lecture 5 - Outline 1. 2. What to look for in a statement...

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Unformatted text preview: Outline 1. 2. What to look for in a statement of cash flows Liquidity and Solvency Analysis Preparing a statement of cash flows Computing Free Cash Flows Cash Flows Analysis 3. 4. Lecture 5 2 A Skeleton Statement of Cash Flows Sample Company Consolidated Statement of Cash Flows For year ended Jan. 28, 2008 OPERATING ACTIVITIES Net Income Add: Depreciation Amortization Change in Def Taxes (net) Loss (Gain) on Sale of PPE (G PPE Decrease (increase) in other assets Equals: Working Capital from Operations Decrease (increase) in AR Decrease (increase) in Inventory Decrease (increase) in other current assets (increase) in other current assets Increase (decrease) in AP Increase (decrease) in accrued expenses Increase (decrease) in other current liab. Equals: Cash from Operations INVESTING ACTIVITIES Subtract: Net Purchases of Property, Plant & Equip. Acquisitions net of divestitures Equals: Cash from Investing Activities FINANCING ACTIVITIES FINANCING ACTIVITIES Change in interest bearing debt Proceeds from issuance of equity (net of repurchases) Dividends Paid Equals: Cash from Financing Activities Equals: Cash from Financing Activities Beginning Cash Net Change in cash & equivalents (CFO+CFI+CFF) Ending cash 3 Analyzing the statement of cash flows and other cash-related items In addition to a profitability analysis, which focuses primarily on earnings (income statement) and invested capital (balance sheet), it is useful to examine the cash flows of the company This type of analysis can tell us for company. This type of analysis can tell us, for example: Accruals changes in n ‘working r capital’ accounts o Primary sources of cash Primary uses of cash Quality of reported earnings of reported earnings Life cycle of the firm and expected growth Liquidity and Solvency of the firm 4 Key questions to ask using the statement of cash flows 1. Cash Flow Adequacy Key questions to ask using the statement of cash flows A NI CFO ACC Good Quality B 150 170 -20 C 150 120 +30 Bad Quality Is the cash from operations consistently positive? If not, why not? 150 200 -50 2. Quality of Earnings Recall the relationship between net income and cash flows: fl Net Income = CFO + Total Accruals CFO represents permanent earnings because CFO CFO is less subject to accounting distortions and di manipulations. Total Accruals represent temporary earnings (more mean reverting) possibly due to managerial manipulation. 5 Net income accompanied by high current accruals (and therefore low current cash flows) accruals (and therefore low current cash flows) tend to have lower future earnings and cash flows than net income accompanied by low current accruals. Therefore, net income accompanied by high hi accruals is of lower earnings quality while net income accompanied by low accruals is of higher earnings quality. If investors are unable to distinguish between low quality and high quality earnings, they would overvalue stocks with high accruals and undervalue stocks with low accruals more undervalue stocks with low accruals – more about that later. 6 Key questions to ask using the statement of cash flows Total Accruals to Assets (TATA) Accruals to Assets (TATA) Net Income t - Cash From Operations t Total Assetst Where the numerator is referred to as total accruals. A positive TATA ratio (i.e. greater than 0) is often problematic, especially if the firm has negative earnings. bl ll if th fi A TATA ratio of less than -5% is usually a good sign, especially if the company has positive earnings. 7 8 Key questions to ask using the statement of cash flows (cont’d.) 3. Management of Working Capital Key questions to ask using the statement of cash flows (cont’d.) 3. Management of Working Capital (cont’d.) Remember that changes in non-cash working capital accounts are accruals. Examine changes in these accounts to see how well firms are managing their working capital. E.g. are receivables going uncollected for longer periods? Is inventory building up? Is the company stretching its payables? company stretching its payables? Working capital based ratios (note these require the full set of financial statements, not just the SCF The SCF tells you the operating changes SCF. The SCF tells you the operating changes in the AR, Inventory, and AP balances): Turnover Ratios: AR Turnover Sales Average or Ending AR To convert to number of days outstanding: Days Receivables Average or Ending AR Sales / 365 Days Inventory Average or Ending Inventory COGS / 365 Avg. or Ending Accounts Payable Purchases / 365 Days Accounts Payable Inv. Turnover AP Turnover COGS Average or Ending Inventory Purchases Avg. or Ending Accounts Payable 9 10 Key questions to ask using the statement of cash flows (cont’d.) 4. Key areas (and amount) of investment Key questions to ask using the statement of cash flows (cont’d.) 5. Sources of Financing What has the company been investing in? How heavily? Are they growing through acquisitions or through organic growth or through organic growth? Examples: Is cash from financing positive or negative? What are the means of financing? What are the implications of financing choices for operating cash flow or for shareholder wealth? What do financing activities signal about future growth opportunities? Examples: Although R&D or advertising represent investments as well, you will not find these fi explicitly listed on an indirect statement of cash flows. Note: the change in the cash balance and CFO can be tho can be thought of as a use or source of cash. of as or so of cash 12 11 Key questions to ask using the statement of cash flows (cont’d.) 6. Company growth dynamics Reading and Interpreting the Statement of Cash Flows Company A ______________ December 30, 2007 Year Ended December 31, 2006 January 1, 2006 Not every company with negative CFO is in trouble. The CFO Th relative size of a company’s CFO, CFI, and CFF is related to growth dynamics. Relation of income and cash flows and the product life cycle Revenue growth + 0 - Cash flows from operating activities Net loss Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization Realized gain on sale of marketable securities Non-cash interest expense Amortization of discount on marketable securities Stock-based compensation expense Loss on disposal of property and equipment Warrant revaluation expense Changes in operating assets and liabilities: Accounts receivable, net Inventories Other current assets Accounts payable Accrued liabilities, compensation payable and deferred rent Deferred revenue Net cash used in operating activities Cash flows from investing activities Purchases of property and equipment Purchases of property and equipment Purchases of marketable securities Proceeds from sales and maturities of marketable securities Proceeds from sale of property and equipment Net cash used in investing activities $ (26,932 ) 5,337 — — (182 ) 3,978 — — 3,056 (5,305 ) (3,032 ) 4,914 3,857 7,359 (6,950 ) $ (25,988 ) 4,169 (14 ) 646 — 640 76 8,431 (15,386 ) (1,167 ) (1,810 ) 3,201 2,134 7,768 (17,300 ) $ (19,185 ) 2,596 — 69 — 5 — 141 (4,515 ) (807 ) (172 ) 1,113 1,280 1,064 (18,411 ) Net Income + 0 Operations (7 (7,284 ) (71,581 ) 24,995 — (53,870 ) (5 (5,340 ) (691 ) 2,508 32 (3,491 ) (3 (3,733 ) (3,253 ) 1,450 — (5,536 ) Investing + 0 - Cash flows from financing activities Proceeds from issuance of preferred stock Proceeds from issuance of common stock Proceeds from issuance of common stock, employee stock purchase plan Proceeds from notes payable Repurchases of unvested common stock Payment of offering costs Payments of notes payable and capital lease obligations Net cash (used in) provided by financing activities Effect of exchange rate changes on cash and cash equivalents Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year — 782 365 — (94 ) (1,135 ) — (82 ) 2 (60,900 ) 99,899 38,999 9,945 108,801 — 54,524 — (1,376 ) (62,061 ) 109,833 4 89,046 10,853 99,899 19,927 183 — 13,467 — — (7,398 ) 26,179 3 2,235 8,618 10,853 $ $ $ Financing 13 14 Introduction Growth Maturity Decline Reading and Interpreting the Statement of Cash Flows Reading and Interpreting the Statement of Cash Flows Company B ______________ 2007 2006 2005 Company C ______________ 2007 Years Ended May 31, 2006 2005 Year Ended June 30 Operations Net income Depreciation, amortization, and other noncash items Stock-based compensation Net recognized gains on investments Stock option income tax benefits Excess tax benefits from stock Excess tax benefits from stock-based payment arrangements payment arrangements Deferred income taxes Unearned revenue Recognition of unearned revenue Accounts receivable Other current assets Other long-term assets Other current liabilities Other long-term liabilities Net cash from operations Financing Common stock issued Common stock repurchased Common stock cash dividends Excess tax benefits from stock-based payment arrangements Other Net cash used in financing Net cash used in financing Investing Additions to property and equipment Acquisition of companies, net of cash acquired Purchases of investments Maturities of investments Sales of investments Securities lending payable Net cash from investing Net change in cash and equivalents Effect of exchange rates on cash and equivalents Cash and equivalents, beginning of period Cash and equivalents, end of period $ 14,065 1,440 1,550 (292 ) – (77 (77 ) 421 21,032 (19,382 ) (1,764 ) 232 (435 ) (552 ) 1,558 17,796 6,782 (27,575 ) (3,805 ) 77 (23 ) (24 (24,544 ) (2,264 ) (1,150 ) (36,308 ) 4,736 41,451 (376 ) 6,089 (659 ) 56 6,714 $ 12,599 903 1,715 (270 ) – (89 (89 ) 219 16,453 (14,729) (2,071 ) (1,405) (49 ) (145) 1,273 14,404 2,101 (19,207 ) (3,545) 89 – (20 (20,562 ) (1,578 ) (649) (51,117 ) 3,877 54,353 3,117 8,003 1,845 18 4,851 $ 12,254 855 2,448 (527 ) 668 – (179 ) 13,831 (12,919 ) (1,243 ) (245 ) 21 396 1,245 16,605 3,109 (8,057 ) (36,112 ) – (18 ) (41 (41,078 ) (812 ) (207 ) (68,045 ) 29,153 54,938 – 15 15,027 (9,446 ) (7 ) 14,304 Cash flows from operating activities: Net loss Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization Write-down of intangibles Gain on property and equipment disposals Minority interest Stock-based compensation expense Gain on investments, net Deferred income taxes In-process research and development Equity interest in (income) loss of unconsolidated joint venture Changes in assets and liabilities: Accounts receivable Inventories Other assets Accounts payable Other liabilities li Net cash provided by (used in) operating activities Cash flows from investing activities: Purchases of investments Proceeds from maturities and sales of investments Purchases of property and equipment Businesses acquired in purchase transactions, net of cash acquired Proceeds from sale of property and equipment Net cash (used in) provided by investing activities Cash flows from financing activities: Issuances of common stock Repurchases of common stock Proceeds from long term debt Repayments of borrowings Di Di vidend paid to minority interest shareholder Other, net Net cash provided by (used in) financing activities Effect of exchange rate changes on cash and equivalents Net change in cash and equivalents during period Cash and equivalents, beginning of period Cash and equivalents, end of period $ (88,589 ) $ (100,675 ) $ (195,686 ) 74,990 — (14,714 ) 26,192 20,095 (1,417 ) (10,487 ) 35,753 — (24,677 ) 50,589 32,368 (34,760 ) 100 100,195 165,538 44,685 — (646 ) 11,074 9,863 (235 ) 121 650 (11,016 ) 5,913 (23,047 ) 1,891 3,430 (28 (28,172 ) (86,164 ) 51,852 1,404 (4,741 ) — 2,841 (1,580 ) 3,044 6,775 6,922 4,708 (9,629 ) 748 19,224 (21 (21,476 ) (135,594 ) (225,005 ) 609,342 (28,331 ) (898,529 ) 36 36,580 (505,943 ) (421,279 ) 629,036 (17,404 ) 110,407 — 300,760 (618,320 ) 931,122 (21,121 ) (355,686 ) 51 51,300 (12,705 ) 23,588 (13,463 ) 415,811 — (40 (40,785 ) 2,787 387,938 10,587 58,120 501,097 $ 559,217 $ 22,801 (7,076 ) — — — — 15,725 2,241 232,562 268,535 501,097 $ 15,459 (73,545 ) — (1,308 ) — — (59,394 ) (46 ) (207,739 ) 476,274 268,535 $ 6,111 $ 6,714 $ 4,851 15 16 Liquidity Risk Analysis Long-term solvency risk ratios Liquidity risk refers to the ability of a firm to meet its short term obligations. Analytical Tools: Tools: Solvency risk refers to the ability of a firm to service its external debt. Analytical Tools: 1. Debt and Leverage Ratios : includes debt to equity; liabilities to equity; net debt to equity; debt to capital; net debt to capital. 2. Interest Coverage Ratios Income based = (net income + interest exp + tax exp) / interest exp Cash based = (CFO + interest exp + tax exp) / interest exp Current Ratio = Current Assets / Current Liabilities Quick Ratio = (Cash + short term investments + AR) Current liab AR) / Current liab. Operating Cash Flow to Current Liabilities = Cash from operations / Current liabilities Note: interest expense and tax expense are used to approximate interest paid and taxes paid in the cash based ratio. 3. Operating cash to capital expenditures = Operating cash to capital expenditures CFO / Capital Expenditures (acquisitions & purchases of PPE) 18 17 Preparing a statement of cash flows from I/S and B/S Why Preparing a statement of cash flows from I/S and B/S (cont’d.) is this important? Rearranging we get: Recall the fundamental Accounting Equation: Assetst = Liabilitiest + Equityt Liabilities Equity Assetst-1 = Liabilitiest-1 + Equityt-1 Assets = Liabilities + Equity Cash + Current assets + Non-current assets = Current Liabilities + Non-current liabilities + Equity Cash = - Current assets – Non-current assets + Current liabilities + Non-current liabilities + Equity where Non-current assets = Asset Purchases – Asset Sales +(–) gain (loss) on sale of assets – depreciation expense Equity = Net Income – Dividends paid +/– stock issued (repurchased) 20 Cash = Net Income + depreciation - (+) gain (loss) on sale of assets (loss) on sale of assets – Current assets + assets Current liabilities – Asset Purchases + Asset Sales - Non-current liabilities +/– stock issued (repurchased) – Dividends paid In general, because of the fact that assets equal li liabilities plus equity, all changes in the th balance sheet other than cash have to be accounted for. This will ensure your statement of cash flows balances. Then, the only cash flows balances. the only remaining concern is classifying the changes as operating, investing, or financing. 21 Classification of changes in balance sheet accounts (some of these can vary in reality) lit Operating Investing Assets Marketable securities or investments in securities Accounts Receivable Inventory Other Current Assets Other Current Assets Property, Plant & Equipment Accumulated depreciation Other Assets Liabilities and Equity Accounts Payable Notes Payable Current portion of long-term debt Other current liabilities Long-term debt Deferred Taxes (can be asset too) Other non-current liabilities Common Stock Additional Paid in capital Retained Earnings Treasury stock Financing Worksheet to prepare the statement of cash flows X X X X X X X X X X X X X X X X X X (dividends) X X X (Net Inc) Each line sums up to zero. line sums up to zero The change in cash is explained using all the other accounts in the balance sheet. As the balance sheet balances out, this must work! The sum of the bottom line of the spreadsheet (i.e. cash flows from operating, investing and financing fi activities) sums up to the total change in cash change in cash. 22 23 What is Free Cash Flow? What is Free Cash Flow? (Cont.) Basic Definition: The cash that would be able to pay the debt and equity holders without affecting pay the debt and equity holders, without affecting the firms operations. Two basic types: Free cash flow to the firm and free cash flow to equity We will be focusing on free cash flow to equity. We will be focusing on free cash flow to equity for this class since we are primarily interested in equity valuation. The definition of free cash flow to equity also takes into account the cash flow that is associated with servicing debt costs. As we will see later, the value of the firm can be derived as: Value of Equity = PV (FCFe) What is free cash flows to equity? What is free cash flows to the firm? Notice, this definition gets us away from the actual payment of dividends, towards the ability to pay dividends in order to value the firm. Note: an often overlooked assumption is whether the cash on hand is excess (i an idle asset) or operating To on hand is excess (i.e. an idle asset) or operating. To simplify analysis, it’s often easiest to forecast for only operating cash (i.e. excess cash=0). Changes in operating cash will be treated as investments of cash (and not available as free cash flows) available as free cash flows). 26 27 Calculating Free cash flow to the Equity Robert Olstein’s Free Cash Flow Numbers for Xerox are Highly Misleading (XRX) Misleading (XRX) TUESDAY, JUNE 13, 2006 Free Cash Flow at Xerox Fl By William Trent, CFA of Stock Market Beat TheStreet.com: Weighing Options With Robert Olstein included some comments on Xerox (XRX) that had us a little puzzled. Our regular readers will recognize some of what we have to say from previous articles what we have to say from previous articles. One stock in our fund which I’d like to talk about is Xerox. Xerox is a company we identified early as paying down a lot of debt. Plus they have a good leader in [Chairman and CEO] Anne Mulcahy and great free cash flow. The key to Xerox’s success is that they transformed their business from black-and-white copiers to digitization and color. The margins are much higher now. And now the free cash flow yield is north of 10%. Now that the margins are higher, we think the free cash flow of this company is probably in the area of $1.25 a share. We think it is worth around $19 to $20, yet the market is focusing on the fact that there is excess depreciation instead of the tremendous transformation taking place. We didn’t see much to argue with at first. Xerox has been paying down debt, and while we still see it as early goings, Anne Mulcahy is doing about as good a job as could be expected with the hand she was dealt. But the free cash flow yield part got us. We always thought of free cash flow as being cash from operations less capital always thought of free cash flow as being cash from operations less capital expenditures. If a company uses acquisitions as part of its growth strategy we usually count them as part of capital expenditures. Another way would be to look at the free cash flow available to equity holders, which takes into account changes in debt. If this is done, the reductions in debt actually reduce free cash flow to equity in the year the debt is repaid because that is money that could otherwise be given to equity owners. On the other repaid because that is money that could otherwise be given to equity owners. On the other hand, not having the interest expense and future obligation increases future free cash flow to equity. Either way, the CFFO-CapEx formula is the base number. 28 29 Free cash flow to equity is the cash flow available to shareholders without hampering the firm’s operations and after servicing the debt. Two common ways to define FCFE: FCFE = CFO – CFI – Net debt payments – Increase in debt payments in cash + Other financing cash flows FCFE = Net income – Increase in Common Equity 1,246,536 (1,219,278) 13 10,248 548,163 31,345 617,027 In the case of Starbucks: Cash flow from operations Cash flow from investing activities Current portion of long term debt Commercial paper Long term debt Decrease in the cash balance Free cash flow Or: Net income Increase in Shareholders’ Equity in Shareholders Equity Free cash flow 672,638 (55,611) 617,027 Robert Olstein’s Free Cash Flow Numbers for Xerox are Highly Misleading (XRX) Misleading (XRX) As plain as day, despite rising net income cash from operations has fallen, taking free cash flow with it (Note: Our capex cash flow with it. (Note: Our capex number includes both the property and equipment includes both the property and equipment line and the capitalized software line, but this adjustment makes little overall difference.) Well, to be fair Olstein didn’t say that free cash flow was rising - he said the free cash flow yield was 10 percent. The free cash flow yield is calculated by dividing free cash flow by enterprise value. free cash flow yield is calculated by dividing free cash flow by enterprise value. Xerox has an enterprise value of $19 billion and free cash flow of $1.2 billion, resulting in a yield of 6.3 percent. It appears that Olstein is calculating the free cash flow yield based on market cap rather than enterprise value. That doesn’t make any sense, as the debt holders have first claim on the cash flow. The alternative measure, using free cash flow to equity over market cap, would have to take into account any changes in the debt level. Since, as Olstein points out, Xerox has been paying off debt the paydowns should be deducted from the free cash flow number. Last year Xerox paid off $2.5 billion in debt, leaving it with free cash flow to equity of negative $1 billion. In each of the last three years debt reduction has more than equalled free cash flow. fl So by no appropriate measure does Xerox have a 10 percent free cash flow yield. Further, unless they reverse the declines it won’t be long before there is no free cash flow by any measure. You can judge a good leader by how they manage their finances. This was a problem company. They had a bad leader, they had bad accounting, and they had a huge debt load. But all of a sudden you see debt coming down and other good things. And you can see it in the financial statements. We judge management via the financial statements. We pay attention to how they act, not what they say. We look to see if they are conservative and if they care about free cash flow. We can’t argue with that. http://stockmarketbeat.com/blog1/ 30 ...
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