Chapter 7 - Analysis of Cash Flows

Chapter Seven Analysis of Cash Flows

Learning Objectives

• LO 7.1: Understand why cash flow analysis is important.

• LO 7.2: Define cash flow quality.

• LO 7.3: Understand cash flow quality within each SCF section.

• LO 7.4: Cash flow ratios.

Topical Overview:

• What is cash flow quality.

  • Motivating example - Does cash flow analysis matter?

  • Definition.

• The link between cash flow quality and earning quality.

• Analysis of cash flow quality using the SCF.

  • CFO.

  • CFI.

  • CFF.

  • Cash-based financial ratios.

What Is Cash Flow Quality?

• Motivating Questions: Does cash flow analysis matter in the analysis of accrual- based financial statements? Yes!

  • Text eg of Netflix

• Timing of short-term cash flows realization matters to creditors.

• Employees, vendors, banks require cash settlement of wages, invoices, and interest.

• Creditors can initiate bankruptcy proceedings against a firm if not paid.

• Timing of long-term cash flows matter for capital expenditures and principal repayments.

• Large cash balances may be needed to make these payments on specified dates.

• Does the interpretation of cash flows (CFO, CFI, CFF) differ across firms? Yes!

  • Cash Flow from Operations is a function of:

    • Cash flows tied to financing activities (For example, interest expense).

    • Cash flows tied to investing activities (For example, interest- and dividend revenue).

    • Cash flows generated by earnings and cash flow generated by working capital.

  • Cash Flow from Investing is a function of:

    • Cash flows tied to financing activities (For example, capitalized interest).

• Cash Flow from Financing is a function of:

  • Cash transactions with capital providers (equity, debt, employees) except for:

    • Cash paid as interest to debt holders.

    • Cash paid as taxes from employee stock options.

• Understanding cash flow quality is necessary in financial statement analysis!

Cash Flow Quality Definition

• Cash flow quality is a characteristic of the firm’s statement of cash flow that jointly describes:

  • The degree to which the cash inflows and cash outflows associated with a specific activity are matched within with each section of the SCF.

  • The ease that an analyst can forecast the timing and level of future operating, investing, and financing cash flows.

• High cash flow quality has two characteristics:

  1. SCF sections capture high percentage of cash inflows/outflows related to individual activities.

     • Examples:

       • Cash outflows due to salaries and wages are matched against the cash inflows from the revenues those salaries and wages produced → CFO.

  2. Analysts can accurately forecast the amount and timing of CFO, CFI, and CFF.

     • Examples:

       • Firms with stable business models tend to have high cash flow quality.

Cash Flow Quality: Link to Earnings Quality

• The link between cash flow quality and earnings quality:

  • Why does this matter:

    • Earnings comprised/backed by realized cash flows → Higher quality earnings.

    • Earnings primarily comprised of persistent cash flows → Higher quality earnings.

    • CFO, CFI, CFF contain cash flows that may not be operating, investing, and financing.

Cash Flow from Operating Activities (CFO): Presentation

• Two presentation styles:

  1. Indirect Method.

     • Most common method of presentation.

     • CFO items represent reconciling items (accruals), not cash flows.

  2. Direct Method.

     • Very uncommon method of presentation.

     • CFO items represent cash inflows/outflows.

Cash Flow from Operating Activities (CFO): Indirect Method

• Reconciling items are accruals.

  • Nontransaction accruals (NTAcc):

    • Upper half of reconciliation.

    • Direct effect on net income.

    • NTAcc represent the accrual- component of earnings.

    • Require significant managerial estimation discretion.

  • Net Working Capital accruals (NWC):

    • Bottom half of reconciliation.

    • Indirect effect on net income.

    • Often require very little managerial estimation discretion.

• Key Takeaways:

  • $CF = NI + NTAcc$.

    • ≈ Cash-based earnings.

  • $CFO = CF – NWC$.

    • ≈ Cash-based earnings after working capital adjustments.

  • CF ≠ CFO because NWC accruals do not have dollar-to- dollar effect on net income.

    • Purchases of inventory.

    • Payments of A/P.

Cash Flow from Operating Activities (CFO): Direct Method

• Line items represent actual cash flows.

  • Cash received from customers.

  • Cash paid for interest.

• Must provide reconciliation to net income.

  • Represents.

  • Indirect effect on net income.

• Key Takeaways:

  • Direct method allows analyst to quantify exact amounts collected from customers and paid to vendors.

  • Direct method does not provide accrual reconciling items.

    • These are reported in the indirect method.

Evaluating Cash Flow Quality: Cash Flow from Investing Activities (CFI)

• Line items represent actual cash flows.

  • Cash flows from purchases/sales of financial assets.

  • Cash flows from purchases/dispositions of non-current operating assets.

• Key Takeaways:

  • CFI tend to be lumpier than CFO.

  • CFI comprises a significant part of free cash flow.

Evaluating Cash Flow Quality (CFF) Cash Flow from Investing Activities:

• Line items represent actual cash flows.

  • Cash flows relate to transactions with financial capital providers.

    • Debt.

    • Preferred Stock.

    • Common Stock.

  • Cash flows from purchases/dispositions of non- current operating assets.

• Key Takeaways:

  • CFF important for corporate treasury actions.

  • CFF key input for DCF valuation models.

Assessing Non-Current Liabilities: Cash-Flow Ratios

• Solvency ratios:

  • Debt-coverage ratios

    • $\frac{CFO}{Current \ Debt}$

    • $\frac{CF}{Current \ Debt}$

  • Interest-coverage ratios

    • $\frac{CFO + Interest \ Expense}{Interest \ Expense}$

    • $\frac{CF}{Interest \ Expense}$

• Liquidity ratios:

  • Current ratio:

    • $\frac{Current \ Assets}{Current \ Liabilities}$

  • Quick ratio:

    • $\frac{Cash + A/R}{Current \ Liabilities}$