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Financial Statement Analysis K.R. Subramanyam Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-2 Cash Flow Analysis 07 CHAPTER 7-3 Statement of Cash Flows Relevance of Cash Cash is the most liquid of assets. - Offers both liquidity and flexibility. - Both the beginning and the end of a company's operating cycle. Contrast: Accrual accounting and Cash basis accounting. - Net cash flow as the end measure of profitability. - Cash flow analysis helps in assessing liquidity, solvency, and financial flexibility. 7-4 Statement of Cash Flows Relevance of Cash Statement of cash flows (SCF) helps address questions such as: How much cash is generated from or used in operations? What expenditures are made with cash from operations? How are dividends paid when confronting an operating loss? What is the source of cash for debt payments? How is the increase in investments financed? What is the source of cash for new plant assets? Why is cash lower when income increased? What is the use of cash received from new financing? 7-5 Statement of Cash Flows Reporting by Activities The SCF reports cash receipts and cash payments by operating, financing, and investing activities: Operating activities are the earning-related activities of a company. Beyond revenue and expense activities represented in an income statement, they include the net inflows and outflows of cash resulting from related operating activities like extending credit to customers, investing in inventories, and obtaining credit from suppliers. 7-6 Statement of Cash Flows Reporting by Activities Investing activities are means of acquiring and disposing of noncash assets. - Involve assets expected to generate income; lending funds and collecting the principal on these loans. Financing activities are means of contributing, withdrawing, and servicing funds to support business activities. - Include borrowing and repaying funds with bonds and other loans; contributions and withdrawals by owners and their return on investment. 7-7 Statement of Cash Flows Reporting by Activities 7-8 Statement of Cash Flows Constructing the Cash Flow Statement Indirect Method - Net income is adjusted for non-cash income (expense) items and accruals to yield cash flow from operations Direct Method - Each income item is adjusted for its related accruals Both methods yield identical results-only the presentation format differs. 7-9 Statement of Cash Flows Preparation of the SCF (Indirect method) Consider first the net cash from operations. 7-10 Statement of Cash Flows Preparation of the Statement of Cash Flows Depreciation and amortization add-back. 7-11 Statement of Cash Flows Income v/s Cash Flows - Example Consider a $100 sale on account (1) In period of sale, net income is increased by $100 but no cash has been generated. Net Income 100 Depreciation and amortization expense 0 Gains (losses) on sale of assets 0 Change in accounts receivable (100) Net Cash flow from operations 0 In period of collection no income is recorded. Net Income Depreciation and amortization expense Gains (losses) on sale of assets Change in accounts receivable Net Cash flow from operations 0 0 0 100 100 7-12 Statement of Cash Flows Preparation of the Statement of Cash Flows Adjustments for changes in balance sheet accounts can be summarized as follows: Statement of Cash Flows 7-13 Constructing the Statement 1. The company purchased a truck during the year at a cost of $30,000 that was financed in full by the manufacturer. 2. A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year for $7,000. There were no other sales of depreciable assets. 3. Dividends paid during Year 2 are $51,000 Statement of Cash Flows Steps in Constructing the Statement (1) Start with Net Income (2) Adjust Net Income for non-cash expenses and gains (3) Recognize cash inflows (outflows) from changes in current assets and liabilities (4) Sum to yield net cash flows from operations (5) Changes in long-term assets yield net cash flows from investing activities (6) Changes in long-term liabilities and equity accounts yield net cash flows from financing activities (7) Sum cash flows from operations, investing, and financing activities to yield net change in cash (8) Add net change in cash to the beginning cash balance to yield ending cash 7-14 7-15 Statement of Cash Flows 7-16 Statement of Cash Flows Special Topics Equity Method Investments - The investor records as income its percentage interest in the income of the investee company and records dividends received as a reduction of the investment balance. - The portion of undistributed earnings is noncash income and should be eliminated from the SCF. Acquisitions of Companies with Stock - Such acquisitions are non-cash. - Changes in balance sheet accounts reflecting the acquired company will not equal cash inflows (outflows) reported in the SCF. 7-17 Statement of Cash Flows Special Topics Postretirement Benefit Costs - The excess of net postretirement benefit expense over cash benefits paid must be added to net income in computing net cash flows from operations Securitization of Accounts Receivable - Companies account for the reduction in receivables as an increase in cash flow from operations since that relates to a current asset. - Analysts should question whether they represent true improvement in operating performance or a disguised borrowing. 7-18 Statement of Cash Flows Direct Method The direct (or inflow-outflow) method reports gross cash receipts and cash disbursements related to operationsessentially adjusting each income statement item from accrual to cash basis - Reports total amounts of cash flowing in and out of a company from operating activities - Preferred by analysts and creditors - Implementation costs - When companies report using the direct method, they must disclose a reconciliation of net income to cash flows from operations (the indirect method) in a separate schedule 7-19 Statement of Cash Flows Converting from Indirect to Direct Method 7-20 Analysis Implications of Cash Flows Limitations in Cash Flow Reporting Some limitations of the current reporting of cash flow: - Practice does not require separate disclosure of cash flows pertaining to either extraordinary items or discontinued operations. - Interest and dividends received and interest paid are classified as operating cash flows. - Income taxes are classified as operating cash flows. - Removal of pretax (rather than after-tax) gains or losses on sale of plant or investments from operating activities distorts our analysis of both operating and investing activities. 7-21 Analysis Implications of Cash Flows 7-22 Analysis Implications of Cash Flows Interpreting Cash Flows and Net Income 7-23 Analysis Implications of Cash Flows Interpreting Cash Flows and Net Income An income statement records revenues when earned and expenses when incurred. - It does not show the timing of cash inflows and outflows, nor the effect of operations on liquidity and solvency. - This information is available in the SCF. Cash flows from operations (CFO) is a broader view of operating activities than is net income. - It is not a measure of profitability. Note: A net measure, be it net income or cash flows from operations, is of limited usefulness. The key is information about components of these net measures. 7-24 Analysis Implications of Cash Flows Interpreting Cash Flows and Net Income Accounting accruals determining net income rely on estimates, deferrals, allocations, and valuations. - Subjectivity Note: CFO effectively serve as a check on net income, but not a substitute for net income. CFO exclude elements of revenues and expenses not currently affecting cash. - Our analysis of operations and profitability should not proceed without considering these elements. 7-25 Analysis of Cash Flows In evaluating sources and uses of cash, the analyst should focus on questions like: Are asset replacements financed from internal or external funds? What are the financing sources of expansion and business acquisitions? Is the company dependent on external financing? What are the company's investing demands and opportunities? What are the requirements and types of financing? Are managerial policies (such as dividends) highly sensitive to cash flows? 7-26 Analysis of Cash Flows Case Analysis of Cash Flows of Campbell Soup 7-27 Analysis of Cash Flows Inferences from Analysis of Cash Flows Inferences from analysis of cash flows include: - - - - - Where management committed its resources Where it reduced investments Where additional cash was derived from Where claims against the company were reduced Disposition of earnings and the investment of discretionary cash flows - The size, composition, pattern, and stability of operating cash flows 7-28 Analysis of Cash Flows Alternative Cash Flow Measures Net income plus depreciation and amortization - EBITDA (earnings before interest, taxes, depreciation, and amortization) 7-29 Analysis of Cash Flows Issues with EBITDA The using up of long-term depreciable assets is a real expense that must not be ignored. The add-back of depreciation expense does not generate cash. It merely zeros out the noncash expense from net income as discussed above. Cash is provided by operating and financing activities, not by depreciation. Net income plus depreciation ignores changes in working capital accounts that comprise the remainder of net cash flows from operating activities. Yet changes in working capital accounts often comprise a large portion of cash flows from operating activities. 7-30 Analysis of Cash Flows Company and Economic Conditions While both successful and unsuccessful companies can experience problems with cash flows from operations, the reasons are markedly different. We must interpret changes in operating working capital items in light of economic circumstances. Inflationary conditions add to the financial burdens of companies and challenges for analysis. 7-31 Analysis of Cash Flows Free Cash Flow Another definition that is widely used: FCF = NOPAT - Change in NOA (net operating profits after tax (NOPAT) less the increase in net operating assets (NOA)) 7-32 Analysis of Cash Flows Free Cash Flow Positive free cash flow reflects the amount available for business activities after allowances for financing and investing requirements to maintain productive capacity at current levels. Growth and financial flexibility depend on adequate free cash flow. Recognize that the amount of capital expenditures needed to maintain productive capacity is generally not disclosedinstead, most use total capital expenditures, which is disclosed, but can include outlays for expansion of productive capacity. 7-33 Analysis of Cash Flows Cash Flow as Validators The SCF is useful in identifying misleading or erroneous operating results or expectations. SCF provides us with important clues on: Feasibility of financing capital expenditures. Cash sources in financing expansion. Dependence on external financing. Future dividend policies. Ability in meeting debt service requirements. Financial flexibility to unanticipated needs/opportunities. Financial practices of management. Quality of earnings. 7-34 Specialized Cash Flow Ratios Cash Flow Adequacy Ratio - Measure of aa company's ability to Cash Flow Adequacy Ratio - Measure of company's ability to generate sufficient cash from operations to cover capital expenditures, generate sufficient cash from operations to cover capital expenditures, investments in inventories, and cash dividends: investments in inventories, and cash dividends: Three-year sum of cash from operations Three-year sum of cash from operations Three-year sum of expenditures, inventory additions, and cash dividends Three-year sum of expenditures, inventory additions, and cash dividends Cash Reinvestment Ratio - Measure of the percentage of Cash Reinvestment Ratio - Measure of the percentage of investment in assets representing operating cash retained and reinvested investment in assets representing operating cash retained and reinvested in the company for both replacing assets and growth in operations: in the company for both replacing assets and growth in operations: Operating cash flow - Dividends Operating cash flow - Dividends Gross plant + Investment + Other assets + Working capital Gross plant + Investment + Other assets + Working capital Financial Statement Analysis K.R. Subramanyam Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-2 Prospective Analysis 9 CHAPTER 9-3 Prospective Analysis Importance Security Valuation -- free cash flow and residual Security Valuation free cash flow and residual income models require estimates of future financial income models require estimates of future financial statements. statements. Management Assessment -- forecasts of financial Management Assessment forecasts of financial performance examine the viability of companies' performance examine the viability of companies' strategic plans. strategic plans. Assessment of Solvency -- useful to creditors to Assessment of Solvency useful to creditors to assess a company's ability to meet debt service assess a company's ability to meet debt service requirements, both short-term and long-term. requirements, both short-term and long-term. 9-4 The Projection Process Projected Income Statement Sales forecasts are a function of: Sales forecasts are a function of: 1) Historical trends 1) Historical trends 2) Expected level of macroeconomic activity 2) Expected level of macroeconomic activity 3) The competitive landscape 3) The competitive landscape 4) New versus old store mix (strategic 4) New versus old store mix (strategic initiatives) initiatives) 9-5 The Projection Process Target Corporation Income Statements 9-6 The Projection Process Projected Income Statement Steps: 1. 2. 3. 4. 5. 6. Project sales Project cost of goods sold and gross profit margins using historical averages as a percent of sales Project SG&A expenses using historical averages as a percent of sales Project depreciation expense as an historical average percentage of beginning-of-year depreciable assets Project interest expense as a percent of beginning-ofyear interest-bearing debt using existing rates if fixed and projected rates if variable Project tax expense as an average of historical tax expense to pre-tax income 9-7 The Projection Process Target Corporation Projected Income Statement 9-8 The Projection Process Target Corporation Projected Income Statement 9-9 The Projection Process Projected Balance Sheet Steps: 1. 2. 3. 4. 5. Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios as described below. Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report. Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios as described below Obtain current maturities of long-term debt from the long-term debt footnote. Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends. (continued) 9-10 The Projection Process Projected Balance Sheet Steps: 6. Assume initial long-term debt balance is equal to the prior period long-term debt less current maturities from Step 4. 7. Assume other long-term obligations are equal to the prior year's balance unless they have exhibited noticeable trends. 8. Assume initial estimate of common stock is equal to the prior year's balance 9. Assume retained earnings are equal to the prior year's balance plus (minus) net profit (loss) and less expected dividends. 10. Assume other equity accounts are equal to the prior year's balance unless they have exhibited noticeable trends. 9-11 The Projection Process Target Corporation Balance Sheet 9-12 The Projection Process Steps in Projection (Target) 9-13 The Projection Process Target Corporation Balance Sheet 9-14 The Projection Process Projected Balance Sheet If the estimated cash balance is much higher or lower, further adjustments can be made to: 1. invest excess cash in marketable securities 2. reduce long-term debt and/or equity proportionately so as to keep the degree of financial leverage consistent with prior years. 9-15 The Projection Process Target Corporation Projected Statement of Cash Flows 9-16 The Projection Process Sensitivity Analysis Vary projection assumptions to find those with Vary projection assumptions to find those with the greatest effect on projected profits and the greatest effect on projected profits and cash flows cash flows Examine the influential variables closely Examine the influential variables closely Prepare expected, optimistic, and pessimistic Prepare expected, optimistic, and pessimistic scenarios to develop a range of possible scenarios to develop a range of possible outcomes outcomes 9-17 Application of Prospective Analysis in the Residual Income Valuation Model The residual income valuation model defines equity value The residual income valuation model defines equity value at time ttas the sum of current book value and the present at time as the sum of current book value and the present value of all future expected residual income: value of all future expected residual income: where BVt is book value at the end of period t, RIt + n is residual income in where BVt is book value at the end of period t, RIt + n is residual income in period t t+ n, and kkis cost of capital (see Chapter 1). Residual income at period + n, and is cost of capital (see Chapter 1). Residual income at time t tis defined as comprehensive net income minus a charge on time is defined as comprehensive net income minus a charge on beginning book value, that is, RIt = NIt --(k xxBVt - 1). beginning book value, that is, RI = NI (k BV ). t t t-1 9-18 Application of Prospective Analysis in the Residual Income Valuation Model In its simplest form, we can perform a In its simplest form, we can perform a valuation by projecting the following valuation by projecting the following parameters: parameters: -Sales growth. -Sales growth. -Net profit margin (Net income/Sales). -Net profit margin (Net income/Sales). -Net working capital turnover (Sales/Net WC). -Net working capital turnover (Sales/Net WC). -Fixed-asset turnover (Sales/Fixed assets). -Fixed-asset turnover (Sales/Fixed assets). -Financial leverage (Operating assets/Equity). -Financial leverage (Operating assets/Equity). -Cost of equity capital -Cost of equity capital 9-19 9-20 Trends in Value Drivers The Residual Income valuation model defines residual income as: The Residual Income valuation model defines residual income as: RIt t = NIt t- (k X BVt-1)) RI = NI - (k X BVt-1 = (ROEt t- k) X BVt-1 = (ROE - k) X BVt-1 Where ROE = NI/BVt-1 Where ROE = NI/BVt-1 --Stock price is only impacted so long as ROE kk Stock price is only impacted so long as ROE --Shareholder value is created so long as ROE > kk Shareholder value is created so long as ROE > --ROE is a value driver as are its components ROE is a value driver as are its components --Net Profit Margin Net Profit Margin --Asset Turnover Asset Turnover --Financial leverage Financial leverage Two relevant observations: Two relevant observations: --ROEs tend to revert to a long-run equilibrium. ROEs tend to revert to a long-run equilibrium. --The reversion is incomplete. The reversion is incomplete. 9-21 Trends in Value Drivers Reversion of ROE 9-22 Trends in Value Drivers Reversion of Net Profit Margin 9-23 Trends in Value Drivers Reversion of Total Asset Turnover