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Cash Flow Analysis
and Forecasting
For other titles in the Wiley Finance series
please see www.wiley.com/finance
Cash Flow Analysis
and Forecasting
The Definitive Guide to Understanding
and Using Published Cash Flow Data
Timothy D.H. Jury
A John Wiley & Sons, Ltd., Publicatio
n
This edition first published 2012
© 2012 Timothy D.H. Jury
Registered Office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ,
United Kingdom
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required, the services of a competent professional should be sought.
Library of Congress Cataloging-in-Publication Data:
ISBN 978-1-119-96265-6
A catalogue record for this book is available from the British Library.
Set in 10/12pt Times by Aptara Inc., New Delhi, India
Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK
To my mother and father,
brother and sisters for always being there
Contents
Introduction ix
SECTION ONE HISTORIC CASH FLOW ANALYSIS
1 Understanding How Cash Flows in a Business 3
2 Understanding Cash Flows Properly 21
3 Start-up, Growth, Mature, Decline 47
4 Restating the Cash Flows of a Real Business 59
5 Restating US GAAP Cash Flows 83
6 Analysing the Cash Flows of Mature Businesses 99
7 Analysing the Cash Flows of Growth Businesses 135
8 Growth and Mature – Further Analysis Issues 153
9 Analysing the Cash Flows of Start-up Businesses 171
10 Analysing the Cash Flows of Decline Businesses 179
11 What to do about Bad Cash Flows 185
12 Cash Versus Profit as a Measure of Performance 191
viii Contents
13 Cash Flow Analysis and Credit Risk 201
14 Cash Flow Analysis and Performance Measurement 215
15 Analysing Direct Cash Flow Statements 223
16 Generating a Cash Flow Summary from Profit and Loss Account
and Balance Sheet Data 231
17 Summarising Historic Free Cash Flow 247
SECTION TWO FORECASTING CASH FLOWS
18 Introduction 255
19 Spreadsheet Risk 263
20 Good Practice Spreadsheet Development 275
21 The Use of Assumptions in Spreadsheet Models 295
Index 305
Introduction
This book is the definitive guide to cash flow analysis. It is designed to be the
definitive first reference on all aspects of historic cash flow analysis. It also provides
an incisive overview of the risks to be managed in preparing cash flow forecasts.
It has been written from a cash flow-centric point of view. Other financial and
analytical information is introduced whenever relevant to support the process of
cash flow analysis.
This book is designed for people trying to understand and analyse cash flows,
probably in a professional context. Whilst it contains some theoretical content, the
primary objective is to offer a practical handbook of cash flow analysis.
Ideally, it should first be read like a novel and then dipped into chapter-by-
chapter as required; a detailed guide to the contents of each chapter follows this
introduction. Much of the information in the book has been laid out to facilitate
direct reference from the index; also allowing it to be used as a pure reference text.
Considerable effort has been expended to make the book as user friendly as
possible. It has been designed to be relevant and useful both to persons who are
coming to cash flows for the first time, and to those who are more experienced
in the perils of financial statement analysis! I have paid particular attention to the
needs of those who are not native English speakers. I have tried to keep the use
of English as clear and concise as possible whilst avoiding the use of unnecessary
complexity.
Whilst the book is written primarily for those employed as financial analysts,
I have identified four other major user groups whose needs are specifically dealt
with in different sections of the book. They are:
Novices in financial analysis and other persons new to, or relatively unfamiliar
with, cash flows in general and their analysis in particular, in all fields of
endeavour, who wish to improve their understanding of cash flow.
x Introduction
Bankers, credit analysts and others involved in business lending and the man-
agement of credit exposures and credit risk.
Investors, fund managers and credit analysts involved in taking investment
decisions.
Entrepreneurs, managers and business people involved in controlling business
entities.
The guide to the book, which follows this introduction, provides an indication
of the content of each chapter and its relevance to different users. For example,
persons who have no desire to actually perform the analysis of the cash flows of
a business themselves, but who still wish to understand cash flow, will initially
gain little from Chapters 4 and 5 as they are written for persons who are seeking
to practically apply the technique for the restatement of published cash flows.
THE LOGIC OF THE BOOK DESIGN
Years of experience as a financial trainer have taught me that people acquire
technical knowledge in a very random way from a variety of sources as they come
across information relevant to their needs. This sometimes results in a partial,
incomplete and often inaccurate understanding of the particular subject in issue.
As a trainer and author my objective is to organise the information relevant to a
subject or task in a logical and structured way to facilitate and ease the assimilation
process. The metaphor I like to use is that of a jigsaw. My audiences will typically
have many of the pieces of the jigsaw already in their possession; however, until
I facilitate the process of assimilation they have not previously assembled the
pieces into a complete picture. When working as a trainer not only do I assist in
completing the jigsaw, I also provide the missing pieces, which are different for
each participant!
For this reason the book has been organised into specific blocks of knowledge.
It can be read sequentially. It can also be used as a reference to provide answers
to specific queries and problems by dipping into the relevant part of the book.
COMPLEXITY
The word complex is regularly misused to mean difficult, or beyond the users
present comprehension. When things labelled complex are analysed it often be-
comes clear that what is actually meant is there is a lot of information to assimilate
before comprehension of the whole can be gained. The information itself is not
particularly demanding to comprehend; there is, however, a lot of it! Writing com-
puter software or learning a musical instrument or foreign language are typical
examples.
Introduction xi
My strategy for this type of assimilation problem is to chop the information up
into lots of little bits that are sufficiently elemental that they can be adequately
digested by the person seeking to assimilate the whole area of knowledge and then
build the knowledge in a pyramid form by adding blocks and layers in an ordered
way. This is the approach I have taken in writing this book.
THE USE OF CASE STUDIES IN THE BOOK
Once the initial chapters have introduced the concepts upon which the analysis
of cash flows rely, the book includes a number of case studies that illustrate the
use of the technique for cash flow analysis offered. Most of these cases are based
on financial information taken from the accounting statements of real business
entities. I prefer to do this because there is then no challenge as to the reality of
business behaviour. If I create fictional cases for the book there is a risk users will
question my conclusions about them and cash flow analysis in general on the basis
that the examples are fictionalised and therefore do not represent a reasonable
representation of business reality.
However, this inevitably results in problems with dates! The question of how
to deal with dates in the book is one that has vexed me significantly. The problem
for the publisher and I is that the book will soon appear dated if we show the
years from which the case studies were taken in the original. Users may wrongly
assume the message and content of the book is somehow less relevant because the
material used to illustrate the logic of the technique offered is ageing.
The logic of the cash flow analysis technique offered in the book is essentially
timeless, it should work virtually anywhere and anytime financial information is
available to perform the analysis. For this reason I have partially disguised the
original dates of the material used to illustrate the cases. The timeline of most of
the case studies offered is incidental; the examples are there to illustrate the use
and benefits of the cash flow analysis technique that is the basis of this book.
Experienced analysts will know that in performing any business analysis the
economic context in which the company operates is sometimes highly relevant.
Matters such as inflation, interest rates and the state of the economy may affect the
conclusions drawn about the relative performance of a business. For this reason,
in a small number of cases and where the context of the example warrants it, I
have left the dates as they were originally. This allows the reader to put the case
into the context of the economic conditions prevailing at the time.
Considerable effort has been expended to keep the various examples, tables and
other information both numerically and factually correct, however, it is inevitable
in a work of this length that, despite our best efforts, errors may still creep into
print. Please do not hesitate to bring these to my attention, to further improve the
book as it develops.
xii Introduction
I hope this book changes your life. For those whose job is to analyse cash flows
for a living it may actually do so!
Capitalisation
Throughout the book, where you see CAPITALISED WORDS, these refer directly
to key words in tables and figures that are being discussed and explained in the
text.
GUIDE TO THE BOOK
The book is organised into two sections, the first dealing with the analysis of
historic cash flow data, the second dealing with the forecasting of cash flow
information.
Section One – Historic Cash Flow Analysis
Chapter 1 – Understanding How Cash Flows in a Business
Level basic – the chapter is designed as a layperson’s introduction to the whole
subject of cash flow in business. In addition to introducing the cash flow patterns
seen in business, it outlines a number of other fundamental issues and risks that
managers must overcome in order to trade successfully. No prior knowledge of
cash flow is assumed. The material is presented from the ground up through the
use of straightforward examples.
Despite being offered as a basic introduction everyone seeking to utilise the
cash flow analysis technique presented in the book should read this chapter as it
introduces and defines part of the terminology used throughout the book.
Chapter 2 – Understanding Cash Flows Properly
Level intermediate – this chapter explains the knowledge and the steps required
to analyse cash flows properly. It then commences the process by explaining all
the terminology used in a simple cash flow example and introduces the analysis
technique for the first time.
Chapter 3 – Start-up, Growth, Mature, Decline
Level intermediate – this chapter introduces the non-financial information needed
to get the most out of the cash flow analysis technique offered in the book.
Everything offered in this chapter is covered in more detail in Chapters 6 to 10.
Introduction xiii
Chapter 4 – Restating the Cash Flows of a Real Business
Level advanced – readers without some prior knowledge of financial statement
analysis and accounting will find this chapter demanding. Considerable effort has
gone into explaining the accounting and analytical knowledge required to properly
utilise the cash flow analysis technique offered. The example chosen to illustrate
the process being taken from a business preparing its accounts using International
Financial Reporting Standards.
Chapter 5 – Restating US GAAP Cash Flows
Level advanced – this follows on from the previous chapter by taking an example
of the technique based on a business following US financial accounting rules in
the preparation of its financial statements. It is necessary to be familiar with the
content of the previous chapter in order to get most benefit from this one.
Chapter 6 – Analysing the Cash Flows of Mature Businesses
Level advanced – this chapter defines the term ‘mature’ and presents the informa-
tion required to comprehensively analyse the cash flows of a mature business.
Chapter 7 – Analysing the Cash Flows of Growth Businesses
Level advanced – this chapter defines the term ‘growth’ and presents the informa-
tion required to comprehensively analyse the cash flows of a growth business.
Chapter 8 – Growth and Mature – Further Analysis Issues
Level advanced – this chapter presents two important further issues relevant to the
analysis of both growth and mature businesses.
Chapter 9 – Analysing the Cash Flows of Start-up Businesses
Level advanced – this chapter defines the term ‘start-up’ and presents the infor-
mation required to comprehensively analyse the cash flows of a start-up business.
Chapter 10 – Analysing the Cash Flows of Decline Businesses
Level advanced – this chapter defines the term ‘decline’ and presents the informa-
tion required to comprehensively analyse the cash flows of a decline business.
xiv Introduction
Chapter 11 – What to do about Bad Cash Flows
Level advanced – this chapter offers a variety of strategies to make decisions about
cash flows that are bad. It suggests a number of questions that the analyst should
seek to answer, before coming to conclusions about bad cash flows.
Chapter 12 – Cash Versus Profit as a Measure of Performance
Level advanced – this chapter explains in detail the differences between profit and
cash generation as a measure of performance. It points out the pitfalls of using
profit alone as a performance indicator.
Chapter 13 – Cash Flow Analysis and Credit Risk
Level advanced – this chapter explains how to tailor the cash flow analysis tech-
nique offered specifically to the needs of bankers and others who are exposed to
credit risk.
Chapter 14 – Cash Flow Analysis and Performance Measurement
Level advanced – this chapter looks at ways the cash flow analysis technique
offered in the book can be used for business performance measurement.
Chapter 15 – Analysing Direct Cash Flow Statements
Level advanced – this chapter deals with the differences between direct and indirect
cash flow statements and how to deal with them in applying the cash flow analysis
technique. It is necessary to be familiar with the earlier content of the book in
order to get the most out of this chapter.
Chapter 16 – Generating a Cash Flow Summary from Profit and Loss
Account and Balance Sheet Data
Level advanced – this chapter illustrates how to arrive at a summary of the cash
flows of a business entity that does not produce a cash flow statement as part of
their financial information. It is essential to be familiar with all the earlier content
of the book in order to get the most out of this chapter.
Chapter 17 – Summarising Historic Free Cash Flow
Level advanced – this chapter illustrates how to identify the historic free cash flow
of a business entity from the cash flow information derived by using the cash flow
Introduction xv
analysis technique presented earlier in the book. It is necessary to be familiar with
the earlier content of the book in order to get the most out of this chapter.
Section Two – Forecasting Cash Flows
Chapter 18 – Introduction
Level advanced – this chapter discusses the risks and benefits of forecasting when
compared to the analysis of historic information.
Chapter 19 – Spreadsheet Risk
Level advanced – this chapter introduces spreadsheet risk and offers strategies to
minimise the problem.
Chapter 20 – Good Practice Spreadsheet Development
Level advanced – this chapter introduces a number of techniques to reduce spread-
sheet risk through good modelling practice. It illustrates four examples of common
cash flow forecasting models.
Chapter 21 – The Use of Assumptions in Spreadsheet Models
Level advanced – this chapter offers guidance on dealing with assumptions in
spreadsheet forecasting models. It then discusses the use of scenarios for risk
analysis using spreadsheet forecasts.
Section One
Historic Cash Flow Analysis
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
1
Understanding How Cash Flows in
a Business
INTRODUCTION
This chapter is designed to enable those with less direct experience of the operation
of businesses to grasp the fundamental financial and economic logic that governs
how successful businesses operate. It represents the starting point for our journey
through the landscape of cash flow analysis. In order to gain benefit from this
chapter no prior knowledge of either cash flow or business is required.
We start our journey by developing a model of how the cash flows in a simple
business work. We then develop our knowledge of cash flows by incrementally
adding complexity to this model.
Whilst developing this model based on the cash flows of a business we also
introduce some fundamental logic about what different types of business must do
in order to be successful.
THERE IS NOTHING NEW ABOUT BUSINESS
Humans have been engaging in trade for thousands of years, initially through
some sort of barter process. Archaeologists have discovered ancient manufactured
goods such as pottery and metal objects that have travelled vast distances from
their point of manufacture. There are numerous examples of early Greek and
Roman shipwrecks being discovered in many different parts of the Mediterranean
dating back 2000 years or more. In the 1960s evidence was finally discovered
that proved that the Vikings were the first Europeans to discover America some
500 years before Columbus. The remains of a Norse settlement at L’Anse aux
Meadows on the northern tip of Newfoundland have been authenticated and dated
to around 1000AD. During the excavation of the site over 100 objects of European
manufacture were unearthed.
A more recent development in human history was the introduction of money
in the form of coinage and, later, notes. Whilst there is much debate about what
should be recognised as the first coin, a good candidate would be a small lump
of electrum (a natural alloy of gold and silver) stamped with a design and minted
around 600BC in Lydia, Asia Minor (now known as Turkey). Paper money seems
to have emerged in China at about the same time.
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
4 Cash Flow Analysis and Forecasting
This innovation, together with many others such as agriculture, settlements, the
wheel and writing led to the modern, technologically based world economy we
have today. Trade or business, in one form or another, has probably been part of
the human condition from our earliest origins.
UNDERSTANDING MONEY IN BUSINESS
We are going to start with two simple examples of business activity. The first
one represents one of the simplest forms of business. (More complex business
examples follow over the next few pages.)
The Simplest Form of Business
Newspaper vending, by which I mean the activity of selling newspapers to passers-
by on a street corner, is a good example of a really simple business. The vendor,
or businessman, buys the newspapers from the publisher or a wholesaler and then
retails them to passers-by for a price that gives him a margin over the cost of
purchasing the newspapers.
A second example of a really simple business is an antique dealer, someone
who buys and sells old objects. We will work with this example from now on.
The Debate About the Purpose and Objectives of a Business
The varying cultures around the world place different emphasis on how the benefits
generated by a successful business should be shared amongst its stakeholders.
I do not propose to examine the merits or otherwise of these views. There is
considerable literature on what measures should be used to assess success or
failure in business. Both growth and profit increase look like good candidates but
fail as measures of success if the improvement in growth or profits is achieved by
investing disproportionate amounts of cash. I do not propose to go much further
with this debate other than to say that increasing the value of a business over
time is now considered the most appropriate measure of success. This is achieved
by continually improving the present and future cash flows of a business on an
ongoing basis.
So, at this point in my explanation, I am assuming that the business I am
describing is being run with the objective of wealth maximisation for the owners.
For the purposes of this book I define that as maximising the future cash flows of
the business.
Understanding How Cash Flows in a Business 5
The Objective of Being in Business is to Generate More Cash
It is important to introduce the purpose of a business here because specifying the
objective of the business defines the task of the business person, entrepreneur,
manager or other business controller (which is to get more cash). In both the
business examples introduced so far we have a trader or dealer who buys and sells,
typically without changing or modifying the items traded in any way. This is the
simplest form of business.
The trader’s objective is to generate more cash than they started with. (Note that
I have not used the terms profit or gain as we are developing a model containing
only items that represent the cash flows in a business. What we mean by profit is
actually quite an abstract concept. This is dealt with in more detail in Chapter 12.)
How Does a Trading Business Add Value?
An initial observation might be that these businesses make money by buying things
for less than they can sell them. While this is an accurate observation of what a
successful trading business does, this fails to explain why or how the business is
able to achieve this beneficial outcome.
What is the key skill for an antique dealer? Is it knowledge of the antiques
traded in? Whilst this may help, much of this information is available from books.
Is it renovation skills? Again this may or may not add value to the items being
renovated depending on consumer taste at the time. The key skill is probably,
knowing where to buy cheaply and where to sell expensively. Here is an example
of what I mean.
For many years the typical vehicle of choice for a British antique dealer has
been the Volvo estate, which is used to travel to distant parts of Scotland and Wales
so that the dealer can purchase furniture and other antiques from remote house
sales and auctions where they are often sold cheaply. The goods purchased are
then transported to London where they can be auctioned through the major auction
houses or retailed to wealthy collectors at collectors’ fairs or from retail premises.
What this antique dealer is doing is relocating the goods traded from a place
where they can be bought cheaply to a place where they can be sold more expen-
sively. It’s all about the relocation of the goods. Why is this so important?
Consider what happens when you get up in the morning. Do you travel to Java
for your coffee beans, Florida for your orange juice, Jamaica for your sugar, and
to your local farm for your milk?
This is unlikely. What most of us do is go to the nearest convenience store,
which may be just down the street and buy what we wish to consume for our
breakfast. So, what then is the owner of the convenience store doing to add value?
What he does is relocate a range of goods he knows we are likely to consume for
6 Cash Flow Analysis and Forecasting
breakfast to a place convenient for us to make our purchases as consumers. The
convenience of the location is the most important thing, the goods offered are in
a sense irrelevant, they are whatever we want to consume.
So, the key to most trading, retail and wholesale businesses is location. What
these businesses do is relocate goods from their places of production or, if second-
hand, their present location, to a location convenient for the target consumer to
consume them. It follows that there is little point in locating a business in a
remote part of the world as there are few consumers there! The ideal location for
newspaper vending is directly outside a major railway station in central London
or any other major city in the world, this is where you will have thousands of
potential consumers passing by every hour of the working day. In other words,
you will sell more newspapers. The location is the essence of the business’s ability
to generate cash.
So, the cash flows of our simplest business look like the model shown in
Fig. 1.1. Overheads is the term commonly used in business to refer to all the costs
of trading other than inventory costs.
Using CASH the trader makes purchases of goods, which he holds as INVEN-
TORY. Some time later he resells the goods acquired for more than he paid for
them, receiving cash in exchange for the items. He will typically incur some
OVERHEADS in the process, in our example of the antique dealer these will be
transport, location and communication costs.
This is effectively all a trading, retail or distribution business does, repeating the
journey round the circle many times. Now let us look at a more complex business,
one where work is performed on the purchased inputs of the business.
Cash
Inventory
Overheads
Cash
Non-Cash
Purchase Purchase
Added
value Relocation
knowledge
Sale
Figure 1.1 Diagram of the cash flows of a simple trading business
Understanding How Cash Flows in a Business 7
THE SIMPLE MANUFACTURING BUSINESS
In my other life as a financial trainer I have travelled all over the world offering
training seminars on financial analysis and related subjects. One of the places I
have visited on my travels is Nairobi in Kenya. When travelling from Nairobi
airport to the training location I noticed business people selling beds and other
simple items of furniture outside their workshops by the side of the road. This
then is the next example we will examine; a simple manufacturing business.
How Does a Simple Manufacturing Business Add Value?
What do manufacturers do to create wealth for themselves? They take raw materials
and change them into something more useful; economists talk about adding utility.
For example, I could sleep on a log. However, this would not be particularly
comfortable, the bark would make my back itch and I might roll off! If the log is
cut up into timber and then turned into a bed frame I am likely to be willing to pay
more for it in this form. Now, I could of course do this myself with the aid of a saw
and a few basic woodworking tools, so why do I not normally bother? There are
three reasons: time, quality and cost. I could make the bed, but it would take me
three days whilst the manufacturer does it in half an hour. Secondly, the result I
achieve might not have the quality of the professionally manufactured alternative
and, finally, it would almost certainly be more expensive when the opportunity
cost of my time as well as the cost of the raw materials is taken into account.
So, manufacturers do not just convert things (raw materials) into more useful
things (finished goods), they are experts at the process of doing so. Successful
manufacturers do it very quickly and efficiently to a very high standard. The key
word here is expert. If you are analysing the performance of a manufacturing
business and find that it receives many customer complaints and returned goods
due to manufacturing defects, or is experiencing significant difficulties actually
producing goods, this suggests they are not experts. To use a metaphor: it implies
they are amateurs rather than professionals. Any business being operated in a non-
professional way is at a higher risk of poor financial performance and eventual
failure than its more professional and competent competitors. The extreme levels
of professionalism required just to be competitive in most manufacturing activities
is simply a consequence of competition over long periods of time.
So the cash flows of our simple manufacturing business look like the model
shown in Fig. 1.2.
Using CASH the manufacturer makes a purchase of RAW MATERIALS and
does work on them, so converting them to WORK IN PROGRESS and eventually
FINISHED GOODS. These items being akin to INVENTORY in our previous
model. Some time later he resells the finished goods for more than the cash costs
of producing them, receiving cash in exchange for the items. He will typically
8 Cash Flow Analysis and Forecasting
Cash
Work in
Progress
Raw
Materials
Finished
Goods
Overheads
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.2 Diagram one of the cash flows of a manufacturing business
incur some OVERHEADS in the process of conversion, these being purchasing,
manufacturing, premises, and selling costs in our example.
This is what the cash flows of a new small manufacturing business look like.
Cash is generated by repeating the journey round the circle many times. Now let
us see how this develops as the business evolves over time.
Developing Our Model – the Next Step
Continuing with our example of an African entrepreneur who has recently estab-
lished himself as a manufacturer of furniture, let us assume his new business is
successful. Our entrepreneur is working many hours a day and all the product he
produces sells well. What is likely to be his first major issue in developing his
business?
Given his location his next move is most likely to be adding labour to the
business to increase output and hence cash flow. This is because there is much
labour available and, given the emerging market location of the business, this
labour is available relatively cheaply (Fig. 1.3).
LABOUR now joins overheads as an item purchased and consumed by the
business to add value to raw materials.
If our entrepreneur furniture designer was in Munich in Germany the decision
might be quite different. In this location the economic environment is different
to that in Nairobi in Kenya. In Germany labour costs are significantly higher per
hour and employees are protected in many ways by a mass of social legislation
Understanding How Cash Flows in a Business 9
Cash
Work in
Progress
Raw
Materials
Finished
Goods
Overheads
Labour
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.3 Diagram two of the cash flows of a manufacturing business
giving them extensive rights and obliging employers to compensate employees in
the event of job losses. From an economic point of view the cost of labour is higher
and the cost itself is less variable. In Germany the first major initiative to build our
business is more likely to be the purchase of machinery (i.e. fixed assets) to increase
output and hence cash flow, rather than the addition of more labour (Fig. 1.4).
Why is the decision different depending on the location of the business? This is
because the economic environment is different. Factors that affect the decision of
whether to employ labour or purchase fixed assets would be things like, the law
and regulations affecting the cost and flexibility of labour, the local environment
governing labour and investment in fixed assets, and the availability and quality
of labour.
There are other issues that might inform or determine the decision. Machines
have certain characteristics that could arguably make them superior to labour in
many situations. They do not go on strike; they can, assuming they are properly
maintained, produce a succession of perfect and identical output 24 hours a day
without requiring sleep or food. But, there are also some key negative charac-
teristics of machines. They usually require infrastructure such as electricity, gas,
compressed air and water constantly available without interruption. They are very
good at doing the same thing again and again; they are not so good when the
required output keeps changing. Any change to the product manufactured may
necessitate hours of re-engineering and re-programming of the machine before
productive output recommences.
10 Cash Flow Analysis and Forecasting
Cash
Fixed assets
Work in
Progress
Raw
Materials
Finished
Goods
Overheads
Labour
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.4 Diagram three of the cash flows of a manufacturing business
Labour, despite its imperfections, is very flexible. It can make the tea, collect
the raw materials, deliver finished product and paint the wall, in addition to
being available to produce product as required. It copes well with a succession
of variable tasks. The negatives are that it can go on strike, it requires a safe
and healthy working environment and protection from the risk of injury or death
(known collectively as health and safety). It also needs constant breaks for food
and rest, and it can produce substandard and defective work if not properly trained
and supervised.
So, labour is flexible but inconsistent, machinery is inflexible but consistent. As
our example business grows, whether situated in Kenya or Germany, labour and
fixed assets will be added as required according to their relative utility to cost in
the local environment.
You may have noticed the use of a dotted line to denote the sale of fixed assets.
This is because when we acquire fixed assets we intend to keep them to assist us
in the process of producing or trading our goods and services. We do not intend
to sell them or trade them during their useful lives. Only when they are no longer
of operational use to us do we sell them if we can. The cash flow we get when we
sell them is usually small relative to the cash flow spent on new assets.
The Consequences of Growth and Success
As the business develops it becomes more complex, typically because growth
means an increase in everything. The numbers of labour, machines, products,
Understanding How Cash Flows in a Business 11
customers and suppliers can all increase. With this complexity comes new risks.
When a business is small it can be controlled by one person. As it grows this
becomes more and more difficult because too many things that require control are
happening simultaneously. Delegation of authority to others is required, which
implies the creation of a management structure.
Similarly the cash flows involved in the business all get larger. Turnover, costs,
investment, debtors and creditors all increase. At this point it is sensible to consider
limiting the risk of the owner. How can this be achieved?
The owner can sell the business to a limited company owned by him or herself.
Until this point our example business has been trading as a sole trader. In English
law there are three different ways a person can trade, as a sole trader, as a partner
in a partnership and through the use of some sort of company owned by the
person.
As a sole trader or partner an individual’s risk is unlimited. Should there be any
negative event that results in significant liabilities for the business in which they are
involved, the sole trader and any partner are personally liable for the full amount.
Should a business operating as a limited company suffer an event that leads to
huge liabilities the company itself is the party responsible for the liabilities, not the
owners. The owners are only liable to the extent they have subscribed for shares,
(in other words they may lose the equity they own in the company). As long as
the directors have acted lawfully they cannot be made personally liable for the
liabilities of the company. This means if the company collapses into bankruptcy
the director owner can keep his house, pension fund and other personal assets that
are separate from the limited company in which the business resides.
So, from a risk management viewpoint, are companies a good idea or a bad idea?
For society as a whole they appear to be a good idea, partly because they facilitate
the pooling of investment for new projects. A developed nation has extensive
infrastructure in the form of roads, railways, airports, pipelines, communications,
electricity and oil and gas infrastructure which requires the capital of hundreds of
thousands of individuals to create. By issuing shares to millions of people, each
of which is a part owner of the business, these beneficial assets for society can
be created and maintained. They also encourage risk-taking in the form of new
business creation because entrepreneurs can protect their personal assets by using
a limited company as the vehicle for their new ventures.
The negative aspects of companies arise if you are a creditor of a company.
Banks, suppliers and employees lose money when companies fall into bankruptcy.
In extreme situations a limited company can be used deliberately to acquire the
cash flow of a business, which is then stolen by the owners. This is of course
criminal and fraudulent. This is why it is essential that stakeholders who are
creditors monitor the creditworthiness (or credit risk) of any company they are
involved with as a creditor.
Figure 1.5 introduces equity (and debt) to the model.
12 Cash Flow Analysis and Forecasting
Cash
Fixed assets
Work in
Progress
Raw
Materials
Finished
Goods
Overheads
Labour
DebtEquity
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.5 Diagram four of the cash flows of a manufacturing business
The business is now owned by an independent legal entity (a company) that
is separate from the person or persons who formerly owned it. Their interest is
represented by their shareholding in the EQUITY of the company. The company
may also have raised cash to invest in the company by borrowing, perhaps from a
bank, which is recognised in Fig. 1.5 as DEBT.
Debt, in the form of loans or leases may be used by the company to acquire fixed
assets such as factory premises and machines. Debt may also be used to provide
working capital in the form of an overdraft facility or via the use of factoring or
invoice discounting.
Having introduced these new sources of capital we need to add further items to
the model to keep it consistent with reality. Cash borrowed from banks is not lent
for nothing. Banks charge INTEREST (essentially a rent) for the period that the
money is advanced to the borrower. Similarly, if the company is successful it may
pay DIVIDENDS to its shareholders. Finally, most governments demand that the
company pay TAXATION on any taxable profits from trading or other investment
income generated by the company.
These potential cash outflows do not represent operating costs because they
arise for reasons that differ from the other cash outflows required to operate the
Understanding How Cash Flows in a Business 13
Cash
Fixed assets
Work in
Progress
Raw
Materials
Finished
Goods
Overheads
Labour
DebtEquity Dividends
TaxationInterest
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.6 Diagram five of the cash flows of a manufacturing business
business. DIVIDENDS and INTEREST represent rewards paid to financiers as a
consequence of their investment. TAXATION is a government levy on surpluses
generated by the company. All the other operating costs of the business should be
incurred because they are necessary in order to generate the operating cash flow of
the business. When we add these items our model of the cash flows of the business
looks like Fig. 1.6.
The Implications of Supplier and Customer Credit
So far we have assumed that all transactions in the business take place in cash.
In the real world this is not so. There is often a difference between the time we
take physical delivery of something we have purchased and when we pay for it.
Conversely, it is common to sell something to a customer allowing them a period
of time to pay, the cash due on the sale of the product being received some time
later.
14 Cash Flow Analysis and Forecasting
Let us consider the example of our business of our African entrepreneur some
years on. He is no longer manufacturing furniture outside his home; he now has
a substantial factory full of machinery and labour, owned by a limited company
controlled by him.
When he buys timber he does not collect it on foot with a handcart any more.
He telephones his timber merchant and asks him to deliver three truckloads of
timber. When the timber arrives he does not pay for it, he signs a delivery note.
A CREDITOR (or PAYABLE) is created at this point (being the money due to
the supplier in payment for the goods) which may be settled (paid) one to three
months later.
Similarly when the business sells a bed it is no longer sold for cash on the
side of the road. Instead the beds are now manufactured in the form of flat packs,
stuffed in a container and sent to IKEA, a major global discount furniture retailer.
When IKEA receive the beds they do not pay cash, they sign a delivery note for the
goods and create a DEBTOR (or RECEIVABLE), (being the money due from the
customer for the goods sold to them) which may be settled one to three months later.
So, CREDITORS effectively grant the business a short-term interest-free loan
whilst the liability to them remains unpaid. Conversely, our furniture business
essentially lends its DEBTORS short-term, interest-free funds for the duration of
the period whilst the debt owed to the furniture business remains unpaid.
These time delays have a substantial and important effect on the cash flows of a
business and must therefore be incorporated in our model. Our model now evolves
further (Fig. 1.7).
The model is now essentially complete; it contains all the cash flows relating
to a single business entity. We can see clearly how the cash flows round a busi-
ness. Having constructed this model, we can now work with it to develop our
understanding of cash flow and business practice. What else is important to our
understanding of cash flow?
The Working Capital Cycle
We can now see that cash flows round the business as follows:
1. The business orders goods and services (these being either RAW MATERIALS,
LABOUR or OVERHEADS).
2. The goods and services are delivered, creating a CREDITOR. They enter
production or are consumed in the production process.
3. The RAW MATERIALS are converted into WORK IN PROGRESS and finally
FINISHED GOODS.
4. The FINISHED GOODS are then sold, creating a DEBTOR.
5. The DEBTOR pays the invoice some time later providing CASH to the business.
6. The CASH is used to pay CREDITORS as they fall due.
Understanding How Cash Flows in a Business 15
Cash
Fixed assets
Work in
Progress
Raw
Materials
Finished
Goods
Creditors
Overheads
Labour
Debt
Debtors
Equity Dividends
Ta xInterest
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.7 Diagram six of the cash flows of a manufacturing business
This movement of cash and resources around the business is known as the
WORKING CAPITAL CYCLE. It represents the most active and volatile set
of cash flows through most businesses. It is the most demanding area of cash
management to control. Experienced managers know that managing the working
cash flows is a demanding exercise. Most of the daily tasks of management arise
from problems achieving the timely supply of goods and services at the right level
of quality to the business, and the problems of manufacturing the product right
first time without quality defects. Both tasks have to be satisfactorily completed
before delivery and invoicing can take place in turn resulting in cash flow from
customers to the business.
The investment requirements of a business and the amount of business risk
inherent in a particular business are both affected by the nature and behaviour of
the working capital cycle. Understanding the working capital cycle is therefore
very important. The main problem is recognising the risk implications – of the
impact of time – on the business.
You may be wondering what time has to do with all this. Timing is the essence
of working capital management which, in turn, is the key component of cash flow
management. Let us take two examples:
16 Cash Flow Analysis and Forecasting
On day one Tesco plc (a leading UK supermarket group) orders a truckload
of beans from Heinz plc (a major global food manufacturer). The beans arrive at
Tesco’s distribution depot on day three and arrive in the store on day four. By the
end of day five all the beans are sold to customers for cash or credit card payment
with Tesco in possession of cleared funds by day seven. Tesco then holds the cash
for 53 days before paying Heinz for the beans. Contrast this with Airbus Industrie
(a major civil aircraft manufacturer) who are constructing an Airbus A380 for a
major airline.
Following years of negotiation Airbus receives an order for a number of aircraft,
this in turn initiates the thousands of orders necessary to obtain the various compo-
nents and sub-assemblies required from their respective suppliers. Over a period
of many months raw materials are received and the aircraft is assembled (being
work in progress at this point, which takes about 12 months), then completed and
tested (becoming finished goods at this point). Finally, after further performance
tests by Airbus and the purchasing airline the aircraft is accepted into service
and paid for. The journey round the working capital cycle takes between one and
two years.
What conclusions can we draw from these two deliberately extreme examples?
If Tesco has agreed 60 day settlement terms with Heinz they will be able to sell
the beans and hold the resultant cash for 53 days before settling their liability to
Heinz. In other words Tesco plc generates cash from the working asset cycle as
a consequence of trading. No external finance is required to trade. All the cash
required comes from credit provided by suppliers. The operating creditors of Tesco
exceed the inventory and there are no debtors. Where the operating creditors of
a business exceed the amounts invested in the inventory and operating debtors of
a business we say the business has negative net working asset investment. In this
situation the more turnover increases the more cash is generated from working
assets. Another way of illustrating the benefits of this is that Tesco would have the
benefit of this cash for 53 days and be able to earn interest on it even if Tesco sold
the goods acquired with trade credit at the same price they were purchased from
the supplier.
Airbus Industrie enjoys much less favourable working asset behaviour. They
have to invest many millions of euros in the working capital cycle to manufacture
each Airbus A380. The funding of the working capital requirement for each major
contract is a major undertaking. Each aircraft sells for approximately $US320
million. The more successful Airbus is at selling the Airbus A380 aircraft the
more cash has to be found to invest in working capital. Airbus has to invest vast
sums into the working asset cycle in order to trade. Increased trading requires
more cash to be invested in the working capital cycle. Airbus has positive working
asset investment. No cash is generated from working assets; as the business grows
cash is typically absorbed by working asset investment.
Understanding How Cash Flows in a Business 17
Investing in Fixed Assets
Cash is also required to invest in FIXED ASSETS as required. The need for
investment is determined largely by the nature of competition in the markets
in which the business operates. In a competitive market, changes in consumer
expectations and technology will constantly drive suppliers to design better and
cheaper products to satisfy consumer needs, the fixed asset investment needed to
do this must then be committed before production can take place. Depending on
the nature of the fixed assets acquired, it may be possible to borrow much of the
funds required to finance acquisition or construction.
Timing is also important when investing in fixed assets. Invest too early and you
may not achieve sufficient utilisation to recover your investment, invest too late
and your competitors may have already captured markets and reduced operating
costs ahead of you.
HOW DOES ANY BUSINESS GENERATE CASH?
In order to generate cash the business must go round the WORKING ASSET
CYCLE at least once. Every time the business completes a circuit more cash is
generated. It follows from this that it makes sense to get very good at going round
the working asset cycle very quickly as this will generate more and more surplus
cash! This is what good businesses seek to optimise. Delays in completing a circuit
can wipe out the extra cash simply due to the cost of financing the working asset
investment. If you can regularly make a circuit round the WORKING ASSET
CYCLE faster than your competitors you have a competitive advantage.
What Causes Businesses to Fail?
There is only one answer to this question. It is because they have run out of cash.
In a crisis all the boxes in the model become temporary or short term sources of
cash, fixed assets can be sold, inventory reduced, creditors increased, overheads
reduced, and so on. However, there is a natural limit to this process, there comes
a point where the assets left in the business and overheads remaining are those
without which it cannot continue to trade. As the business is distressed equity
providers and lenders are no longer interested in supporting the business. At this
point the business has run out of sources of cash.
More specifically, businesses fail because two adverse events take place simul-
taneously. A creditor demands payment in respect of a liability and the business
does not have the cash available to pay as is demanded. As a result the creditor
successfully forces the business into bankruptcy.
The rules regarding the actions to take when a business becomes insolvent vary
depending on the location of the business. In countries with Roman law legal
18 Cash Flow Analysis and Forecasting
Cash
Fixed assets
Surplus
Cash
Work in
Progress
Raw
Materials
Finished
Goods
Creditors
Overheads
Labour
Debt
Debtors
Equity Dividends
Ta xInterest
Cash
Non-Cash
Purchase Purchase
Added
value Conversion
knowledge
Sale
Figure 1.8 Diagram seven of the cash flows of a manufacturing business
systems the directors may be obliged to apply for court supervision and direction
when the business becomes insolvent.
In Anglo-Saxon law countries it is usually an offence to trade whilst knowingly
insolvent. However, exactly what constitutes this condition is not tightly speci-
fied. So, if there is no creditor who has any interest in forcing the business into
bankruptcy it is unlikely to happen, irrespective of the state of the balance sheet
or the availability of liquidity.
Remember the only sustainable (and most important) source of cash generation
is the cash generated from operating the business (for which I use the term the
OPERATING CASH MARGIN), which is the extra cash generated each time
the business goes round the inner circle in the model (which I have labelled the
WORKING CAPITAL CYCLE). This is shown in Fig. 1.8.
THE COMPLETE REAL BUSINESS MODEL
Our model is now almost complete. We see the WORKING CAPITAL CYCLE,
we see cash spent on FIXED ASSETS and we see the sources of the cash invested
in the business, these being labelled EQUITY and DEBT in the model.
Understanding How Cash Flows in a Business 19
For the purposes of this model and any further discussion in this book, DEBT
represents all forms of borrowing, such as loans, mortgages, commercial paper,
bonds, lease finance, hire purchase, factoring, invoice discounting and any other
form of external debt financing. Basically, if the company pays interest in some
form or other in exchange for the loan of the cash, the liability that results is a
debt liability.
Any cash surpluses generated that are not paid out are retained in the business as
SURPLUS CASH. When this is added to the model the model is complete. This
represents an accurate and comprehensive representation of all the significant
cash flows of a single business entity. The descriptions on the left-hand side of the
diagram refer to the nature of the items shown in the model. Debtors, creditors
and cash are items generally denominated as cash values. The non-cash items,
inventory, overheads, labour and fixed assets all represent real as opposed to
monetary items.
SUMMARY OF THE CHAPTER
Running a business is all about cash. More specifically it is about generating as
much cash as possible from going round the working capital cycle again and again.
The primary objective is to receive more cash when we sell goods or services than
we paid out in fixed asset investment, overheads, labour and raw materials to make
or create them.
Businesses receive cash from the following sources:
From successful trading (this being the OPERATING CASH MARGIN)
From owners in the form of EQUITY
From lenders and other cash providers in the form of DEBT
In certain businesses (such a supermarkets) from the WORKING CAPITAL
CYCLE itself
Businesses spend cash in the following ways.
Within the trading cycle of the business to pay for:
RAW MATERIALS, LABOUR and OVERHEADS
Investing in the WORKING ASSET CYCLE
Investing in FIXED ASSETS
They also make payments to external finance providers and the government in
the form of:
INTEREST
DIVIDENDS
TAXATION
20 Cash Flow Analysis and Forecasting
Debt repayment
Equity buy backs and redemptions
Any cash held but not invested in the operations of the business is defined as
SURPLUS CASH. This cash may be the accumulation of historic surpluses or be
debt and equity not yet invested in the business itself. It may be retained in order
to display that the business has adequate liquidity to operate in the future and to
reinforce its credibility as a reliable counter-party.
CONCLUSION
Irrespective of the level of your prior knowledge you should now have an under-
standing of the way a business operates from a cash flow centric point of view.
You should also now appreciate some of the fundamental logic that underpins
business operation. The purpose of this chapter is to provide an adequate grasp
of the fundamentals of business, and more specifically cash flow, to assist in the
assimilation of the more advanced material that follows.
2
Understanding Cash Flows
Properly
INTRODUCTION
It is human nature to seek short cuts when engaged in any repetitive process. The
main purpose of these shortcuts being to save time and expense.
In my other life as a trainer I have observed experienced financial analysts adopt
a number of strategies to try to reduce the amount of time they spend evaluating
financial statements in order to come up with the required output. Many use pre-
prepared spreadsheet models and groups of ratios with which they are familiar.
Less experienced analysts generally seek to oversimplify the task, ignoring im-
portant information they do not yet understand and placing too much emphasis
on what they believe are the most important numbers. The tendency is to overem-
phasise and over-analyse what they know about and to underemphasise the source
information that is beyond their current level of comprehension.
However, there comes a point where omitting to gain a proper understanding
of the task and then failing to complete the analysis fully leads to the wrong
conclusions.
I have added the word ‘properly’ to this chapter heading in order to empha-
sise that it is necessary to acquire a solid understanding of cash flow analysis,
accounting theory, business strategy and financial control issues, before drawing
conclusions about a business entities cash flows. Those seeking immediate short
cuts are going to be disappointed! Although I would always encourage users of
this book to read as widely as possible around the subject, this book contains all
the knowledge required in order to complete this task.
There are three discrete steps involved in the process of analysing the reported
cash flows of a business. These are as follows:
1. We need to be able to understand a published cash flow statement.
2. We need to know how restate it into a more user-friendly format.
3. Finally, we need to understand what the restated values and totals signify.
This chapter deals with these tasks.
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
22 Cash Flow Analysis and Forecasting
THE NATURE OF THE BEAST
We will start by familiarising ourselves with the basic anatomy of a cash flow
statement. Table 2.1 is a fairly simple cash flow statement. This is in the format of
a typical cash flow statement prepared in accordance with International Accounting
Standard 7 – Cash Flow Statements (IAS 7).
Table 2.1 A typical cash flow statement
Simple Limited
Cash Flow Statement Euros Euros
For the year ended 31st December 20XX ’000 ’000
Cash flows from operating activities
Profit before taxation 5600
Adjustments for:
Depreciation 550
Increase in operating provision 30
Investment income 500
Interest expense 350
6030
Increase in trade and other receivables 600
Decrease in inventories 1100
Decrease in trade payables 1690
Cash generated from operations 4840
Interest paid 310
Income taxes paid 1800
Net cash from operating activities 2730
Cash flows from investing activities
Acquisition of subsidiary X net of cash acquired 650
Purchase of property plant and equipment 460
Proceeds from sale of equipment 30
Interest received 350
Dividends received 320
Net cash used in investing activities 410
Cash flow from financing activities
Proceeds from issue of share capital 400
Proceeds from long term borrowings 360
Payment of finance lease liabilities 110
Dividends paid 1450
Net cash used in financing activities 800
Net increase in cash and cash equivalents 1520
Understanding Cash Flows Properly 23
Looking at the statement in its entirety the first thing that is evident is the cash
flow is split into three main sections. These have the following headings:
Cash flows from operating activities,
Cash flows from investing activities, and
Cash flows from financing activities.
These primary headings have been used since the first standards on cash flows
were introduced in 1987. It appears the choice of these headings was quite arbitrary,
the objective being to make the cash flow statement more logical for the user.
Remember that the cash flow statement is still a relatively new invention when
compared to the balance sheet and profit and loss account. They have been around
for hundreds of years.
Let us see what each section contains.
CASH FLOWS FROM OPERATING ACTIVITIES
This section of a cash flow statement discloses two things:
1. The cash generated by the business, which is derived from generating more
cash from selling goods or services than the cash costs of production.
2. The amount invested or generated from the net working assets of the business.
In this example both these values sub-total to an item headed ‘Cash generated
from operations’. This section also contains the cash interest paid and the cash
taxes paid.
What is the Cash Generated from Operations?
In Chapter 1 Understanding How Cash Flows in a Business I introduced a cash
flow model, which I call the complete real business model. I offered the observation
that modern financial theory implies that the purpose of running a business is to
generate cash flow by selling goods and/or services for more cash than it costs to
produce them. Typically this is achieved in a manufacturing business by purchasing
raw materials and other inputs such as labour and overheads, which are combined
into finished products and then sold.
Notice I am talking solely in terms of cash, not profit. Profit and cash flow are
not the same thing. Over the past few decades the issue of what is profit has
become very complex. This will be discussed in more detail later in the book.
For a single product the cycle begins when we purchase the raw materials and
ends when the debt relating to the sale of the finished goods to the customer is
24 Cash Flow Analysis and Forecasting
paid. In an established business it is usual to enjoy a period of credit from suppliers
when purchasing raw materials and other overheads. To summarise, in order to
generate a cash flow from producing products we typically do the following:
1. Purchase inputs, typically RAW MATERIALS, LABOUR and OVERHEADS,
being granted credit by suppliers (and so creating a CREDITOR) in the
process.
2. Process these inputs through WORK IN PROGRESS into FINISHED GOODS.
3. Sell the FINISHED GOODS to a customer, typically granting them a credit
period as well (so creating a DEBTOR).
4. Collect the cash due from the customer at the appropriate time.
Intuitively it appears obvious that the cash generated from operations is likely to
be the value of the cash value received from customers when they have purchased
finished goods minus the cash costs of purchasing the inputs required to produce
them, such as raw materials, labour and overheads. There is, however, something
else we have to do in order to get this cash flow from customers.
We need to recognise that we have to invest cash in raw materials, work in
progress and finished goods. We also have to invest cash in lending money to our
customers until they pay us. Offsetting this is the fact that we get an interest free
loan from our suppliers for the period that they grant us credit when we purchase
goods from them. The amount invested in the inventory and debtors minus the
amount invested in operating creditors is known as the amount invested in net
working assets.
At the beginning of the reporting period we already have cash invested in these
items. As we proceed through the year it may be necessary to adjust the values
invested making them higher or lower depending on the flow of work through our
business and changes in the price and credit period granted in respect of inputs
to our business and the effects of changing our prices and the credit we give to
customers.
So, the effects of these changes to net working assets are also recognised in
the cash flow statement. They are to be found in the cash flow from operating
activities section of the cash flow statement together with the cash generated from
operations value.
To summarise, the business generates cash by going round the circle (Fig. 2.1)
at least once (and ideally many times) in a given period.
The business also needs to have cash invested in DEBTORS and INVENTORY,
less any contribution from CREDITORS, in order to trade. These three values may
also increase or decrease in any given reporting period.
Let us now go through this section in detail to understand its contents more
thoroughly.
Understanding Cash Flows Properly 25
Cash
Work in
Progress
Raw
Materials
Finished
Goods
Creditors Debtors
Cash
Non-Cash
Figure 2.1 Diagram of the working asset cycle
CASH FLOWS FROM OPERATING
ACTIVITIES – DETAILED REVIEW
Profit Before Taxation
The first item shown is the profit before taxation. You may be wondering what a
profit number is doing in the cash flow. Most published cash flows are prepared
using the indirect method. This means the reported cash flows are identified by
deriving them from data contained in the profit and loss account of the business for
the period and by identifying changes between the values disclosed in the opening
and closing balance sheets for the same period.
There is a second method of preparing a cash flow statement in published
accounts known as the direct method. This method is explained in more detail
in chapter 15 – Analysing direct cash flow statements.
When preparing an indirect cash flow statement the process commences by taking
one of the profit values disclosed in the profit and loss account. This is then
converted into the value of the operating cash flow by adjusting the profit value for
non-cash items that have already been added or deducted. Non-cash expenses are
added back and non-cash income items are removed. In this particular example
the cash flow statement begins with the profit before taxation value from the profit
and loss account of Simple Limited.
26 Cash Flow Analysis and Forecasting
Indirect cash flow statements can start from other profit values in the profit
and loss account. This depends on local GAAP variations and local custom in
preparing cash flow statements. Usually the starting value is either the profit
before interest and tax (also known as earnings before interest and tax ‘EBIT’,
or operating profit) or the profit after tax (also known as net income). These
variations are explained in more detail later in the book
GAAP stands for Generally Accepted Accounting Principles. This acronym
being used to encompass the laws, regulations, standards and customs used in
a particular jurisdiction to arrive at a set of published accounts.
A non-cash item is an income or expense item that appears in the profit and
loss account for which there is no corresponding cash flow. Typically, the most
substantial of these is the amount charged in the period for depreciation (also
known in some regions as amortisation). Depreciation is a non-cash item. You do
not write a cheque to anyone for depreciation!
Depreciation
Depreciation is an accounting adjustment. Its purpose is to charge the original cost
of purchasing an asset to the profit and loss account in a series of instalments over
its estimated useful life. Depreciation was invented by accountants a long time
ago to make the profit and loss account more meaningful as a document seeking
to communicate the annual performance of a business to its owners. If we did
not have depreciation in accounts and capital expenditure was simply a cost, the
business would show losses every time a substantial number of new fixed assets
were acquired and much higher profits in periods when no fixed asset expenditure
took place.
The effect of depreciation is to spread the cost effect of acquiring capital assets
over their estimated useful life. This is a reasonable way of dealing with fixed
assets because we continue to have the use of the fixed assets to assist us in
producing goods for the duration of their useful life. Another way of considering
the nature of depreciation is to think of it as a notional rent for the use of the fixed
assets from the balance sheet to the profit and loss account, which is charged each
year of the life of an asset to the profit and loss account.
The cash flow statement deals solely with cash flows. Depreciation is not a cash
flow. We must therefore adjust for the value of depreciation charged to profits in
identifying the cash flow generated from operations because it is a non-cash item.
When depreciation is deducted in the profit and loss account it is a cost or
expense item. Thus, when we adjust for it in the cash flow statement we are adding
it back to the disclosed profit before taxation value from the profit and loss account
in the process of arriving at the operating cash margin. This is why depreciation
appears as a positive value when disclosed in the cash flow statement.
Understanding Cash Flows Properly 27
Increase in Operating Provision
In a typical indirect cash flow statement there may be a number of further items
listed representing other non-cash items of income or expenditure in the profit and
loss account. In this particular example, in order to arrive at the correct value for
the cash generated from operations we are also adjusting the profit before taxation
value for an increase in operating provision. This label is a little vague. It does
not tell us exactly what operating provision is involved. For example, it might be
a provision relating to warranty claims on the years production, or further costs to
be incurred in respect of a recent product recall.
Vague labels of this type crop up again and again in published cash flow
statements. The fact that the label is vague is merely irritating, it will not affect our
ability to analyse the cash flow statement as long as we know what to do with the
item. As this item appears within the section of the cash flow statement labelled
‘adjustments’ we know it represents another add back to the profit before taxation
value required in order to arrive at the cash generated from operations value. It
is listed as an adjustment because movements in provisions do not represent cash
flows. They represent the recognition in this period’s accounts of the value of
a future expected cost related to activities within the current accounting period,
(an example of this might be the future warranty costs arising on this year’s
production).
The recognition of an expected future cost in the current periods profit and loss
account is not a cash flow. The fundamental accounting concept known as the
prudence concept requires that we recognise this future expected cost as soon as
we are aware of it. However, we do not expend any cash flow in respect of this
item until customers actually claim from the business in respect of warranties. The
cash costs involved therefore arise in future accounting periods and are shown as
such in the cash flow statement at that time.
The value of an increase in operating provision is shown as a positive number
in the cash flow statement. This is because, once again, we are reversing an item
that originally represented an increase in a future expected cost when charged to
the profit and loss account.
Conversely, the value of a decrease in operating provision is shown as a negative
number in the cash flow statement, this is because we are reversing an item that
originally represented a reduction in a future expected cost in the profit and loss
account.
Investment Income
This value represents the amount of investment income recognised in the profit
and loss account in the current period. Once again we are showing it here in the
cash flow statement as a reversing item because we need to remove it in order to
arrive at the correct value for the cash generated from operations.
28 Cash Flow Analysis and Forecasting
As we have mentioned before this cash flow statement commences with the
value profit before taxation. The investment income of the business has already
been recognised in the profit and loss account before arriving at this value. In order
to arrive at the correct value for the cash generated from operations we need to
remove this value. This doesn’t mean that the investment income is left out of the
cash flow statement. It is included in the cash flow statement elsewhere. We find
it in the investing activities section where it appears as dividends received.
You may recognise that the value shown in the cash flows from investing
activities as dividends received of 320 from the example cash flow statement
of Simple Limited (Table 2.1) does not match the value of investment income
adjusted for in the cash flow from operating activities section of minus 500.
Again, differences of this type crop up regularly in cash flow statements; the rules
for recognising income and expense in the profit and loss account are different
from the recognition of the underlying cash flow itself.
The fundamental accounting concept known as the ‘accruals concept’ requires
us to match revenues and costs consistently as time passes. It may be possible then
that the business has accrued investment income in the profit and loss account
(perhaps because a dividend has been declared and approved for payment in a
company in which the business has an investment). However, at the period end,
the relevant dividend has not yet been paid and therefore is not recognised in the
cash flow statement even though it is recognised in the profit and loss account.
This is because the cash flow statement only deals with cash flows.
Interest Expense
This value represents the amount of interest expense recognised in the profit and
loss account in the current period. Once again we are showing it here in the cash
flow statement as an add back item because we need to adjust for it in order to
arrive at the correct value for the cash generated from operations.
As we have mentioned before this cash flow statement commences with the
value profit before taxation. The interest expense of the business has already been
recognised in the profit and loss account before arriving at this value. In order
to arrive at the correct value for the cash generated from operations we need to
remove this value. This does not mean that the interest expense is left out of
the cash flow statement. It is included in the cash flows from operating activities
section further down where it appears as interest paid.
You will note that the value shown in the cash flows from operating activities as
interest expense of 350 from the example cash flow statement of Simple Limited
does not match the value of interest paid further down the same section of minus
310. Again, differences of this type crop up regularly in cash flow statements; this
is due to the different rules for recognising income and expense in the profit and
loss account. The fundamental accounting concept known as the accruals concept
Understanding Cash Flows Properly 29
requires us to match revenues and costs consistently as time passes. It may be
possible then that the business has accrued interest expense in the profit and loss
account (because interest is accrued but is not yet due for payment). Only interest
actually paid in the period should be recognised in the cash flow statement because
the cash flow statement only deals with cash flows.
The First Total of 6030
This represents the cash generated from selling goods or services less the cash costs
of production. It is an important measure of performance and a key component of
the cash generated from operations. The term OPERATING CASH MARGIN is
used in this book to describe this item.
Increase in Trade and Other Receivables
This represents the difference in value between the trade and other receivables (i.e.
DEBTORS) at the beginning and end of the accounting period to which the cash
flow statement relates. When the value in the cash flow is negative it represents an
increase in the value invested in providing credit to the business’s customers. In
order to lend our customers more cash we have to invest more cash in trade and
other receivables.
Decrease in Inventories
This item is equal to the change in the value of the inventories in the business
between the beginning and end of the accounting period. In this example the
inventory value has decreased, so resulting in a cash inflow to the business. This
means less cash is invested in inventory at the end of the period than at the
beginning. We have recovered some of the cash invested.
Decrease in Trade Payables
This item represents the change in the value of the trade payables (i.e. CREDI-
TORS) between the beginning and end of the accounting period. In this case the
amount owed to trade creditors has reduced. Cash has been expended to achieve
this. To reduce the amount invested in the creditors of a business it is necessary to
pay out cash to repay some of the trade credit granted by the supplier.
Cash Generated from Operations
This is the first major summary total appearing in this example. The cash generated
from operations is 4840. This represents the difference between the cash cost of
30 Cash Flow Analysis and Forecasting
inputs to the manufacturing process and the cash received in respect of outputs,
as well as the changes in the amount invested in the net working assets of the
business.
The contents of this section of the cash flow so far are summarised in Table 2.2.
Table 2.2 Analysis of the cash generated from operations total
’000
Cash generated by the business from the cash
margin on its products
6030
Cash invested or generated from the net working
assets of the business
(1190)
Cash generated from operations 4840
These are the two key totals normally to be found in this section. When we
come to introducing the recommended method used to analyse cash flows, the
reasons why this split is extremely important will be made clear. For the moment
let us say that the split is important because different causative factors affect each
value:
The cash generated by the business from the cash margin on its products is af-
fected amongst other things by macro economic conditions, sector fundamentals,
input cost issues, customer demand, manufacturing efficiency, and competitive
pressure on output pricing.
The cash invested or generated from the net working assets of the business is
affected by the style of production (lean, just in time, etc.), the need to carry
inventory to satisfy consumer needs and the typical sector structure of working
assets. (For example, retailers generally sell for cash and therefore do not need
to invest in providing credit to their customers.)
As a consequence each key total communicates different information to the
analyst about the state of the business when analysing the cash flows of the
business.
There are two remaining values left in the cash flows from operating activities
section. They are the interest paid and the income taxes paid. IAS 7 makes it clear
that both interest and dividends can appear in any of the three main sections, as
there is no consensus on the classification of these cash flows for entities other
than financial institutions. Taxes are generally shown in this section unless the
cash tax paid relates to an investing or financing activity in which case the relevant
amount of tax may be allocated to those sections as appropriate. What do these
values represent?
Understanding Cash Flows Properly 31
Interest Paid
This is the amount of cash interest paid in the accounting period. This number
may not match the profit and loss account charge for interest paid because there
are different rules for the recognition of interest in the profit and loss account.
The major difference is that it is normal to accrue for interest due but not paid
in the profit and loss account. It is also normal in the profit and loss account to
accrue the notional interest on other forms of debt with non-typical features such
as deep discount bonds where no interest is paid during the life of the instrument.
Income Taxes Paid
This is the value of the cash taxes paid during the financial period. This number
is normally different to the value shown in the profit and loss account because
taxes are usually paid in arrears. In small- and medium-sized businesses the cash
taxes paid in the current period often relate to the trading of the previous period.
For large businesses the law often requires quarterly payment of Corporation Tax
during the period to which it relates with one final balancing payment in respect
of the accounting period after the period end. This means there is unlikely to
be any significant relationship between the current period’s cash generated from
operations and the taxes shown in the same cash flow statement.
Cash Flows From Operating Activities – Summary
The first section of most published cash flow statements deals with the cash flows
from operating activities. Whilst there may be a bewildering array of adjusting
items, the bulk of the content can be summarised by two key totals: the cash
generated by the business from the cash margin on its products (known as the
operating cash margin); and the cash invested or generated from the net working
assets of the business (known as the movement or change in the Net Working
Assets). In Table 2.1 the cash interest paid and the cash taxes paid are also
disclosed in this section. The sum of all these cash flows is labelled the net cash
from operating activities. We may also refer to these as the cash flows relating to
TRADING.
CASH FLOWS FROM INVESTING ACTIVITIES
This section of a cash flow statement also discloses two things:
1. The cash spent on purchasing or creating tangible and intangible fixed as-
sets, and the cash received on disposing of obsolete or unwanted tangible or
intangible fixed assets.
32 Cash Flow Analysis and Forecasting
2. The cash spent on purchasing other businesses or investing in other businesses
as associates or joint ventures or buying shares in other businesses as invest-
ments or to gain influence or to speculate and the cash received on disposing of
businesses or shares in associates or interests in joint ventures or investments.
These represent the main elements of the investing activities section. In this
particular business example we also find the cash interest received and the cash
dividends received.
The headings in this section are reasonably self-explanatory. Typically we find
two types of investment transaction in this section. The first relates to the purchase,
creation or disposal of tangible and intangible fixed assets. By tangible fixed
assets we mean items such as property or land and buildings, plant and machinery,
fixtures and fittings, computer hardware and software, vehicles, ships and aircraft.
Typically these represent the pool of tangible fixed assets used by the business to
generate operating cash flow.
More rarely we may also encounter the purchase, creation or disposal of certain
intangible fixed assets such as patents and know how and overheads relating to
the creation of capital assets which have been capitalised as permitted by IAS 38.
We may also refer to both of these as ASSET level cash flows.
The second type of investment transaction is where a business purchases or
disposes of an interest in another business. This may range from, buying one share
in (or lending one euro/dollar/yen/pound sterling to) the business, up to purchasing
the whole of the business outright. Similarly it also encompasses disposing of the
same. The interest may be an investment, recognised as an associate or joint
venture, or giving control to the acquirer in which case the business acquired will
be consolidated after acquisition as a subsidiary. We may also refer to all of these
as BUSINESS level cash flows.
CASH FLOWS FROM INVESTING ACTIVITIES –
DETAILED REVIEW
Acquisition of Subsidiary, X Limited, Net of Cash Acquired
This represents cash expended on the acquisition of a new business, X Limited.
This will represent the purchase of a majority of, or all of, the share capital of X
Limited. Goodwill will have been created if Simple Limited has paid more than
the net asset value (less cash) of the balance sheet of X Limited. The goodwill will
subsequently appear in the consolidated balance sheet of Simple Limited.
You may be wondering why this is shown net of cash acquired. To put this
simply there is no point in acquiring cash when buying a business. The reason
for this is you would be exchanging cash for cash if you bought cash, which is
pointless. If, for some reason, cash is acquired in the balance sheet purchased it
Understanding Cash Flows Properly 33
simply becomes part of the new groups cash pool. This is why it is normal to see
the words ‘net of cash acquired’.
The value of 10 today is 10. How much would you give me for 10? Answer
10!
As a consequence of this, it is normal practice for the vendor to strip any
surplus cash out of a business to be disposed of prior to the sale, usually by paying
a dividend.
Purchase of Property Plant and Equipment
This represents the cash expended in the accounting period on the purchase of
new property, plant and equipment. Analysts and others commonly refer to this
value as capital expenditure. It is often abbreviated to the term Capex.
Proceeds from Sale of Equipment
This represents the cash received when we have disposed of equipment that is no
longer required. Typically this is because it is obsolete or worn out.
Do not confuse the proceeds from sale of equipment with the profit on sale of
equipment, even though the two terms sound very similar. The profit on sale of
fixed assets is an adjustment value to the cash generated from operations and
is explained in more detail later in the book.
The proceeds of sale value is often insignificant in the context of the other cash
flows. When summarising cash flows for analysis it is common to offset it with the
period Capex to arrive at the value known as net Capex. Net Capex is the capital
expenditure on new fixed assets minus the proceeds of sale of old fixed assets.
Interest Received
This value represents the cash interest received on cash surpluses held in the
business during the accounting period. These surpluses may be recognised in the
notes to the cash flow and accounts as cash and cash equivalents. The definition
of cash equivalents varies across different GAAPs.
IAS 7 defines cash equivalents as short-term, highly liquid investments that
are readily convertible to known amounts of cash and which are subject to an
insignificant risk of changes in value.
34 Cash Flow Analysis and Forecasting
This definition is designed to distinguish between investments that are very near
to cash in nature and investments that may suffer from material price (or value)
changes in the period over which they are held, even if this is relatively short term.
Dividends Received
This value represents dividends received from all interests in other business held
by Simple Limited other than interests in subsidiaries. When a subsidiary pays a
dividend to its parent company the transaction cancels out on consolidation. This
means it will not appear in the consolidated statement of cash flows.
This amount will typically be reported in the profit and loss account as invest-
ment income.
Cash Flows from Investing Activities – Summary
This second section of most published cash flows deals with the cash flows relating
to investment activities. Once again the section can usually be summarised by two
key totals: the cash flows relating to ASSET level transactions; and the cash flows
relating to BUSINESS level transactions.
In this example the cash interest received and the cash dividends received were
also disclosed in this section. The sum of all these cash flows is labelled the net
cash used in investing activities.
CASH FLOWS FROM FINANCING ACTIVITIES
The final section of the cash flow statement discloses two things:
1. The cash flows relating to changes in the business’s equity capital.
2. The cash flows relating to changes in the business’s debt position.
These are the main elements of the section. In this particular example we also
find the cash dividends paid.
This section of the cash flows deals with the funding and liquidity of the
business. If the business is using cash it reveals to us how this has been financed.
If the business is generating cash it reveals what the cash surplus has been used for
(reducing debt for example). Generally it is useful to summarise this information
into two main values: the change in equity and the change in debt.
Understanding Cash Flows Properly 35
CASH FLOWS FROM FINANCING ACTIVITIES –
DETAILED REVIEW
Proceeds from Issue of Share Capital
This represents the cash received from the sale of new shares to investors; it may
be shown net of issue expenses, although these are usually disclosed if they are
material.
This value shown in the cash flow statement may not agree with the change in
share capital in the balance sheet as the shares may have been issued at a premium
or discount to their par value. Any premium over par value is usually shown in the
balance sheet equity as share premium or its local equivalent.
Proceeds from Long Term Borrowings
This value represents the cash received from banks or investors in respect of an
increase in long-term borrowings. In other words this represents a debt increase.
Payments of Finance Lease Liabilities
This value represents the reduction in the liability outstanding in respect of finance
leases entered into by Simple Limited. As a finance lease represents an interest
bearing liability this item is part of the changes to debt in the accounting period.
In other words this represents debt repayment.
Dividends Paid
This value represents the cash dividends paid out to investors in Simple Limited
during the financial period. This value may not agree to the amount of dividends
shown in the profit and loss account due to timing differences between the dividend
being proposed, approved and paid. For example the final dividend for period one
is usually paid in period two.
Cash Flows from Financing Activities – Summary
The final section of most published cash flows deals with the cash flows relating to
financing activities. The section can usefully be summarised down to a change in
EQUITY and a change in DEBT. In our example in Table 2.1, the cash dividends
paid are also disclosed in this section. The total of all these cash flows is labelled
the net cash used in financing activities.
36 Cash Flow Analysis and Forecasting
Cash and Cash Equivalents
The final value in the cash flow statement is the net increase in cash and cash
equivalents. This represents the increase or decrease in cash and cash equivalents
held by the business in the period. In this example it is an increase of 1520.
THE NATURE OF THE BEAST – CONCLUSION
We have now examined, in some detail, the basic anatomy of a cash flow. We have
learned that all the values disclosed represent pure cash flows, and that many of
them do not agree to their corresponding values in the profit and loss account and
balance sheet for technical reasons.
However, it is not enough to know what each value means. This is simply a
starting point. We need to know what to do with each of these values in order to
learn something useful about the business. The sort of questions we seek to answer
are as follows:
Is the business performing satisfactorily?
Can we lend more money to this business?
Can this business pay me if I supply it?
Should I invest in this business?
Is this business good or bad?
Unfortunately, the published cash flow does not answer these questions by
providing convenient, user-friendly disclosure in an appropriate format. We have
to work for our supper! In the next section we look at ways to overcome this
problem.
SUMMARISING AND RESTATING CASH FLOWS FOR
ANALYSIS – INTRODUCTION
Now that we understand what the contents of a simple cash flow statement repre-
sents we can now start to consider how best to summarise and restate these cash
flows in order to best understand what is going on in the business.
Before we start to get radical, let us consider what we can glean directly from the
information offered. For convenience the cash flow statement of Simple Limited
is repeated (Table 2.3).
Understanding Cash Flows Properly 37
Table 2.3 A typical cash flow statement
Simple Limited
Cash flow statement Euros Euros
For the year ended 31st December 20XX ’000 ’000
Cash flows from operating activities
Profit before taxation 5600
Adjustments for:
Depreciation 550
Increase in operating provision 30
Investment income 500
Interest expense 350
6030
Increase in trade and other receivables 600
Decrease in inventories 1100
Decrease in trade payables 1690
Cash generated from operations 4840
Interest paid 310
Income taxes paid 1800
Net cash from operating activities 2730
Cash flows from investing activities
Acquisition of subsidiary X net of cash acquired 650
Purchase of property plant and equipment 460
Proceeds from sale of equipment 30
Interest received 350
Dividends received 320
Net cash used in investing activities 410
Cash flow from financing activities
Proceeds from issue of share capital 400
Proceeds from long term borrowings 360
Payment of finance lease liabilities 110
Dividends paid 1450
Net cash used in financing activities 800
Net increase in cash and cash equivalents 1520
The initial and most obvious way of summarising the cash flows disclosed is to
examine what the totals of each section communicate as in (Table 2.4).
Table 2.4 Unadjusted cash flow section totals
Simple Limited – Summary cash flow:
Year ended 31st Dec 20XX ’000
% of operating
cash item
Net cash from operating activities 2730 100%
Net cash used in investing activities (410) 15%
Net cash used in financing activities (800) 29%
Net increase in cash and cash equivalents 1520 56%
38 Cash Flow Analysis and Forecasting
On the face of it these values look healthy. Simple Limited appears to be
generating a healthy surplus from operations after dealing with the cost of working
asset investment, interest paid and taxes. Investment and financing needs appear
modest with the resulting increase in cash and cash representing over 50% of the
net cash from operating activities. However, by summarising to this level we are
losing a lot of potentially valuable information.
In investing activities the Capex and business level investment has been offset by
substantial amounts of interest and dividends received, which implies this business
has a substantial non-operating surplus of cash, cash equivalents and investments
in its balance sheet.
In financing activities we have in fact increased the amount of cash invested in
the business. This has been offset by the substantial dividend paid by the business.
IAS 7 allows those who prepare financial statements to show dividends paid as
either a financing cash flow or an operating cash flow. Let us see what happens to
the summary cash flow if we make this one adjustment (Table 2.5).
Table 2.5 Adjusted cash flow section totals
Simple Limited – Summary cash flow. Dividends paid
shown as part of cash flow from operating activities
rather than financing activities: Year ended
31st Dec 20XX ’000
%of
operating
cash item
Net cash from operating activities 1280 100%
Net cash used in investing activities (410) 32%
Net cash used in financing activities 650 51%
Net increase in cash and cash equivalents 1520 119%
The cash flows in the summary have changed dramatically. More importantly,
the apparent relationship between the values is now different. Whilst Simple
Limited still appears healthy, the amount of net cash from operating activities
expended in investing activities now appears to have doubled relative to the first
example. The net cash used in financing activities has become net cash generated
from financing activities. The increase in cash and cash equivalents now appears
to be derived partly from operations and partly from new finance.
CONCLUSION
In Table 2.5 we have only made one simple adjustment, a variation that is allowed
by IAS GAAP. The result is to change completely the apparent relationships
between the numbers. Remember that it is also acceptable to show interest paid
and interest and dividends received in any of the three sections and corporate
Understanding Cash Flows Properly 39
taxes can appear in sections other than operating if they relate to an investing or
financing activity.
These permitted variations make a mockery of attempting to analyse cash flow
performance directly from a published cash flow statement. This also means there
is no direct comparability between cash flow statements, as their layout can vary
markedly without contravening IAS GAAP.
So, how do we get around this problem? The answer is to use a standard layout.
What characteristics should this layout have? We need something that is suf-
ficiently simple to allow us to assimilate quickly and effectively what the cash
flows represent in terms of performance. However, we also require sufficient de-
tail to enable us to avoid the distortions that would arise if we net off too much
information as we did in the earlier example.
It is imperative to use a standard layout in order to gain comparability and
eliminate the layout distortions arising from IAS GAAP alternatives. What is this
layout?
The recommended template is shown in Table 2.6.
Table 2.6 Jury’s master cash flow template
Simple Limited
Summary group cash flow statement Euros
Year ended 31st December 20XX ’000
OPERATING CASH MARGIN 6030
(INVESTED)/GENERATED FROM NET WORKING
ASSETS
1190
NET CAPITAL EXPENDITURE 430
TAXATION 1800
CASH AVAILABLE TO SATISFY FINANCE
PROVIDERS
2610
NET INTEREST 40
NET DIVIDENDS 1130
OTHER NON-OPERATING INCOME/(EXPENDITURE) 650
NET CASH GENERATED/(ABSORBED) BEFORE
FINANCING
870
Financed by:
INCREASE/(DECREASE) IN EQUITY 400
INCREASE/(DECREASE) IN DEBT 250
(INCREASE)/DECREASE IN CASH 1520
TOTAL CHANGE IN FINANCING 870
What follows is an introduction to the template. After we have reviewed this we
will revisit our analysis of the cash flows of Simple Limited to see if this layout is
any more helpful in assisting us in understanding the business.
40 Cash Flow Analysis and Forecasting
Later in the book we will develop our understanding of the power of this
approach and develop our knowledge of the meaning of each line item as we
examine a number of examples of the use of my template. This chapter merely
serves as an initial introduction to my template.
Operating Cash Margin
This represents the cash generated from selling goods or services less the cash
costs of production. It is derived from values disclosed in the cash flow from the
operating activities section of a published cash flow statement. You will notice
that the value is the same as that shown by the first total in the Simple Limited
cash flow statement. In the Simple Limited example it is the value of the profit
before taxation together with the sum of the four adjustments below it.
This value can essentially be considered as the cash flow equivalent of profit.
It measures the success with which a business generates a cash flow surplus from
doing things! Businesses with negative operating cash margin are receiving less
cash for the goods and services they sell than the cash costs of materials and cash
overheads suffered in producing them.
This value is the equivalent to the cash generated from going round the circle
in the complete real business model.
(Invested)/Generated from Net Working Assets
This represents the net change in the amount invested in the net working assets of
the business. The amount invested in the net working assets is the amount invested
in inventories and the trade and other debtors, less the amount of interest free
credit received from suppliers and other creditors because the business is trading.
Inventories represent the amount invested in raw materials, work in progress
and finished goods less provisions for slow moving, damaged and obsolete items.
Seeing this value as a distinct total, independent of the cash generated from
operations total, is important because the amount invested or generated from net
working assets can be volatile and is affected by different drivers of change to the
operating cash margin. Movements in this value convey a lot of useful information
to the cash flow analyst about management quality, sectoral investment needs and
relative efficiency.
Net Capital Expenditure
Represents the amount invested in new fixed assets in the period less the proceeds
of selling old fixed assets. This is where we show the cash flows relating to ASSET
level transactions.
Understanding Cash Flows Properly 41
The level of capital expenditure in a business is influenced by a number of
factors, such as the market and business growth rate, technological change, changes
in consumer demand and the need to invest to maintain competitiveness.
Taxation
This represents the taxes actually paid in the period.
Cash Available to Satisfy Finance Providers
This total represents the cash available after the business has satisfied its fixed
and working asset investment needs and paid its taxes. In the long run a business
needs to generate sufficient cash in order to satisfy finance providers, to service
its interest burden, repay debt due in the period and provide the expected dividend
to shareholders.
This value represents a key total for the cash flow analyst. Intriguingly, it doesn’t
appear at all in a published cash flow statement!
Net Interest
This is the value of the cash interest paid, less the value of any cash interest
received. Essentially this communicates to the analyst the cost to the businesses of
its net debt financing position. Net debt is the amount of interest bearing liabilities
less the value of cash and cash equivalents.
Net Dividends
This is the value of the cash dividends paid, less the value of the cash dividends
received.
Netting off dividends in this way simplifies the cash flow summary without
losing much information. There are arguments that the net dividend cost is a more
useful value to examine (the shareholders indirectly own the dividends receivable
anyway!)
If more detail is required it is available from the source cash flow statement
used to make the template. The template can of course be expanded should this be
needed. It is up to the user how best to summarise the raw data for analysis.
Other Non-Operating Income/(Expenditure)
This is where we capture the BUSINESS level cash flows, such as the cash
spent on purchasing other businesses or investing in other businesses as associates
or joint ventures or buying shares in other businesses as investments and the
42 Cash Flow Analysis and Forecasting
cash received on disposing of businesses or shares in associates or interests in
joint ventures or investments. We would also introduce here any grants, subsidies
or other government assistance received in respect of business acquisition or
development. Again, the title is meant to be largely self-explanatory. If it is not
an operating cash flow item or an item related to the purchase or disposal of fixed
assets it probably goes here!
Net Cash Generated/(Absorbed) Before Financing
This is the second key total. This total represents the cash surplus or deficit for the
period after all cash costs incurred in the period have been satisfied. The remainder
of the template deals with the impact of changes in the financing of the business.
Again, it is unusual for this value to be stated implicitly in a published cash flow
statement.
Increase/(Decrease) in Equity
This represents the net cash change in equity during the period. Businesses raise
new equity by issuing shares and, in most countries, larger businesses are able to
buy back or cancel some of their equity should they wish to do so.
Increase/(Decrease) in Debt
This represents the net cash change in the total debt of the business in the period.
By netting in this way we eliminate the effects of re-financing (this being replacing
old debt with new debt) leaving us with a view of the actual debt change in the
period.
(Increase)/Decrease in Cash
This represents the change in the value of cash and cash equivalents during the
period. Notice that in my template the signage of this value is reversed compared
to the value disclosed in a typical published cash flow statement. An increase in
cash and cash equivalents is shown as a negative number, a decrease in cash and
cash equivalents is shown as a positive number.
It is necessary to reverse the sign of the last number to take advantage of
a property of the cash flow statement that is not obvious from the published
version and is particularly valuable to the analyst. A cash flow statement bal-
ances just like a balance sheet. As is clear from the master template the net cash
generated/(absorbed) before financing is always equal in value to the financing
cash flows themselves (after adjusting the signage of the cash and cash equiva-
lents). This balancing property enables us to confirm that we have not made any
Understanding Cash Flows Properly 43
arithmetic errors or omitted any of the values from the original cash flow state-
ment, so improving accuracy. Bear in mind that having balanced the cash flow
template it is still possible to make errors of allocation by entering a source value
into the wrong heading.
Why is the signage of the last cash and cash equivalents number in a typical
cash flow statement different to the signage used in the template?
Cash Change Signage – Algebraic Explanation
It has to do with the way a published cash flow statement is laid out. As you can
see from Simple Limited the published cash flow statement is not laid out as a
balancing statement. The cash flows are summarised and then added up to arrive
at a final total or difference. The effect of this layout is to make the signage of the
last number only in the cash flow incorrect should we wish to make a layout with
the balancing feature. This is a problem with virtually all published cash flows
irrespective of their national origin.
We can show this algebraically. A typical published cash flow is laid out like
this:
O±I±F=C
where
O=The cash flows from operating activities
I=The cash flows from investing activities
F=The cash flows from financing activities
C=The change in cash and cash equivalents
In the template, in order to have two balancing totals which cancel each other
out to zero we bring the cash value to the left side of the formula so it looks like
this:
O±I±FC=0
So, in order to make the layout in my template mathematically consistent it is
necessary to change the sign of the final cash value shown in the published cash
flow.
Cash Change Signage – Double Entry Explanation
A second explanation relies on the process of double entry accounting to illuminate
what is actually going on. If you have any familiarity with book keeping you will
know that every transaction in a set of double entry accounts has two entries. These
two entries for each transaction are known as a debit entry and a credit entry. At
the end of a period all the entries are added up, if no arithmetic errors have been
44 Cash Flow Analysis and Forecasting
made all the debits and all the credits will total to the same value. In other words
they will be in balance.
Balance Sheet
Debit side Credit side
ASSETS LIABILITIES
When I designed the template I had a choice as to how I dealt with the signage
of the equity, debt and cash numbers. I chose to represent an increase in equity as
positive, because for most people this is the intuitive signage to use for an increase,
as debt is also on the same side of the balance sheet (a liability item) an increase
in debt must also be positive, which again is largely intuitive for most people.
Cash, however, is not a liability. It is an asset item, this means an increase in
cash must have the opposite signage to the equivalent equity and debt value for the
three numbers to set off correctly in arriving at the balancing total. This inevitably
means that showing the cash increase as negative is not particularly intuitive for
most people, however, I believe it is preferable to reversing the signage of the
other two items – equity and debt – because it leaves us with only one value whose
sign is counter-intuitive rather than two.
Balance Sheet
Debit side Credit side
ASSETS LIABILITIES
Cash Debt and Equity
If you mentally take the values shown above for the equity, debt and cash of
Simple Limited and insert them in the above diagram it should become clear why
it is necessary to change the sign associated with cash.
I have provided two explanations as to why it is necessary to change the last
number only of a published cash flow in order to balance the master template.
Increased familiarity by the user with the restatement of published cash flows
will inevitably reinforce this point until it is no longer an issue in the mind of
the user.
To summarise, unless the published cash flow statement is laid out as a balancing
statement (something I have observed on a few rare occasions) it will always be
necessary to reverse the sign of the last cash number in the cash flow statement
only in order to get the master template values to balance correctly.
Understanding Cash Flows Properly 45
ANALYSING THE CASH FLOWS IN THE
MASTER TEMPLATE
So, we have successfully summarised the published cash flows into the template.
What does it tell us?
By having a standardised layout we have eliminated the distortions that might
arise due to positional differences in the disclosure of interest, dividend and
taxation values. We have also laid out the values in such a way that two key totals
not shown in the original published cash flow statement are exposed for analysis
and assessment (Table 2.7).
Table 2.7 The completed Jury’s master cash flow template for Simple Limited
Simple Limited
Summary group cash flow statement Euros
Year ended 31st December 20XX ’000
OPERATING CASH MARGIN 6030
(INVESTED)/GENERATED FROM NET WORKING ASSETS 1190
NET CAPITAL EXPENDITURE 430
TAXATION 1800
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 2610
NET INTEREST 40
NET DIVIDENDS 1130
OTHER NON-OPERATING INCOME/(EXPENDITURE) 650
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 870
Financed by:
INCREASE/(DECREASE) IN EQUITY 400
INCREASE/(DECREASE) IN DEBT 250
(INCREASE)/DECREASE IN CASH 1520
TOTAL CHANGE IN FINANCING 870
Here is an explanation of what the cash flows of Simple Limited might reveal
to an analyst experienced in the application of the analysis techniques explained
in more detail as we proceed to the more advanced parts of the book.
Simple Limited appears to enjoy a healthy operating cash margin with ap-
proximately 20% of it being absorbed in working capital changes. Net capital
expenditure appears low (we know this because we can compare it with the depre-
ciation value in the adjustments part of the cash flows from operating activities),
net capital expenditure is 78% of the period depreciation charge. IAS depreciation
is based on writing off assets over their estimated useful life and therefore provides
a crude estimate of the amount required each year to replace fixed assets. Thus it
appears the business is investing less in fixed assets than it needs to compensate
for the wearing out of the existing assets each year.
46 Cash Flow Analysis and Forecasting
Taxes appear consistent with a business with no net debt. The taxation value is
28% of the operating cash margin, which may not signify anything if the taxation
paid this year relates to cash generated in the previous year. If taxes are in arrears the
tax paid implies the business’s last accounting period enjoyed a similar operating
cash margin value assuming no net leverage. The cash available to satisfy finance
providers is a surplus of 2610.
The net interest value is positive, implying no net debt on average over the year,
the net dividend is a substantial outflow even after offsetting dividends received.
Simple Limited has made a small acquisition during the year. The remaining
surplus of 870, together with the net increase in equity and debt has resulted in
an increase in cash retained in the business of 1520.
These cash flows are typical of an established and successful mature business.
Notice that everything mentioned above has been derived solely from the cash
flow statement, no reference is made anywhere to any other value available in the
full set of accounts.
THE STATE OF PLAY
So far we have started to address the nature of a cash flow statement and what
this tells us about the cash flows of a business. Secondly we have introduced
Jury’s Cash Flow Template and restated the cash flows of Simple Limited into the
template.
Finally, we have scratched the surface of what we can glean from the restated
cash flows. It is now time to develop a deeper and more thorough understanding of
this process. In the next chapter we introduce a further element of the knowledge
set required to fully grasp cash flow analysis.
3
Start-up, Growth, Mature, Decline
INTRODUCTION
In order to gain further benefit and insight from the results of our cash flow
restatement we need to understand what a typical set of ‘good’ cash flows should
look like.
The typical ‘good’ pattern of cash flows varies dramatically between different
businesses. The most important reason for this variety is to do with where the
business is in its life cycle.
In this section we look at the typical cash flows of a business at start-up, in
the growth phase, the mature phase, and finally the decline phase. To make this
section as useful as possible to the analyst I have included a short discussion of
exactly what we mean by the terms start-up, growth, maturity and decline when
applied to business analysis.
Later in the book there are separate chapters on each of the four phases. They go
into more detail about various aspects of analysis relevant to that particular phase.
All cash flow values quoted in the text from the examples represent thousands.
THE START-UP PHASE
When does business commence?
As any entrepreneur knows, there are a number of steps that precede the com-
mencement of trade.
Most entrepreneurs start with an idea for a new product or service. They then
research the viability of the idea, the initiatives required, assess the feasibility of
operations, the business risks involved and develop a business plan. This part of
the process can take years. Assuming the viability of the project looks good, the
entrepreneur at some point raises capital and invests in the necessary initiatives to
develop the product or service.
At some point, once operations are established on a commercial scale, sales
commence to customers of the business. This is when the first cash inflows from
operations arrive. Prior to this point we do not have a true business. You could
say we have a charity! Some person or persons (the project sponsors) are giving
money to other persons to do things for them.
Why is this issue of what constitutes a true business so significant?
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
48 Cash Flow Analysis and Forecasting
In the past I have observed numerous situations where entrepreneurs and busi-
nessman have claimed to be running a business, but in fact there is no true
business there. There may be products, factories, employees, sales literature and
administration. What missing is sales and hence cash flow from customers! In
other words demand for the product or service provided has not yet been proven
to exist.
I recollect visiting a start-up business that had developed a new form of solar
heating device, I was shown a completed version of the product, met employees
and was shown a factory containing various machinery purchased to manufacture
the product. However, at this point, there was no sales activity at all! The business
closed having run out of cash before any material level of sales had been achieved.
So, for the purposes of analysing cash flows, my definition of ‘a start-up busi-
ness’ is the achievement of regular operating cash flow from customers. The
business may not be proven to be viable in the long run at this point; however,
some important milestones will have been passed.
1. The product or service is being delivered successfully.
2. Someone, somewhere (a customer) is willing to pay for it.
3. Customers are continuing to consume the product or service after their first
purchase (there are repeat purchases).
The business will almost certainly still be cash negative and loss making at
this point. The long journey to success is not yet complete. However, the basic
credibility of the business model has been demonstrated. In the later chapter on
the start-up phase we will discuss in more detail what happens in the period before
this point.
So, in this initial example, my start-up business has already designed the first
product or service to be sold and invested sufficiently to deliver this. Customers
are starting to buy the product.
The cash flows of a start-up business could look like the example in Table 3.1.
Let us assume that an entrepreneur has recently started a new business. The busi-
ness is manufacturing some sort of consumer product that requires an investment
in machinery.
The restated cash flow summary reports the cash flows over the first year of
operation. Let us review what the template tells us about the business.
The operating cash margin is negative as the business is still producing goods
for more cash cost than they receive in sales income. This is because the volume
through the plant is still too low to capture the necessary economies of scale to
be profitable. The workforce is still learning to manufacture the product to the
required levels of quality in an efficient manner. Production is not yet particularly
efficient.
The business is investing in the net working assets it requires. The business has
to invest in inventory; it must have sufficient raw materials, work in progress and
Start-up, Growth, Mature, Decline 49
Table 3.1 The cash flows of a start-up business
Start-up example
Restated cash flows Dollars
Year 1 ’000
OPERATING CASH MARGIN 10
(INVESTED)/GENERATED FROM NET WORKING ASSETS 200
NET CAPITAL EXPENDITURE 500
TAXATION 0
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 710
NET INTEREST 30
NET DIVIDENDS 0
OTHER NON-OPERATING INCOME/(EXPENDITURE) 300
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 380
Financed by:
INCREASE/(DECREASE) IN EQUITY 500
INCREASE/(DECREASE) IN DEBT 0
(INCREASE)/DECREASE IN CASH 120
TOTAL CHANGE IN FINANCING 380
finished goods to be able to satisfy customer needs as required. In addition it will
be obliged to provide trade credit to its customers (invest in debtors) as it acquires
them if this is normal practice in the market in which the business operates. It will
enjoy little if any trade credit from its suppliers, however, due to the newness of
the business and lack of track record on which the suppliers could base a credit
assessment. Most raw material purchases will be in cash.
The business is investing in fixed assets. In this year the entrepreneur has
purchased the first machine required to commence production as well as other
fixed assets needed to package and distribute the product.
The business pays no taxes at this point, as it has never made a profit, indeed
there is likely to be a tax loss carried forward at the end of the year.
The cash available to satisfy finance providers is a substantial negative. This is
typically what we expect to see at this point in the start-up businesses development.
The business has a small amount of interest received due to the having a net
cash position in its balance sheet. There is no interest payable as the business has
no debt at this point in its development.
The business does not pay a dividend at this point because any cash available
at this point is used for investment and because it’s probably illegal! In many
countries dividends can only be paid out of positive revenue reserves. At this point
the revenue reserves of the business are negative in the balance sheet.
50 Cash Flow Analysis and Forecasting
The business receives a substantial grant from the government because it is
creating employment in its location. The entrepreneur has employed five persons
on start-up.
The net cash absorbed before financing at the end of the first year’s trading is
$380. This is financed by the introduction of $500 in equity from the entrepreneur,
her family and other investors. At the end of the period $120 of this new equity
remains in the business cash account unspent.
This is a typical set of start-up cash flows. Generally the business is cash
negative, the shortfall being financed by investors.
THE GROWTH PHASE
The next three most important objectives are to achieve a positive cash flow
position, to break even and to make this sustainable into the future. Ideally these
objectives are achieved in the first two to three years of the life of the business.
The business then enters the growth phase.
What exactly do we mean by a growth business? We mean a business whose
VOLUME of output (or if it is a service business, its scale of operations) is
growing. Inevitably this requires investment in both working assets and fixed assets
(Table 3.2).
Table 3.2 The cash flows of a growth business
Growth example
Restated cash flows Dollars
Year 4 ’000
OPERATING CASH MARGIN 1000
(INVESTED)/GENERATED FROM NET WORKING ASSETS 400
NET CAPITAL EXPENDITURE 900
TAXATION 300
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 600
NET INTEREST 100
NET DIVIDENDS 0
OTHER NON-OPERATING INCOME/(EXPENDITURE) 100
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 600
Financed by:
INCREASE/(DECREASE) IN EQUITY 300
INCREASE/(DECREASE) IN DEBT 210
(INCREASE)/DECREASE IN CASH 90
TOTAL CHANGE IN FINANCING 600
Start-up, Growth, Mature, Decline 51
Let us assume our example manufacturing business has successfully negotiated
the start-up phase, the business is now growing strongly. How does this change
what we see?
The operating cash margin is now positive and the business is generating
a healthy cash surplus against its cash costs every time it sells its product to
customers.
The business is still investing in net working assets because it is growing
its unit output strongly. It therefore requires investment in increasing its inven-
tory and its debtors. The business is now able to obtain some trade credit from
its major suppliers as it is trading profitably and has a three-year track record
available for analysis. This offsets some of the investment required in inventory
and debtors.
The business is still investing in fixed assets because it is still growing; further
machinery is purchased as required to increase output as the business expands.
Periodically the factory itself may require expansion.
The business is now paying some taxes; however, the liability is not large.
As a consequence of the capital investment there is substantial tax depreciation
available to reduce the tax liability.
The cash available to satisfy finance providers is still negative. Again, this is
typically what we expect in a growth business. The reason it is negative is that
the business is making the fixed and working asset investment required to keep
pace with growth in demand for its products faster than it is generating cash from
the operating cash margin. The presumption when the investment is made is that
the investment in fixed and working assets in the current period will yield more
operating cash margin from the resulting increases in the volume of output in
future years as the business continues to grow. Investors are prepared to finance
this if they believe the future increase in operating cash flow as a result of the
investment will be sufficient to recover or exceed the cash they invest in the new
fixed and working assets.
The business is now paying interest. In our example, finance leases have been
used to acquire some of the machinery and represent part of the capital expenditure.
The young business in the growth phase is still too risky for most commercial banks
to consider lending medium-term finance. However, leasing companies are less
concerned about the business risk issues as they have the security of the machinery
(against which they have lent) to rely on should the business cease to make the
monthly payments required for any reason.
No dividends are being paid at this time, as the business is still cash negative.
All surplus resources are focused on continuing the rapid growth of the business.
The business continues to receive grants from the government in respect of em-
ployment creation as it continues to take on more new employees for the first time.
The net cash absorbed before financing at the end of the fourth year’s trading
is $600. This is financed by the introduction of $300 in equity from growth stage
52 Cash Flow Analysis and Forecasting
investors and the introduction of $210 of debt being the principal outstanding in
respect of the finance leases on new fixed assets. The remaining $90 required has
come from cash and cash equivalents already in the business as the beginning of
year four.
This is a typical set of growth cash flows. The business is still cash negative
in this stage, because it is investing more in fixed and working assets in a given
period than it is generating in operating cash margin. The shortfall is financed by
growth investors, lenders with an appetite for lending to such businesses and the
cash, which was retained in the business from previous periods.
THE MATURE PHASE
In a business analysis context the term ‘mature’ is somewhat ambiguous. All busi-
nesses want to grow if they can, including businesses considered by investors and
analysts to be mature. They continue to invest significant amounts of management
time and effort in seeking ways to increase turnover, profits and cash flows.
So, what exactly do I mean by a business that is mature? I will start by defining
a business that is mature as one that is no longer growing the VOLUME of its
output. This means that the new investment in fixed and working assets to grow
the output of the business is no longer required. In a successful mature business
the overall cash flows are positive (Table 3.3).
Table 3.3 The cash flows of a mature business
Mature example
Restated cash flows Dollars
Year 9 ’000
OPERATING CASH MARGIN 3500
(INVESTED)/GENERATED FROM NET WORKING ASSETS 600
NET CAPITAL EXPENDITURE 1000
TAXATION 1000
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 900
NET INTEREST 400
NET DIVIDENDS 400
OTHER NON-OPERATING INCOME/(EXPENDITURE) 0
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 100
Financed by:
INCREASE/(DECREASE) IN EQUITY 0
INCREASE/(DECREASE) IN DEBT 100
(INCREASE)/DECREASE IN CASH 0
TOTAL CHANGE IN FINANCING 100
Start-up, Growth, Mature, Decline 53
Let us assume our example business is now mature. The business has reached
a position in the geographic markets in which it chooses to compete where it
controls a significant market share and enjoys adequate competitive advantages
to sustain its position. At this point it has no immediate plans for further new
investment or growth in the planned volume of its output.
The operating cash margin is now substantial, the business is generating a
healthy cash surplus against its cash costs each time it sells its products to cus-
tomers. It has thousands of customers spread over a wide geographic area. It has
learned how to manufacture its product in a highly efficient way and has used cap-
ital expenditure over many years to lower costs and improve quality. It is selling
its product in millions of units a year. The volume of output is not growing or is
growing very slowly.
The business is still investing in net working assets. Why is this?
The business does not require further investment in net working assets in respect
of volume growth because there is none! However, there is one other external
variable affecting the business that may still trigger a need for further investment
each year. This is the effect of inflation on the business. If the economy in which
the business operates suffers inflation at say 2% a year this means that it will
cost 2% more at the end of the year to replace the same physical inventory that
was present at the beginning of the year. The same logic applies to debtors.
Conversely the interest-free loan that represents supplier credit will increase 2%
a year in respect of the same physical purchasing. So, even in a mature business,
it may be necessary to invest in net working assets each period to offset inflation
effects.
The business is still investing in fixed assets. Again, it may not immediately
be obvious why. The business is no longer growing so it does not require fixed
asset investment to provide increased output capacity. As with the net working
assets there is a second driver of investment at work. Machines wear out, vehicles
and computers need replacing regularly. We have a name for this type of capital
expenditure (this term often being abbreviated to Capex). This is known as main-
tenance or replacement Capex. This distinguishes it clearly from growth Capex,
which is new capital expenditure made with the intention of increasing output or
operations.
So, when a business stops growing its output Capex doesn’t drop to zero. It
drops to a lower number representing the maintenance or replacement Capex. For
a business to maintain its productive capacity it needs to keep its fixed assets
in appropriate productive condition. Competitive and technological changes may
also stimulate fixed asset replacement even in conditions of no growth of output.
So our mature business will still have net capital expenditure, this being devoted
mainly to maintenance or replacement Capex.
The business is now paying a substantial amount in cash taxes, as there is less
capital expenditure to reduce the tax bill through accelerated tax depreciation.
54 Cash Flow Analysis and Forecasting
Remember that the amount shown in respect of taxes in this year’s cash flow
statement may in some countries relate to the previous year’s profits and this
means the value may have no direct relationship with this year’s operating cash
margin.
The cash available to satisfy finance providers is now positive. This is what we
expect to see in a successful mature business. All mature businesses should be
producing a positive cash flow available to satisfy finance providers. If the cash
flow is negative at this point it means the business is not generating sufficient
operating cash flow to cover investment needs and taxes, a situation that is not
sustainable. The business is probably distressed and without significant change
may collapse at some point in the future. If a business cannot meet its mainte-
nance investment needs and pay its taxes from the operating cash margin it is in
serious trouble. Remember that this measure of performance is before we con-
sider the additional cash outflows relating to the servicing of debt and providing
dividends to investors. Neglecting either of these will also result in problems in
the future.
The business is now paying interest. It is now nine years old and has built
up a substantial balance sheet full of assets. It should be an attractive lending
opportunity for most lenders and the business should have little trouble in raising
any kind of debt as it requires it. Our example business now has bank debt in its
balance sheet as well as finance leases.
The business now pays a dividend. Whist the decision to pay a dividend is
largely a matter of tax efficiency in a private company it would be essential in a
mature public company if the business were to sustain a reasonable share price.
Corporate finance theory suggests mature businesses should be distributing cash
back to investors because they no longer require their cash surpluses for investment
in the business.
Other non-operating income/(expenditure) is zero as the business is not engaged
in the acquisition or disposal of other businesses or investments and is no longer
receiving any grants.
There is a small cash surplus before financing at the end of the ninth year’s
trading of $100. There is no longer any need to introduce further new equity to
the business. If the business required investment for any reason it would normally
borrow to fund it. In this example the $100 has been used to reduce the debt
outstanding. Other than that required for day to day liquidity there is no cash in
the business as it now has a net debt position. This is why there is no movement
in the cash change value.
This is a typical set of mature cash flows. The business is generating cash
at both the cash available to satisfy finance providers total and the net cash
generated/(absorbed) total. It now has net debt and pays dividends. Other than
maintaining its fixed and working assets its investment needs are minimal.
Start-up, Growth, Mature, Decline 55
THE DECLINE PHASE
The word ‘decline’ is used by analysts for a variety of purposes. A business
that is suffering poor performance may be referred to as being ‘in decline’. In
this sense a business can be in decline in any of the four phases. The whole
issue of bad performance in each of the four phases is dealt with the later in
Chapters 6–11, which go into more depth about what constitutes ‘good’ and ‘bad’
cash flows.
What we are going to examine here is the effect on the cash flows of being a
successful business whose product or service markets are in decline. That is to
say they are reducing in size year on year. This implies that the volume of output
produced by the business is falling year on year. What will the cash flow look like
now?
This is not a poorly managed business or failing business. What is illustrated
in Table 3.4 is a successful business in a declining market. The best example
available at the moment is probably a cigarette manufacturing company. In Eu-
rope cigarette consumption is declining at about 3% a year. The cash flow decline
example is included at this point to illustrate to the reader what should be hap-
pening to the behaviour of the cash flows in such a situation in a successful
business.
Table 3.4 The cash flows of a decline business
Decline example
Restated cash flows Dollars
Year 20 ’000
OPERATING CASH MARGIN 7000
(INVESTED)/GENERATED FROM NET WORKING ASSETS 1000
NET CAPITAL EXPENDITURE 1500
TAXATION 3200
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 6300
NET INTEREST 1000
NET DIVIDENDS 3000
OTHER NON-OPERATING INCOME/(EXPENDITURE) 0
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 2300
Financed by:
INCREASE/(DECREASE) IN EQUITY 1000
INCREASE/(DECREASE) IN DEBT 1300
(INCREASE)/DECREASE IN CASH 0
TOTAL CHANGE IN FINANCING 2300
56 Cash Flow Analysis and Forecasting
We expect to see something along the following lines: The operating cash margin
is substantial. The business is generating a healthy cash surplus against its cash
costs each time it sells its product to customers. It has learned how to manufacture
its product in a highly efficient way and has been exploiting a significant position in
its market for decades. It is selling its product in millions of units a year. Turnover
is declining at a few percent a year. The operating cash margin is still substantial
but is falling slowly year on year.
The business is now recovering its investment in working assets. As the business
turnover declines the need to invest in inventory and debtors – less the interest-free
loan from suppliers – disappears and, as the amount invested in working assets
declines, the cash invested in working assets in the growth phase of the business
returns to the business as a cash inflow.
The business is now recovering its investment in fixed assets. As volume output
reduces manufacturing capacity is rationalised. Factories that are not required are
closed and where possible the plant and machinery is sold to others or relocated. As
the factory was built decades ago in or near centres of population the land on which
it sits may be very valuable for redevelopment. Production is concentrated in the
lowest cost and most modern facilities, further increasing margins. Maintenance
Capex may still be required. However, this is minimal due to the availability of
surplus assets elsewhere to substitute for it. The proceeds of sale of fixed assets
exceeds the replacement Capex, so resulting in a cash inflow from net capital
expenditure.
The business pays a very substantial amount in cash taxes, as there is minimal
capital expenditure to reduce the tax bill through accelerated tax depreciation.
The cash available to satisfy finance providers is now massively positive. This
is what should be happening in a successful decline business. Not only are we
receiving the operating cash margin, we are recovering the investment in net
working assets and fixed assets.
In our example the business now carries a significant amount of debt and now
pays a lot of interest. If the business is large the management may be increasing
the debt in the business periodically and using the cash inflow to buy back equity,
so supporting the share price. The massive operating cash flow is used to service
interest and repay debt. Every few years the process of adding more debt to buy
back equity may be repeated.
In our example the business also pays a massive dividend. If the business is
listed this is the only reason to invest in the business as there is no longer any
expected future volume growth. Investors assess a share in such a company on the
basis of its dividend yield relative to debt yields.
Other non-operating income/(expenditure) is zero as the business is not engaged
in the acquisition or disposal of other businesses or investments and is no longer
receiving any grants.
Start-up, Growth, Mature, Decline 57
There is a massive cash surplus before financing at the end of the years trading of
$2300. This is used to buy back equity and repay debt. A process that theoretically
could continue until the business finally self liquidates.
This is a typical set of successful decline cash flows. It is included to provide
a complete understanding of how the basic patterns of cash flow should appear in
the four phases of the life of a successful business. In the real world a declining
business rarely displays this sort of cash flow performance. This is discussed in
more detail in Chapter 10.
CONCLUSION
We should now have gained an understanding of what we expect the cash flows of
business to look like through the four phases of a successful businesses existence.
This is summarised in Table 3.5.
Table 3.5 The cash flows through the four phases of a successful business
Summary example Start-up Growth Mature Decline
Restated cash flows $’000 $’000 $’000 $’000
OPERATING CASH MARGIN 10 1000 3500 7000
(INV)/GEN FROM NET WORKING
ASSETS
200 400 600 1000
NET CAPITAL EXPENDITURE 500 900 1000 1500
TAXATION 0 300 1000 3200
CATS FINANCE PROVIDERS 710 600 900 6300
NET INTEREST 30 100 400 1000
NET DIVIDENDS 0 0 400 3000
OTHER NON-OPERATING INC/(EXP) 300 100 0 0
NET CASH GEN/(ABS) BEFORE
FINANCING
380 600 100 2300
Financed by:
INCREASE/(DECREASE) IN EQUITY 500 300 0 1000
INCREASE/(DECREASE) IN DEBT 0 210 100 1300
(INCREASE)/DECREASE IN CASH 120 90 0 0
TOTAL CHANGE IN FINANCING 380 600 100 2300
58 Cash Flow Analysis and Forecasting
SUMMARY
The goal of this chapter was to present to the reader a typical set of cash flows for
a successful business in the four phases in the life of that business, these being:
Start-up, Growth, Mature and Decline. These examples provide a sort of budget
or ideal against which we can examine actual cash flows taken from the real
world.
It should now be clear that each line of the cash flow template is driven by
different cash flow drivers or behaviours. By developing our understanding of
these drivers we can improve our ability to evaluate the cash flows of a business
when presented in the Jury’s Template format.
4
Restating the Cash Flows
of a Real Business
INTRODUCTION
This chapter commences the more detailed part of the book. The following chapters
present everything the financial analyst may require to become fully conversant
with historic cash flow analysis.
This chapter seeks to present all the information required by an analyst to
summarise and restate an indirect cash flow statement into a common format for
analysis.
The restatement process that is described is essentially a technical exercise.
Accordingly, this chapter is organised to be as user friendly as possible when
read for the first time and easily accessible subsequently when used as a technical
reference.
OUR OBJECTIVE
We have a cash flow statement to analyse, how do we go about our task?
There are two possible ways of preparing and presenting a cash flow statement,
these are known as the direct method and the indirect method. The first task to
ascertain is whether the cash flow is a direct cash flow or an indirect cash flow.
In this chapter we will concentrate on the restatement of indirect cash flows.
The reason for this is most of the published cash flows in the world are prepared
using the indirect method. Cash flow statements prepared using the direct method
are rare. If you wish to know more about direct cash flows at this point Chapter
15 is devoted entirely to direct cash flows.
A direct cash flow is prepared by taking the cash records of the business, coding
each cash transaction during the period into its relevant cash flow constituent
and then summarising the resulting information into a cash flow statement.
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
60 Cash Flow Analysis and Forecasting
We can identify whether a cash flow statement is direct or indirect by examining
the first few lines of the cash flow statement. In the case of direct cash flow
statements instead of starting with a profit value taken from the profit and loss
account the cash flow typically starts with receipts from customers and payments
to employees and suppliers.
An indirect cash flow is prepared by identifying the various cash flows required
to prepare the cash flow statement from information contained within the profit
and loss account and the current and previous balance sheet of the business.
THE IMPLICATION OF DIFFERENT GAAPs
GAAP is an acronym for Generally Accepted Accounting Principles. The next
question we need to consider is, under which GAAP rules has the cash flow
statement been prepared?
Whilst most countries follow a broadly similar approach to the preparation and
presentation of cash flow statements, there are differences in the minutiae of the
different GAAP rules. This chapter starts by showing how to summarise cash
flows prepared under International Accounting Standards (IAS) GAAP rules.
Once you are familiar with a variety of the cash flow statements from different
countries, you will be able to anticipate the typical problems that you will be
likely to encounter when restating particular countries cash flows. For this reason,
Chapter 5 is devoted to the specific issues involved in analysing the cash flows of
entities prepared using US GAAP.
We can now proceed to understanding in detail the restatement process. We
will work through this process section by section using the a cash flow statement
taken from the accounts of Nokia (the global mobile telephone group) as an initial
example. Nokia has been producing IAS accounts for many years.
Arithmetic Signage in the Cash Flows
By signage we mean whether a cash flow is positive (an inflow) or negative (an
outflow). Generally the treatment of the signage of values contained within a
cash flow statement is straightforward. Positive values represent cash inflows and
negative values represent cash outflows. All signage should be summarised into
Jury’s Template as observed.
In the template, brackets are used with certain of the labels to signify the
meaning of the signage of the cash flow, in the examples brackets or a minus sign
may be used to signify negative cash flows.
The only exception to this rule is the last number in the cash flow statement,
which is usually the change in cash, or the change in cash and cash equivalents.
Restating the Cash Flows of a Real Business 61
Unless the published cash flow is laid out as a balancing statement the final cash
value shown will require its signage reversing to make the restated cash flow
template balance. The reasons for this being explained in Chapter 2.
Acronyms
From now on we will start to use the following acronyms to describe certain
values. The first time the term is used in the text the acronym will normally follow.
EBIT Earning before interest and tax
EBITDA Earnings before interest, tax, depreciation and amortisation
P&L Profit and loss account
IAS International Accounting Standard
IFRS International Financial Reporting Standard
M or m Million meaning 1 000 000
RESTATING THE CASH FLOWS FROM
OPERATING ACTIVITIES
The information in Table 4.1 is taken from the published accounts of Nokia.
Table 4.1 is the cash flow from operating activities part of the full IFRS cash
flow statement.
Table 4.1 Summary of net cash from operating activities
20XX
FINANCIAL YEAR ENDED DECEMBER 31st Notes M
CASH FLOW FROM OPERATING ACTIVITIES
Profit attributable to equity holders of the parent 3988
Adjustments, total 32 3469
Change in net working capital 32 2546
Cash generated from operations 4911
Interest received 416
Interest paid 155
Other financial income and expenses, net received 195
Income taxes paid, net received 1780
NET CASH FROM OPERATING ACTIVITIES 3197
62 Cash Flow Analysis and Forecasting
Generally the cash flow from operating activities section of a published cash
flow statement contains values relating to the first two lines of the template. It may
also contain other values relating to interest and taxation. The persons responsible
for the preparation of the cash flow statement can choose to disclose them here.
So, in Table 4.2 we are going to extract the values relating to the items shown in
bold below.
Table 4.2 Building up the template – dealing with the first two lines
OPERATING CASH MARGIN
(INVESTED)/GENERATED FROM NET WORKING ASSETS
NET CAPITAL EXPENDITURE
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
IDENTIFYING THE OPERATING CASH MARGIN
The cash flow statement starts with the value net profit. Where does this come
from in the profit and loss account (P&L)?
In Table 4.3, we can see that this is identical to the value of the profit after tax
and minority interests (shown as the Profit attributable to equity holders of the
parent in Table 4.3). In other words the cash flow statement starts with the profit
after interest and after tax and minority interests. This means that we will expect
to find the following values as add-backs in Note 32 when we examine it.
1. Minority interests
2. Tax
3. Financial income and expenses
4. Share of results of associated companies
5. Depreciation and amortisation
6. Profit and loss on sale of fixed assets
7. Movements on provisions and other non-cash adjustments
Why do I know this before examining the note? The reason is that the first
value we require for the template, the OPERATING CASH MARGIN, is typically
Restating the Cash Flows of a Real Business 63
Table 4.3 Nokia – Consolidated profit and loss account
20XX
FINANCIAL YEAR ENDED DECEMBER 31st Notes M
Net sales 50 710
Cost of sales 33 337
Gross profit 17 373
Research and development expenses 5968
Selling and marketing expenses 4380
Administrative and general expenses 1284
Other income 6 420
Other expenses 6,7 1195
Operating profit 2–9,22 4966
Share of results of associated companies 14,31 6
Financial income and expenses 10 2
Profit before tax 4970
Tax 11 1081
Profit before minority interests 3889
Minority interests 99
Profit attributable to equity holders of the parent 3988
similar in value to (but not the same as) the profit and loss sub-total known as
EBITDA (Earnings before interest, tax depreciation and amortisation). (In Nokia’s
accounts EBIT is labelled Operating profit.) That means that the first five items in
the list above must be added back just to get to this value. The reason the EBITDA is
not he same as the OPERATING CASH MARGIN is to do with the last two items.
Remember that in the last chapter we learned that the OPERATING CASH
MARGIN is actually the cash received from selling goods and services less the
cash paid out in creating those same goods and services. Unfortunately the profit
and loss account does not disclose these values implicitly. The nearest we get from
the Nokia P&L is the first four values shown in the P&L in Table 4.3:
Nokia 20XX
Consolidated profit and loss accounts, IFRS M
Net sales 50 710
Cost of sales 33 337
Research and development expenses 5968
Selling and marketing expenses 4380
Administrative and general expenses 1284
POSSIBLE OPERATING CASH MARGIN 5741
64 Cash Flow Analysis and Forecasting
Is this the correct answer? Unfortunately it is not! The reason for this is that
certain of the expense items above shown contain within them other items which
have been recognised as expenses and are non-cash items.
Typically there are three commonly recurring non-cash items included in these
expenses.
1. Depreciation and Amortisation
The terms depreciation and amortisation essentially mean the same thing. In
certain countries such as the UK it is a convention to use the word depreciation
for tangible assets and the word amortisation for intangible assets. In the USA the
word amortisation is used for both tangible and intangible assets.
Depreciation was created as a concept a long time ago to make the P&L more
meaningful to users. Imagine for a moment a world without depreciation. In
periods where a business acquired fixed assets it would show a big loss in the P&L
(because buying the asset is simply treated as a cost like any other). In years when
little or no asset purchase took place it would show a profit. This would make it
very difficult to assess whether the business was in fact consistently successful at
generating a profit from its activities.
Even more worrying the asset is still contributing to the generation of profit
after the year in which it is shown as a cost. So we have a matching problem,
in subsequent periods we have the benefit of the asset (the income generated
by the asset) but no corresponding cost of the asset. If there was no concept of
depreciation we would be showing all the cost at the beginning of the life of the
asset even though we have the benefit of the asset for many accounting periods
after this.
So, depreciation was created to spread the cost of assets in the P&L over their
estimated useful lives and that is exactly what it does. In order to calculate the
periodic depreciation charge on an asset the person responsible for preparing the
accounts estimates the assets useful life and residual value at the end of its useful
life. The difference between original cost and residual value is then written off
over the estimated useful life. This can be expressed as a formula:
Periodic depreciation charge =Original cost Estimated residual value
Estimated useful life
So we now know what depreciation (and amortisation) represents. Why does it
appear as an adjustment to net profit in the cash flow statement? This is because it
is a non-cash cost. No one writes a cheque for depreciation.
Restating the Cash Flows of a Real Business 65
Let us consider what happens in cash terms when we buy and use an asset.
There are only two cash transactions involved, buying the asset (known as capital
expenditure or capex) and selling the asset when it has reached the end of its useful
life (known as the proceeds from the sale of fixed assets). The transactions in the
P&L relating to the recognition of depreciation as a cost are not cash flows. So,
the amount relating to depreciation and amortisation must be added back to the net
profit value to arrive at the correct value for the OPERATING CASH MARGIN.
2. Profit or Loss on the Disposal of Fixed Assets
The label on this adjustment does little to explain the true nature of this item. The
profit or loss on the disposal of fixed assets is a non-cash, balancing adjustment
to depreciation that arises on disposal. The label itself is misleading; it should
be called additional depreciation arising on disposal or, alternatively, reduction in
depreciation arising on disposal. What follows is a detailed explanation of how
the profit or loss on disposal of fixed assets arises and what it represents.
When a fixed asset is disposed of, various book entries are required in the nom-
inal ledger of the business to complete the bookkeeping relating to the disposal.
The most convenient way to explain this is to show the entries required. A disposal
account is opened each time an asset is sold or scrapped. The first entry to this
account is the proceeds of sale, (which is the cash or consideration we receive
when we dispose of the asset when we no longer want it). This is debited to the
cashbook and credited to the disposal account. As the fixed asset has now been
disposed of, the next thing we need to do is remove the original cost from the nom-
inal ledger of the business. To do this we credit the original cost account and debit
the disposal account. We also need to remove the accumulated depreciation on the
asset by debiting the accumulated depreciation account and crediting the disposal
account, at which point the process of removing the asset appears complete. This
is what the disposal account might look like at this point.
Disposal Account – example one
Original cost 20 000 Proceeds of sale 2000
Accumulated depreciation 14 000
However, there is a problem. As you can see, there is a difference between the
two sides of the disposal account. We have to deal with this difference in some
way; this is achieved by writing off the difference to the P&L as a profit or loss
on disposal of fixed asset. In the example below a loss on disposal of fixed assets
arises of 4000.
66 Cash Flow Analysis and Forecasting
Disposal Account – example two
Original cost 20 000 Proceeds of sale 2000
Accumulated depreciation 14 000
Loss on disposal of fixed asset 4000
Total 20 000 Total 20 000
In the next example the proceeds of sale have been increased to 8000. As a
consequence of this we now have a profit on disposal of fixed assets of 2000.
Disposal Account – example three
Original cost 20 000 Proceeds of sale 8000
Accumulated depreciation 14 000
Profit on disposal of fixed assets 2000
22 000 22 000
Does this represent a real profit? A little thought should reveal the insight that
profit is made when goods and services are sold for more than it costs to produce
them. Generally we are not in the business of generating profits from selling our
fixed assets, most businesses buy fixed assets such as buildings and plant to assist
them in making profits from selling goods and services. Typically we will have
sold our fixed asset for a small fraction of what we paid for it as it is obsolete and
no longer required. So this is not really profit as such. The key question that finally
reveals the nature of this item is: which of the transactions shown above are cash
transactions?
Disposal Account – example four
Original cost – CASH 20 000 Proceeds of sale – CASH 2000
Accumulated depreciation 14 000
Loss on disposal of fixed asset 4000
20 000 20 000
The proceeds of sale is a recent cash item and the original cost was a cash item
when the asset was originally purchased. The accumulated depreciation is not a
cash item and the loss on disposal is not a cash item either. In the above example,
what has happened is we have purchased the asset for 20 000, charged depreciation
on it of 14 000, and sold it for 2000. In other words we have under-depreciated
Restating the Cash Flows of a Real Business 67
the asset. The loss on disposal of the fixed asset simply represents additional
depreciation that should have been charged over the asset’s estimated useful life.
It means the original estimate of useful life or residual value was optimistic or the
asset has suddenly become surplus due to some other unexpected external change
affecting the business.
I am going to take this opportunity to propose that from now on the loss on
disposal of fixed assets be renamed ‘additional depreciation arising on disposal’
because that’s what it actually is!
Let us consider the second example.
Disposal Account – example five
Original cost 20 000 Proceeds of sale 8000
Accumulated depreciation 14 000
Profit on disposal of fixed assets 2000
22 000 22 000
Here we bought the asset for 20 000 depreciated it 14 000 and sold it for 8000.
This means we have over-depreciated the asset. The profit on disposal isn’t a real
profit, it represents a reversal of the over-depreciation of the asset.
I am going to take this further opportunity to propose that from now on the
profit on disposal of fixed assets be renamed ‘reduction of depreciation arising on
disposal’ because that is what it actually is!
To summarise, the profit or loss on disposal of fixed assets represents a final
positive or negative balancing adjustment to depreciation required on disposal
to make the carrying value on disposal match the proceeds of sale. As such it is
identical in nature to depreciation. It is a non-cash income or expense item charged
to the P&L that needs to be adjusted for when identifying the OPERATING CASH
MARGIN.
3. Movements in Provisions and Other Adjustments Within the Operating
Income and Expenses in the Profit and Loss Account Relating to Non-Cash
Items
The third item which is typically disclosed as an adjustment is any movements in
provisions charged as operating expenses in the P&L and other adjustments for
items which are either non-cash, or belong in another cash flow category such as
financing costs.
Let us now look at the note to the cash flow statement from the Nokia accounts
and see what items are not yet accounted for in our reconciliation of operating
cash margin to net profit (Table 4.4).
68 Cash Flow Analysis and Forecasting
Table 4.4 Nokia consolidated accounts note 32
20XX
32. Notes to cash flow statement M
Adjustments for:
Depreciation and amortisation (Note 9) 1617
(Profit)/loss on sale of property, plant and equipment and 11
available-for-sale investments
Income taxes (Note 11) 1081
Share of results of associated companies (Note 14) 6
Minority Interest 99
Financial income and expenses (Note 10) 2
Impairment charges (Note 7) 149
Retirements (Note 8, 12) 186
Share based compensation (Note 22) 74
Restructuring charges 448
Customer financing impairment charges and reversals
Finnish pension settlement (Note 5) 152
Other income and expenses 124
Adjustments, total 3469
Change in net working capital
Increase in short-term receivables 534
Decrease(+)/Increase() in Inventories 321
Decrease ()/Increase(+) in interest-free short-term 2333
liabilities
Change in net working capital 2546
Compare this with the profit and loss account shown at Table 4.3, we can
immediately match the following four items:
Income taxes 1081
Share of results of associated companies 6
Minority interest 99
Financial income and expenses 2
Depreciation and amortisation is also here as a reversing item as expected. So
we are left with the following outstanding items to consider:
Restating the Cash Flows of a Real Business 69
(Profit)/loss on sale of property, plant and equipment and available-for-sale
investments
11
Impairment charges 149
Retirements 186
Share based compensation 74
Restructuring charges 448
Customer financing impairment charges and reversals 0
Finnish pension settlement 152
Other income and expenses 124
Items from the Table Above Representing Movements in Provisions
Impairment charges 149
Retirements 186
Restructuring charges 448
Customer financing impairment charges and reversals 0
These items both relate to movements in provisions for foreseeable losses, or
the write-off of assets formerly carried at higher values.
Impairment Charges
Impairment charges could be viewed as an emergency depreciation charge.
IAS 36 – Impairment charges – is the relevant international accounting standard.
For a detailed understanding of the accounting GAAP on impairment you should
read the standard itself. What follows is a brief pr´
ecis of the main provisions.
Impairment charges are required whenever an asset or cash-generating unit is
being carried in the accounts at more than its recoverable amount. Its recoverable
amount is the higher of its fair value less costs to sell and its value in use. Value in
use is defined as the present value of the future cash flows expected to be derived
from an asset or cash-generating unit.
To summarise, whenever you expect to get less back in the future (adjusted for
the time cost of money) than the current carrying value, the asset is considered
impaired and IAS 36 requires an impairment charge for the difference to be
recognised in the P&L. The impairment charge is, of course, a non-cash item
as we have not sold or disposed of the asset or cash-generating unit at this point.
Another way of expressing this is that we are recognising in the P&L an unrealised
loss. Unrealised means we have not yet sold it, we have just changed our mind
70 Cash Flow Analysis and Forecasting
about what it’s worth! The same logic applies to the reversal of an impairment
charge in later periods.
Retirements
Retirements is an unusual heading. Reviewing the accounts of Nokia reveals that
most of this relates to the acquisition of Symbian. Symbian is the entity that
licences the operating system used in a number of PDA-style mobile phones
produced by Nokia and others; during the reporting period Nokia increased its
ownership of Symbian from 47.9% to 100%. Nokia wished to establish an open
source framework for the operating system and therefore donated the Symbian
software and S60 platform software to a foundation set up to licence the Symbian
platform. This means that the group has to write off the existing carrying values of
the software which are 55 million for the Symbian identifiable intangible assets
and 110 million for the value of capitalised S60 development costs. So, in this
case, this is similar in nature to an impairment adjustment. As no cash flow is
involved this represents another add-back or adjustment required to arrive at the
operating cash margin.
Restructuring Charges
Restructuring charges typically represents provisions for restructuring activities
within the group, the recognition of such an item as a cost is an application of the
prudence concept which obliges the preparers of accounts to provide for losses as
soon as they are foreseeable. Again there is no cash outflow until the actual costs
of the restructuring are actually incurred in future accounting periods.
Customer Financing Impairment Charges and Reversals
Customer-financing impairment charges and reversals are essentially movements
in bad-debt provisions. Customer financing may be provided as trade credit or as a
more complex (and usually longer term) lending transaction (this is often referred
to as vendor finance). It is normal practice to provide for doubtful debts each year,
which are debts where you believe you may not receive payment. Bad debts are
already written off in the period to sales. Again we come across the concept of an
unrealised and realised loss. The provision for doubtful debts is a provision for
an unrealised loss (or a loss that is not yet certain). Realised losses (losses where
we are certain we will not get the money back) are recognised in the P&L as
expense. So, customer finance impairment charges and reversals are also non-cash
movements in provisions for foreseeable losses. As they do not represent cash
flows we reverse them out when identifying the operating cash margin.
Restating the Cash Flows of a Real Business 71
Other Adjustments Within the Operating Income and Expenses in the
Profit and Loss Account Relating to Non-Cash Items
Three items are now left from Note 32. We will deal with each one in turn.
(Profit)/loss on sale of property, plant and equipment
and available-for-sale investments
11
The (profit)/loss on sale of property, plant and equipment is another way of
labelling the profit or loss on disposal of fixed assets. The nature of this has already
been explained in detail earlier in the chapter. The (profit)/loss on available-for-sale
investments is something new. What is this?
First of all we know this represents some sort of unrealised profit or loss,
otherwise it would not be shown as an adjusting item. An examination of Nokia’s
accounting policies reveals that this is the recognition in the P&L of changes to
the fair value of a pool of investments that Nokia classifies as available-for-sale.
IAS 39 – Financial instruments – recognition and measurement requires that
investments be shown at their fair value each year and the profit or loss be charged
to the P&L. This is, of course, an unrealised profit or loss, as we have not sold the
investments at this point.
This is another example of a misleading label. The use of the terms profit and
loss implies the investments have been disposed of when in fact they haven’t.
Using the term change in the value of, or recognition of the change in value of
available-for-sale investments would be clearer. It would then be more obvious
these items do not represent cash flows.
Share based compensation 74
Share-based compensation arises when employees are granted rights over shares
in Nokia that can be exercised in the future. They are typically share options. No
cash flow arises when they are granted as they represent a right to buy shares at a
specified price at some point in the future.
IFRS 2 – Share-based payment – requires that these rights be valued using
option-pricing models and the resulting cost be recognised in the P&L as pay. As
this is non-cash it needs to be adjusted for in the cash flow statement.
Finnish pension settlement 152
Following a significant re-organisation of the way it recognises and administers
its pension obligations Nokia has changed the way it accounts for certain pension
liabilities so that they are treated as defined benefit pension liabilities in the
accounts.
72 Cash Flow Analysis and Forecasting
IAS19 – employee benefits – requires that any deficit be recognised as a liability.
However this only represents a change in the value of the liability recognised in
the balance sheet and is not a cash flow.
Other income and expenses 124
This label turns up a lot in accounts! This is extremely annoying for any analyst
as it can be used to hide things that should be disclosed. Its use is acceptable where
the amounts disclosed are immaterial to the overall analysis (as they are in the
Nokia accounts). The comments about materiality above are relevant. Again as
Nokia have applied these values as adjustments we will assume they are appropriate
and accept them. The notes to the accounts reveal a variety of items some of which
constitute this item. Once again this represents non-cash items.
We have now explored much of the minutiae involved in correctly identifying
the value of the OPERATING CASH MARGIN when restating cash flows. We
will continue this process in a number of further examples. We have now identified
the first value in the template (Table 4.5).
Table 4.5 Building up the template – completing line one
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS
NET CAPITAL EXPENDITURE
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Identifying the Amount (Invested)/Generated from Net Working Assets
Typically, the second part of the cash flow from operating activities section deals
with the amount invested or generated from changes in the amounts invested in
net working assets.
In the Nokia example the net value has been disclosed as a total in the cash flow
statement and an analysis of that value is shown in a note as follows (M):
Restating the Cash Flows of a Real Business 73
Change in net working capital
Increase in short-term receivables 534
Decrease(+)/Increase() in Inventories 321
Decrease ()/Increase(+) in interest free short term liabilities 2333
Change in net working capital 2546
Identifying the changes in the amounts invested in net working assets in this
example is therefore straightforward. In future examples we will see that identify-
ing which values to include can sometimes be more difficult. It is quite common
to see movements in provisions included as a working asset item (it is, of course,
an adjustment to the operating cash margin).
It is tempting to see if these asset change values can be reconciled to relevant
changes disclosed in the balance sheet. In a simple business this may be possible,
however, for Nokia it is not possible. This is explained in a note directly underneath
the cash flow statement.
The figures in the consolidated cash flow statement cannot be directly traced
from the balance sheet without additional information as a result of acquisitions
and disposals of subsidiaries and net foreign exchange differences arising on
consolidation.
The implications of this will be explained in detail in chapter 16 which deals
with the creation of a notional cash flow statement from profit and loss account
and balance sheet data.
Identifying the Taxation and Net Interest Values
Again, in the case of Nokia this is relatively straightforward, there is one taxation
value disclosed and three values relating to finance costs. Interest received and
interest paid are clear and self-explanatory. What do we do with other financial
income and expenses, net received?
Finance costs include all costs relating to financing the business using debt
instruments, this must include arrangement fees and other income or expenses
relating to instruments used to hedge or modify debt such as interest rate and
currency swaps and other derivatives forming part of the debt financing of the
business. So, it is reasonable to include this item in the NET INTEREST line of
the restated cash flows as it is part of the overall financial cost (or income) of Nokia.
We can now complete those elements of Jury’s Template that relate to the cash
flows from operating activities (Table 4.6).
74 Cash Flow Analysis and Forecasting
Table 4.6 Building up the template – Cash flow from operating activity items
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS 2546
NET CAPITAL EXPENDITURE
TAXATION 1780
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST 66
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Restating the Cash Flows from Investing Activities
The information in Table 4.7 is taken from the published accounts of Nokia (M)
Table 4.7 Summary of net cash from investing activities
Nokia cash flow statement
Cash flow from investing activities
Acquisition of Group companies, net of acquired cash 5962
Purchase of current available-for sale investments, liquid assets 669
Purchase of non-current available-for-sale investments 121
Purchase of shares in associated companies 24
Additions to capitalised development costs 131
Long term loans made to customers
Proceeds from repayment and sale of long-term loans receivable 129
Recovery of impaired long-term loans made to customers
Proceeds from (+)/payment of () other long–term receivables 1
Proceeds from (+)/payment of () short–term loans receivable 15
Capital expenditures 889
Proceeds from disposal of shares in associated companies 3
Proceed from disposal of businesses 41
Proceeds from maturities and sale of current available-for-sale
investments, liquid assets
4664
Proceeds from sale of non-current available-for-sale investments 10
Proceeds from sale of fixed assets 54
Dividends received 6
Net cash from (+)/used in () investing activities 2905
Table 4.7 shows the cash flow from the investing activities part of the full IFRS
cash flow statement.
Restating the Cash Flows of a Real Business 75
Generally, the cash flow from investing activities section of a published cash
flow statement contains values relating to NET CAPITAL EXPENDITURE and
OTHER NON-OPERATING INCOME/(EXPENDITURE) from the template. It
may also contain other values relating to interest, taxation or dividends should it
be the preferences of the persons responsible for the preparation of the cash flow
statement to disclose them here. So, in Table 4.8 we are going to extract the values
relating to the items shown in bold.
Table 4.8 Building up the template – Investing cash flow items
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS 2546
NET CAPITAL EXPENDITURE
TAXATION 1780
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST 66
NET DIVIDENDS – the dividend received part of this value
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Identifying the Net Capital Expenditure
The number of items disclosed in Nokia’s cash flows from investing activities
appears extensive. Reading through them reveals that most of the items relate to
the purchase or sale of investments or businesses owned by Nokia. Which of the
remaining items relate to net capital expenditure?
The two values we expect to see are as follows:
Capital expenditures 889
Proceeds from sales of fixed assets 54
This is the amount spent on new fixed assets and the cash received on disposing
of old, unwanted fixed assets. In this example there is one other value that should
76 Cash Flow Analysis and Forecasting
be included in the net capital expenditure.
Additions to capitalised development costs 131
IAS 38 – Intangible Assets – allows businesses to recognise internally cre-
ated intangible assets in certain circumstances. Essentially, these are cash flows
spent on internal projects that are expected to generate probable future economic
benefits and all the resources are available to complete the project, together with
the intention to use or sell the intangible asset. So, the additions to capitalised
development costs represent investments in intangible fixed assets. They should
be included in capital expenditure as they are intended to contribute to the pool of
assets that generate the businesses operating cash margin. So, the NET CAPITAL
EXPENDITURE is the sum of these three values or 966 million.
Identifying the Other Non-Operating Income/(Expenditure)
In the Nokia example the other non-operating income/(expenditure) is everything
else in this section other than the value of dividends received at the bottom of the
section.
Careful examination of these items will reveal that they relate to four things:
1. Acquisition and disposal if interests in group companies, (by which I think they
mean subsidiaries).
2. Purchase or sale of interests in associated companies.
3. Purchase or sale of investments representing the investment of cash surpluses
in things other than cash equivalents.
4. Vendor-financing activities such as lending or receiving repayment of loans
to customers and the proceeds of securitising future cash flows due from cus-
tomers.
In certain circumstances it might be beneficial to disclose some of this sub-analysis
by modifying Jury’s Template to accommodate the additional data. This idea will
be explored in later chapters dealing with the specific interests of groups such as
lenders and equity analysts. For the moment we are going to report all these values
as one number in the template.
Identifying the Dividend Received
This is the last number in this section. Its meaning is self-explanatory. So we can
now summarise the investing cash flows into the template (Table 4.9).
We have now sufficient information to identify the cash available to satisfy
finance providers. I have inserted the total, which is 2165 million.
Restating the Cash Flows of a Real Business 77
Table 4.9 Building up the template – inserting the investing cash flow items
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS 2546
NET CAPITAL EXPENDITURE 966
TAXATION 1780
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 2165
NET INTEREST 66
NET DIVIDENDS – the dividend received part of this value 6
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1945
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Restating the Cash Flows from Financing Activities
The information below is taken from the published accounts of Nokia.
Nokia cash flow statement
Cash flows from financing activities
Proceeds from stock options exercises 53
Purchase of treasury shares 3121
Proceeds from long-term borrowings 714
Repayment of long-term borrowings 34
Proceeds from (+)/ repayment of () short-term borrowings 2891
Dividends paid 2048
Net cash used in financing activities 1545
This is cash flow from financing activities part of the full IFRS cash flow
statement.
Generally, the cash flow from financing activities section of a published cash
flow statement contains values relating to the last three lines of the template. It
may also contain other values relating to interest, taxation and dividends should
it be the preferences of the persons responsible for the preparation of the cash
78 Cash Flow Analysis and Forecasting
flow statement to disclose them here. So in Table 4.10 we are going to extract the
values relating to the items shown in bold below.
Table 4.10 Building up the template – financing cash flow items
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS 2546
NET CAPITAL EXPENDITURE 966
TAXATION 1780
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 2165
NET INTEREST 66
NET DIVIDENDS – the dividend paid part of this value 6
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1945
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Identifying the Change in Equity
The first three lines of the cash flow from financing activities section relate to
cash equity changes. The proceeds from stock option exercises is cash received
for new equity issued to employees and directors in respect of stock options. The
purchase of treasury shares is the cash expended on buying back Nokia’s own
equity from the stock market. In some countries this is only allowed if the shares
are then cancelled; under Finnish company law it appears to be allowed to retain
these shares in the company for later re-sale. I know this because the treasury
shares appear in the balance sheet as a negative equity item, implying the shares
still exist and can be resold.
Identifying the Change in Debt
The next three line items relate to changes in debt. They are all clearly labelled as
such and simply require summarising into one value.
Identifying the Dividend Paid
This is the last number in this section. Its meaning is self-explanatory. So we can
now summarise the investing cash flows into the template (Table 4.11).
Restating the Cash Flows of a Real Business 79
Table 4.11 Building up the template – financing cash flow items
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS 2546
NET CAPITAL EXPENDITURE 966
TAXATION 1780
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 2165
NET INTEREST 66
NET DIVIDENDS 2042
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1945
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 1756
Financed by:
INCREASE/(DECREASE) IN EQUITY 3068
INCREASE/(DECREASE) IN DEBT 3571
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Identifying the Cash Change Value and Balancing the Template
Our template is almost complete; we now need to input the final values in respect of
the movement in cash and cash equivalents to the template in order to complete it.
Foreign exchange adjustment 49
Net increase (+)/ decrease () in cash and cash equivalents 1302
Cash and cash equivalents at beginning of period 6850
Cash and cash equivalents at end of period 5548
NOTE VALUE CHANGE 6050 BECOMES 6850
To complete the restatement process we need to identify the overall change in
cash and cash equivalents. The value required is shown below.
Foreign exchange adjustment 49
(Increase)/decrease in cash and cash equivalents 1302
(INCREASE)/DECREASE IN CASH 1253
Foreign Exchange Adjustment
The foreign exchange adjustment represents the gain or loss on restating the
opening cash value of cash held locally or overseas in currencies other than the
reporting currency at the rate of exchange used to prepare the accounts at the
period end. This adjustment is required as a consequence of consolidation and is
80 Cash Flow Analysis and Forecasting
necessary or the cash flow statement (and balance sheet) will not reconcile with
the previous year.
An example will make this clearer.
A European group has a foreign subsidiary in the US. The group reports in
euros, to consolidate the US subsidiary all accounting values are translated at
the closing exchange rate at the end of each accounting period. The table below
summarises the effect of this process on the cash change value over two years:
End of period
cash dollars
End of period
exchange
rate $ :
End of period
translated value
31 Dec 20XX 10 000 1 : 0.9 9000
31 Dec 20XY 8000 1 : 1.2 9600
Change (2000) 600
In dollar terms we see a decrease in cash of 2000. After translation this appears
to be an increase in euro currency terms of 600. This means a cash flow statement
prepared in dollar terms will appear to be out of balance, when translated, if the
opening euro cash value is same as the previous period closing cash value in
the cash flow statement. The reason for this is because we take the opening cash
value at its value in euros using last year’s exchange rate (we have to do this to
reconcile from one period cash and cash equivalents value to the next). In order
for the statements to remain in balance on translation we have to restate last year’s
opening cash balance using this years closing exchange rate. When this is done all
the values disclosed in the cash flow statement remain equivalent on translation.
End of period
cash dollars
End of period
exchange
rate $ :
End of period
translated
value
31 Dec 20XX dollar cash 10 000 1 : 0.9 9000
Foreign exchange adjustment 3000
31 Dec 20XX restated at
20XY rate
10 000 1 : 1.2 12 000
31 Dec 20XY dollar cash 8000 1 : 1.2 9600
Change in dollar cash (2000) (2400)
By restating the opening cash value using the closing exchange rate we restore
the correct relationship between the dollar and euro exchange rate cash value.
Now the change in cash in dollars is equivalent to the change in the same values
expressed in euros at the closing exchange rate. To reconcile between the two
Restating the Cash Flows of a Real Business 81
periods closing cash position we need both the foreign exchange adjustment and
the cash change value expressed in the reporting currency.
The foreign exchange adjustment is not a cash flow. It represents the gain
or loss in value of the opening cash held in currencies other than the reporting
currency due to changes in exchange rates during the accounting period. The need
to make this adjustment arises solely as a consequence of consolidation. We have
not repatriated the cash or spent it and there has been no real gain or loss because
the currency has not actually been converted to euros. The cash is still held in
dollars. In that sense the value of the dollars shown at the period end in euro terms
is a notional value on that date, (this is the value of the cash if the dollars were
converted at the closing exchange rate used to consolidate the rest of the accounts).
The day after the accounting period end the notional value of the dollars in euros
will have changed again due to exchange rate changes.
(Increase)/Decrease in Cash and Cash Equivalents
The decrease in cash and cash equivalents value in the cash flow statement of
Nokia is shown as 1302 million. It is arrived as follows:
Nokia 20XX
Summary cash flow statement M
Net cash from operating activities 3197
Net cash used in investing activities 2905
Net cash used in financing activities 1545
Foreign exchange adjustment 49
Net increase (+)/decrease () in cash and cash equivalents 1302
The value is negative because it is the sum of the items above. This cash flow
statement is not laid out as a balancing statement. If we modified the layout to
make the total at the bottom zero (this is a balancing layout where the cash inflows
precisely equal the cash outflows in the cash flow statement), look at what happens
to the signage of the last number.
Nokia 20XX
Summary cash flow statement M
Net cash from operating activities 3197
Net cash used in investing activities 2905
Net cash used in financing activities 1545
Foreign exchange adjustment 49
Net increase ()/decrease (+) in cash and cash equivalents 1302
Total 0
82 Cash Flow Analysis and Forecasting
The change in cash and cash equivalents is still a decrease. However, its sign
changes to positive to represent a decrease in a balancing layout. In this version
the cash flows in precisely equal the cash flows out. This is the form taken in
the cash flow template, and this is why it is necessary to change the sign of
the last number (in the case of Nokia from negative to positive). This issue is
explained in more detail in Chapter 2. When we do this we sum it with the foreign
exchange adjustment and enter it into the template; the template cash flows balance
(Table 4.12).
Table 4.12 Building up the template – the completed balanced template
OPERATING CASH MARGIN 7457
(INVESTED)/GENERATED FROM NET WORKING ASSETS 2546
NET CAPITAL EXPENDITURE 966
TAXATION 1780
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 2165
NET INTEREST 66
NET DIVIDENDS 2042
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1945
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 1756
Financed by:
INCREASE/(DECREASE) IN EQUITY 3068
INCREASE/(DECREASE) IN DEBT 3571
(INCREASE)/DECREASE IN CASH 1253
TOTAL CHANGE IN FINANCING 1756
CONCLUSION
We have successfully summarised the cash flows of Nokia for the accounting
period ending December 31, 20XX into the template and balanced it. We know
what the constituents of each value represent and we have created two new totals
that do not appear in the published cash flow statement. We are now ready to
analyse the resulting data.
5
Restating US GAAP Cash Flows
INTRODUCTION
In the United States all entities subject to the US Securities and Exchange Com-
mission (SEC) control have been required to publish a cash flow statement as part
of their statutory disclosure since 1998.
In Chapter 4 we analysed in detail the cash flow statement of Nokia, a business
that has been reporting using IAS GAAP for some years.
Rather than repeating in detail the general issues involved in restating the oper-
ating, investing and financing cash flows into the recommended template, in this
chapter we will look at the essential points of difference between the IAS GAAP
restatement and a US GAAP restatement. This approach will also be used in the
following chapters when discussing differences between types of GAAP and IAS.
This means if you have started with this chapter because you only wish to
analyse a US GAAP cash flow, you should initially read Chapter 4 covering IAS
GAAP restatement as well.
THE US GAAP CASH FLOW ANALYSIS PROCESS
We have a US GAAP cash flow statement to analyse, how do we go about our
task?
There are two possible ways of preparing and presenting a cash flow statement,
these are known as the direct method and the indirect method. The first task to
ascertain is whether the cash flow is a direct cash flow or an indirect cash flow.
FAS 95 – Statement of cash flows – encourages US companies to use the direct
method. Despite this guidance from the standard setters I have yet to come across a
US GAAP cash flow statement prepared using the direct method. All the US GAAP
cash flow statements I have ever seen were prepared using the indirect method.
A direct cash flow is prepared by taking the cash records of the business, coding
each cash transaction during the period into its relevant cash flow constituent
and then summarising the resulting information into a cash flow statement.
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
84 Cash Flow Analysis and Forecasting
We can identify whether a cash flow statement is direct or indirect by examining
the first few lines of the cash flow statement. In the case of direct cash flow
statements instead of starting with a profit value taken from the profit and loss
account the cash flow typically starts with receipts from customers and payments
to employees and suppliers.
An indirect cash flow is prepared by identifying the various cash flows required
to prepare the cash flow statement from information contained within the profit
and loss account and balance sheet of the business. All the US GAAP cash
flow statements I have ever analysed were indirect cash flow statements.
We can now proceed to understanding in detail the restatement process for a
US GAAP reporting entity. We will deal with this issue section by section using
Black & Decker, the US manufacturer of DIY power tools as an example.
Arithmetic Signage in the Cash Flows
By signage we mean whether a cash flow is positive (an inflow) or negative (an
outflow). Generally the treatment of the signage of values contained within a
cash flow statement is straightforward. Positive values represent cash inflows and
negative values represent cash outflows. All signage should be summarised into
the template as observed.
In the template, brackets are used with certain of the labels to signify the
meaning of the signage of the cash flow, in the examples brackets or a minus sign
may be used to signify negative cash flows.
The only exception to this rule is the last number in the cash flow statement,
which is usually the change in cash, or the change in cash and cash equivalents.
Unless the published cash flow is laid out as a balancing statement the final cash
value shown will require its signage reversing to make the restated cash flow
template balance. The reasons for this are explained in Chapter 3.
Acronyms
From now on we will start to use the following acronyms to describe certain
values. The first time the term is used in the text the acronym will normally follow.
EBIT Earning before interest and tax
EBITDA Earnings before interest, tax, depreciation and amortisation
P&L Profit and loss account
IAS International accounting standard
IFRS International financial reporting standard
M or m Million meaning 1 000 000
Restating US GAAP Cash Flows 85
SOURCES OF CASH FLOW DATA
All filings of businesses listed on US stock markets are available online at
www.sec.gov/edgar.shtml.
Domestic US entities file a Form 10-K. Overseas entities file a Form 20-F. These
forms are the regulatory equivalents of annual reports, they contain the same
information, but in a highly organised regulatory format, with much additional
disclosure required by US regulators. Many larger companies also issue a glossy
annual report and accounts, which is typically available as a pdf file download
from the group’s corporate web site.
The Major Differences Between US GAAP Cash Flows and IAS GAAP
Cash Flows
Firstly, indirect US GAAP cash flows start with the value net income or net
earnings. This is the profit value from the P&L that represents the equity providers’
earnings. It is the value of profit after interest, tax and minority interests. As a
consequence of this we expect to see a significant number of add-backs in the
operating cash flow section of the cash flow statement in order to arrive at the
OPERATING CASH MARGIN.
Secondly, we do not find the values relating to interest-paid or taxation-paid in
the cash flow. As a consequence if we restate all of the numbers in a US GAAP cash
flow into the template we have no entries for interest or taxation in the template
and the resulting OPERATING CASH MARGIN value at the top of the template
is actually the operating cash margin after interest and taxes.
The good news is that the values of interest and tax paid are usually disclosed
elsewhere in the 10-K Form. In the case of Black & Decker the interest payments
are shown in Note 8 to the accounts and the taxation payments are shown in
Note 11. Sometimes these values are disclosed in a note referring to cash flows;
sometimes they are shown as additional information directly underneath the cash
flow statement.
RESTATING THE CASH FLOWS FROM
OPERATING ACTIVITIES
The information in Table 5.1 is taken from the form 10-K of Black & Decker for
a sample year.
This is cash flow from the operating activities part of the full 10-K cash flow
statement.
Generally the cash flow from operating activities section of a published cash
flow statement contains values relating to the first two lines of the template.
Because of the omission of interest and taxation information from the published
86 Cash Flow Analysis and Forecasting
Table 5.1 Consolidated statement of cash flows, the Black & Decker Corporation
and subsidiaries (millions of dollars)
YEAR ENDED DECEMBER 31st
OPERATING ACTIVITIES
Net earnings $518.1
Adjustments to reconcile net earnings to cash flow
from operating activities of continuing operations:
Loss from discontinued operations
Non-cash charges and credits:
Depreciation and amortisation 143.4
Stock-based compensation 25.9
Amortization of actuarial losses and prior service costs 25.7
Tax settlement (153.4)
Restructuring and exit costs 19.0
Other .5
Changes in selected working capital items
(net of effects of businesses acquired or divested):
Trade receivables 99.4
Inventories (32.0)
Trade accounts payable 32.6
Other current liabilities 33.3
Restructuring spending (1.0)
Other assets and liabilities 14.4
CASH FLOW FROM OPERATING ACTIVITIES 725.9
OF CONTINUING OPERATIONS
CASH FLOW FROM OPERATING ACTIVITIES
OF DISCONTINUED OPERATIONS
CASH FLOW FROM OPERATING ACTIVITIES 725.9
cash flow there will be no reference to either value in the cash flow statement
itself.
How then do we analyse the cash flows of a US entity reporting under US
GAAP?
Our strategy is to first complete Jury’s Template without the interest or taxation
values inserted and make it balance, so confirming that we have avoided arithmetic
errors in our extraction and summarising of the cash flow statement. In this form
the template will be incomplete.
The most important thing to remember is that without the interest and tax values
inserted the top line does not represent the operating cash margin, it represents the
operating cash margin after interest and tax payments.
Restating US GAAP Cash Flows 87
Table 5.2 Building up the template – dealing with the first two lines
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments)
(INVESTED)/GENERATED FROM NET WORKING ASSETS
NET CAPITAL EXPENDITURE
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Once we have summarised all three sections into the template and made it
balance we will then add the interest and tax values and adjust the operating cash
margin value accordingly. This is an important step that should not be omitted, the
reason for this is that it changes the CASH AVAILABLE TO SATISFY FINANCE
PROVIDERS to the correct value. Without the interest and tax values inserted this
value is incorrect and the template is incomplete.
IDENTIFYING THE OPERATING CASH MARGIN
(AFTER INTEREST AND TAX PAYMENTS)
The cash flow statement starts with the value net earnings/(loss). Where does
this come from in the profit and loss account (P&L)? The full P&L is shown in
Table 5.3, from this it can be seen that it is identical to the net earnings value in the
P&L, which is the share of profit ‘owned’ by the equity providers. In US GAAP
it is also the value on which the net earnings per common share is calculated.
The second line of the cash flow then explains that the next few items are
‘adjustments to reconcile net earnings to cash flow from operating activities’.
These are the add-backs (or reversals) required in order to identify the operating
cash margin after interest and taxes. Once again we have a misleading label in the
US GAAP cash flow, the item referred to as cash flow from operating activities, is
actually the cash flow from operating activities after interest and taxation.
88 Cash Flow Analysis and Forecasting
Table 5.3 Consolidated statement of earnings, the Black & Decker Corporation and
subsidiaries (dollars in millions except per share data)
YEAR ENDED DECEMBER 31st
SALES $6563.2
Cost of goods sold 4336.2
Selling, general, and administrative expenses 1625.8
Restructuring and exit costs 19.0
OPERATING INCOME 582.2
Interest expense (net of interest income of
$19.8 for 2007, $29.6 for 2006, and $36.5 for 2005) 82.3
Other expense (income) 2.3
EARNINGS FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES 497.6
Income taxes (benefit) (20.5)
NET EARNINGS FROM CONTINUING OPERATIONS 518.1
Loss from discontinued operations (net of income taxes)
NET EARNINGS 518.1
BASIC EARNINGS PER COMMON SHARE
Continuing operations 8.06
Discontinued operations
NET EARNINGS PER COMMON SHARE – BASIC 8.06
DILUTED EARNINGS PER COMMON SHARE
Continuing operations 7.85
Discontinued operations
NET EARNINGS PER COMMON SHARE –
ASSUMING DILUTION 7.85
See Notes to Consolidated Financial Statements.
The adjustments to reconcile net earnings to cash flow from operating assets
from the cash flow statement of Black and Decker are listed below:
Loss from discontinued operations
Non-cash charges and credits:
Depreciation and amortisation
Stock-based compensation
Amortisation of actuarial losses and prior service costs
Tax settlement
Restructuring and exit costs
Other
Restating US GAAP Cash Flows 89
The loss from discontinued operation is split out because cash flows relating to
discontinued operations are disclosed separately in the cash flow statement.
The nature of depreciation and amortisation has been adequately covered in the
previous chapter. However, there are a number of items we have not come across
earlier.
Stock-Based Compensation
Stock-based compensation is the removal of the recognition as a cost of the value
of employee compensation in the form of stock options or similar arrangements.
From June 2005 FASB Statement 123R – Share Based Payment – requires the
recognition of share options or other forms of deferred equity reward to be recog-
nised as a cost at their value when granted. We are adding this back because there
is no cash flow at the time the share option is awarded to the employee.
Amortisation of Actuarial Losses and Prior Service Costs
Amortisation of actuarial losses and prior service costs relates to the writing off
through the P&L of liabilities recognised in respect of pension plans operated by
the company for its employees. Again there is no cash flow associated with this
charge so it is added back.
Tax Settlement
Tax settlement is an unusual item, examination of the notes reveals this is result
of settling litigation between Black & Decker and the US government on this
year’s taxes of reinstating capital losses originally disallowed in previous years.
We remove this in the cash flow because it is essentially a prior-year adjustment.
It saves cash in the current year but relates to matters arising in previous years.
Restructuring and Exit Costs
Restructuring and exit costs is likely to be a provision or accrual and hence non-
cash.
Other
‘Other’ is not helpful as a label for the analyst, but can be forgiven, as the amounts
involved are immaterial.
Whilst it is useful to understand what these add-backs relate to, it is not essential
as the cash flow statement tells us these are all adjustments to reconcile net earnings
to cash flow from operating activities. As long as we are comfortable that the cash
flow has been properly prepared we can normally accept these items at face value.
90 Cash Flow Analysis and Forecasting
Working Capital Items
The second element in the operating activities section is headed ‘Changes in
selected working asset items’. This is where we expect to find the changes in
inventory, debtors and creditors and, indeed, we do!
The only item that appears out of place is ‘restructuring spending’, if this label
is correct I consider it should be treated as an operating cost rather than a working
asset change item. So, in my answer, I have classified this item as part of the
operating cash margin.
We have now explored the major point of difference between this cash flow and
the earlier example involved in correctly identifying the value of the OPERAT-
ING CASH MARGIN and the amount (INVESTED)/GENERATED FROM NET
WORKING ASSETS when restating cash flows. We have now identified the first
two values in Jury’s Template (Table 5.4).
Table 5.4 Building up the template – competing the first two lines
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments) 578.2
(INVESTED)/GENERATED FROM NET WORKING ASSETS 147.7
NET CAPITAL EXPENDITURE
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
RESTATING THE CASH FLOWS FROM
INVESTING ACTIVITIES
The information in Table 5.5 is taken from the Form 10-K of Black & Decker.
Generally the cash flow from investing activities section of a US GAAP cash
flow statement contains values relating to NET CAPITAL EXPENDITURE and
OTHER NON OPERATING INCOME/(EXPENDITURE). So in this example we
are going to extract the values relating to the items shown in bold in Table 5.6.
Restating US GAAP Cash Flows 91
Table 5.5 Consolidated statement of cash flows, the Black & Decker Corporation
and subsidiaries (millions of dollars)
YEAR ENDED DECEMBER 31st
INVESTING ACTIVITIES
Capital expenditures (116.4)
Proceeds from disposal of assets 13.0
Purchase of business, net of cash acquired
Reduction in purchase price of previously acquired
business
Proceeds from sale of business, net of cash transferred
Proceeds from sale of discontinued operations, net of
cash transferred
Cash inflow from hedging activities 2.0
Cash outflow from hedging activities (47.4)
Other investing activities, net (1.0)
CASH FLOW FROM INVESTING ACTIVITIES (149.8)
See Notes to Consolidated Financial Statements.
Table 5.6 Building up the template – Investing cash flow items
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments) 5193
(INVESTED)/GENERATED FROM NET WORKING ASSETS 299
NET CAPITAL EXPENDITURE
TAXATION 1368
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS
NET INTEREST 219
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE)
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
92 Cash Flow Analysis and Forecasting
Identifying the Net Capital Expenditure
There are nine items disclosed in the cash flows from investing activities of Black
& Decker. Reading through them reveals that many of the items relate to the
purchase or sale of investments or businesses owned by Black & Decker. We also
have cash flow relating to hedging activities to consider. Which of the remaining
items relate to net capital expenditure?
The two values we expect to see are as follows:
Capital expenditures 116.4
Proceeds from disposal of assets 13.0
This is the amount spent on new fixed assets and the cash received on disposing
of old, unwanted fixed assets. So, the NET CAPITAL EXPENDITURE is the sum
of these two values or –$103.4 million.
Identifying the Other Non-Operating Income/(Expenditure)
In the Black & Decker example, the other non-operating income/(expenditure) is
everything else in this section other than the two cash flows relating to hedging
activities.
This consists of:
Purchase of business, net of cash acquired
Reduction in purchase price of previously acquired business
Proceeds from the sale of business, net of cash transferred
Proceeds from sales of discontinued operations, net of cash transferred
Other investing activities, net
The first four headings all relate to the purchase or sale of businesses, the last
one is ambiguous and immaterial so we will include it here. There is little point
in spending any significant time on non-material items with unhelpful labels such
as ‘Other’. This is because, irrespective of where you put them in the template,
they will not affect the resulting value significantly, or alter your analysis of the
resulting template summary.
The Cash Flows Relating to Hedging Activities
These cash flows almost certainly relate to financial hedging activities such as
swapping fixed and floating interest rates and possibly different currencies to
reduce risk. Accordingly they represent part of the finance costs of the business
Restating US GAAP Cash Flows 93
and therefore will be shown in the template in the net interest line. So we can now
summarise the investing cash flows into the template (Table 5.7).
We now have all the information we are able to get from the cash flow statement
to identify the cash available to satisfy finance providers. I have inserted the total,
which is $622.5 million.
Table 5.7 Building up the template – inserting the investing cash flow items
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments) 578.2
(INVESTED)/GENERATED FROM NET WORKING ASSETS 147.7
NET CAPITAL EXPENDITURE 103.4
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 622.5
NET INTEREST 45.4
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
RESTATING THE CASH FLOWS FROM FINANCING
ACTIVITIES AND DEALING WITH THE FINAL
CASH BALANCE
The information in Table 5.8 is taken from the form 10-K of Black & Decker
Generally, the cash flow from the financing activities section of a published
cash flow statement contains values relating to the last three lines of the template.
As in this case it may also contain other values relating to dividends. So, in this
example, we are going to extract the values relating to the items shown in bold in
Table 5.9. When this is completed correctly the template should balance.
Identifying the Change in Equity
The change in equity consists of three things. The purchase and issuance of
common stock represents cash changes to the common equity of the business. The
repayment of preferred stock of subsidiary also represents a cash change to the
94 Cash Flow Analysis and Forecasting
Table 5.8 Consolidated statement of cash flows, the Black & Decker Corporation
and subsidiaries (millions of dollars)
YEAR ENDED DECEMBER 31st
FINANCING ACTIVITIES
Net increase (decrease) in short-term borrowings 68.8
Proceeds from issuance of long-term debt (net of debt issue
cost of $2.4 for 2006)
Payments on long-term debt (150.3)
Repayment of preferred stock of subsidiary
Purchase of common stock (461.4)
Issuance of common stock 83.3
Cash dividends (108.6)
CASH FLOW FROM FINANCING ACTIVITIES (568.2)
Effect of exchange rate changes on cash 13.5
INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS
21.4
Cash and cash equivalents at beginning of year 233.3
CASH AND CASH EQUIVALENTS AT END OF YEAR 254.7
See Notes to Consolidated Financial Statements.
Table 5.9 Building up the template – financing cash flow items
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments) 578.2
(INVESTED)/GENERATED FROM NET WORKING ASSETS 147.7
NET CAPITAL EXPENDITURE 103.4
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 622.5
NET INTEREST 45.4
NET DIVIDENDS
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING
Financed by:
INCREASE/(DECREASE) IN EQUITY
INCREASE/(DECREASE) IN DEBT
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Restating US GAAP Cash Flows 95
total equity employed by the group and so must also be included in the equity
change value.
Identifying the Change in Debt
The first three line items in the cash flows from financing activities section relate
to changes in debt. They are all clearly labelled as such and simply require
summarising into one value.
Identifying the Dividend Paid
This is the last number in this section. Its meaning is self-explanatory. So we can
now summarise the investing cash flows into the template (Table 5.10).
Table 5.10 Building up the template – inserting the financing cash flows
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments) 578.2
(INVESTED)/GENERATED FROM NET WORKING ASSETS 147.7
NET CAPITAL EXPENDITURE 103.4
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 622.5
NET INTEREST 45.4
NET DIVIDENDS 108.6
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 467.5
Financed by:
INCREASE/(DECREASE) IN EQUITY 378.1
INCREASE/(DECREASE) IN DEBT 81.5
(INCREASE)/DECREASE IN CASH
TOTAL CHANGE IN FINANCING
Identifying the Cash Change Value and Balancing the Template
Our template is almost complete. We now need to input the final values in respect of
the movement in cash and cash equivalents to the template in order to complete it.
To complete the restatement process we need to identify the overall change in
cash and cash equivalents. The value required is shown in the following.
96 Cash Flow Analysis and Forecasting
Effect of exchange rate changes on cash 13.5
(Increase)/decrease in cash and cash equivalents 21.4
(INCREASE)/DECREASE IN CASH -7.9
Notice that I have once again reversed the signage of the last cash flow value
only. The value still represents an increase as it did in the original cash flow
statement. Its signage is reversed to allow the template to show two balancing
values, which, when summed, equal zero.
The need for the signage reversal is explained in detail in Chapter 2. The reason
for the recognition of the effect of exchange rate changes on cash is explained in
detail in Chapter 4.
We have now completed summarising all the cash flows shown in the cash flow
statement of Black & Decker into the template (Table 5.11). The good news is
that the template balanced as predicted, so reassuring us that we have avoided any
errors relating to incorrect values being inserted in the template.
It is still possible to make errors of classification, for example, by putting values
under the wrong heading. Indeed, you may not necessarily agree with the decisions
I have made about where things go in the template. Whatever you consider to be
appropriate remember that if the value is small it is unlikely to have much impact
on the outcome of your analysis; the most important values to get right are the
large ones!
Table 5.11 Building up the template – the completed balanced template
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN (after interest and tax payments) 578.2
(INVESTED)/GENERATED FROM NET WORKING ASSETS 147.7
NET CAPITAL EXPENDITURE 103.4
TAXATION
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 622.5
NET INTEREST 45.4
NET DIVIDENDS 108.6
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 467.5
Financed by:
INCREASE/(DECREASE) IN EQUITY 378.1
INCREASE/(DECREASE) IN DEBT 81.5
(INCREASE)/DECREASE IN CASH 7.9
TOTAL CHANGE IN FINANCING 467.5
Restating US GAAP Cash Flows 97
Remember also that we have not yet completed the task of summarising the
cash flows of Black & Decker. We still have no values for interest or taxation in the
template. Remember the 45.1 shown earlier in the template related to hedging
activities. It is now time to introduce them.
INTRODUCING THE INTEREST AND TAXATION CASH
FLOWS TO A US GAAP CASH FLOW TEMPLATE
The numbers, which are taken from the notes in the Form 10-K are shown below:
Information from the notes ($millions)
Interest payments – Note 8 104.3
Taxation payments – Note 11 139.5
We can now introduce these values to the template. Having brought them into
the interest and taxation lines we must also add the same value to the OPERATING
CASH MARGIN line in order for the template to be correct. This will also change
the value of the CASH AVAILABLE TO SATISFY FINANCE PROVIDERS total
(Table 5.12).
Table 5.12 Building up the template – the completed template with interest and
taxes included
BLACK & DECKER – Summary cash flow template
OPERATING CASH MARGIN 822.0
(INVESTED)/GENERATED FROM NET WORKING ASSETS 147.7
NET CAPITAL EXPENDITURE 103.4
TAXATION 139.5
CASH AVAILABLE TO SATISFY FINANCE PROVIDERS 726.8
NET INTEREST 149.7
NET DIVIDENDS 108.6
OTHER NON-OPERATING INCOME/(EXPENDITURE) 1
NET CASH GENERATED/(ABSORBED) BEFORE FINANCING 467.5
Financed by:
INCREASE/(DECREASE) IN EQUITY 378.1
INCREASE/(DECREASE) IN DEBT 81.5
(INCREASE)/DECREASE IN CASH 7.9
TOTAL CHANGE IN FINANCING 467.5
98 Cash Flow Analysis and Forecasting
CONCLUSION
We have successfully summarised the cash flows of Black & Decker into Jury’s
Template, we know what the constituents of each value represent and we have
created two new totals that do not appear in the published cash flow statement. We
are now ready to analyse the resulting data to gain insights about the performance
and cash flow behaviour of the business.
Notice that we have taken a complicated looking document (the published cash
flow statement) and simplified it considerably, it is now simpler and clearer, this
will assist us when we interpret the values.
6
Analysing the Cash Flows of
Mature Businesses
In Chapter 3, covering Start-up, Growth, Mature, Decline we introduced the typical
cash flow patterns to be observed in successful businesses in the four phases of the
life of a business. The purpose of this was to develop an understanding of what
the cash flows should look like in the four phases and to introduce some of the
drivers of each line of the cash flow. The word ‘driver’ being used to denote the
fundamental economic and market forces or management decisions that causes
cash flows to change.
In this chapter we are going to go into more detail about what we mean by the
word ‘mature’ when used in this context. We will also look at what constitutes
success from a cash flow point of view when managing a mature company and
finally examine the cash flows of a number of real-world, mature businesses taken
from different countries around the world.
WHAT DO WE MEAN BY ‘MATURE’?
Earlier in the book I made the point that all businesses want to grow and that gen-
erally a mature business is no longer growing the volume of its output significantly
and hence has reduced investment needs compared to a growth business. However,
these insights, whilst useful, are insufficient if we are seeking to understand the
cash flows of mature businesses properly.
THE FIRST PROBLEM: INFLATION
Table 6.1 has been assembled from data sets maintained by the International
Labour Organisation in Geneva. I am indebted to them for this dataset. It shows the
inflation in consumer prices including housing costs over the year 2005–2006. This
period has been chosen because it was the moment when inflation in Zimbabwe
was getting out of control.
The data has been sorted to display lowest to highest inflation. Where a country
has been omitted, it is because the data for 2006 was not present in the sample.
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
100 Cash Flow Analysis and Forecasting
Table 6.1 A snapshot of global country inflation rates
INTERNATIONAL LABOUR ORGANISATION Geneva
LABORSTA Labour Statistics Database Consumer price inflation for one year 2005 to 2006
Copyright International Labour Organisation 1998–2010
COUNTRY INFLATION COUNTRY INFLATION COUNTRY INFLATION
Kiribati
India
Seychelles
Niger
Brunei
Darussalam
Japan
Taiwan, China
Kosovo (Serbia)
Cayman Islands
Switzerland
Singapore
Poland
Netherlands
Sweden
China
Maldives
Austria
Faeroe Islands
Mali
Finland
Germany
France
Tuvalu
Belgium
Algeria
Bahamas
Denmark
Guinea-Bissau
Peru
Gambia
Canada
Guadeloupe
Italy
Bahrain
1.52%
0.40%
0.37%
0.08%
0.20%
0.30%
0.60%
0.61%
0.77%
0.98%
1.00%
1.03%
1.15%
1.36%
1.40%
1.43%
1.50%
1.53%
1.56%
1.60%
1.66%
1.68%
1.73%
1.79%
1.80%
1.83%
1.91%
1.97%
2.00%
2.04%
2.04%
2.04%
2.05%
2.05%
French Guiana
Hong Kong,
China
San Marino
Vanuatu
Senegal
Israel
Korea,
Republic of
Saudi Arabia
Togo
Norway
Niue
Saint Lucia
Papua New
Guinea
Burkina Faso
Albania
Martinique
Cˆ
ote d’Ivoire
Slovenia
Cyprus
Panama
Fiji
R´
eunion
Greenland
Czech
Republic
Dominica
Gibraltar
Burundi
Luxembourg
Malta
French
Polynesia
2.09%
2.09%
2.10%
2.11%
2.16%
2.17%
2.20%
2.21%
2.25%
2.26%
2.31%
2.35%
2.36%
2.36%
2.37%
2.39%
2.43%
2.46%
2.49%
2.51%
2.54%
2.56%
2.56%
2.58%
2.62%
2.64%
2.67%
2.67%
2.72%
2.74%
New Caledonia
Jersey
American
Samoa
Isle of Man
Bermuda
Kuwait
Saint Vincent
and the
Grenadines
Oman
Portugal
Macedonia,
The former
Yugoslav
Rep. of
United
Kingdom
Croatia
Greece
Andorra
United States
Netherlands
Antilles
Ecuador
Morocco
New Zealand
Cook Islands
Chile
Oman
Armenia
Spain
Australia
Malaysia
Mexico
2.88%
2.94%
2.99%
3.01%
3.03%
3.03%
3.05%
3.09%
3.15%
3.19%
3.19%
3.20%
3.20%
3.20%
3.23%
3.25%
3.30%
3.32%
3.34%
3.36%
3.39%
3.44%
3.51%
3.52%
3.55%
3.60%
3.63%
(Continued)
Analysing the Cash Flows of Mature Businesses 101
Table 6.1 (Continued)
INTERNATIONAL LABOUR ORGANISATION Geneva
LABORSTA Labour Statistics Database Consumer price inflation for one year 2005 to 2006
Copyright International Labour Organisation 1998–2010
COUNTRY INFLATIONCOUNTRY INFLATIONCOUNTRY INFLATION
Aruba
Lithuania
Benin
West Bank and
Gaza Strip
Samoa
Hungary
Ireland
Colombia
Gabon
El Salvador
Brazil
Saint Helena
Bolivia
Marshall
Islands
Slovakia
Tunisia
Belize
Estonia
Thailand
South Africa
Cambodia
Northern
Mariana
Islands
Bhutan
Namibia
India
Cuba
Cameroon
3.64%
3.74%
3.75%
3.76%
3.83%
3.90%
3.95%
3.97%
4.03%
4.04%
4.18%
4.25%
4.28%
4.35%
4.44%
4.46%
4.46%
4.48%
4.67%
4.69%
4.77%
4.89%
5.00%
5.04%
5.10%
5.11%
5.14%
Macau, China
Swaziland
Cape Verde
Kyrgyzstan
Honduras
Lesotho
India
Bosnia and
Herzegovina
Mauritania
Philippines
Jordan
Viet Nam
Uruguay
Congo
Guatemala
Romania
Latvia
Central African
Republic
Lebanon
Guyana
Iceland
Bangladesh
Lao People’s
Dem. Rep.
India
Belarus
Tonga
Tanzania
(Tanganyika)
5.15%
5.29%
5.39%
5.55%
5.62%
5.94%
5.99%
6.12%
6.24%
6.24%
6.26%
6.33%
6.41%
6.52%
6.56%
6.56%
6.56%
6.59%
6.62%
6.69%
6.76%
6.77%
6.79%
6.90%
7.00%
7.19%
7.20%
Bulgaria
Barbados
Uganda
Norfolk
Island
Dominican
Republic
Nepal
Egypt
Pakistan
Solomon
Islands
Sierra Leone
Anguilla
Chad
Nigeria
Trinidad and
Tobago
Azerbaijan
Kazakhstan
Jamaica
Rwanda
Mauritius
Zambia
Ukraine
Nicaragua
Georgia
United Arab
Emirates
Sierra Leone
Turkey
7.26%
7.31%
7.38%
7.41%
7.55%
7.61%
7.65%
7.92%
8.02%
8.06%
8.10%
8.21%
8.24%
8.33%
8.33%
8.57%
8.62%
8.84%
8.92%
9.02%
9.08%
9.16%
9.16%
9.29%
9.54%
9.60%
(Continued)
102 Cash Flow Analysis and Forecasting
Table 6.1 (Continued)
INTERNATIONAL LABOUR ORGANISATION Geneva
LABORSTA Labour Statistics Database Consumer price inflation for one year 2005 to 2006
Copyright International Labour Organisation 1998–2010
COUNTRY INFLATION COUNTRY INFLATION COUNTRY INFLATION
Russian
Federation
Syrian Arab
Republic
Paraguay
Madagascar
Ghana
Argentina
Suriname
Costa Rica
Botswana
Guam
Serbia
Qatar
9.67%
10.03%
10.58%
10.73%
10.87%
10.90%
11.27%
11.46%
11.56%
11.58%
11.70%
11.84%
Iran, Islamic
Rep. of
Haiti
Moldova,
Republic of
Indonesia
Mozambique
Angola
Ethiopia
Mozambique
Venezuela,
Bolivarian
Rep. of
Sri Lanka
11.93%
12.33%
12.78%
13.10%
13.25%
13.31%
13.50%
13.58%
13.66%
13.69%
Malawi
Ethiopia
Puerto Rico
Kenya
Myanmar
Yemen
Sao Tome and
Principe
Guinea
Iraq
Zimbabwe
13.90%
13.98%
14.66%
19.56%
20.00%
21.31%
23.07%
34.69%
53.23%
1016.68%
Some countries appear more than once due to data being sourced from different
agencies within the country.
Table 6.1 provides an overview of consumer price inflation from a worldwide
perspective and demonstrates that inflation is still a significant issue in many
countries.
In 2006 the United Kingdom was experiencing retail price inflation at about
3%, India was at about 6%, Indonesia 13% and Zimbabwe 1016%. Zimbabwe
was experiencing runaway inflation. Inflation is still a significant global problem
and there are many commentators who think it may become a much more serious
problem in the next decade. Why is inflation important?
If we make the assumption that our mature company is not going to expand
geographically or invest significantly to increase the volume of its output the first
thing a mature business must do is make sure its sales match the rate of inflation in
nominal turnover terms. This means its turnover will represent the same volume
of output as it enjoyed in the previous year.
Analysing the Cash Flows of Mature Businesses 103
So, if a business faces 6% inflation in its market, it must increase its prices by
6% a year at a constant volume of output (with all other things being equal)
in order to be in the same position at the end of the year as it was in the
beginning.
We use the term ‘nominal’ to denote the values we observe in annual reports.
In most countries the monetary values shown in accounts are after the effects
of inflation, unless they originate from countries that adjust for inflation each
year, a practice known as current purchasing parity (CPP) accounting. We use the
term ‘real’ to denote what is actually happening, to show the performance of the
business before the effects of inflation on the monetary values.
This means that, unless we are in a zero inflation economy (such as Japan), we
expect all mature companies to increase their turnover year on year in nominal
terms, however, this does not necessarily mean they have increased their output!
Indeed, it may have dropped in real terms!
THE SECOND PROBLEM: THE MARKET GROWTH RATE
Mature companies produce most of the products that we see in a modern supermar-
ket. For many of the segments served demand is driven mainly by demography.
The market for food products is large, as everyone in the entire population is
a potential consumer. However, the growth rate of the market is very small. It
grows at less than 1% a year (this due to population change). Within this mar-
ket each individual product faces competition from similar versions produced by
competitors and the supermarkets themselves. Some segments achieve growth
rates greater than the whole market due to changes in consumer preferences. For
example, there has been a trend towards convenience for some years, consumers
preferring to purchase partly prepared or fully prepared meals instead of purchas-
ing raw ingredients and preparing the whole meal themselves. Businesses focused
on this market may have growth rates in double digits as the market abandons
more traditional products in favour of convenience foods.
So, the second thing a mature company must do in order to be in the same
situation as it was in the previous year is to match the market growth rate. This
may be negligible or it may be 15% or more if there is significant change in the
mature segment served by the business.
So, mature businesses must match both inflation and the market growth rate
of the segments they serve, in order to stand still in real terms relative to their
competitors. If the market growth rate is say 2% and inflation 3% this means a 5%
increase in turnover and profits each year is equivalent to standing still. Less than
this and the business is in decline relative to competitors. Another way of looking
104 Cash Flow Analysis and Forecasting
at this is to say the business must maintain its market share in nominal turnover
terms each year.
THE THIRD PROBLEM: DO WE REALLY MEAN
‘MATURE’ COMPANY?
When we talk about a mature company in an analysis context what we actually
mean is a company operating in a mature market. As I have mentioned already all
companies want to grow if they can.
So, why does competing in a mature market result in many companies achieving
low or zero growth?
In most mature markets adoption took place decades or centuries ago. By
adoption we are referring to consumers adopting the use of the product for the
first time. Adoption of foods such as rice as a staple food goes back to the very
origins of agriculture. Tea, coffee, beer and milk have been around for centuries!
This means that the businesses competing in these markets have been around a
very long time. These industries have spent hundreds of years improving the way
things are done and reducing unit costs. They are, in many ways, hyper-efficient
producers. They have had a lot of time to think about it.
How then do businesses grow in these markets? Occasionally, small shifts in
consumer preferences offer opportunities to grow market share. Whilst the product
is usually a commodity there may be opportunities in repackaging or repositioning
the product to better satisfy sub-groups of consumers. M¨
uller have reinvented the
yoghurt concept with a double product where the consumer mixes the two items
just before consumption. This is a good example from the dairy industry. Cans
are a relatively recent innovation in the brewing industry; prior to the use of cans,
beer was only available in draught form or in bottles.
However, growth in mature markets is different to growth in growth mar-
kets. In a growth market all participants can grow in a given year. In a mature
market if one participant grows more than the market growth rate in one year
it follows that its direct competitors have lost market share and hence sales.
The market itself is effectively a zero sum game. Generally, competitors re-
spond aggressively to any innovation that results in lost sales to a competitor,
the usual response is to copy the innovation and reflect it in their own products
and business so negating the advantage over time and returning to some sort of
equilibrium.
Other growth options are to acquire your competitors or to expand the markets in
which you operate. The result of this over time is very large companies! Anheuser-
Busch Inc, InBev, Nestl´
e and Unilever all had their corporate origins over
100 years ago.
Analysing the Cash Flows of Mature Businesses 105
Anheuser-Busch Inc has it roots in 1852 in a Bavarian brewery.
Inbev has its roots in Den Horen in Leuven, Belgium. It began making beer
in 1366.
In 1866, Henry Nestl´
e developed a food for babies who were unable to
breastfeed.
In 1890, William Lever, founder of Lever brothers, wrote down his ideas for
Sunlight soap.
So, when we talk about a mature company we usually mean a business operating
in a mature market. The business itself may be experiencing zero, negative or
positive growth in any given measurement period depending on sector conditions.
It is a consequence of the nature of mature markets that it is very difficult to grow
a successful mature business consistently.
THE FOURTH PROBLEM: WHERE MATURE
BUSINESSES COMPETE
Having defined a mature business as a business operating in a mature market, the
final issue is location. All of the above discussion about the meaning of mature is
relative to where a business chooses to compete.
The business may compete in a single town, or in a county, state or province or
it may be regional or national, or it may be transnational, operating in a number
of countries, or it may be a multinational operating across whole continents.
The point being that the market may be mature in one location, but growth
in another! So the market for after-market replacement exhaust systems in the
UK is mature (a little further explanation may help here for some readers, after-
market means an exhaust or muffler produced by a supplier other than the original
supplied by the car manufacturer). There are dozens of companies in the UK listed
in national directories all competing fiercely to supply wholesalers and retailers.
As a consequence margins for producers are tiny. When I visited Egypt in the
1990s there were two manufacturing businesses operating in this market, one
being dominant. Competition was minimal and huge growth opportunities were
available. Many markets that are mature in developed nations are in the growth
phase in emerging market countries.
So, it is the market conditions in the location where the business chooses to
operate that define whether we should treat the business as mature or not for the
purpose of analysing its cash flows.
106 Cash Flow Analysis and Forecasting
IN CASH FLOW TERMS, WHAT CONSTITUTES SUCCESS
FOR MATURE COMPANIES?
The analysis of the cash flows of a mature business can be summed up in one
sentence.
In the long run, mature businesses must generate sufficient Cash Available
to Satisfy Finance Providers to cover interest, dividends and scheduled debt
repayment.
In order to develop our understanding of the sentence let us start by looking at an
example of a really successful mature business. Here is the Jury’s Template version
of the cash flows of Coca-Cola taken from a recent Form 10-K and summarised into
the recommended format. This is one of the most successful mature businesses in
the world. The cash flow available to satisfy finance providers has averaged $5397
million over the three years shown in Table 6.2!
Table 6.2 An example of the cash flows of a successful mature company
COCA COLA 20XX 20XW 20XV
Summary Cash Flows $millions $millions $millions
Cash from operations 8909 8182 7667
Change in NWA 6 615 430
Net Capex 1409 1295 811
Cash taxes 1596 1601 1676
CASH FLOW AVAILABLE TO 5910 4671 5610
SATISFY CAPITAL PROVIDERS
Net interest 169 92
Net dividends 3149 2911 2678
Other 5310 405 685
NET CASH INFLOW/(OUTFLOW) 2718 1346 2249
Inc/(Dec) in equity 219 2268 1825
Inc/(Dec) in debt 4341 1404 2282
(Inc)/Dec in cash 1404 2326 1858
FINANCING CASH FLOW 2718 1346 2249
Note – Interest received value taken from P&L
Really successful mature businesses may generate substantial surpluses of cash
after their interest, dividend and debt repayment needs. Businesses that are capable
Analysing the Cash Flows of Mature Businesses 107
of this usually have significant competitive advantages not generally available to
their competitors or new entrants.
THE CONSEQUENCES OF FAILURE TO GENERATE
SUFFICIENT CASH FLOW
However, to understand the sentence better let us consider what happens to mature
companies when they fail to achieve the equilibrium state summarised above. To
do this we will use a fictional example.
Let us assume we are analysing a medium sized manufacturing group whose
products are widely used by a variety of other industries. The business is listed on
a stock exchange and has recently seen a fall in performance. Demand for the core
products is falling due to changes in technology and fashion. A failure to innovate
at the same speed as competitors has reduced financial performance. At the end
of the year the cash available to satisfy finance providers is insufficient to cover
interest and dividends. What actions do the senior managers typically take at this
point in time?
Observation of a number of early distress business scenarios has revealed the
usual response of managers at this point is to borrow. Whether the business can
borrow is largely determined by the existing leverage. If the business has low or
negligible net debt it is normally easy to borrow substantial sums without problems.
The business is well established with mature products selling to thousands of
customers in markets with good geographic spread, the balance sheet is strong at
this point with substantial fixed assets to provide asset backing for the lenders.
Even if the business has typical levels of leverage it is still likely to be feasible to
borrow more money.
Managers rarely take more vigorous action at this point; they still believe that
the factors causing underperformance are either outside their control or temporary
in nature.
Let us assume that despite the signals from the business of continuing under-
performance the managers again fail to take sufficiently robust action. Another
six months of underperformance ensues. What actions would the senior managers
now take at this point? Observation of real businesses in this condition reveals the
usual response is to borrow even more money!
In one sense they have no choice; the business requires cash to operate and this
has to come from somewhere, if the operating cash margin is falling, the only
other quick source of cash is by borrowing. Banks will be more wary at this point,
only providing further funds against better security, documentation and at a higher
interest rate (due to the existing leverage and increasing credit risk). The business
may now be reaching the limits of the leverage available to it.
108 Cash Flow Analysis and Forecasting
Eventually, perhaps in the following six months, there will come the point
at which more radical actions will have to be taken. In markets more wedded to
aggressive styles of capitalism this will involve early management change, with the
chairman, chief executive and possibly the finance director all being vulnerable
to replacement. Job losses (redundancies), cost reduction and restructuring all
commence. The disposal of non-core businesses, or secondary elements of the
core business may be considered.
It may also be necessary at this point to reduce or eliminate the dividend
temporarily. Mature businesses are always reluctant to mess with the dividend
because any negative announcement regarding dividends will have a negative
impact on the share price. By maintaining the dividend in the early stages of what
has now developed into a crisis the managers are signalling that the problems
are considered to be temporary. Managers will do this even if they are paying
an uncovered dividend. (An uncovered dividend is a dividend not paid for out of
the current period’s profits. This means the business may have to borrow, or use
cash generated in previous years, to pay the dividend.) Disturbing announcements
regarding dividends occur late in the succession of adverse events. The same logic
applies to raising further equity capital; announcements of the intention to raise
new equity will normally adversely affect the stock price. Moreover, the additional
equity means the business has to generate even more returns to provide the same
reward per share as it achieved before the cash flow problems arose.
So what eventually emerges from this process is a smaller, more focused, ma-
ture business whose Cash Available to Satisfy Finance Providers is greater than
or equal to its need to pay interest, dividends and any scheduled debt repayment.
It is rare for listed groups of mature businesses to fail completely; they usu-
ally go through this restructuring and divestment process until they recover their
ability to perform. Takeover by a larger competitor is also a possibility at this
point.
So, to summarise, in the long run mature businesses must generate sufficient
Cash Available to Satisfy Finance Providers to cover interest, dividends and sched-
uled debt repayment. In the short run (by which I mean six months to three years)
they may fail to do so, surviving on historic surpluses and leverage. However, time
is running out in this scenario and at some point action has to be taken to rectify
the underperformance. If managers fail to act, external forces on the business will
typically force the issue.
Invensys
Invensys is a good example of the above. Between 1960 and 1998 this business,
formerly known as Siebe, had developed, through acquisition and organic growth,
Analysing the Cash Flows of Mature Businesses 109
from a small UK-based safety business to being a multinational engineering group
with sales of £3900 million focused on control systems. In 1999, one year after
new CEO Allan Yurko was appointed, the group acquired a number of companies
including BTR, a large UK-based industrial and engineering conglomerate, and
changed its name to Invensys. As a consequence, the groups leverage increased
significantly. 1999 marked the start of a significant global recession that hit the
group hard. Despite this they continued acquiring companies, particularly in in-
dustrial software and services. One of these was the Dutch software company
Baan (purchased for $700m in June 2000).
In October 2001 the leadership changed again. A new CEO, Rick Haythorn-
thwaite, was appointed. By this time Invensys had reduced its workforce by
23 000, the share price had dropped from 195p to 27p, and the group had over
£3500 million of debt. The debt was so large that disposing of significant parts of
the group was the only option. Over the next five years the group made a number
of significant disposals one of which was the sale in June 2003 of Baan to SSA
Global technologies for $135m – a loss of $565m.
The cash flows of Invensys for the 10 years to 2008 summarised into the template
are shown in Table 6.3.
The cash flow generally exhibits the behaviour outlined in the earlier fictional
example used to illustrate our summarising sentence (in the long run, mature
businesses must generate sufficient Cash Available to Satisfy Finance Providers
to cover interest, dividends and scheduled debt repayment). The operating cash
margin was in decline from 1999. By 2001 the group is unable to service in-
terest and dividends from current-period cash generation and debt increases by
£605 million in this year. In 2002 the company is unable to increase debt further
because it is not available on reasonable terms.
It achieves debt service by cutting Capex (depreciation in this year being
£260 million), by recovering money invested in net working assets and busi-
ness disposal. In 2003 the group starts selling significant parts of the group raising
£1473 million from disposals, which is used to service and reduce outstanding
debt. This process continues for the next five years. The group is cash negative from
2001 until 2007 when once again the cash available to satisfy finance providers is
sufficient to cover interest and dividends. In 2007 and 2008 business disposal and
debt reduction is still continuing.
Notice that, despite problems being evident from 2001, the dividend is not
eliminated until 2004, when the company also raises new equity because it has no
other acceptable options.
What we end up with is a smaller, mature engineering group, which is generating
sufficient cash available to satisfy finance providers to cover interest, dividends
and scheduled debt repayment.
Let us now look at a number of examples of other mature businesses.
Table 6.3 An example of the cash flows of an underperforming mature business
INVENSYS PLC
SUMMARY CASH FLOW £ millions 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999
OPERATING CASH MARGIN 205 274 102 80 5 315 446 883 1239 1370
INV/(GEN)FROM NET WORKING ASSETS 45 27 10 30 212 105 90 560 171 135
NET CAPITAL EXPENDITURE 57 71 66 74 122 103 98 236 458 580
TAXATION 37 23 25 76 73 62 43 135 60 292
CASH FLOW AVAILABLE TO 66 207 21 40 402 45 395 48 550 363
SATISFY FINANCE PROVIDERS
NET INTEREST 57 112 110 113 119 113 167 210 174 208
NET DIVIDENDS 1300273 220 276 331 451
OTHER NON-OPERATING INC/(EXP) 264 162 179 347 493 1473 178 298 903 3050
NET CASH IN/(OUT) BEFORE FINANCING 272 254 90 194 30 1332 186 832 948 2754
Financed by:
CHANGE IN EQUITY INCREASE/(DECREASE) 13 323 0 0 448 0 0 4 990 1596
CHANGE IN DEBT INCREASE/(DECREASE) 363 697 305 111 165 1417 0 605 117 1639
CHANGE IN CASH (INCREASE)/DECREASE 104 120 215 83 253 85 186 223 159 481
TOTAL CHANGE IN FINANCING 272 254 90 194 30 1332 186 832 948 2754
Analysing the Cash Flows of Mature Businesses 111
Black & Decker
The Black & Decker Corporation, is a leading global manufacturer and marketer
of power tools and accessories, hardware and home improvement products, and
technology-based fastening systems. With products and services marketed in over
100 countries, the corporation enjoys worldwide recognition of its strong brand
names and a superior reputation for quality, design, innovation, and value. The
corporation is one of the world’s leading producers of power tools, power tool
accessories, and residential security hardware, and the corporation’s product lines
hold leading market share positions in these industries. The corporation is also a
major global supplier of engineered fastening and assembly systems.
The above paragraph is extracted from the most recent Form 10-K filing for
Black & Decker. The markets in which it operates are mature and fiercely com-
petitive. There are numerous other manufacturers of similar products to those
produced by Black & Decker.
I am now going to illustrate a cash flow centric analysis exercise. That is to say
I start with cash flow data and pull in other data as I require it.
Table 6.4 shows a sample six years’ cash flows of Black & Decker summarised
in Jury’s Template form. What do they tell us?
In each of the six years, the cash flow to satisfy finance providers has exceeded
the value spent on net interest and net dividends by a factor of two or three.
In five of the six years the business has achieved a cash surplus at the net cash
inflow/(outflow) line. In 20X4 the only time the business failed to generate a
surplus at the net cash inflow/(outflow) line the group made a major acquisition
(Other non-operating income/(expenditure) line 727.10). This was financed in
that year by the residual cash flow generated in that year plus an increase in equity
and debt.
The business has repaid debt in four of the six years illustrated. In the two years
where debt increased 20X4 was the year of the acquisition mentioned above. In
the other year (20X5) the business added leverage by increasing debt and using
this to reduce equity, so improving the return to shareholders.
Already it should be clear this is a good set of cash flows. From the template I can
deduce much of what has been changing in the business. Whilst it is always useful
to read the financial report in full I can use the template to monitor performance
very effectively without looking at any other data. Indeed, with experience, once
the cash flows have been summarised in this way, they can be assessed in seconds.
This time saving for the analyst can be invaluable. It is one of the most powerful
aspects of this style of analysis.
Let us review the business year on year. All the insights below come directly
from Jury’s Template alone. If we wish to be more specific about the cause of any
particular movement or change in the cash flow values we can, of course, look at
all the other information disclosed in the Form 10-K filed by Black & Decker:
Table 6.4 Six years cash flows for Black and Decker
20X7 20X6 20X5 20X4 20X3 20X2
BLACK AND DECKER $m$m$m$m$m$m
Cash from operations 822.00 1018.00 981.20 728.10 574.70 513.10
Change in Net Working Assets 147.70 75.60 107.00 57.70 158.20 86.30
Net Capex 103.40 89.90 98.40 91.80 87.50 89.70
Cash taxes 139.50 221.70 165.80 89.50 82.00 47.00
CASH FLOW AVAILABLE TO 726.80 630.80 610.00 604.50 563.40 462.70
SATISFY CAPITAL PROVIDERS
Net interest 149.70 111.40 91.80 77.90 80.30 100.80
Net dividends 108.60 109.10 88.60 67.50 44.30 38.60
Other 1.00 137.70 61.30 727.10 280.60 0.90
NET CASH INFLOW/(OUTFLOW) 467.50 272.60 490.90 268.00 158.20 322.40
Inc/(Dec) in equity 378.10 847.80 591.80 168.00 65.90 22.30
Inc/(Dec) in debt 81.50 168.00 565.10 291.40 315.50 41.10
(Inc)/Dec in cash 7.90 743.20 464.20 191.40 223.20 259.00
FINANCING CASH FLOW 467.50 272.60 490.90 268.00 158.20 322.40
Analysing the Cash Flows of Mature Businesses 113
In 20X2 the major issues were:
A healthy operating cash margin.
A reduction in the amount invested in net working assets. This implies a reduc-
tion in debtors and/or inventory and/or an increase in the operating creditors.
The resulting cash surplus being used to reduce debt and equity and increase
closing cash by $259 million.
In 20X3 the major issues were:
A healthy operating cash margin.
A further reduction in the amount invested in net working assets.
There was net acquisition activity costing $280 million.
The business generated a cash surplus that was used to reduce debt and equity.
Closing cash was reduced by $223 million.
In 20X4 the major issues were:
An impressive increase in operating cash margin.
A further reduction in the amount invested in net working assets.
A major net acquisition costing $727 million. This being financed from the
year’s cash flow surplus and a modest increase in debt and equity.
Closing cash increased by $191 million.
In 20X5 the major issues were:
A further increase in operating cash margin.
An increase in the amount invested in net working assets.
Some modest business level disposals.
A healthy cash surplus on the year.
A reduction in equity financed largely by an increase in debt.
Closing cash increased by $464 million.
In 20X6 the major issues were:
A modest increase in operating cash margin.
A modest increase in the amount invested in net working assets.
Some acquisition activity.
A major reduction in equity financed by the surplus on cash for the year.
An increase in debt.
A major reduction in the cash surplus built up over previous years of
$743 million.
In 20X7 the major issues were:
A reduction in the operating cash margin of about 20%.
This was partially offset by a reduction in the amount invested in net working
assets.
114 Cash Flow Analysis and Forecasting
The business was still generating a healthy net cash surplus.
The cash surplus was used to reduce equity and debt.
The big question that now arises is: is the reduction in the operating cash margin
a serious problem?
Notice how the template tells us a story about the business in each of the years
in question. We can deduce many of the major initiatives taken by the business
without actually reading anything else in the accounts!
From the six years’ cash flow summarised into the template we can observe the
following:
Emphasis on operating cash margin improvement.
Good working asset control.
Significant acquisition activity in two of the years.
A decision taken in 2005 to reduce equity and increase the leverage used by the
group to improve equity performance.
Notice also I have not commented significantly about capital expenditure, taxes,
interest or dividends. This is because none of these numbers stand out as particu-
larly exceptional or unusual in this example.
What is particularly impressive about Black & Decker is the consistency of their
performance. They operate in highly competitive markets. They have reduced their
exposure to cyclical effects by operating on a global basis where possible. They
acquire other companies in complimentary areas of their business where they see
opportunities for further growth or value generation.
There are other things we can do to further assess performance. At this point,
whilst our tentative conclusion is that all is well, we are not certain that the
operating cash margin performance is as good as it looks because the business
may have been recovering from a very poor performance at the beginning of the
sample period. Maybe the operating cash margin should be higher. What can we
do to examine this?
Table 6.5 shows the sales, operating cash margin and other non-operating cash
income and expenditure line from the cash flow, together with some percentage
change data.
Firstly, we can see that when the sales grew substantially there was significant
acquisition activity in the previous year. It is probable that much of the sales
increase can be attributed to the acquisitions.
Reviewing the Form 10-K confirms this. In the last three years sales have been
flat, this being classic behaviour for a mature business operating in a mature
market.
Secondly, the operating cash flow margin as a percentage of sales is remarkably
consistent at 13%. In 20X5 and 20X6 it exceeded this level, possibly due to the
benefits of the previous acquisition activity and/or beneficial sector conditions or
Analysing the Cash Flows of Mature Businesses 115
Table 6.5 Six years sales data for Black and Decker
20X7 20X6 20X5 20X4 20X3 20X2
BLACK & DECKER $m$m$m$m$m$m
Sales 6563.2 6447.3 6523.7 5398.4 4482.7 4291.8
Sales increase/
(decrease) year %
1.80% 1.17% 20.85% 20.43% 4.45%
Cash from operations 822.00 1018.00 981.20 728.10 574.70 513.10
Cash operations/
Sales %
12.5% 15.8% 15.0% 13.4% 12.8% 12.0%
Other non-operating
inc/(exp)
1.00 137.70 61.30 727.10 280.60 0.90
currency movements. This sample of performance suggests that Black & Decker
is capable of sustaining this margin in normal economic and sector conditions. It
also means that the fall observed in the most recent years’ performance may not
be due to management failure.
By comparing the operating cash flow margin data with sales we are able to
satisfy ourselves that the operating cash values are not distorted by a previous
period of underperformance. We can, of course, compare this data with other
similar companies within the hand tool sector and elsewhere. This would give us
further evidence for over or underperformance.
There is one other exercise we can perform at this point to satisfy ourselves
that all is well with Black & Decker. Another reason they may be generating
such healthy net cash surpluses from their business is they may be underinvesting,
running down their capital assets and harvesting the resulting cash flow. This
approach can lead to disaster when our ageing capital assets are no longer efficient
or in extreme cases fail completely. What can we do to examine this issue?
Table 6.6 shows the depreciation and amortisation values from the Form 10-K.
For the most recent three years we have the depreciation value only. The net Capex
is from the cash flow.
Before we can interpret this data there are a number of issues that must be consid-
ered. The depreciation and amortisation value includes an element of amortisation
of intangible assets. Examination of Form 10-K reveals that this amortisation is
in relation to customer relationships, technology and patents and trademarks and
trade names. The depreciation value alone is quoted in Form 10-K for 20X7 as
relating solely to tangible assets. For this reason I have calculated the ratio for the
last three years only.
When Black & Decker acquires a business the cash expended in acquir-
ing the business is in the cash flow template on the other non-operating
116 Cash Flow Analysis and Forecasting
Table 6.6 Six years depreciation and capex data for Black and Decker
20X7 20X6 20X5 20X4 20X3 20X2
BLACK & DECKER $m$m$m$m$m$m
Depreciation &
amortisation
143.4 154.9 150.6 142.5 133.4 122.4
Depreciation 132.65 146.2 146
Capital expenditures 116.4 104.6 111.1 117.80 102.50 94.30
Proceeds from disposal
of assets
13 14.7 12.7 26.00 15.00 4.60
Net Capex 103.40 89.90 98.40 91.80 87.50 89.70
New Capex/
Depreciation %
88% 72% 76%
income/(expenditure) line. What Black & Decker recognises in its balance sheet in
exchange for this is the net assets of the business together with excess paid which
is treated as goodwill. This means that when acquisitions are made, fixed assets
arrive in the balance sheet which have not appeared as Capex in the cash flow.
What net Capex represents in the cash flow is the net value spent by the group on
fixed assets other than those acquired in the same period as part of a business. The
same logic applies in reverse when the group makes material disposal of entire
businesses by sale of their equity. This means the ratio above will not be mean-
ingful in any year where there is material acquisition (or disposal) of businesses
from the group.
However, the cash flow template shows us there was no material acquisition or
disposal activity in 20X7. In this year Black & Decker invested in new Capex at a
rate 88% of its depreciation charge. This appears to be low.
Given that the apparent trend over the six years looks similar there may be
reasons why this particular sector has unusually low investment needs going
forward, compared to its historic investment rate. It could be that the cost of new
machinery is lower for the same output than was the case historically (meaning
that there could be price deflation in the machinery used by the sector). It could
be there has been little technological change in the last few years compared to
earlier periods thus requiring much less investment. It could be that, as a mature
group with numerous manufacturing units all over the world, investment needs
are limited to maintenance asset replacement of computer, machines and transport
only. It could be that the group over depreciates its assets by writing them off
before their useful life is in fact over. It is not clear whether this pattern of
apparent underinvestment is sustainable or not.
Analysing the Cash Flows of Mature Businesses 117
Finally, there is a reasonable contribution to cash flow from proceeds of disposal
of fixed assets. It could be that the group has been steadily concentrating production
in fewer and fewer low cost centres thus slowly realising its older, less efficient
manufacturing facilities back to cash.
Comparing the charge for depreciation with the level of Capex can give us
insights about the level of investment taking place in a business. It can be a useful
addition to the examination of the cash flows in the template form. Bear in mind
that it is not a particularly exact relationship; it is affected by inflation, acquisitions
and disposals, technology change, and demand supply change in the markets for
capital assets themselves. Generally we expect the Capex of a mature business
to be similar to fixed asset depreciation (when the depreciation is calculated in
accordance with IAS standards by writing off the asset over its estimated useful life
to an estimate of its residual value) because the business has no growth investment
needs. It is merely maintaining its output, replacing machinery and other assets,
as required.
Black & Decker is a good example of a successful mature business operating in
mature markets. Let us now consider the cash flows of another mature business.
Dairy Crest
The main activity of Dairy Crest Group plc is the manufacture and trading of
milk and dairy products. The Group’s strategy continues to be focused on grow-
ing its branded business together with the value added elements of its key re-
tailer relationships. The group is one the leading national milk processing groups
in the UK.
Table 6.7 is a sample of the cash flows of Dairy Crest, summarised in Jury’s
Template form.
The operating cash margin peaked in 20X4 and has been falling since then. In
four of the six years the cash flow to satisfy finance providers has exceeded the
value spent on net interest and net dividends. In two of the six years the business
has achieved a cash surplus at the net cash inflow/(outflow) line. The group made
major acquisitions in 20X3, 20X6 and 20X7. A brief examination of the template
data suggests this is a less attractive business from a cash flow point of view than
Black & Decker.
Let us review the business year on year.
In 20X2 the major issues were:
A reasonable operating cash margin.
What looks like a big increase in the amount invested in net working assets,
(which implies an increase in debtors and/or inventory and/or a decrease in the
operating creditors).
118 Cash Flow Analysis and Forecasting
Table 6.7 A further sample of the cash flows of a mature business
DAIRY CREST PLC
TEMPLATE SUMMARY CASH FLOWS
20X7 20X6 20X5 20X4 20X3 20X2
£m £m £m £m £m £m
Operating cash margin 97.0 89.7 122.4 126.4 111.0 100.6
Change in NWA 2.8 16.3 20.6 10.2 6.1 52.1
Net Capex 26.6 34.6 29.5 29.7 27.0 52.3
Cash taxes 6.1 15.5 12.6 8.7 4.1 5.3
CASH FLOW AVAILABLE TO 61.5 23.3 100.9 98.2 73.8 9.1
SATISFY CAPITAL PROVIDERS
Net interest 15.3 16.4 17.7 20.6 22.0 18.7
Net dividends 18.8 16.6 23.9 19.9 17.4 15.9
Other 235.0 43.7 9.7 6.6 93.4 1.1
NET CASH INFLOW/(OUTFLOW) 207.6 53.4 49.6 64.3 59.0 42.6
Inc/(Dec) in equity 39.7 0.7 3.6 0.2 1.0 4.4
Inc/(Dec) in debt 178.4 39.9 42.6 57.7 65.2 35.9
(Inc)/Dec in cash 10.5 12.8 10.6 6.8 7.2 2.3
FINANCING CASH FLOW 207.6 53.4 49.6 64.3 59.0 42.6
This, together with extremely high net Capex, resulted in a negative cash flow
to satisfy finance providers and indicates a negative net cash flow performance.
The year results in a cash deficit of £42.6 million, which is financed largely by
an increase in debt.
In 20X3 the major issues were:
The operating cash margin increases by 11%.
There is a further small increase in the amount invested in net working assets.
Net Capex is much reduced at £27 million.
The cash flow available to satisfy finance providers is now positive and sufficient
to cover interest and dividend service.
The business spent £93.4 million on acquisitions.
This resulted in a net cash outflow for the year £59 million, which was again
financed largely by an increase in debt.
In 20X4 the major issues were:
The operating cash margin increases by 13%.
The amount invested in net working assets reduces by £10.2 million.
The cash flow available to satisfy finance providers is improved and is sufficient
to cover interest and dividend service by a factor of more than two.
Analysing the Cash Flows of Mature Businesses 119
The resulting net cash inflow of £64.3 million is used mainly to reduce debt.
This is the peak year for cash flow performance.
In 20X5 the major issues were:
The operating cash margin is starting to decline compared to the previous year.
There is a reduction in the amount invested in net working assets of £20.6
million.
The cash flow available to satisfy finance providers is further improved and
sufficient to cover interest and dividend service by a factor of over two.
The resulting cash surplus of £49.6 million is used to reduce debt and increase
cash.
In 20X6 the major issues were:
Operating cash margin continuing to decline (with a drop of 25%).
An increase in the amount invested in net working assets of £16.3 million.
The cash flow available to satisfy finance providers is dramatically reduced and
is insufficient to cover interest and dividend service.
There is a deficit before acquisition activity of £9.7 million.
After acquisitions of £43.7 million the resulting net cash outflow of £53.4 million
is financed by an increase in debt and utilising cash reserves from previous years.
In 20X7 the major issues were:
A increase in the operating cash margin of about 8%, but still well below the
peak of 20X4.
There is a small increase in the amount invested in net working assets.
The cash flow available to satisfy finance providers is adequate to cover interest
and dividend service leaving a modest surplus before acquisition activity.
There is major acquisition activity of £235 million.
The deficit for the year of £207.6 million being financed by some equity, a large
increase in debt and some of the existing cash surplus.
Notice how the template tells us a story about the business in each of the years
in question. We can deduce many of the major initiatives taken by the business
without actually reading anything else in the accounts!
From the six years’ cash flow summarised into the template we can observe the
following:
A variable operating cash margin which appears to be in decline.
Significant variation in working asset investment with increases in the years
when cash available to satisfy is inadequate to cover interest and dividends.
Significant acquisition activity in three of the years.
Significant reliance on debt.
120 Cash Flow Analysis and Forecasting
Notice also I have not said much about taxes, interest or dividends. This is
because none of these numbers stand out as particularly exceptional or unusual in
this example.
The cash flows of Dairy Crest are not as good as those of Black & Decker. They
show a lot more variability, a significant reliance on debt for financing as required
and mediocre operating cash margin performance.
Some of this is likely to be attributable to the nature of the market in which Dairy
Crest operates (analysts generally refer to this as sector risk). The basic business
of milk processing is brutally competitive and distribution to consumers is via the
major supermarket groups who often regard milk merely as a major traffic builder
for their stores (and therefore seek to offer it a cheaply as possible). There is huge
low cost emphasis throughout the value chain. The sector itself has gone through
a series of step changes in the last decade as the delivery model moved from home
delivery in glass bottles to supermarket purchase in plastic containers. There has
been massive consolidation in the processing and distribution of milk.
The farmer has also been affected. The minimum economic size of a primary
milk producer has increased to the point where super farms are now being created
to capture the necessary economies of scale required to keep milk production a
viable business.
Dairy Crest is aware of these fundamentals. It is seeking to move into areas
where it can generate more value added and hence cash flow for itself from the
products it produces. As the managing director points out in a recent report the
group’s strategy continues to be focused on growing its branded business together
with the value added elements of its key retailer relationships.
What this means is moving towards branded products where better retail margins
are available for producers and only working with supermarkets whenever there is
an adequate return. The group is expanding in cheese and spreads, products with
more potential to add value for the producer.
Notice that, whilst I am still stressing a cash-centric approach, some sector
knowledge is invaluable for putting the numbers onto context whenever the ana-
lysts seeks to understand business performance through cash flows. As in the last
example it would seem sensible to examine the operating cash margin relationship
to sales (Table 6.8).
Given that we have inflation at about 2% the first five years sales performance
is average at best. The business is losing turnover in real terms. Let us look at this
in more detail. Table 6.9 uses the data from Table 6.8 with an inflation adjustment
added.
Before continuing let me note that there are many potential pitfalls for the
analyst in adjusting data for inflation. Some of the problems are:
Selecting an index which has a meaningful relationship with the dataset to be
adjusted (to do this well can take a significant amount of time).
Analysing the Cash Flows of Mature Businesses 121
Table 6.8 Six years sales data for Diary Crest
20X7 20X6 20X5 20X4 20X3 20X2
DAIRY CREST £m £m £m £m £m £m
Sales 1309.3 1161.0 1348.8 1361.8 1326.1 1366.7
Sales increase/
(decrease) year %
12.8% 13.9% 1.0% 2.7% 3.0%
Cash from operations 97.0 89.7 122.4 126.4 111.0 100.6
Cash operations/
Sales %
7.4% 7.7% 9.1% 9.3% 8.4% 7.4%
Other non-operating
inc/(exp)
235.0 43.7 9.7 6.6 93.4 1.1
Identifying the correct values to be used (it’s easier to work with the index series
data rather than the percentage change data).
Avoiding errors in setting up the spreadsheet formulae.
Recognising that the outcome of the exercise is not correct in any sense unless
the index used has constituents that match the constituents of turnover in the
business. The result is an approximation.
Table 6.9 Six years inflation adjusted sales data for Diary Crest
20X7 20X6 20X5 20X4 20X3 20X2
DAIRY CREST £m £m £m £m £m £m
Sales 1309.3 1161.0 1348.8 1361.8 1326.1 1366.7
Nominal sales inc/
(dec) year %
12.8% 13.9% 1.0% 2.7% 3.0%
Inflation UK RPI
excluding housing
2.70% 2.60% 1.60% 1.20% 1.70% 1.40%
Index 13 January
1987 =100
183.2 178.3 173.7 170.9 168.9 166.0
Real sales inc/(dec)
year in 20X7 money
1309.3 1192.9 1422.6 1459.8 1438.4 1508.3
Real sales inc/(dec)
year %
9.8% 16.1% 2.6% 1.5% 4.6%
Cash from operations 97.0 89.7 122.4 126.4 111.0 100.6
Cash operations/
Sales %
7.4% 7.7% 9.1% 9.3% 8.4% 7.4%
Other non-operating
inc/(exp)
235.0 43.7 9.7 6.6 93.4 1.1
122 Cash Flow Analysis and Forecasting
When we see the adjusted data it is clear that the business is failing to grow
at all in real terms. The increase in turnover in the most recent period is likely
to be largely due to the acquisition of two businesses in France and Italy during
the financial year. Segment analysis reveals the majority of the group’s turnover
(70%) is still in the lower value-added milk-processing area with the remaining
30% in foods.
So we can see that the business is still dealing with the step changes in its tradi-
tional market. The milk business is being steadily rationalised and consolidated to
reduce costs and attain greater economies of scale. To use a military metaphor, this
is a little like a rearguard action, seeking to preserve as much profitable business
as possible whilst managing the transitions. The group sees its future in branded
foods and is steadily moving in this direction to improve its return on investment.
Finally, let us examine the relationships between Capex and depreciation
(Table 6.10).
Table 6.10 Six years depreciation and capex data for Dairy Crest
20X7 20X6 20X5 20X4 20X3 20X2
DAIRY CREST £m £m £m £m £m £m
Depreciation 40.6 38.3 34.4 36 35.8 37
Payment to acquire Property 37.4 44.3 37.7 41.7 61.6 60.2
Plant and Equipment
Grant received 1.1 0.3
Proceeds from disposal 9.7 9.4 8.2 12 34.6 7.9
Net Capex 26.60 34.60 29.50 29.70 27.00 52.30
New Capex/Depreciation % 92% 116% 110% 116% 172% 163%
Dairy Crest has a net Capex below depreciation in the last five years of the
sample. Investigation of this reveals that the proceeds of sale from the steady
rationalisation of the historic investment in milk processing is offsetting the new
Capex. The level of investment in new Capex is above depreciation in every year
except 20X7. New Capex in 20X2 and 20X3 was considerably above depreciation.
This could be due to changes in health regulations, technological change or it could
be due to investment needed to create new facilities at the size required to capture
economies of scale.
Dairy Crest is a mature business operating in a low value-added mature market
undergoing fundamental sector change. It appears to be in the latter stages of a
business transformation designed to optimise the returns from the historic business
(milk) and move the business into products related to its historic core business
(milk based) with higher potential value-added available to the group. Cash flows
are volatile and there is evidence of gradual decline in performance. It may be that
Analysing the Cash Flows of Mature Businesses 123
the move to higher value added markets is not taking place fast enough to offset
the decline.
Fiat Group
Our next example is taken from Europe. Fiat Group is a diversified industrial group
involved in car, truck, bus, agricultural and construction equipment manufacture.
All the markets in which the group operates are mature, many facing intense
competition on a global basis. Sectors such as cars, trucks and agricultural products
have seen steady rationalisation and consolidation over the last few years. At this
point Fiat controls the following car brands, Fiat, Lancia, Alfa Romeo, Maserati
and Ferrari.
The cash flows of the group for the sample seven years chosen are shown in
Table 6.11.
Before we commence our analysis of the seven years of Fiat performance the
first thing we should notice is that the template has changed. A new line item
‘(Increase)/Decrease in vendor financed assets’ and a further sub-total have been
added. I will briefly discuss the variation between this template and the earlier
versions of the template.
The Issue of Vendor Financing
Over the last 50 years or so it has become more and more common for sellers of
capital goods in particular not only to sell the product, but also provide a loan,
deferred purchase arrangement or lease arrangement to the customer which is then
paid off from the cash flows generated by using the product, directly or indirectly.
For example Ford Motor Credit, the original finance business of the Ford Motor
Company, was founded in 1959. FCE Bank plc, the European arm of Ford’s vendor
financing activities, was founded in 1964.
This approach to selling capital goods is common not only for vehicles but
also for most moveable plant and machinery. The technique has also been ex-
tended to include assets such as immovable plant and machinery, power stations,
bridges, pipelines and mobile phone networks, where it is more normally known
as project financing or non-recourse project financing. In these larger projects
both the vendors in house finance operation and external finance providers will be
involved.
The provision of a loan to a customer is a banking activity. The risks inherent
in such a loan are identical to those taken by any banking institution that lends
money to a customer to buy a vehicle.
For this reason it is preferable for us to keep the cash flows associated with
the financing of customers (other than typical trade credit) separate from the cash
flows of the rest of the business. This separation means that we can assess the
Table 6.11 Seven years cash flows for Fiat Group
FIAT GROUP - SEVEN YEAR SUMMARY
FIAT GROUP 2007 2006 2005 2004 2003 2002 2001
Operating cash margin 5637 4864 4817 617 232 511 339
(Inv)/Gen from net working assets 1588 812 114 609 1282 2016 2388
Net Capital expenditure 3726 3402 2625 1754 2156 460 786
Taxation paid in period estimate 833 551 419 292 132 660 660
CATS (before investment in leased assets) 2666 1723 1887 2038 510 1305 1281
(Increase)/Decrease in vendor financed assets 1032 876 251 2976 1146 2456 189
Cash Available To Satisfy Finance Providers 1634 847 1636 938 1656 3761 1092
Net interest paid estimate 564 576 843 74 301 208 368
Net dividends 229 46 18 165 15 228 380
Other 220 2665 2500 45 2660 645 2027
Net cash 1061 2982 3311 984 4000 3096 947
Increase/(Decrease) in equity 390 22 0 20 1842 1138 266
Increase/(Decrease) in debt 1675 1730 2839 2735 3055 2703 1364
Decrease/(Increase) in cash 1004 1274 472 1731 2787 1531 151
1061 2982 3311 984 4000 3096 947
CATS is an abbreviation of Cash Available To Satisfy (Finance Providers)
All amounts millions
Analysing the Cash Flows of Mature Businesses 125
performance of the businesses business activities separate from the businesses
banking activities!
Whilst it is my preference to keep Jury’s Template absolutely standard and to
deal with variations due to sector differences by way of explanation, it is clear
to me that an exception should be made in the case of vendor financing. I have
introduced a new line to deal with the vendor financing activities of a business
after the Cash available to Satisfy Finance Providers value (CATS) and before
the Net interest paid. After inserting the movement in Vendor Financed Assets
I have created a second Cash Available to Satisfy Finance Providers Total after
Vendor Financing. This has the effect of separating the cash flow related to vendor
financing, and so on from the remaining cash flows of the business.
Bear in mind that in larger groups the financing subsidiary itself may raise
finance directly from capital markets to engage in its chosen activities. These
loans will end up being consolidated as part of the group debt. This means that the
change in debt value in the group cash flow statement will include both finance
raised to invest in the manufacturing and other business activities of the group and
finance raised for vendor financing purposes.
The Use of Estimates for Interest and Taxation
In the case of Fiat the original cash flow statements from which Jury’s Cash Flow
Template was prepared contain no interest or taxation numbers. This is because
the commencing profit value is the net result (this being the profit after interest
and taxation from the P&L).
To complete the template I have used the values of net interest and taxation
taken from the notes to the annual report and accounts. Where a taxation or net
interest paid value has been disclosed I have used it. I have adjusted the taxa-
tion value to remove the change in the deferred tax provision, which is not a
cash flow. I have assumed the remaining taxes disclosed are cash taxes paid in
the period in which they are disclosed. It is unlikely that the cash net interest
value is materially different from the P&L value; this is because the only dif-
ferences should be for opening and closing accruals of interest due but not yet
paid, and any interest recognised in the P&L on deep discount bonds and other
debt instruments that do not require any cash interest service during the life of
the loan.
Taxation may be distorted if the taxes recognised in the current period P&L are
paid over in the following year. I do not know whether this is the case for Fiat
or not.
Note that to change our perception of the performance of the Fiat Group business
from a cash flow point of view the estimation error on these values would have
to be large. The magnitude of the net interest and taxation values used is small
relative to the other values in Jury’s Template.
126 Cash Flow Analysis and Forecasting
I have chosen Fiat Group to illustrate what a worrying set of mature company
cash flows look like. It is public knowledge that the Fiat Group has gone through
a sustained period of underperformance. In the period 2001 to 2004 the operating
cash margin was wholly inadequate to sustain the group and in 2002 and 2003 it
was negative! Since 2005 the top line performance has improved to a point where,
in 2008, the group is trying to expand its sales with important new model launches.
Let us review the business year on year.
In 2001 the major issues were:
Severely inadequate operating cash margin.
2.3 billion recovered from a reduction in the amount invested in working assets.
Massively reduced Capex.
Positive CATS Finance Providers of 1.2 billion.
A small increase in vendor financed assets.
Net interest receivable – this includes the interest earned on vendor financing
receivables.
Major acquisition activity of 2 billion resulting in a negative net cash position
of just under 1 billion.
The deficit on the year being financed by an increase in debt of 1.4 billion with
a reduction in equity and an increase in cash.
In 2002 the major issues were:
A negative operating cash margin, this means that overall the business spent
more cash on the expenses of its operating business than it generated from
customers, a very worrying result.
The amount invested in net working assets reduces by a further 2 billion, which
is the main reason the business has a positive CATS Finance Providers.
The net Capex is a positive value implying significant fixed assets disposal
during the year.
The decrease in vendor assets of 2.4 billion is the other major contributor to
cash.
The net cash surplus of 3.1 billion is used to repay debt of 2.7 billion.
A share issue raises 1.1 billion and cash has increased by 1.5 billion.
In 2003 the major issues were:
Another year of negative operating cash margin.
The investment in net working assets now increases by 1.2 billion.
The net Capex is a positive value implying substantial assets disposal in the
year.
Dividend payments cease. Notice how late this action occurs in the process of
recovering performance.
There is a further decrease in vendor assets of 1.1 billion.
Analysing the Cash Flows of Mature Businesses 127
This, together with net business disposals of 2.7 billion, generates sufficient
cash to repay 3.1 billion of debt.
There is a further equity issue raising 1.8 billion.
Cash increases by 2.7 billion.
In 2004 the major issues were:
A modest improvement in operating cash margin; however, it is still significantly
below the sort of value needed to sustain the group.
Investment in net Capex recommences.
There is another huge reduction in vendor receivables of 3.0 billion.
This allows the business to finish with a cash surplus of 1.0 billion.
Debt reduces by a further 2.7 billion, with 1.7 billion of this coming from
cash.
In 2005 the major issues were:
A significant recovery of performance at the operating cash margin.
Control of working asset investment looks good.
Net Capex returning to more normal levels.
Vendor financed assets now start to increase.
Interest paid has increased.
There is significant business disposal raising 2.5 billion.
Debt reduces again, by 2.8 billion.
In 2006 the numbers all start to look as they should in a successful mature
business:
Investment in working assets further reduces.
Major business disposals raise 2.7 billion.
Debt is reduced again by 1.7 billion with a cash increase of 1.3 billion.
In 2007:
The operating cash margin appears healthy with further net working asset re-
duction.
Vendor financing activities are increasing and absorb 1 billion.
Dividend payment is resumed.
Debt is reduced again by 1.7 billion.
Equity is reduced, cash reduces by 1 billion.
This is the third example we have considered. By now you should be starting to
become familiar with the process. The template tells us a story about what is going
on in the business. In the first four years of the time line we can see a seriously
underperforming mature business. The effect of this on the business is to cause
128 Cash Flow Analysis and Forecasting
the finance providers (mainly debt providers), to lose faith in the company, which
results in the need for constant debt reduction over the ensuing few years.
Fiat Group becomes unable to access the short-term credit market directly. This
means the business is then unable to offer its own vendor finance. Fiat has to enter
into joint ventures with other banks in order to continue to provide vendor finance
to its customers, this also means sharing the rewards of such business with third
parties so reducing the financial benefit flowing to the group.
In order to survive the complete loss of operating cash margin (mainly due to
losses in the car business) the group sells off fixed assets and recovers the amount
invested in historic vendor finance transactions as the customers repay their loans
without new loans being added and sells interests in a number of businesses. Over
the six years 2002 to 2007 the group has reduced debt by 14.7 billion.
A review of the annual reports and the group’s Form 20-F reveals that the group
is an industrial engineering conglomerate involved in hundreds of business around
the world. The recovery story is a classic one of asset and business disposal, cost
reduction and business reinvention. Notice that it took at least five years before the
business entered the recovery phase in cash flow terms. Notice also that despite
being recognised as a seriously damaged business it never entered any formal
insolvency process. Recovery was achieved by refocussing the business.
Let us see how this compares with the cash margin to sales data (Table 6.12).
Table 6.12 Seven years sales data for Fiat Group
2007 2006 2005 2004 2003 2002 2001
FIAT GROUP MMMMMMM
Sales 58 529 51 832 46 544 45 637 48 346 55 427 57 525
Sales increase/
(decrease)
year %
12.9% 11.4% 2.0% 5.6% 12.8% 3.6%
Cash from
operations
5637 4864 4817 617 232 511 339
Cash operations/
Sales %
10% 9% 10% 1% 0% 1% 1%
Other non-operating
inc/(exp)
220 2665 2550 45 2660 645 2027
Notice both the falling turnover and negligible margin in the first four years. The
group is downsizing, concentrating on the most profitable parts of the business,
and dropping those that are less profitable. When we take inflation into account
turnover does not begin to increase until 2006. During the period 2003 to 2007 the
group has disposed of about 8 billion of business interests.
Once again let us examine the relationships between Capex and depreciation
(Table 6.13).
Analysing the Cash Flows of Mature Businesses 129
Table 6.13 Seven years depreciation and capex data for Fiat Group
2007 2006 2005 2004 2003 2002 2001
FIAT GROUP mmmmmmm
Depreciation 2738 2969 2590 2168 2269 2614 2880
Investments in Fixed Assets 3985 3789 3052 2112 2011 2771 3438
Proceeds from disposal 259 387 427 358 4167 3231 2652
Net Capex 3726 3402 2625 1754 2156 460 786
New Capex/Depreciation % 146% 128% 118% 97% 89% 106% 119%
Net Capex/Depreciation % 136% 115% 101% 81% Neg Neg 27%
Notice first that the depreciation charge itself falls then rises through time; the
business is contracting from 2001 to 2004. The same pattern can be seen in the new
Capex where there are two years where new Capex is lower than depreciation. The
proceeds from disposal show us there were substantial disposals of fixed assets in
2001 to 2003. Once again the data appears consistent with the portrait of a poorly
performing mature business group engaged in a prolonged period of restructuring
and business reinvention.
As expected, this additional analysis essentially confirms what we have already
deduced from the template cash flows themselves, the business has been through
four years of losses followed by three years of recovery, which is ongoing.
ISSUES RELATED TO MATURE BUSINESS DIVERSITY
All three examples we have looked at are groups of businesses. The first two are
groups which have a relatively narrow strategic and market focus: Black & Decker
(various tools containing small electric motors); and Dairy Crest (milk processing
distribution and derivative products).
Fiat has a broader strategic focus. The 2007 annual report lists the reporting
segments as follows:
Automobiles.
Agricultural and construction equipment.
Trucks and commercial vehicles.
Components and production systems (virtually all vehicle related).
Other businesses (publishing and group services).
Again, all these segments are essentially mature markets. This is why the
example fits for the purpose for which it has been designed. However, groups are
not always this homogeneous.
130 Cash Flow Analysis and Forecasting
When I commenced writing this chapter I spent some time trying to develop
an example of a mature market around the market for televisions. Having written
half a page or so I realised this is not suitable, the reason being that elements of
the market for television were not mature. The market for televisions based on
cathode ray tube technology is in terminal decline. The market for plasma and
LCD based screens is a growth market. In most developed economies the market
for televisions themselves as a category is a mature market (initial adoption of the
product having taken place 40 years ago), with the overall market going through
an important step change to a new delivery technology. In emerging markets the
market for televisions is a growth market with fundamental technology change
taking place. Finally, the products themselves are produced by very large mature
groups (Sony, Panasonic, Toshiba, Samsung Phillips and LG, for example).
So, when we discuss ‘mature’ in the context of a group we need to be careful. As
you can see from the above examples this works if the group has a narrow focus,
it also works if most of the businesses in a group serve mature markets. It does
not work if the group consists of a mix of mature businesses, growth businesses,
decline businesses and possibly even start-up businesses.
This does not mean it is pointless to analyse the group cash flows of such an
entity, the exercise will still reveal much about the performance, cash efficiency
and investment pattern of the group. It will be difficult or impossible, however,
to relate this to particular external drivers of change other than the most basic
macro economic changes. In order to do this for a group it will be necessary
to disaggregate its activities into elements that are more amenable to in-depth
analysis, and then analyse the cash flows of each one.
It may be possible to disaggregate the activities by reporting by segment, sector
or market. Alternatively, it may be possible to group mature segments and growth
segments separately. Every group is different, it is this important point that makes
analysis both challenging and interesting. Making elegant decisions about how to
go about identifying the true performance of a business entity is the essence of
good analysis practice.
ISSUES RELATED TO BUSINESS SIZE
Earlier in this chapter I presented the idea of a sort of mature business, cash flow
break-even point as follows. I said that the analysis of the cash flows of a mature
business could be encapsulated in one sentence:
In the long run, mature businesses must generate sufficient Cash Available
to Satisfy Finance Providers to cover interest, dividends and scheduled debt
repayment.
Analysing the Cash Flows of Mature Businesses 131
To apply this in the real world we need to break this down further, into large,
medium and small examples. What do I mean by this?
The Large Business
A large business will almost certainly be a group. It is often a business sufficiently
large that it is essentially immune to problems involving the raising of finance.
It can raise debt or equity at any time should it wish to do so. It does not need
banks as lenders as it is sufficiently large that it can issue bonds, medium-term
notes and commercial paper directly into capital markets in a variety of geographic
locations.
Most businesses of this type are publicly listed entities with their shares traded
on one or more major stock markets. There is a small group of large private
companies that also qualifies – examples are the Mars Group (a confectionery and
pet food producer) and Maersk (the Danish shipping group).
Such businesses usually have permanent leverage. If you look in their accounts
you will find both short- and long-term debt items. However, when these are due
for renewal they are rolled over into whatever debt instrument is most cost effective
at the time. They fund themselves as cheaply as possible in any currency using a
variety of sophisticated financing techniques to do so (using, for example, swaps,
options, derivatives). Unless they have made fundamental management errors they
are unlikely ever to be in a situation where they are faced with the need to repay
all their debt quickly.
Where such a large mature group has ‘normal’ leverage the sentence can be
restated as follows:
In the long run, large mature businesses must generate sufficient Cash Available
to Satisfy Finance Providers to cover interest and dividends.
For large listed entities the dividend is as important as interest service. This
is because the share price will drop rapidly if the business announces dividend
reduction or omission. Senior managers are largely rewarded on stock price per-
formance, so paying the dividend is to them as important as interest service despite
not being a contractual obligation.
If the group has ‘abnormal’ leverage then the situation is as stated in the
original version of the one sentence, in addition to interest and dividend service,
debt repayment may be required. The typical scenario where this may occur
is where large amounts of debt finance have been raised to make a substantial
acquisition. As a result the group’s leverage is significantly above a level that
would be regarded as normal or sustainable. Large groups in this position will
normally place significant emphasis on debt repayment until their leverage is once
132 Cash Flow Analysis and Forecasting
more at a level considered ‘normal’ for their sector after which they will resume
the pattern of rolling over debt into whatever instrument is most suitable at the
time.
The Small Business
A small business is typically a private company or sole trader. Access to debt
is almost exclusively via banks and other debt finance providers, which act as
intermediaries between the business and capital markets. Small businesses are
therefore vulnerable to banking cycles, event risk that affects debt markets, and
fashion in banks, which can result in the withdrawal of liquidity at quite short
notice. Unlike large businesses, small businesses cannot assume that they can
refinance on demand. This means they should always seek to generate sufficient
Cash Available To Satisfy Finance Providers to be able repay scheduled debt
obligations without refinancing or replacing them.
However, small businesses do not need to pay dividends, and many do not.
Dividend payment is largely a decision driven by tax considerations. If paying a
dividend is the most tax effective way of extracting cash from a small business then
the business may pay a dividend. However, there are no negative consequences
in not paying a dividend, the dividend is truly discretionary. So we can exclude
dividends from the sentence for small businesses. It now becomes:
In the long run, small mature businesses must generate sufficient Cash Available
to Satisfy Finance Providers to cover interest and scheduled debt repayment.
The Medium-Sized Business
We are now left with the remainder – medium-sized businesses. They may be
small- and medium-sized listed groups, or medium and large private businesses.
Businesses in this group may have the need to service dividend and may also be
too small to guarantee access to refinancing as required. For them the original
sentence still stands:
In the long run, medium-sized mature businesses must generate sufficient
Cash Available to Satisfy Finance Providers to cover interest, dividends and
scheduled debt repayment.
So, a business that is able to comply with the one sentence test is performing in
a cash flow sense.
If a business passes the test consistently this tells us its cash flows are sufficient
for the business to sustain itself. The most successful businesses from a cash flow
Analysing the Cash Flows of Mature Businesses 133
point of view are those that generate vast amounts of surplus cash, this can be paid
out as dividend, used to reduce equity or debt, or retained for future investment.
SUMMARY
This chapter has covered much of the knowledge of cash flows required to assess
whether a mature business is performing or not. Additional insights, which are
also relevant to mature business analysis, are contained in the following chapters
on growth, decline and start-up.
Summarising reported cash flows into Jury’s Cash Flow Template and analysing
them is an efficient and powerful method of analysis that avoids many of the
problems of seeking to evaluate performance from the P&L.
7
Analysing the Cash Flows of
Growth Businesses
In Chapter 3 on Start-up, Growth, Mature, Decline we introduced the typical cash
flow patterns to be observed in successful businesses in the four phases of the
life of a business. The purpose of this was to develop an understanding of what
the cash flows should look like in the four phases and to introduce some of the
drivers of each line of the cash flow. The word ‘driver’ being used to denote the
fundamental economic and market forces or management decisions that cause
cash flows to change.
In this chapter we are going to go into more detail about what we mean by the
word ‘growth’ when used in this context. We will also look at what constitutes
success from a cash flow point of view when managing a growth company and,
finally, examine the cash flows of a number of real growth businesses taken
from different countries around the world. As some of the commentary assumes
knowledge of the previous chapter, this chapter should be read in conjunction with
the previous chapter discussing the analysis of mature businesses.
WHAT DO WE MEAN BY ‘GROWTH’?
When we talk about a growth business what we usually mean is a business
operating in a growth market. A growth market is a market where adoption of
new products or services is taking place for the first time. Some of the big growth
markets of the last 25 years have been mobile phones, computers and freight
containerisation.
Growth markets are different to mature markets. In a growth market all the
businesses participating in the market can grow at the market rate. If a market
is expanding at say 40% a year this means all the businesses involved can also
grow at 40% a year on average. This makes such markets very attractive places
to invest. Once a new growth market is recognised as such – and assuming there
are no unusual barriers to entry – we can expect many new entrants in the early
growth phase. Typically, these will be existing businesses that have the knowledge
and expertise to supply the new growth product or service.
As the new market becomes established and develops, those participants who
can capture market share faster than their competitors will start to enjoy any
Cash Flow Analysis and Forecasting: The Definitive Guide to
Understanding and Using Published Cash Flow Data
by Timothy D.H. Jury
Copyright © 2012, Timothy D.H. Jury
136 Cash Flow Analysis and Forecasting
economies of scale that are available earlier than their competitors, so leading to
a cost advantage for them over time. In the latter stages of the development of
the new market the growth rate starts to reduce year on year. In this latter part of
the growth phase (which is sometimes referred to as ‘shake-out’) we expect to
see the gradual consolidation of the numerous competitors as they get taken over,
merge or exit leaving a handful of large players in an increasingly static market
structure. Over the last decade Dell and HP Compaq have been the dominant
players in desktop computers and Nokia was the clear leader in mobile phones
although this is rapidly changing.
It follows from this that once a growth market has been identified as such and
the decision is made to enter, strategy is usually all about gaining market share.
The more the better! So, what are the problems of growth?
IRRATIONAL INVESTOR BEHAVIOUR
Growth markets are so attractive that investors will invest in them at almost any
price. This can result in extreme and absurd outcomes. The most recent example
of this was the dot-com boom. In 1990, Tim Berners-Lee started developing a
GUI browser at CERN. He made up WorldWideWeb as a name for the program
and World Wide Web as a name for the project, which was initially an internal
CERN initiative. By 1994 the load on the first web server (info.cern.ch) was 1000
times what it had been three years earlier. On 1 October 1994 the world wide web
consortium (W3C) was founded. Over the next five years, knowledge of this new
platform became widely disseminated. Once the significance of the browser/web
combination was recognised this resulted in a frenzy of web site development to
exploit this new way of interacting with potential consumers.
The term Silicon Valley came into use to describe the concentration of new IT
companies in the Santa Clara Valley outside San Francisco. Here could be found
young entrepreneurs busy developing concepts for consumer web sites. These
businesses were able to raise millions of dollars from venture capitalists or IPO on
NASDAQ, to spend on web site development. Many of these businesses regarded
their project as successful if they generated thousands of hits a day, meaning
their site was been surfed by thousands of users a day. Share prices valued these
companies in the millions and values often rocketed.
However, a web site is not a business. In the introductory chapter on start-ups
I pointed out that my definition for a business (as opposed to a charity) is one
where products or services are being supplied to customers in exchange for cash.
In other words there is cash flow from customers. This in turn implies that the
product or service has some economic value to the consumer. Many of these web
sites were proud to inform investors that it was too early to get users to subscribe
for or otherwise pay for content, the argument being that building a user base
(measured in hits) or developing markets share was more important. The flaw
Analysing the Cash Flows of Growth Businesses 137
in this argument is that the service may have no real economic value when a
charge is made, with consumers simply identifying a cheaper or free substitute, or
abandoning the service altogether because they do not really need it.
Whilst a small number of these companies went on to success in the late 1990s,
most collapsed spectacularly. History now recognises this as the dot-com bubble.
The term ‘bubble’ referring to the collective hysteria that results in stock prices
in such companies rising to levels that bear no relationship with reality. This has
happened many times before in many different markets – Europe has lived through
the Dutch tulip bulb bubble (difficult to pronounce!) and the South-Sea Company
bubble hundreds of years ago.
So, my first observation about the nature of growth is that attractive new growth
markets can lead to irrational investor behaviour and a general delusion about the
real cash flow potential of the new growth market.
NEGATIVE CASH FLOWS
The second problem with growth companies is that they require investment in order
to grow. Going back to my definition of a growth business as one that has already
demonstrated the viability of its offer by gaining real sales from customers, the
next problem for the business is to build the necessary infrastructure to produce and
sell the product to the target customer group. This can involve so much investment
that the net cash flow is negative for years.
Even though a successful growth company may be earning a healthy margin
from its existing customers, the need to invest in working assets, and new facto-
ries, distribution facilities and possibly retail outlets typically results in a negative
value for Cash Flow Available to Satisfy Finance Providers and Net Cash In-
flow/(Outflow). Cash may also be consumed in the late growth phase acquiring
the businesses and/or assets of former competitors.
So, my second observation about growth is that we expect the net cash flows of
many successful growth businesses to be negative!
CORPORATE COLLAPSE
Over the previous decade we have observed the failure of a number of large listed
businesses. The most high profile of these was Enron, others were Worldcom and
Global Crossing. All of these businesses were exploiting growth markets. In the
rest of the world we have seen the failure of Daiwoo and Parmalat.
It is striking how many of these business are growth businesses or, in the case
of business failures involving fraud, seeking to give the impression that they are
growth businesses. The reason they collapse is that they run out of cash and there
are no other cash generative businesses available within the group to offset this. It
138 Cash Flow Analysis and Forecasting
is far less likely for large mature businesses to collapse in this way for the reasons
already stated in the previous chapter.
In the early 1990s there were two large growth business failures in the United
Kingdom – these were Tiphook and Brent Walker. When Brent Walker collapsed
there were 65 banks that had lent money to various parts of the group. This means
that 65 different credit functions had looked at the credit risk inherent in their
exposure to the group and decided that the risks involved were acceptable. This
implies to me some sort of systemic failure. It implies that identifying whether
growth companies are in fact viable business entities is a challenging and difficult
problem. It implies the performance of growth businesses is difficult to analyse.
So, my third observation about growth is that we expect growth companies to
be cash negative, even if seeking equity or debt for investment. It appears there is
a self-fulfilling prophesy at work.
We are growing, so we are cash negative, therefore we need funds.
This accords with investor’s perceptions, so they provide finance, even though
in some cases the growth is false (not real) in some way. This false growth only
becoming apparent to many investors after the businesses collapse. To make
this even more obvious I could restate the above statement as:
We are running a fraud, so we are cash negative, therefore we need funds.
or, if not a fraud:
We are spending lots of money on something that might or might not be
successful in the future, so we are cash negative, therefore we need funds.
TO SUMMARISE THIS INTRODUCTION
New growth markets may be so attractive that this leads to irrational investor
behaviour and a general delusion about the real business potential of the new
growth market.
We expect the cash flows of many successful growth businesses to be negative.
Growth companies justify their need for funds by using a circular argument. We
are growing, so we are cash negative, therefore we need funds. Unfortunately,
the only growth business worth funding in the long run is a growth business
that results in a sustainable, cash generative mature business. During the market
growth phase it is extremely difficult to predict whether this will be the eventual
outcome for a growth market business.
Analysing the Cash Flows of Growth Businesses 139
IN CASH FLOW TERMS, WHAT CONSTITUTES SUCCESS
FOR GROWTH BUSINESSES?
There are a wide variety of patterns that we can encounter when looking at growth
company cash flows. We can usefully characterise these as follows:
1. The success – a self financing growth company.
2. The investor – a growth company investing in more operating assets each year
to expand output.
3. The acquirer – a growth company acquiring other growth companies to achieve
apparent or real strategic benefits.
4. The investor/acquirer – a growth company both investing and acquiring.
5. The aspirant – a growth company yet to properly validate its growth model as
viable in the long term.
Let us introduce the profile of each one in turn.
The Success
The success is a business that is growing and generating sufficient operating cash
margin from the sale of its goods and/or services to provide for all of its investment
needs. The investment needs being the investment required to maintain and expand
market share in its chosen markets (generally known as research and developments
costs) and the expenditure in fixed assets and net working assets needed to grow
its output.
Generally, research and development (R&D) costs are absorbed as part of the
cash costs put against sales in identifying the operating cash margin, as a result we
do not see them identified separately in Jury’s Template. Working asset expenditure
and capital expenditure (Capex) appear in the template as separate items.
Such a business will generate a surplus at both the Cash Available To Satisfy
Finance Providers line and the Net Cash Inflow/(Outflow) line. I have labelled this
type of business ‘The success’ because it is entirely self-financing and is likely to
achieve a very high valuation if offered for sale. Its destiny is entirely in the hands
of its owners and managers, as it does not require further investment from equity
or debt providers. It can move forward irrespective of any disruption or fashion
issues that may be affecting the availability of capital from capital markets.
The Investor
The ‘investor’ is a business that has demonstrated to investors and customers it
has a viable long-term business model and is growing its output. It is not able to
do this entirely from internally generated cash flow. In order to grow its output the
business requires investment in working assets and Capex. This investment may
140 Cash Flow Analysis and Forecasting
Table 7.1 Illustration of the patterns in growth cash flows
Growth Growth Growth Growth
Example 1
£’000
Example 2
£’000
Example 3
£’000
Example 4
£’000
OPERATING CASH MARGIN 5500 4000 2500 1000
(INV)/GEN FROM NWA 500 500 500 500
NET CAPITAL EXPENDITURE 2000 2000 2000 2000
TAXATION 1200 700 400 200
CATS Finance Providers 1800 800 400 1700
NET INTEREST 1000 1000 1000 1000
NET DIVIDENDS 400 200 0 0
OTHER NON-OP INC/(EXP) 0 0 0 0
NET CASH GENERATED/
(ABSORBED) BEFORE
FINANCING
400 400 1400 2700
Financed by:
CHANGE IN EQUITY –
INC/(DEC)
100 650 1200
CHANGE IN DEBT – INC/(DEC) 200 650 1300
CHANGE IN CASH – (INC)/DEC 400 100 100 100
TOTAL CHANGE IN
FINANCING
400 400 1400 2600
or may not be financed from operating cash flow. This can result in a variety of
cash flow outcomes as shown in Table 7.1.
In Example 1 we see the business has generated sufficient cash flow to cover all
its investment needs, taxes and interest costs. Only the dividend payment results
in a deficit, which is financed from existing cash reserves. This business is still in
the well performing category.
In Example 2 the business is generating sufficient cash flow to cover all its
investment needs and pay taxes. It does not have sufficient cash to cover all its
interest and dividend payments. Unless this cash deficit can be financed from
existing cash reserves it will require further equity or debt finance to continue
to trade.
In Example 3 we see the business not generating sufficient cash flow to cover
its investment needs and taxes. It has a deficit at the CATS Finance Providers line
and a larger deficit at the net cash inflow/(outflow) level. Unless the business has
considerable cash reserves it will require further equity or debt finance to continue
to trade.
In Example 4 we see the business is only generating a modest proportion of
the cash required to finance its investment needs and taxes. It has a substantial
Analysing the Cash Flows of Growth Businesses 141
deficit at the CATS Finance Providers line and a larger deficit at the net cash
inflow/(outflow) level. Unless the business has considerable cash reserves it will
require substantial injections of further equity or debt finance to continue to trade.
In Examples 2, 3 and 4 the business is vulnerable to financing risk, the possibility
that investors will not wish to invest more in the business. Their willingness to
do so will be determined by their view of the effect on future periods cash flow
of the investment in increased output. Will it increase the operating cash margin
sufficiently for the business to be cash generative in the future?
In other words, in these examples the business is more sensitive to investors
future expectations about the cash flows of the business. In turn these expectations
change with external economic conditions.
It should also be clear from these examples that, in general, default risk (credit
risk) is increasing as we move from left to right across the cases illustrated.
We know that Examples 1 and 2 are probably fine in terms of their viability as
businesses, because they are generating a surplus CATS Finance Providers after
investing to grow their output. Even if Example 2 has too much leverage, new
investors might purchase the business from old investors because it is likely to
continue to be cash generative and hence has a positive value.
Examples 3 and 4 are more difficult to test because the key numbers are negative.
The management will be justifying their current cash flow position by claiming
that the investment in working assets and Capex in this year will increase the
operating cash margin generated in future years, so tipping the cash flows back
to positive sometime in the future. The problem for the analyst is identifying
whether this is a likely outcome or not. Remember the self-fulfilling prophecy
I mentioned earlier. The management says, ‘We are a growth company, we are
cash negative, therefore we need funds for investment’. The investor (lender or
equity provider) says, ‘Of course, you are a growth company, therefore you are
cash negative’. In normal market conditions the investor will most likely then
invest.
The real issue, however, is whether the growth business will ever reach the point
of cash flow break even (or cash neutrality). The eventual outcome being affected
by both management actions (internal factors) and equity and debt market condi-
tions, sovereign and sector risk and market, technology and competitor behaviour
(external factors).
The Acquirer
At certain point in their development, growth businesses may acquire other busi-
ness. This may be for offensive or defensive reasons. If the business is a market
leader, acquiring similar businesses in adjacent territories to those the business is
already operating in may save years of start-up time. These businesses may then
be re-branded and integrated into the existing operations of the growth company.
142 Cash Flow Analysis and Forecasting
Other offensive reasons for acquisition activity might be to acquire brands, market
share, technology or even customers.
Defensive reasons for acquisitions are likely to be market share related, in the
shake-out phase of a growth market when increasing consolidation takes place.
For example, at the beginning of the shake-out phase there may be 100 companies.
Later, the market may end up with just 15. Four of these are large and the rest
niche specialists. Number three may acquire number four to become number two,
particularly if there are material economies of scale involved in the industry. In the
last decade we have seen this type of acquisition activity in personal computers
(e.g. HP/Compaq) and in aluminium producers (e.g. Rio Tinto/Alcan).
The examples identified above represent reasons for acquisitions that appear
strategically sound. Managers may also make acquisitions for many reasons that
are not necessarily strategically sound. Advisers may approach companies seeking
to initiate both sales and purchases. Companies may underperform to the extent
they become vulnerable to acquisition.
Finally, there is a substantial academic literature that concludes 50% of all
acquisitions fail in terms of delivering the expected outcome (wealth, success,
value) to the acquirer. The failure rate rises to 75% when the acquisition is an
unrelated industry or sector.
Whilst the consolidated P&L of the acquirer will have more turnover and profit
in it at the end of a year involving acquisitions, the acquisitions themselves do not
represent any growth in value for the acquirer. This is because the company has
paid to purchase the business what it considers to be the present value of the future
cash flows of the business acquired. We have not added value, we have merely
exchanged cash or shares or both for the future cash flows of a business.
The added value comes when additional benefits in economies of scale, mar-
ket share, technology and cost savings are achieved. Collectively these things are
known as synergies, these being benefits that will typically arise by taking man-
agement action after the acquisition. It is common for sellers to demand a share of
the present value of the planned synergies in the purchase price. If the acquiring
managers give away too much at this point the transaction may destroy value in
the medium term rather than adding it. It is common knowledge that gaining the
financial benefit of the synergies in the post acquisition phase may be difficult,
or indeed, may never be achieved. The purported synergies may not in fact exist!
Many acquisitions fail for these kind of reasons.
Finally, we have problems with information asymmetry. The seller knows all
about the business being sold, the buyer knows far less. Buyers try to compensate
for this by carrying out a due diligence process. This means checking that every-
thing offered is in fact bona fide. This process can never deliver 100% certainty
and every year there are stories of acquisitions of companies that turn out to be
carrying substantial undisclosed liabilities. In extreme cases this has resulted in
bankruptcy for the acquirer.
Analysing the Cash Flows of Growth Businesses 143
So, when growth companies make acquisitions, they are considerably increasing
their business risk in the short term. Until the acquisition is properly digested into
the acquiring group, the extra burden of managing two businesses at the same time
may cause more problems than the acquisition was meant to solve.
In cash flow terms, the success of an acquisition cannot usually be measured
for two years. This is because in the year after acquisition we usually see the one-
off costs associated with redundancies, plant closures and other reorganisation
and restructuring. It is only after these costs have passed that we can look at the
operating cash margin and assess whether it has increased sufficiently to justify
the earlier acquisition cost.
When analysing the cash flows of an entity, if we find evidence of acquisition
activity in a business we should consider the following:
The size of the acquisition relative to the present business of the acquirer. How
material is the transaction?
The leverage and cash position after the transaction. Does the business have a
cushion of surplus cash or debt facilities to deal with any unexpected costs or
losses in the post acquisition phase?
The strength and sustainability of the operating cash flow margin of the existing
business. Is it resilient or is it vulnerable to known cycle or sector risks?
The managements track record of managing acquisition activity in the past.
Have they successfully completed and integrated acquisitions in the past?
The strategic logic underpinning the acquisition activity. Does it make sense?
The Investor/Acquirer
In this scenario we have a business that is both investing in operating assets at
a rate ahead of its ability to generate operating cash margin and acquiring other
businesses.
It should be obvious from my earlier observations that this is a high-risk com-
bination. The metaphor that springs to mind is that of tightrope walking. For the
managers pursuing such a strategy there is no margin for error. The amount of
change that is being managed is immense. As well as opening new factories/outlets
and managing the changes associated with rapid growth, they also have the burden
of integrating newly acquired businesses.
In very attractive growth markets there may be periods where taking such risks
is justified, the result being a bigger market share and lower costs than competitors.
For this strategy to be justified the potential benefits should bear some relationship
to the risks involved. In the last few years we have seen a spate of ill-advised
takeovers in the banking industry in the UK and Holland which have effectively
ruined the businesses of the acquirers, all of whom have required state assistance
to survive. For the acquiring group these transactions appear to be more about
getting bigger than adding value.
144 Cash Flow Analysis and Forecasting
The Aspirant
The aspirant is a business that is selling its product for a reasonable margin and
is growing its turnover. However, it has not yet reached a point where it is cash
positive at the Net Cash Inflow/(Outflow) Total. The usual reason for this is because
adoption is not taking place at the rate foreseen when the decision to invest was
taken. The business has not yet reached the size necessary to establish itself as a
long-term member of the sector in which it operates. The junior stock markets of
those nations that have them are full of such companies. These businesses have
not yet demonstrated that they have a viable long-term cash generative business.
Turnover is small but growing, they may or may not be profitable; cash flow is not
yet adequate to be self-sustaining.
Whilst we may be confident about our predictive abilities, as analysts we should
not anticipate whether the business will or will not make it to viability. All we can
do is assess the significance of the principle factors that will affect the outcome, and
express an opinion about our view of the likelihood of success. This is essentially
a forecasting exercise. Forecasting cash flow is dealt with as a separate subject in
section two of this book.
What we can look at is the resources available to support the business until its
viability is properly secured and demonstrated. This is represented by the cash
and banking facilities that are in place for the business to draw on in the short- and
medium-term. These can be compared to the rate at which cash is being consumed,
which is why a focus on cash flow is essential for those running the business and
for those seeking to analyse it. From this we can estimate how many months or
years the business can continue assuming there are no changes to the business.
When developing your analysis, making any assumption is dangerous. We may
fail to recognise threats and weaknesses that cause a more rapid business decline
than history suggests is likely. In general, however, the no change assumption is
generally a conservative assumption.
Managers are there to manage change, so, if we assume competence in
management, we normally expect to observe a succession of beneficial changes
in the business. In other words, in most cases, there will be a general bias in
management actions towards positive change. In a few cases there will be adverse
events, which make the effects of change negative, this will of course accelerate
the speed at which the business proceeds towards bankruptcy unless there are
later positive changes.
We are using this assumption because it enables us to develop a useful measure.
Lets call this measure the no-change time to default. If we are looking at default
risk in particular, for example, we may be comfortable if this measure reveals the
business has three years’ worth of finance but less happy if this measure is only
six months of finance.
Having reviewed the different profiles of growth companies let us consider a
number of examples.
Analysing the Cash Flows of Growth Businesses 145
GROWTH CASH FLOW EXAMPLES: THE SUCCESS
Nokia is a good example of a successful growth company from the last decade.
Table 7.2 shows the cash flows for a recent six year period.
In each of the six years Nokia has generated a surplus at both the Cash Available
to Satisfy Finance Providers line and for five years at the Net Cash Inflow/(Outflow)
line. In all years the Cash Available to Satisfy Finance Providers has been more
than sufficient to cover interest and dividends. The only reason the Net Cash
before Financing was negative in 2008 was due to two major acquisitions for
Nokia. They purchased Navtec, a US-based GPS and mapping specialist and they
increased their remaining ownership of Symbian from 47.5% to 100%. At this
point in time, this is, by any standards, a very successful business having evolved
to become the world’s number one supplier of mobile phones.
Table 7.2
Nokia
Summary group cash flow
statement 20X8 20X7 20X6 20X5 20X4 20X3
Year ended 31st December mmmmmm
OPERATING CASH MARGIN 7457 8474 6163 5390 5193 6545
(INV)/GEN FROM NET
WORKING ASSETS
2546 605 793 366 299 194
NET CAPITAL EXPENDITURE 966 800 748 593 643 631
TAXATION 1780 1457 1163 1254 1368 1440
CASH FLOW AVAILABLE TO 2165 6822 3459 3177 3481 4280
SATISFY FINANCE
PROVIDERS
NET INTEREST 66 260 271 374 219 341
NET DIVIDENDS 2042 1748 1553 1530 1391 1354
OTHER NON-OPERATING
INC/(EXP)
1945 78 1754 2436 292 2608
NET CASH GEN/(ABS)
BEFORE FINANCING
1756 5412 3931 4457 2601 659
Financed by:
INCREASE/(DECREASE) IN
EQUITY
3068 2832 3325 4256 2648 1332
INCREASE/(DECREASE) IN
D