Solution

CASE 3-1 Cash Flow Analysis Orthodontic Centers of America

1. Actual cash collection for year 1998 to 2000:

2000 3.535.000 (84.028.000) 268.836.000 84.028.000 352.864.000 1999 87.563.000 21.086.000 (4.326.000) 226.290.000 (21.086.000) (4.326.000) 200.878.000 1998 66.477.000 66.477.000 4.326.000 4.326.000 171.298.000 (66.477.000) 4.326.000 109.147.000

Total Receivables net change Patient prepayments net change Net Revenue Less: change in account receivable Plus: change in advances Actual Cash Collections

2. (i) Comparison of cash collection with revenue reported for each year:
2000 352.864.000 268.836.000 31,26% 84.028.000 1999 200.878.000 226.290.000 -11,23% (25.412.000) 1998 109.147.000 171.298.000 -36,28% (62.151.000)

Cash Collections Reported Revenue % Change Difference

(ii) Comparison of cash collection with revenue using pre-Januay 1, 2000 recognition method:
2000 Cash Collections Revenue recognition pre-Jan1, 2000 method % Change Difference 352.864.000 295.136.000 20% 57.728.000 1999 200.878.000 249.081.576 -19% (48.203.576) 1998 109.147.000 189.915.926 -43% (80.768.926)

(iii) Comparison of cash collection with revenue using post-Januay 1, 2000 recognition method with adjustment on reported 1998 and 1999 revenue, using pro-forma earnings and assumption 35% tax rate:
2000 Cash Collections Revenue recognition postJan1, 2000 method % Change Difference 352.864.000 242.536.000 45,49% 110.328.000 1999 200.878.000 201.302.308 -0,21% (424.308) 1998 109.147.000 151.002.769 -27,72% (41.855.769)

3. From tax perspective, revenue recognition post-January 1, 2000 method is appropriate as it results in a lower net revenue and thus lowering the tax expense. And a straight line allocation method is better represent the actual revenue recognized at the time the contract is signed. 4. The trends of cash from operations, cash for investing, free cash flows, and cash from financing: Free Cash Flow used here is FCF to Equity
2000 Cash Flow from Operating activities Less: Net Investment in Fixed Capital Less: Debt Repayment Free Cash Flow to Equity 39.644.000 (20.271.000) (6.530.000) 12.843.000 1999 23.347.000 (22.520.000) (6.742.000) (5.915.000) 1998 22.109.000 (17.638.000) (7.864.000) (3.393.000)

Cash flow from operation is increasing with 34% growth and cash flow used in investing activities also increase due to the acquisition of new affiliated orthodontists and the purchase of property & equipment. However, free cash flow to equity is negative in 1998 and 1999 means that OCA does not have enough operating cash flow over amounts needed for investments and repayment of debt. Further, cash flow derived from financing activities decrease by -21% from 1998 to 2000.
2000 39.644.000 (48.533.000) 12.843.000 7.884.000 1999 23.347.000 (43.075.000) (5.915.000) 23.949.000 1998 Growth 22.109.000 34% (43.159.000) 6% (3.393.000) n/a 12.786.000 -21%

Cash From Operations Cash for Investing Free Cash flows Cash from Financing

5. The company acquires new affiliated orthodontists through a stock purchase, and entering into a Service Agreement with the orthodontist.
Transactions with Orthodontic Entities Notes payable issued Remainder (primarily cash) Share Value (at average cost) Total Acquisition Costs Common Stock Shares Issued $ $ $ $ Years Ended December 31 2000 1999 1.255.000 $ 3.600.000 $ 28.246.000 $ 17.190.000 $ 4.719.000 $ 910.000 $ 34.220.000 $ 21.700.000 $ 227.000 80.000

1998 8.700.000 43.994.000 4.206.000 56.900.000 253.000

(a) Since Notes payable issued and Share Value (at average cost) is a Noncash Investing And Financing Activities, the transactions do not affect OCAs cash from operation, cash for investing, and free cash flow. The transactions are reported separately in Supplemental Disclosure. However, the remainder of the total acquisition cost is allocated to an intangible asset acquired, which represents the costs of obtaining the Service Agreement, so that it affects OCAs cash for investing activities, but it does not affect free cash flow as it is not investment of fixed capital.

(b) The reporting of the cash flows associated with the acquisition of affiliated practices reported as an intangible asset, because the acquisition ussually in a form of a stock purchase or entering a service agreement. Or it can also be reported as acquisition of businesses but the acquired tangible asset is not part of fixed capital. While, the reporting of cash flows associated with newly developed practices deals with investing in fixed capital which ussually need expenditures for property and equipment. And this investment will affect the amount of free cash flow. 6. The effect of the companys treatment of the affiliated practice acquisition costs on the analysis of the companys cash flows is adding the investing activities in intangible assetss acquired that increases cash outflow used in investing activities . An alternative approach to cash flow analysis are: common size analysis which to express each line item as a percentage of net revenue; cash flow ratio with one of the ratio is cash flow from operation devided by cash outflows for investing and financing activities; then free cash flow to the firm.
2000 39.644.000 (20.271.000) 19.373.000 39.644.000 (48.533.000) 19.373.000 7.884.000 98% 1999 23.347.000 (22.520.000) 827.000 23.347.000 (43.087.000) 827.000 23.949.000 122% 1998 22.109.000 (17.638.000) 4.471.000 22.109.000 (44.937.000) 4.471.000 12.786.000 69% Growth 34% 4% 108% -21%

Cash Flow from Operating Less: Net Capital Expenditures Free Cash Flow Cash From Operations Cash for Investing (acquisition cost adjustment) Free Cash flows Cash from Financing Investing & Financing Ratio

Using this free cash flow approach results in a higher growth of free cash flow.