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Users of Financial Information

Investors
– Make judgments about the firm's securities
– Financial Analysts report to investment community

Vendors
– Sell to the firm on credit

Management
– Highlight areas in which attention will improve
performance

Cash Flow Analysis

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Orientation of Financial Analysts

Sources of Financial Information

Annual Report Other Sources Critical and investigative

– Management's report – Reports from
card to stockholders on brokerage firms
own performance and advisory
services Looking for current or potential
– The primary source of
financial information – Value Line
problems
– Required of publicly – Credit reports
traded companies Looking for the physical reasons behind
– Must be audited financial results
– GAAP

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Statement of Cash Flows Building the Statement of Cash

Businesses run on cash, not accounting
profits
It is possible for a business to go out of
business while making a profit
Statement of Cash Flows
– Reports inflows and outflows of money
– Developed from the income statement and
balance sheet
Flows – Basic Approach
Build a Statement of Cash Flows from two
balance sheets and an income statement
Analyze where money has come from and
gone to
Begin with some personal examples

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Table 3-1 Cash Flow Rules Buying a Car on Credit

Joe Jones and His New Car

Asset Increase = Use

Liability Increase = Source
Asset Decrease = Source
Liability Decrease = Use

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Buying and Selling Cars - Buying and Selling Cars -

Sally Smith and Her Two Cars Sally Smith and Her Two Cars

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Business Cash Flows

Three sources of cash flows:

Operating Activities – day-to-day activities

Investing Activities – firm buys or sells ( or invests
in) fixed assets that enable it to do business.

Financing Activities – borrow money, pay off loans,

sell stock, pay dividends.

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Figure 3.2 BUSINESS CASH FLOWS Example 3-1 Business Cash Flows

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Additional Information

Belfry also sold new stock during

the year receiving a total of $800
and paid its shareholders dividends
of $500.

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Operating Activities Investing Activities

Net Income $ 1,000
Depreciation 500
Net Change in Current Accts (600)
Cash from Operating Activities $ 900
Purchase of Fixed Assets $(2,000)

Detail of Changes in Current Accounts

Account Begin End Source/(Use) Use Change in Gross Fixed Asset
Receivables $3,000 $2,900 $ 100
Inventory 2,000 3,200 (1,200)
Account
Payables 1,500 2,100 600
Accruals 500 400 (100)
$ (600)

Financing Activities

Increase in Long Term Debt $ 1,200

Sale of Stock 800
Dividends Paid (500)
Cash from Financing Activities $ 1,500

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TRY THIS!
Problem with TAX IMPLICATION
Compute cash flows from operations:
The Problematic Inc. had an operating
income (EBIT) of $300,000 this year. The firm
had $20,000 in depreciation expenses,
$15,000 in interest expense, and $100,000 in
cost of goods sold. If it has a marginal tax
rate of 30 percent and interest expense is
equal to interest paid, what was its cash flow
from operating activities this year?
Free Cash Flows (FCF): Why exclude other
Free Cash Flows (FCF): Basic Idea
What is a company’s discretionary cash
flow each year?
We only factor in cash flows from
operations and CAPEX. Why?
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Free Cash Flows (FCF)
Used to estimate whether a company
will provide or require cash in future
Cash generated by operations that’s
available for distribution to investors.
If negative, owners must borrow or sell
equity just to keep going as before
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items?
Cash Flow from investing and financing
sections are “optional” and not truly
required to run the business
Only required things
– Paying for COGS, OPEX, WC, CAPEX
Are we required to borrow money? To
sell stocks? To really run the
operations?
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Free Cash Flow for the Firm (FCFF) or

Calculating Free Cash Flow
Free Cash Flows (FCF)
FCFF – measure the level of the cash NOPAT is net operating profit.
available to a company’s investors net of T = tax rate
all required investments in working capital
and fixed capital (CAPEX), for a period.
NOPAT = EBIT – (T)(EBIT) = EBIT (1 – T)
– As FCF increases, balance sheet strength
increases
– However, it is important to note that negative
free cash flows is not a bad indicator in itself. Note: If there is no debt, NOPAT equals net
If it’s FCF is negative, it could be a sign of
significant investments (long-run effect)
income

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Calculating Free Cash Flow Calculating Free Cash Flow

Depreciation and amortization are subtracted
from revenue when calculating EBIT. Money available to investors can be written
Depreciation and amortization are noncash as:
charges, so EBIT understates cash flow by at
least those amount.
Adding back non-cash charges gives a figure FCF = Operating Cash Flow
that’s closer to cash flow called operating cash – Increase in Gross Fixed Assets
flow.
– Increase in Net Current
Operating Cash Flow = NOPAT + Non-cash Charges Accounts

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Calculating Free Cash Flow Calculating Free Cash Flow to Equity (FCFE)

FCF can also be computed as: If a company is able to distribute cash to

stockholders, then the equation becomes:
a. FCF = Cash Flow from Operating Activities
– CAPEX (if there is no interest expense)
b. FCF = [EBIT x (1-TR)] + Depreciation and FCFE = Operating Cash Flow
Amort. – Change in NWC – CAPEX – Increase in Gross Fixed Assets
c. FCF = (EBITDA x 1-TR) + (TR x Dep. And – Increase in Current Accounts
Amort.) – Change in NWC – CAPEX – (1-T)Interest – Principal Reduction

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Use of Free Cash Flow Use of Free Cash Flow

What are the uses of FCF when analyzing and Can FCF exceeds net income?
valuing companies?
– Leveraged Buyout (LBO) Analysis What does it mean?
– Standalone Analysis: Example
BEST – FCF is growing because the entity sells more,
– Cause might be of NON-CASH CHARGES
capturing more market – No CAPEX
NOT AS GOOD – FCF is growing because of creative cost
cutting or because it’s re-investing less into CAPEX
(short-term)
WARNING – FCF is growing despite falling sales and
profits, because it’s playing games with working capital
or non-cash charges or slashing CAPEX, or earning more
from non-core business activities.

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TRY THIS! The Cash Conversion Cycle

Problem with TAX IMPLICATION Racetrack Diagram
Free cash flows:
The Problematic Inc. had an operating
income (EBIT) of $300,000 this year. The firm
had $20,000 in depreciation expenses,
$15,000 in interest expenses, and $100,000
in cost of goods sold. If it has a marginal tax
rate of 30 percent and interest expense is
equal to interest paid, what was its free cash
flows this year assuming CAPEX amounted
to P 10,000 and decrease in current accounts
amounted to P 15,000?

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