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					Statement of Cash Flows

EBITDA
 Many people define cash flow as EBITDA
– What is its relevance? – What is it missing? – Do it do a reasonably good job?

 Why not use the statement of cash flows?

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Importance of the Statement of Cash Flows
 Combines balance sheet & income statement analysis  Eliminates differences in accounting  Directly assesses “quality of earnings” — or ―How to go broke while making a profit...‖  Components:
– Operating activities (cash profits) – Investing activities – Financing activities.
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Articulation of Financial Statements
Cash Flow Statement
Cash from operations Cash from investing

Beginning Balance Sheet
Cash + Other Assets

Cash from financing
Net change in cash

Ending Balance Sheet
Cash + Other Assets

Statement of Shareholders’ Equity
Total Assets
Investment and disinvestment

Total Assets
by owners Net income and other earnings Net change in owners’ equity

- Liabilities Owners’ equity

- Liabilities Owners’ equity

Income Statement
Revenues

Expenses

FIN 591: Financial Fundamentals/Valuation Net income

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W. T. Grant
 Accounting profits versus cash operating profits  Cash flow frequently defined as:
Net income + depreciation
» Poor definition.

 Look at W. T. Grant’s trend...  And then at Salton…
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What Happened to W. T. Grant?
100 50 0 -50 -100 -150 -200 '66 '67 '68 '69 '70 '71 '72 '73 '74 '75
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NI + depr. NI CFFO

FIN 591: Financial Fundamentals/Valuation

What Happened to Salton?
80 60 40 20 0 -20 -40 -60 '93 '94 '95 '96 '97 '98 '99
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EBITDA CFFO

FIN 591: Financial Fundamentals/Valuation

Accounting Methods for Measuring Performance
 Strict cash basis of accounting.
– Revenues are recorded when cash is received and expenses are recorded when cash is paid

 Accrual basis of accounting
– Revenues and expenses are recorded on an economic basis independently of the actual flow of cash.

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Cash vs. Accrual Accounting
Cash Basis
Easy to understand. Provides a reliable picture of the the change in cash and the firm’s liquidity. Revenues and expenses are recorded according to cash inflows and outflows. Can be manipulated by changing the cash flows timing.

Accrual Basis
Theoretically difficult. Provides a more reliable picture of the economic changes in wealth. Revenues and expenses are recorded according to economic change in wealth (the rules are discussed later on in this clinic). Can be manipulated by the changing the recognition rules.

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Accrual Accounting: The Question
 At what point of the operating cycle of the firm should revenues and their related expenses be recognized?

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Accrual Accounting: Basic Rules
 Revenue and expense should be recognized at the first point at which both of the following criteria are met:
1. Revenue is earned
• • Revenue-producing activity has been performed Amount of cash to be collected can be estimated with reasonable accuracy.
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2. Revenue is either realized or realizable

Revenue Recognition
 For product sale transactions, revenue is typically recognized when when title passes to the customer  For service transactions, revenue is typically recognized when the substantial performance occurred
– Because of the intangibility of services, it is often difficult to ascertain when a service consisting of more than a single act has been satisfactorily performed so as to warrant recognition of revenue.
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Expense recognition
 According to the matching principle, selecting a revenue-recognition basis also determines whether related costs are expensed immediately or capitalized and expensed subsequently  Generally, expenses and losses are recognized when an entity's economic benefits are used up in the process of generating revenues.

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Earnings and Cash Flows
 Rather than matching cash inflows and outflows, earnings match revenues and expenses
Revenues = cash receipts + revenue accruals Expenses = cash disbursements – cash investments + expense accruals Earnings

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Revenue and Expense Accruals
Revenue Accruals

Value added that is not cash flow

Adjustments to cash inflows that are not value added

Expense Accruals

Value decreases that are not cash flow

FIN 591: Financial Fundamentals/Valuation

Adjustments to cash outflows that are not value decreases
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The Revenue Calculation
Revenue = Cash receipts from sales + New sales on credit

 Cash received for previous periods' sales
 Estimates of credit sales not collectible  Estimated sales returns and rebates  Deferred revenue for cash received in advance of sale + Revenue previously deferred.

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The Expense Calculation
Expense = Cash paid for expenses
+ Amounts incurred in generating revenue but not yet paid  Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period.

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Rules for Identifying Cash Flows
Balance Sheet
Assets increase Use Financing increases Source Financing decreases Use

Assets decrease Source

Revenues = Source Expenses = Use

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Sources = Uses
 Construct two columns for balance sheet changes
– Sources = decreases in assets & increases in financing – Uses = increases in assets & decreases in financing

 Sources must equal uses  Construct the SCF.
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Example: Construct a SCF
Beginning Balance Sheet Cash 100 Payables 50 AR 150 Accruals 75 Invent 200 Equity 475 Fixed 150 Total 600 600 Income Statement Sales 500 COS 300 Expenses (Deprec. = 5) 170 Profit 30 Ending Balance Sheet Cash 120 Payables 125 AR 100 Accruals 50 Invent 250 Equity 495 Fixed 200 Total 670 670 Statement of Cash Flows

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Worksheet

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On to Free Cash Flow
 Definition of free cash flow:
–

After-tax operating earnings + non-cash charges - investments in operating working capital, PP&E and other assets.
»

It doesn’t incorporate financing related cash flows

 Operating free cash flow = Cash flow to debt holders + cash flow to equity owners
» In other words, the sum of operating flows = sum of financing flows.
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Free Cash Flow
 Normal approach is to use the SCF
–

Operating cash flows less investing activity Not all investments are necessary
» Eliminate discretionary investments

 Problems:
– – –

Operating cash flows includes interest expense
» Eliminate it and put in financing category

Operating cash flows exclude all cash
» Add necessary transaction balances.
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FCF Per the Valuation Text
 FCF = NOPLAT - net operating investment  What is NOPLAT?
NOPLAT means ―net operating profit less adjusted taxes‖ – See Exhibit 7.3 of Valuation text for an example – Comparable to EBIT * (1 - t)
–

» Tax expense adjusted
• •

Change in deferred taxes Tax shield provided by interest expense & other non-operating expenses.
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Questions Raised by the SCF...
 How strong is internal cash flow generation?  Is cash flow from operations positive? Why? If negative, why?  Is the company growing? Too quickly?  Are operations profitable?  Are there problems managing working capital?
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Questions...
 Can the company meet short-term obligations from operating cash flows?  Can it continue to meet these obligations without reducing operating flexibility?  How much is invested in growth?  Are these investments consistent with the business strategy?  Was internal cash used to finance growth?
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Questions...
 Does free cash flow exist? Is this a longterm trend?  What plan does management have to deploy free cash flow?  Were dividends paid from free cash flow? Or was external financing used?  If external financing is used for dividends, is the dividend policy sustainable?
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Questions...
 What type of external financing does the company rely on?
– – –

Equity Short-term debt Long-term debt

 Is the financing consistent with the company’s overall business risk?
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Questions...
 Are there significant differences between a firm’s net income and its operating cash flow?  Is it possible to identify the sources of this difference?  Which accounting policies contribute to it?  Do one-time events contribute to the difference?
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Questions...
 Is the relationship between operating cash flow and net income changing over time? Why?  Is it because of changes in business conditions or accounting policies and estimates?  What is the time lag between the recognition of revenue and expenses and the receipt and disbursement of cash flows?

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Questions
 Are the changes in receivables, inventories, and payables normal?  If not, is there adequate explanation for the changes?

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The End

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