1. INTRODUCTION TO CASH FLOW ANALYSIS Chapter 10

2. CHAPTER 10 OBJECTIVES Explain the relationships between operating, investing, and financing cash flows and stages in the business life cycle. Explain the relationships between operating, investing, and financing cash flows and stages in the business life cycle. Convert indirect CFOs to direct CFOs. Convert indirect CFOs to direct CFOs. Describe the significance of cash received as a percentage of revenues and paid as percentage of cost of goods sold to business operations. Describe the significance of cash received as a percentage of revenues and paid as percentage of cost of goods sold to business operations.

3. CHAPTER 10 OBJECTIVES (CONT.) Discern stability, efficiency, and inefficiency in an entity’s operating cash flows and liquidity measures. Discern stability, efficiency, and inefficiency in an entity’s operating cash flows and liquidity measures. Analyze a company or industry’s CFOs. Analyze a company or industry’s CFOs.

4. THE OBJECTIVE OF CASH FLOW ANALYSIS An evaluation of past events and present conditions so that the amount, timing, and probability of future cash flows can be forecast An evaluation of past events and present conditions so that the amount, timing, and probability of future cash flows can be forecast Analyst seek to understand Analyst seek to understand Cash flows into and out of an entity Cash flows into and out of an entity The primary sources and uses of cash The primary sources and uses of cash Relative consistency of cash flows over time Relative consistency of cash flows over time

5. BUSINESS DECISIONS AND CASH FLOWS Business success depends on an entity taking in more cash in its life than it pays out over time Business success depends on an entity taking in more cash in its life than it pays out over time Initial cash flows Initial cash flows Provided by debt and equity investors Provided by debt and equity investors Used to acquire productive assets Used to acquire productive assets Reflect managerial decisions about how to maximize wealth Reflect managerial decisions about how to maximize wealth

6. BUSINESS DECISIONS AND CASH FLOWS (CONT.) The Financial Accounting Standards Board’s perspective The Financial Accounting Standards Board’s perspective Requires that companies disclose a statement of cash flows Requires that companies disclose a statement of cash flows The cash flow statement should provide equity investors and creditors with information to make judgments about the The cash flow statement should provide equity investors and creditors with information to make judgments about the Amount of future cash flows Amount of future cash flows Timing of future cash flows Timing of future cash flows Uncertainty of future cash flows Uncertainty of future cash flows

7. BUSINESS DECISIONS AND CASH FLOWS (CONT.) Cash flows and corporate life Cash flows and corporate life An entity’s life cycle stage affects cash acquisitions and disbursements An entity’s life cycle stage affects cash acquisitions and disbursements The life cycle stages are (Exhibit 10-1) The life cycle stages are (Exhibit 10-1) Emergence Emergence Growth Growth Maturity Maturity Decline Decline

8. BUSINESS DECISIONS AND CASH FLOWS (CONT.) Cash flow relationships to life cycle stages (Exhibit 10-2) Cash flow relationships to life cycle stages (Exhibit 10-2) Operating activities Operating activities Outflows during emergence and early growth Outflows during emergence and early growth Inflows peak during maturity Inflows peak during maturity Inflows decrease (trending toward zero) in decline Inflows decrease (trending toward zero) in decline

9. BUSINESS DECISIONS AND CASH FLOWS (CONT.) Financing activities Financing activities Inflows during emergence and growth Inflows during emergence and growth Outflows during late maturity and decline (i.e., the return of investment) Outflows during late maturity and decline (i.e., the return of investment) Investing activities Investing activities Outflows during emergence and early growth Outflows during emergence and early growth Inflows during late maturity Inflows during late maturity Decreasing cash inflows during business decline Decreasing cash inflows during business decline

10. CASH FLOWS FROM OPERATING ACTIVITIES The most important part of cash flow statement The most important part of cash flow statement Reports the difference between cash received and paid for conducting core business activities Reports the difference between cash received and paid for conducting core business activities Less subjective than accrual-based disclosures Less subjective than accrual-based disclosures Analyst must determine the sustainability of operating cash flows Analyst must determine the sustainability of operating cash flows

11. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.) Direct method Direct method The superior method of reporting The superior method of reporting Reports cash collected from revenues and cash paid for operating expenses Reports cash collected from revenues and cash paid for operating expenses Easy for financial statement users to understand Easy for financial statement users to understand Companies do not disclose CFOs on a direct basis Companies do not disclose CFOs on a direct basis

12. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.) Indirect method Indirect method The inferior method of reporting The inferior method of reporting Reconciles net income to operating cash flows Reconciles net income to operating cash flows Hard for financial statement users to understand Hard for financial statement users to understand Companies disclose CFOs on an indirect basis Companies disclose CFOs on an indirect basis

13. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.) Converting indirect operating cash flows to direct operating cash flows Converting indirect operating cash flows to direct operating cash flows Procedure for producing direct CFOs from the indirect ones reported by companies Procedure for producing direct CFOs from the indirect ones reported by companies An analyst lists each revenue and operating expense category An analyst lists each revenue and operating expense category Each income statement account is adjusted for changes in balance sheet accounts (e.g., accounts receivable changes affect cash collected from sales) Each income statement account is adjusted for changes in balance sheet accounts (e.g., accounts receivable changes affect cash collected from sales)

14. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.) Converting indirect operating cash flows to direct operating cash flows (cont.) Converting indirect operating cash flows to direct operating cash flows (cont.) Certain operating expense categories are adjusted for non-cash expenses (e.g., deprecation) Certain operating expense categories are adjusted for non-cash expenses (e.g., deprecation) Cash collected from sales minus cash paid for each expense category determines direct cash flows Cash collected from sales minus cash paid for each expense category determines direct cash flows

15. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.) Direct CFOs are more informative than indirect CFOs Direct CFOs are more informative than indirect CFOs Analyst can directly see how much cash was received from continual activities in a reporting period Analyst can directly see how much cash was received from continual activities in a reporting period Analyst can directly see how much cash was paid for continual activities in a reporting period Analyst can directly see how much cash was paid for continual activities in a reporting period

16. eSTUFF’S DIRECT CASH FLOWS

18. eSTUFF’S CFO RECONCILIATION

19. CASH FLOWS FROM OPERATING ACTIVITIES (CONT.) Drawbacks of direct CFOs Drawbacks of direct CFOs Conversion process takes time Conversion process takes time Judgment is often required in classifying and adjusting accounts Judgment is often required in classifying and adjusting accounts

20. INTERPRETING CFOs Analysts judge how well an entity performs its core business activities Analysts judge how well an entity performs its core business activities Cash flows from operating activities provide numerous insights Cash flows from operating activities provide numerous insights The focal point is operating cycle activity The focal point is operating cycle activity Cash collected on sales Cash collected on sales Cash paid for inventory Cash paid for inventory

21. INTERPRETING CFOs (CONT.) Operating cycle cash flows are classified in three categories (Exhibit 10-4) Operating cycle cash flows are classified in three categories (Exhibit 10-4) Stable operations Stable operations Cash collected from customers as a percentage of sales remains constant over time Cash collected from customers as a percentage of sales remains constant over time Cash paid to vendors as a percentage of cost of goods sold remains constant over time Cash paid to vendors as a percentage of cost of goods sold remains constant over time

22. INTERPRETING CFOs (CONT.) Efficient operations Efficient operations Cash collected from customers as a percentage of sales increases over time Cash collected from customers as a percentage of sales increases over time Cash paid to vendors as a percentage of cost of goods sold decreases over time Cash paid to vendors as a percentage of cost of goods sold decreases over time Inefficient operations Inefficient operations Cash collected from customers as a percentage of sales decreases over time Cash collected from customers as a percentage of sales decreases over time Cash paid to vendors as a percentage of cost of goods increases over time Cash paid to vendors as a percentage of cost of goods increases over time

23. INTERPRETING CFOs (CONT.) Operating cash flow and trends Operating cash flow and trends Trend data increases insights about operating cycle cash flows (Exhibit 10-5) Trend data increases insights about operating cycle cash flows (Exhibit 10-5) Trends are sometimes difficult to deduce for existing companies Trends are sometimes difficult to deduce for existing companies

24. INTERPRETING CFOs (CONT.) Relationships between operating cycle cash flow and short-term liquidity measures (Exhibit 10-6) Relationships between operating cycle cash flow and short-term liquidity measures (Exhibit 10-6) Reports the direction of change (increase or decrease) for Reports the direction of change (increase or decrease) for Inventory activity measures Inventory activity measures Accounts receivable activity measures Accounts receivable activity measures Accounts payable activity measures Accounts payable activity measures

25. INTERPRETING CFOs (CONT.) Changes in these activity measures can be applied to Changes in these activity measures can be applied to Stable operations Stable operations Efficient operations Efficient operations Inefficient operations Inefficient operations

26. INTERPRETING CFOs (CONT.) Forecasting operating cash flows Forecasting operating cash flows Uses operating cash flow history and trends to predict the future Uses operating cash flow history and trends to predict the future Incorporates short-term liquidity analysis into the assessment Incorporates short-term liquidity analysis into the assessment Knowledge of other areas of analysis (e.g., operating performance) assists in cash flow forecasts Knowledge of other areas of analysis (e.g., operating performance) assists in cash flow forecasts

27. APPLE COMPUTER AND THE PC INDUSTRY Company is in its late growth or early maturity life cycle stage Company is in its late growth or early maturity life cycle stage Focus of the operating cash flow analysis is on the cash provided by and used for making and selling PCs Focus of the operating cash flow analysis is on the cash provided by and used for making and selling PCs

28. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Industry cash flows Industry cash flows Industry demonstrated strong operating cash flows from 1993 to 1998 (Exhibit 10- 7A) Industry demonstrated strong operating cash flows from 1993 to 1998 (Exhibit 10- 7A) Industry’s cash flows were less than stable over time Industry’s cash flows were less than stable over time Compaq’s poor performance reduced operating and net cash flows in 1998 (Exhibit 10-7B) Compaq’s poor performance reduced operating and net cash flows in 1998 (Exhibit 10-7B)

30. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Apple Computer’s direct operating cash flows Apple Computer’s direct operating cash flows Apple’s indirect operating cash flows were converted to a direct basis to improve interpretation (Exhibit 10-8) Apple’s indirect operating cash flows were converted to a direct basis to improve interpretation (Exhibit 10-8) The company reported positive CFOs during the period analyzed The company reported positive CFOs during the period analyzed

31. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Cash flows were positive because of Apple’s Cash flows were positive because of Apple’s Return to profitability Return to profitability Continued reductions of inventory Continued reductions of inventory Favorable changes in the account balances of current assets and restructuring costs Favorable changes in the account balances of current assets and restructuring costs

32. APPLE COMPUTER AND THE PC INDUSTRY(CONT.) Operating cycle cash flows Operating cycle cash flows Industry data was analyzed from 1994 to 1998 (Exhibit 10-9) Industry data was analyzed from 1994 to 1998 (Exhibit 10-9) Dell and Gateway demonstrated stable operating cash flows during that time period Dell and Gateway demonstrated stable operating cash flows during that time period Apple and Compaq’s collection on sales and payments to vendors were erratic Apple and Compaq’s collection on sales and payments to vendors were erratic Compaq’s paid a higher percentage on its cost of goods sold than it collected on its sales Compaq’s paid a higher percentage on its cost of goods sold than it collected on its sales Apple collected more than 100% of revenues in cash (a trend that cannot continue) Apple collected more than 100% of revenues in cash (a trend that cannot continue)

35. APPLE COMPUTER AND THE PC INDUSTRY(CONT.) Operating cash flow data support the analysis of short-term liquidity Operating cash flow data support the analysis of short-term liquidity Dell and Gateway are more liquid than Apple and Compaq Dell and Gateway are more liquid than Apple and Compaq Dell’s and Gateway’s operations are more stable than those of Apple and Compaq Dell’s and Gateway’s operations are more stable than those of Apple and Compaq Apple’s inability to sell computers profitability results in its lagging the industry Apple’s inability to sell computers profitability results in its lagging the industry