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Unformatted text preview: The Cash Flow Statement
Chapter 10 What does it tell us?
What does it tell us? The Cash Flow Statement provides a reconciliation between the Net Income number and the actual change in the company's cash balance. It explains how that cash is used to impact Debt and cash balances (this actually happens in the Debt Schedule) If the income statement says that net income is $8.3 million, does that mean that the firm has $8.3 million more in its checking account? NO! Why is this wrong?
Why is this wrong? That would assume that every dollar of Revenue was paid to the company immediately in cash and every dollar of expense was paid out by the company immediately in cash. It would also assume that all of the cash generated during the year was applied to the cash balance, with no borrowing or repayment of Debt. Getting Started
Operating Activities Operating Activities
Operating Activities The portion of a Cash Flow Statement that starts with Net Income and adjusts for noncash income and expenses and changes in Working Capital. Link to Income Statement
Link to Income Statement Net Income provides a good starting point for calculating the cash generated by the company. Link up Net Income to the Income Statement. Add back all noncash expenses
In general, the Cash Flow Statement needs to add back any noncash expenses from the Income Statement. Add back Depreciation
Add back Depreciation Net Income includes a deduction for the noncash Depreciation expense (buried in the Total COGS figure). Adding back the amount of this noncash expense reverses its impact and gets us closer to the cash generated by the business. Add back Amortization
Add back Amortization Amortization of Intangibles is a noncash expense on the Income Statement (either buried in SG&A or broken out separately Add back this noncash expense as well. It can be linked to the Income Statement. Add back Amortized Financing Add back Amortized Financing Costs Capitalized Financing Costs represents the fees incurred raising debt financing. These fees are not expensed immediately, but instead are Amortized over the term of the Debt This is yet another form of noncash expense that needs to be added back. So far…
So far… Net income Plus Depreciation Amortization Capitalized Finance Costs Next we examine Changes in Net Working Capital
Increasing an asset uses cash.
Increasing a liability creates cash Revenues Drive Net Income, but..
Revenues Drive Net Income, but.. We care about how much CASH the firm actually generated Working capital items impact that amount of cash Understanding the Revenue line
Understanding the Revenue line If Revenue is $129 million during the year, that means customers paid the company $129 million, right? Actually NO: it means the company's accountants "recognized" $129 million of revenue on the Income Statement – e.g., because the company shipped out goods to customers for which it expects to receive $129 million. So how much did get paid to the So how much company from customers? To answer this question, we need to subtract the current year's Accounts Receivable from the current year's Revenue Cash Collections = Revenue – Change in Accounts Receivable Why to we have to subtract out Why to we have to subtract out Changes in Receivables? The Cash Flow Statement started with Net Income, so it already includes the impact of Revenue. To reconcile to the actual cash collected by the company, we now need to subtract the change in receivables What about Inventory?
What about Inventory? If Cost of Goods Sold is $96 million during last historical year, it's tempting to think the company spent $96 million during the year to manufacture products. However, that is not the case. Why not?
Why not? We must account for the impact of our remaining Inventory Cash Manufacturing Costs = COGS (w/o Depreciation) – Change in Inventory Why subtract out Changes in Why subtract out Changes in Inventory? Our Cash Flow Statement started with Net Income, so it already includes the impact of Cost of Goods Sold. To reconcile to the actual cash spent in manufacturing, we now need to subtract the change in Inventory What about Inventory we bought on What about Inventory we bought on credit and have not yet paid for in full? Are we overpenalizing ourselves for Inventory expenses? Not really, you’ll see that they are offset by the change in Accounts Payable which will be discussed shortly. Changes in Prepaid expenses
Changes in Prepaid expenses Other Working Capital Asset accounts such as Prepaid Expenses work the same way as Accounts Receivable and Inventory. We need to subtract the change in the account in order to reconcile to cash. Working Capital Liabilities
Working Capital Liabilities Working Capital Liabilities have the opposite impact from Working Capital Assets. The net change in Working Capital Liabilities is added back on the Cash Flow Statement. Changes in Accounts Payable
Changes in Accounts Payable Accounts Payable increase when suppliers ship more goods (along with invoices!) to the company. When the company pays for the goods in cash, the liability decreases. Why add back changes in Accounts Why add back changes in Accounts Payable? If the company's Accounts Payable increase during the period, it means the company "got more stuff" than it paid for in cash during the period. To reflect this positive impact on cash, we add the increase in Accounts Payable in order to reconcile to cash. A note about dragging payables
A note about dragging payables The more a company can buy on credit and stretch its payables, the better its cash flow will be. However, a company can get in trouble if it stretches its suppliers too far because they may stop extending credit to the company. Changes in Accrued Expenses
Changes in Accrued Expenses Accrued expenses are items that have been expensed on the Income Statement but not paid for in full. Examples of accrued expenses include salaries. Why add back changes in accrued Why add back changes in accrued expenses For example, if a company ends its fiscal year between pay periods, accrual accounting will require that all salaries reflecting work in that year are expensed in that year, but not all of these expenses will have actually been paid in cash. If all of these expenses were not actually paid in cash, then we should add the amount accrued to cash flow (a source of cash). Adding up changes in net working Adding up changes in net working capital Subtract changes in receivables Subtract Changes in inventory Subtract changes in prepaid expenses Add back changes in payables Add back changes in accrued expenses Sum up the cash flows from Operating Activities Investing Activities
Investing Activities The portion of a Cash Flow Statement that starts with Net Income and adjusts for noncash income and expenses and changes in Working Capital. Capital Expenditures
Capital Expenditures Investments made in the long term Assets of the company; primarily represents additions to Property, Plant and Equipment (PP&E). Subtracting out CAPEX
Subtracting out CAPEX In Operating Activities section of the Cash Flow Statement, we added back Depreciation because it is a noncash expense related to prior investment in PP&E. Capex represents the cash actually spent in the period on PP&E. Set up a link to Capex from the Operating Assumptions page. – Use a negative sign to reflect the fact that Capex is a use of cash. Cash Available for Debt Cash Available for Debt Repayment Sum together the Cash from Operations with the Cash used by Investing Activities Cash Available for Debt Repayment (CADR) represents the cash generated during the year that is available to pay down Debt or increase the cash balance
– Or, if negative, it is the shortfall that the company must borrow or come up with from available funds. Why CADR important?
Why CADR important? An equity holder is essentially indifferent between having $1.00 more cash or $1.00 less Debt. The less Debt (or the more cash) on the company's books, the better off the equity holder. The 2nd portion of the Cash Flow The 2nd portion of the Cash Flow Statement is the DEBT SCHEDULE Demonstrates how cash is applied to pay off.. Repay various debt pieces Add to the cash balance Result in additional borrowing (if cash generation is negative) The importance of Net Debt. Net Debt = Total Debt – Cash & Equivalents Debt and cash are somewhat Debt and cash are somewhat fungible. If a company has both cash and Debt, it can use some of its cash to repay some of its Debt. Would you keep a balance on your credit card, if you had the money to pay off the balance sitting in your checking account? Probably not! Why?
Why? Negative Spread: Cash earns interest income at a lower rate than Debt accrues Interest Expense. For example, a company with $10 of Debt and $10 of cash would pay more interest than it earns. – It would therefore be better to pay off the Debt with the cash if possible. Different kinds of debt
Different kinds of debt Bank Debt – Revolvers
– Term Loans In most situations, Bank Debt has higher priority rights and a shorter maturity than other types of Debt Bullet Notes (bonds/debentures) Debt is listed by priority
Debt is listed by priority Most senior debt listed first This corresponds to the order in which they are repaid with any available cash. Revolvers
Revolvers Line of Credit used to fulfill seasonal or temporary shortterm funding needs. It is typically Secured by a lien on the assets of the company. Revolver characteristics
Revolver characteristics The revolver’s balance will vary over time. – It may increase one week to fund an Inventory purchase and then get repaid a few weeks later with proceeds from a large sale. The Revolver typically has the shortest maturity of the primary debt pieces (often one year) and is repaid with any available cash. – There is no scheduled Amortization for this type of Security. Important note
Revolvers can never have a negative balance and should not ever increase beyond the amount available. Do not allow the Revolver to have $15 million outstanding if the Line of Credit is $10 million. Term Loans
Term Loans Whereas the Revolver funds seasonal or shortterm cash needs, the Term Loan is a form of longer term capital Often used to finance longterm Assets such as the purchase of a new factory. Characteristics of Term Loans
Characteristics of Term Loans The maturity of this loan will almost always be less than eight years (usually five years or less) and is repaid by means of an Amortization schedule. It's typical to use excess cash proceeds to repay Term Loan Debt prior to its scheduled repayments after the Revolver Notes about bank debt
Notes about bank debt The Term Loan and Revolver will most likely be provided by banks (together they are referred to as Bank Debt). The interest on these loans will typically be lower than the Bullet Note and will be based on a floating rate (such as LIBOR or Prime plus a spread). Bullet Notes
Bullet Notes Another form of long term Debt capital. The terms "bullet note" and "bond" are roughly synonymous. These notes are typically Unsecured. A Senior Subordinated Note is a specific type of Bullet Note. These Securities will usually have a fixed interest rate. Characteristics of Bullet Notes
Characteristics of Bullet Notes This type of Debt will have the longest maturity and will NOT have an Amortization schedule. The entire amount of the loan is due at maturity (in one "bullet" payment), and there are usually restrictions on prepayment prior to maturity. Bullet Notes are considered to be a Bullet Notes are considered to be a more permanent piece of a company's capital structure. In most instances, a company doesn't really expect to repay these loans at maturity. Usually the company will refinance the Debt with a new Security. RULES:
What are the "rules" that govern how much of the cash flow pays down each piece of Debt and how much increases the cash balance? The Debt Schedule provides these rules
Debt Schedule ensures that Debt is repaid according to their terms and ensures you don't end up with negative cash or negative Debt. Debt Schedule – sources and uses
Debt Schedule – sources and uses See how much cash the firm has available (sources of cash) and then determine how that cash is used to repay Debt or add to cash (uses of cash). Since every dollar the firm needs must come from somewhere, the Sources of Funds must always equal the Uses of Funds. Assets = Liabilities + Equity
If you buy something, someone has to pay for it Two key sources of cash
Two key – – Existing Excess Cash is the prior year’s cash balance
Taken directly from the Balance Sheet Cash generated during the year (CADR) Taken directly from the Cash Flow Statement Incremental Revolver Borrowing
Third Source of Funds… This will be our plug. More on this later Now we examine USES – what can we do with that money?
Begin with scheduled debt retirement, pay back the principal on your debt Scheduled Debt retirement section
Scheduled Debt retirement section The Scheduled Debt Retirement section gave us the contractually required minimum annual payments of principal. The terms of each Debt piece will specify how much principal is due back each period. Scheduled Term Loan Scheduled Term Loan Payments These are driven by the amortization schedule Bullet Notes
Bullet Notes No principal payments are due before maturity. Enter $0 for each year until maturity, at which point there will be a balloon payment. If the company has paid down Debt If the company has paid down Debt early, Then the scheduled Debt payment could exceed the total Debt outstanding for a given Debt piece To make sure we don't repay more Debt than is shown on the Balance Sheet, we use a MIN formula. Optional Debt Repayment
Optional Debt Repayment When the company has Excess Cash Flow, it may have the option to repay its Debt obligations. This is often more attractive than earning Interest Income at low rates while paying Interest Expense at higher rates. Not all forms of Debt permit these Not all forms of Debt permit these prepayments Bonds rarely allow optional prepayments without a penalty. Bank debt can usually be prepaid without a penalty Optional Debt Retirement Formula
Optional Debt Retirement Formula If there is excess cash available to the business after Required Debt Retirement then 1. Pay down the Revolver first. If there is cash left over, prepay the Term Loan. If there is still cash remaining, pay down more junior debt pieces if permitted. 2.
1. This depends on whether the Bank Debt allows early retirement of junior securities. If there is still cash remaining, add the excess cash to the cash balance Excess Cash
Excess Cash If the company generates more cash during the year than it is able to apply to Debt repayment, the excess adds to the company's cash balance on the Balance Sheet. Excess Cash = Sources Subtotal Uses Subtotal Incremental Revolver Borrowings Incremental Revolver Borrowings If the company generates strong cash flow and has a significant amount of Cash Available for Debt Repayment, it isn't likely to need additional funds. But sometimes cash generation is negative or cash generation plus the beginning cash balance are not sufficient to allow the firm to repay Debt obligations coming due What then? The company must borrow on its The company must borrow on its Revolver to meet the financing gap Incremental Revolver Borrowings = Uses Subtotal Sources Subtotal This formula tells us the cash shortfall for the company, which must be borrowed on the Revolver. By definition, you'll either have Excess Cash or Incremental Revolver Borrowings in a given year, but not both! The Debt schedule check
The Debt schedule check The Total Sources of Funds must equal the Total Uses of Funds. Otherwise, money that's required is unaccounted for Linking to the Cash Flow Statement
Linking to the Cash Flow Statement The Debt Schedule now needs to feed the “Financing Activities” on the Cash Flow Statement. The relevant line items on the Debt Schedule are the Required Debt Retirement, Optional Debt Retirement, and any Borrowing. Doing the linkage
Doing the linkage Link up the Financing Activities: Revolver, Term Loan, and Notes to the Debt Schedule. Reflect borrowing with a positive sign (provides cash) and Debt retirements with a negative sign (uses cash). Linking the Statement of Cash Linking the Statement of Cash Flows to the Balance Sheet You've got the tough part done. All you need to do now is link up the Debt and Cashnumbers in the Balance Sheet to the Cash Flow Statement.
Cash = Prior Year's Cash + Net Increase in Cash What about linking debt to the What about linking debt to the balance sheet? The Revolver, Term Loan, and Notes formulas all work the same way: Debt = Prior Year’s Debt + Net Borrowings Stress testing your model
Stress testing your model Your model works for the specific forecasting case shown, but is it robust? Will it work in all circumstances? You will test a number of adjustments to your model. Make them one at a time, and hit Undo ('Ctrl+z') after each step to return to your model's original state. After each step, make sure that: After each step, make sure that: You don't have negative cash or negative Debt balances Total Assets = Total Liabilities + Equity in each year Your cash balance doesn't build up until the Revolver is paid down Adjustment 1 – increase capex Adjustment 1 – increase capex Increase Capex substantially for a given year (e.g. $100 in the second projected year). This creates negative Cash Available for Debt Repayment, and your model will only work if you set up the Incremental Revolver Borrowing line properly. Adjustment 2 – add a salvage value Adjustment 2 – add a salvage value Use a large negative number for Capex in a given year (e.g. $100 in the second projected year). This action pays down all of the Debt that has permitted Optional Retirements (Revolver and Term Loan) and builds the Cash balance. If your model is set up incorrectly, you'll end up with negative Debt balances. ...
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