Cash Flow Analysis

Traditional SCF Life-Cycle Phases

Each cash flow activity will increase or decease over time depending upon the life-cycle of the companys products. Here is the most common pattern for revenues, net income, and cash flows.

Analyzing Cash Flow Information

Cash flow analysis can be used to address a variety of questions regarding a firm's cash flow dynamics: How strong is the firm's internal cash flow generation?

Is the cash flow from operations positive or negative? If it is negative, why? Is it because the company is growing? Is it because its operations are unprofitable? Or is it having difficulty managing its working capital properly?

Does the company have the ability to meet its short-term financial obligations, such as interest payments, from its operating cash flow?

Can it continue to meet these obligations without reducing its operating flexibility?

Analyzing Cash Flow Information

How much cash did the company invest in growth?

Are these investments consistent with its business strategy? Did the company use internal cash flow to finance growth, or did it rely on external financing?

Did the company pay dividends from internal free cash flow, or did it have to rely on external financing?

If the company had to fund its dividends from external sources, is the company's dividend policy sustainable?
Equity, short-term debt, or long-term debt? Is the financing consistent with the company's overall business risk?

What type of external financing does the company rely on?

Does the company have excess cash flow after making capital investments?

Is it a long-term trend? What plans does management have to deploy the free cash flow?

Recasting the SCF

Although it is possible to answer these questions using the GAAP SCF format, recasting the SCF makes answering these questions easier. In addition, using a standard format makes comparison between companies easier. Here is the model that we will use in this class.

Traditional SCF Format

Recast SCF Format

Net Income + Depreciation and Amortization Deferred Taxes Gains/Losses Changes in Working Capital = Cash Flow from Operating Activities
- Purchases of Long Term Assets + Sales of Long Term Assets = Cash Flow from Investing Activities + Sale of Stock + New Borrowing - Debt Payments - Dividends - Stock Repurchases = Cash Flow from Financing Activities Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities = Net Change in Cash

Net Income + Interest Expense (Net of Tax) + Depreciation and Amortization Deferred Taxes Gains/Losses = OCF before Working Capital Investments Changes in Working Capital = OCF before Investment in Long Term Assets - Purchases of Long Term Assets + Sales of Long Term Assets = FCF Available to Debt and Equity - Interest Expense (Net of Tax) - Debt Payments + New Borrowing = FCF Available to Equity + Sale of Stock - Dividends - Stock Repurchases = Net Change in Cash
OCF = Operating Cash Flow FCF = Free Cash Flow

Operating Cash Flow

Operating Cash Flow is broken up into two components, OCF before working capital investments and OCF before investments in long term assets. Over the long run OCF must be positive, but firms in the early stages of development, growing rapidly, or investing heavily in research and development, marketing and advertising, and other future growth opportunities will have negative OCF.

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 longterm growth opportunities and must rely on external financing. 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.

Free Cash Flow

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. They can also reduce their investments in working capital, long term investments, or issue additional equity.

Free Cash Flow

Cash flow after payments to creditors is free cash flow available to owners. 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.

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 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.

Summary

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

Analyzing Quality of Income

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

Analyzing Quality of Income

If there are significant differences between net income and operating cash flow ask the following questions:
What are the sources of the difference? Is it due to accounting policy? Is it due to one-time events or on-going activities?

Is the relationship changing over time?

If so, why? (see above for possible reasons). Is it because of changes in business conditions or accounting policies and estimates?

Analyzing Quality of Income

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.)

Are the changes in working capital accounts normal?

If not, is there an adequate explanation for the changes?