Types of Cash Flow

You’d think a cash flow statement would be easy to read. Since cash is real money, there are no assumptions and estimates incorporated in the numbers. Cash coming in is a positive number, cash going out is a negative one, and net cash is simply the sum of the two. In fact, though, we find that nearly every nonfinancial manager takes a while to understand a cash flow statement. One reason is that it is always divided into categories, and the labels on the categories can be confusing. A second reason is that the positives and the negatives aren’t always clear. (A typical line item might say, “(increase)/decrease in accounts receivable”, followed by a positive or negative number. Is it an increase or a decrease?) A final reason is that it can be tough to see the relationship between the cash flow statement and the other two financial statements.

I’ll take up the last issue in the following lesson. Right now, let’s just sit down with a cash flow statement and learn the basic vocabulary.

Types of Cash Flow

The statement shows the cash moving into a business, called the inflows, and the cash moving out of a business, called the outflows. These are divided into three main categories.

Cash From or Used in Operating Activities

At times you’ll see slight variations to this language, such as “cash provided by or used for operating activities”. Whatever the specifics, all of this is more accountant-speak: too many accountants can’t say, “operations”, they have to say, “operating activities”. But whatever the exact language, this category includes all the cash flow, in and out, that is related to the actual operations of the business. It includes the cash customers send in when they pay their bills. It includes the cash the company pays out in salaries, to vendors, and to the landlord, along with all the other cash it must spend to keep the doors open and the business operating.

Cash From or Used in Investing Activities

Note that investing activities here refers to investments made by the company, not by its owners. The biggest subcategory here is cash spent on capital investments – that is, the purchase of assets. If the company buys a truck or a machine, the cash it pays out shows up on this part of the statement. Conversely, if the company sells a truck or a machine (or any other asset), the cash it receives shows up here.

Cash From or Used in Financing Activities

Financing refers to borrowing and paying back loans, on the one hand, and transactions between a company and its shareholders on the other. So, if a company receives a loan, the proceeds show up in this category. If a company gets an equity investment from a shareholder, that too shows up here. Should the company pay off the principal on a loan, buy back its own stock, or pay a dividend to its shareholders, those expenditures of cash also would appear in this category.

You can see right away that there is a lot of useful information in the cash flow statement. The first category shows operating cash flow, which in many ways is the single most important number indicating the health of a business. A company with a consistently healthy operating cash flow is probably profitable, and it is probably doing a good job of turning its profits into cash. A healthy operating cash flow, moreover, means that it can finance more of its growth internally, without either borrowing or selling more stock.

The second category shows how much cash the company is spending on investments in its future. If the number is low, relative to the size of the company, it may not be investing much at all; management may be treating the business as a “cash cow”, milking it for the cash it can generate while not investing in future growth. If the number is high, relatively, it may suggest that management has high hopes for the future of the company. Of course, what counts as high or low will depend on the type of company it is. A service company, for instance, typically invests less in assets than a manufacturing company. So, your analysis has to reflect the big picture of the company you’re assessing.

The third category shows to what extent the company is dependent on outside financing. Look at this category over time, and you can see whether the company is a net borrower (borrowing more than it is paying off). You can also see whether it has been selling new shares to outside investors or buying back its own stock.

Finally, the cash flow statement allows you to calculate Warren Buffett’s famous “owner earnings” metric.

Wall Street in recent years has been focusing more and more on the cash flow statement. As Warren Buffett knows, there is much less room for manipulation of the numbers on this statement than on the others. To be sure, “less room” doesn’t mean “no room”. For example, if a company is trying to show good cash flow in a particular quarter, it may delay paying vendors or employee bonuses until the next quarter. Unless a company delays payments over and over, however – and eventually, vendors who don’t get paid will stop providing goods and services – the effects are significant only in the short term.

The Power of Understanding Cash Flow

First, knowing your company’s cash situation will help you understand what is going on now, where the business is headed, and what senior management’s priorities are likely to be. You need to know not just whether the overall cash position is healthy but specifically where the cash is coming from. Is it from operations? That’s a good thing – it means the business is generating cash. Is investing cash flow a sizeable negative number? If it isn’t, it may mean that the company isn’t investing in its future. And what about financing cash flow? If investment money is coming in, that may be an optimistic sign for the future, or it may mean that the company is desperately selling stock to stay afloat. Looking at the cash flow statement may generate a lot of questions, but they are the right ones to be asking. Are we paying off loans? Why or why not? Are we buying equipment? The answers to those questions will reveal a lot about senior management’s plan for the company.

Second, you affect cash. As I’ve said before, most managers focus on profit, when they should be focusing on both profit and cash. Of course, their impact is usually limited to operating cash flow – but that’s one of the most important measures there is. For instance:

·       Accounts receivable. If you’re in sales, are you selling to customers who pay their bills on time? Do you have a close enough relationship with your customers to talk with them about payment terms?[1] If you’re in customer service, do you offer customers the kind of service that will encourage them to pay their bills on time? Is the product free of defects? Are the invoices accurate? Does the mail room send invoices timely? Is the receptionist helpful? All these factors help determine how customers feel about your company, and indirectly influence how fast they are likely to pay their bills. Disgruntled customers are not known for prompt payments – they like to wait until any dispute is resolved.

·       Inventory. If you’re in engineering, do you request special products all the time? If you do, you may be creating an inventory nightmare. If you’re in operations and you like to have lots in stock, just in case, you may be creating a situation in which cash is just sitting on the shelves, when it could be used for something else. Manufacturing and warehouse managers can often reduce inventory hugely by studying and applying the principles of “lean” enterprise, pioneered at Toyota.

·       Expenses. Do you defer expenses when you can? Do you consider the timing of cash flow when making purchases? Obviously, I’m not saying it’s always wise to defer expenses; it’s just wise to understand what the cash impact will be when you do decide to spend money, and to take that into account.

·       Giving credit. Do you give credit to potential customers too easily? Alternatively, do you withhold credit when you should give it? Both decisions affect the company’s cash flow and sales, which is why the credit department always has to strike a careful balance.

The list goes on. Maybe you’re a plant manager, and you are always recommending buying more equipment, just in case the orders come in. Perhaps you’re in IT, and you feel that the company always needs the latest upgrades to its computer systems. All these decisions affect cash flow, and senior management usually understands that very well. If you want to make an effective request, you need to familiarise yourself with the numbers that they are looking at.

Third, managers who understand cash flow tend to be given more responsibilities, and thus tend to advance more quickly, than those who focus purely on the income statement. In the following part, for instance, you’ll learn to calculate ratios such as days sales outstanding (DSO), which is a key measure of the company’s efficiency in collecting receivables. The faster receivables are collected, the better a company’s cash position. You could go to someone in finance and say, “Say, I notice our DSO has been heading in the wrong direction over the last few months – how can I help turn that around?” Alternatively, you might learn the precepts of lean enterprise, which focuses on (among other things) keeping inventories to a minimum. A manager who leads a company in converting to lean thereby frees up huge quantities of cash.

But my general point here is that cash flow is a key indicator of a company’s financial health, along with profitability and shareholders’ equity. It’s the final link in the triad, and you need all three to assess a company’s financial health. It’s also the final link in the first level of financial intelligence.

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[1] There is an argument to be made, though, that it may not be desirable for your salespeople to discuss payment terms with customers in case they alienate them (except, of course, in negotiating contracts). In a “good cop, bad cop” situation, your salespeople always play “good cop” and leave the “bad cop” part to credit control.

The Power of Financial Ratios

Ratios indicate the relationship of one number to another. People use them every day. A football player’s scoring rate per matches played, that is, how many goals scored for a given number of games. The odds of winning a lottery jackpot, say one in 6 million, show the relationship between winning tickets sold (1) and total tickets sold (6 million). Ratios don’t require any complex calculations. To figure a ratio, usually, you just divide one number by another and then express the result as a decimal or as a percentage.

All kinds of people use all kinds of financial ratios in assessing a business. For example:

·       Bankers and other lenders examine ratios such as debt-to-equity, which gives them an idea of whether a company will be able to pay back a loan.

·       Senior managers watch ratios such as gross margin, which helps them be aware of rising costs or inappropriate discounting.

·       Credit managers assess potential customers’ financial health by inspecting the quick ratio, which gives them an indication of the customer’s supply of ready cash compared with its current liabilities.

·       Potential and current shareholders look at ratios such as price-to-earnings, which help them decide whether a company is valued high or low by comparison with other stock (and with its own value in previous years).

The ability to calculate them – to read between the lines of the financials, so to speak – is a mark of financial intelligence. Learning about ratios will give you a host of intelligent questions to ask your boss or CFO. And, of course, I’ll show you how to use them to boost your company’s performance.

The power of ratios lies in the fact that the numbers in the financial statements by themselves don’t reveal the whole story. Is net profit of $10 million a healthy bottom line for a company? Who Knows? It depends on the size of the company, on what net profit was last year, on how much net profit was expected to be this year, and on many other variables. If you ask whether a $10 million profit is good or bad, the only possible answer is the one given by the woman in the old joke. Asked how her husband was, she replied, “Compared to what?”

Ratios offer points of comparison and thus tell you more than the raw numbers alone. Profit, for example, can be compared with sales, or with total assets, or with the amount of equity shareholders have invested in the company. A different ratio expresses each relationship, and each gives you a way of gauging whether a $10 million profit is good news or bad news. As we’ll see, many of the different line items on the financials are incorporated into ratios. Those ratios help you understand whether the numbers you’re looking at are favourable or unfavourable.

What’s more, the ratios themselves can be compared. For instance:

·       You can compare ratios with themselves over time. Is profit relative to sales up or down this year? This level of analysis can reveal some powerful trend lines – and some big warning flags if the ratios are headed in the wrong direction.

·       You can also compare ratios with what was projected. To pick just one of the ratios we’ll be examining in this part, if your inventory turnover is worse than you expected it to be, you need to find out why.

·       You can compare ratios with industry averages. If you find that your company’s key ratios are worse than those of your competitors, you definitely want to figure out the reason. To be sure, not all the ratio results we discuss will be similar from one company to another, even in the same industry. For most, there’s a reasonable range. It’s when the ratios get outside of that range, as Sunbeam’s DSO did, that its worth your attention.

There are four categories of ratios that managers and other stakeholders in a business typically use to analyse the company’s performance: profitability, leverage, liquidity, and efficiency. I will give you examples in each category. Note, however, that many of these formulas can be tinkered with by the financial folks to address specific approaches or concerns. Tinkering of this sort doesn’t mean that anyone is cooking the books, only that they are using their expertise to obtain the most useful information for particular situations (yes, there is art even in formulas). What I will provide are the foundational formulas, the ones you need to learn first. Each provides a different view – like looking into a house through windows on all sides.

First, do no harm

 To employees

To stakeholders

 

To the community

 

To the government and institutions and laws and rules

 

To the environment…

 

Thereafter, the sky is the limit

Risk Analysis

Risk Assessment Process and Analysis

There is, of course, no return without risk. There is a tendency in investment project modelling to believe that the cash flows from investment models are somehow “real”. The inputs for the model may or may not occur, and, at best, are a considered estimate of what might happen two or more years into a project time span.

Since finance theory teaches that rational people are risk averse, then the next stage of the exercise should be to include in the model techniques for estimating the risk and uncertainty. The model should be tested to see how likely the organisation is to achieve the desired net present value. The upsides may not be a problem, but management needs to assess the possibility of lower than anticipated returns. Again, following theory, if the project earns a lower rate than the cost of capital, then the shareholder value in the company diminishes.

Two types of risk can be identified:

·       Project risk. Which is the variability of the project return.

·   Corporate risk. Since management need to invest in a mixture of projects, which have varying degrees of risk and potential return.

Risk could also be split into two categories:

·       Risk. Which can be described and quantified using some of the techniques in this lesson.

·       Uncertainty. Which can be described as random events.

Sources of risk and uncertainty could include one or more of the following:

·       Commercial and administration.

·       Competitive responses leading to reduced demand.

·       Market shifts, especially with new technology.

·       Financial – liquidity, profitability, and financial structures.

·       Knowledge and information dissemination.

·       Legal issues.

·       Currency issues, both on the supply and sales sides.

·       Partners, suppliers and subcontractors.

·       Political events in home and overseas markets (for instance, Brexit, President Trump impeachment, and so on).

·       Health emergencies (for instance, Covid-19, Ebola, HIV/AIDS).

·       Economic cycles and the effect on demand and prices.

·       Quality issues leading to reduced sales.

·       Resource availability leading to lower production.

·       Technical ability of company.

·       Innovation, copyright and the availability of new technologies.

·       Management competence and drive.

Project risk is related to corporate risk since the latter will change if management invests in risky projects.

Financial Planning and Investments

Many of the financial decisions that individuals have to make in their personal lives - choosing a mortgage, investing in their savings, planning for retirement - require using financial models. In this blog I illustrate additional applications of the time value of money concept and also involve inflation and taxation.

Inflation

Inflation is one of the key factors that has to be incorporated in many models for making personal finance decisions, especially when long-term planning is involved. If you are saving money to buy a car three years from now, inflation may not be an important factor. But if you are 30 now, plan to retire at age 65, and expect to live until you are 90, inflation must be factored into the models you use. For example, it is impossible for any of us to guess how much we will need in nominal Rands per year during retirement - it may be 35 years away! However, we may be able to say more comfortably that we will need in today’s Rands (also called constant Rands or buying power) an amount equal to 80% of our current expenses.

Long-term planning has to be done in one of two ways. We can do the analysis in constant or real Rands, but then we cannot reflect taxes realistically because taxes have to be paid on nominal rand income and investment returns, not on real rand amounts. Alternately, we can do all calculations in nominal Rands but carefully reflect in them the impact of anticipated inflation.

Taxes

We generally have to factor in three types of taxes into our models: income taxes, taxes on dividends (if any), and taxes on capital gains.

Income taxes apply to wages, salaries, and other income, as well as most interest income (except where there may be exemptions, for example on savings or certain bonds). This tax is charged at different rates depending on one’s income level or tax bracket. Unless you want to calculate income taxes in detail by taking into consideration different rates for different tax brackets, you should generally use the marginal tax rate in your models.

Capital gains are defined as the appreciation in the value of an investment asset. One important point to keep in mind is that capital gains taxes have to be paid only when the asset is sold (unless there are applicable exemptions, for example on your primary home); until then no taxes have to be paid, even if the asset’s value keeps growing. When we buy and sell assets over time in tranches, the calculation of the capital gains taxes can get somewhat complicated.

In building models, you have to know whether you are dealing with taxable accounts, tax-deferred accounts, or tax-free accounts. Sometimes you can develop models that will work for both taxable and tax-deferred or even tax-free accounts. For taxable applications, the user has to input the appropriate tax rate, and for tax-deferred and tax-free applications the user will set the tax rates to zero. However, not all models can be built with this flexibility, and you should always document any tax-related limitation a model.

Reinvestment Income

Many stocks pay dividends, and most fixed income investments (for example, bonds) provide ongoing interest income. Unless these investments are in tax-deferred accounts, we have to pay taxes on these returns before reinvesting the funds at rates available at that time. Because the taxes and the reinvestment rates we assume can significantly affect actual returns earned over time, our models should explicitly incorporate them and let the user specify the tax rates as well as reinvestment rates.

Structuring Portfolios

For long-term investment success, it is essential that an investor creates and maintains a properly structured portfolio. A portfolio is generally structured at three levels.

First, the investor has to choose the broad asset classes (for example, stocks, bonds, etc.) in which to invest and decide how much of the portfolio to invest in each asset class. That is generally called the portfolio’s asset allocation. Studies have shown that a portfolio’s asset allocation has the largest impact on its long-term return.

Second, the investor has to choose within each asset class the categories of securities in which to invest. For stocks, the categories may be large-cap stocks, small-cap value stocks, and so on. For bonds, these may be short-term bonds, long-term bonds, foreign bonds, and so on. The investor must then decide what percentage of his allocation to each asset class he wants to allocate to each category within that class.

Third, within each category of securities the investor has to choose specific securities and mutual funds and decide how much to invest in each of them. To make this decision, the investor will probably start with a select list of stocks of funds in each category and then do an allocation among them.

Although both financial theory and analysis of historical data provide some guideline for portfolio structuring, there is quite a bit of leeway in choosing the allocation at each level. There is no perfect answer, and even for the same person the “right” portfolio will change over the years as family circumstances change (for example, children finish college, the person approaches retirement, and so forth). Although most people think they should adjust their portfolios at least periodically in response to changing market outlook, market history shows that no one can reliably predict what the market will do in the future and which stocks will do better than others over the years. Contrary to what most people believe, then, the structure and holdings of a portfolio should not be influenced much by anyone’s views on the market outlook.

A Step-By-Step Guide to Analysing Capital Expenditures

You’ve been talking with your boss about buying a new piece of equipment for the plant, or maybe mounting a new marketing campaign. He ends the meeting abruptly. “Sounds good”, he says. “Write me up a proposal with the ROI and have it on my desk by Monday”.

Don’t panic, here’s a step-by-step guide to preparing your proposal.

A.     Remember that ROI means “return on investment” – just another way of saying, “Prepare an analysis of this capital expenditure”. The boss wants to know whether the investment is worth it, and he wants calculations to back it up.

B.     Collect all the data you can about the cost of the investment. In the case of a new machine, total costs would include the purchase price, shipping costs, installation, factory downtime (while installation occurs), debugging, and so on. Where you must make estimates, note that fact. Treat the total as your initial cash outlay. You will also need to determine the machine’s useful life, not an easy task (but part of the art I enjoy so much!) You might talk to the manufacturer and to others who have purchased the equipment to help you answer the question.

C.     Determine the benefits of the new investment, in terms of what it will save the company or what it will help the company to earn. A calculation for a new machine should include any cost savings from greater output speed, less rework, a reduction in the number of people required to operate the equipment, increased sales because customers are happier, and so on. The tricky part here is that you need to figure out how all these factors translate into an estimate of cash flow. Don’t be afraid to ask for help from your finance department – they are trained in this kind of thing and should be willing to help.

D.    Find out the company’s hurdle rate (remember, this is the interest rate you will use to discount the future cash flows) for this kind of investment. Calculate the net present value of the project using this hurdle rate.

E.     Calculate payback and internal rate of return as well. You’ll probably get questions about what they are from your boss, so you need to have the answers ready.

F.     Write up the proposal. Keep it brief. Describe the project, outline the costs and benefits (both financial and otherwise), and describe the risks. Discuss how it fits with the company’s strategy or competitive situation. Then give your recommendations. Include your NPV, payback, and IRR calculation in case there are questions about how you arrived at your results.

Managers sometimes go overboard in writing up capital expenditure proposals. It’s probably human nature: we all like new things, and it’s usually pretty easy to make the numbers turn out so that the investment looks good. But I advise conservatism and caution. Explain exactly where you think the estimates are good and where you think they may be shaky. Do a sensitivity analysis, and show (if you can) that the estimate makes sense even if cash flows don’t materialise at quite the level you hope. A conservative proposal is one that is likely to be funded – and one that is likely to add the most to the company’s value in the long run.