Chapter 13
Making Sure the Company Has Cash to Carry On
In This Chapter
Determining a company’s solvency
Gauging financial strength by looking at debt
Checking cash sufficiency
No business can operate without cash. Unfortunately, the balance sheet (refer to Chapter 6) and income statement (refer to Chapter 7) don’t tell you how well a company is managing its cash flow, which is critical for finding out about a company’s ability to stay in business. To find this important information, you need to turn to the statement of cash flows, which looks at how cash flowed into and out of the business through its operations, investments, and financing activities.
In this chapter, we show you some basic calculations that help you determine the cash flow from sales and help you find out whether the cash flow is sufficient to meet the company’s cash needs. Throughout the chapter, we use Tesco and Marks and Spencer (two leading retail companies) as examples to help you learn how to use these tools to evaluate a company’s financial health. (See Appendix A for these companies’ financial statements. You can find Tesco’s complete annual report at www.tesco.com/investor and Marks and Spencer’s at www.marksandspencer.com and click on ‘The company’.
Measuring Income Success
Looking at whether a company is generating enough cash income can help you determine the company’s solvency – its capability to meet its financial obligations (in other words, its ability to pay all its outstanding bills). If a company can’t pay its bills, its creditors won’t be happy, and it could be forced into bankruptcy or to discontinue operations. In this section, we show you two ratios that can help you determine a company’s solvency based on its sales success.
Calculating free cash flow
The first step in determining a company’s solvency is to find out how much money the company earned from its operations that can actually be put into a savings account for future use – in other words, a company’s discretionary cash, which is also called the free cash flow.
A company with significant cash flow has a lot of flexibility to decide whether it wants to use its discretionary cash to purchase additional investments, pay down more debt, or add to its liquidity – which means to deposit additional funds in cash and cash equivalent accounts (including current accounts, savings accounts, and other holdings that can easily be converted to cash). The formula for calculating the free cash flow is a simple one:
cash provided by operating activities – net cash used in investing activities – dividends paid – interest paid – tax paid = free cash flow
You can find cash flows from operating activities at the top of the operating activities section of the statement of cash flows. Net cash flow from investing activities is a line item on the statement of cash flows. Dividends, interest, and tax paid are also line items on the statement, but, unfortunately, are not always in the same place.
Tesco
Using Tesco’s 2007 and 2006 cash-flow statements, Table 13-1 shows how to calculate the free cash flow:
| 2007 | 2006 | |
|---|---|---|
| Cash flow provided by operating activities | 3,532 | 3,412 |
| Net cash used in investing activities | 2,343 | (1,962) |
| Dividends paid | 467 | (441) |
| Interest paid | 376 | (364) |
| Tax paid | 545 | (216) |
| Free cash flow | –199 | 216 |
As you can see, Tesco’s free cash flow dropped significantly from 2006 to 2007. The increase in dividends accounts for £26 million and explains a small portion of that drop, but the total drop in free cash flow between the 2006 and 2007 is about £415 million.
Clearly, Tesco is not maintaining its 2006 cash levels. That could mean that the company decided to maintain lower cash levels and invest in new opportunities, or it could mean that it’s having difficulty generating new cash. But you can’t determine that with this calculation. What you do find out from this formula is that you must seek additional information by continuing the financial analysis of other line items (such as accounts receivable and inventory) and by reading the notes to the financial statements (refer to Chapter 9) or management’s discussion and analysis in the Operating and Financial Review (go to Chapter 5). This formula is used as a red flag that there’s a problem, but it doesn’t give you a specific answer as to what the problem might be. Remember too the business Tesco is in: The company generates a lot of cash every day because customers pay cash but payment to suppliers is made after a period of time.
Marks and Spencer
Using Marks and Spencer’s 2007 and 2006 cash-flow statements, Table 13-2 shows how to calculate the free cash flow:
| 2007 | 2006 | |
|---|---|---|
| Cash flow provided by operating activities | 1,442.6 | 1,183.6 |
| Net cash used in investing activities | 650.8 | 253.4 |
| Dividends paid | 260.6 | 204.1 |
| Interest paid | 145.0 | 142.8 |
| Tax paid | 150.8 | 101.5 |
| Free cash flow | 235.4 | 481.8 |
Marks and Spencer’s free cash flow is much stronger than Tesco’s for 2007. Also, Marks and Spencer’s free cash flow wasn’t hit as hard as Tesco’s from 2006 to 2007. Although Marks and Spencer’s free cash flow dropped about £246 million, that loss was a good bit less than the loss to cash flow that Tesco suffered. What this means is that Marks and Spencer is having less trouble maintaining its cash-flow levels.
What do the numbers mean?
No question, the more free cash flow a company has, the better the company is doing financially. A company with significant free cash flow is in a much stronger position to weather a financial storm, whether it be a recession, a slow down in sales, or another type of financial emergency.
Figuring out cash return on sales ratio
You can test how well a company’s sales are generating cash using the cash return on sales ratio. This ratio looks at profitability from cash rather than from the accrual-based income prospective. Remember, in the accrual-based income perspective (which means income and expenses are recognised when the transaction is complete), there’s no guarantee that cash has been received. (We talk more about cash-based and accrual accounting methods in Chapter 4.)
Making sure a business is properly managing its cash flow is critical when assessing a company’s ability to stay in business and pay its bills. Sales are the primary way a company generates its cash. The following formula looks specifically at the cash that’s being generated by its sales.
Here’s the formula for calculating the cash on sales ratio:
cash provided by operating activities ÷ sales = cash return on sales
To calculate cash return on sales, you need to use the line item called ‘cash provided by operating activities’ on the cash-flow statement in the operating activities section and ‘sales’ or ‘ revenue’ at the top of the income statement.
Tesco
Using Tesco’s cash-flow and income statements here’s how to calculate the cash return on sales ratio:
£3,532 (cash provided by operating activities) ÷ £42,641 (net sales) = 8.3 per cent (cash return on sales)
From looking at this equation, you can see that 8.3 per cent of the pounds that Tesco generates from its sales results are in cash for the company. Tesco’s net profit margin (the bottom line, or how much the company made after all costs and expenses are calculated), which we show you how to calculate in Chapter 11, was 4.45 per cent. Tesco’s cash return on sales is higher than its net profit margin, which is a good sign. The only time you need to worry is if you find that the sales ratio from cash is less than the net profit margin.
Marks and Spencer
Using Marks and Spencer’s cash-flow and income statements, here’s how to calculate the cash return on sales ratio:
£1,442.60 (cash provided by operating activities) ÷ £8,588.10 (net sales) = 16.8 per cent (cash return on sales)
You can see that 16.8 per cent of the pounds that Marks and Spencer generates from its sales provides cash for the company. Marks and Spencer’s net profit margin was 7.68 per cent (look at Chapter 11), less than half of its cash return on sales, which is a strong sign that Marks and Spencer is efficiently converting its sales to cash.
What do the numbers mean?
The cash return on sales looks at the efficiency with which the company turns its sales into cash. Marks and Spencer’s results show that it’s more efficient at turning its sales into cash for the company than Tesco is. Add the fact that Tesco’s cash flow was negatively impacted by decreases in cash from 2006 to 2007 (see ‘Calculating free cash flow’ earlier in the chapter), and you get a clearer picture that Tesco may have a problem converting its sales to cash. Given, however, the nature and success of their business, Tesco almost certainly is in control of this line item.
Checking Out Debt
In addition to how much cash the company is generating from sales, you need to look at the cash flow going out of the company to pay its debts. Whenever a company cannot pay its bills, or the interest on its debt, it runs the risk of supply cut-offs and possible insolvency. Few suppliers continue delivering products to a company that doesn’t pay its bills, and most creditors seek ways to collect a debt if they don’t receive the interest and principal due on that debt.
You can check out a company’s ability to pay this debt by looking at the company’s debt levels and the cash available to pay that debt. You do this by collecting numbers related to debt levels from the balance sheet and comparing them with cash-outflow numbers from the statement of cash flows.
Determining current cash-debt coverage ratio
You can determine whether a company has enough cash to meet its short-term needs by calculating the current cash-debt coverage ratio. You calculate this number by dividing the cash provided by operating activities by the average current liabilities.
Here’s the two-step formula for calculating the current cash-debt coverage ratio:
1. Find the average current liabilities.
current liabilities for 2007 + current liabilities for 2006 ÷ 2 = average current liabilities
2. Find the current cash-debt coverage ratio.
cash provided by operating activities ÷ average current liabilities = current cash-debt coverage ratio
You can find current liabilities for 2007 and 2006 on the balance sheet. You can find cash provided by operating activities on the statement of cash flows.
Tesco
Using the cash provided by operating activities from Tesco’s 2007 cash-flow statement and the average of its current liabilities from its 2007 and 2006 balance sheets, we show you how to calculate the current cash-debt coverage ratio. Using the two-step process, first calculate the average current liabilities. Then use that number to calculate the ratio:
1. Calculate average current liabilities.
£8,152 (2007 current liabilities) + £7,518 (2006 current liabilities) ÷ 2 = £7,835 (average current liabilities)
2. Calculate the ratio for the current reporting year.
£3,532 (cash provided by operating activities, 2007) ÷ £7,835 (average current liabilities) = 0.45 (current cash-debt coverage ratio)
£3,412 (cash provided by operating activities, 2006) ÷ £6,599 (average current liabilities) = 0.52 (current cash-debt coverage ratio)
This comparison shows you that Tesco’s cash position worsened from the end of 2006 to the end of 2007. A ratio of 0.45 in 2007 shows that less than a half of its current liabilities were paid for by cash taken in from sales, while in 2006, the ratio of 0.52 shows that slightly more than half of its current liabilities were paid for by cash taken in from sales.
Marks and Spencer
Now we use the cash provided by operating activities from Marks and Spencer’s 2007 cash-flow statement and the average of its current liabilities from its 2007 and 2006 balance sheets to show you how to calculate the current cash-debt coverage ratio:
1. Calculate average current liabilities.
£1,606.20 (2007 current liabilities) + £2,017.00 (2006 current liabilities) ÷ 2 = £1,811.60 (average current liabilities)
2. Calculate the ratio for the current reporting year.
£1,442.60 (cash provided by operating activities, 2007) ÷ £1,811.60 (average current liabilities) = 0.80 (current cash-debt coverage ratio)
For comparison’s sake, calculate the ratio for the 2006 reporting year as well:
£1,183.60 (cash provided by operating activities, 2006) ÷ £1,627.20 (average current liabilities) = 0.73 (current cash-debt coverage ratio)
Marks and Spencer ended 2007 in a stronger cash position than Tesco. Its current cash-debt coverage improved over the two years.
What do the numbers mean?
The current cash-debt coverage ratio looks at the company’s ability to pay its short-term needs. The higher the ratio, the better.
A negative ‘cash provided by operating activities’ number is a possible danger sign that a company isn’t generating enough cash from operations. You need to investigate why its cash from operations is insufficient. You should look for explanations in the notes to the financial statements or in management’s discussion and analysis. If you don’t find the answers there, call the company’s investor relations department. Also look at analysis written by the financial press or independent analysts.
Computing cash-debt coverage ratio
You also want to look at the company’s ability to pay its debt that will be due over the long term. Current liabilities include only debt that a company must pay in the next 12 months. Long-term liabilities are debt that a company must pay beyond that 12-month period. If there are signs that the company may have difficulties meeting long-term debt: That, too, is a major cause for concern. Although you may find that a company is generating enough cash to meet its current liabilities, if long-term debt levels are too high, the company eventually will run into trouble paying off its debt and meeting its interest obligations. You can test a company’s cash position to meet long-term debt needs by using the cash-debt coverage ratio.
The formula for the cash-debt coverage ratio is a two-step process:
1. Find the average total liabilities.
(2007 total liabilities + 2006 total liabilities) ÷ 2 = average total liabilities
2. Find the cash-debt coverage ratio.
cash provided by operating activities ÷ average total liabilities = cash-debt coverage ratio
You can find the last- and previous-year total liabilities on the balance sheet. You can find cash provided by operating activities on the statement of cash flows.
Tesco
Using the cash provided by operating activities from Tesco’s 2007 cash- flow statement and the average of its total liabilities from its 2007 and 2006 balance sheet, we show you how to calculate the cash-debt coverage ratio. Using the two-step process, first calculate the average total liabilities. Then use that number to calculate the ratio:
1. Calculate average total liabilities.
£14,236 (2007 total liabilities) + £13,119 (2006 total liabilities) ÷ 2 = £13,678 (average total liabilities)
2. Find the cash-debt coverage ratio.
£3,532 (2007 cash provided by operating activities) ÷ £13,678 (average total liabilities) = 0.26 (cash-debt coverage ratio)
To judge whether a company’s cash provided by activities is improving or not, you calculate the ratio for both the last reporting year and the 2006 reporting year:
£3,412 (2006 cash provided by operating activities) ÷ £12,310 (average total liabilities) = 0.28 (cash-debt coverage ratio)
This ratio serves as further evidence that Tesco’s cash position worsened from the end of 2006 to the end of 2007. Tesco’s long-term debt increased between 2006 and 2007 by £483 million according to its balance sheet (see Appendix A).
Marks and Spencer
To show you how to calculate the cash-debt coverage ratio, we use the cash provided by operating activities from Marks and Spencer’s 2007 cash-flow statement and the average of its total liabilities from its 2007 and 2006 balance sheet:
1. Calculate average total liabilities.
£3,732.80 (2007 total liabilities) + £4,055.20 (2006 total liabilities) ÷ 2 = £3,894.00 (average total liabilities)
2. Calculate the cash-debt coverage ratio for the current reporting year.
£1,442.60 (2007 cash provided by operating activities) ÷ £3,894.00 (average total liabilities) = 0.37 (cash-debt coverage ratio)
Calculate the ratio for 2006 as well:
£1,183.60 (2006 cash provided by operating activities) ÷ £4,006.70 (average total liabilities) = 0.30 (cash-debt coverage ratio)
Taking total liabilities into consideration, Marks and Spencer ended 2007 in a stronger cash position than Tesco. Notice also the improvement in this ratio from 0.30 to 0.37 over the two years.
What do the numbers mean?
The cash-debt coverage ratio looks at a company’s ability to pay its long- term debt obligations. As you can see, when long-term debt was taken into consideration, Marks and Spencer’s position remains stronger than Tesco’s. So calculating only one ratio or the other – current cash-debt coverage ratio or cash-debt coverage ratio – won’t give you the full picture of a company’s financial health. You need to look at both ratios to be certain that the company is generating enough cash to cover both its short-term and long-term debt. In Chapter 9 we talk more about this debt-structure difference when looking at the explanations given in the notes to the financial statements.
Calculating Cash-Flow Coverage
Debt and the interest paid on that debt are not a company’s only cash requirements. A company also needs cash for capital expansion to grow the company (including new plants, tools, and equipment) and pay dividends to shareholders.
As a shareholder, the only way you make money is when the company’s shares go up in price. The stock market rewards a company with good growth potential by bidding up the price of its shares. Companies that show low growth prospects usually have few buyers and end up with lower share prices. So you want to invest in companies that not only are generating enough cash to pay their bills, interest, and the principals on their long-term debts, but also have money left over to pay dividends to their shareholders and grow their company. Remember that many growth companies do not pay dividends at all but instead reinvest all profits toward future growth.
You want to test whether the company is generating enough cash to cover its capital expenditures, pay its dividends, and pay its debt obligations by calculating the cash-flow coverage ratio.
Finding out the cash-flow coverage ratio
You use a two-step process to calculate the cash-flow coverage ratio:
1. Calculate the company’s cash requirements.
Add the following:
Net cash used in investing activities (listed in the investing activities section of the cash-flow statement)
Cash dividends paid (listed in the financing activities section of the cash-flow statement
Interest paid (which may be listed in any of the sections of the cash-flow statement)
Tax paid (listed in the operating activities section of the cash-flow statement)
2. Calculate the cash-flow coverage ratio.
Cash provided by operating activities ÷ cash requirements = cash-flow coverage ratio
You can find cash provided by operating activities on the statement of cash flows.
Tesco
We use the financial statements for Tesco to show you how to calculate the cash-flow coverage ratio:
1. Find Tesco’s cash requirements.
Net cash used in investing activities 2,343
Cash dividends paid 467
Interest paid 376
Tax paid 545
Cash requirement 3,731
2. Calculate the cash-flow coverage ratio.
£3,532 (cash flows from operating activities) ÷ £3,731 (cash requirements) = 0.95 (cash-flow coverage ratio)
Tesco didn’t generate enough cash from its operations to pay all its cash requirements for 2007. This means that Tesco generated only enough to cover 95 per cent of the cash it needed to meet all its cash requirements. To cover the rest of its cash needs, it had to draw down cash on hand from activities in 2006 or borrow money. Any company that must draw down savings to maintain its operating activities may be showing signs of trouble. Because Tesco has a large cash stash, it has enough to cover, but how long can it do that before the cash runs out and it gets in trouble? Tesco probably has the situation under good control.
Tesco had to find sources other than operations to meet the shortfall in their cash requirements. Tesco used cash on hand at the beginning of the year to make up the cash shortfall, which you can see when you look at the cash and short-term investments on hand (in the balance sheet in Appendix A) at the beginning of the year versus what was on hand at the end of the year.
Marks and Spencer
Now we use the financial statements for Marks and Spencer to show you how to calculate the cash-flow coverage ratio:
1. Find Marks and Spencer’s cash requirements.
Net cash used in investing activities 650.80
Cash dividends paid 260.60
Interest paid 145.00
Tax paid 150.80
Cash requirement 1,207.20
2. Calculate the cash-flow coverage ratio.
£1,442.6 (cash flows from operating activities) ÷ £1,207.2 (cash requirements) = 1.19 (cash-flow coverage ratio)
Marks and Spencer improved its cash-flow ratios from 2006 to 2007 and had no need of further borrowings in 2007. Unlike Tesco (see preceding section), Marks and Spencer generated enough cash from its operations to pay all its cash requirements for 2007. This ratio shows that Marks and Spencer generated enough cash to cover 119 per cent of its cash requirements, which means Marks and Spencer could add to its cash reserves in 2007 or (as it actually did) choose to pay off part of its loans.
What do the numbers mean?
If you’re trying to use the cash-flow coverage ratio to assess future cash needs then you must consider adjusting the cash requirements figure to remove any one-off costs. For example, in the case of Marks and Spencer (see preceding section), there is an amount of £21.6 million shown in the cash-flow statement (see Appendix A) as ‘Exceptional interest paid’. Presumably, this will not need to be paid next year and so future cash requirements should be £21.6 million lower than in the current year.
However, life is not that simple. In Chapter 12, we refer to the fact that the amount included in the cash-flow statement was the actual amount paid but the profit and loss account showed the higher figure for exceptional interest of £30.4 million because of amounts accrued. Presumably therefore the accrued amount of £8.8 million (that is the difference between £30.4 million and £21.6 million) will need to be paid in the next year – leading to yet another adjustment in the cash requirements figure.
However, there may be different exceptional items in the future that we cannot predict so, perhaps, on balance, it’s not worth making the adjustment to the ratio at all!
Long term you should expect Tesco to improve these ratios and return to a positive free cash flow. It’s worth keeping an eye on though: In the end, no company can run with negative ratios for ever.