1. Free cash flow Cash Flow Analysis

2. Free Cash Flow If cash flow after investing in long term assets is not positive then the firm did not generate enough cash from operations to pursue long- term growth opportunities and must rely on external financing. If cash flow after investing in long term assets is not positive then the firm did not generate enough cash from operations to pursue long- term growth opportunities and must rely on external financing. These firms have less flexibility than firms that can generate the necessary funds internally. These firms have less flexibility than firms that can generate the necessary funds internally. Cash flow after long term investments is cash flow available to both debt and equity holders. Cash flow after long term investments is cash flow available to both debt and equity holders.

3. Free Cash Flow Payments to debt holders include interest and principal payments. Payments to debt holders include interest and principal payments. Firms with negative free cash flow after investments in long term assets must borrow additional funds to meet their interest and principal payments. Firms with negative free cash flow after investments in long term assets must borrow additional funds to meet their interest and principal payments. They can also reduce their investments in working capital, long term investments, or issue additional equity. They can also reduce their investments in working capital, long term investments, or issue additional equity.

4. Free Cash Flow Cash flow after payments to creditors is free cash flow available to owners. Cash flow after payments to creditors is free cash flow available to owners. Payments to equity holders include dividends and stock repurchases. Payments to equity holders include dividends and stock repurchases. If firms pay dividends despite negative cash flows available to equity holders then they are borrowing to pay dividends. This is not sustainable in the long term. If firms pay dividends despite negative cash flows available to equity holders then they are borrowing to pay dividends. This is not sustainable in the long term.

5. Summary Examine cash flow from operations before investment in working capital to verify the company is able to generate a cash surplus from its operations. Examine cash flow from operations before investment in working capital to verify the company is able to generate a cash surplus from its operations. Examine cash flow from operations before investment in long term assets to how the firms working capital is being managed and to see if the company can invest in long-term assets for future growth. Examine cash flow from operations before investment in long term assets to how the firms working capital is being managed and to see if the company can invest in long-term assets for future growth.

6. Summary Examine free cash flow to debt and equity holders to asses a firm’s ability to meet its principal and interest payments. Examine free cash flow to debt and equity holders to asses a firm’s ability to meet its principal and interest payments. Examine free cash flow to equity holders to asses a firm’s ability to sustain its dividend policy. Examine free cash flow to equity holders to asses a firm’s ability to sustain its dividend policy. All cash flow analysis must be done taking into consideration the company’s business, its growth strategy, and its financial policies. All cash flow analysis must be done taking into consideration the company’s business, its growth strategy, and its financial policies.

7. Analyzing Quality of Income The Quality of Income Ratio is calculated as The Quality of Income Ratio is calculated as Cash Flow from Operations Cash Flow from Operations Net Income Net IncomeOR Cash Flow from Operations Cash Flow from Operations Net Income + Depreciation Net Income + Depreciation This ratio should be > 1 for a healthy firm. This ratio should be > 1 for a healthy firm.

8. Analyzing Quality of Income If there are significant differences between net income and operating cash flow ask the following questions: If there are significant differences between net income and operating cash flow ask the following questions: What are the sources of the difference? What are the sources of the difference? Is it due to accounting policy? Is it due to accounting policy? Is it due to one-time events or on-going activities? Is it due to one-time events or on-going activities? Is the relationship changing over time? Is the relationship changing over time? If so, why? (see above for possible reasons). If so, why? (see above for possible reasons). Is it because of changes in business conditions or accounting policies and estimates? Is it because of changes in business conditions or accounting policies and estimates?

9. Analyzing Quality of Income What is the time lag between recognition of revenues and expenses and the receipt or payment of cash? What is the time lag between recognition of revenues and expenses and the receipt or payment of cash? What uncertainties are there regarding cash collection or cash payments (e.g. bad debts, contingent liabilities, etc.) What uncertainties are there regarding cash collection or cash payments (e.g. bad debts, contingent liabilities, etc.) Are the changes in working capital accounts normal? Are the changes in working capital accounts normal? If not, is there an adequate explanation for the changes? If not, is there an adequate explanation for the changes?