1. Statement of Cash Flows

2. FIN 591: Financial Fundamentals/Valuation2 EBITDA  Many people define cash flow as EBITDA –What is its relevance? –What is it missing? –Do it do a reasonably good job?  Why not use the statement of cash flows?

3. FIN 591: Financial Fundamentals/Valuation3 Importance of the Statement of Cash Flows  Combines balance sheet & income statement analysis  Eliminates differences in accounting  Directly assesses “quality of earnings” — or “How to go broke while making a profit...”  Components: –Operating activities (cash profits) –Investing activities –Financing activities.

4. FIN 591: Financial Fundamentals/Valuation4 Articulation of Financial Statements Revenues Expenses Net income Income Statement Investment anddisinvestment by owners Net income and other earnings Net change in owners’ equity Statement of Shareholders’ Equity Cash from operations Cash from investing Cash from financing Net change in cash Cash Flow Statement Cash + Other Assets Total Assets - Liabilities Owners’ equity Beginning Balance Sheet Cash + Other Assets Total Assets - Liabilities Owners’ equity Ending Balance Sheet

5. FIN 591: Financial Fundamentals/Valuation5 W. T. Grant  Accounting profits versus cash operating profits  Cash flow frequently defined as: Net income + depreciation »Poor definition.  Look at W. T. Grant’s trend...  And then at Salton…

6. FIN 591: Financial Fundamentals/Valuation6 What Happened to W. T. Grant?

7. FIN 591: Financial Fundamentals/Valuation7 What Happened to Salton?

8. FIN 591: Financial Fundamentals/Valuation8 Accounting Methods for Measuring Performance  Strict cash basis of accounting. –Revenues are recorded when cash is received and expenses are recorded when cash is paid  Accrual basis of accounting –Revenues and expenses are recorded on an economic basis independently of the actual flow of cash.

9. FIN 591: Financial Fundamentals/Valuation9 Cash vs. Accrual Accounting Cash Basis Accrual Basis Easy to understand. Theoretically difficult. Provides a reliable picture of the the change in cash and the firm’s liquidity. Provides a more reliable picture of the economic changes in wealth. Revenues and expenses are recorded according to cash inflows and outflows. Revenues and expenses are recorded according to economic change in wealth (the rules are discussed later on in this clinic). Can be manipulated by changing the cash flows timing. Can be manipulated by the changing the recognition rules.

10. FIN 591: Financial Fundamentals/Valuation10 Accrual Accounting: The Question  At what point of the operating cycle of the firm should revenues and their related expenses be recognized?

11. FIN 591: Financial Fundamentals/Valuation11 Accrual Accounting: Basic Rules  Revenue and expense should be recognized at the first point at which both of the following criteria are met: 1.Revenue is earned Revenue-producing activity has been performedRevenue-producing activity has been performed 2.Revenue is either realized or realizable Amount of cash to be collected can be estimated with reasonable accuracy.Amount of cash to be collected can be estimated with reasonable accuracy.

12. FIN 591: Financial Fundamentals/Valuation12 Revenue Recognition  For product sale transactions, revenue is typically recognized when when title passes to the customer  For service transactions, revenue is typically recognized when the substantial performance occurred – Because of the intangibility of services, it is often difficult to ascertain when a service consisting of more than a single act has been satisfactorily performed so as to warrant recognition of revenue.

13. FIN 591: Financial Fundamentals/Valuation13 Expense recognition  According to the matching principle, selecting a revenue-recognition basis also determines whether related costs are expensed immediately or capitalized and expensed subsequently  Generally, expenses and losses are recognized when an entity's economic benefits are used up in the process of generating revenues.

14. FIN 591: Financial Fundamentals/Valuation14 Earnings and Cash Flows  Rather than matching cash inflows and outflows, earnings match revenues and expenses Revenues = cash receipts + revenue accruals Expenses = cash disbursements – cash investments + expense accruals Earnings

15. FIN 591: Financial Fundamentals/Valuation15 Revenue and Expense Accruals Revenue Accruals Value added that is not cash flow Adjustments to cash inflows that are not value added Expense Accruals Value decreases that are not cash flow Adjustments to cash outflows that are not value decreases

16. FIN 591: Financial Fundamentals/Valuation16 The Revenue Calculation Revenue = Cash receipts from sales + New sales on credit + New sales on credit  Cash received for previous periods' sales  Cash received for previous periods' sales  Estimates of credit sales not collectible  Estimated sales returns and rebates  Deferred revenue for cash received in advance of sale + Revenue previously deferred.

17. FIN 591: Financial Fundamentals/Valuation17 The Expense Calculation Expense = Cash paid for expenses + Amounts incurred in generating revenue but not yet paid  Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period.

18. FIN 591: Financial Fundamentals/Valuation18 Rules for Identifying Cash Flows Assets increase Use Assets decrease Source Financing increases Source Financing decreases Use Balance Sheet Revenues = Source Expenses = Use

19. FIN 591: Financial Fundamentals/Valuation19 Sources = Uses  Construct two columns for balance sheet changes –Sources = decreases in assets & increases in financing –Uses = increases in assets & decreases in financing  Sources must equal uses  Construct the SCF.

20. FIN 591: Financial Fundamentals/Valuation20 Example: Construct a SCF Beginning Balance Sheet Cash 100 Payables 50 AR 150 Accruals 75 Invent 200 Equity 475 Fixed 150 Total 600 600 Income Statement Sales500 COS 300 Expenses (Deprec. = 5) 170 Profit 30 Ending Balance Sheet Cash 120 Payables 125 AR 100 Accruals 50 Invent 250 Equity 495 Fixed 200 Total 670 670 Statement of Cash Flows

21. FIN 591: Financial Fundamentals/Valuation21 Worksheet

22. FIN 591: Financial Fundamentals/Valuation22 On to Free Cash Flow  Definition of free cash flow: – After-tax operating earnings + non-cash charges - investments in operating working capital, PP&E and other assets. » It doesn’t incorporate financing related cash flows  Operating free cash flow = Cash flow to debt holders + cash flow to equity owners »In other words, the sum of operating flows = sum of financing flows.

23. FIN 591: Financial Fundamentals/Valuation23 Free Cash Flow  Normal approach is to use the SCF – Operating cash flows less investing activity  Problems: – Not all investments are necessary »Eliminate discretionary investments – Operating cash flows includes interest expense »Eliminate it and put in financing category – Operating cash flows exclude all cash »Add necessary transaction balances.

24. FIN 591: Financial Fundamentals/Valuation24 FCF Per the Valuation Text  FCF = NOPLAT - net operating investment  What is NOPLAT? – NOPLAT means “net operating profit less adjusted taxes” – See Exhibit 7.3 of Valuation text for an example – Comparable to EBIT * (1 -  ) »Tax expense adjusted Change in deferred taxes Change in deferred taxes Tax shield provided by interest expense & other non-operating expenses. Tax shield provided by interest expense & other non-operating expenses.

25. FIN 591: Financial Fundamentals/Valuation25 Questions Raised by the SCF...  How strong is internal cash flow generation?  Is cash flow from operations positive? Why? If negative, why?  Is the company growing? Too quickly?  Are operations profitable?  Are there problems managing working capital?

26. FIN 591: Financial Fundamentals/Valuation26 Questions...  Can the company meet short-term obligations from operating cash flows?  Can it continue to meet these obligations without reducing operating flexibility?  How much is invested in growth?  Are these investments consistent with the business strategy?  Was internal cash used to finance growth?

27. FIN 591: Financial Fundamentals/Valuation27 Questions...  Does free cash flow exist? Is this a long- term trend?  What plan does management have to deploy free cash flow?  Were dividends paid from free cash flow? Or was external financing used?  If external financing is used for dividends, is the dividend policy sustainable?

28. FIN 591: Financial Fundamentals/Valuation28 Questions...  What type of external financing does the company rely on? – Equity – Short-term debt – Long-term debt  Is the financing consistent with the company’s overall business risk?

29. FIN 591: Financial Fundamentals/Valuation29 Questions...  Are there significant differences between a firm’s net income and its operating cash flow?  Is it possible to identify the sources of this difference?  Which accounting policies contribute to it?  Do one-time events contribute to the difference?

30. FIN 591: Financial Fundamentals/Valuation30 Questions...  Is the relationship between operating cash flow and net income changing over time? Why?  Is it because of changes in business conditions or accounting policies and estimates?  What is the time lag between the recognition of revenue and expenses and the receipt and disbursement of cash flows?

31. FIN 591: Financial Fundamentals/Valuation31 Questions  Are the changes in receivables, inventories, and payables normal?  If not, is there adequate explanation for the changes?

32. FIN 591: Financial Fundamentals/Valuation32 The End