operations in 2000 Filed for bankruptcy in 2001 But...

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Enron... Amounts fluctuated widely Did not track with net income It is difficult to explain Enron’s adjustments to net income in calculating cash flow from operations

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Global Crossing... Had positive cash flow from operations before filing for bankruptcy in 2002 But...

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Adjustments to net income involved: Losses on sales of businesses Write-downs of investments The company had large additions to long-term debt Global Crossing...

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Kmart... Had positive cash flow from operations in 2001 Filed for bankruptcy in 2002 But...

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Kmart... Adjustments to net income involved: Charges for store closings Reductions in inventory from store closings

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Finally... Always look at underlying causes for positive or negative cash flow from operations And remember: No one piece of analysis tells the entire story

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Caution Flags Failure to generate cash from operating activities Large fluctuations in cash flow from operating activities over time Net income growing faster than cash flow from operations

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing More Caution Flags Net income & cash flow from operations moving in different directions Positive cash flow from investing activities because company is selling assets to generate cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Even More Caution Flags Positive cash flow from financing activities because company is borrowing to offset lack of internal cash Company highlights cash flow in shareholders’ letter in same paragraph discussing falling stock price

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Yet, More Caution Flags Adjustments to net income from changes in receivables, inventories, & payables not in line with sales Management’s explanations of adjustments to net income obtuse or missing