Analyzing Cash Flow Statement

• A cash flow statement tells you about a company’s cash movement and where a company generates funds 

1. a) Was cash generated from operations? 

   1. Positive or negative? 

      1. “Engine of the business is running”  

2. b) Was net income a source of cash? 

   1. “No strings attached” 

   2. ALWAYS add back depreciation when looking at net income

   3. Is it the largest source of cash? 

3. c) What are the sources and uses from operations? 

   1. Tell a story, what do the numbers indicate? 

   2. DON’T FORGET MATCHING - short term uses and sources

      1. Inventory & AR → AP 

         1. Ex. If AP is higher than AR and INV, what is the company doing with a significant source of income? 

            1. Are they paying down their WCL or Line of Credit (check financing activities) 

            2. Are they using AP or loans to pay for investing activities? 

               1. If AP/short term loans, this is short term use of course to fund long-term investment = bad matching 

4. d) What are the remaining sources and uses? 

5. e) Recommendations for the future? 

• Are you making clear links to cash management and their ability to repay a loan?

• When look at the statement of cash flows ALWAYS refer back to balance sheet

• Gross profit increases a lot but operating expenses doesn’t, OE is more efficient than it was before

• When looking at inventory, also look at the age of inventory to see if they're stocking up. Is their inventory actually leaving their store?

* Recommendations for future: 

• Round up the 3-4 key points for the statement, point out things you think are a red flag. If there is nothing wrong with the statement, then highlight the good points.

• Consider if sources/uses will affect account for NEXT YEAR 

Analyzing Ratios

*ALWAYS Calculate Working Capital Gap 

1. Age of INV + Age of AR - Age of AP 

Age of INV - consider if factors such as perishable/out of style/industry inventory and how this would affect the volume of inventory 

Ex. farming business should not have excessive inventory or else it will perish 

2. What is the trend? 

3. What is driving the trend? Cause? 

   1. Is it sustainable? 

      1. Refer to raw numbers from financial statements 

4. Compare with historical data and industry standards 

5. How will these ratios change next year (use case facts) 

Profitability Ratios 

1. COGS

   1. The two reasons this could go up is 1) goods are being discounted or 2) The cost of the actual goods sold is increasing (due to suppliers) 

   2. The two reasons this could go down is 1) sales is going up 2) costs of goods is going down

   3. Like to see CoGS go down over time - either from selling goods for more, or got discount on inventory

2. Operating expenses

3. Interest

4. Net earning after tax

5. Return on equity

Liquidity Ratios

1. Current assets

2. Quick ratio

3. Working capital

Interest

• Has interest expense decreased because CLTP is being paid? 

Stability:

1. Do they have too much debt than they can afford?

2. If there is no net earnings growth it means we went from a negative to a positive

3. Why are they growing? 

   1. Consider how these ratios compare to each other 

      1. Ex. If assets are growing, yet sales are not, what are the implications? 

         1. Asset growth? - more equipment  

         2. Sales growth? 

         3. Earnings growth? - increase in profits 

         4. Equity growth? - increase in investments 

Interest Expense: calculate based on how much is outstanding

Analyzing Statement of Retained Earnings 

STOP, DROP, AND ROLL

• Talk about net income

  • Has that improved?

    • Consider the industry, does it have growth potential? 

  • Why has profitability increased/decreased 

  • CALCULATE NPM

• Talk about your assumptions, particularly sales assumption

  • Do you actually think it’s going to grow?

  • ALWAYS HAVE A RATIONALE (using case facts) 

• Talk about Ending Retained Earnings

  • Has it increased? It is important because… 

    • Lenders care b/c high retained earnings mean that their assets are funded by their own money

• Dividends

  • Is it too much relative to the net income they’re making

  • Is it low? And why?

THE PLUG

Demonstrate that you a have a strong understanding of the link between the WCL and cashflow

1. Why did you get here? Imagine what the cash flow statement would have looked like

2. If the two plugs are dramatically different, WHY?

• What do these plugs indicate?

• What has caused these plugs to be the way they are?

• Will seasonality affect the plug?

• Will sensitivity affect the plug?

Signs of Seasonality 

1. Qualitative facts about seasonality

   1. Some items of the year busy, some are slow

2. Number is given for seasonality

3. Check that your statements aren’t already in the seasonal period

Signs of Sensitivity 

1. Choose the most vulnerable to change (A/R, A/P, Inv.) (generally go with the biggest account)

2. Explain what would happen to my plug if days went up or down

3. Which is more reasonable (up or down)? - consider case facts 

   1. Ex. AP - have they established strong relationships with suppliers? 

      1. HOW WILL THIS IMPACT LIKELIHOOD OF LOAN PAYMENT?

4. How does this impact WCL? 

   1. Considering the limit of WCL, as a lender, is it a cause for concern? 

5. ONLY PICK ONE TO EXPLAIN

Risk Assessment

• Assess risks and whether a lender is more or less likely to loan money 

• Have one side for pros and cons (1-2 each) 

• Have a subheader and then one side for pros, one side for cons - 1 to 2 of each

• Don't forget to discuss capacity ratios! Talk about the trend, WHY this has happened, and how you feel about lending as a result

• EXPLAIN why the bank would care about that

• At the end of each section give a risk spectrum to point out whether it’s low, medium, or high risk

THE THREE C’S 

1. Conditions of the business

   1. Qualitative

   2. Have to do with the industry, company, customers, etc.

   3. Location

   4. Industry/Competition

   5. Seasonality 

2. Character of the borrower

   1. Qualitative

   2. Do they have good relationships

   3. Are they good business owners

   4. Education

   5. Experience

   6. History

   7. Possible conflict

3. Capacity to repay

   1. Quantitative

   2. How do we expect LIQUIDITY and STRUCTURE ratios to change given the projections? 

   3. Calculate projected ratios to determine if the company can repay in the future

      1. DISCUSS RATIOS: trend, why this happened, how we feel about lending as a result

   4. CALCULATE CURRENT RATIO, ACID TEST, and INTEREST COVERAGE

      1. Add in your working capital plug

      2. Negative PLUG should be included as cash when calculating ratios

Essay 

I recommend (loan or no loan) 

Argument #1

Argument #2

Argument #3 

Risks & Mitigation

• Our risks of the decision we make

• If there’s a glaring risk to your argument put it in this category

• Put 1 risk. Just a sentence showing the other decision's perspective. 

Conclusion

FINANCE AND ACCOUNTING EXAM FORMAT 

Decision essay: (worth 20% 20/100 marks) recommends 2 pages

• 2 qualitative, 1 quantitative

• Specific dollar amounts for numbers

• Intro - state decision and 3 reasons why

• 3 main paragraphs after. 1 for each point.

Time Breakdown

Read Case (30 min)

45 min SCF analysis/ratios (45 min) (25%)

Projected statements, IS/SRE  Analysis (60 min) 

Plug analysis, risk assessment (60 min)

Decision and Review (45 min)

45 min SCF analysis/ratios (25%)

Projected statement IS/sre analysis , plug analysis (45%)

Risk analysis (10%)

Decision and Review (20%)

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