Financial Analysis
Section 2.
Classifying Company Cash Flows:
the Operating Cycle is of critical importance
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Fahmi Ben Abdelkader ©
ESCP, Paris
Fall 2013
10/23/2013 11:38 AM
1
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Overview of Cash Flows
Cash flows from 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
(repurchasing own shares) and share issues
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Financial Statement Analysis
2
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The Cash Conversion Cycle (CCC)
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).
Source: Berk & DeMarzo (2011), Corporate Finance. Pearson
Capital is needed to finance the cash conversion cycle: the Working Capital
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Financial Statement Analysis
3
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
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 receivable – Accounts Payable
Example: Nike Inc. Balance Sheet for 2013 (in $ million)
Incurred expenses still unpaid
Assets
Liabilities
Current assets:
Current liabilities
Inventory
Accounts receivable
3,434
3,425
Accounts payable
3,730
6,859
Working Capital Needs
The firm incurred $6,859 M to build
stocks and deliver finished products :
incurred expenses (from suppliers)
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+3,129
Incurred expenses already paid
Financial Statement Analysis
4
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The Cash Conversion Cycle (CCC) : measuring Working Capital Needs
Quick check question
Example: Vodafone PLC Balance Sheet for 2012 (in $ million)
Assets
Liabilities
Current liabilities
Accounts payable
Working Capital Needs = 486 + 10,744 – 15,236 = - 4,006
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Financial Statement Analysis
5
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital Needs over time
An increase in Working Capital always reflects poor performance.
True
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False
Financial Statement Analysis
6
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital Needs in days’ worth of sales
Working Capital can be expressed in terms of the number of days’ worth of sales:
Working Capital Needs Days =
Working Capital Needs Days =
Working Capital Needs
* 365
Sales
Inventory + Accounts receivable – Accounts Payable
* 365
Sales
Example: Nike Inc. and Dell for 2013 (in $ million)
Nike
3,434
Inventory
=
* 365 = 50
* 365
25,313
Sales
3,425
Accounts receivable
* 365 = 49
Accounts Receivable Days =
* 365 =
25,313
Sales
Inventory Days =
Accounts Payable Days =
Accounts Payable
* 365
Sales
Working Capital Needs Days
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=
3,730
* 365 = 54
25,313
= 50 + 49 - 54 = +45
Financial Statement Analysis
Dell
1,382
* 365 = 9
56,940
9,842
=
* 365 = 62
56,940
=
=
15,223
* 365 = 97
56,940
= 9 + 62 - 97 = −26
7
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital Needs in days’ worth of sales or the Cash Conversion Cycle
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Financial Statement Analysis
8
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital and industry
Working Capital in Various Industries (2012)
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Financial Statement Analysis
9
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital and industry
Working Capital in Various Industries (2009)
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Financial Statement Analysis
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Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital and cash conversion performance
Cash-Rich companies: the example of Apple and Microsoft
“With a $145 billion cash hoard, Apple could acquire Facebook, HewlettPackard and Yahoo. Put another way, it could buy every office building and retail
space in New York, according to city estimates.”
The New York Times, APRIL 30, 2013,
In 2004, Microsoft stunned financial markets by announcing plans to pay the largest
single cash dividend payment in history, a one-time dividend of 32$ billion, or 3$
per share
Since then, Microsoft has purchased over 100$ billion in shares, and raised its
quarterly dividend 8 times
September 17, 2013
Microsoft’s board had approved a new $40 billion stock buyback program
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Financial Statement Analysis
11
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Working Capital Over Time
Working Capital Needs – Nike Inc. from 2011 to 2013
Working Capital Needs ($ million)
2011
2012
2013
+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
Working Capital Needs ($ million)
Inventory (Days of sales)
2011
2012
-4,902
-4,006
4
4
74
84
Accounts Payable (Days of sales)
117
120
Working Capital Needs (Days of sales)
-39
-32
Accounts Receivable (Days of sales)
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Financial Statement Analysis
2013
12
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
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
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Financial Statement Analysis
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Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
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” 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
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
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Financial Statement Analysis
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Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Managing Working Capital
Objective : reduce capital invested in the operating cycle … without altering the proper functioning of the firm
+ negotiate optimal credit terms
+ pay on the latest day allowed
- Stretching accounts payable may be costly
WCN = Inventory + Accounts receivable – Accounts Payable
(-) Excessive inventory uses cash:
Acquisition costs, order costs,
carrying costs (storage space,
insurance taxes, opportunity costs,
etc.)
+ Determining the credit policy: establishing credit
standards, credit terms and a collection policy
+ Monitoring Accounts receivable
- Cost of monitoring and collection
(+) benefits of holding inventory:
avoid stock-outs, seasonality
factors
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Financial Statement Analysis
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Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
Managing Working Capital
Corporate Finance – B&DM: Chap 26 - Working Capital Managment
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Financial Statement Analysis
16
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
What is the difference between investment and operating outflows?
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 the length of the operating cycle.
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
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Financial Statement Analysis
17
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The Free Cash Flow
Operating inflows
- Operating outflows
(I) Cash from Operating activities
Cash generated thanks to the core business activities
Investment inflows
- Investment outflows
(II) Cash from Investment activities
Cash needed to maintain or develop the production
equipment
(I) + (II) = Free Cash Flow
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
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Financial Statement Analysis
18
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The Free Cash Flow
A common and generally accepted definition:
FCF = Cash flow from operating activities + Cash From Investing Activities
FCF = EBIT * (1- t) + Noncash charges (such as D&A) – Increase in Working capital - Capex
Alternative measures of FCF:
Free Cash Flows to the Firm (FCFF)
FCFF = EBIT * (1- t) + Noncash charges (D&A) – Increase in Working capital - Capex + Interest*(1-t)
Free Cash Flows to the equity (FCFE)
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
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Financial Statement Analysis
19
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The Free Cash Flow
Quick check question
Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: http://finance.yahoo.com/
Free Cash Flow = +1,960,000
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Financial Statement Analysis
+2,413,000
+791,000
20
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
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 both
net 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?
0
1
2
4
3
…
€19,000
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€19,000 * (1 + 4% )
Financial Statement Analysis
€19,000 * (1 + 4% )
2
€ 19 , 000 * (1 + 4 % )
3
21
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
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
- 800
+19,000
- 19,200
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?
0
1
2
4
3
…
€19,200
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€19,200 * (1 + 4% )
Financial Statement Analysis
€19,200 * (1 + 4% )
2
€ 19 , 200 * (1 + 4 % )
3
22
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The financing cycle is the “flip-side” of the investment 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 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
(-) 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
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Financial Statement Analysis
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Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The financing cycle is the “flip-side” of the investment and operating cycles
Scenario I
The operating cycle
Cash from operating activities
Cash from
Investment
activities
The investment cycle
Free cash Flow
FCF > 0
The financing cycle
Cash
surplus
Cash from operating
activities
FCF < 0
Raising capital :
Increase in equity
Or
Increase in borrowings
> Or < 0
> Or < 0
Fahmi Ben Abdelkader ©
Financial Statement Analysis
Cash
shortfall
Cash from Investment activities
Paying debt interests
Paying dividends
Decrease in borrowings
Cash surplus
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Scenario II
24
Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
The financing cycle is the “flip-side” of the investment and operating cycles
Quick check question
Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: http://finance.yahoo.com/
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Financial Statement Analysis
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Classifying company cash flows
The Operating Cycle and the Working Capital
The Investment Cycle and the Free Cash Flow
The Financing Cycle
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-cut
The 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’.
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Financial Statement Analysis
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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,
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
firm is managing its operating cycle poorly?
6.
How does working capital impact a firm’s value?
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Financial Statement Analysis
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