Financial Analysis and Cash Flow Statements

Understanding Cash Flow Statements

Overview

• The chapter focuses on understanding cash flow statements, their format, preparation, and analytical considerations.

Consolidated Statements of Cash Flows: Examples

• Examples from Colgate-Palmolive and Apple are used to illustrate cash flow statements.
• Colgate-Palmolive:
  • Net decrease in cash and cash equivalents in 2018: $(809)$ million.
  • Net increase in 2017: $220$ million.
  • Net increase in 2016: $345$ million.
  • Cash and cash equivalents at the end of 2018: $726$ million, 2017: $1,535$ million, 2016: $1,315$ million.
• Apple:
  • Increase in cash and cash equivalents: $5,624$ million
  • Cash and cash equivalents, end of the period: $25,913$ million

Classification of Activities on the Statement of Cash Flows

• Operating activities: Activities related to delivering or producing goods for sale and providing services.
  • Examples: Receiving cash from customers, paying cash to suppliers, and paying cash for operating expenses.
• Investing activities: Activities related to buying or selling long-term assets and other investments.
  • Examples: Property, plant, and equipment (PP&E) and other companies’ securities (that are not cash equivalents).
• Financing activities: Activities related to obtaining or repaying capital.
  • Examples: Borrowing from creditors, repaying principal, issuing or repurchasing stock, and paying dividends.

Colgate-Palmolive: Cash Flows Classified by Activity

• Net cash provided by operations:
  • 2018: $3,056$ million
  • 2017: $3,054$ million
  • 2016: $3,141$ million
• Net cash used in investing activities:
  • 2018: $(1,170)$ million
  • 2017: $(471)$ million
  • 2016: $(499)$ million
• Net cash used in financing activities:
  • 2018: $(2,679)$ million
  • 2017: $(2,450)$ million
  • 2016: $(2,233)$ million
• Effect of exchange rate changes:
  • 2018: $(16)$ million
  • 2017: $87$ million
  • 2016: $(64)$ million
• Net (decrease) increase in cash and cash equivalents:
  • 2018: $(809)$ million
  • 2017: $220$ million
  • 2016: $345$ million
• Cash and cash equivalents at the beginning of the year:
  • 2018: $1,535$ million
  • 2017: $1,315$ million
  • 2016: $970$ million

Colgate's Operating Cash Flows

• Net income including noncontrolling interests:
  • 2018: $2,558$ million
  • 2017: $2,174$ million
  • 2016: $2,586$ million
• Adjustments to reconcile net income to net cash provided by operations include depreciation, amortization, restructuring, stock-based compensation, and changes in receivables, inventories, and payables.
• Net cash provided by operations:
  • 2018: $3,056$ million
  • 2017: $3,054$ million
  • 2016: $3,141$ million

Colgate's Investing Cash Flows

• Capital expenditures:
  • 2018: $(436)$ million
  • 2017: $(553)$ million
  • 2016: $(593)$ million
• Proceeds from the sale of marketable securities and investments:
  • 2018: $156$ million
  • 2017: $391$ million
  • 2016: $378$ million
• Payment for acquisitions:
  • 2018: $(728)$ million
• Net cash used in investing activities:
  • 2018: $(1,170)$ million
  • 2017: $(471)$ million
  • 2016: $(499)$ million

Colgate's Financing Cash Flows

• Principal payments on debt:
  • 2018: $(7,355)$ million
  • 2017: $(4,808)$ million
  • 2016: $(7,274)$ million
• Proceeds from the issuance of debt:
  • 2018: $7,176$ million
  • 2017: $4,779$ million
  • 2016: $7,438$ million
• Dividends paid:
  • 2018: $(1,591)$ million
  • 2017: $(1,529)$
  • 2016: $(1,508)$ million
• Purchases of treasury shares:
  • 2018: $(1,238)$ million
  • 2017: $(1,399)$ million
  • 2016: $(1,335)$ million
• Net cash used in financing activities:
  • 2018: $(2,679)$ million
  • 2017: $(2,450)$ million
  • 2016: $(2,233)$ million
• Cash and cash equivalents at the end of the year:
  • 2018: $726$ million
  • 2017: $1,535$ million
  • 2016: $1,315$ million

Common-Size Statement of Cash Flow for Colgate (Abbreviated)

• Each line item is presented as a percentage of net revenue.
• Net income including non-controlling interests:
  • 2018: $16.5$%
  • 2017: $14.1$%
  • 2016: $17.0$%
• Net cash provided by operations:
  • 2018: $19.7$%
  • 2017: $19.8$%
  • 2016: $20.7$%

Colgate’s Cash Flows: Summary

• Overall $244$ million net decrease in cash over three years (2016-2018).
• Consistent cash inflow from operating activities and cash outflow for investing and financing activities (Typical for mature companies).
• Operating cash flow exceeded net income (desirable for mature companies).
• Operating cash was more than capital expenditures in the year.
• Dividend payments have steadily increased over the past three years.
• Operating cash after capital expenditures was sufficient to cover dividend payments, showing a positive cash flow profile.

Indirect Method for Presenting Operating Cash Flows

• Begins with net income and adjusts it to derive operating cash flows.
• Clearly shows the reasons for differences between net income and operating cash flows.
• Mirrors forecasting approach that begins with a forecast of income, then derives cash flows.

Direct Method for Presenting Operating Cash Flows

• Shows each cash inflow and outflow related to receipts and disbursements.
• Provides information on the specific sources of operating cash receipts and payments.
• Does not net amounts.

Indirect vs. Direct Method

• Indirect method:
  • Permitted by both IFRS and U.S. GAAP
  • Used by the majority of companies
• Direct method:
  • Encouraged by IFRS
  • Encouraged by US GAAP, but requires a reconciliation of net income to cash flow from operating activities.

Tech Data's Operating Cash Flows: Example of Direct Method

• Cash received from customers: $42,981,601$ (in thousands).
• Cash paid to vendors and employees: $(41,666,356)$
• Interest paid, net: $(86,544)$
• Income taxes paid: $(131,632)$
• Net cash provided by operating activities: $1,097,069$.

Classification of Cash Flows under IFRS vs. U.S. GAAP

Non-Cash Investing and Financing Activities

• Non-cash transactions do not involve an inflow or outflow of cash (e.g., exchange of one non-monetary asset for another).
• These are not incorporated in the cash flow statement but must be disclosed.

Preparation of the Statement of Cash Flows: Steps

1. Determine the change in cash.
2. Determine the net cash flow from operating activities (using the current year's income statement and information on current assets and liabilities).
3. Determine net cash flows from investing and financing activities (examine all other changes in the balance sheet accounts).
4. Include a summary of the net increase (decrease) in cash, cash at beginning, and cash at end.
5. Disclose any significant non-cash transactions separately.

Example: Company Transactions

• Company sells stock for $100$.
• Buys a building for $50$.
• Makes credit sales of $100$, and subsequently collects $90$.
• Accrues SG&A expense of $40$, and subsequently pays cash of $25$.
• Records depreciation expense of $10$.

Indirect Method

• Depreciation expense: $+10$
• Non-cash expense
• Change in receivables: $-10$
• Only collected $90$

Investing Cash Flows

• Determine investing cash flows by examining changes in long-term assets.
• Beginning PP&E + Purchases – Dispositions = Ending PP&E
• Ending PP&E – Beginning PP&E = Purchases – Dispositions (i.e., investing cash flows)
• PP&E increased by $50$, indicating cash spent acquiring PP&E.

Financing Cash Flows

• Determine financing cash flows by examining changes in debt and equity accounts.
• Beginning stock + Issuances – Repurchases = Ending stock
• Ending stock – Beginning stock = Issuances – Repurchases
• Stock account increased by $100$, indicating cash was raised by issuing stock.

Free Cash Flow (FCFF & FCFE)

• Free Cash Flow to the Firm (FCFF): Cash flow available to the company’s suppliers of capital (debt and equity) after operating expenses and investments in fixed and working capital have been made.
• Free Cash Flow to Equity (FCFE): Cash flow available to the company’s common stockholders after operating expenses, borrowing costs, and investments in fixed and working capital have been paid.

Compute FCFF

• FCFF = Net Income + Non-cash charges – Working capital investment + [Interest expense × (1 – Tax rate)] – Fixed capital investments
• Interest is added back because it's a cash flow available to one of the capital providers and was deducted from net income.

FCFF from Cash Flow from Operating Activities

• FCFF = Cash from operating activities + [Interest expense × (1 – Tax rate)] – Fixed capital investments
• CFO already includes adjustments for non-cash items and working capital investment.

Compute FCFE

• FCFE = Net Income + Non-cash charges – Working capital investment – Fixed capital investment + Net new borrowing
• Positive FCFE indicates an excess of operating cash flow over capital expenditures and debt repayment.

Cash Flow Performance Ratios

Cash Flow Coverage Ratios

Summary

• The cash flow statement reports a company’s cash receipts and payments during an accounting period, categorized into operating, investing, and financing activities.
• IFRS provides more classification choices than U.S. GAAP.
• The operating activities section can be presented using the direct or indirect method.
• Common-size cash flow statements can be developed using the total cash inflows/outflows method or the percentage of net revenues method.
• Cash flow ratios are used to measure a company’s profitability, performance, and financial strength.

Financial Analysis Techniques

Financial Analysis Tools: Description

• Graphics
• Regression
• Common-Size Analysis
• Financial Ratio Analysis

Common-Size Analysis

• Express financial data in relation to a single financial statement item or base.
• Vertical common-size:
  • Balance sheet: Each item as a percentage of total assets.
  • Income statement: Each item as a percentage of total net revenues.
  • Cash flow: Each line as a percentage of sales, assets, or total in and out.
  • Highlights composition and identifies what’s important.
• Horizontal common-size:
  • Percentage increase or decrease of each item from the prior year or showing each year relative to a base year.
  • Highlights items that have changed unexpectedly or remained unchanged.

Financial Ratios

• Express one number in relation to another.
• Standardize financial data in terms of mathematical relationships (percentages, times, or days).
• Facilitate comparisons—trends and across companies.
• Ratios are interrelated.
• A ratio is NOT the answer, it's an indicator—of relative activity, profitability, liquidity, solvency.
• Interpretation generally involves comparison, and analysis will address the question of why.

Using Financial Analysis Tools

• Analysis goes beyond data collection and computation, encompassing computations and interpretations. Past performance analysis:
  • What aspects of performance are critical to successfully competing in the industry?
  • How well did the company perform (relative to its own history and relative to competitors)?
  • Why? What caused the performance?
• Does the performance reflect the company’s strategy?
• Not every ratio is relevant in every situation.
• Industry-specific ratios can be as important as general financial ratios.
• Different users and questions (e.g., creditors, investors) focus on different ratios.

Categories of Financial Ratios

Measure of Profitability: Return on Equity (ROE)

• ROE = Net income / Average equity
  ROE = ROA * Leverage

Decompose ROE

• With a business strategy, by increasing its ROA and/or
• With a financial strategy, by increasing its use of leverage as long as returns on the incremental investment exceed the cost of borrowing.

Return on Assets

• What rate of return has the firm earned on the assets it had available to use during the year?

• The general form of this computation is the same:
  Rate of Return = Amount of return / Amount invested

• Two variants of ROA computation:
  (1) ROA = Net income / Average assets
  (2) ROA = (Net income + [Interest expense × (1 – Tax rate)]) / Average assets

• ROA = Profit margin × Turnover (efficiency)

Decomposing Return on Equity

• ROE = (Net income / Revenue) × (Revenue / Average assets) × (Average assets / Average equity)
• ROE = Profit margin × Turnover × Leverage

Dupont Analysis : Further Decomposition

• ROE = Net income/Average equity
• Decompose ROE into five factors
  ROE = (Net income / EBT) × (EBT / EBIT) × (EBIT / Revenue) × (Revenue / Average assets) × (Average assets / Average equity)

Profitability: Return on Sales

• Gross profit margin = Gross profit/Revenue
  • Measures the ability to translate sales into profit after consideration of cost of products sold.
• Operating profit margin = Operating profit/Revenue
  • Measures the ability to translate sales into profit after consideration of operating expenses.
• Net profit margin = Net profit/Revenue
  • Measures the ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes, and non-operating items.

Activity Ratios

• How efficiently is the firm using its assets? How many dollars of sales was the firm able to generate from each dollar of assets?
• Low or declining ratios could mean:
  • Sales are sluggish,
  • A heavy investment in assets (inefficient? plant modernization to help in future? strategy shift?), and/or
  • Asset mix changed.
• Specifically, for fixed assets:
  • Fixed asset turnover = Revenue/Average net fixed assets

Activity Ratios

Other Common Activity Ratios

Activity Ratios and the Cash Cycle

• Cash cycle: How long does it take for the firm to go from cash to cash?
• Cash conversion cycle = Days sales outstanding + Days inventory held – Number of days of payables
• Close link to liquidity
• Working capital reflects the investment required to support this cycle.

Liquidity Ratios

• How well positioned is the firm to meet its near-term obligations?
• Current ratio = Current assets/Current liabilities
• Quick ratio = (Cash + Short-term marketable investments + Account receivables)/Current liabilities
• Cash ratio = (Cash + Short-term marketable investments)/ Current liabilities

Solvency: How Well Positioned Is the Firm to Meet its Longer-Term Liabilities?

• Debt ratios: How has the company financed itself?
  • Debt to total assets
  • Debt to equity
  • Debt to total capital
• Coverage ratios: Degree to which earnings or cash flow can decline without affecting firm’s ability to pay interest.
• EBIT interest coverage = (EBT + Interest payments)/Interest payments
• Fixed charge coverage = (EBIT + Lease payments)/(Interest payments + Lease payments)

Common Solvency Ratios

Valuation Ratios: Price-to-Earnings Ratio

• P/E relates earnings per common share to the market price. Measures the multiple that the stock market places on a firm's earnings.
• High P/E indicates:
  • Firm is valued highly by market, possibly because of growth expectations, or
  • That a firm may have very low earnings per share.
• P/E = Price / Earnings per share

Valuation Ratios

Dividend-Related Quantities

• Dividend payout ratio = Dividends per share
• Dividend yield = Dividends per share

Financial Statement Analysis: Applications

Evaluation of a Company’s Past Performance

Forecasting

Assessing Credit Quality

• Credit risk: risk of loss caused by a debtor’s failure to make a promised payment.
• Credit analysis: evaluation of credit risk:
  Risk in a particular transaction or for a particular security
  Obligor’s overall creditworthiness

Stock Screening

• Back-testing
• Caveats when back-testing:
  Survivorship bias
  Look-ahead bias
  Data-snooping bias

Analyst Adjustments

• Different sources categorize some ratios differently and include different ratios.
• Differences in accounting standards can limit comparability.