1. ADVANCED CASH FLOW ANALYSIS Chapter 11

2. CHAPTER 11 OBJECTIVES Explain the importance of investing and financing cash flows. Explain the importance of investing and financing cash flows. Relate cash flows from investing and financing activities to those from operations. Relate cash flows from investing and financing activities to those from operations. Describe an entity’s need for sufficient and efficient cash flows. Describe an entity’s need for sufficient and efficient cash flows.

3. CHAPTER 11 OBJECTIVES (CONT.) List and compute measures of cash sufficiency and efficiency. List and compute measures of cash sufficiency and efficiency. Provide an in-depth analysis of corporate and industry cash flows. Provide an in-depth analysis of corporate and industry cash flows.

4. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES Cash flows from investing activities (CFIs) Cash flows from investing activities (CFIs) Cash flows related to the acquisition and disposal of three types of wealth-building resources Cash flows related to the acquisition and disposal of three types of wealth-building resources Property, plant, and equipment Property, plant, and equipment Intangible assets Intangible assets Debt and equity securities Debt and equity securities

5. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) Cash flows from investing activities (CFIs) Cash flows from investing activities (CFIs) Reported after cash flows from operating activities in a statement of cash flows Reported after cash flows from operating activities in a statement of cash flows Analysts study CFIs to gain perspective about investments’ relative cost and benefits Analysts study CFIs to gain perspective about investments’ relative cost and benefits

6. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) Cash flows from investing activities (CFIs) Cash flows from investing activities (CFIs) Cash flows are related to an entity’s life cycle stage Cash flows are related to an entity’s life cycle stage Significant cash outflows in the emerging and growth stages of business Significant cash outflows in the emerging and growth stages of business They become positive and peak during business maturity They become positive and peak during business maturity CFIs trend toward zero as a firm declines and ceases operations CFIs trend toward zero as a firm declines and ceases operations

7. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) Cash flows from financing activities (CFFs) Cash flows from financing activities (CFFs) Those types of cash flows related to the acquisition and disposal of external resources needed to acquire productive assets Those types of cash flows related to the acquisition and disposal of external resources needed to acquire productive assets Equity issues and their reacquisition (treasury stock) Equity issues and their reacquisition (treasury stock) Equity returns on investments (cash dividends) Equity returns on investments (cash dividends) Debt issues and retirements Debt issues and retirements

8. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) Cash flows from financing activities (CFFs) Cash flows from financing activities (CFFs) Reported as the final section in a statement of cash flows Reported as the final section in a statement of cash flows

9. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) CFFs are related to an entity’s life cycle stage CFFs are related to an entity’s life cycle stage Significant cash inflows in the emerging and growth stages of business Significant cash inflows in the emerging and growth stages of business They decline during business maturity They decline during business maturity CFFs negative as a firm declines and ceases operations (return of investment) CFFs negative as a firm declines and ceases operations (return of investment)

10. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) In addition to the cash flow statement itself, information about CFIs and CFFs can be found in In addition to the cash flow statement itself, information about CFIs and CFFs can be found in Management’s discussion and analysis Management’s discussion and analysis Disclosures about market risk Disclosures about market risk The financial media (pending debt and equity issues) The financial media (pending debt and equity issues)

11. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES (CONT.) Correlation of CFIs and CFFs Correlation of CFIs and CFFs Sometimes cash provided by a financing activity can be traced to the cash used for an investment (e.g., issuing a bond to acquire a building) Sometimes cash provided by a financing activity can be traced to the cash used for an investment (e.g., issuing a bond to acquire a building) Correlations between CFIs and CFFs become more obscure as a business matures Correlations between CFIs and CFFs become more obscure as a business matures

12. CASH FLOW MEASURES Objectives Objectives A company must produce enough cash from business operations to satisfy investors A company must produce enough cash from business operations to satisfy investors Measure the relationship between operating cash flows and those from investing and financing activities Measure the relationship between operating cash flows and those from investing and financing activities Determine if an enterprise produces enough of the right kinds of cash flows to grow the business Determine if an enterprise produces enough of the right kinds of cash flows to grow the business

13. CASH FLOW MEASURES (CONT.) Primary cash sufficiency measures Primary cash sufficiency measures Provides evidence as to whether an entity produces enough cash from operations to meet its needs Provides evidence as to whether an entity produces enough cash from operations to meet its needs Cash flow adequacy is the primary measure of cash sufficiency Cash flow adequacy is the primary measure of cash sufficiency

14. CASH FLOW MEASURES (CONT.) Cash flow adequacy is computed as: cash flows from operations / (fixed assets purchased + long-term debt paid + cash dividends distributed) Cash flow adequacy is computed as: cash flows from operations / (fixed assets purchased + long-term debt paid + cash dividends distributed) General interpretation: a ratio of one or more indicates an entity’s operations produce sufficient cash to meet necessary business obligations General interpretation: a ratio of one or more indicates an entity’s operations produce sufficient cash to meet necessary business obligations A ratio of less than one indicates potential liquidity problems A ratio of less than one indicates potential liquidity problems Discretionary cash flows exist if the ratio exceeds one Discretionary cash flows exist if the ratio exceeds one

15. CASH FLOW MEASURES (CONT.) Decomposition of cash flow adequacy ratio Decomposition of cash flow adequacy ratio Individually examines each component of the cash flow adequacy ratio Individually examines each component of the cash flow adequacy ratio Inverts ratio’s numerator and denominator to avoid mathematical problems Inverts ratio’s numerator and denominator to avoid mathematical problems

16. CASH FLOW MEASURES (CONT.) Decomposed ratio is computed as Decomposed ratio is computed as Reinvestment ratio: fixed assets purchased / cash flows from operations Reinvestment ratio: fixed assets purchased / cash flows from operations Long-term debt repayment ratio: long-term debt paid / cash flows from operations Long-term debt repayment ratio: long-term debt paid / cash flows from operations Dividend payout ratio: cash dividends paid / cash flows from operations Dividend payout ratio: cash dividends paid / cash flows from operations In general, analysts favor low ratios for the components of cash flow adequacy In general, analysts favor low ratios for the components of cash flow adequacy

17. CASH FLOW MEASURES (CONT.) Free cash flows Free cash flows Computed as: cash flows from operations – (capital expenditures + dividends) Computed as: cash flows from operations – (capital expenditures + dividends) Interpretation: the more free cash the greater an entity’s amount of discretionary cash and liquidity Interpretation: the more free cash the greater an entity’s amount of discretionary cash and liquidity Depend on firm size Depend on firm size Ignore long-term term debt repayment in the calculation Ignore long-term term debt repayment in the calculation Commingles fixed asset replacement with fixed asset expansion Commingles fixed asset replacement with fixed asset expansion Could exclude the purchase of productive intangible assets in its calculation Could exclude the purchase of productive intangible assets in its calculation

18. CASH FLOW MEASURES (CONT.) Depreciation impact ratio Depreciation impact ratio Computed as: (depreciation + amortization expenses) / cash flows from operations Computed as: (depreciation + amortization expenses) / cash flows from operations Interpretation: small ratio indicates financial strength as the non-cash addition to income isn’t the driving force behind operating cash flows Interpretation: small ratio indicates financial strength as the non-cash addition to income isn’t the driving force behind operating cash flows A large ratio (approaching one) indicates insufficient cash flow from core activities A large ratio (approaching one) indicates insufficient cash flow from core activities

19. CASH FLOW MEASURES (CONT.) Recapitalization ratio Recapitalization ratio Computed as: reinvestment ratio / depreciation impact ratio Computed as: reinvestment ratio / depreciation impact ratio Interpretation: a ratio in excess of one means that a company’s investment in productive resources exceeds its use of productive resources Interpretation: a ratio in excess of one means that a company’s investment in productive resources exceeds its use of productive resources A ratio below one means capital assets are not being replaced in a timely manner A ratio below one means capital assets are not being replaced in a timely manner Fails to measure capitalization as opposed to recapitalization (e.g., for an emerging firm) Fails to measure capitalization as opposed to recapitalization (e.g., for an emerging firm)

20. CASH FLOW MEASURES (CONT.) Cash efficiency measures Cash efficiency measures A company must invest wisely in productive resources A company must invest wisely in productive resources Measure the relationship between operating cash flows and assets and revenues Measure the relationship between operating cash flows and assets and revenues Determine if an enterprise’s investments produced enough operating cash flows Determine if an enterprise’s investments produced enough operating cash flows

21. CASH FLOW MEASURES (CONT.) Three measures of cash efficiency Three measures of cash efficiency Cash flow return on assets: cash flow from operations / total assets Cash flow return on assets: cash flow from operations / total assets Cash flow return on sales: cash flow from operations / revenues Cash flow return on sales: cash flow from operations / revenues Operations index: cash flow from operations / operating income Operations index: cash flow from operations / operating income

23. CASH FLOW MEASURES (CONT.) Signs of cash efficiency Signs of cash efficiency Large rates of cash returns on assets and revenues Large rates of cash returns on assets and revenues Strong correlation between operating cash flows and operating income Strong correlation between operating cash flows and operating income

24. CASH FLOW MEASURES (CONT.) Cash sufficiency versus cash efficiency Cash sufficiency versus cash efficiency An entity must produce sufficient cash to prosper An entity must produce sufficient cash to prosper They should do in an efficient manner (i.e., generating maximum revenues from its productive base.) They should do in an efficient manner (i.e., generating maximum revenues from its productive base.) Cash flow sufficiency is a necessary component of cash flow efficiency Cash flow sufficiency is a necessary component of cash flow efficiency

25. APPLE COMPUTER AND THE PC INDUSTRY Investing and financing measures Investing and financing measures Inventory reductions created cash, which manifested itself in Inventory reductions created cash, which manifested itself in Securities investments made throughout the industry Securities investments made throughout the industry Compaq’s debt repayment and technology acquisitions Compaq’s debt repayment and technology acquisitions Dell’s contraction of capital Dell’s contraction of capital

26. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Apple’s investing and financing activities Apple’s investing and financing activities Substantial investments were made in available-for-sale debt and equity securities Substantial investments were made in available-for-sale debt and equity securities Preferred stock and long-term bond were issued from 1996-1998 Preferred stock and long-term bond were issued from 1996-1998

27. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Cash sufficiency measures Cash sufficiency measures Volatile cash flow adequacy measures (Exhibit 11-3A and 11-3B) Volatile cash flow adequacy measures (Exhibit 11-3A and 11-3B) Dell produced the most discretionary cash flows Dell produced the most discretionary cash flows Gateway demonstrated increasing levels of adequate cash flows Gateway demonstrated increasing levels of adequate cash flows Compaq’s 1998 performance eliminated its discretionary cash flows Compaq’s 1998 performance eliminated its discretionary cash flows Apple’s performance lagged those of its competitors Apple’s performance lagged those of its competitors

30. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Component measures provide additional insights about the industry’s cash flow adequacy Component measures provide additional insights about the industry’s cash flow adequacy Dell and Gateway had lower component measures, which indicated adequate cash flows Dell and Gateway had lower component measures, which indicated adequate cash flows Those for Compaq were higher than the industry leaders’ component ratios Those for Compaq were higher than the industry leaders’ component ratios

31. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Apple’s component analysis demonstrated inadequate cash flows, by its Apple’s component analysis demonstrated inadequate cash flows, by its extremely high depreciation impact ratio (Exhibit 11-6A) extremely high depreciation impact ratio (Exhibit 11-6A) cumulative recapitalization index that was significantly below one (Exhibit 11-6B) cumulative recapitalization index that was significantly below one (Exhibit 11-6B) decreasing recapitalization index over time (Exhibit 11-6C) decreasing recapitalization index over time (Exhibit 11-6C)

34. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Cash efficiency measures Cash efficiency measures Reinforce the analysis of the superior cash flows produced by Dell and Gateway Reinforce the analysis of the superior cash flows produced by Dell and Gateway Dell led the industry on operating cash returns on sales and assets Dell led the industry on operating cash returns on sales and assets Gateway and Compaq generated an equal amount of operating cash per sales dollar, but Gateway’s cash return on assets exceeded that for Compaq Gateway and Compaq generated an equal amount of operating cash per sales dollar, but Gateway’s cash return on assets exceeded that for Compaq Apple produced significantly less cash per sales or investment dollar than the returns produced by the other firms Apple produced significantly less cash per sales or investment dollar than the returns produced by the other firms

37. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Operations Index (Exhibits 11-9A and 11-9B) Operations Index (Exhibits 11-9A and 11-9B) Gateway, Dell, and Compaq’s operating cash flows correlated with operating income from 1993 to 1998 Gateway, Dell, and Compaq’s operating cash flows correlated with operating income from 1993 to 1998 Apple’s operating cash was negatively correlated with operating income during the period analyzed Apple’s operating cash was negatively correlated with operating income during the period analyzed