Cash Flow Analysis

K.VISWANATHAN

4/22/2012

What is Cash flow and its analysis

Cash flow is essentially the movement of money into and out of any business; it's the cycle of cash inflows and cash outflows that determine the business' solvency. Cash flow analysis is the study of the cycle of the business' cash inflows and outflows, with the purpose of maintaining an adequate cash flow for the business, and to provide the basis for cash flow management. Cash flow analysis involves examining the components of the business that affect cash flow, such as accounts receivable, inventory, accounts payable, and credit terms. By performing a cash flow analysis on these separate components, we can more easily identify cash flow problems and find ways to improve the cash flow of the business

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The How and why of Cash Flow analysis A quick and easy way to perform a cash flow analysis is to compare the total unpaid purchases to the total sales due at the end of each month. If the total unpaid purchases are greater than the total sales due, we need to spend more cash than we receive in the next month, indicating a potential cash flow problem. A cash flow analysis of the accounts receivable shows which customers are slow payers.
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How to do a Cash Flow Analysis ?

Cash is the gasoline that makes any business run. Cash flow can be defined as the way money moves into and out of business; good cash flow management is the difference between just being able to open a business and being able to stay in business. Cash flow analysis is a method of checking up on the firms financial health. It is the study of the movement of cash through the business, called a cash budget, to determine patterns of how we take in and pay out money. The goal is to maintain sufficient cash for firm operations from month to month. This type of cash flow analysis is called developing the cash budget.
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Steps involved in Cash Flow Analysis

This type of cash flow analysis is called cash budgeting analysis. It is part of a firm's financial forecasting plan. Step 1: Cash inflow: Determine the amount of cash that will flow into the firm during the month. If it is a starting business, we need to include the beginning balance in cash that should be available every month. There would also be the amount of sales made/ to be made during the first month. Sales would include both cash sales and sales that to the customers who pay on credit.

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Steps involved in Cash Flow Analysis

Step 2: Cash Outflow: Determine the amount of cash that will flow out of the firm during the month. Determine expenses. We have to buy office supplies; other monthly expenses may include advertising, vehicle expenses, payroll expenses, just to name a few. There could be some quarterly expenses, such as taxes. There also could be expenses that just occur occasionally, like purchases of computer equipment, vehicles, or other larger expenses. Taking into account all these, we can prepare a Schedule of Cash Payments and that is the second step of the cash budget.
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Steps involved in Cash Flow Analysis

Deciding acceptable end balance We expect the cash flow into the firm (Step 1) to be greater than the cash that will flow out of the firm (Step 2). Then we will have sufficient cash to operate the firm. This can be calculated using a work sheet. The ending balance for the first month becomes the beginning balance for the second month. We may do the same type of analysis. Each month, we may have to add more items to the cash flow analysis as the business grows. We need to decide what the minimum acceptable ending cash balance for the firm and aim towards that figure each month.
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Steps involved in Cash Flow Analysis

What to do, if cash flow turns negative? If the cash flow turns negative for any one month, we may have to borrow money for that month from family or friends, investors, or from a bank or other financial institutions. Then, when the cash flow turns positive the next month, we can repay that loan. We need to keep on doing this each month for the entire forecasting period. We need to keep the borrowing to a minimum and keep cash inflow greater than the outflows. Cash budget is a financial forecasting document, so we should follow it as closely as possible.
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Types of Cash Flows

The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to the change in cash balance over this period: -positive if the cash balance increases (more cash becomes available), -negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas: Operating, Financing and Investing cash flows 1. Operating Cash Flows : Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term, this must be net 4/22/2012 9 positive if the company is to remain solvent.

Types of Cash Flows

2. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets). 3. Financing Cash Flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments. Let us see how we can calculate them.

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Operating Cash flows

Equation to calculate Operating cash flow : EBIT (earnings before interest and taxes)+ DepreciationTaxes. EBIT is also known as operating income. This information can be found in a company's annual report Operating cash flow is a solid measure of a company's profits because it refers to actual cash made from operations and is thus hard to manipulate. Operating cash flow is important since a company could be bringing in tons of money but still be struggling to pay its bills.
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Operating Cash flows

Looking at operating cash flow will show us whether a company is burning more money than it is earning. Operating cash flow is a good at-a-glance snapshot of how the business is doing. Positive cash flow is a good sign, while negative cash flow needs to have a one-time explanation (an investment or expense that will not be repeated; for example, an acquisition or a new factory). If a company's cash flow has been negative for years, or if its cash flow is steadily decreasing, this is a warning sign that means we need to dig deeper before making any type of investment in the company.
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Operating Cash flows

In recent years, cash flow has gained in popularity as a financial measure because it is more difficult to manipulate than certain other metrics, such as revenues. A company could make its revenues look bigger by, for example, postponing rebates (which would lower revenues) until the next reporting period, thus creating the appearance of a business that's more prosperous than it really is. However, because operating cash flow deals with actual money, it's much harder for a company to "massage the numbers" into saying what management wants them to say. That is why it is such a key financial metric, despite its seeming simplicity.
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Operating Cash flow- Example

We are interested in calculating OCF for: 2002 2002 Timeline 31/ 12/01=1/1/02 12/31/02 Financial Data for the company: Item Year 2001 Year 2002 ( Amts. In lacs of Rs) Net profit 282 487 Depreciation expense 50 65 Cash & equivalents 75 90 Accts. receivable 400 600 Inventory 250 350 Accts. payable 175 250 Calculating OCF: 487 + 65 - 225 (How was this determined? Refer next slide) 327 OCF2002 or CFFO2002
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Operating Cash flow- Example

OCF= Net Income + Depreciation - Amount by which Net Working Capital Changes (latter in symbols: NWC) = 487 + 65 - NWC NWC changes EXCLUDING Cash = 552 - NWC Marketable Securities Current Portion (Current Maturities) of Long Term Debt We can remember a simple formula to link the three major working capital accounts to change in net working capital: NWC = AR(Accounts Receivable) + I (Inventory) - AP (Accounts Payable = (600-400) + (350-250) - (250-175) = (200) + (100) - (75) = 300 - 75 = 225 4/22/2012

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Investing Cash flows

What is an investing cash flow? An item on the cash flow statement that reports the aggregate change in a company's cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries, and changes resulting from amounts spent on investments in capital assets such as plant and equipment. When analyzing a company's cash flow statement, it is important to consider each of the various sections which contribute to the overall change in cash position. In many cases, a firm may have negative overall cash flow for a given quarter, but if the company can generate positive cash flow from its business operations, the negative overall cash flow may be a result of heavy investment expenditures, which is not bad .

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The activities of acquisition and disposal of long term assets and other investments not included in cash equivalent are investing activities.

Examples of Investing Cash flows

It includes making and collecting loans, acquiring and disposal of debt and equity instruments, property and fixed assets etc.
Examples of cash flows arising from investing activities are as follows: Cash payments to acquire fixed assets Cash receipts from disposal of fixed assets Cash payments to acquire shares, warrants or debt instruments of other enterprises and interest in joint ventures Cash receipt from disposal of above investments
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Using cash flow for investment decisions

An example: A firm is deciding on investing in an energy efficiency system. Two possible systems are under investigation One yields quicker results in terms of energy savings than the other, but the second may be more efficient later Which should the firm invest in?

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Using cash flow for investment decisions

Discounted Cash Flow System A

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Using cash flow for investment decisions

Discounted Cash Flow System B

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Using cash flow for investment decisions

System A represents the better investment System B yields the same return after six years but the returns of System A occur faster and are worth more to the firm than returns occurring in future years even though those returns are greater
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Financing Cash flows

Those activities that result in changes in size and composition of owners capital and borrowing of the organization. It includes receipts from issuing shares, debentures, bonds, borrowing and payment of borrowed amount, loan etc. Sale of share Buy back of shares Redemption of preference shares

Issue / redemption of debentures

Long term loan / payment thereof Dividend / interest paid
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Financing Cash flows

The formula for cash flow from financing activities is as follows:
Cash Received from Issuing Stock or Debt - Cash Paid as Dividends and for Re-Acquisition of Debt/Stock Negative numbers can mean the company is servicing debt But it can also mean the company is making dividend payments and stock repurchases, which investors might be glad to see.

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Cash Flows and life cycle state of a company

Under Discounted Cash Flow Method, we come across two major states of the company in its life cycle : 1. The first one is the period when the company is in its active growth phase. In this phase, normally the company will have to be extremely careful and calculative about the management of all its cash flows. 2. The second state represents the period when the company is supposed to have attained steadiness and the further growth of the company is more or less steady. By now, the companys system of managing the cash flows should have become steady.
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Cash Flows and life cycle state of a company

During the first state- i.e the growth phase, the cash flows have to be monitored carefully. The following should be ensured: 1. Enough cash flows should be available to continue with the process of operations- payment for raw materials / inventory , salary to workers, payment of interest on borrowings etc. The inflows from sales / services provided should be meticulously monitored to receive them in a timely manner. 2. All investments to be carefully considered, before making them. Each investment should be appraised to ensure that the ROI is greater than cost of funds 3. There will be more financial cash inflows than outflows during this period.
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Cash Flows and life cycle state of a company

During the second state- i.e the consolidated phase, the cash flows have to be continued as predicted. 1. Continuance of operations has to be ensured. Enough cash flows to be available to continue with the process of operations. Adequate systems to be in place by this time to ensure meticulous monitoring of the inflows and out flows in a timely manner. 2. More investments could be needed to replace existing fixed assets. There could also be adequate cash flows from the sale of old investments. All new investments to be carefully considered, before making them-to ensure that the ROI is greater than cost of funds. 3. The Company also could go for repayment of its debt and increase of equity. Non cash flows like bonus shares may be there. The company may also go for consolidation of its control by purchase of its own shares.
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Cash Flows and Financial flexibility Management of cash flows is nothing but maintenance of the financial flexibility of the company. The cash flows-both inward and outwardshould be adequate and timely. There is no point in keeping the company rich, if it is unable to meet, for example, its day to day operational commitments.

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Cash Flows and Dividend Policy

Cash flows happen mainly from revenue / sales. Cash flows are also impacted by the Dividend policy of the company, which determines the amount of earnings to be retained in the company for its future growth and the amount to be distributed by way of dividend. The company cannot follow the policy of distribution of all its net earnings as dividend. It also cannot follow the policy of retaining all its net earnings. So a prudent policy in terms of the industry, in which the company operates as well as the financial strength of the company needs to be followed.
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Some suggestions to improve Cash Flows and Financial flexibility

We should take a look at a 2 months cash budget going forward. We should take a look on a week-by-week basis, roughly a month to a quarter out in the future, and put down what we expect to receive and what payments we actually expect to make. Though it sounds simple, a lot of companies dont do that. If we look at the historical business from last month or last year, thats an indicator of the ability of the company to be profitable. Hence when we are able to match the cash in and cash out, it can be enlightening.
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 We should be more aware of the sources and uses of cash in the balance sheet and working capital accounts. Three primary issues to be considered here: 1. Appropriately managing the accounts receivable, which includes preparing bills faster for customers. When economic times are better, some companies may go a week or two at a time without preparing and sending bills because the cash flow is not quite as important. But now a days it is becoming more important to prepare and collect the cash faster 2. The second component is inventory. Having a lot of cash tied up in the inventory can be a constraint on the company. We need to limit the amount of time that cash is tied up in inventory. (Economic Order Quantity) 4/22/2012 30

Some suggestions to improve Cash Flows and Financial flexibility

Some suggestions to improve Cash Flows and Financial flexibility

3. The third item is accounts payable and how slowly or quickly the company pays its vendors. If the company has the ability to wait a little bit longer without impairing its credit standing with them, that can ultimately be a source of cash. Another way is to have a close look at the items, considered under cash flow. Some of the traditional companies will look at their net income, add back non-cash items like depreciation and include them in their cash flow. But we need to be more realistic in doing it and do it only when warranted.

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Some suggestions to improve Cash Flows and Financial flexibility

How can the companys budget be made flexible for any unexpected receipts of expenditures? The idea is to keep it on a rolling basis. The better way is to look at it weekly, so that the company can better account for the things, not originally planned. Suppose they need to pay for something else, they can look out over four to six weeks ahead and find if some vendor credit terms can allow them to delay the payment of an item for a week. This way they can manage their short-term future much better. Constantly updating it allows the firm to be flexible.
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Why should you improve your cash flow? Ultimately, its not a lack of profitability that causes problems for a company but a lack of liquidity. People talk about the five Cs of credit (character, capacity, capital, collateral and conditions), but the most important C is cash-i.e .Capital. Liquidity is either cash or the companys ability to turn their assets into cash quickly. Without this, the company can have a hard time making its payroll, paying its bills, etc.
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Benefits of improving your cash flow On improving cash flow, the first thing the company achieves is financial flexibility. When the company is as efficient as it can be, that gives them the ability to reduce leverage and not carry a big debt load. It allows them to be in a better position during a period of time when revenue drops or general economic conditions are tough. Thus financial flexibility buys the company the required time during those tough circumstances to tide over the hardships.
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Cash Flow Analysis

THANK YOU
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