2CASH FLOW OBJECTIVES Traditional, or EBITDA cash flow. Accrual cash flow. Sources and uses of cash flow. FASB 95. (History of financial statements) DIRECT/INDIRECT Methods. (Top down/bottom up) UCA CASH FLOW (Uniform Credit Analysis from RMA) CONTRACTOR’s cash flow. GLOBAL cash flow. SHORT TERM cash flow and repayment. LONG TERM cash flow and repayment. RECAP.
3CASH FLOW OBJECTIVES (Continued) There are three types of cash flow that weare going to discuss today:1) TRADITIONAL CASH FLOW.2) ACCRUAL CASH FLOW. (And as a subset ofaccrual cash flow we will take a quick look at contractor’scash flow).3) GLOBAL CASH FLOW.
4TRADITIONAL CASH FLOW What is traditional cash flow? Traditional cash flow is often referred to as “EBITDA”or some form of “EBITDA” (EBIT, EBIDA). “EBITDA” is an acronym for Earnings Before Interest,Taxes, Depreciation, and Amortization. EBITDA cash flow is easily obtained from reviewingfinancial statements and spreads. See exhibit 1 for an example of traditional cash flow.
5TRADITIONAL CASH FLOW Traditional cash flow is a cursory review of acompany’s operations. While it is areasonable measure of profitability it hasserious shortcomings as a cash flowmeasure. What do you think are some of thoseshortcomings?
6TRADITIONAL CASH FLOW SHORTCOMINGS INCLUDE:1) It is a pretax measure of debt service coverage.2) It does not consider quality of earnings or impactfrom dividends.3) It does not consider fixed asset expenditures(either for maintaining or expanding operations).4) It does not consider working capital needs or theirimpacts. In general, it fails (for the most part) to incorporatethe balance sheet.
TRADITIONAL CASH FLOW OTHER CONSIDERATIONS: Net profits do not repay loans. Sales are considered income whether or not cashhas been collected (e.g. how much of sales are A/R?) COGS may include the cost of materials that havenot yet been paid for. In essence, timing differences are not consideredwhen EBITDA is used.7
8TRADITIONAL CASH FLOW If traditional cash flow has so manyshortcomings, why is it used?1) EBITDA is a common language that theborrower and lender can agree upon.2) It’s a “quick and dirty” method lenders canuse while in the customer’s presence.3) The methodology of EBITDA cash flowallows the lender to set understandablecovenants that can be applied by theborrower. (i.e. application is easier).
9ACCRUAL CASH FLOW In order to remedy the shortcomings oftraditional cash flow, the lender can turn toaccrual cash flow. (Typically UCA cash flow.) Accrual cash flow allows the lender tointegrate balance sheet changes withoperating results. In order to understand accrual cash flow, thelender must have a firm grasp of cashsources and uses.
10ACCRUAL CASH FLOWSOURCES AND USES The following information indicates when a cash source or useoccurs.SOURCES USESASSETS ASSETSLIABILITIES LIABILITIESEQUITY EQUITY Sources of funds can be summarized by the acronym DAILIE. DAILIE = Decline in Assets, Increase in Liabilities, Increase inEquity = Sources of funds. Remember that income increases equity while expensesdecrease equity. HINT: Consider a personal loan transaction if you are everconfused by sources and uses.
11ACCRUAL CASH FLOWMETHODS For those of you who have been in banking a limited time,accrual cash flow is a relatively recent phenomenon, gaining inimportance over the last 25 years. History of financial statements. FASB 95, which went into effect in 1988 is the precursor for themodern cash flow statement. FASB 95 required that cash flow reporting be standardized tosegregate cash flow into three groups: OPERATING activities,INVESTING activities and FINANCING activities. FASB 95 also required firms to report cash flow by either thedirect or indirect methods.
ACCRUAL CASH FLOWMETHODS OPERATING ACTIVITIES – Focused on the current portion of thebalance sheet and costs/expenses affecting net income. EXAMPLES: The purchase and sale of inventory, collection ofreceivables, and payment of operating expenses. INVESTING ACTIVITIES - Buying and selling of noncurrent assets. EXAMPLES: Acquire property plant or equipment, purchase a businessor invest in another company, lending money to affiliates (due from’s) oroutside third parties (investments). FINANCING ACTIVITIES – Debt and equity financing activities. EXAMPLES: Obtain loans or reduce principal on loans. Obtain additional equity capital or pay dividends.12
13ACCRUAL CASH FLOWMETHODS Both cash flow methods (DIRECT AND INDIRECT) list cash flow byoperating, investing and financing activities. (see exhibits 3 & 4) The indirect method is more cumbersome starting with net income andreconciling to cash. The direct method provides a better breakdown of operating receiptsand expenses, and is closer to what bankers use today. It starts withsales/revenues and reconciles to cash. So which do bankers use? The answer is neither (well almost). Mostbanks use “UCA cash flow” developed by RMA and presented via mostfinancial spreading software. UCA is an acronym for Uniform CreditAnalysis. It is popular with bankers because it eliminates the confusionof the indirect method and it provides more cash detail than the directmethod (although it closely mirrors the direct method in many ways).See exhibit 3 which reflects the UCA cash flow for the same companythat we looked at earlier. On exhibit 3 calculate the UCA cash flow for2011. We will pause here while you calculate the 2011 UCA cash flow.
14ACCRUAL CASH FLOWSUMMARY Notice the difference between the traditional cash flow and theaccrual cash flow. The difference arose from balance sheetchanges. Receivables, payables and accruals were all cashuses in 2011 for this company. (Exhibits 1 AND 3.) EBITDA equaled +$784K, while net cash after operations toservice debt was a negative ($X,XXX K). The differencebetween the two numbers = $X,XXX K. As a final note, the difference in cash flow of $X,XXXK does notinclude investing and financing activities. Investing activitiesconsumed another $357K in cash while financing activitiesprovided $1,022K to support the company’s cash needs.
15CONTRACTOR’S CASH FLOWA BRIEF OVERVIEWPlease refer to exhibits 5,6, and 7.FUTURE CASH INFLOW (000’S) FYE 09 FYE 10 INFO FROM?Total Contracts $9,913 $ WIP reportLess: Billed to Date $4,908 $ WIP reportRemaining to be billed $5,005 $Plus: Receivables $ 184 $ Balance sheetTotal Future Cash Flow $5,189 $FUTURE CASH OUTFLOW (000’s)Total Estimated Costs $7,658 $ WIP reportLess: Cost incurred to date $3,708 $WIP reportRemaining to be spent $3,950 $Plus: Accounts Payable/Accruals $ 783 $ Balance SheetDeferred Income Taxes $ 0 $ Balance SheetTotal Future Cash Outflow $4,733 $NET CASH INFLOW $ 456 $OPERATIONAL OVERHEADLess: CMLTD $ 64 $ Balance SheetLess: Interest Expense $ 67 $ Inc. StatementLess: Operating Expenses $ 1,354 $ Inc. StatementTotal Additional Outlays $1,485 $OVERHEAD COVERAGE 3.68 mths x.xx mths NCI/(op.exp/12)
16CONTRACTOR’S CASH FLOWA BRIEF OVERVIEWPlease refer to exhibits 5,6, and 7.FUTURE CASH INFLOW (000’S) FYE 09 FYE 10 INFO FROM?Total Contracts $9,913 $9,742 WIP reportLess: Billed to Date $4,908 $7,067 WIP reportRemaining to be billed $5,005 $2,675Plus: Receivables $ 184 $ 34 Balance sheetTotal Future Cash Flow $5,189 $2,709FUTURE CASH OUTFLOW (000’s)Total Estimated Costs $7,658 $8,172 WIP reportLess: Cost incurred to date $3,708 $5,864WIP reportRemaining to be spent $3,950 $2,308Plus: Accounts Payable/Accruals $ 783 $ 320 Balance SheetDeferred Income Taxes $ 0 $ 0 Balance SheetTotal Future Cash Outflow $4,733 $2,628NET CASH INFLOW $ 456 $ 81OPERATIONAL OVERHEADLess: CMLTD $ 64 $ 74 Balance SheetLess: Interest Expense $ 67 $ 91 Inc. StatementLess: Operating Expenses $ 1,354 $ 756 Inc. StatementTotal Additional Outlays $1,485 $ 921OVERHEAD COVERAGE 3.68 mths 1.05 mths NCI/(op.exp/12)
17CONTRACTOR’S CASH FLOWSUMMARY Notice that future cash inflows and outflows from the Work-In-Progress report were weaved together with the balance sheet toderive an accrual cash flow for the contractor. Then operating expenses were incorporated on the lower half ofthe contractor’s cash flow to deduct any overhead from theaccrual cash flow. This is much like the operating portion of theUCA cash flow. Please note that all non-cash expenses, such as depreciationand amortization have been removed from overhead expense. The contractor’s cash flow should reveal to you two points: 1)what the net cash flow will be from the work currently inprogress, and 2) how long that net cash flow will continue tocomfortably fund the contractor’s day to day obligations. As a final note keep in mind any cash already held on the B/S.
18CASH FLOW AND REPAYMENT Now that we have examined the two principalmethods of reviewing cash flow, we need to considerhow cash flow repays loans. Loan repayment is generally expected to occur overthe short term or the long term. Therefore we shouldconsider cash flow on the same basis. The diagram on the next page depicts short termcash flow via the asset conversion cycle.
19SHORT TERM CASH FLOWINVENTORY=100 DAYSRECEIVABLES=45 DAYSPAYABLES=45 DAYSLOC=10 DAYSCASHShort term cashflowcycle.
20SHORT TERM REPAYMENT Prior page the smaller circle represents trade cycle, larger circle = year. The trade cycle on the prior page is cycling at 90 days or approximatelyfour times per year. This is derived by examining the components ofthe trade cycle: TRADE CYCLE Inventory = 100 days Receivables = 45 days Less: Payables = 45 days Less: ST LOC = 10 days TRADE CYCLE = 90 DAYS During the course of the trade cycle the conversion of assets (Inventoryand Receivables) will provide for repayment on the line of credit. Basedon the example above there is a 10-day financing need on the line ofcredit. This 10-day need will rise and fall as inventory and receivablesexpand or contract (cash too). Thus, at a time when inventory andreceivables contract the line will be repaid, and when those assetsexpand again, the line will be drawn. When the line remains drawn foran extended period of time, it can be said that there is a permanentworking capital need, which should be accomodated by term financing.
22LONG TERM REPAYMENT As seen on the previous slide the continuous conversion ofassets produces long term cash flow, which can be applied toterm debt repayment. While it is easier to conceive of cash flowbeing produced on a 90 day or annual cycle, it is ultimatelybeing produced at all times. However, cash flow is consideredand reviewed in a cyclical manner, typically on an annual basis,because it is easier for the reviewer to calculate the repaymentcapacity at a fixed point in time (i.e. annual basis). The amount of cash flow produced for term debt repayment willvary by industry. For example, manufacturers or contractorswill generally produce a stronger cash flow than a wholesaler orretailer with similar size revenues. This is a reflection of aparticular industry’s profitability margins. (e.g. in general, themore value added the higher margins.)
LONG TERM REPAYMENT When depending on the long term repayment of a loan from acompany that produces a weak margins or has sizable termdebt, your bank may take measures to better understand andmonitor the cash flow cycle. For example, the bank may requirean ABL audit, a borrowing base formula, financial covenants orother requirements that assure the bank of collateral valueand/or the ability to be repaid. Remember bankers are focused on revenues that arerepeatable and sustainable. A gain on sale of assets is typicallya one time event, but not a good sign of sustainable cash flow. Long term repayment is typically tied to durable assets. Assetsthat are expected to help produce cash flow over an extendedperiod of time.23
CASH FLOW DRIVERS Sometimes when reviewing repayment ability, you may want tocreate a projection to better understand a company’srepayment ability. In order to do so, you will first have toconsider cash flow drivers. Cash flow drivers typically include the following: INCOME STATEMENT BALANCE SHEET * Sales Growth * Accounts Receivable Days * COGS (%) * Inventory Days * Operating expense (%) * Accounts Payable Days24
CASH FLOW DRIVERS Forecasting these variables will typically provide theanalyst with a good model for future repayment. Other considerations a projection should include: 1) Expansion within fixed assets? 2) Adding financing for fixed assets or other? 3) Intercompany loans, tax changes, interest ratechanges, etc.?25
GLOBAL CASH FLOW “Global cash flow, which is a variation of personal cash flow, blendsbusiness income and business debt service into the same model”.John Cassis (9/06) This can be done horizontally or vertically. Horizontally: Art B. Cobb ABC Company Combined Salaries/Net cash flow $50K $175K $225K Schedules B, C, D $20K N/A $20K Schedule E (R/E) $15K N/A $15K Schedule E (distr.) $100K ($100K) $ 0K Net cash flow $185K $75K $260K Mortgage debt $30K $50K $80K Installment debt $10K $20K $30K Revolving debt $2K $ 3K $5K Total debt Service $42K $73K $115K Debt Service Coverage 4.40x 1.03x 2.26x This is a simplistic model, see the vertical model attached (exhibit 8). 26
27RECAP EBITDA cash flow is an inadequate measure by itself, but isalso a measure that borrowers can measure for themselves. Sources & uses of cash flow provide a more accurate picture ofloan repayment. A contractor’s cash flow is an accrual based cash flow thatintegrates the contractor’s current work-in-progress with theirbalance sheet and income statement. Short term cash flow repayment is typically referred to as the“conversion of assets” and is repaid out of a company’s tradecycle. The lack of ability to repay short term debt from the tradecycle indicates a permanent working capital need. Long term debt repayment is typically derived from multipleshort term cash flow cycles, which produce c/f over an extendedperiod of time. A review of cash flow drivers helps to forecast,or project, long term cash flow. Global cash flow has become increasingly more important asbanks seek to understand the cash flow dynamics between theborrower and guarantor(s).