Brief Review on Financial Statements and Cash Flow Analysis

Chapter 2
Business Finance
Dr. Bennett

Please note: I am not going to have you calculate operating cash flow or “cash flow from
assets” or any of these other figures on the test. But I do want you to understand this
chapter including the basics of the financial statements and what we are looking at with
cash flow and the cash flow identity. Business people are generally taught to look at
income whereas finance people are more interested in cash flow. Most of the time, we
simply look at EBITDA (which I will explain) but the figure “free cash flow” refines
EBITDA further by considering working capital and capital expenditures (CAPEX). I
don’t want you to get too heavily in the mechanics of the calculations or statement of cash
flows. I would like for you to develop a general understanding of the concept of “free cash
flow” and what it tells you. It is basically all the cash generated by the company that
doesn’t have some internal or external “claim” upon it.

https://www.investopedia.com/terms/f/freecashflow.asp

https://www.investopedia.com/ask/answers/111314/whats-difference-between-free-cash-
flow-and-operating-cash-flow.asp

Accounting is all about looking at the results of business and reporting on either a point in time
(snapshot balance sheet) or the recording the results of what happened in a period in terms of
revenue, expense, and profit (income statement). Accounting looks in the rear view mirror in
terms of where the company stands now and what happened relatively recently (i.e. the last
quarter or the last year). Finance is all about projecting future cash flows and making
decisions about the future in terms of making investments in various projects or entities
that will provide cash flow to the company. As such we are interested in cash flow
generated by the business. We are interested in sources and uses of cash. More
specifically, we are looking for cash to be generated by the operations or “projects”
initiated by the company, although a growing company can really eat cash. Cash usually
flows to either owners or creditors. In general, we would like for more cash to flow to
owners in the form of retained earnings and dividends and less cash to be eaten up by debt
payments. On the other hand, we have learned that debt is cheaper than equity financing
and by using leverage (utilizing creditor money to make more money for a smaller group of
equity owners), we can maximize the financial performance of the organization. All of this
is certainly a balancing act.

Accounting statements use “accrual” accounting to make sure statements are presented fairly and
more evenly over time. For example, you may pay cash for a piece of equipment this year but
your firm’s income statement will recognize the expense over the next several years via
depreciation expense. Even though depreciation is an expense which brings down your income,
it is not a use of cash (it is a non-cash expense) and depreciation is usable cash even though it
is counted as an expense under accrual accounting. This is why when we are considering the
cash available to service debt, we consider EBITDA which is “earnings before interest, taxes,
depreciation, and amortization.” Also, there are certain forms of income and expense that we
accrue even though we haven’t actually received or spent the cash.

Accounting looks through the “rear view mirror” whereas finance looks through the
“windshield.” With finance, we are making decisions about the investments, operations, and
management for the future. To do this, we need to understand CASH FLOW, among a lot of
other things.

Our accounting statements are the balance sheet, income statement, statement of retained
earnings, and cash flow statement. Accounting identity says that assets are equal to liabilities
plus owners’ equity. You hopefully remember from your accounting class that double entry
accounting insures that the balance sheet will always “balance.” If we make one entry, we must
make a balancing entry. We use debits and credits to insure that the balance sheet balances.

On the balance sheet, the various important categories are as follows:

1. Cash account (included in current assets).

2. Working capital accounts: current assets (usually cash, deposits, marketable securities,
accounts receivable, other receivables, and inventory) and current liabilities (usually
accounts payable, other payables, notes and other short-term loans payable within the
year, and the current portion/maturities of long-term debt (also due within one year).
3. Long-term capital assets: plant, equipment, real estate, vehicles, furniture and fixtures,
other property (net of depreciation)
4. Long-term liabilities (debt) of the company (usually long-term debt (bonds and loans
payable) with maturities/payments beyond the one-year time frame)
5. Ownership equity (stock investments sold, retained earnings, plus current earnings).

On the income statement, you start with revenue or total sales and subtract “costs of sales”
or “costs of goods sold” to get gross profit. From gross profit you subtract depreciation
expense, SG&A expenses (selling, general, and administrative expenses), and other
expenses to get income from operations or operating income. This gives you EBIT, which
is normally (along with operating cash flow and cash flow from assets) what finance people
are interested in.

Income is always a good place to start when looking at cash flow generated, but the problems
with net income are as follows:
1. Accrual accounting.
2. Noncash expenses.
3. We should consider interest expense as cash flow.

With proper adjustment, we get OCF, operating cash flow:

Operating cash flow = EBIT + depreciation - taxes

From a debt repayment standpoint, most bankers or debt analysts include taxes as operating cash
flow because if you think about it, debt payments are made before taxes are actually calculated,
but if you really want to gauge true cash flow (especially if you want to know what investors will
get back), taxes must be considered (so subtract them).

To gain insight into the operations and financing decisions of a company, we use the CASH
FLOW IDENTITY, which states that the net cash flow from assets is equal to the net cash
flow to creditors plus the net cash flow to owners. It is essentially saying that if assets equal
liabilities plus owners equity, then the net cash flow from and to each of these will equal as well.
I emphasize the word NET because we are constantly having cash flow going both ways in all
three of these items.

Cash flow from/to assets: shows the success or failure of how the company uses the assets
(operating and capital spending decisions) to generate cash inflow. Obviously, over time
this is going to have to be a huge source of cash. Referred to as “free cash flow.”

Cash flow from/to creditors: shows how the firm uses debt to finance the operations and
its repayment of the debt.

Cash flow from/to owners: shows any additional contributions by the owners or return of
capital to the owners

Here are the formulas if you want to give this a try:

First, the identity: cash flow from assets = net cash flow to creditors + net cash flow to
owners

CASH FLOW FROM ASSETS (sometimes referred to as “free cash flow”)

Cash flow from assets = operating cash flow - net capital (CAPEX) spending - change in
working capital (cash flow from assets is referred to as free cash flow)

Operating cash flow = EBIT (operating profit) + depreciation/amortization - taxes

Net capital spending = ending net fixed assets - beginning net fixed assets + depreciation

Change in net working capital = ending NWC - beginning NWC

Net working capital = current assets - current liabilities

CASH FLOW TO CREDITORS

Cash flow to creditors = interest expense - net new borrowing from creditors

Net new borrowing = ending long-term liabilities - beginning long-term liabilities

CASH FLOW TO OWNERS

Cash flow to owners = dividends - net new borrowing from owners

Net new borrowing from owners = change in equity

Change in equity = ending common stock and paid-in surplus - beginning common stock and
paid-in surplus

From a practical standpoint, we are trying to calculate how much net cash flow came from
operations and how much went back to creditors and how much went back to investors.
Clearly we want to generate as much cash flow as possible from operations, but there will
be years where a great deal is invested (new equipment, new computers, new building, new
locations, etc.). At some point this cash flow must turn positive in a BIG WAY or else all
the investment would not have been worth it. Oftentimes, analysts look at net cash flow
from assets (free cash flow) over a few years period or look at an average.

Let’s break down the cash flow of “Vermont Heritage” furniture company located in the Mini
Case on Page 53. You might want to work through this on your own and then compare to
my calculations. This will help you see where the numbers came from in calculated cash
flow. I am not going to have you do anything like this on a test, I just want your to
familiarize yourself with these concepts.
First, cash flow from assets = net cash flow to creditors + net cash flow to owners

CASH FLOW FROM ASSETS

Cash flow from assets = operating cash flow - net capital spending - change in working
capital

Operating cash flow = EBIT + depreciation - taxes

130.20 + 21.30 - 49.2 = 102.3

Net capital spending = ending net fixed assets - beginning net fixed assets + depreciation

(275.2 + 88.8) - (277 + 81.79) + 21.30 = 26.6

Change in net working capital = ending NWC - beginning NWC

Net working capital = current assets - current liabilities

(329.07 -31.0) - (329.7 - 34.27) = 298.07 -295.43 = 2.64

So, cash flow from assets = 102.3 - 26.6 - 2.64 = 73.06

Most analysts refer to “cash flow from assets” as “free cash flow,” and this term/figure is
used all the time in valuing businesses. It is basically the cash flow available to either pay
creditors or pay owners, something an investor would be very interested in.

So let’s look now how the cash flow from assets (free cash flow) was divided between creditors
and owners.
CASH FLOW TO CREDITORS (Notice a lot of debt was paid back)

Cash flow to creditors = interest expense - net new borrowing from creditors

Net new borrowing = ending long-term liabilities - beginning long-term liabilities

Cash Flow to Creditors = .8 - (3.2 +5.5) - (4.5 + 52.4)

.8 - (8.7-56.9) =

So Cash Flow to Creditors = .8 + 48.2 = 49

CASH FLOW TO OWNERS

Cash flow to owners = dividends - net new borrowing from owners

Net new borrowing from owners = change in equity

Change in equity = ending common stock and paid-in surplus - beginning common stock and
paid-in surplus

(In this case there is no change in equity (230-230) so cash flow to owners is simply dividends.
Cash flow to owners = 24.06

So, going back to our cash flow identity, cash flow from asssets should equal cash flow to
creditors plus cash flow to owners. 73.06=49 + 24.06

Luckily, in real life we already have these calculations done for us in the statement of cash
flows which we receive as part of the company financial statements. Free cash flow, the
number we are most interested in can be calculated by adding cash flow from operating
activities (OCF) and cash flow from investing activities (which is almost always a negative
number).

THE STATEMENT OF CASH FLOWS: The three sections of the cash flow identity all
contribute to the statement of cash flow, which is another kind of financial statement. An
annual report always includes a statement of cash flows prepared by the accountants. This
is something I always use when underwriting or reviewing a loan to a company.

Cash Flow from Assets (free cash flow)= Cash flow from operating activities + Cash flow
from investing activities. So if you go to page 39 and look at the statement of cash flows for
Battista Products, free cash flow is $6 billion (6,000 million) minus roughly $2.6 billion or
$3.4 billion.

Cash Flow from Creditors and Owners = Cash flow from Financing Activities

The three parts of the statement of cash flows are as follows:

A. Cash flow from operating activities

B. Cash flow from investing activities

C. Cash flow from financing activities

Cash flow from assets influence A and B above.

Cash flow to creditors and to owners influence C above.

So once again looking at Vermont Heritage.

Sources from operating activities = OCF – increase in current assets – decrease in current
liabilities

Sources (uses) from operating activities: 102.3 - 3.57 - 3.27 = 95.46 SOURCE

Operating Cash Flow: 102.3

Change in current assets

(other than cash) (268.10 - 271.67) = 3.57 increase (USE OF CASH
because this means we either increased accounts receivable, inventory or some other current
asset account)

Change in current liabilities. (34.27 - 31.00) = 3.27 decrease (USE OF CASH

because this means we either paid a creditor or a supplier)

Sources (uses) from investing activities = Capital Spending (Ending Net Fixed Assets –
Beginning Net Fixed Assets + depreciation)

(364 - 358.7) + 21.30= 26.6 USE

So, according to this cash flow statement calculation, free cash flow (cash flows from assets)
would be about $69 million. Free cash flow would be much larger, and very close to
EBITDA, if the company hadn’t paid back so much debt during the year.
Sources (uses) from financing activities = Interest Expense + Dividends + Decrease in
Long Term Debt + Decrease in Common Stock

.8 + 24.06 + 48.2 + 0= 73.06 USE

Net sources (uses) = 95.46 -26.6-73.06 = -$4.2 Change in Cash

Ending Cash $57.40 minus Beginning Cash $61.60 = -$4.2

Note: In my audio I mentioned that I missed the figure by about $4 million dollars. As you
can see what I failed to include in my initial calculation was the actual “change in cash”
during the year. You can tell that I am not an accountant! haha

Financial Performance Reporting: All publicly traded companies are required by the Securities
and Exchange Commission to disclose their financial statements in an annual report. The report
is provided to all owners as well as the SEC. We also call this the 10-K filing. Companies
must also file a quarterly report of earnings called the 10-Q. So three 10Q’s are filed per
year and one 10K (the latter is filed at the end of the company’s fiscal year). Companies
file 8K or 8Q to disclose material events such as an acquisition, big contract, loss of a major
customer, earnings guidance, etc. Firms us “Form 4” to disclose insider trading
transactions.

The SEC has a rule called “REG FD” (which stands for Regulation Fair Disclosure) which
requires that all “material” information about the company be released to the public/all
investors at the same time.