ADVANCED CASH FLOW ANALYSIS Chapter 11. CHAPTER 11 OBJECTIVES Explain the importance of investing and financing cash flows. Explain the importance of

ADVANCED CASH ADVANCED CASH FLOW ANALYSISFLOW ANALYSIS

Chapter 11Chapter 11

CHAPTER 11 OBJECTIVESCHAPTER 11 OBJECTIVES

Explain the importance of Explain the importance of investing and financing cash flows.investing and financing cash flows.

Relate cash flows from investing Relate cash flows from investing and financing activities to those and financing activities to those from operations.from operations.

Describe an entity’s need for Describe an entity’s need for sufficient and efficient cash flows.sufficient and efficient cash flows.

CHAPTER 11 OBJECTIVES CHAPTER 11 OBJECTIVES (CONT.)(CONT.)

List and compute measures of cash List and compute measures of cash sufficiency and efficiency.sufficiency and efficiency.

Provide an in-depth analysis of Provide an in-depth analysis of corporate and industry cash flows.corporate and industry cash flows.

CASH FLOWS FROM CASH FLOWS FROM INVESTING AND INVESTING AND FINANCING ACTIVITIESFINANCING ACTIVITIES

Cash flows from investing activities Cash flows from investing activities (CFIs)(CFIs)

Cash flows related to the acquisition Cash flows related to the acquisition and disposal of three types of wealth-and disposal of three types of wealth-building resourcesbuilding resources Property, plant, and equipmentProperty, plant, and equipment Intangible assetsIntangible assets Debt and equity securitiesDebt and equity securities

CASH FLOWS FROM CASH FLOWS FROM INVESTING AND INVESTING AND FINANCING ACTIVITIES FINANCING ACTIVITIES (CONT.)(CONT.)

Cash flows from investing activities Cash flows from investing activities (CFIs)(CFIs)

Reported after cash flows from Reported after cash flows from operating activities in a statement operating activities in a statement of cash flowsof cash flows

Analysts study CFIs to gain Analysts study CFIs to gain perspective about investments’ perspective about investments’ relative cost and benefitsrelative cost and benefits


Cash flows from investing activities (CFIs)Cash flows from investing activities (CFIs) Cash flows are related to an entity’s life Cash flows are related to an entity’s life

cycle stage cycle stage Significant cash outflows in the emerging and Significant cash outflows in the emerging and

growth stages of business growth stages of business They become positive and peak during They become positive and peak during

business maturitybusiness maturity CFIs trend toward zero as a firm declines and CFIs trend toward zero as a firm declines and

ceases operationsceases operations


Cash flows from financing activities (CFFs)Cash flows from financing activities (CFFs) Those types of cash flows related to the Those types of cash flows related to the

acquisition and disposal of external acquisition and disposal of external resources needed to acquire productive resources needed to acquire productive assetsassets Equity issues and their reacquisition (treasury Equity issues and their reacquisition (treasury

stock)stock) Equity returns on investments (cash Equity returns on investments (cash

dividends) dividends) Debt issues and retirementsDebt issues and retirements


Cash flows from financing activities Cash flows from financing activities (CFFs)(CFFs)

Reported as the final section in a Reported as the final section in a statement of cash flowsstatement of cash flows


CFFs are related to an entity’s life CFFs are related to an entity’s life cycle stage cycle stage Significant cash inflows in the emerging Significant cash inflows in the emerging

and growth stages of business and growth stages of business They decline during business maturityThey decline during business maturity CFFs negative as a firm declines and CFFs negative as a firm declines and

ceases operations (return ceases operations (return ofof investment)investment)


In addition to the cash flow In addition to the cash flow statement itself, information about statement itself, information about CFIs and CFFs can be found in CFIs and CFFs can be found in Management’s discussion and Management’s discussion and

analysisanalysis Disclosures about market riskDisclosures about market risk The financial media (pending debt The financial media (pending debt

and equity issues)and equity issues)


Correlation of CFIs and CFFsCorrelation of CFIs and CFFs Sometimes cash provided by a Sometimes cash provided by a

financing activity can be traced to the financing activity can be traced to the cash used for an investment (e.g., cash used for an investment (e.g., issuing a bond to acquire a building)issuing a bond to acquire a building)

Correlations between CFIs and CFFs Correlations between CFIs and CFFs become more obscure as a business become more obscure as a business maturesmatures

CASH FLOW MEASURESCASH FLOW MEASURES

ObjectivesObjectives A company must produce enough cash from A company must produce enough cash from

business operations to satisfy investorsbusiness operations to satisfy investors Measure the relationship between operating Measure the relationship between operating

cash flows and those from investing and cash flows and those from investing and financing activitiesfinancing activities

Determine if an enterprise produces enough Determine if an enterprise produces enough of the right kinds of cash flows to grow the of the right kinds of cash flows to grow the business business

CASH FLOW MEASURESCASH FLOW MEASURES(CONT.)(CONT.)

Primary cash sufficiency measuresPrimary cash sufficiency measures Provides evidence as to whether Provides evidence as to whether

an entity produces enough cash an entity produces enough cash from operations to meet its needsfrom operations to meet its needs

Cash flow adequacy is the primary Cash flow adequacy is the primary measure of cash sufficiency measure of cash sufficiency


Cash flow adequacy is computed as: cash Cash flow adequacy is computed as: cash flows from operations / (fixed assets flows from operations / (fixed assets purchased + long-term debt paid + cash purchased + long-term debt paid + cash dividends distributed)dividends distributed) General interpretation: a ratio of one or more General interpretation: a ratio of one or more

indicates an entity’s operations produce indicates an entity’s operations produce sufficient cash to meet necessary business sufficient cash to meet necessary business obligationsobligations

A ratio of less than one indicates potential A ratio of less than one indicates potential liquidity problemsliquidity problems

Discretionary cash flows exist if the ratio Discretionary cash flows exist if the ratio exceeds oneexceeds one


Decomposition of cash flow Decomposition of cash flow adequacy ratioadequacy ratio

Individually examines each Individually examines each component of the cash flow component of the cash flow adequacy ratio adequacy ratio

Inverts ratio’s numerator and Inverts ratio’s numerator and denominator to avoid denominator to avoid mathematical problemsmathematical problems


Decomposed ratio is computed as Decomposed ratio is computed as Reinvestment ratio: fixed assets purchased Reinvestment ratio: fixed assets purchased

/ cash flows from operations/ cash flows from operations Long-term debt repayment ratio: long-term Long-term debt repayment ratio: long-term

debt paid / cash flows from operationsdebt paid / cash flows from operations Dividend payout ratio: cash dividends Dividend payout ratio: cash dividends

paid / cash flows from operationspaid / cash flows from operations In general, analysts favor low ratios for In general, analysts favor low ratios for

the components of cash flow adequacythe components of cash flow adequacy


Free cash flowsFree cash flows Computed as: cash flows from operations – Computed as: cash flows from operations –

(capital expenditures + dividends)(capital expenditures + dividends) Interpretation: the more free cash the greater an Interpretation: the more free cash the greater an

entity’s amount of discretionary cash and liquidityentity’s amount of discretionary cash and liquidity Depend on firm size Depend on firm size Ignore long-term term debt repayment in the Ignore long-term term debt repayment in the

calculationcalculation Commingles fixed asset replacement with fixed Commingles fixed asset replacement with fixed

asset expansionasset expansion Could exclude the purchase of productive Could exclude the purchase of productive

intangible assets in its calculationintangible assets in its calculation


Depreciation impact ratioDepreciation impact ratio Computed as: (depreciation + Computed as: (depreciation +

amortization expenses) / cash flows amortization expenses) / cash flows from operationsfrom operations

Interpretation: small ratio indicates Interpretation: small ratio indicates financial strength as the non-cash financial strength as the non-cash addition to income isn’t the driving force addition to income isn’t the driving force behind operating cash flowsbehind operating cash flows

A large ratio (approaching one) indicates A large ratio (approaching one) indicates insufficient cash flow from core activitiesinsufficient cash flow from core activities


Recapitalization ratioRecapitalization ratio Computed as: reinvestment ratio / depreciation Computed as: reinvestment ratio / depreciation

impact ratioimpact ratio Interpretation: a ratio in excess of one means Interpretation: a ratio in excess of one means

that a company’s investment in productive that a company’s investment in productive resources exceeds its use of productive resources exceeds its use of productive resourcesresources

A ratio below one means capital assets are not A ratio below one means capital assets are not being replaced in a timely mannerbeing replaced in a timely manner

Fails to measure capitalization as opposed to Fails to measure capitalization as opposed to recapitalization (e.g., for an emerging firm) recapitalization (e.g., for an emerging firm)


Cash efficiency measuresCash efficiency measures A company must invest wisely in A company must invest wisely in

productive resourcesproductive resources Measure the relationship between Measure the relationship between

operating cash flows and assets and operating cash flows and assets and revenuesrevenues

Determine if an enterprise’s Determine if an enterprise’s investments produced enough investments produced enough operating cash flowsoperating cash flows


Three measures of cash efficiencyThree measures of cash efficiency Cash flow return on assets: cash flow Cash flow return on assets: cash flow

from operations / total assetsfrom operations / total assets Cash flow return on sales: cash flow Cash flow return on sales: cash flow

from operations / revenuesfrom operations / revenues Operations index: cash flow from Operations index: cash flow from

operations / operating incomeoperations / operating income

Cash Flow Ratios 2003 2002 2001Cash flow adequacy 0.54 72.00 (0.62) Reinvestment ratio 0.75 - (1.59) Long-term debt repayment 1.12 - - Dividend payout - 0.01 (0.03) Free cash flow 27.00 142.00 (165.00) Depreciation impact ratio 1.32 0.87 (1.98) Recapitalization index 0.57 - 0.80 Cash flow return on assets 0.12 0.16 (0.08) Cash flow return on sales 0.08 0.12 (0.05) Operations index 21.40 2.44 (1.15)


Signs of cash efficiencySigns of cash efficiency Large rates of cash returns on Large rates of cash returns on

assets and revenuesassets and revenues Strong correlation between Strong correlation between

operating cash flows and operating operating cash flows and operating incomeincome


Cash sufficiency versus cash Cash sufficiency versus cash efficiencyefficiency An entity must produce sufficient cash An entity must produce sufficient cash

to prosperto prosper They should do in an efficient manner They should do in an efficient manner

(i.e., generating maximum revenues (i.e., generating maximum revenues from its productive base.) from its productive base.)

Cash flow sufficiency is a necessary Cash flow sufficiency is a necessary component of cash flow efficiencycomponent of cash flow efficiency

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRYTHE PC INDUSTRY

Investing and financing measuresInvesting and financing measures Inventory reductions created cash, Inventory reductions created cash,

which manifested itself inwhich manifested itself in Securities investments made Securities investments made

throughout the industrythroughout the industry Compaq’s debt repayment and Compaq’s debt repayment and

technology acquisitionstechnology acquisitions Dell’s contraction of capital Dell’s contraction of capital

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRY (CONT.)THE PC INDUSTRY (CONT.)

Apple’s investing and financing Apple’s investing and financing activitiesactivities Substantial investments were made in Substantial investments were made in

available-for-sale debt and equity available-for-sale debt and equity securitiessecurities

Preferred stock and long-term bond Preferred stock and long-term bond were issued from 1996-1998were issued from 1996-1998


Cash sufficiency measuresCash sufficiency measures Volatile cash flow adequacy measures Volatile cash flow adequacy measures

(Exhibit 11-3A and 11-3B)(Exhibit 11-3A and 11-3B) Dell produced the most discretionary cash Dell produced the most discretionary cash

flowsflows Gateway demonstrated increasing levels of Gateway demonstrated increasing levels of

adequate cash flowsadequate cash flows Compaq’s 1998 performance eliminated its Compaq’s 1998 performance eliminated its

discretionary cash flowsdiscretionary cash flows Apple’s performance lagged those of its Apple’s performance lagged those of its

competitorscompetitors

PC IndustryCash Flow Adequacy Ratios

1993-1998

-400%

-200%

0%

200%

400%

600%

800%

1000%

1200%

1400%

1993 1994 1995 1996 1997 1998

Apple Computer, Inc. Compaq Computer Corp.Dell Computer Corp. Gateway 2000, Inc.

PC IndustryWeighted Average Cash Flow Adequacy Ratio

1993-1998

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

Apple Compaq Dell Gateway


Component measures provide Component measures provide additional insights about the additional insights about the industry’s cash flow adequacyindustry’s cash flow adequacy Dell and Gateway had lower Dell and Gateway had lower

component measures, which indicated component measures, which indicated adequate cash flowsadequate cash flows

Those for Compaq were higher than Those for Compaq were higher than the industry leaders’ component ratiosthe industry leaders’ component ratios


Apple’s component analysis Apple’s component analysis demonstrated inadequate cash demonstrated inadequate cash flows, by its flows, by its extremely high depreciation impact extremely high depreciation impact

ratio (Exhibit 11-6A)ratio (Exhibit 11-6A) cumulative recapitalization index that cumulative recapitalization index that

was significantly below one (Exhibit 11-was significantly below one (Exhibit 11-6B)6B)

decreasing recapitalization index over decreasing recapitalization index over time (Exhibit 11-6C)time (Exhibit 11-6C)

PC IndustryWeighted Average Depreciation Impact Ratio

1993-1998

0%

10%

20%

30%

40%

50%

60%

70%

80%


PC IndustryWeighted Average Recapitalization Indices

1993-1998

0

0.5

1

1.5

2

2.5



Cash efficiency measuresCash efficiency measures Reinforce the analysis of the superior cash Reinforce the analysis of the superior cash

flows produced by Dell and Gatewayflows produced by Dell and Gateway Dell led the industry on operating cash returns Dell led the industry on operating cash returns

on sales and assetson sales and assets Gateway and Compaq generated an equal Gateway and Compaq generated an equal

amount of operating cash per sales dollar, but amount of operating cash per sales dollar, but Gateway’s cash return on assets exceeded that Gateway’s cash return on assets exceeded that for Compaqfor Compaq

Apple produced significantly less cash per sales Apple produced significantly less cash per sales or investment dollar than the returns produced or investment dollar than the returns produced by the other firmsby the other firms

PC IndustryWeighted Average Cash Flow Return on Assets

1993-1998

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%


PC IndustryWeighted Average Cash Flow Return on Sales

1993-1998

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%



Operations Index (Exhibits 11-9A Operations Index (Exhibits 11-9A and 11-9B)and 11-9B) Gateway, Dell, and Compaq’s Gateway, Dell, and Compaq’s

operating cash flows correlated with operating cash flows correlated with operating income from 1993 to 1998operating income from 1993 to 1998

Apple’s operating cash was Apple’s operating cash was negatively correlated with operating negatively correlated with operating income during the period analyzedincome during the period analyzed

PC IndustryWeighted Average Operations Index

1993-1998

-1.5

-1

-0.5

0

0.5

1

1.5

2


Documents

ADVANCED CASH FLOW ANALYSIS Chapter 11. CHAPTER 11 OBJECTIVES Explain the importance of investing and financing cash flows. Explain the importance of