Describe the analysis of cash flows in business.

For this very last analysis case, we can complete it as stand alone case without having to incorporate it into our DuPont method ROE paper. The rest of the work through the prior P/E ratio is enough for that purpose.

Cash Flows analysis may be the one single tool that alone can tell us how well a company is performing. Cash Flows strip all of the accrual accounting tricks away and show us only how a company sources money and spends money. Analyzing earnings and spending on a cash basis can tell us more than any other single accrual basis financial statement can. Cash flows also supplies a check against the accuracy of the accrual based financial statements to let us know how much we should trust them.

This procedure will present the basics of cash flow analysis first. Then it will provide an example of a strong cash flow company and a second example of a weak cash flow company. Your company will certainly be different in several ways from each of these examples, likely displaying some characteristics of both of them. It is less important that you mirror exactly what I model here, and it is more important that you strive to understand your company’s performance story and to reflect your specific company story in your write up according to your sound, evidence supported interpretation.

General cash flows analysis process:

The statement of cash flows is prepared in three sections: Operating activities, investing activities, and financing activities. Operating activities has a clear set of standards that can be independently assessed. Interpreting investing activities and financing activities not depends on their relationship to each other and to operating activities. This is very important to understand as you read through the following information.

Operating Activity Cash Flows

The income statement measure the company’s ability to create wealth on an accrual basis. Operating activities cash flows also measure the company’s ability to create wealth, but only in the form of cash. The first step in analyzing operating cash flows is to compare Net Income against Total Cash Flow from Operating Activities (aka operating cash flow).

If these two numbers essentially tell the story, then you ought to able to trust the quality of the Net Income number. Here’s why: Net income relies on accrual accounting. This includes year-end adjustments to capture revenues and expenses for which cash has not yet changes hands. If a company falsify boosts revenues and falsely underreports expenses to artificially prop up earnings, the required false adjusting entries will not bring in any more cash, they will only alter the revenue and expense accounts and the accrual accounts like accounts receivable and accounts payable. In short, when fraud exists, there is no cash to support the fraud. If Net Income is larger than operating cash flows, then we should be suspicious of the company’s accounting processes and should question Net Income’s accuracy.

Operating cash flows should actually be larger than Net Income. Why? In stripping out the effects of accrual accounting, the biggest item is normally depreciation expense. Depreciation is not a cash based item; no check is ever written for depreciation. It only exists as an accounting assignment to periods other than when the money to purchase the asset was actually spent. Since the depreciation expense is removed from Net Income to convert it to operating cash flows, operating cash flows should be a larger positive number than should be Net Income.

Operating cash flows share a similar core purpose with the income statement. So they can be interpreted in much the same way. If operating cash flows are positive, then the core business is making money (actually real money). This is what the company is supposed to do, make money. If operating cash flows are negative, then the core business is not making money. Operating cash flows is the tool that measures that critical performance metric. Do you want to know if the company is making money? Look at operating cash flows.

Investing Activities Cash Flows

This section details how much cash a company is paying to purchase long term plant assets and to purchase other companies. Reversals of these expenditures are also investing activities. While positive cash flows are the norm for operating activities, negative cash flows are more common and expected for investing cash flows. Investing cash outflows mean that the company is investing in their future. Such investments should being higher earning capacity in future years or at least maintain current earning capacity through regular equipment replacement.

How much should a company be investing? Here we need to relate the investing cash flows to the operating cash flows. Does the company earn enough cash through their operating activities to be able to afford their investing cash flows? If a company earns $1 billion in operating cash flows but spends all of it on capital equipment, then there is nothing left over to reward stockholders for their ownership. If A company earns $1 billion in operating cash flows and spends $2 billion on investing activities they have spent twice what the company earned and they will have to go borrow money or sell stock to fund the investing expenditures.

What is good here? A mature company should spend only a portion of operating cash flows on investing activities to leave a satisfying amount of cash to pay out to investors. A growing company may require so much cash for investing in growth-enabling infrastructure that they don’t have any money to pay out to investors. This may find with you if you believe the company will one day require less investing cash outflows and instead route future earnings to the owners.

What is bad here? If a company has negative operating cash flows, they may have to sell off plat assets to fund the operating shortfall. This may leave them with diminished earnings ability for the coming years. Unless they find a way to stop the decline, they may spiral downward into failure. Some selling of retired plant assets is normal, but so is replacing those assets by buying new ones.

Financing Cash Flows

This section details the borrowing and stock transactions for the company. Taking out bank loans, issuing bonds payable, and issuing stock to investors all generate financing cash inflows. Repaying loans, retiring bonds, repurchasing stock, and paying dividends are all financing cash outflows. All companies have different finance cash flow needs, so interpreting what is good or bad depends on the company’s position in the life cycle and on their operating and investing cash flows too.

How do I interpret finance cash flows?

A new firm is going to be building infrastructure and spending money faster than their operations can generate enough to fulfil their expansion needs. Fueling this “cash burning” is typically done by borrowing and selling ownership. These positive financing cash flows are normal for a new or fast growing firm. If you believe they will someday earn enough to reverse this flow and then provide a return to investors, then these positive financing cash flows are perfectly fine.

A mature firm should earn plenty of cash from their operations to easily afford their capital investment requirements and also return a healthy amount of cash to the owners. Such a company is often referred to as a “cash cow”, because it requires little input and it can be milked for money reliably.

A company at the end of its life cycle may find itself earning less cash from operations every year. They may first start borrowing to cover this shortfall if they can convince lenders that they are able to reverse the slide. Watch for increasing positive financing cash flows along with decreasing operating cash flows as a sign of impending trouble.

Even worse? After a company has run up too much debt to and has too much risk for any sensible lender to gamble on loaning more money, you might actually see positive investing cash flows and negative financing cash flows as the company sells off their productive assets to repay lenders.

What is even worse than that? Imagine a company with negative operating cash flows still spending money on required capital investing cash outflows. This same cash strapped company must take on more debt to cover those operating cash shortfalls and desperately try to keep their equipment refreshed and their production running.

One more worse than that? Imagine that very last company borrowing even more money to fuel dividend payments to their shareholders – despite the fact that they are very near bankruptcy. That was General Motors shortly before they declared bankruptcy. Their cash flows provided a horrific view into the distorted attempts to make shareholders think they had a short at redemption. If only they could read a cash flows statement.

Overall cash flow analysis

It is not necessarily that important how much the cash account balance increased or decreased in any given year. What is really important? Where the cash came from and where the cash went are both key pieces of information to analyzing a company’s success. Also important is how much cash a company generates that it can then decide how to use. A metric called Free Cash Flow generally measure the amount of left over cash a company generates that it can then discretionally decide how to utilized. My favorite calculation for free cash flow is:

Mikk’s free cash flow = Cash from operating activities – Capital expenditures

This method treats the equipment refreshment depicted by capital expenditures as a required cost of doing business, very similar to an expense. This Free Cash Flow result is the amount of cash we have available to buy up competitors, repay debt, buy back stocks, or pay dividends. A company with a large amount of free cash flow is one worthy of consideration to own. Growth potential and cash payouts are great things, Free Cash Flows demonstrates a company’s ability to make them both happen. The text uses a slightly different formula, so be sure to use it in any homework problems.

Cash Cow Example:

Kraft’s Net Income is $1.6 billion, and their Operating Cash Flows are nearly twice that big at just over $3 billion. Both of these tell a story of a healthy core business that builds wealth. Operating cash flows are larger than Net Income so I have no reason to think that Net Income is artificially propped up by fraud either. The cash is coming to support their reported earnings. This helps me trust all of the other accrual accounting analysis already done in earlier steps.

Kraft makes over 7 times in operating cash flows than they need to spend to keep their factories up and running. They can easily afford their equipment refreshment needs with only $440million in capital expenditures, and they don’t show any “Investments” line item indicating that are not acquiring other companies. If these low investment amounts are enough to keep the company running properly, then Kraft has a tremendous amount of free cash flow available to reward investors.

That $1.255billion Investing cash outflow means that Kraft is using much of their free cash flow to pay down their debt. This is good news since their debt ratio stands at 86%, well over the 50% ideal target. This is a very responsible use of their cash earnings, and this company will be very attractive if they continue this process of reducing their debt.

The amount of cash they generate is staggering. Their profitability ratio of 9% is pretty impressive too. Their 86% debt ratio wasn’t even that much of a worry since their interest coverage ratio of 1,000 percent indicates they could easily afford that high level of borrowing. Their powerful cash flow performance tells me that they could easily pay down that debt to a normal level if to choose to, and they are starting to do just that. With a p/e ratio of 17, this company has a lot going for it and is not too terribly expensive either. I think this one could easily be a part of a responsible investment portfolio.

Speaking of iconic American brands, let’s look at Sears now:

Sears Net Income is actually a Net Loss of $930million. Since operating cash flows are larger, a Net Loss of $303million is more positive, I have no reason to believe that Sears has falsely propped up their earnings. Why is that somehow funny? Still, $303million Operating cash outflow means that Sears core business is not generating wealth, it is consuming wealth and consuming, gulp, consuming lots of cash. If Sears can’t figure out how to make money from their core business activities they have no business being in business. The core reason for Sears to be a company is to make money and they are not doing it.

The company required $378million in capital expenditures to keep the business running, thereby more than doubling the damage of their operating cash outflows. They had to sell off some other long term assets to fund this shortfall, and they only keep selling off long term assets until they are all gone. This is unsustainable and unless corrected will lead the business to inevitable failure. In balance Sears brought in only $191 million in positive investing cash flows, so those asset sales didn’t quite cover the shortfall.

Total financing cash flows were a negative $27 million driving their cash balance down even further. Two financing cash flow line items are very worrisome. There is no way Sears can afford to pay $50 million in dividends. They are not earning anything, they are selling off assets, and yet they are putting themselves in an even worse position by giving away money to investors. Bad choice. They also repaid $311 million in loans at a time when they may be in need of borrowing even more. If lenders are requiring repayment they may also be reluctant to loan any more money to Sears. If this is the case, then the end for Sears is very near. That’s just a very sad thing.

Sears appears to be doing something right with their 200% asset turnover rate, indicating at least a company with some potential to be productive. It starts falling apart with their low 25% gross margin. From there, their Selling General & Operating expenses of $10.6 billion spend all $10.5 billion grow margin dollars leaving them no profitability and a Net Loss. This has been going on for quite some time Eroding their retained earnings balance until it stands now at under a billion dollars. This has contributed to their awfully high 86% debt ratio which puts them at high default risk. Their cash flow performance really spells doom for this company. Operations are consuming cash, selling off long term assets to fund that shortfall, creditors demanding repayment. The nail in the coffin? Sears continue to pay cash dividends to stockholders in a naïve attempt to appear that everything is under control. They’d better do something big soon. I would not think this stock should be a part of a responsible portfolio unless somebody heard a good turnaround plan that had a very strong purpose and plan behind it.

I do hope your company turns out better!!!

Chapter 14 Cash flows Reporting Form:

Report your company’s overall increase or decrease in cash as displayed in the cash account on the balance sheet from last year to this year.

________________ ̶ ________________ = _____________ Increase/Decrease


Report your company’s total operating cash flows:

Net Operating Activities Cash Flows $________________ Inflow/Outflow

Report detailed investing cash flows:

Capital Expenditures $________________ Inflow/Outflow

Investments and other $________________ Inflow/Outflow

Net Investing Activities Cash Flows $________________ Inflow/Outflow

Report financing cash flows:

Item Description

_______________ $________________ Inflow/Outflow

_______________ $________________ Inflow/Outflow

_______________ $________________ Inflow/Outflow

_______________ $________________ Inflow/Outflow

Net Financing Activities Cash Flows $________________ Inflow/Outflow

See interpretive questions that follow.

Compare Net income to Net Operating Activities Cash Flows. Report and label both numbers. Does the relation build or destroy trust in their accrual accounting reporting? Why and how?

Compare Net Operating Activities Cash Flows to Capital Expenditures. Report and label both numbers. Explain whether or not this this company can afford these asset purchases? Explain anything else important that is happening in this section, and interpret it to describe what management may be addressing in their actions.

Compare both Operating cash flows and Investing cash flows to the Net Financing Activities Cash Flows. Assess the balance between these three and advise on the company’s management of their financing cash flows.

Explain the overall increase or decrease in cash in just a few sentences that a non-accountant could understand. Use the numbers from your calculations. Tell the story of what management is doing to drive those cash flows.

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