ADVANCED CASH FLOW ANALYSIS

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					ADVANCED CASH
FLOW ANALYSIS
    Chapter 11
CHAPTER 11 OBJECTIVES
  Explain the importance of investing and
   financing cash flows.
  Relate cash flows from investing and
   financing activities to those from
   operations.
  Describe an entity’s need for sufficient
   and efficient cash flows.
CHAPTER 11 OBJECTIVES
(CONT.)
  List and compute measures of cash
   sufficiency and efficiency.
  Provide an in-depth analysis of
   corporate and industry cash flows.
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES
  Cash flows from investing activities (CFIs)
  Cash flows related to the acquisition and
   disposal of three types of wealth-building
   resources
        Property, plant, and equipment
        Intangible assets
        Debt and equity securities
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
  Cash flows from investing activities
   (CFIs)
  Reported after cash flows from
   operating activities in a statement of
   cash flows
  Analysts study CFIs to gain perspective
   about investments’ relative cost and
   benefits
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
  Cash flows from investing activities (CFIs)
  Cash flows are related to an entity’s life cycle
   stage
        Significant cash outflows in the emerging and
         growth stages of business
        They become positive and peak during business
         maturity
        CFIs trend toward zero as a firm declines and
         ceases operations
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
  Cash flows from financing activities (CFFs)
  Those types of cash flows related to the
   acquisition and disposal of external resources
   needed to acquire productive assets
        Equity issues and their reacquisition (treasury
         stock)
        Equity returns on investments (cash dividends)
        Debt issues and retirements
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
  Cash flows from financing activities
   (CFFs)
  Reported as the final section in a
   statement of cash flows
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
    CFFs are related to an entity’s life cycle
     stage
      Significant cash inflows in the emerging
       and growth stages of business
      They decline during business maturity

      CFFs negative as a firm declines and
       ceases operations (return of investment)
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
    In addition to the cash flow statement
     itself, information about CFIs and CFFs
     can be found in
      Management’s discussion and analysis
      Disclosures about market risk

      The financial media (pending debt and
       equity issues)
CASH FLOWS FROM
INVESTING AND FINANCING
ACTIVITIES (CONT.)
    Correlation of CFIs and CFFs
      Sometimes cash provided by a financing
       activity can be traced to the cash used for
       an investment (e.g., issuing a bond to
       acquire a building)
      Correlations between CFIs and CFFs
       become more obscure as a business
       matures
CASH FLOW MEASURES
    Objectives
        A company must produce enough cash from
         business operations to satisfy investors
        Measure the relationship between operating cash
         flows and those from investing and financing
         activities
        Determine if an enterprise produces enough of the
         right kinds of cash flows to grow the business
CASH FLOW MEASURES
(CONT.)
  Primary cash sufficiency measures
  Provides evidence as to whether an
   entity produces enough cash from
   operations to meet its needs
  Cash flow adequacy is the primary
   measure of cash sufficiency
CASH FLOW MEASURES
(CONT.)
    Cash flow adequacy is computed as: cash
     flows from operations / (fixed assets
     purchased + long-term debt paid + cash
     dividends distributed)
        General interpretation: a ratio of one or more
         indicates an entity’s operations produce sufficient
         cash to meet necessary business obligations
        A ratio of less than one indicates potential liquidity
         problems
        Discretionary cash flows exist if the ratio exceeds
         one
CASH FLOW MEASURES
(CONT.)
  Decomposition of cash flow adequacy
   ratio
  Individually examines each component
   of the cash flow adequacy ratio
  Inverts ratio’s numerator and
   denominator to avoid mathematical
   problems
CASH FLOW MEASURES
(CONT.)
    Decomposed ratio is computed as
      Reinvestment ratio: fixed assets purchased
       / cash flows from operations
      Long-term debt repayment ratio: long-term
       debt paid / cash flows from operations
      Dividend payout ratio: cash dividends paid
       / cash flows from operations
    In general, analysts favor low ratios for
     the components of cash flow adequacy
CASH FLOW MEASURES
(CONT.)
    Free cash flows
        Computed as: cash flows from operations –
         (capital expenditures + dividends)
        Interpretation: the more free cash the greater an
         entity’s amount of discretionary cash and liquidity
        Depend on firm size
        Ignore long-term term debt repayment in the
         calculation
        Commingles fixed asset replacement with fixed
         asset expansion
        Could exclude the purchase of productive
         intangible assets in its calculation
CASH FLOW MEASURES
(CONT.)
    Depreciation impact ratio
      Computed as: (depreciation + amortization
       expenses) / cash flows from operations
      Interpretation: small ratio indicates
       financial strength as the non-cash addition
       to income isn’t the driving force behind
       operating cash flows
      A large ratio (approaching one) indicates
       insufficient cash flow from core activities
CASH FLOW MEASURES
(CONT.)
    Recapitalization ratio
        Computed as: reinvestment ratio / depreciation
         impact ratio
        Interpretation: a ratio in excess of one means that
         a company’s investment in productive resources
         exceeds its use of productive resources
        A ratio below one means capital assets are not
         being replaced in a timely manner
        Fails to measure capitalization as opposed to
         recapitalization (e.g., for an emerging firm)
CASH FLOW MEASURES
(CONT.)
  Cash efficiency measures
  A company must invest wisely in productive
   resources
  Measure the relationship between operating
   cash flows and assets and revenues
  Determine if an enterprise’s investments
   produced enough operating cash flows
CASH FLOW MEASURES
(CONT.)
    Three measures of cash efficiency
      Cash flow return on assets: cash flow from
       operations / total assets
      Cash flow return on sales: cash flow from
       operations / revenues
      Operations index: cash flow from
       operations / operating income
Cash Flow Ratios              2003     2002      2001
Cash flow adequacy            0.54    72.00     (0.62)
Reinvestment ratio            0.75      -       (1.59)
Long-term debt repayment      1.12      -         -
Dividend payout                -       0.01     (0.03)
Free cash flow               27.00   142.00   (165.00)
Depreciation impact ratio     1.32     0.87     (1.98)
Recapitalization index        0.57      -        0.80
Cash flow return on assets    0.12     0.16     (0.08)
Cash flow return on sales     0.08     0.12     (0.05)
Operations index             21.40     2.44     (1.15)
CASH FLOW MEASURES
(CONT.)
  Signs of cash efficiency
  Large rates of cash returns on assets
   and revenues
  Strong correlation between operating
   cash flows and operating income
CASH FLOW MEASURES
(CONT.)
    Cash sufficiency versus cash efficiency
      An entity must produce sufficient cash to
       prosper
      They should do in an efficient manner (i.e.,
       generating maximum revenues from its
       productive base.)
      Cash flow sufficiency is a necessary
       component of cash flow efficiency
APPLE COMPUTER AND THE
PC INDUSTRY
  Investing and financing measures
  Inventory reductions created cash,
   which manifested itself in
      Securities investments made throughout
       the industry
      Compaq’s debt repayment and technology
       acquisitions
      Dell’s contraction of capital
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)
    Apple’s investing and financing activities
      Substantial investments were made in
       available-for-sale debt and equity securities
      Preferred stock and long-term bond were
       issued from 1996-1998
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)
  Cash sufficiency measures
  Volatile cash flow adequacy measures
   (Exhibit 11-3A and 11-3B)
        Dell produced the most discretionary cash flows
        Gateway demonstrated increasing levels of
         adequate cash flows
        Compaq’s 1998 performance eliminated its
         discretionary cash flows
        Apple’s performance lagged those of its
         competitors
                                  PC Industry
                          Cash Flow Adequacy Ratios
                                   1993-1998


1400%

1200%

1000%

800%

600%

400%

200%

  0%
        1993      1994                1995     1996         1997         1998
-200%

-400%

               Apple Computer, Inc.              Compaq Computer Corp.
               Dell Computer Corp.               Gateway 2000, Inc.
                              PC Industry
               Weighted Average Cash Flow Adequacy Ratio
                               1993-1998


500%
450%
400%
350%
300%
250%
200%
150%
100%
50%
 0%
       Apple             Compaq             Dell           Gateway
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)
    Component measures provide additional
     insights about the industry’s cash flow
     adequacy
      Dell and Gateway had lower component
       measures, which indicated adequate cash
       flows
      Those for Compaq were higher than the
       industry leaders’ component ratios
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)
    Apple’s component analysis
     demonstrated inadequate cash flows,
     by its
      extremely high depreciation impact ratio
       (Exhibit 11-6A)
      cumulative recapitalization index that was
       significantly below one (Exhibit 11-6B)
      decreasing recapitalization index over time
       (Exhibit 11-6C)
                       PC Industry
        Weighted Average Depreciation Impact Ratio
                        1993-1998


80%
70%
60%
50%
40%
30%
20%
10%
0%
      Apple         Compaq           Dell            Gateway
                       PC Industry
         Weighted Average Recapitalization Indices
                        1993-1998

2.5

 2

1.5

 1

0.5

 0
      Apple         Compaq            Dell           Gateway
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)
  Cash efficiency measures
  Reinforce the analysis of the superior cash
   flows produced by Dell and Gateway
        Dell led the industry on operating cash returns on
         sales and assets
        Gateway and Compaq generated an equal amount
         of operating cash per sales dollar, but Gateway’s
         cash return on assets exceeded that for Compaq
        Apple produced significantly less cash per sales or
         investment dollar than the returns produced by
         the other firms
                       PC Industry
        Weighted Average Cash Flow Return on Assets
                        1993-1998


30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
        Apple        Compaq           Dell            Gateway
                       PC Industry
        Weighted Average Cash Flow Return on Sales
                        1993-1998


12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%
        Apple        Compaq           Dell           Gateway
APPLE COMPUTER AND THE
PC INDUSTRY (CONT.)
    Operations Index (Exhibits 11-9A and
     11-9B)
      Gateway, Dell, and Compaq’s operating
       cash flows correlated with operating
       income from 1993 to 1998
      Apple’s operating cash was negatively
       correlated with operating income during
       the period analyzed
                          PC Industry
               Weighted Average Operations Index
                           1993-1998

  2
1.5
  1
0.5
  0
-0.5   Apple          Compaq           Dell        Gateway

 -1
-1.5

				
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