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Cash Flow Analysis
K.VISWANATHAN
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What is Cash flow and its analysis
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Cash flow is essentially the movement of money into and out of
any business; it's the cycle of cash inflows and cash outflows that
determine the business' solvency.
Cash flow analysis is the study of the cycle of the business' cash
inflows and outflows, with the purpose of maintaining an
adequate cash flow for the business, and to provide the basis for
cash flow management.Cash flow analysis involves examining the components of the
business that affect cash flow, such as accounts receivable,
inventory, accounts payable, and credit terms. By performing a
cash flow analysis on these separate components, we can moreeasily identify cash flow problems and find ways to improve the
cash flow of the business
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The How and why of Cash Flow analysis
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A quick and easy way to perform a cash flow
analysis is to compare the total unpaidpurchases to the total sales due at the end of
each month.
If the total unpaid purchases are greater thanthe total sales due, we need to spend more
cash than we receive in the next month,
indicating a potential cash flow problem.
A cash flow analysis of the accounts receivable
shows which customers are slow payers.
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Steps involved in Cash Flow Analysis
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This type of cash flow analysis is called cash budgeting
analysis. It is part of a firm's financial forecasting plan.Step 1: Cash inflow:
Determine the amount of cash that will flow into the
firm during the month.
If it is a starting business, we need to include thebeginning balance in cash that should be available
every month. There would also be the amount of sales
made/ to be made during the first month.
Sales would include both cash sales and sales that to
the customers who pay on credit.
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Steps involved in Cash Flow Analysis
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Deciding acceptable end balance
We expect the cash flow into the firm (Step 1) to be
greater than the cash that will flow out of the firm
(Step 2). Then we will have sufficient cash to operate
the firm. This can be calculated using a work sheet.
The ending balance for the first month becomes thebeginning balance for the second month. We may do
the same type of analysis. Each month, we may have to
add more items to the cash flow analysis as the
business grows.We need to decide what the minimum acceptable
ending cash balance for the firm and aim towards that
figure each month.
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Steps involved in Cash Flow Analysis
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What to do, if cash flow turns negative?
If the cash flow turns negative for any one month, we
may have to borrow money for that month from family
or friends, investors, or from a bank or other financial
institutions.
Then, when the cash flow turns positive the nextmonth, we can repay that loan.
We need to keep on doing this each month for the
entire forecasting period. We need to keep the
borrowing to a minimum and keep cash inflow greaterthan the outflows.
Cash budget is a financial forecasting document, so
we should follow it as closely as possible.
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Types of Cash Flows
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The (total) net cash flow of a company over a period
(typically a quarter or a full year) is equal to the change
in cash balance over this period:
-positive if the cash balance increases (more cash
becomes available),
-negative if the cash balance decreases.The total net cash flow is the sum of cash flows that are
classified in three areas: Operating, Financing and
Investing cash flows
1. Operating Cash Flows : Cash received or expendedas a result of the company's internal business activities.
It includes cash earnings plus changes to working
capital. Over the medium term, this must be net
positive if the company is to remain solvent.
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Types of Cash Flows
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2. Investment cash flows: Cash received from the sale
of long-life assets, or spent on capital expenditure
(investments, acquisitions and long-life assets).
3. Financing Cash Flows: Cash received from the issue
of debt and equity, or paid out as dividends, share
repurchases or debt repayments.Let us see how we can calculate them.
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Operating Cash flows
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Equation to calculate Operating cash flow :
EBIT (earnings before interest and taxes)+ Depreciation-
Taxes.
EBIT is also known as operating income.
This information can be found in a company's annual
report Operating cash flow is a solid measure of a
company's profits because it refers to actual cash made
from operations and is thus hard to manipulate.
Operating cash flow is important since a companycould be bringing in tons of money but still be
struggling to pay its bills.
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Operating Cash flows
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Looking at operating cash flow will show us whether
a company is burning more money than it is earning.
Operating cash flow is a good at-a-glance snapshot
of how the business is doing. Positive cash flow is a
good sign, while negative cash flow needs to have a
one-time explanation (an investment or expense thatwill not be repeated; for example, an acquisition or a
new factory).
If a company's cash flow has been negative for years,
or if its cash flow is steadily decreasing, this is awarning sign that means we need to dig deeper before
making any type of investment in the company.
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Operating Cash flows
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In recent years, cash flow has gained in popularity as a
financial measure because it is more difficult to
manipulate than certain other metrics, such as revenues.
A company could make its revenues look bigger by, for
example, postponing rebates (which would lower
revenues) until the next reporting period, thus creating
the appearance of a business that's more prosperous
than it really is.
However, because operating cash flow deals with
actual money, it's much harder for a company to
"massage the numbers" into saying what management
wants them to say.
That is why it is such a key financial metric, despite its
seeming simplicity.
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Operating Cash flow- Example
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OCF= Net Income + Depreciation - Amount by which Net
Working Capital Changes (latter in symbols: NWC)
= 487 + 65 - NWCNWC changes EXCLUDING
Cash
= 552 - NWC Marketable Securities
Current Portion (CurrentMaturities) of Long Term Debt
We can remember a simple formula to link the three major
working capital accounts to change in net working capital:
NWC = AR(Accounts Receivable) + I (Inventory) - AP
(Accounts Payable
= (600-400) + (350-250) - (250-175)
= (200) + (100) - (75)
= 300 - 75
= 225
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Investing Cash flows
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What is an investing cash flow?
An item on the cash flow statement that reports the aggregate
change in a company's cash position resulting from any gains (orlosses) from investments in the financial markets and operating
subsidiaries, and changes resulting from amounts spent on
investments in capital assets such as plant and equipment.
When analyzing a company's cash flow statement, it isimportant to consider each of the various sections which
contribute to the overall change in cash position.
In many cases, a firm may have negative overall cash flow for a
given quarter, but if the company can generate positive cash flow
from its business operations, the negative overall cash flow may
be a result of heavy investment expenditures, which is not bad .
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Using cash flow for investment decisions
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An example:
A firm is deciding on investing in an energyefficiency system. Two possible systems are
under investigation
One yields quicker results in terms ofenergy savings than the other, but the
second may be more efficient later
Which should the firm invest in?
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Using cash flow for investment decisions
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Discounted Cash Flow System A
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Using cash flow for investment decisions
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Discounted Cash Flow System B
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Using cash flow for investment decisions
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System A represents the better
investment
System B yields the same return after six
years but the returns of System A occur
faster and are worth more to the firm than
returns occurring in future years even
though those returns are greater
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Financing Cash flows
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Those activities that result in changes in size and composition
of owners capital and borrowing of the organization.
It includes receipts from issuing shares, debentures, bonds,borrowing and payment of borrowed amount, loan etc.
Sale of share
Buy back of shares
Redemption of preference shares
Issue / redemption of debentures
Long term loan / payment thereof
Dividend / interest paid
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Financing Cash flows
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The formula for cash flow from financing activities is
as follows:
Cash Received from Issuing Stock or Debt - Cash Paidas Dividends and for Re-Acquisition of Debt/Stock
Negative numbers can mean the company isservicing debt
But it can also mean the company is makingdividend payments and stock repurchases, whichinvestors might be glad to see.
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Cash Flows and life cycle state of a company
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Under Discounted Cash Flow Method, we come acrosstwo major states of the company in its life cycle :1. The first one is the period when the company is in
its active growth phase. In this phase, normally thecompany will have to be extremely careful andcalculative about the management of all its cashflows.
2. The second state represents the period when thecompany is supposed to have attained steadiness
and the further growth of the company is more orless steady. By now, the companys system ofmanaging the cash flows should have becomesteady.
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Cash Flows and life cycle state of a company
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During the first state- i.e the growth phase, thecash flows have to be monitored carefully. The
following should be ensured:1. Enough cash flows should be available to continue
with the process of operations- payment for rawmaterials / inventory , salary to workers, paymentof interest on borrowings etc. The inflows fromsales / services provided should be meticulouslymonitored to receive them in a timely manner.
2. All investments to be carefully considered, beforemaking them. Each investment should be appraised
to ensure that the ROI is greater than cost of funds3. There will be more financial cash inflows thanoutflows during this period.
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Cash Flows and life cycle state of a company
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During the second state- i.e the consolidated phase,the cash flows have to be continued as predicted.
1. Continuance of operations has to be ensured. Enoughcash flows to be available to continue with the processof operations. Adequate systems to be in place by thistime to ensure meticulous monitoring of the inflowsand out flows in a timely manner.
2. More investments could be needed to replace existingfixed assets. There could also be adequate cash flowsfrom the sale of old investments. All new investmentsto be carefully considered, before making them-toensure that the ROI is greater than cost of funds.
3. The Company also could go for repayment of its debtand increase of equity. Non cash flows like bonusshares may be there. The company may also go forconsolidation of its control by purchase of its ownshares.
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Cash Flows and Financial flexibility
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Management of cash flows is nothing butmaintenance of the financial flexibility ofthe company.
The cash flows-both inward and outward-
should be adequate and timely. There is nopoint in keeping the company rich, if it isunable to meet, for example, its day to dayoperational commitments.
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Cash Flows and Dividend Policy
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Cash flows happen mainly from revenue / sales.
Cash flows are also impacted by the Dividend policyof the company, which determines the amount ofearnings to be retained in the company for its futuregrowth and the amount to be distributed by way ofdividend.
The company cannot follow the policy ofdistribution of all its net earnings as dividend. It alsocannot follow the policy of retaining all its netearnings. So a prudent policy in terms of the
industry, in which the company operates as well asthe financial strength of the company needs to befollowed.
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Some suggestions to improve Cash Flows and
Financial flexibility
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We should take a look at a 2 months cash budgetgoing forward.
We should take a look on a week-by-week basis,roughly a month to a quarter out in the future, andput down what we expect to receive and whatpayments we actually expect to make.
Though it sounds simple, a lot of companies dontdo that.
If we look at the historical business from last month
or last year, thats an indicator of the ability of thecompany to be profitable. Hence when we are ableto match the cash in and cash out, it can beenlightening.
i i h l d
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Some suggestions to improve Cash Flows and
Financial flexibility
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We should be more aware of the sources and uses
of cash in the balance sheet and working capitalaccounts. Three primary issues to be considered here:1. Appropriately managing the accounts receivable,
which includes preparing bills faster for customers.
When economic times are better, some companiesmay go a week or two at a time without preparingand sending bills because the cash flow is not quiteas important. But now a days it is becoming moreimportant to prepare and collect the cash faster
2. The second component is inventory. Having a lot ofcash tied up in the inventory can be a constraint onthe company. We need to limit the amount of timethat cash is tied up in inventory. (Economic Order
Quantity)
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Some suggestions to improve Cash Flows and
Financial flexibility
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3. The third item is accounts payable and how slowlyor quickly the company pays its vendors. If thecompany has the ability to wait a little bit longerwithout impairing its credit standing with them, thatcan ultimately be a source of cash.
Another way is to have a close look at the items,considered under cash flow. Some of the traditionalcompanies will look at their net income, add backnon-cash items like depreciation and include themin their cash flow. But we need to be more realisticin doing it and do it only when warranted.
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Some suggestions to improve Cash Flows and
Financial flexibility
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How can the companys budget be made flexible forany unexpected receipts of expenditures?
The idea is to keep it on a rolling basis. The better way
is to look at it weekly, so that the company can better
account for the things, not originally planned. Suppose they need to pay for something else, they
can look out over four to six weeks ahead and find if
some vendor credit terms can allow them to delay the
payment of an item for a week. This way they can
manage their short-term future much better. Constantly
updating it allows the firm to be flexible.
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Why should you improve your cash flow?
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Ultimately, its not a lack of profitability that
causes problems for a company but a lack of
liquidity.
People talk about the five Cs of credit(character,
capacity, capital, collateral and conditions), but the most
important C is cash-i.e .Capital.
Liquidity is either cash or the companys abilityto turn their assets into cash quickly. Without
this, the company can have a hard time making
its payroll, paying its bills, etc.
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Benefits of improving your cash flow
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On improving cash flow, the first thing the
company achieves is financial flexibility.When the company is as efficient as it can be,
that gives them the ability to reduce leverage and
not carry a big debt load.It allows them to be in a better position during
a period of time when revenue drops or general
economic conditions are tough.
Thus financial flexibility buys the company the
required time during those tough circumstances
to tide over the hardships.
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THANK YOU
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Cash Flow Analysis
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