FBA FA Section2 Cash classification - Freefahmi.ba.free.fr/docs/Courses/2013 ESCP FA/fba_fa_section2_cashc… · Any reduction in Working Capital needs generates a positive free cash

Financial AnalysisFinancial Analysis

Section 2.Section 2.Section 2.Section 2.Section 2.Section 2.

Classifying Company Cash Flows: Classifying Company Cash Flows: the Operating Cycle is of critical importancethe Operating Cycle is of critical importance

The Operating Cycle and the Working CapitalThe Operating Cycle and the Working CapitalThe Investment Cycle and the Free Cash FlowThe Investment Cycle and the Free Cash FlowThe Financing Cycle The Financing Cycle

Section 2.Section 2.

Classifying Company Cash Flows: Classifying Company Cash Flows: the Operating Cycle is of critical importancethe Operating Cycle is of critical importance

The Operating Cycle and the Working CapitalThe Operating Cycle and the Working CapitalThe Investment Cycle and the Free Cash FlowThe Investment Cycle and the Free Cash FlowThe Financing Cycle The Financing Cycle

Fahmi Ben Abdelkader ©

ESCP, ParisFall 2013

10/23/2013 11:38 AM 1

Classifying company cash flows The Operating Cycle a nd the Working CapitalThe Investment Cycle and the Free Cash FlowThe Financing Cycle Overview of Cash Flows

Cash flows from operating activities :

Net cash flows from primary operating activities Net cash flows from primary operating activities

Cash flows from investment activities :

Cash flows from investments in (or disposal of) noncurrent assets (plants, machines, office equipments, etc.)

Cash flows from financing activities :

Cash flows due to repayment of debt or raising of new debt, payment of dividends

Fahmi Ben Abdelkader © Financial Statement Analysis10/23/2013 11:38 AM 2

Cash flows due to repayment of debt or raising of new debt, payment of dividends (repurchasing own shares) and share issues

The Cash Conversion Cycle (CCC)

Classifying company cash flows The Operating Cycle a nd the Working CapitalThe Investment Cycle and the Free Cash FlowThe Financing Cycle

The operating cycle is characterized by a time lag between the positive and negative cash flows deriving from the length of the production process (which varies from business to business) and the commercial policy (customer and supplier credit).


Capital is needed to finance the cash conversion cycle: the Working Capital

Source: Berk & DeMarzo (2011), Corporate Finance. Pearson

The Cash Conversion Cycle (CCC) : measuring Working Capital Needs


Working Capital is cash required in the short term to run the business

It reflects the time lag between operating cash outflows and inflows

Working Capital Needs = Inventory + Accounts receiv able – Accounts Payable

Current assets: Current liabilities

3,730

Incurred expenses still unpaid

Example: Nike Inc. Balance Sheet for 2013 (in $ million)

Assets Liabilities

Accounts payable3,425Accounts receivable3,434Inventory


Working Capital Needs +3,129

The firm incurred $6,859 M to buildstocks and deliver finished products : incurred expenses (from suppliers)

Incurred expenses already paid

3,425Accounts receivable

6,859

The Cash Conversion Cycle (CCC) : measuring Working Capital Needs


Quick check question

Example: Vodafone PLC Balance Sheet for 2012 (in $ million)

Current liabilities

Assets Liabilities

Accounts payable


Working Capital Needs = 486 + 10,744 – 15,236 = - 4,006

Working Capital Needs over time


An increase in Working Capital always reflects poor performance.

True False


Working Capital Needs in days’ worth of sales


Working Capital can be expressed in terms of the number of days’ worth of sales:

365*Sales

Needs Capital Working Days Needs Capital Working =

Example: Nike Inc. and Dell for 2013 (in $ million)

Sales

365*Sales

Payable Accounts– receivable Accounts Inventory Days Needs Capital Working

+=

Nike Dell

365*Sales

Inventory DaysInventory = 50365*

25,313

3,434 == 9365*

56,940

1,382 ==


365*Sales

receivable Accounts Days Receivable Accounts =

Sales

365*Sales

Payable Accounts Days Payable Accounts =

Days Needs Capital Working

25,313

49365*25,313

3,425 ==

54365*25,313

3,730 ==

4554-4905 +=+=

56,940

62365*56,940

9,842 ==

97365*56,940

15,223 ==

2679-629 −=+=

Working Capital Needs in days’ worth of sales or th e Cash Conversion Cycle



Working Capital and industry


Working Capital in Various Industries (2012)


Working Capital and industry


Working Capital in Various Industries (2009)


Working Capital and cash conversion performance


Cash-Rich companies: the example of Apple and Micro soft

“With a $145 billion cash hoard, Apple could acquire Facebook, Hewlett-Packard and Yahoo. Put another way, it could buy every office building and retail space in New York, according to city estimates.”

The New York Times, APRIL 30, 2013,

In 2004, Microsoft stunned financial markets by announcing plans to pay the largest single cash dividend payment in history, a one-time dividend of 32$ billion , or 3$


single cash dividend payment in history, a one-time dividend of 32$ billion , or 3$ per share Since then, Microsoft has purchased over 100$ billion in shares , and raised its quarterly dividend 8 times

September 17, 2013Microsoft’s board had approved a new $40 billion stock buyback program

Working Capital Over Time


Working Capital Needs – Nike Inc . from 2011 to 2013

2011 2012 2013

Working Capital Needs ($ million) +2,594 +3,061 +3,129

Inventory (Days of sales) 49 50 50

Accounts Receivable (Days of sales) 63 53 49

Accounts Payable (Days of sales) 65 56 54

Working Capital Needs (Days of sales) +47 +48 +45

Working Capital Needs – Vodafone from 2011 to 2012

2011 2012 2013


2011 2012 2013

Working Capital Needs ($ million) -4,902 -4,006

Inventory (Days of sales) 4 4

Accounts Receivable (Days of sales) 74 84

Accounts Payable (Days of sales) 117 120

Working Capital Needs (Days of sales) -39 -32

Working Capital and firm value


How does working capital impact a firm’s value or a project’s opportunity cost ?

(Example 26.1 B&DM, p.889)


Although the company receives back all of its investment in working capital, it loses the time value of money on this cash

Working Capital Needs: the bottom line


The Working Capital needs are necessary expenses, essential to run the business and to fund its daily operations

The Working Capital is not a potential need, but a “compulsory” investmentThe Working Capital is not a potential need, but a “compulsory” investment

The evolution of the Working Capital depends on :

The evolution of sales

The length of the operating cycle

The evolution of the Cash Conversion Cycle: credit terms from suppliers, average collection period, inventory turnover


inventory turnover

Any reduction in Working Capital needs generates a positive free cash flow that increases the firm value

Efficiently managing working capital will maximize firm value

Managing Working Capital


Objective : reduce capital invested in the operating cycle … without altering the proper functioning of the firm

+ negotiate optimal credit terms

(-) Excessive inventory uses cash: Acquisition costs, order costs, + Determining the credit policy: establishing credit

+ pay on the latest day allowed

- Stretching accounts payable may be costly

WCN = Inventory + Accounts receivable – Accounts Pay able


Acquisition costs, order costs, carrying costs (storage space, insurance taxes, opportunity costs, etc.)

(+) benefits of holding inventory: avoid stock-outs, seasonality factors

+ Determining the credit policy: establishing creditstandards, credit terms and a collection policy

+ Monitoring Accounts receivable

- Cost of monitoring and collection

Managing Working Capital


Corporate Finance – B&DM: Chap 26 - Working Capital Managment


What is the difference between investment and opera ting outflows?

Classifying company cash flows The Operating Cycle and the Working CapitalThe Investment Cycle and the Free Cash FlowThe Financing Cycle

Like the operating cycle, the investment cycle is characterized by a series of inflows and outflows. But the length of the investment cycle is far larger than t he length of the operating cycle .

Investments are carried out from a long -term perspective and their impact is spread over several Investments are carried out from a long -term perspective and their impact is spread over several operating cycles

Investments involve higher risks : they will be beneficial only if overall generated operating cash flow increases (a certain Return On Investment)

Investments impact the operating cycle

New inventory, new credit terms from suppliers, …


The purpose of investments outflows - or Capital Expenditure - is to enhance operating cash flows

The Free Cash Flow


Operating inflows

- Operating outflows

(I) Cash from Operating activities Cash generated thanks to the core business activities(I) Cash from Operating activities

Investment inflows

- Investment outflows

(II) Cash from Investment activities

(I) + (II) = Free Cash Flow

Cash generated thanks to the core business activities

Cash needed to maintain or develop the production equipment


Free Cash Flow > 0 : cash flow generated by a firm’s activities covers its operating and investment needs (it may be used to pay dividend or to pay down debt)

Free Cash Flow < 0 : additional financial resources will have to be raised to cover the company’s capital requirements

The Free Cash Flow


A common and generally accepted definition:

FCF = Cash flow from operating activities + Cash Fr om Investing Activities

Alternative measures of FCF:

FCFF = EBIT * (1- t) + Noncash charges (D&A) – Increa se in Working capital - Capex + Interest*(1-t)

FCF = EBIT * (1- t) + Noncash charges (such as D&A) – Increase in Working capital - Capex

Free Cash Flows to the Firm (FCFF)


FCFE = Net income + Noncash charges (D&A) – Increase in Working capital - Capex + Net Borrowing

See also section 6 . Accrual-based Versus Cash-Flow-based performance measures

Free Cash Flows to the equity (FCFE)

The Free Cash Flow



Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: http://finance.yahoo.com/


Free Cash Flow = +1,960,000 +2,413,000 +791,000

How does Working Capital impact Free Cash Flow and firm value?


Problem

The projected net income and free cash flows next year for Emerald City Paints are:

Net income 20,000

+ Depreciation +5,000

- Increase in Working capital -1,000

- Capital expenditures -5,000

Free Cash Flow +19,000

The company expects capital expenditures and depreciation to continue to offset each others, and for bothnet income and increase in working capital to grow at 4% per year. The opportunity cost of capital is 12%. What is the current value of the firm?

…210 3 4


( )4%1*€19,000 + ( )2%41*000,19€ + ( )3%41*000,19€ +000,19€

How does Working Capital impact Free Cash Flow and firm value?


Problem

The projected net income and free cash flows next year for Emerald City Paints are:

Net income 20,000

+ Depreciation +5,000

- Increase in Working capital -1,000

- Capital expenditures -5,000

Free Cash Flow +19,000

If the company were able to reduce its annual increase in working capital by 20% by managing its WC more efficiently without adversely affecting any other part of the business, what would be the effect on the firm’s value?

…210 3 4

- 800

- 19,200


( )4%1*€19,200 + ( )2%41*200,19€ + ( )3%41*200,19€ +200,19€

The financing cycle is the “flip-side” of the inves tment and operating cycles


When a company’s free cash flow is negative, the company covers its funding shortfall through its financing cycle by raising capital.

Financial inflows: equity or debtFinancial inflows: equity or debt

Financial outflows: dividends, share repurchase, capital repayments, interest payments, etc.

As future cash flows are uncertain, a distinction has to be made between a firm’s commitments regarding capital providers:

Equity holders: (+) decision-making powers and control (voting rights)(+) entitled to benefits generated by the business


(+) entitled to benefits generated by the business(-) risk: uncertain revenues and no possible repayment obligations

Debt holders: (+) predetermined fixed income and certain revenues, regardless of the firm’s performance(+) do not take part in the venture’s risk (except for default risk)(-) lower revenue and opportunity costs



The operating cycle Cash from operating activitiesCash from operating activitiesCash from operating

activitiesCash from operating

activities

Scenario I Scenario II

Cash shortfall The operating cycle

The investment cycle

Free cash Flow

Cash from operating activitiesCash from operating activities

Cash from Investment activities

Cash from Investment activities

Cash surplus

FCF > 0

activitiesactivities

Cash from Investment activitiesCash from Investment activities

FCF < 0

shortfall


The financing cyclePaying debt interestsPaying dividendsDecrease in borrowings

Paying debt interestsPaying dividendsDecrease in borrowings

Raising capital :Increase in equityOrIncrease in borrowings

Raising capital :Increase in equityOrIncrease in borrowings

Cash surplus > Or < 0 > Or < 0




Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: http://finance.yahoo.com/


Operating versus financing activities


� In calculating financial ratios which intend to measure a firm’s profitability, it is beneficial to separate ‘operations’ and ‘investments in operations’ from financing activities

� In financial statements, the distinction between operating items and financial items is not always easy to make due to several factors:

The definition of operations is not clear-cutThe specifications in the income statement and the balance sheet do not clearly distinguish between operating and financing activities


� Which activities included in operations depend on the business model and the characteristics of the firm?

Items that are sometimes categorised as belonging to ‘operations’ may at other times be classified as belonging to ‘financing’.

Concept Check and Critical Thinking

1. What is the difference between a firm’s cash cycle and operating cycle?

2. How will a firm’s cash cycle be affected if (i) the firm increases its inventory, 2. How will a firm’s cash cycle be affected if (i) the firm increases its inventory, all else being equal? (ii) the firm begins to take the discounts offered by its suppliers, all else being equal?

3. What are the costs of stretching accounts payable?

4. What factors determine working capital variation over time?

5. Does an increase in a firm’s working capital needs necessarily mean that the


5. Does an increase in a firm’s working capital needs necessarily mean that the firm is managing its operating cycle poorly?

6. How does working capital impact a firm’s value?

Documents

FBA FA Section2 Cash classification - Freefahmi.ba.free.fr/docs/Courses/2013 ESCP FA/fba_fa_section2_cashc… · Any reduction in Working Capital needs generates a positive free cash