Bank of America Merrill Lynch White Paper
Digging Deeper Into Cash Flow
There’s no such thing as “too much information” when it
comes to knowing your cash flow position
Executive summary
Contents
There are a number of different models for forecasting cash flow, and while each may
Capital as a
competitive edge. . . . . . . . . . . . 2
be best suited to a specific objective, they all share the common goal of providing critical
The basic cash flow model . . . 2
information you can use to do a better job of running your business. This white paper looks
at some of the most popular models, how they work in conjunction with each other and
how they can help you achieve your business goals.
Discounted cash flow. . . . . . . . 4
Free cash flow. . . . . . . . . . . . . . 4
Putting all the
pieces together. . . . . . . . . . . . . 5
Conclusion. . . . . . . . . . . . . . . . . 6
DIGGING DEEPER INTO CASH FLOW | 2
Capital as a competitive edge
It would be difficult to overstate the importance of cash flow to the ultimate success of
any business. In the simplest of terms, companies don’t go out of business because they
show a loss on their income statements. “They go out of business because they run out of
money; that is, they have negative cash flow, and they cannot find a resource to fund that
shortfall,” says Raz Silberman, a corporate growth consultant and developer of the MVP
(Map, Vision, Performance) system for the acceleration of business growth.
Businesses use cash and capital as competitive weapons in today’s marketplace.
Companies that are financially strong can “hoard” capital to reduce the flow of cash
to potential competitors, says John A. Tracy, professor of accounting, emeritus, at the
University of Colorado Boulder and author of Accounting for Dummies. Among other
benefits, maintaining an advantageous cash flow may force competitors to use more
expensive and inappropriately structured capital — money that could be better spent on
generating sales and other core business activities. “The stronger company not only tends
to have less expensive capital, such as a lower-cost line of credit, but more importantly,
it can focus on more productive elements of the business,” he says.
No such thing as too much information
Given cash flow’s centrality to business vitality, cash flow analysis and cash management
represent the most important tasks a company and its leaders can undertake, says Michael
H. Hoffman, a partner in the accounting and consulting firm of Adeptus Partners, LLC. “You
can never have too much information, provided that information is accurate,” he says. “No
one wants to make a decision on a key acquisition, investment or financing move only to
discover they don’t have the cash required to execute it.” This white paper explores several
approaches companies can adopt to take a deeper dive into cash flow and ways they can
utilize the resulting insights to improve business performance.
The basic cash flow model
When businesses need to place a value on a project or on the business itself, the basic
cash flow model is generally the starting point. This model calculates a value by projecting
all the future income the project or business is expected to earn over time and subtracting
expenses. Among the important factors to consider when modeling basic cash flow are
the length of time the business or project is expected to earn income, what expenses
will be incurred, whether the income and expenses are expected to fluctuate over time,
macroeconomic trends, and industry-specific trends, says Sophia Duffy, an attorney, CPA
and assistant professor of employee benefits at The American College.
DIGGING DEEPER INTO CASH FLOW | 3
Three business reports considered essential by lenders and financial analysts are the
balance sheet, the income statement and the cash flow report; and the last is widely
believed by financial professionals to be the hardest to fudge, says Darren Veerapa,
a financial analyst at Toll Holdings Limited. “It is also prized for providing a good grasp
of an entity’s financial performance to outsiders,” he says.
The basic cash flow model is the most reality-based of the various approaches to cash
flow modeling because it is the least presumptive, Hoffman agrees, but its viability and
usefulness are dependent on the integrity of the data used to calculate it. Primary sources
of information such as department heads, division heads, vendors and material creditors
are best, and they should be mined for relevant data as often as necessary. That generally
means more frequently in businesses with a higher degree of cyclicality.
Potential pitfalls
As important as basic cash flow modeling is, taking too simplistic an approach to it can be
dangerous, warns Tage C. Tracy, owner and founder of TMK & Associates, an accounting
and consulting firm, and co-author of Cash Flow for Dummies. “Businesses often assume
that cash generated from a project or business opportunity less expenses — which, for
most companies, equates to net income or loss — should be relatively close to the cash
flow generated, but that’s not always the case,” he says. Operations showing a profit on
paper may fail to produce actual cash-in-hand, and, conversely, cash can actually increase
even when operations produce a net loss.
The explanation for such glaring disconnects usually lies in a misunderstanding of critical
operations and their relationship to how cash is generated and consumed in a business. To
truly understand cash flow and to create and utilize properly functioning models, business
leaders must have a solid grasp of two key capital structure components, Tage Tracy says:
yyWorking capital, comprising current or short-term capital sources. Net working
capital is defined as total current assets (cash, trade receivables, inventory) less total
current liabilities (trade payables, accrued liabilities, loans or debt due within one year).
It is imperative that any cash flow model include accurate information on the rate of
asset turnover, especially a real-world reflection of customer payment cycles. “All key
attributes associated with working capital must be captured in a cash flow model to
really understand what cash is needed to support the project and how that cash will
be consumed,” he says.
yyFinancial capital/investments (long-term or permanent capital sources). Most
businesses must secure some type of long-term commitment of capital to execute
their business plans. This may come in the form of equity (e.g., selling common stock
to investors) or long-term debt (e.g., a 20-year mortgage to purchase a building or
manufacturing facility). Many businesses also require a substantial investment in fixed
or permanent assets such as machinery, equipment, technology and intellectual property.
“Again, the same theme is present with long-term or permanent capital as with working
capital,” Tage Tracy says. “A solid grasp of the types of investment needed and the best
form and structure of capital to support the project can have a significant influence on
the cash flow generated or consumed.”
DIGGING DEEPER INTO CASH FLOW | 4
Discounted cash flow
The discounted cash flow model is an approach that takes into account the time value
of money (TVM) (i.e., the concept that money currently available is worth more than the
same amount in the future due to its potential earning capacity). TVM is a core principle
of finance, holding that any amount of money, as long as it has the ability to earn interest,
is worth more the sooner it is received. This concept is also referred to as the present
discounted value. Generally, this model is required when the project is longer in nature
(three to five years) or when there are significant early project costs, such as building a
manufacturing plant that will have a lifespan of many years and will require many years
to pay off construction costs, says Lawrence R. Litowitz, a partner in SCA Group, LLC,
a provider of comprehensive board and management advisory services to companies of
all sizes.
The discounted cash flow model utilizes the same logic and structure as the basic cash
flow model to prepare financial forecasts, but a discount rate is applied to future cash flow
projections to reflect TVM. In most cases, it is used to calculate the current value of a
number of investment scenarios and compare them. “For example, if two investments
generate similar cash flow and have similar risk, then the one generating it earlier will
have higher net present value (NPV) and is better from a pure investment perspective,”
MVP system developer Silberman says. Projections should be based on what you expect
to happen, not what you want to happen, he adds. “You really need growth expectations
rather than growth targets, and there is more of a ‘guessing’ element the farther out the
projection goes.”
The key to getting the most from this model is the discount rate used in its calculation:
the higher the discount rate used, the lower the current value of the business or project.
The discount rate is dependent on numerous factors but is heavily influenced by the
perceived level of risk in the business or project being modeled. This, of course, makes
sense since the higher the risk, the greater the return realized on any capital secured
needs to be in order to compensate for that risk, Tage Tracy says.
Free cash flow
Free cash flow (FCF) represents the amount of cash a company is able to generate and
use for projects that will enhance the value of the company, SCA Group’s Litowitz says.
It is generally defined as net income plus depreciation and amortization less required
capital expenditures. Required dividends and changes in working capital needs may also
be included in the calculation. The sources of data needed for FCF calculations are virtually
identical to those used in other types of cash flow models, including external market data
to determine revenue assumptions and both internal (salary, overhead, administrative
costs) and external (supplier, vendor, contractor costs) data to conduct cost analysis.
DIGGING DEEPER INTO CASH FLOW | 5
“Free cash flow attempts to calculate the true excess earnings potential of a company
after normal essential investments and distributions are made in the business in order to
be able to continue to produce earnings,” Tage Tracy explains. It is important to note that
free cash flow is not necessarily what the financial statements say but is, rather, what is
truly needed in the business to operate and remain competitive going forward. This can
be particularly important in the case of prospective acquisitions. “If a company wanted to
increase its free cash flow figure to justify a higher valuation, management could attempt
to reduce capital expenditures for a year or two to create an illusion that the company is
generating higher free cash flow levels than is actually the case,” he says.
Putting all the pieces together
In broad strokes, the basic cash flow model is best for evaluating distinct projects or
tasks, the discounted cash flow model is best for long-term projects where positive cash
flow may occur years in the future and FCF models are best used to determine how much
cash is available for total projects, Litowitz says. However, the ultimate goal of any cash
flow model is to provide useful information to the organization’s decision makers and to
enhance shareholder value. The choice of a specific model may be industry-dependent
to some extent, “but the key is getting the information you need to make informed
operational decisions,” Adeptus Partners’ Hoffman says. “It’s tough to know when you can
develop new products, make an acquisition or even determine a marketing spend without
knowing what cash you have available.”
All three of these cash flow models — and the vast number of related hybrids —tend to
be dependent on one another and should be used in conjunction with each other. The
free cash flow model determines how much cash is available for all projects in which an
enterprise might wish to engage, and the basic and discounted cash flow models are
then used to rank individual projects against each other to determine which will provide
the greatest returns. “This may turn out to be an iterative process over a period of time,”
Litowitz says. “For example, some projects may require additional outside funding such as
a line of credit from a bank. You would then put the bank repayments back into the free
cash flow model to determine whether projects are feasible.”
While discounted cash flow modeling is done as needed for new projects or investment
opportunities, basic cash flow and FCF modeling should be done on an ongoing basis.
Tage Tracy dismisses the once common practice of forecasting on an annual basis as
“archaic and no longer appropriate for most businesses, given how quickly competitive
environments can change.” Silberman suggests adopting a 13-week cash flow forecast
cycle that is updated every week, or at least every month. In some industries, such as
retailing, daily cash flow monitoring is recommended.
DIGGING DEEPER INTO CASH FLOW | 6
Conclusion
Cash flow models can be further refined and made more strategically useful through cash flow
sensitivity analysis (i.e., the application of “what if” scenarios to determine how changes
to different variables in your models might affect business operations). Sensitivity analysis
provides a window into what cash flow would look like under various scenarios rather than
just the most likely one, which the standard forecast represents. “The sensitivity analysis
can show the potential upside and, more importantly, downside of cash flow should things
go better or worse than expected,” Silberman says. “What if” analyses represent a critical
management tool to help plan for and understand different operating scenarios that
historically have ranged from best case (high) to expected case (medium) to worst case
(low). In today’s volatile environment, Tage Tracy suggests extending the range to include
a disaster-planning — Armageddon, in his terminology — scenario as well.
Perhaps most important of all, cash modeling exercises must be mapped against your
operational and strategic goals in order to return the most benefit. Cash flow and other
financial forecasts must be checked against your original strategic goals and objectives
on a regular basis, and all segments of the business must be in sync when it comes to
understanding the multiple cause-and-effect relationships involved in cash flow modeling.
“The deeper the understanding the management team has of the complete business
cycle and how cash is generated and consumed, the better they will be able to execute
their job responsibilities and identify areas where cash flows can be improved,” Tage
Tracy says. Adds The American College’s Duffy, “Good cash flow management is not
only advantageous, it is essential to the growth and success of any business.”
Keys to building a
worthwhile cash flow
model:
• The income statement and
balance sheet provide critical
information needed to produce
a viable cash flow forecast.
• Understand the entire selling
process — your customers,
the prices they will pay,
payment terms — the entire
sales cycle from the start of
prospecting/marketing to
close to payment to follow-up
customer service efforts.
•U
nderstand the disbursement
cycle, including trade payables
(vendor/supplier information,
payment terms, etc.), payroll/
employee requirements and
any other variables required
to support the project or
business opportunity.
• Identify all capital
investments required and
when they will be needed.
• Secure the proper type,
amount and structure
of capital.
• Complete proper due
diligence on the project/
business opportunity and
develop a solid business plan.
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