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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? FIN 591: Financial Fundamentals/Valuation 2 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. FIN 591: Financial Fundamentals/Valuation 3 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 4 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… FIN 591: Financial Fundamentals/Valuation 5 What Happened to W. T. Grant? 100 50 0 -50 -100 -150 -200 '66 '67 '68 '69 '70 '71 '72 '73 '74 '75 6 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 7 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. FIN 591: Financial Fundamentals/Valuation 8 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. FIN 591: Financial Fundamentals/Valuation 9 Accrual Accounting: The Question At what point of the operating cycle of the firm should revenues and their related expenses be recognized? FIN 591: Financial Fundamentals/Valuation 10 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. FIN 591: Financial Fundamentals/Valuation 11 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. FIN 591: Financial Fundamentals/Valuation 12 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. FIN 591: Financial Fundamentals/Valuation 13 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 FIN 591: Financial Fundamentals/Valuation 14 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 15 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. FIN 591: Financial Fundamentals/Valuation 16 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. FIN 591: Financial Fundamentals/Valuation 17 Rules for Identifying Cash Flows Balance Sheet Assets increase Use Financing increases Source Financing decreases Use Assets decrease Source Revenues = Source Expenses = Use FIN 591: Financial Fundamentals/Valuation 18 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. FIN 591: Financial Fundamentals/Valuation 19 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 FIN 591: Financial Fundamentals/Valuation 20 Worksheet FIN 591: Financial Fundamentals/Valuation 21 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. FIN 591: Financial Fundamentals/Valuation 22 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. FIN 591: Financial Fundamentals/Valuation 23 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. FIN 591: Financial Fundamentals/Valuation 24 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? FIN 591: Financial Fundamentals/Valuation 25 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? FIN 591: Financial Fundamentals/Valuation 26 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? FIN 591: Financial Fundamentals/Valuation 27 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? FIN 591: Financial Fundamentals/Valuation 28 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? FIN 591: Financial Fundamentals/Valuation 29 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? FIN 591: Financial Fundamentals/Valuation 30 Questions Are the changes in receivables, inventories, and payables normal? If not, is there adequate explanation for the changes? FIN 591: Financial Fundamentals/Valuation 31 The End FIN 591: Financial Fundamentals/Valuation 32