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CASH FLOW ANALYSIS

Learning Objectives explain the meaning, usefulness and purpose of cash flow statement

identify cash flow from three different activities


understand two different methods of preparing cash flow statement understand free cash flow study various types of cash flow ratios test solvency by calculating cash flow ratios
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CASH FLOW ANALYSIS

The income statement is based on the accrual method, and net income may not represent cash generated from operations.

Net income, based on accrual accounting, is not the same thing as cash earnings.

When the timing of revenue or expense recognition differs from the receipt or payment of cash, it is reflected in changes in balance sheet accounts.
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A company may be generating positive and growing net income but .

may be headed for insolvency because insufficient cash is being generated from operating activities.
Therefore constructing a statement of cash flows is very important in an analysis of a firms activities and its prospects.
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THE CASH FLOW STATEMENT

The cash flow statement provides information about.a companys cash receipts and cash payments during an accounting period.
showing how these cash flows link the ending cash balance to the beginning balance shown on the company s balance sheet.

The cash flow statement reconciles the beginning and ending balances of cash over an accounting period. The change in cash is a result of the firms operating, investing, and financing activities.
+ + + = + Operating Activities Investing Activities Financing Activities Change in cash balance Beginning Cash Balance Ending Cash Balance.

The cash flow statement provides information beyond that available from the income statement, which is based on accrual, rather than cash accounting.

The cash flow statement provides the following.


provide information on cash inflows, outflows for a period. Information about a companys cash receipts and cash payments during an accounting period.
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Information about a companys investing and financing activities.

operating,

An understanding of the impact of accrual accounting events on cash flows. provides information to assess the firms liquidity, solvency, and financial flexibility.

An analyst can use the statement of cash flows to determine whether; Regular operation generate enough cash to sustain the business Enough cash is generated to pay off existing debts as they mature.

The firm is likely to need additional financing


Unexpected obligations can be met.

The firm can take advantage of new business opportunities as they arise.
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A firms cash receipts and cash payments are classified on the cash flow statement as operating, investing, or financing activities. Cash flow from operating activities

Cash flow from financing activities


Cash flow from investing activities
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CASH FLOW FROM OPERATING ACTIVITIES Sometimes it is referred to as cash flow from operations/operating cash flow.

Operating activities include the companys day-to-day activities that create revenues, such as selling inventory and providing services.
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Cash inflows result from cash sales and from collection of accounts receivable. Examples.. cash receipts from the provision of services and royalties, commissions, and other revenue. To generate revenue, companies undertake activities such as manufacturing inventory, purchasing inventory from suppliers, and paying employees.
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Cash outflows result payments

from

cash

for inventory, salaries, taxes, and other operatingrelated expenses and from paying accounts payable.

Additionally, operating activities include cash receipts and payments related to securities held for dealing or trading purposes (as opposed to being held for investment).
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CASH FLOW FROM INVESTING ACTIVITES

Investing activities include purchasing and selling investments. . Investments include property, plant, equipment; other long-term assets; and and

both long-term and short-term investments in the equity and debt (bonds and loans) issued by other companies.

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Cash inflows in the investing category include. cash receipts from the sale of non-trading securities; property, plant, and equipment; or other long-term assets. Cash outflows include cash payments for the purchase of these assets.

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CASH FLOW FROM FINANCING ACTIVITIES Financing activities include obtaining or repaying capital, such as equity and long-term debt. Cash inflows in this category include.

cash receipts from issuing stock (common or preferred) or bonds and cash receipts from borrowing.

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Cash outflows include

cash payments to repurchase stock (e.g., treasury stock), to pay dividends, and
to repay bonds and other borrowings. Note that indirect borrowing using accounts payable is not considered a financing activitysuch borrowing would be classified as an operating activity.
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NON CASH INVESTING/FINANCING ACTIVITIES These activities are not reported in the cash flow statement since they do not result in flows or outflows of cash. These are significant investing and financing activities that do not directly affect cash. These activities involve only on long-term assets, long-term liabilities and stock holders equity.
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These transactions must be disclosed in either footnote or supplement schedule to the cash flow statement. Analyst should incorporate these transactions into analysis of past and current performance, and include their effects in estimating future cash flows.
EXAMPLE: Issuance of common stock to retire long-term debt Purchase of equipment with a note payable Issuance of stock to acquire land
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MAJOR SOURCES AND USES OF CASH

Cash flow analysis begins with an evaluation of the firms sources and uses of cash from operating, investing, and financing activities.
Sources and uses of cash change as the firm moves through its life cycle.

For example: In the early stage of growth Experience negative operating cash flow
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Negative operating cash flow usually financed externally by issuing debt or equity securities Over the long term firm must be able to generate operating cash flows that exceed capital expenditure and provide a return to debt and equity holders.

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CASH FLOWS FROM INVESTING ACTIVITIES


Cash flows are related to an entitys life cycle stage
Significant cash outflows in the emerging and growth stages of business They become positive and peak during business maturity CFIs trend toward zero as a firm declines and ceases operations
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CASH FLOWS FROM FINANCING ACTIVITIES


CFFs are related to an entitys life cycle stage
Significant cash inflows in the emerging and growth stages of business They decline during business maturity CFFs negative as a firm declines and ceases operations (return of investment)
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OPERATING CASH FLOW & ANALYST An analyst should identify the major determinants of operating cash flow.

Positive operating cash flow can be generated by the firms earnings related activities.
Positive operating cash flow can also be generated by decreasing non-cash working capital, such as liquidating inventory and receivables or increasing payables.
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Operating cash flow also provides a check of the quality of a firms earnings. A stable relationship of operating cash flow and net income is an indication of quality earnings Earnings that significantly exceed operating cash flow may be an indication of aggressive accounting choices. Ex: recognizing revenues too soon or delaying the recognition of expenses.

The variability of net income and operating cash flow should also be considered.
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INVESTING CASH FLOW

The sources and uses of cash from investing activities should be examined. A firm may reduce capital expenditure or sell capital assets in order to save or generate cash.
Increasing capital expenditure is usually an indication of growth. Generating operating cash flow that exceeds capital expenditures is a desirable trait.
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FINANCING CASH FLOW This cash flow reveals information about whether the firm is generating cash flow by issuing debt or equity. This also provides information about whether the firm is using cash to repay debts, re acquire stock or pay dividends.

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LINKAGES OF THE CASH FLOW STATEMENT WITH THE INCOME STATEMENT AND BALANCE SHEET
Cash is an asset. The statement of cash flows ultimately shows the change in cash during an accounting period.

The beginning and ending balances of cash are shown on the companys balance sheets for the previous and current years,
and the bottom of the cash flow statement reconciles beginning cash with ending cash.
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Beginning Balance + Beginning cash Cash receipts (from operating, investing, and financing activities)

Ending Balance Cash payments Ending cash (for operating, investing, and financing activities)

The beginning and ending balance sheet values of cash and cash equivalents are linked through the cash flow statement.
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Retained Earnings
Beginning Balance + Beginning retained Net income or minus Dividends net loss from the earnings income statement for year Ending Balance Ending retained earnings

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A companys operating activities are reported on an accrual basis in the income statement..
Any differences between the accrual basis and the cash basis of accounting for an operating transaction result in an increase or decrease in some (usually) short-term asset or liability on the balance sheet.

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For example if revenue reported using accrual accounting is higher than the cash actually collected, the result will be an increase in accounts receivable. If expenses reported using accrual accounting are lower than cash actually paid, the result will be a decrease in accounts payable

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A companys investing activities typically relate to the long-term asset section of the balance sheet, and

its financing activities typically relate to the equity and long-term debt sections of the balance sheet.
Each item on the balance sheet is also related to the income statement and/or cash flow statement through the change in the beginning and ending balance.
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Beginning Balance + Ending Balance Beginning Accounts Income Statement Cash Collected from Ending Accounts Revenue Receivables Customers Receivable

Knowing any three of these four items makes it easy to compute the fourth.

Understanding these interrelationships between the balance sheet, income statement, and cash flow statement is useful in not only understanding the companys financial health but also in detecting accounting irregularities.
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METHODS OF PRESENTING CASH FLOW STATEMENT There are two acceptable formats for reporting cash flow from operations.

1.Direct method 2.Indirect method

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The amount of operating cash flow is identical under both methods; only the presentation format of the operating cash flow section differs.

The presentation format of the cash flows from investing and financing is exactly the same, regardless of which method is used to present operating cash flows.
The difference in the methods relates to the presentation of cash flow from operating activities.
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DIRECT METHOD This method converts an accrual basis income statement into cash-basis income statement. That is, the direct method reports gross cash receipts and cash disbursements related to operations.

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DIRECT METHODCont/.

Creditors preferred the direct method. The direct method reports total amounts of cash flowing in and out of a company from operating activities. This offers most analysts a better format to readily assess the amount of cash inflows and outflow.
When companies report using the direct method, they must disclose a reconciliation of net income to cash flows from operations (the indirect method) in a separate schedule
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INDIRECT METHOD
Under this method net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions.

These adjustments includes


Eliminating non-cash expenses [depreciation/amortization] Non-operating items [gain/losses] Changes in balance sheet accounts [resulting from accrual accounting events]

Total cash flow from operating activities is exactly the same under both methods, only the presentation method is different.
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Statement of Cash Flows


Indirect method

Consider first the net cash from operations.

Statement of Cash Flows


Preparation of the Statement of Cash Flows

Depreciation and amortization add-back.

Statement of Cash Flows


Preparation of the Statement of Cash Flows

Adjustments for changes in balance sheet accounts can be summarized as follows:

STEPS IN PREPARING THE CASH FLOW STATEMENT

The preparation of the cash flow statement uses data from both the income statement and the comparative balance sheets. As noted earlier, companies often only disclose indirect operating cash flow information, whereas analysts prefer direct-format information.
Operating Activities: Direct Method Investing Activities: Direct Method Financing Activities: Direct Method
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OPERATING ACTIVITIES: DIRECT METHOD First determine how much cash received from its customers

how much cash was paid to suppliers and to employees as well as how much cash was paid for other operating expenses, interest, and income taxes.

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Cash Received from Customers To determine the cash receipts from its customers, it is necessary to adjust this revenue amount by the net change in accounts receivable for the year.

If accounts receivable increase during the year, revenue on an accrual basis is higher than cash receipts from customers, and vice versa.
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Revenue Less: Increase in accounts receivable Cash received from customers

$23,598 (55) $23,543

Cash received from customers affects the accounts receivable account as follows:
Beginning accounts receivable Plus revenue Minus cash collected from customers Ending accounts receivable $957 23,598 (23,543) $1,012

The accounts receivable account information can also be presented as follows:


Beginning accounts receivable Plus revenue Minus ending accounts receivable Cash collected from customers $957 23,598 (1,012) $23,543

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Cash Paid to Suppliers


To determine purchases from suppliers, cost of goods sold is adjusted for the change in inventory. If inventory increased during the year, then purchases during the year exceeded cost of goods sold, and vice versa. If accounts payable increased during the year, then purchases on an accrual basis are higher than they are on a cash basis, and vice versa.

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Cost of goods sold Plus: Increase in inventory Equals purchases from suppliers

$11,456 707 $12,163

Less: Increase in accounts payable Cash paid to suppliers

(263) $11,900

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Once purchases have been determined, cash paid to suppliers can be calculated by adjusting purchases for the change in accounts payable.

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Purchases from suppliers affect the inventory account, as shown below


Beginning inventory Plus purchases Minus cost of goods sold Ending inventory $3,277 12,163 (11,456) $3,984

The cash paid to suppliers was $11,900, determined as follows:

Purchases from suppliers


Less: Increase in accounts payable Cash paid to suppliers

$12,163
(263) $11,900
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Cash Paid to Employees To determine the cash paid to employees, it is necessary to adjust salary and wage expense by the net change in salary and wage payable for the year. If salary and wage payable increased during the year, then salary and wage expense on an accrual basis is higher than the amount of cash paid for this expense, and vice versa.
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Salary and wage expense $4,123 Less: Increase in salary and wage payable (10) Cash paid to employees $4,113

The amount of cash paid to employees is reflected in the salary and wage payable account, as shown below:
Beginning salary and wages payable Plus salary and wage expense Minus cash paid to employees Ending salary and wages payable $75 4,123 (4,113) $85

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Cash Paid for Other Operating Expenses

To determine the cash paid for other operating expenses, it is necessary to adjust the other operating expenses amount on the income statement by the net changes in prepaid expenses and accrued expense liabilities for the year.
If prepaid expenses increased during the year, other operating expenses on a cash basis were higher than on an accrual basis, and vice versa. Likewise, if accrued expense liabilities increased during the year, other operating expenses on a cash basis were lower than on an accrual basis, and vice versa.
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Cash Paid for Other Operating Expenses.

Other operating expenses

$3,577

Less: Decrease in prepaid expenses (23) Less: Increase in other accrued liabilities Cash paid for other operating expenses (22) $3,532

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Cash Paid for Interest. To determine the cash paid for interest, it is necessary to adjust interest expense by the net change in interest payable for the year. If interest payable increases during the year, then interest expense on an accrual basis is higher than the amount of cash paid for interest, and vice versa.

Interest expense

$246

Plus: Decrease in interest payable


Cash paid for interest

12
$258
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Alternatively, cash paid for interest may also be determined by an analysis of the interest payable account, as shown below:

Beginning interest payable Plus interest expense Minus cash paid for interest Ending interest payable

$74 246 (258) $62

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Cash Paid for Income Taxes. To determine the cash paid for income taxes, it is necessary to adjust the income tax expense amount on the income statement by the net changes in taxes receivable, taxes payable, and deferred income taxes for the year. If taxes receivable or deferred tax assets increase during the year, income taxes on a cash basis will be higher than on an accrual basis, and vice versa. Likewise, if taxes payable or deferred tax liabilities increase during the year, income tax expense on a cash basis will be lower than on an accrual basis, and vice versa.
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Cash Paid for Income Taxes.


Income tax expense Less: Increase in income tax payable Cash paid for income taxes $1,139 (5) $1,134

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INVESTING ACTIVITIES: DIRECT METHOD*** The second and third steps in preparing the cash flow statement are to determine the total cash flows from investing activities and from financing activities. The presentation of this information is identical, regardless of whether the direct or indirect method is used for operating cash flows. Investing cash flows are always presented using the direct method.

FINANCING ACTIVITIES: DIRECT METHOD***

As with investing activities, financing activities are always presented using the direct method
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Total Liabilities = Total liabilities - Par value of preferred stock The higher ratio indicates that the company has lost some ground with respect to covering all its debts with net tangible assets.

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COMMON SIZE CASH FLOW STATEMENT In common-size analysis of a companys income statement, each income and expense line item is expressed as a percentage of net revenues (net sales). For the common-size balance sheet, each asset, liability, and equity line item is expressed as a percentage of total assets.

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For the common-size cash flow statement, there are two alternative approaches. The first approach is to express each line item of cash inflow (outflow) as a percentage of total inflows (outflows) of cash. second approach is to express each line item as a percentage of net revenue.

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FREE CASH FLOW The excess of operating cash flow over capital expenditures is known generically as free cash flow. For purposes of valuing a company or its equity securities, an analyst may want to determine a more precise free cash flow measure. Methods of Measure of Free cash flow

1. free cash flow to the firm (FCFF) 2. free cash flow to equity (FCFE).
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FREE CASH FLOW TO THE FIRM Free cash flow to the firm [FCFF] is the cash available to all investors, both equity owners and debt holders. FCFF can be calculated by starting with either net income or operating cash flow.

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FREE CASH FLOW TO EQUITY Free cash flow to equity [FCFE] is the cash flow that would be available for distribution to common shareholders.

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CASH FLOW RATIOS The cash flow statement can be analysed by comparing the cash flows either over time or to those of other firms. profits are very important for a company. companies that appear very profitable can actually be at a financial risk if they are generating little cash from these profits For example, if a company makes a ton of sales on credit, they will look profitable but haven't actually received cash for the sales, which can hurt their financial health since they have obligations to pay. Cash flow ratios can be categorized Performance ratio Coverage ratio

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Performance ratio Cash flow-to-revenue Cash return-on-asset ratio Cash return-on-equity ratio Cash flow per share

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Cash flow-to-revenue

The cash flow-to-revenue ratio, also known as the operating cash flow-to-sales ratio or the cash flowto-sales ratio, is the ratio of operating cash flow to revenue.
It indicates management's ability to turn revenue into profits and net cash flow.

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Management, investors and other stakeholders can use the cash flow-to-revenue ratio to evaluate the effectiveness of internal cost controls. A high ratio usually means the company is able to turn a higher percentage of its revenue into profits and net cash flow.

A flat or increasing trend line is generally an indication of consistent sales growth and effective expense management.
Poor receivables collection and higher expenses are some of the reasons for a declining trend line.
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Operating cash flow depends on net income, which is revenue minus expenses. Therefore, if a company generates higher revenue, it must keep expenses steady relative to revenue to drive operating cash flow and the cash flow-to-revenue ratio higher. If revenue declines, the company must make a corresponding reduction in expenses to maintain the same cash flow-to-revenue ratio.

Other strategies to increase the ratio include using credit instead of cash for purchases, tightening credit requirements and following up on overdue accounts.
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Cash return-on-asset ratio


cash return on assets is designed to measure managements success in making operating decisions

Cash return on assets measures managements success in generating cash from operating activities.
Because CFO is available to pay dividends and to finance investments, a high ratio is desirable.

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This ratio used to compare a businesses performance among other industry members. The ratio can be used internally by the company's analysts, or by potential and current investors. When a high cash return on assets ratio is listed, it can indicate to investors that a higher return is anticipated. This is due to the theory that the higher the ratio, the more cash the company has made available for reinvestment in the company either through replacements.
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Cash Return On Equity Ratio The cash return on equity ratio is the ratio of cash flow from operations to average shareholders' equity. This ratio measures the amount of cash generated from operations per one dollar of average shareholders' equity.

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Cash flow per share A measure of a firm's financial strength Many analysts and investors place more weight on cash flow per share than earnings per share. Because EPS is more easily manipulated, its reliability can at times be questionable. Cash, on the other hand, is difficult to fake. Therefore, cash flow per share is a useful measure for the strength of a firm and the sustainability of its business model.
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Cash flow per share...........................

cash flow per share takes into consideration a company's ability to generate cash.
it is regarded by some analysts as a more accurate measure of a company's financial situation than the earnings per share metric.

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