Strategy Financial Analysis Cash Flow Analysis (www.gazhoo.com)

Author: AAA Contributor: BBB XXX & Company Cash Flow

Cash Flow Agenda

The importance of cash flow

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow Agenda

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow What is Cash Flow? Cash flow describes the movement of cash into (sources) and out of (uses) a company. Sources of cash Company Uses of cash $ $ $ $ $ $ $ $

Cash Flow Why Do We Care About Cash?

The market value of a company is equal to the present value of its expected future cash flows

Various stakeholders demand cash

investors demand CASH returns

suppliers and employees require CASH compensation

debtholders demand CASH payments

Accounting methods can be used to “manage” earnings; CASH is harder to manipulate

Cash is King! Cash flow is the measure of a company’s strategic value.

Cash Flow Earnings vs. Cash Flow*

Some accounting decisions impact earnings, but not cash

In 1988, General Motors made at least four decisions that impacted earnings but not cash

Earnings do not equal cash flow. *Earnings are also called after tax profits or net income

Successful high growth companies tend to have high earnings, but low cash flow; successful low growth companies tend to have low earnings, but high cash flow

Earnings Impact $790MM $480MM $217MM $270MM Cash Impact None None None None Total: $1,757MM None Accounting Decision

Extended useful plant life from 35 to 45 year schedule

Changed the way it accounted for its pension plan

Adjusted its inventory valuation policy

Changed the residual value assumption for cars it leased

Cash Flow Agenda

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow Types of Cash Flow Net cash flow is equal to the sum of the cash flows from operating, investing, and financing activities. Operating cash flow Investing cash flow Financing cash flow

Ability of a company’s recurring operations to generate cash

Ability of a company’s investment decisions to generate cash

How a company funds its operations

Operating profits

Decrease in working capital

Sale of fixed assets

Long-term issuance of shares

Examples of sources:

Operating losses

Increase in working capital

Purchase of fixed assets

Repayment of loans

Payment of dividends

Examples of uses:

Cash Flow Operating Cash Flow *Investing activities not related to ongoing operations (such as the purchase or sale of divisions or companies, or investments in unrelated businesses) are not included in investing cash flow. They are included in financing cash flow.

Operating cash flow excludes all cash flows related to a firm’s capital structure

cash generation ability is independent of how a firm is financed

It excludes one-time events

these are not related to a firm’s recurring operations

Operating cash flow is used to measure the strategic value of a business

for company valuations, operating and investing cash flows are used, not financing cash flow

Bain is usually more interested in operating and investing* cash flow than in financing cash flow

Operating cash flow measures the ability of a business’s recurring operations to generate cash.

Cash Flow Investing Cash Flow

Investments in ongoing operations - property, plant and equipment - are included in investing cash flow

cash is used to replace assets as they wear out

if a business is to grow, additional assets must be acquired

in some cases, the cash used to acquire these assets is generated from the sale of existing noncurrent assets

such cash inflows, however, seldom cover the entire cost of asset acquisitions. Often times cash flow from operations is used to finance acquisitions, or, failing a positive operating cash flow, external financing is used

Pure financing activities are not included in investing cash flow. They are included in financing cash flow

purchase or sale of divisions or companies

investments in unrelated businesses

Investing cash flows relating to ongoing operations are used as a measure of the strategic value of a business. Those that are purely financing/investment mechanisms are used to evaluate the financial strategy of the business

Investing cash flow measures the use of a business’s cash for the acquisition of non-current assets.

Cash Flow Financing Cash Flow

Major types of financing cash flow include:

debt-related transactions

changes in long-term debt

interest income and expense

equity-related transactions

changes in common and preferred stock

dividends

short-term investments

long-term asset and liability transactions

purchase or sale of a division or company

changes in long-term liabilities

Financing cash flow captures all the non-operating cash changes experienced during the year, and it provides information on how a company is funding its operations.

Cash Flow Statement of Cash Flows

The SCF is divided into three sections: operating, investing, and financing

Each section shows sources and uses of funds for the accounting period

The SCF shows the amounts for

depreciation and amortization

capital expenditures

taxes paid

dividends paid

It does not show sources and uses by business unit

It does not provide much detail

for example, it does not show capital expenditures by project, nor individual equipment purchases

The SCF is not a substitute for cash flow analysis The statement of cash flows (SCF) found in annual reports is a good source of data for constructing cash flows, but sometimes it does not have the detail required for the analysis being done.

Cash Flow Agenda

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow Applications Bain case teams use cash flow (CF) analysis to value investments/acquisitions, to improve the health of business units, and to help companies manage their portfolios. Valuation (mergers, acquisitions) Business unit analysis Portfolio management

What is the cash generation potential of an investment/ acquisition?

What are we willing to pay (in cash) for that investment/acquisition?

How healthy is a business unit?

What factors have effected the business unit’s ability to generate cash/value over time?

How can the business unit’s cash management be improved?

What is the overall balance of cash users/cash generators in a client’s portfolio of businesses?

How does this effect the client’s overall cash position/outlook?

What restructuring can be done to improve this profile?

CF = common denominator CF = measuring stick CF = portfolio tool

Cash Flow Agenda

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow Cash Flow Cookbook *Cash is defined as cash plus marketable securities minus short-term notes **I/S = income statement, SCF = statement of cash flows, B/S = balance sheet + +/ - +/ - - +/ - = 1. Profit before interest and tax (PBIT) 2. Depreciation 3. Other non-cash expenses/income 4. Decrease/increase in working capital (excluding cash) 5. Taxes paid 6. Tax impact of interest income/expense Operating cash flow Bain case teams use the following cash flow cookbook: - = 7. Capital expenditures Investing cash flow +/ - +/ - +/ - +/ - - +/ - = 8. Interest income/expense 9. Tax impact of interest expense/income 10. Increase/decrease in long-term debt 11. Increase in outstanding stocks/shares 12. Dividends 13. Changes in other accounts Financing cash flow 14. Reconcile with change in cash* from Balance Sheet Net cash flow Source** I/S SCF, B/S and Notes Notes B/S I/S, B/S I/S SCF, B/S and Notes I/S I/S B/S B/S SCF, B/S, and Notes B/S, I/S B/S

Cash Flow Agenda

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow Exercise - Background (p. 1) *This exercise is based on The Gillette Company’s financial statements in 1996. Since several modifications have been made to the financial statements, the information provided hereafter should not be used to analyze Gillette’s financial performance.

Net Sales

Cost of Sales

Gross Profit

SG&A

Profit from Operations

Interest Expense

Income before taxes

Income Taxes

Net Income

1996 $9,697.7MM ($3,681.7MM) $6,016.0MM ($4,379.7MM) $1,636.3MM ($111.3MM) $1,525.0MM ($576.3MM) $948.7MM Income Statement: The New England Razor Company* Use the following data to calculate the cash flow for The New England Razor Company:

Cash Flow *Deferred taxes can be a liability account, an asset account, or both (as is the case here). Assets Current Assets

Cash

Marketable securities

Receivables

Inventories

Deferred income taxes*

Prepaid expenses

Total Current Assets Property, Plant & Equipment Liabilities and Stockholders’ Equity Current Liabilities

Loans payable

Current portion of Long-Term debt

Accounts payable and accrued expenses

Income taxes payable

Total Current Liabilities Long-Term Debt Deferred Income Taxes* Other Long-Term Liabilities Dividends Payable Stockholders’ Equity

Common stock

Additional Paid-in Capital

Retained Earnings

Treasury stock

Total Stockholder’s Equity

$76.9 $7.0 $2,724.6 $1,358.2 $359.3 $227.2 $4,753.2 $5,192.0 $9,945.2 $656.7 $14.5 $1,964.9 $298.6 $2,934.7 $1,490.4 $298.9 $630.2 $100.1 $671.4 $707.0 $4,168.7 ($1,056.2) $4,490.9 1995 $81.6 $1.6 $2,290.8 $1,267.6 $246.8 $199.3 $4,087.7 $4,456.6 $8,544.3 $634.7 $26.5 $1,609.8 $319.4 $2,590.4 $1,048.4 $303.4 $635.1 $66.7 $667.1 $574.8 $3,704.2 ($1,045.8) $3,900.3 $9,945.2 $8,544.3 Balance Sheet December 31, 1996 and 1995 (in $MM) 1996 Exercise - Background (p. 2)

Cash Flow

Property, Plant and Equipment

Less accumulated depreciation

Net Property, Plant, and Equipment

1996 (in $MM) $7,820.4 $2,628.4 $5,192.0 1995 (in $MM) $6,885.0 $2,428.4 $4,456.6 Note 1: Property, Plant and Equipment Note 2: Dividends The company declared dividends of $484.2MM in 1996 Note 3: Sale of assets A loss of $22MM was incurred on equipment sold during the year The equipment had an original cost of $244.0MM and was sold for $40.9MM Exercise - Background (p. 3) Notes to the financial statements are a critical source of information.

Cash Flow Operating Cash Flow *Cash is defined as cash plus marketable securities minus short-term notes **I/S = income statement, SCF = statement of cash flows, B/S = balance sheet + +/ - +/ - - +/ - = 1. Profit before interest and tax (PBIT) 2. Depreciation 3. Other non-cash expenses/income 4. Decrease/increase in working capital (excluding cash) 5. Taxes paid 6. Tax impact of interest income/expense Operating cash flow - = 7. Capital expenditures Investing cash flow +/ - +/ - +/ - +/ - - +/ - = 8. Interest income/expense 9. Tax impact of interest expense/income 10. Increase/decrease in long-term debt 11. Increase in outstanding stocks/shares 12. Dividends 13. Changes in other accounts Financing cash flow 14. Reconcile with change in cash* from Balance Sheet Net cash flow Source** I/S SCF, B/S and Notes Notes B/S I/S, B/S I/S I/S I/S B/S B/S B/S, I/S B/S SCF, B/S and Notes SCF, B/S and Notes

Cash Flow Step 1 - Profit Before Interest and Tax Where to find: Process: Comments:

Income statement

It can be labeled in many different ways, including profit before interest and tax, profit from operations, operating profit, and earnings before interest and tax

If income statement is provided, pick number from income statement

If income statement is not provided, calculate profit before interest and tax:

Profit before taxes

- Interest income and other income (earned)

+ Interest expense and other expenses (incurred)

- Any one-time gains included in profit before taxes

+ Any one-time losses included in profit before taxes

= Profit before interest and tax (PBIT)

The goal is to get profit before interest payments, tax payments, and extraordinary items

Cash Flow Step 1 - Profit Before Interest and Tax - Answer Profit before interest and tax*: $1,636.3MM 1996 Operating cash flow begins with profit before interest and tax. *Shown as profit from operations on The New England Razor Company’s income statement

Cash Flow Steps 2 and 3 - Depreciation and Other Non-Cash Income/Expenses Where to find: Process:

Depreciation - statement of cash flows, or calculate from Balance Sheet and Notes

Other Non-Cash Income/Expenses - Notes

Review assets and liabilities that are not taken into account in working capital (elements of working capital include current assets and liabilities with the exception of cash, tax items, and financing assets and liabilities (e.g., interest and dividends payable))

Ask two questions:

was the item non-cash?

was the item included in profit before interest and tax?

If the answer to both is yes , adjust profit before interest and tax

e.g., depreciation - add back to profit before interest and tax

e.g., loss on sale of asset - add back to profit before interest and tax

If answer to either question is no , make no adjustments

Cash Flow Step 2 - Depreciation Where to find: Process:

Statement of cash flows, or calculate from Balance Sheet and Notes

If depreciation is provided in the statement of cash flows, pick number from there

If not, calculate depreciation:

Accumulated depreciation at year end

- Accumulated depreciation at year beginning

+ Depreciation from sale of asset

= Depreciation expense for the year

Depreciation from sale of asset:

Original cost of asset

- Proceeds from sale of asset

- Losses incurred

= Depreciation from sale of asset

Step 2 - Depreciation - Answer (p. 1) Depreciation from sale of asset = The original cost of asset - proceeds from sale of asset - losses incurred = $244.0MM - $40.9MM - $22.0MM = $181.1MM Depreciation expense for 1996 = Accumulated depreciation at year end - accumulated depreciation at year beginning + depreciation from sale of asset = $2,628.4MM - $2,428.4MM + $181.1MM = $381.1MM Cash Flow Depreciation is a non-cash expense. Therefore, it is added to profit before interest and tax in the operating cash flow.

Cash Flow Step 2 - Depreciation - Answer (p. 2) The depreciation expense for the year can be calculated from the balance sheet and notes. - + =

Cash Flow Step 3 - Other Non-Cash Expenses - Answer Loss on equipment sold during the year: $22.0MM (from Note 3) 1996 Other non-cash expenses are added to profit before interest and tax in the operating cash flow.

Cash Flow Step 4 - Change in Working Capital (Excluding Cash) Where to find: Process:

Balance sheet

Working capital = current assets - current liabilities

Review each current asset and current liability

Include: Exclude:

Cash and cash equivalents

Tax items

include in taxes paid calculation (Step 5)

Financing assets and liabilities, such as:

interest payable

dividends payable

current portion of long-term debt

Operating assets and liabilities

Cash Flow Working Capital Current Assets and Liabilities Included in Change in Working Capital Calculation

Current assets

cash

marketable securities

inventory

accounts receivable

pre-paid expenses

deferred income taxes

Current liabilities

accounts payable

accrued expenses

loans payable

income taxes payable

current portion of long-term debt

interest payable

dividends payable

Included in cash, not working capital Included in cash, not working capital Included in operating cash flow, but not in working capital Included in financing cash flow Not all current assets and liabilities are included in working capital. Included in operating cash flow, but not in working capital Included in financing cash flow Included in financing cash flow

Cash Flow Current Assets Changes in working capital asset items have cash flow impacts. … means cash is being used to fund the business … means cash is being generated by the business Increase in non-cash working capital Decrease in non-cash working capital Decreases in current assets... Increases in current assets...

Increase in inventories

cash spent to buy inventories

Increase in pre-paid expenses

cash used to pre-pay bills

Reduction in inventories

cash generated by selling inventories

Reduction in accounts receivable

cash received from customers

Cash Flow Current Liabilities Changes in working capital liability items have cash flow impacts. … means cash is being retained by the business … means cash is being used to fund the business Decrease in non-cash working capital Increase in non-cash working capital Decrease in current liabilities... Increases in current liabilities...

Increase in accounts payable

cash saved by delaying payment to suppliers

Increase in deferred tax liability

cash saved by delaying payment of taxes

Decrease in accounts payable

cash paid to suppliers

Decrease in accrued expenses

cash used to reduce accrued expenses

Cash Flow Step 4 - Change in Working Capital - Answer Loans payable: Receivables: Inventories: Prepaid expenses: 1995 ($MM) $2,290.8 $1,267.6 $199.3 $1,609.8 $634.7 1996 ($MM) $2,724.6 $1,358.2 $227.2 $1,964.9 $656.7 Asset or Liability Asset Asset Asset Liability Liability Change Increase Increase Increase Increase Increase Impact on Working Capital Increase Increase Increase Decrease Decrease Impact on Working Capital ($MM) $433.8 $90.6 $27.9 ($22.0) Change in Working Capital $175.2MM $175.2MM Increase Accounts payable & accrued expenses: ($355.1) An increase in working capital has a negative impact on operating cash flow. Increase

Cash Flow Step 5 - Taxes Paid Where to find: Process: Deferred taxes:

Provision for income taxes - Income Statement

Change in deferred income taxes - Balance Sheet

Current tax expense - Notes or calculate from Income Statement and Balance Sheet

Income taxes payable - Balance Sheet

+ Income taxes payable (beginning of period) - Income taxes payable (end of period)

Deferred taxes arise when pre-tax income reported on the income statement differs from that shown on the tax return

Deferred taxes are sometimes shown on the balance sheet as an asset and sometimes as a liability

= Taxes paid Provision for income taxes + Increase in deferred income taxes asset account + Decrease in deferred income taxes liability account = Current tax expense Current tax expense

Cash Flow Step 5 - Taxes Paid - Deferred Taxes

Deferred taxes can be shown either as an asset or as a liability, or even as both (as in this exercise)

When deferred taxes are shown as an asset, an increase increases taxes paid and is therefore a use of cash (negative impact on cash flow). When deferred taxes are shown as a liability, an increase decreases taxes paid and is therefore a source of cash (positive impact on cash flow)

Deferred taxes are a complication to look out for in the cash flow analysis. Deferred income taxes (asset): Deferred income taxes (liability): 1995 ($MM) 1996 ($MM) Asset or Liability Change Cash Flow Impact Result ($MM) $246.8 $303.4 $359.3 $298.9 Asset Liability Increase Decrease Decrease Decrease ($112.5) ($4.5) Net result ($117.0)MM

Cash Flow Step 5 - Taxes Paid - Answer (p. 1) Taxes paid is a use of cash, therefore it should be deducted from operating cash flow. Provision for income tax + Increase in deferred income taxes asset account = Current tax expense Current tax expense + Income taxes payable (beginning of year) - Income taxes payable (end of year) = $576.3MM $112.5MM $693.3MM $693.3MM $319.4MM ($298.6)MM $714.1MM Taxes paid + Decrease in deferred income taxes liability account $4.5MM

Cash Flow Step 5 - Taxes Paid - Answer (p. 2) Incr. In def. tax asset $117.0 Provision for income tax $576.3 Taxes paid can be calculated from the income statement and the balance sheet. + = + - =

Step 6 - Tax Impact of Interest Income/Expense Where to find: Process: Comment: Calculate from income statement Interest income/expense x Effective tax rate = Tax impact of interest income/expense Cash Flow

Since interest income/expense is a result of financing decisions, the tax impact of interest income/expense must be removed from the operating cash flow and included in the financing cash flow

The effective tax rate =

The tax impact of interest income/expense will be offset by Step 9 of the financing cash flow

Provision for income taxes Income before taxes

Cash Flow Step 6 - Tax Impact of Interest Income/Expense - Answer Effective tax rate = Provision for income taxes Income before taxes $576.3MM $1,525.0MM = 37.8% = Interest expense X Effective tax rate = Tax impact of interest expense $111.3MM X 37.8% $42.1MM The tax impact of interest expense is subtracted from operating cash flow because interest expense results from financing decisions, not operating ones.

Cash Flow Operating Cash Flow Calculation Profit before interest and tax $381.1MM $22.0MM ($175.2MM) ($714.1MM) ($42.1MM) $1,108.0MM $1,636.3MM The New England Razor Company’s cash flow from operations is $1,108.0MM. = Cash Flow from Operations + Depreciation expense for the year + Other non-cash expenses - Increase in working capital - Taxes paid - Tax impact of interest expense

Cash Flow Investing Cash Flow *Cash is defined as cash plus marketable securities minus short-term notes **I/S = income statement, SCF = statement of cash flows, B/S = balance sheet + +/ - +/ - - +/ - = 1. Profit before interest and tax (PBIT) 2. Depreciation 3. Other non-cash expenses/income 4. Decrease/increase in working capital (excluding cash) 5. Taxes paid 6. Tax impact of interest income/expense Operating cash flow - = 7. Capital expenditures Investing cash flow +/ - +/ - +/ - +/ - - +/ - = 8. Interest income/expense 9. Tax impact of interest expense/income 10. Increase/decrease in long-term debt 11. Increase in outstanding stocks/shares 12. Dividends 13. Changes in other accounts Financing cash flow 14. Reconcile with change in cash* from Balance Sheet Net cash flow Source** I/S SCF, B/S and Notes Notes B/S I/S, B/S I/S I/S I/S B/S B/S B/S, I/S B/S SCF, B/S and Notes SCF, B/S and Notes

Cash Flow Step 7 - Capital Expenditures Where to find:

Statement of cash flows or calculate from balance sheet and notes

If SCF is unavailable, use one of the following two methods to calculate capital expenditures:

PPE, at cost, at end of year

- PPE, at cost, at start of year

+ Original cost of PPE sold during year

- Proceeds from sale of PPE

= Capital expenditures

Net PPE at end of year

- Net PPE at start of year

+ Depreciation expense

+ Loss from sale of assets

= Capital expenditures

Process:

Obtain capital expenditures number from SCF

Balance sheet alone is insufficient to determine capital expenditures due to complications caused by asset sales

Purchase and sale of assets

if assets are directly related to recurring operations, e.g., PPE, include in capital expenditures

if assets are not directly related to recurring operations, include in financing cash flow

Comments: Method 1: Method 2:

Cash Flow Step 7 - Capital Expenditures - Answer (p. 1) - + - = PPE, at cost, at end of year PPE, at cost, at start of year Original cost of PPE sold during year Proceeds from sale of PPE Capital expenditures ($6,885.0)MM ($40.9)MM $1,138.5MM $7,820.4MM (from Note 3) (from Note 1) (from Note 3) (from Note 1) Capital expenditures decrease investing cash flow. - + + = Net PPE at end of year Net PPE at start of year Depreciation expense Loss from sale of assets Capital expenditures ($4,456.6)MM $381.1MM $22.0MM $1,138.5MM $5,192.0MM (from B/S) (from Step 2) (from Note 3) (from B/S) $244.0MM

Cash Flow Step 7 - Capital Expenditures - Answer (p. 2) Capital expenditures can be calculated from the Balance Sheet and Notes. + - = -

Cash Flow Investing Cash Flow Calculation Cash flow from investing ($1,138.5)MM Capital expenditures ($1,138.5)MM The New England Razor Company has a cash flow from investing of ($1,138.5)MM.

Cash Flow Financing Cash Flow *Cash is defined as cash plus marketable securities minus short-term notes **I/S = income statement, SCF = statement of cash flows, B/S = balance sheet + +/ - +/ - - +/ - = 1. Profit before interest and tax (PBIT) 2. Depreciation 3. Other non-cash expenses/income 4. Decrease/increase in working capital (excluding cash) 5. Taxes paid 6. Tax impact of interest income/expense Operating cash flow - = 7. Capital expenditures Investing cash flow +/ - +/ - +/ - +/ - - +/ - = 8. Interest income/expense 9. Tax impact of interest expense/income 10. Increase/decrease in long-term debt 11. Increase in outstanding stocks/shares 12. Dividends 13. Changes in other accounts Financing cash flow 14. Reconcile with change in cash* from Balance Sheet Net cash flow Source** I/S SCF, B/S and Notes Notes B/S I/S, B/S I/S I/S I/S B/S B/S B/S, I/S B/S SCF, B/S and Notes SCF, B/S and Notes

Cash Flow Step 8 - Interest Income/Expense Where to find:

Income statement

Process:

Find interest income/expense on income statement

interest income is added to financing cash flow

interest expense is subtracted from financing cash flow

Step 8 - Interest Income/Expense - Answer 1996 Interest expense $111.3MM Cash Flow Interest expense decreases financing cash flow.

Cash Flow Step 9 - Tax Impact of Interest Income/Expense Where to find:

Calculate from income statement

Process:

Interest income/expense x Effective tax rate

= Tax impact of interest income/expenses The effective tax rate = Provision for income taxes

Income before taxes Comments:

This item simply offsets the impact of Step 6. The purpose of these two items is to correctly allocate the tax impact of interest to financing cash flow, not operating cash flow.

Interest expense reduces taxes, and so the amount of the reduction needs to be added to financing cash flow

the benefit of the interest tax shield is effectively a source of cash due to financing decisions (not operating ones)

Interest income has the opposite effect

Cash Flow Step 9 - Tax Impact of Interest Income/Expense - Answer Effective tax rate = Provision for income taxes Income before taxes $576.3MM $1,525.0MM = 37.8% = Interest expense x Effective tax rate = Tax impact of interest $111.3MM X 37.8% $42.1 MM Interest expense reduces taxes and, therefore, the tax impact of interest expense has a positive effect on financing cash flow.

Cash Flow Step 10 - Change in Long-Term Debt Where to find:

Balance Sheet

Process:

The change (from the start to the end of the period) is the sum of the following two items:

current portion of long-term debt (a current liability)

long-term debt (a long-term liability)

An increase in the sum of these items means debt has increased, which is a source of cash and is added to financing cash flow

A decrease has the opposite impact

Comments:

Cash Flow Step 10 - Change in Long-Term Debt - Answer Current portion of long-term debt: +/ - Change in long-term debt: 1995 ($MM) $26.5 $1,048.4 1996 ($MM) $14.5 $1,490.4 Asset or Liability Liability Liability Change Decrease Increase Impact on Cash Flow Decrease Increase Result ($MM) ($12.0) $442.0 Change in long-term debt $430.0 MM Increase An increase in long-term debt increases financing cash flow. Increase

Cash Flow Step 11 - Change in Outstanding Stocks and Shares Where to find:

Balance Sheet

Process:

Identify changes in the equity accounts which were sources or uses of cash, such as:

new share issues (source of cash)

share re-purchases (use of cash)

Comments:

Changes in retained earnings should be ignored. They reflect the profit generated by the business during the year, which has already been accounted for by using operating profit as the starting point for our cash flow calculation.

Cash Flow Step 11 - Change in Outstanding Stocks and Shares - Answer Common stock: Additional paid-in capital: 1995 ($MM) $667.1 $574.8 1996 ($MM) $671.4 $707.0 Asset or Liability Liability Liability Change Increase Increase Impact on Cash Flow Increase Increase Result ($MM) $4.3 $132.2 Change in outstanding stocks and shares $126.1MM Increase Treasury stock: ($1,045.8) ($1,056.2) Liability Decrease Decrease ($10.4) The increase in outstanding stocks and shares has a positive impact on financing cash flow.

Cash Flow Step 12 - Dividends Where to find:

Statement of Cash Flows or calculate from Balance Sheet and Notes

Process:

Obtain the dividends from the Statement of Cash Flows

Subtract any dividends paid from financing cash flow

If a Statement of Cash Flow is not available, use the following calculation:

Dividends payable at start of year (from B/S)

- Dividends payable at end of year (from B/S)

+ Dividend declared during year (from Notes)

= Dividends

Cash Flow Step 12 - Dividends - Answer

1996

Dividends payable at start of year $66.7MM

- Dividends payable at end of year ($100.1MM)

+ Dividend declared during year $484.2MM

= Dividends $ 450.8MM

Dividends decrease financing cash flow.

Cash Flow Step 13 - Changes in Other Accounts Where to find:

Income Statement, Balance Sheet

Process (income statement accounts):

Examine each item between operating profit and profit before taxes

If non-cash If cash Ignore If related B/S account exists, include the I/S amount, plus the change in the B/S account If no related B/S account, include in financing cash flow as is Gain/loss on sale of division Dividends (as shown in Step 12) Interest income (as shown in Step 8) Example: Process (balance sheet accounts):

Review any B/S accounts not already considered (usually just long-term assets and liabilities); add changes in their balance to financing cash flow

ignore changes in PPE; their cash impact has been addressed through the “capital expenditure” and “depreciation” items in operating cash flow

ignore changes in deferred taxes; their cash impact has been addressed by the “taxes paid” item in operating cash flow

Cash Flow Step 13 - Changes in Other Accounts - Answer Other long-term liabilities: 1995 ($MM) $635.1 1996 ($MM) $630.2 Change Decrease Impact on Cash Flow Decrease Result ($MM) ($4.9) A decrease in other long-term liabilities decreases financing cash flow.

Cash Flow Financing Cash Flow Calculation - + + + - - Interest expense Tax impact of interest expense Increase in long-term debt Increase in outstanding stocks and shares Dividends Decrease in other long-term liabilities Financing cash flow $42.1MM $430.0MM $126.1MM ($450.8)MM $31.2 ($111.3)MM ($4.9)MM Financing is a source of $31.2MM in cash for The New England Razor Company.

Cash Flow Cash Flow Summary 1. Profit Before Interest and Taxes (PBIT) 2. + Depreciation 3. + Other non-cash expenses 4. - Increase in working capital 5. - Taxes paid 6. - Tax impact of interest expense 7. - Capital expenditures 8. - Interest expense 9. + Tax impact of interest expense 10. + Increase in long-term debt 11. + Increase in outstanding stocks and shares 12. - Dividends 13. - Decrease in other long-term liabilities 14. Change in cash $1,636.3MM $381.1MM $22.0MM ($175.2)MM ($714.1)MM ($42.1)MM ($1,138.5)MM ($111.3)MM $42.1MM $430.0MM $126.1MM ($450.8)MM ($4.9)MM $31.2MM $1,108.0MM $0.7MM Operating cash flow Financing cash flow The New England Razor Company has a net change in cash of $0.7MM. ($1,138.5)MM Investing cash flow

Cash Flow Step 14 - Cash Reconciliation Balance Sheet Where to find: Process: The cash flow should reconcile with the change in cash and cash equivalents on the balance sheet. Change in cash + Change in marketable securities = Change in cash Comment: Cash equivalents are combined with cash to give an accurate picture of cash position

Cash Flow Step 14 - Cash Reconciliation - Answer Cash: Marketable Securities: 1996 ($MM) 1995 ($MM) Change ($MM) $76.9 $7.0 $81.6 $1.6 ($4.7) $5.4 Change in cash position $0.7MM The Balance Sheet for the New England Razor Company shows a net change in cash of $0.7MM.

Cash Flow Agenda

Types of cash flow

Applications

Cash flow steps

Exercise

Key takeaways

Cash Flow Key Takeaways

“ Cash is King”

cash flow is a very useful measure of a company’s performance

earnings can be very different from cash flow

Operating cash flow + investing cash flow + financing cash flow = net cash flow

The major components of operating cash flow are:

profit before income and tax

non-cash expenses/income (mainly depreciation)

change in non-cash working capital

The major component of investing cash flow is:

capital expenditures

The major components of financing cash flow are:

Financial statements often have some unusual features, but 95% of the cash flow can usually be understood by looking at the items listed above

The value of cash flow analysis is in understanding the components or drivers of cash flow

Takeaway Slides (p. 1) Cash Flow Cash is King Cash Flow Cookbook + +/ - +/ - - +/ - 1. Profit before interest and tax (PBIT) 2. Depreciation 3. Other non-cash expenses/income 4. Decrease/increase in working capital (excluding cash) 5. Taxes paid 6. Tax impact of interest income/expense - = 7. Capital expenditures Investing cash flow +/ - +/ - +/ - +/ - - +/ - 8. Interest income/expense 9. Tax impact of interest expense/income 10. Increase/decrease in long-term debt 11. Increase in outstanding stocks/shares 12. Dividends 13. Changes in other accounts Net cash flow Source I/S SCF, B/S and Notes Notes B/S I/S, B/S I/S I/S I/S B/S B/S B/S, I/S B/S 14. Reconcile with change in cash from Balance Sheet6 Balance Sheet Where to find: Process: Change in cash + Change in marketable securities = Change in cash Comment: Cash equivalents are combined with cash to give an accurate picture of cash position Cash Position Applications SCF, B/S and Notes SCF, B/S and Notes Operating cash flow Financing cash flow = =

The market value of a company is equal to the present value of its expected future cash flows

Various stakeholders demand cash

investors demand CASH returns

suppliers and employees require CASH compensation

debtholders demand CASH payments

Accounting methods can be used to “manage” earnings; CASH is harder to manipulate

Cash is King! Valuation (mergers, acquisitions) Business unit analysis Portfolio management

What is the cash generation potential of an investment/ acquisition?

What are we willing to pay (in cash) for that investment/acquisition?

How healthy is a business unit?

What factors have effected the business unit’s ability to generate cash/value over time?

How can the business unit’s cash management be improved?

What is the overall balance of cash users/cash generators in a client’s portfolio of businesses?

How does this effect the client’s overall cash position/outlook?

What restructuring can be done to improve this profile?

CF = common denominator CF = measuring stick CF = portfolio tool

Takeaway Slides (p. 2) Cash Flow Types of Cash Flow Operating Cash Flow Investing Cash Flow Financing Cash Flow Operating cash flow Investing cash flow Financing cash flow

Ability of a company’s recurring operations to generate cash

Ability of a company’s investment decisions to generate cash

How a company funds its operations

Operating profits

Decrease in working capital

Sale of fixed assets

Long-term issuance of shares

Examples of sources:

Operating losses

Increase in working capital

Purchase of fixed assets

Repayment of loans

Payment of dividends

Examples of uses:

Investments in ongoing operations - property, plant and equipment - are included in investing cash flow

cash is used to replace assets as they wear out

if a business is to grow, additional assets must be acquired

in some cases, the cash used to acquire these assets is generated from the sale of existing noncurrent assets

such cash inflows, however, seldom cover the entire cost of asset acquisitions. Often times, cash flow from operations is used to finance acquisitions, or, failing a positive operating cash flow, external financing is used

Pure financing activities are not included in investing cash flow. They are included in financing cash flow

purchase or sale of divisions or companies

investments in unrelated businesses

Investing cash flows relating to ongoing operations are used as a measure of the strategic value of a business. Those that are purely financing/investment mechanisms are used to evaluate the financial strategy of the business