Assessing financial risk using cash flow data Franz, an analyst at a large insurance company, receives the following e-mail from Sylvie, his boss.

‘Can you take a look at Unilever’s financial leverage for me? I’m concerned about the impact of the Bestfoods acquisition in 2000. It played havoc with their balance sheet. Their profitability seems to have recovered in 2001 but their debt levels still look very high.

‘I’m particularly interested in the group’s net debt-to-Ebitda ratio. I read that Procter & Gamble, Unilever’s big rival in the household products market, had a net debt-to-Ebitda ratio of only 1.37 in 2001/02 and it’s been pretty steady in recent years (2000/01: 1.39; 1999/2000: 1.33). How does Unilever compare with P&G on this ratio?

‘There’s another cash flow measure of financial leverage I’d like you to calculate. It’s called the cash flow adequacy ratio – or CFAR. The folks at Fitch, the credit rating agency, devised it.12 It’s calculated as follows:
CFAR = where:
Net free cash flow = Ebitda – Taxes paid – Interest paid – Preference dividends – Capex, net Average annual debt maturities . . . = (Debt principal payments due in next five years)/5 ‘Fitch claims CFAR is a reliable indicator of changes in corporate credit quality. P&G had a CFAR of 2.9 in 2001/02. According to Fitch, that shows financial strength: in effect, the company’s free cash flow covered average debt payments 2.9 times that year.’
Franz collects income and balance sheet data from the 1999–2001 accounts of the Anglo-Dutch food and household products group (see Exhibit 18.11). In addition, he extracts the following cash flow information from the group’s cash flow statements for these years.
2001 2000 1999 Income taxes paid 1,887 1,734 1,443 Interest paid (net of interest received) 1,651 620 58 Capital expenditures (net of disposals) 957 890 1,249 He’s about to start work on the assignment when he gets called away on another project. He asks you to complete the assignment for him.
Required

(a) Calculate Unilever’s net debt-to-Ebitda and CFAR ratios for each of the three years 1999–2001.
Identify the main reasons for the changes in the two ratios over this time. Do the two ratios send the same signals about the group’s credit quality and changes in it? If not, why not?

(b) Compare the two ratios, net debt-to-Ebitda and CFAR. Which of these ratios, in your opinion, provides a more accurate and reliable measure of a firm’s debt-paying ability – and why?AppenedixLO1

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Exhibit 18.10 Nestl Group: consolidated cash flow statement, 2001 In millions of Swiss francs Operating activities Net profit of consolidated companies 2001 2000 6,338 5,580 Depreciation of property, plant and equipment 2,581 2,737 Impairment of property, plant and equipment 222 223 Amortisation of goodwill 494 414 Depreciation of intangible assets 150 179 Impairment of goodwill 184 230 Increase/(decrease) in provisions and deferred taxes (92) (4) Decrease/(increase) in working capital (870) (368) Other movements (393) (140) Operating cash flow 8,614 8,851 Investing activities Capital expenditure (3,611) (3,305) Expenditure on intangible assets (288) Sale of property, plant and equipment 263 (188) 355 Acquisitions (18,766) (2,846) Disposals 484 780 Income from associates 133 107 Other movements 143 39 Cash flow from investing activities (21,642) (5,058) Financing activities Dividend for the previous year (2,127) (1,657) Purchase of treasury shares (1,133) Sale of treasury shares and options 880 (765) 1,837 Premium on warrants issued 209 81 Movements with minority interests (172) (221) Bonds issued 3,338 1,016 Bonds repaid (380) (1.143) Increase/(decrease) in other long-term financial liabilities (71) (155) Increase/(decrease) in short-term financial liabilities 16,754 821 Decrease/increase) in marketable securities and other liquid assets (2,330) (2,788) Decrease/(increase) in short-term investments 216 1,452 of year Cash flow from financing activities Translation differences on flows Increase/(decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Effects of exchange rate changes on opening balance Cash and cash equivalents retranslated at beginning Fair-value adjustment on cash and cash equivalents Cash and cash equivalents at end of year 15,184 (1,422) 60 (175) 2,216 2,196 5,451 3,322 (29) (67) 5,422 (21) 3,255 7,617 5,451