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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

This edition ﬁrst published 2012

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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

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

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.

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

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±F−C=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.

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

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.

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

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.

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

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.

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

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

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%

2.05%

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%

2.10%

2.11%

2.16%

2.17%

2.20%

2.21%

2.25%

2.26%

2.31%

2.35%

2.36%

2.37%

2.39%

2.43%

2.46%

2.49%

2.51%

2.54%

2.56%

2.58%

2.62%

2.64%

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%

3.05%

3.09%

3.15%

3.19%

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

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%

4.48%

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%

6.26%

6.33%

6.41%

6.52%

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%

8.57%

8.62%

8.84%

8.92%

9.02%

9.08%

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

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 −1−300−2−73 −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 €M€M€M€M€M€M€M

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 €m€m€m€m€m€m€m

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.

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

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 €m€m€m€m€m€m

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