Cash Flow Analysis
Traditional SCF Life-Cycle Phases
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Each cash flow activity will increase or decease
over time depending upon the life-cycle of the
company’s products.
Here is the most common pattern for revenues,
net income, and cash flows.
Analyzing Cash Flow
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Cash flow analysis can be used to address a variety of
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questions regarding a firm's cash flow dynamics:
How strong is the firm's internal cash flow generation?
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Is the cash flow from operations positive or negative?
If it is negative, why?
Is it because the company is growing?
Is it because its operations are unprofitable?
Or is it having difficulty managing its working capital properly?
Does the company have the ability to meet its short-term
financial obligations, such as interest payments, from its
operating cash flow?
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Can it continue to meet these obligations without reducing its
operating flexibility?
Analyzing Cash Flow
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How much cash did the company invest in growth?
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Did the company pay dividends from internal free cash flow,
or did it have to rely on external financing?
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If the company had to fund its dividends from external sources, is
the company's dividend policy sustainable?
What type of external financing does the company rely on?
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Are these investments consistent with its business strategy?
Did the company use internal cash flow to finance growth, or did it
rely on external financing?
Equity, short-term debt, or long-term debt?
Is the financing consistent with the company's overall business risk?
Does the company have excess cash flow after making capital
investments?
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Is it a long-term trend?
What plans does management have to deploy the free cash flow?
Recasting the SCF
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Although it is possible to answer these questions
using the GAAP SCF format, recasting the SCF
makes answering these questions easier.
In addition, using a standard format makes
comparison between companies easier.
Here is the model that we will use in this class.
Traditional SCF Format
Net Income
+ Depreciation and Amortization
± Deferred Taxes
± Gains/Losses
± Changes in Working Capital
= Cash Flow from Operating Activities
- Purchases of Long Term Assets
+ Sales of Long Term Assets
= Cash Flow from Investing Activities
+ Sale of Stock
+ New Borrowing
- Debt Payments
- Dividends
- Stock Repurchases
= Cash Flow from Financing Activities
Cash Flow from Operating Activities
+ Cash Flow from Investing Activities
+ Cash Flow from Financing Activities
= Net Change in Cash
Recast SCF Format
Net Income
+ Interest Expense (Net of Tax)
+ Depreciation and Amortization
± Deferred Taxes
± Gains/Losses
= OCF before Working Capital Investments
± Changes in Working Capital
= OCF before Investment in Long Term Assets
- Purchases of Long Term Assets
+ Sales of Long Term Assets
= FCF Available to Debt and Equity
- Interest Expense (Net of Tax)
- Debt Payments
+ New Borrowing
= FCF Available to Equity
+ Sale of Stock
- Dividends
- Stock Repurchases
= Net Change in Cash
OCF = Operating Cash Flow
FCF = Free Cash Flow
Operating Cash Flow
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Operating Cash Flow is broken up into two
components, OCF before working capital
investments and OCF before investments in
long term assets.
Over the long run OCF must be positive, but
firms in the early stages of development,
growing rapidly, or investing heavily in research
and development, marketing and advertising,
and other future growth opportunities will have
negative OCF.
Free Cash Flow
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If cash flow after investing in long term assets is
not positive then the firm did not generate
enough cash from operations to pursue longterm growth opportunities and must rely on
external financing.
These firms have less flexibility than firms that
can generate the necessary funds internally.
Cash flow after long term investments is cash
flow available to both debt and equity holders.
Free Cash Flow
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Payments to debt holders include interest and
principal payments.
Firms with negative free cash flow after
investments in long term assets must borrow
additional funds to meet their interest and
principal payments.
They can also reduce their investments in
working capital, long term investments, or issue
additional equity.
Free Cash Flow
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Cash flow after payments to creditors is free
cash flow available to owners.
Payments to equity holders include dividends
and stock repurchases.
If firms pay dividends despite negative cash
flows available to equity holders then they are
borrowing to pay dividends. This is not
sustainable in the long term.
Summary
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Examine cash flow from operations before
investment in working capital to verify the
company is able to generate a cash surplus from
its operations.
Examine cash flow from operations before
investment in long term assets to how the firms
working capital is being managed and to see if
the company can invest in long-term assets for
future growth.
Summary
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Examine free cash flow to debt and equity
holders to asses a firm’s ability to meet its
principal and interest payments.
Examine free cash flow to equity holders to
asses a firm’s ability to sustain its dividend
policy.
All cash flow analysis must be done taking into
consideration the company’s business, its growth
strategy, and its financial policies.
Analyzing Quality of Income
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The Quality of Income Ratio is calculated as
Cash Flow from Operations
Net Income
OR
Cash Flow from Operations
Net Income + Depreciation
This ratio should be > 1 for a healthy firm.
Analyzing Quality of Income
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If there are significant differences between net
income and operating cash flow ask the
following questions:
What are the sources of the difference?
 Is it due to accounting policy?
 Is it due to one-time events or on-going activities?
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Is the relationship changing over time?
If so, why? (see above for possible reasons).
 Is it because of changes in business conditions or
accounting policies and estimates?
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Analyzing Quality of Income
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What is the time lag between recognition of
revenues and expenses and the receipt or
payment of cash?
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What uncertainties are there regarding cash
collection or cash payments (e.g. bad debts,
contingent liabilities, etc.)
Are the changes in working capital accounts
normal?
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If not, is there an adequate explanation for the
changes?