CHAPTER NINE
Analyzing Operating Cash Flow
Though my bottom line is black, I am flat upon my back, My cash flows out and customers pay slow. The growth of my receivables is almost unbelievable; The result is certain—unremitting woe! And I hear the banker utter an ominous low mutter, “Watch cash flow.”1
We first quoted that poem in our book
Financial Warnings, published in 1996.
2 The advice contained in it, which dates to 1975, is timeless, and gets to the heart of what really matters to an investor or creditor. It is cash flow—the lifeblood of any business organization.
The importance of cash flow and its sustainability notwithstanding, many analysts are content simply to view the firm as a cash-generating black box. Cash goes in, taking the form of equity investments and loans. Then, after the passage of an appropriate amount of time during which some amount of management magic is applied, cash comes out and provides the financial wherewithal to service the loans and provide a return on the equity investments. In this line of reasoning, what more can be asked of a company than to generate cash flow that is sufficient to cover the claims of lenders, to provide for reinvestment, and to generate a return for investors?
Of course, from what we have seen in earlier chapters of this book, much more can be asked of such firms. Managers may take numerous steps to boost cash flow artificially, making it appear to be sustainable when in fact it is drawn from nonrecurring sources. Just because a company appears to be generating sufficient cash to service its claims, to invest in itself, and to pay dividends does not mean that it will be able to continue to do so. Adjustments were proposed in earlier chapters to clean up operating cash flow by reclassifying certain operating items and removing nonrecurring items. However, even after such adjustments have been made, a careful analysis of the sources of operating cash flow still is needed to determine whether it is being generated from sustainable sources.
Consider, for example, how changing fundamentals may threaten an otherwise robust cash flow performance. The operating cash flow performance for Blockbuster, Inc., for the five years ended December 31, 2001, is presented in
Exhibit 9.1.
A casual view of the cash flow generated by Blockbuster would suggest that the company was healthy and growing. Between December 31, 1997, and 2001, cash provided by operating activities increased from $991.3 million to $1,395.1 million, respectively, an increase of over 40 percent. Moreover, as measured by cash used for investing activities, which for Blockbuster consisted primarily of rental library purchases and capital expenditures, the company continued to makes investments, ostensibly for the purpose of generating future returns. More recently, it had even begun repaying its debt obligations, as reflected in cash used for financing activities.
Adjustments to operating cash flow, as described in earlier chapters, would not change Blockbuster’s overall cash performance over the time period presented. Yet based on its reported cash performance, it would be erroneous to assume that the company’s business over that time period was improving. For example, in each year between 1997 and 2001, the company lost money.
Exhibit 9.2 presents evidence of the company’s poor earnings performance.
Exhibit 9.1 Blockbuster, Inc., Excerpts from Statements of Cash Flows, Years Ended December 31, 1997, 1998, 1999, 2000, and 2001 ($ millions)
Source: Blockbuster, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 1999, p. 57, and December 31, 2001, p. 48.
Exhibit 9.2 Blockbuster, Inc., Excerpts from Statements of Income, Years Ended December 31, 1997, 1998, 1999, 2000, and 2001 ($ millions)
Source: Blockbuster, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 1999, p. 54, and December 31, 2001, p. 45
As noted in the exhibit, in every year between 1997 and 2001, Blockbuster reported losses. However, because a significant portion of the company’s operating expenses was in the form of noncash depreciation charges on its rental library, even as it reported losses, Blockbuster was able to generate positive operating cash flow. Changes in operating-related accounts, such as increases in deferred tax liabilities, accounts payable, and accrued expenses payable, and reductions in accounts receivable and inventory, also increased operating cash flow. Such balance sheet changes, however, are not sustainable. A truly solid and sustainable cash flow performance requires support from profitable operations and would not be derived primarily from noncash expenses and changes in operating-related balance sheet accounts.
Blockbuster’s story continues to unfold. Recent changes in its business model, including a heavier emphasis on sales of merchandise, did boost profitability, at least temporarily. For example, net income, before the effects of an accounting change, improved to $189.4 million for the year ended December 31, 2002, from a loss of $240.3 million in 2001. However, due to an impairment charge and continuing operational difficulties, the company reported a loss from continuing operations of $979.5 million for the year ended December 31, 2003.
3 During this period, the company continued to generate positive operating cash flow, increasing to $1,451.2 million for the year ended December 31, 2002, from $1,395.1 million in 2001 and continuing at $1,416.1 million for the year ended December 31, 2003.
4We cannot know the ultimate direction of Blockbuster’s fortunes. Our point is that regardless of how ample operating cash flow appears to be, even after it is adjusted to reclassify certain operating items and remove nonrecurring items as described in earlier chapters, a careful consideration of changes in a company’s underlying fundamentals is needed before informed conclusions about cash flow performance can be reached.
Because of Blockbuster’s recurring losses through 2001, improvements in operating cash flow were not necessarily indicative of improving financial performance. In contrast, there may be reason to be optimistic about future results even in the presence of negative operating cash flow. Consider Pharmacy Buying Association, Inc.
Exhibit 9.3 presents selected income and cash flow data for Pharmacy Buying Association for the three years ended December 31, 2000, 2001, and 2002.
As is apparent from the data provided in the exhibit, Pharmacy Buying Association is enjoying significant revenue and earnings growth. Over the time period between December 31, 2000, and 2002, revenue increased from $22,005,000 to $136,997,000. During that same time period, net income also increased, from $987,000 in 2000 to $1,542,000 in 2002. However, due to a decline in gross margin, the percentage increase in net income was less than the increase in revenue.
Exhibit 9.3 Pharmacy Buying Association, Inc., Selected Income and Cash Flow Data, Years Ended December 31, 2000, 2001, and 2002 ($ thousands)
Source: Pharmacy Buying Association, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, pp. 28 and 30.
As revenue and income at Pharmacy Buying Association have grown, operating cash flow has declined. In fact, it appears that the more profits the company generates, the less operating cash flow it enjoys. Referring again to
Exhibit 9.3, as net income has increased from $987,000 in the year ended December 31, 2000, to $1,542,000 in the year ended December 31, 2002, cash provided by operating activities has declined from a source of cash of $1,538,000 in 2000 to a use of cash of $2,795,000 in 2002—a sizable swing.
Focusing on 2002, significant increases in accounts receivable and inventory were the primary reasons why the company consumed so much operating cash flow. On closer examination, however, it can be seen that the increases in these accounts were generally in line with the growth in the scale of the company’s operations, as measured by the growth in sales. Sales growth typically requires comparable growth in operating assets, draining operating cash flow. When growth levels off, assuming operations remain profitable, the company should be in a position to begin generating positive operating cash flow again.
Thus, negative operating cash flow is not necessarily indicative of worsening financial performance. In fact, for the year ended December 31, 2003, even as revenue increased by 13 percent, Pharmacy Buying Association generated positive operating cash flow of $5,142,062.
5In this chapter, we move beyond the adjustments to operating cash flow proposed in earlier chapters that were designed to reclassify certain operating items and remove non-recurring items. Here we provide an approach to cash flow analysis that considers the fundamental drivers underlying a company’s ability to generate operating cash flow. Instrumental to our understanding of cash flow is a revised format for the statement of cash flows, referred to as the cash flow analysis statement.
CASH FLOW ANALYSIS STATEMENT
Exhibit 9.4 presents a format for the cash flow statement that is useful in analysis. Parts of it are similar to the Uniform Credit Analysis® (UCA)® format of the cash flow statement presented in Chapter 1. Lenders and other credit professionals often use the UCA® format cash flow statement when analyzing cash flow. However, we have introduced changes that adjust for, and at times reclassify, certain operating items and remove non-recurring items as noted in earlier chapters. Moreover, the design of the cash flow analysis statement considers the needs of equity analysts and investors.
Cash flow statements prepared in accordance with generally accepted accounting principles (GAAP) report only three main categories of cash flow: cash provided or used by operating, investing, and financing activities. Operating cash flow in a GAAP-based indirect- method format starts with net income and reconciles to a single cash flow figure, cash provided by operating activities. A GAAP-based direct-method format presents the actual cash flows comprising cash provided by operating activities, categories of cash flow such as cash collected from customers and cash paid to suppliers. Operating cash flow is computed by summing these operating-related cash flow items.
As seen in
Exhibit 9.4, the cash flow analysis statement is a combination of the indirect and direct formats. Similar to an indirect-method cash flow statement, the cash flow analysis statement provides a reconciliation of income to cash flow. However, rather than only reconciling net income to operating cash flow, on the cash flow analysis statement each line item of the income statement is reconciled to its cash flow counterpart. For example, among the line items presented on the statement, revenue is reconciled to cash from revenue by removing balance sheet changes in operating receivables and deferred revenue. Similarly, cost of revenue is reconciled to the cash cost of revenue by removing depreciation and amortization expense and changes in inventory and operating payables. Also, selling, general, and administrative expense and research and development expense are reconciled to cash operating expense by removing, in addition to depreciation and amortization expense, changes in prepaids and accruals. Similar to the presentation on a direct-method cash flow statement, each resulting cash flow item—for example, cash from revenue, cash cost of revenue, and cash operating expense—is an actual source or use of cash for a particular function. Added to the cash flow analysis statement are key subtotals, such as cash gross margin and core operating cash flow. These subtotals help the analyst more readily determine if sources of cash are sufficient to cover key operating needs.
Both the indirect and direct cash flow statements present key components of cash provided or used by investing activities drawn to a single total. Cash provided or used by financing activities is presented similarly. No distinction is made among priorities of various claims. The cash flow analysis statement can be considered to be a cash flow coverage statement, as it uses subtotals to highlight whether superior claims on cash flow are being covered by cash collections. For example, interest paid is subtracted from cash available for debt service to derive cash flow from operations. From this subtotal, required principal payments on long-term debt and capital lease obligations are subtracted to yield cash flow after debt service. Dividends then are subtracted to yield cash flow after dividends, which is cash available for investments and capital expenditures. Subtracting investments and capital expenditures yields the change in cash before external financing. As the title suggests, cash would have increased or decreased by this amount in the absence of any external financing, whether through debt or equity. The actual change in cash and equivalents is determined once external financing and the change in accumulated other comprehensive income are taken into account.
6In preparing the cash flow analysis statement, revenue and other income items should be recorded as sources of cash, that is, as positive amounts. Decreases in assets as well as increases in liabilities and shareholders’ equity accounts also are entered as sources of cash. Expenses and dividends, as well as increases in assets and reductions in liabilities and shareholders’ equity, should be entered as uses of cash.
As noted, the cash flow analysis statement format is attuned to adjustments to reclassify certain operating items and remove nonrecurring items discussed in earlier chapters. For example, capitalized operating expense is included with cash operating expense, which is part of core operating cash flow. On a GAAP-based cash flow statement, often such costs are reported as part of cash used for investing activities. When interest is capitalized to inventory or property, plant, and equipment, it is reclassified on the cash flow analysis statement to total interest paid.
On the cash flow analysis statement, cash invested in trading securities is reported as part of cash paid for investments and is not included with cash provided by operating activities as called for by GAAP. Also, securitized receivables are excluded from operating cash flow and are reported as a component of external financing, a line item referred to as receivables-related financing on the cash flow analysis statement. Adjustments such as these were deemed necessary to get a clearer picture of a company’s sustainable cash-generating ability.
7
Creditors and Equity Investors
The cash flow analysis statement is designed with the needs of both credit and equity professionals in mind. For credit professionals, cash flow available for debt service is cash flow that is available for the payment of interest and principal on debt. Creditors can determine readily whether cash flow is sufficient to cover not only interest but also required principal payments on long-term debt and capital lease obligations. To facilitate loan structuring, the time frame of debt financing, that is, current versus long-term, also is provided.
The ability of a company to service its debt is important information for equity investors. Debt-service difficulties, made apparent when cash flow available for debt service is insufficient to cover interest and required principal payments, can be an early indicator of credit quality downgrades or even default. Companies unable to cover debt-service requirements also would have difficulty covering dividends on a recurring basis.
However, of particular interest to equity investors is an addendum to the cash flow analysis statement that provides information regarding free cash flow. As defined in the cash flow analysis statement, free cash flow is discretionary cash flow available for equity holders and may be used for such purposes as incremental debt reductions, common dividends and stock buybacks. The free cash flow calculation begins with cash flow from operations, as reported on the cash flow analysis statement, and subtracts preferred dividends and capital expenditures. Note that the free cash flow computations separate capital expenditures into two amounts, replacement capital expenditures, as proxied by depreciation, and growth-related capital expenditures. Replacement capital expenditures are designed to replace productive capacity consumed in operations. Basically, it maintains productive capacity. Growth-related capital expenditures are based on actual capital expenditures and incorporate the incremental spending needed to maintain a company’s rate of growth in operations. The topic of free cash flow and questions of whether replacement capital expenditures or actual capital expenditures should be used in its calculation is addressed more carefully in Chapter 10.
Details of Selected Accounts
The cash flow analysis statement presents summaries of certain cash flow items, the details of which are important to cash flow analysis. Most of the items are self-explanatory, and an analyst will be able to determine from an item’s description the specific accounts to include when completing the calculations.
For example, operating receivables should include only customer-related receivables. However, even notes receivable should be included with operating receivables if those notes were received from customers and are sale-related. For contractors, operating receivables also should include cost plus profit recognized on contracts less amounts billed, often referred to as unbilled receivables. When billings exceed cost plus profit recognized, the account balance should be included with deferred revenue along with other advance collections from customers. For companies that employ receivables-based financing, the balance of securitized receivables should be removed from operating receivables and reclassified to the financing section of the cash flow analysis statement.
Similar to operating receivables, operating payables consist of amounts due vendors, including accounts payable and notes payable for purchases made. Floor-plan financing should be included with operating payables.
When completing the cash flow analysis statement, noncash expenses, for example, depreciation and amortization expense, should be excluded from such operating expenses as cost of revenue, selling, general and administrative expense, and research and development expense.
Prepaid expenses, referred to as prepaids, consist of all operating expenses paid in advance of being incurred. Accrued expenses payable, referred to as accruals, are comprised of operating expenses incurred that have not been paid.
Two line items on the cash flow analysis statement, other cash income and income taxes paid, require more clarification. Details for other cash income are provided in
Exhibit 9.5.
Exhibit 9.6 provides the components of income taxes paid.
As seen in
Exhibit 9.5, other cash income consists generally of cash flow that is not classified elsewhere. It is important to identify the source of other cash income so that sustainability can be assessed. For example, sustainable sources of other cash income include interest and dividend income, recurring distributions from associate companies, and rental and royalty income. Revenue from noncore operations, trading income, and unidentified other income or expense are likely less sustainable, although judgment is needed in making that decision. A restructuring charge, adjusted for changes in the restructuring reserve in order to derive the cash component of the restructuring, is also an unlikely recurring use of cash.
Other nonrecurring items include discontinued operations, extraordinary, items and the effects of changes in accounting principle. Balance sheet changes, including changes in other operating current and noncurrent assets and other operating current and noncurrent liabilities, also result in nonrecurring sources and uses of cash.
The caption “net cash paid in buyback of shares for options” reflects the buyback of shares that were issued when employees exercised stock options received as compensation. The cash paid in such buybacks should be reduced for any tax benefits received. Consistent with the compensation-like nature of the item, its treatment as other cash income moves its effects to operating cash flow from financing. It should be adjusted out of treasury stock transactions in the financing section of the cash flow statement.
As presented in
Exhibit 9.6, income taxes paid reflect disbursements for income taxes related to continuing operations.
In the calculations presented in this exhibit, income tax expense is the tax provision recorded on income from continuing operations. It is adjusted for changes in current and noncurrent deferred tax assets and liabilities.
8 It also is adjusted for the change in any tax refund receivable or income taxes payable.
On the cash flow analysis statement, tax benefits from stock options are reported as a separate line item within the external financing section. The company will have reported these benefits as a component of additional paid-in capital. For separate recognition of the benefits, they will need to be moved from common equity financing to a separate tax benefits line. However, if shares have been repurchased to serve as an offset to shares issued as a result of stock option exercises, then tax benefits from stock options should be netted against the cash paid in such a buyback. The net buyback amount is reported as a component of other cash income.
On the cash flow analysis statement, total interest paid consists of interest expense adjusted for changes in accrued interest payable. Interest paid also should include interest capitalized to inventory and property, plant, and equipment. Related to interest paid is the line item “required principal payments on long-term debt and capital lease obligations.” This disbursement line reflects principal amounts scheduled for payment during the year. As such, the current portion of long-term debt and capital leases at the beginning of the current year should be entered here as a use of cash. The dividends paid line includes dividends on outstanding preferred and common issues. Any dividends paid on preferred stock also should be used in computing free cash flow.
Changes in investments, notes receivable, goodwill, and other intangibles are all reported in the investments section of the cash flow analysis statement. Capital expenditures are included in this section too. Net capital expenditures can be computed by adjusting the book value change in property, plant, and equipment by depreciation and amortization and any gain or loss resulting from asset dispositions.
9All external financing is reported in a single section of the cash flow analysis statement. Financing amounts are calculated by computing the change in each debt or equity caption.
10 Sale and leaseback financing consists of the proceeds received from sale and leaseback transactions. To the extent these proceeds serve to reduce the book value of property, plant, and equipment, capital expenditures will need to be adjusted upward. Receivables-related financing refers to incremental proceeds received from the sale of operating receivables. Common and preferred equity financing reflect proceeds received for new shares issued, including shares issued resulting from the exercise of stock options.
USING THE CASH FLOW ANALYSIS STATEMENT
To demonstrate use of the cash flow analysis statement, we present four cases using assumed company results. Each cash flow case begins with the same revenue amount and ends with no net change in cash. However, each case presents a markedly different cash flow situation with different implications for the company’s current performance and future cash flow. Although income statements are presented for each of the four cases, balance sheets are not. Relevant balance sheet changes are, however, presented on the cash flow analysis statements. Cash flow cases 1 and 2 employ the income statement presented in
Exhibit 9.7.
As seen in the exhibit, the income results for cash flow cases 1 and 2 are positive. The company reported an operating margin (operating income divided by revenue) of 16.5 percent and a net margin (net income divided by revenue) of 10.1 percent. The origin of other income is not known. However, the amount is not an especially large component of pretax income.
Exhibit 9.7 Assumed Income Statement Data for Cash Flow Cases 1-2 ($ thousands)
| Revenue | | $8,000 |
| Cost of revenue (including depreciation of $600) | $4,760 | |
| Selling, general, and administrative expense | 1,920 | 6,680 |
| Operating income | | 1,320 |
| Other income | 40 | |
| Interest expense | (140) | (100) |
| Pretax income | | 1,220 |
| Tax provision | | 410 |
| Net income | | $ 810 |
Cash flow results for cases 1 and 2, both of which employ the income statement presented in
Exhibit 9.7, are presented in
Exhibits 9.8 and
9.9, respectively. The exhibits present a summarized cash flow analysis statement.
The cash flow analysis statement for case 1 is presented in
Exhibit 9.8. The company generated sufficient cash flow available for debt service, $950,000, to cover interest and required principal payments on its debt. The majority of the company’s cash flow was generated through core operations. That is, other cash income was not significant. Also, income taxes paid were approximately 34 percent of pretax income, a level that is reasonably close to the federal statutory tax rate of 35 percent. When income taxes paid extend well above approximately 40 percent of pretax income or well below 30 percent, the reasons should be identified and a determination made as to whether those taxes paid may decline or increase in the future.
After debt service, the company in case 1 had $500,000 to use toward capital expenditures of $700,000. The shortfall was filled with long-term debt financing, a proper match of long-term needs with long-term financing. After external financing, there was no change in cash during the period.
The case 1 company generated positive free cash flow of $110,000. Cash flow from operations of $810,000 was sufficient to cover the depreciation proxy for replacement capital expenditures of $600,000 and add $100,000 to property, plant, and equipment to support the company’s growth.
Additional analyses would be needed to better understand the factors causing increases in such working capital accounts as operating receivables, inventory and operating payables. However, overall the case 1 company appeared to be doing an ample job of generating cash flow. It was able to service debt with cash generated by core operations and, for shareholders, was providing positive free cash flow. Of course, of concern is the amount of free cash flow that the company generated. On an equity market capitalization of, say $12,150,000, or 15 times net income (15 × $810,000), free cash flow of $110,000 would provide a free-cash return on investment to shareholders of less than 1 percent ($110,000 / $12,150,000).
Exhibit 9.8 Cash Flow Analysis Statement Case 1, Profitable Company, Sufficient Cash Flow to Service Debt and Positive Free Cash Flow. Source (Use) of Cash ($ thousands)
| Revenue | $8,000 |
| Change in operating receivables | (500) |
| Cash from revenue | 7,500 |
| Cost of revenue (excluding depreciation & amortization) | (4,160) |
| Change in inventory | (300) |
| Change in operating payables | 200 |
| Cash cost of revenue | (4,260) |
| Cash gross margin | 3,240 |
| Cash operating expense | (1,920) |
| Core operating cash flow | 1,320 |
| Other cash income | 40 |
| Income taxes paid | (410) |
| Cash flow available for debt service | 950 |
| Total interest paid | (140) |
| Cash flow from operations | 810 |
| Required principal payments on long-term debt & capital lease obligations | (310) |
| Cash flow after debt service | 500 |
| Dividends paid | 0 |
| Cash flow after dividends | 500 |
| Cash paid for capital expenditures | (700) |
| Change in cash before external financing | (200) |
| Short-term debt financing | |
| Long-term debt financing | 200 |
| Equity financing | _________ |
| External financing | 200 |
| Change in cash and equivalents after external financing | $ 0 |
| Free cash flow: | |
| Cash flow from operations | $ 810 |
| Preferred dividends declared | |
| Depreciation proxy for replacement capital expenditures | (600) |
| Growth-related capital expenditures, net of dispositions | (100) |
| Free cash flow | $ 110 |
| Selected Details: |
|---|
| Other income (expense) | $ 40 |
| Change in other operating assets and liabilities | |
| Other cash income | $ 40 |
| Income tax expense | $ (410) |
| Change in deferred tax assets | |
| Change in deferred tax liabilities | 42 |
| Change in tax refund receivable | |
| Change in income taxes payable | (42) |
| Income taxes paid | $ (410) |
The cash flow analysis statement for case 2 is presented in
Exhibit 9.9. The company’s cash flow available for debt service was a use of cash of $850,000 and did not provide the cash needed to pay interest and principal on its debt. The problem was not due to other cash income or income taxes paid, but rather to a lack of cash flow being generated by core operations. The company’s core operating cash flow was a use of cash of $480,000.
The case 2 company had the same operating margins as the company in case 1. However, in case 2, significant increases in operating receivables and inventory that were not offset by increases in operating payables consumed large amounts of cash flow. What is unknown and would require additional analysis is whether the increases in these working capital accounts were due to seasonal factors, growth, or collection problems and problems related to product demand. More is said later about how to analyze changes in working capital accounts.
It appears that the company financed its working capital needs with short-term debt. On the surface, such a move would appear to be a good match of financing needs (working capital) and sources (short-term debt). However, only a seasonal need for working capital could be expected to liquidate in the near term and provide the cash needed to repay a short-term loan. Growth needs for working capital are longer term.
Additional financing in the amount of $700,000 was obtained to complete the company’s $2,000,000 overall shortfall in cash flow. The company apparently financed its capital expenditures needs with long-term debt. Because the company in case 2 generated negative cash flow from operations, its free cash flow was also negative.
Cash flow case 3 employs the income statement data presented in
Exhibit 9.10. The company is profitable; however, less so than cases 1 and 2.
As presented in the exhibit, the case 3 company was profitable. However, while the company generated a net margin of 13 percent ($1,042,000 / $8,000,000), core operations were barely above break-even, reflecting an operating margin of only 2 percent ($160,000 / $8,000,000). Most of the company’s earnings were generated by other income, the origin of which is unknown. Moreover, the company’s effective tax rate (tax provision of $178,000 divided by pretax income of $1,220,000), at 14.6 percent, was unusually low, reduced by the assumed utilization of operating loss carryforwards. At the end of the reporting period, the company had fully utilized its remaining operating loss carryforwards.
Exhibit 9.9 Cash Flow Analysis Statement Case 2, Profitable Company, Insufficient Cash Flow to Service Debt and Negative Free Cash Flow. Source (Use) of Cash ($ thousands)
| Revenue | $8,000 |
| Change in operating receivables | (1,800) |
| Cash from revenue | 6,200 |
| Cost of revenue (excluding depreciation & amortization) | (4,160) |
| Change in inventory | (1,200) |
| Change in operating payables | 600 |
| Cash cost of revenue | (4,760) |
| Cash gross margin | 1,440 |
| Cash operating expense | (1,920) |
| Core operating cash flow | (480) |
| Other cash income | 40 |
| Income taxes paid | (410) |
| Cash flow available for debt service | (850) |
| Total interest paid | (140) |
| Cash flow from operations | (990) |
| Required principal payments on long-term debt & capital lease obligations | (310) |
| Cash flow after debt service | (1,300) |
| Dividends paid | 0 |
| Cash flow after dividends | (1,300) |
| Cash paid for capital expenditures | (700) |
| Change in cash before external financing | (2,000) |
| Short-term debt financing | 1,300 |
| Long-term debt financing | 700 |
| Equity financing | _________ |
| External financing | 2,000 |
| Change in cash and equivalents after external financing | $ 0 |
| Free cash flow: | |
| Cash flow from operations | $ (990) |
| Preferred dividends declared | |
| Depreciation proxy for replacement capital expenditures | (600) |
| Growth-related capital expenditures, net of dispositions | (100) |
| Free cash flow | $(1,690) |
| Selected Details: |
|---|
| Other income (expense) | $ 40 |
| Change in other operating assets and liabilities | |
| Other cash income | $40 |
| Income tax expense | $ (410) |
| Change in deferred tax assets | |
| Change in deferred tax liabilities | 42 |
| Change in tax refund receivable | |
| Change in income taxes payable | (42) |
| Income taxes paid | $ (410) |
Exhibit 9.10 Assumed Income Statement Data for Cash Flow Case 3 ($ thousands)
| Revenue | | $8,000 |
| Cost of revenue (including depreciation of $600) | $5,600 | |
| Selling, general and administrative expense | 2,240 | 7,840 |
| Operating income | | 160 |
| Other income | 1,200 | |
| Interest expense | (140) | 1,060 |
| Pretax income | | 1,220 |
| Tax provision | | 178 |
| Net income | | $1,042 |
The cash flow analysis statement for case 3 is presented in
Exhibit 9.11. Cash flow available for debt service of $1,182,000 was sufficient to cover interest and required principal payments on debt and capital leases. However, of concern is the fact that most of this cash flow was derived from other cash income, which may not be sustainable. Thus, it is not clear whether the company will be able to continue servicing its debt.
Cash flow available for debt service also was boosted by an unusually low amount of income taxes paid. At only 14.6 percent of pretax income ($178,000 / $1,220,000) and lowered by fully utilized operating loss carryforwards, income taxes paid by the company will increase in future periods even if pretax income remains unchanged.
Exhibit 9.11 Cash Flow Analysis Statement Case 3, Profitable Company, Sufficient Cash Flow to Service Debt and Positive Free Cash Flow. Source (Use) of Cash ($ thousands)
| Revenue | $8,000 |
| Change in operating receivables | (500) |
| Cash from revenue | 7,500 |
| Cost of revenue (excluding depreciation & amortization) | (5,000) |
| Change in inventory | (300) |
| Change in operating payables | 200 |
| Cash cost of revenue | (5,100) |
| Cash gross margin | 2,400 |
| Cash operating expense | (2,240) |
| Core operating cash flow | 160 |
| Other cash income | 1,200 |
| Income taxes paid | (178) |
| Cash flow available for debt service | 1,182 |
| Total interest paid | (140) |
| Cash flow from operations | 1,042 |
| Required principal payments on long-term debt & capital lease obligations | (310) |
| Cash flow after debt service | 732 |
| Dividends paid | 0 |
| Cash flow after dividends | 732 |
| Cash paid for capital expenditures | (700) |
| Change in cash before external financing | 32 |
| Short-term debt financing | |
| Long-term debt financing | (32) |
| Equity financing | |
| External financing | (32) |
| Change in cash and equivalents after external financing | $0 |
| Free cash flow: | |
| Cash flow from operations | $1,042 |
| Preferred dividends declared | |
| Depreciation proxy for replacement capital expenditures | (600) |
| Growth-related capital expenditures, net of dispositions | (100) |
| Free cash flow | $342 |
| Selected Details: |
|---|
| Other income (expense) | $1,200 |
| Change in other operating assets and liabilities | _ |
| Other cash income | $1,200 |
| Income tax expense | $ (178) |
| Change in deferred tax assets | |
| Change in deferred tax liabilities | 42 |
| Change in tax refund receivable | |
| Change in income taxes payable | (42) |
| Income taxes paid | $ (178) |
The company used its cash flow after debt service, $732,000, for capital expenditures of $700,000 and debt reduction of $32,000.
Free cash flow for the company in case 3 was positive. At $342,000, it was more than three times the amount reported in case 1. However, concerns about the sustainability of free cash flow remain.
Cash flow case 4 employs the income statement data presented in
Exhibit 9.12. The related cash flow analysis statement for case 4 is presented in
Exhibit 9.13. This company is losing money. Because of the loss, its income tax provision was a benefit.
Although the case 4 company lost money, it generated significant amounts of cash flow. Cash flow available for debt service was $1,160,000 and was sufficient to cover interest and debt principal.
After debt service, the company had $710,000 available, which it returned to shareholders in the form of dividends and stock buybacks. The company did not make any new capital expenditures during the year. The decline in property, plant, and equipment during the year was equal to the amount of depreciation recorded.
Exhibit 9.12 Assumed Income Statement Data for Cash Flow Case 4 ($ thousands)
| Revenue | | $8,000 |
| Cost of revenue (including depreciation of $600) | $5,600 | |
| Selling, general, and administrative expense | 2,440 | 8,040 |
| Operating income | | (40) |
| Other income | 0 | |
| Interest expense | (140) | (140) |
| Pretax income | | (180) |
| Tax (benefit) | | (63) |
| Net loss | | $ (117) |
Exhibit 9.13 Cash Flow Analysis Statement Case 4, Loss Company, Sufficient Cash Flow to Service Debt and Positive Free Cash Flow. Source (Use) of Cash ($ thousands)
| Revenue | $8,000 |
| Change in operating receivables | 500 |
| Cash from revenue | 8,500 |
| Cost of revenue (excluding depreciation & amortization) | (5,000) |
| Change in inventory | 300 |
| Change in operating payables | (200) |
| Cash cost of revenue | (4,900) |
| Cash gross margin | 3,600 |
| Cash operating expense | (2,440) |
| Core operating cash flow | 1,160 |
| Other cash income | 0 |
| Income taxes (paid) benefit | 0 |
| Cash flow available for debt service | 1,160 |
| Total interest paid | (140) |
| Cash flow from operations | 1,020 |
| Required principal payments on long-term debt & capital lease obligations | (310) |
| Cash flow after debt service | 710 |
| Dividends paid | (300) |
| Cash flow after dividends | 410 |
| Cash paid for capital expenditures | 0 |
| Change in cash before external financing | 410 |
| Short-term debt financing | |
| Long-term debt financing | |
| Equity financing | (410) |
| External financing | (410) |
| Change in cash and equivalents after external financing | $ 0 |
| Free cash flow: | |
| Cash flow from operations | $1,020 |
| Preferred dividends declared | |
| Depreciation proxy for replacement capital expenditures | (600) |
| Growth-related capital expenditures, net of dispositions | 600 |
| Free cash flow | $1,020 |
| Selected Details: |
|---|
| Other income (expense) | $ 0 |
| Change in other operating assets and liabilities | ________ |
| Other cash income | $0 |
| Income tax (expense) benefit | $ 63 |
| Change in deferred tax assets | |
| Change in deferred tax liabilities | |
| Change in tax refund receivable | (63) |
| Change in income taxes payable | ________ |
| Income taxes paid | $ 0 |
In case 4, free cash flow was the highest amount yet, $1,020,000. It was due to a high amount of cash flow from operations and no capital expenditures.
Certainly the sustainability of cash flow in case 4 should be questioned. During the reporting period, the company partially liquidated itself. Operating receivables and inventory were reduced. Operating payables were also paid. Even property, plant, and equipment, which were not being replaced, were effectively liquidated through operations.
Periods of decline are mirror images of periods of growth. Although growth requires cash investments in working capital and property, plant, and equipment, decline results in the liquidation of those investments. In the process, cash flow is generated. However, in the absence of a return to profitable operations, positive cash flow will be generated only as long as there are assets available for liquidation.
Summary of the Cash Flow Analysis Cases
In all four of the cash flow cases presented, the top line of the cash flow analysis statement, revenue, was the same. Each company generated revenue of $8,000,000. In addition, in all four cases, the bottom line of the cash flow analysis statement, the change in cash and equivalents after external financing, was the same. All four companies showed no net change in cash and equivalents. Yet all four cases presented very different scenarios. Those differences were the result of changes in the underlying fundamentals, including the fundamentals of profitability and the fundamentals of efficiency, changes in other cash income, and changes in income taxes paid.
Cases 1 and 2 were the more profitable of the four cases examined. In case 1, the company was able to service its debt with cash flow available for debt service. The company used cash flow after debt service for capital expenditures, which required a small amount of long-term debt financing. The company generated positive free cash flow. Although the company in case 2 was as profitable as the company in case 1, increases in working capital, operating receivables, and inventory that were not offset by an increase in operating payables resulted in negative cash flow available for debt service. The company needed substantial amounts of external financing to meet its working capital and capital expenditure needs. Free cash flow was decidedly negative in case 2.
The company in case 3 was less profitable than in cases 1 and 2; however, other cash income and low income taxes paid resulted in the company having sufficient cash flow available for debt service to service its debt. The company also was able to meet its capital expenditure needs with cash flow after debt service. The change in cash before external financing, a positive amount, was used to reduce debt principal. The company generated more than three times the amount of free cash flow generated by the company in case 1. However, important questions remained regarding the sustainability of the company’s other cash income and whether income taxes paid will increase in future periods.
The company in case 4 lost money. Yet because this company liquidated its working capital accounts, sufficient cash flow available for debt service was generated to service its debt. There was even cash flow available after debt service to pay dividends and to buy back stock. With positive cash flow from operations and no capital expenditures, the company in case 4 generated more free cash flow than cases 1 through 3. In the absence of profitable operations, however, such cash flow performance cannot be expected to continue.
The role played by other cash income and income taxes paid in the cash flow analysis of the four cases is readily apparent. Increases in other cash income improved operating cash flow performance. The unknown is whether other cash income is sustainable. A study of the detail of the components of other cash income would help to address that issue and aid in the determination of whether a company’s reported cash flow can continue.
As to income taxes paid, a careful analysis of the amount of income taxes paid relative to pretax income and an assessment of whether income taxes paid may grow or decline in future periods would provide useful insight into the sustainability of cash flow. In particular, the analyst should consider many tax-related factors, including:
• Unsustainable changes in the effective tax rate caused by such factors as operating loss carryforwards, tax credits, tax holidays, or audit adjustments,
• Increases or declines in deferred tax asset or liability accounts at rates that are inconsistent with the rate of change in pretax income, and
• Increases or declines in tax refunds receivable or income taxes payable also at rates that are inconsistent with the rate of change in pretax income.
The company in case 3 saw its effective tax rate decline, reducing income taxes paid, due to the use of operating loss carryforwards.
11 As another example, a company that discontinued capital expenditures for a few years may see deferred tax liabilities resulting from depreciation temporary differences begin to reverse, that is, decline, resulting in an increase in income taxes paid. The payment of those income taxes will continue until either the related deferred tax liability is reduced to zero or the company begins making capital expenditures again, increasing its deferred tax liabilities. Also, a company with an extremely profitable fourth quarter one year may end the year with a large balance in income taxes payable. Those taxes will be paid early in the first quarter of the following year, resulting in a decline in income taxes payable. The increase in income taxes paid related to a reduction in income taxes payable likely would be nonrecurring.
Beyond other cash income and income taxes paid, additional analysis is needed to determine the effects of changes in the underlying fundamentals of profitability and efficiency on cash flow. In particular, in terms of profitability, our interest turns to changes in the profitability measures of gross margin and operating expenses as a percentage of revenue. As to efficiency, we consider investments in operating receivables and inventory less financing provided by the use of operating payables. Because their implications for future cash flow generation are so different, our focus is on determining the effects on cash flow of growth and period-to-period changes in underlying fundamentals of profitability and efficiency.
CASH FLOW DRIVERS
We refer to growth and changes in fundamentals of profitability and efficiency as cash flow drivers. These factors drive changes in cash flow. In particular, when referring to the cash flow analysis statement, they are the fundamental reasons for surpluses or shortfalls of core operating cash flow and changes in that measure over time.
The cash effects of growth are pervasive, impacting virtually every source and use of cash flow. In terms of core operating cash flow, growth increases revenue, which provides cash flow, and also increases cost of revenue, which consumes cash flow. The net effects of growth on the two measures combined, gross margin, or revenue less cost of revenue, will be positive provided gross margin is positive. Growth also increases such operating expenses as selling, general and administrative expense, and research and development expense, which consume cash flow.
There is also a growth impact on the working capital accounts included in the calculation of core operating cash flow. With growth in revenue comes the need for accompanying increases in operating receivables and inventory, which consume core operating cash flow, and are offset by increases in operating payables, which provide cash flow.
The effects of an assumed rate of growth on all of these factors—gross margin, operating expense, operating receivables, inventory, and operating payables—must be considered when projecting core operating cash flow.
Beyond the cash flow effects of growth on these income statement and balance sheet accounts are the effects of changes in underlying profitability and efficiency. In terms of profitability, we mean changes in the gross margin ratio and the operating expense ratio. Here operating expense refers to selling, general and administrative expense plus research and development expense. However, importantly, because we are calculating cash flow impacts, the effects of depreciation and amortization, which are noncash expenses, are not included in the gross margin and operating expense ratios.
The term “operating profit,” also known as operating income, is used to refer to a firm’s core pretax profit from operations. It is measured as gross margin, or revenue less cost of revenue, minus the operating expenses of selling, general and administrative expense, and research and development expense. When operating profit or operating income is measured before or without the effects of depreciation and amortization expense, we refer to the resulting profit measure as operating cushion. Thus, operating cushion is revenue minus cost of revenue, selling, general and administrative expense, and research and development expense, where all expenses are measured without depreciation and amortization expense.
Changes in efficiency refer to changes in effectiveness in managing operating receivables, inventory, and operating payables. Efficiency in managing such working capital accounts can be measured in different ways. For example, receivables turnover might be used for measuring efficiency in collecting operating receivables. Calculated as revenue divided by operating receivables, receivables turnover measures the number of times during a year that operating receivables are collected and replaced with new revenue transactions. Receivables turnover for a company with revenue of $1,000,000 and operating receivables of $100,000 would be 10 ($1,000,000 / $100,000). The higher the turnover measure, the more efficient the company is in managing its operating receivables.
Receivables days, also commonly referred to as days sales outstanding (DSO), is a related measure of efficiency, calculated as 365 divided by receivables turnover. The receivables days statistic measures the length of time it takes for a firm to collect its outstanding operating receivables balance. For the company with a receivables turnover measure of 10, receivables days would be 36.5 (365 / 10).
There are similar measures for inventory and operating payables, although often cost of revenue is used in measuring turnover for inventory and operating payables.
We will use a turnover-related measure of efficiency, where operating receivables, inventory, and operating payables are expressed as a percentage of revenue. This measure of efficiency is actually the reciprocal of a turnover ratio and is unconventional. However, as will be developed later, by expressing these working capital accounts as a percentage of revenue, we will be able to develop a better profile of a firm’s expected cash flow performance given an anticipated rate of growth in revenue.
For example, a company with revenue of $1,000,000, operating receivables of $100,000, and a receivables turnover ratio of 10, operating receivables to revenue would be 10.0 percent ($100,000 / $1,000,000). That is, 10 percent of the company’s revenue is uncollected and reflected in operating receivables.
Inventory and operating payables also will be measured as a percent of revenue. Measured in this way, efficiency improves as a lower percentage of revenue is tied up in working capital.
We have not included other working capital accounts, such as prepaid expenses, deferred revenue, and accrued expenses payable, in this discussion. When material, such accounts should be included with operating receivables, inventory, and operating payables in computing measures of efficiency for purposes of analyzing core operating cash flow. Taken collectively, the sum of operating receivables, inventory, and prepaid expenses, less deferred revenue, operating payables, and accrued expenses payable comprise a company’s operating working capital and represent its investment in net current assets needed to support operations.
Exhibit 9.14 provides a summary of the calculation of the profitability and efficiency measures to be used here.
Calculating Cash Flow Impacts
We refer to cash flow impacts, or simply cash impacts, as the measured effects of the cash flow drivers of growth and changes in profitability and efficiency on core operating cash flow. Such impacts are helpful in better understanding why a company generated positive cash flow or consumed cash and how those cash flows might change in future periods.
Calculating the cash impact of growth on core operating cash flow entails measuring the effects of period-to-period revenue growth on the profitability factors of gross margin and operating expense and on the efficiency factors of operating receivables, inventory, and prepaid expenses, deferred revenue, operating payables, and accrued expenses payable. To make the calculation, the profitability and efficiency factors are kept at their prior year’s levels and revenue is changed for the actual rates of growth experienced during the ensuing year. The year-to-year change, that is, growth in revenue, is applied to prior-year measures of the underlying factors of profitability and efficiency to derive growth-related cash flow measures. To calculate the cash impact of changes in profitability and efficiency, increases and decreases in those underlying factors are applied to revenue for the year being analyzed.
Exhibit 9.14 Calculation of Cash Flow Profitability and Efficiency Measures
| Profitability Measure | Calculation Formula |
|---|
| Gross margin ratio | Gross margin divided by revenuea |
| Operating expense ratio | Operating expense divided by revenueb |
| Operating cushion ratio | Operating cushion divided by revenuec |
| Efficiency Measure | Calculation Formula |
|---|
| Receivables to revenue ratio | Operating receivables divided by revenue |
| Inventory to revenue ratio | Inventory divided by revenue |
| Prepaids to revenue ratio | Prepaid expenses divided by revenue |
| Payables to revenue ratio | Operating payables divided by revenue |
| Accruals to revenue ratio | Accrued expenses payable divided by revenue |
| Operating working capital to revenue ratio | Operating working capital divided by revenued |
| a Gross margin is calculated as revenue less cost of revenue, excluding depreciation and amortization expense. |
| b Operating expense consists of selling, general, and administrative expense plus research and development expense, excluding depreciation and amortization expense. |
| c Gross margin to revenue less operating expense to revenue, excluding depreciation and amortization expense. |
| d The sum of receivables to revenue plus inventory to revenue and prepaids to revenue less the sum of payables to revenue and accruals to revenue. |
An example will help demonstrate the calculations. For this purpose, cash flow case 1 from the previous section is used, though additional information is provided.
The income statement for the company in cash flow case 1 is presented in
Exhibit 9.7. Its cash flow analysis statement is presented in
Exhibit 9.8. As noted earlier, the company was profitable and provided sufficient cash flow available for debt service to cover the interest and required principal reduction on its outstanding debt. However, the company’s free cash flow as a percentage of its equity market capitalization, at less than 1 percent, was rather weak.
Income statement data for the company in cash flow case 1 for the current year, as provided in
Exhibit 9.7, together with assumed prior-year data, are presented in
Exhibit 9.15. Assumed balance sheet data for the company as of the end of the prior year and current year are presented in
Exhibit 9.16.
Exhibit 9.15 Income Statement Data For Calculating Cash Flow Impacts ($ thousands)
| Prior Year | Current Year |
|---|
| Revenue | $7,000 | $8,000 |
| Cost of revenue (including depreciation of $525 and $600) | 4,165 | 4,760 |
| Selling, general and administrative expense | 1,470 | 1,920 |
| Operating income | 1,365 | 1,320 |
| Other income | 40 | 40 |
| Interest expense | (165) | (140) |
| Pretax income | 1,240 | 1,220 |
| Tax provision | 422 | 410 |
| Net income | $ 818 | $ 810 |
Exhibit 9.16 Selected Balance Sheet Data for Calculating Cash Flow Impacts ($ thousands)
| Prior Year | Current Year |
|---|
| Cash | $ 350 | $ 350 |
| Accounts receivable | 575 | 1,075 |
| Inventory | 838 | 1,138 |
| Total current assets | 1,763 | 2,563 |
| Accounts payable | 300 | 500 |
Using income statement and balance sheet data presented in
Exhibits 9.15 and
9.16, ratios and other statistics relevant for calculating cash flow impacts can be computed. Those ratios and statistics together with supporting data are presented in
Exhibit 9.17.
According to the exhibit, revenue increased $1,000,000 during the year to $8,000,000 from $7,000,000, an increase of 14.3 percent. Although gross margin was unchanged between the two reporting periods, the operating expense ratio worsened to 24.0 percent of revenue during the current year from 21.0 percent in the prior year. As a result, the company’s operating cushion declined to 24.0 percent of revenue in the current year from 27.0 percent in the prior year.
Other operating statistics also worsened. Receivables to revenue increased to 13.4 percent in the current year from 8.2 percent while inventory to revenue increased to 14.3 percent from 12.0 percent. Helping to offset the increased investment in these operating current assets was an increase in payables to revenue. That ratio increased to 6.3 percent from 4.3 percent. Taken collectively, operating working capital to revenue increased to 21.4 percent in the current year from 15.9 percent in the prior year.
Exhibit 9.17 Statistics for Calculating Cash Flow Impacts ($ thousands, except ratios)
Although the potential negative implications of a decline in operating cushion to 24.0 percent from 27.0 percent can be readily appreciated, an increase in operating working capital to revenue from a measure of 15.9 percent in the prior year to 21.4 percent in the current year is less intuitive. In the prior year, 15.9 percent of every revenue dollar was tied up in operating working capital. Finding the reciprocal, operating working capital turnover was 6.3 times (1 / 15.9 percent). Dividing 365 by the turnover figure to obtain an operating working capital days figure, we note that in the prior year the company had approximately 58 days’ worth of revenue tied up in operating working capital (365/6.3). In the current year that statistic worsened to approximately 78 days’ worth of revenue (365 / the reciprocal of 21.4 percent). Thus, in the current year the company carried approximately 20 more days of revenue in its operating working capital.
Cash Flow Impact of Growth
The cash impact of growth is computed by applying changes in revenue for the year to measures of profitability and efficiency from the prior year. In effect, our interest is in determining how the company’s core operating cash flow has changed during the year as a result of growth, keeping measures of profitability and efficiency unchanged. Calculations of the cash impact of growth are presented in
Exhibit 9.18.
As shown in the exhibit, the company’s growth in revenue of $1,000,000 translated into an increase in operating cushion of $270,000. If the company were operating on strictly a cash basis, the increase in operating cushion would translate directly into an increase in core operating cash flow.
Of course the company did not operate on a cash basis and needed to invest in operating working capital, including growth-related increases in operating receivables and inventory, less operating payables, to support its growth. Using the prior-year ratio of operating working capital to revenue as a benchmark, 15.9 percent of every dollar increase in revenue must be invested in working capital to support that growth. As a result, the cash impact of growth on operating working capital was a use of cash of $159,000.
Combining the cash impact of growth on operating cushion and the cash impact of growth on operating working capital, the total cash impact of growth for the company was a source of cash of $111,000, or 11.1 percent of the growth in revenue.
It is important to note that the cash impact of growth for this company was a positive amount. Specifically, growth provided cash flow. We often think of companies as consuming cash as they grow. However, that is not always the case. Whether a company consumes cash or generates cash as a result of growth depends on its operating cushion and the percentage of every revenue dollar that must be invested in operating working capital. We refer to the combination of these factors for a company as its growth cash flow profile.
| Cash Flow Determinant | Computations | Source (Use) of Casha |
|---|
| Profitability: |
| Cash impact of growth on gross margin | $1,000,000 × 48.0%b | $ 480,000 |
| Cash impact of growth on operating expense | $1,000,000 × 21.0%c | $(210,000) |
| Total cash impact of growth on operating cushion | $1,000,000 × 27.0%d | $ 270,000 |
| Efficiency: |
| Cash impact of growth on operating receivables | $ 1,000,000 × 8.2%e | $ (82,143) |
| Cash impact of growth on inventory | $1,000,000 × 12.0%f | $(119,714) |
| Cash impact of growth on operating payables | $ 1,000,000 × 4.3%g | $ 42,857 |
| Total cash impact of growth on working capital | $1,000,000 × 15.9%h | $(159,000) |
| Total cash impact of growth | $1,000,000 × 11.1%i | $ 111,000 |
| a The cash impact of growth on gross margin and operating payables are sources of cash. The cash impact of growth on operating expense, operating receivables, and inventory are uses of cash. Negative growth would generate opposite results. The source (use) of cash was computed without rounding of relevant ratios. Thus amounts differ slightly from what would be derived using the rounded ratios of cash impacts listed above. Gross margin, operating expense, and operating cushion are calculated excluding the effects of depreciation and amortization expense. |
| b Growth in revenue times prior year gross margin ratio. |
| c Growth in revenue times prior year operating expense ratio. |
| d Growth in revenue times prior-year operating cushion ratio. |
| e Growth in revenue times prior-year receivables to revenue ratio. |
| f Growth in revenue times prior-year inventory to revenue ratio. |
| g Growth in revenue times prior-year payables to revenue ratio. |
| h Growth in revenue times prior-year operating working capital to revenue ratio. |
| i Growth in revenue times difference of prior-year operating cushion ratio less operating working capital to revenue ratio. |
Growth Cash Flow Profile At 27.0 percent, the company in this example enjoyed a high operating cushion ratio. Such an operating cushion can support significant operating working capital needs. That is, as long as its operating working capital is not more than 27.0 percent of revenue, growth in revenue will add to the core operating cash flow generated by the company.
12
The growth cash flow profile is a combination of operating cushion and operating working capital to revenue designed to highlight the capacity of a firm to generate core operating cash flow as it grows. Firms with even higher operating cushion and lower operating working capital to revenue ratios will generate even more core operating cash flow as revenue increases.
The company analyzed here entered the year with an operating cushion of 27.0 percent and a ratio of operating working capital to revenue of 15.9 percent. Thus, its growth cash flow profile ratio was a positive 11.1 percent of revenue (27.0 percent - 15.9 percent). As noted, the company generated core operating cash flow as a result of growth in revenue. Firms for which operating working capital to revenue exceeds operating cushion will consume increasing amounts of core operating cash flow as revenue grows.
Different industries will have differing growth cash flow profiles. As an example, consider various beverage-manufacturing industries.
Exhibit 9.19 presents the operating cushion ratio and operating working capital to revenue ratio for each of four beverage-manufacturing industries. The exhibit combines the operating cushion ratio and working capital to revenue ratio into the growth cash flow profile ratio. It is a percentage figure, calculated by subtracting the operating working capital to revenue ratio from the operating cushion ratio. As discussed, the statistic measures the percentage of every revenue dollar increase that will translate into core operating cash flow.
As presented in the exhibit, breweries and soft drink manufacturers enjoy the highest growth cash flow profile ratio. For them, every dollar of revenue increase translates into 4.8 cents of core operating cash flow. Breweries have a higher operating cushion ratio than the soft drink manufacturers. However, their businesses require a higher investment in operating working capital. The operating cushion at the coffee manufacturers is 7.1 percent and exceeds working capital to revenue by only 0.8 percent. For these firms, growth in revenue would provide very little core operating cash flow.
Among the four industries, the wineries enjoy the highest operating cushion ratio, at 14.0 percent. However, the 40 percent of revenue working capital requirement for these firms, caused primarily by significant investments in wine inventories as they age, exceeds the operating cushion. As a result, the growth cash flow profile ratio for this industry is -26.0 percent. A $1 increase in revenue requires firms in this industry to raise, on average, 26 cents in funds from other sources.
Because they combine many firms of different sizes or firms whose lines of business may differ slightly, industry statistics can be misleading. Accordingly, we examine the growth cash flow profile for several individual firms.
Exhibit 9.20 presents the growth cash flow profile for four beverage manufacturers taken from each of the industries just reviewed.
Exhibit 9.19 Growth Cash Flow Profile of Selected Beverage Manufacturing Industries
Source: Annual Statement Studies: Financial Ratio Benchmarks, (Philadelphia, PA: Risk Management Association, 2003).
Exhibit 9.20 Growth Cash Flow Profile of Selected Beverage Manufacturers
Source: Company Form 10-K annual report filings with the Securities and Exchange Commission for the years indicated.
As presented in the exhibit, Coca-Cola Co. has the highest growth cash flow profile ratio of the group. The growth cash flow profile statistic of 25.3 percent of revenue is derived primarily from the company’s high operating cushion. On the other end of the spectrum, Robert Mondavi Corp. has a negative growth cash flow profile ratio. Due to significant operating working capital requirements, the company consumes 83.7 cents of core operating cash flow for every dollar increase in revenue.
The working capital to revenue ratio for Adolph Coors Co. is interesting. The company reports higher operating current liabilities than current assets, resulting in a negative operating working capital to revenue ratio and boosting its growth cash flow profile ratio above its operating cushion ratio.
Calculations of the cash impact of growth sets prior-year levels of operating cushion and operating working capital as a benchmark to be used in cash flow calculations. In effect, the cash impact of growth determines the implications for core operating cash flow of growth assuming no change in those opening operating statistics.
Of course, those statistics do change. Operating cushion improves or worsens. Operating working capital needs change as well. A complete analysis of core operating cash flow requires, in addition to the growth impact, an analysis of the cash flow impact of changes in profitability and efficiency.
Cash Flow Impact of Changes in Profitability and Efficiency
Management has a certain level of control over changes in profitability and efficiency and their effects on cash flow. Steps taken to improve profitability and efficiency will manifest directly by increasing core operating cash flow. Declines in such measures will reduce it. Moreover, changes in profitability and efficiency will alter a company’s growth cash flow profile for future periods.
In calculating their cash impact, year-to-year changes in profitability and efficiency are applied to current year revenue. Calculations of such cash impacts for the example company being studied here are presented in
Exhibit 9.21.
The exhibit presents calculations of the cash flow impact of changes in profitability and efficiency for the example company. Recall that the company’s operating expense ratio worsened during the year, resulting in a decline in its operating cushion and a $240,000 reduction in core operating cash flow. The increase in operating working capital to revenue from 15.9 percent to 21.4 percent cost the company an additional $441,000 of core operating cash flow. Combined, the worsening of the company’s profitability and efficiency cost the company $681,000 in core operating cash flow during the year. Stated another way, had underlying profitability and efficiency remained unchanged from the prior year, the company would have generated $681,000 more than it did. Steps taken to improve these measures in the future would once again increase core operating cash flow.
Of course, there is likely an interaction effect between growth and changes in profitability and efficiency. For example, higher spending on advertising, which would increase the operating expense ratio, might have been needed to provide the growth in revenue enjoyed during the year. Similarly, a relaxed credit policy, which would manifest as an increase in operating receivables as a percent of revenue, might have been needed to grow revenue. Such interaction effects are not captured in this analysis. Isolating such interaction effects would require additional analysis, likely including a discussion with management.
Exhibit 9.22 summarizes the cash impacts of growth and of changes in profitability and efficiency on each component of core operating cash flow. The exhibit provides a check on the calculations.
In reviewing the exhibit, it can be seen that for measures of profitability, including gross margin, operating expense, and their difference, operating cushion, current-year amounts are derived by adding to prior-year measures the effects of growth and changes in profitability. For measures of efficiency, including operating receivables, inventory, operating payables, and their sum, operating working capital, the cash impact of growth and of changes in each item as a percent of revenue are totaled to derive the actual account balance change.
Exhibit 9.21 Calculations of Cash Impact of Changes in Profitability and Efficiency
| Cash Flow Determinant | Computations | Source (Use) of Casha |
|---|
| Profitability: | | |
| Cash impact of change in gross margin ratio | $ 8,000,000 × 0%b | $ 0 |
| Cash impact of change in operating expense ratio | $ 8,000,000 × 3.0%c | $(240,000) |
| Total cash impact of change in operating cushion ratio | $8,000,000 × (3.0)%d | $(240,000) |
| Efficiency: | | |
| Cash impact of change in receivables to revenue ratio | $ 8,000,000 × 5.2%e | $(417,857) |
| Cash impact of change in inventory to revenue ratio | $ 8,000,000 × 2.3%f | $(180,286) |
| Cash impact of change in payables to revenue ratio | $ 8,000,000 × 2.0%g | $157,143 |
| Total cash impact of change in operating working capital to revenue ratio | $ 8,000,000 × 5.5%h | $(441,000) |
| Total cash impact of change in profitability and efficiency | $ 8,000,000 × 8.5%i | $(681,000) |
| a The cash impact of an increase in gross margin ratio and payables to revenue ratio are sources of cash. The cash impact of an increase operating expense ratio, operating receivables to revenue ratio, and inventory to revenue ratio are uses of cash. Decreases in these ratios would generate opposite results. Gross margin, operating expense, and operating cushion were calculated without the effects of depreciation and amortization expense. The source (use) of cash was computed without rounding of relevant ratios. Thus amounts differ slightly from what would be derived using the rounded ratios of cash impacts listed above. |
| b Change in gross margin ratio times current year revenue. |
| c Change in operating expense ratio times current year revenue. |
| d Change in operating cushion ratio times current year revenue. |
| e Change in receivables to revenue ratio times current year revenue. |
| f Change in inventory to revenue ratio times current year revenue. |
| g Change in payables to revenue ratio times current year revenue. |
| h Change in operating working capital to revenue ratio times current year revenue. |
| i Change in operating cushion ratio plus change in operating working capital to revenue ratio, times current year revenue. |
The overall effects of both growth and changes in profitability and efficiency on core operating cash flow was a use of cash of $570,000 for the year. Growth provided $111,000 of core operating cash flow during the year; changes in profitability and efficiency consumed $681,000 of operating cash flow.
Recall that earlier, as presented in
Exhibit 9.8, the company being analyzed here reported free cash flow for the current year of $110,000. That amount was less than 1 percent of an assumed market capitalization of equity for the firm. We now know something about why the company was not generating more cash flow. Changes in its underlying fundamentals, its profitability and efficiency, consumed significant amounts of cash. An analyst would need to determine whether improvements in profitability and efficiency might be gained in future periods, supplementing core operating cash flow, or if deterioration in those factors might continue.
Exhibit 9.22 Summary of Cash Impacts on Operating Cushion and Operating Working Capital
| Components of Profitability and Efficiency | Source (Use) of Cash |
|---|
| Profitability: | |
| Prior-year gross margin (excluding depreciation) | $ 3,360,000 |
| Cash impact of growth on gross margin | 480,000 |
| Cash impact of change in gross margin ratio | 0 |
| Current-year gross margin (excluding depreciation) | $ 3,840,000 |
| Prior-year operating expense | $(1,470,000) |
| Cash impact of growth on operating expense | (210,000) |
| Cash impact of change in operating expense ratio | (240,000) |
| Current-year operating expense | $(1,920,000) |
| Prior-year operating cushion | $ 1,890,000 |
| Cash impact of growth on operating cushion | 270,000 |
| Cash impact of change in operating cushion ratio | (240,000) |
| Current-year operating cushion | $ 1,920,000 |
| Efficiency: | |
| Cash impact of growth on operating receivables | $(82,143) |
| Cash impact of change in receivables to revenue ratio | (417,857) |
| Total change in operating receivables | $ (500,000)a |
| Cash impact of growth on inventory | $ (119,714) |
| Cash impact of change in inventory to revenue ratio | (180,286) |
| Total change in inventory | $ (300,000)b |
| Cash impact of growth on operating payables | $ 42,857 |
| Cash impact of change in payables to revenue ratio | 157,143 |
| Total change in operating payables | $ 200,000c |
| Total change in operating working capital | $ (600,000)d |
| a Operating receivables increased to $1,075,000 in the current year from $575,000 in the prior year. |
| b Inventory increased to $1,138,000 in the current year from $838,000 in the prior year. |
| c Operating payables increased to $500,000 in the current year from $300,000 in the prior year. |
| d Operating working capital increased to $1,713,000 in the current year from $1,113,000 in the prior year. |
A Changing Growth Cash Flow Profile During the year under review, the deterioration noted in the sample company’s fundamentals of profitability and efficiency reduced its core operating cash flow. In addition, as a result of those changes, the company’s growth cash flow profile will limit its ability to generate core operating cash flow with increases in revenue in future periods.
During the year, the company’s operating cushion declined to 24.0 percent from 27.0 percent. Operating working capital to revenue also worsened, increasing to 21.4 percent from 15.9 percent. As a result, the company’s growth cash flow profile declined to 2.6 percent of revenue (24.0 percent - 21.4 percent) from 11.1 percent (27.0 percent - 15.9 percent). Thus, in the following year only 2.6 percent of any revenue increase will add to core operating cash flow, down from 11.1 percent.
Management can have a very direct effect on altering a company’s growth cash flow profile. Consider recent changes at Home Depot, Inc. In Chapter 4, we highlighted the cash flow effects of extensions in vendor payment terms at Home Depot. During the year ended February 2, 2002, the company increased the length of time taken to settle accounts payable to approximately 34 days from 22 days in 2001. The change added approximately $1.1 billion to operating cash flow that year. The payment period was increased further to 41 days in the year ended February 2, 2003, adding another $800 million to operating cash flow for the year.
As noted, such changes in operating efficiency provide nonrecurring sources of operating cash flow. Only an additional increase in vendor payment terms would provide incremental cash flow. However, such changes in operating efficiency will alter a company’s growth cash flow profile. As a result, future revenue increases will provide more core operating cash flow.
Exhibit 9.23 summarizes Home Depot’s operating cushion ratio and operating working capital to revenue ratio for four years through the year ending February 2, 2003.
In reviewing the exhibit, it can be seen that after a decline in 2001, Home Depot’s growth cash flow profile ratio, that is, its operating cushion ratio less its operating working capital to revenue ratio, improved markedly in 2002 and 2003. From a low of 3.3 percent in 2001, the growth cash flow profile statistic increased to 7.7 percent in 2002 and 8.4 percent in 2003. As a result, the company was in a much better position to generate increases in core operating cash flow with growth in revenue. A closer look at the components of the company’s growth cash flow profile provides useful insight into how the improvement was achieved.
Due primarily to an improvement in gross margin, the company’s operating cushion improved to 11.6 percent of revenue in 2003 from 10.5 percent in 2001. After a decline in 2002, current assets to revenue remained at 16.6 percent of revenue, the same percentage as in 2001. However, over that same two-year period, reflecting an increase in the length of time taken to settle accounts payable, operating current liabilities increased to 13.4 percent of revenue from 9.4 percent. Thus, the improvement in Home Depot’s growth cash flow profile can be attributed to an improvement in gross margin and an extension of the payment period for accounts payable. Whether the company continues to improve its growth cash flow profile remains to be seen.
CLOSER LOOK AT CORE OPERATING CASH FLOW
As noted in
Exhibit 9.20, due primarily to significant inventory needs, the growth cash flow profile ratio for Robert Mondavi Corp. was -83.7 percent at June 30, 2003. That is, in future years the wine company was expected to consume 83.7 cents of core operating cash flow for every dollar of growth in revenue. The growth statistic compared with positive growth cash flow profile ratios for manufacturers of other beverages, ranging from 7.9 percent for Farmer Brothers Co., a coffee manufacturer, to 25.3 percent for Coca-Cola Co.
Exhibit 9.23 Changing Growth Cash Flow Profile, Home Depot, Inc., Years Ended January 30, 2000, January 28, 2001, February 3, 2002, and February 2, 2003.
Source: Home Depot, Inc., Form 10-K annual report to the Securities and Exchange Commission, January 28, 2001, pp. 19, 20 and 22, and February 2, 2003, pp. 28, 29 and 31.
Given the extreme nature of the growth cash flow profile for Robert Mondavi, we chose to look more closely at the company’s core operating cash flow. To this end, the cash flow analysis statement through core operating cash flow for Mondavi for the year ended June 30, 2003, is presented in
Exhibit 9.24.
In reviewing Mondavi’s cash flow analysis statement as presented in the exhibit, it is readily seen that even with a negative growth cash flow profile, during 2003 the company generated positive core operating cash flow of $61,453,000. Recall that the growth cash flow profile ratio measures the extent to which increases in revenue will result in sources or uses of core operating cash flow. In the absence of revenue growth, given its positive operating cushion, the company should be expected to generate positive core operating cash flow provided it is not consumed by changes in operating working capital accounts.
However, positive core operating cash flow notwithstanding, it is important to look carefully at the cash flow drivers—that is, profitability factors consisting of gross margin and the operating expense ratio and efficiency factors, including operating current assets and operating current liabilities to revenue—to get a better understanding of core operating cash flow and where it might be headed.
Exhibit 9.24 Cash Flow Analysis Statement through Core Operating Cash Flow, Robert Mondavi Corp., Year Ended June 30, 2003.
| Company name: Robert Mondavi Corp. Amounts in: ($000s) Fiscal year-end (June 30) | 2003 |
|---|
| Net revenue | $452,673 |
| Change in operating receivables | (3,556) |
| Change in deferred revenue | |
| Cash from revenue | 449,117 |
| Cost of revenue (excluding depreciation & amortization) | (254,643) |
| Change in inventory | (5,815) |
| Change in operating payables | 5,715 |
| Cash cost of revenue | (254,743) |
| Cash gross margin | 194,374 |
| Selling, general and admin. expense (excluding depreciation & amortization) | (129,993) |
| Change in prepaids | (366) |
| Change in accruals | (2,562) |
| Cash operating expense | (132,921) |
| Core operating cash flow | $ 61,453 |
To help with the analysis, selected income statement and balance sheet data are presented in
Exhibits 9.25 and
9.26, respectively.
Exhibit 9.27 provides statistics for measuring the cash flow impacts of each of the cash flow drivers.
Exhibit 9.28 presents the cash flow impact of growth and changes in profitability and efficiency.
The income statement and balance sheet data presented in
Exhibits 9.25 and
9.26 provide the information needed to calculate the cash flow impact of growth and of changes in profitability and efficiency for Robert Mondavi Corp. The data in the exhibits were taken directly from the company’s financial statements. These data were used in calculating statistics for profitability and efficiency as presented in
Exhibit 9.27. Among the statistics presented in the exhibit are the company’s operating cushion ratio, its operating working capital to revenue ratio, and its growth cash flow profile ratio.
Exhibit 9.28 employs the data presented in
Exhibit 9.27 to calculate the cash flow impacts of growth and of changes in profitability and efficiency.
As shown in
Exhibit 9.27, Mondavi ended 2002 and began 2003 with a negative growth cash flow profile of 79.4 percent. As a result of that profile, the $11,315,000 growth in revenue reported during 2003 resulted in a $8,979,000 reduction of core operating cash flow for the year. Had revenue not increased during 2003, but remained unchanged at 2002 levels, core operating cash flow would have been higher by $8,979,000. The calculations are presented in
Exhibit 9.28.
Exhibit 9.25 Income Statement Data for Calculating Cash Flow Impacts, Robert Mondavi Corp., Years Ended June 30, 2002, and 2003 ($ thousands)
Source: Robert Mondavi Corp., Form 10-K annual report to the Securities and Exchange Commission, June 30, 2003, p. 18.
| 2002 | 2003 |
|---|
| Revenue | $441,358 | $452,673 |
| Cost of goods solda | 249,020 | 278,208 |
| Selling, general and administrative expense | 125,760 | 129,993 |
| Operating incomeb | $ 66,578 | $ 44,472 |
| a Depreciation and amortization expense of $23,088 in 2002 and $23,565 assumed included in cost of goods sold. |
| b Excludes special charges of $12,240 in 2002 and $2,111 in 2003. |
Exhibit 9.26 Selected Balance Sheet Data for Calculating Cash Flow Impacts, Robert Mondavi Corp., Years Ended June 30, 2002, and 2003 ($ thousands)
Source: Robert Mondavi Corp., Form 10-K annual report to the Securities and Exchange Commission, June 30, 2003, p. 17.
| 2002 | 2003 |
|---|
| Operating current assets: | | |
| Accounts receivable | $ 92,555 | $ 96,111 |
| Inventory | 388,574 | 394,389 |
| Prepaid expenses | 12,179 | 12,545 |
| Operating current assets | 493,308 | 503,045 |
| Operating current liabilities: | | |
| Accounts payable | 23,012 | 28,727 |
| Accrued expenses payablea | 30,374 | 27,812 |
| Operating current liabilities | 53,386 | 56,539 |
| Operating working capitalb | $439,922 | $446,506 |
| a Includes noncurrent deferred executive compensation. |
| b Operating current assets minus operating current liabilities. |
During 2003, Mondavi saw its operating cushion ratio decline as a percent of revenue by 5.3 percent. Offsetting that decline was an improvement in its operating working capital as a percent of revenue. The ratio improved by 1.0 percent of revenue during 2003. Combining these measures, the company’s growth cash flow profile worsened as a percent of revenue by 4.3 percent during 2003. The impact of that decline, as reported in
Exhibit 9.28, was a $19,234,000 reduction in core operating cash flow during 2003. The primary reason for the decline during 2003 in the company’s growth cash flow profile ratio was a decline in its operating cushion ratio, caused mostly by a reduction in gross margin. The company attributed the decline in its gross margin generally to “intense competition in the premium wine industry resulting from a weak U.S. economy.” More specifically, the company noted that reasons for the decline in gross margin were “higher cost surplus wines in the Company’s popular and super-premium brands [and the] result of inventory write-downs . . . and grape contract buyouts.”
13 To the extent that a portion of the decline in gross margin can be attributed to nonrecurring items, then gross margin and core operating cash flow can be expected to improve in future years.
Exhibit 9.27 Statistics for Calculating Cash Flow Impacts, Robert Mondavi Corp., Years Ended June 30, 2002 and 2003 ($ thousands, except ratios)
Source: Selected income statement and balance sheet data from
Exhibits 9.25 and
9.26.
Combining the cash flow impact of growth, a use of cash of $8,979,000, and the cash flow impact of changes in profitability and efficiency, $19,234,000, an overall cash flow impact of $28,213,000 is obtained. That is, had revenue not grown during 2003 and had the company maintained the same levels of profitability and efficiency in 2003 as those reported in 2002, it would have generated $28,213,000 more in core operating cash flow than it did. Such observations provide the analyst with insight into the company’s ability to generate core operating cash flow and highlights where management attention is needed in improving the company’s cash flow in the future.
Exhibit 9.28 Calculations of Cash Flow Impact of Growth and Changes in Profitability and Efficiency ($ thousands, except ratios)
| Cash Flow Determinant | Computations | Source (Use) of Casha |
|---|
| Growth: | | |
| Cash impact of growth on operating cushion | $11,315 × 20.3%b | $2,299 |
| Cash impact of growth on working capital | $11,315 × 99.7%c | (11,278) |
| Total cash impact of growth | $11,315 × 79.4%d | $ (8,979) |
| Changes in Profitability and Efficiency: | | |
| Cash impact of change in operating cushion ratio | $452,673 × 5.3%e | $(23,928) |
| Cash impact of change in working capital to revenue ratio | $ 452,673 × 1%f | 4,694 |
| Total cash impact of changes in profitability and efficiency | $452,673 × 4.3%g | $(19,234) |
| a The source (use) of cash was computed without rounding of relevant ratios; thus amounts will differ slightly from what would be derived with rounding. |
| b Growth in revenue times 2002 operating cushion ratio. |
| c Growth in revenue times 2002 operating working capital to revenue ratio. |
| d Growth in revenue times 2002 growth cash flow profile ratio. |
| e Revenue for 2003 times decrease in operating cushion ratio. |
| f Revenue for 2003 times decrease in operating working capital to revenue ratio. |
| g Revenue for 2003 times decrease in growth cash flow profile ratio. |
Reconciling 2003 Results to 2002
It may be instructive for some to reconcile the cash flow impacts of growth and changes in profitability and efficiency in 2003 with results reported for 2002. In 2002 Robert Mondavi generated an operating cushion, operating profit before depreciation and amortization, of $89,666,000. If operations remained static in 2003, leaving revenue, the operating cushion ratio, and operating working capital as a percent of revenue ratio unchanged in 2003, the company would have generated core operating cash flow of an amount equal to its operating cushion, $89,666,000. Incorporating the cash flow impacts of growth and changes in profitability and efficiency yields the actual core operating cash flow reported for 2003. These calculations are presented in
Exhibit 9.29.
SUMMARY
This chapter provides a framework for analyzing cash flow. Seven key points were raised in the chapter:
1. An understanding of a company’s underlying fundamentals is needed to form conclusions about cash flow performance.
Exhibit 9.29 Reconciliation of 2002 Operating Cushion with 2003 Core Operating Cash Flow, Robert Mondavi Corp.
| 2002 Operating cushion | $89,666,000 |
| 2003 Total cash impact of growth | (8,979,000) |
| 2003 Total cash impact of changes in profitability and efficiency | (19,234,000) |
| 2003 Core operating cash flow | $61,453,000 |
2. A cash flow analysis statement, a special format for the cash flow statement, is useful in gaining insight into sustainable sources and uses of cash flow.
3. Fundamental cash flow drivers are growth and changes in profitability and efficiency.
4. Although growth may result in negative core operating cash flow, decline often results in positive cash flow due to the liquidation of working capital accounts.
5. A company’s growth cash flow profile determines whether growth in revenue will provide or consume core operating cash flow.
6. The growth cash flow profile ratio consists of the operating cushion ratio minus the operating working capital to revenue ratio.
7. Changes in profitability and efficiency affect current-period core operating cash flow and alter a firm’s growth cash flow profile for future periods.
NOTES
1 H. S. Bailey, Jr. “Watch Cash Flow,”
Publishers Weekly, January 13, 1975, p. 34.
2 C. Mulford and E. Comiskey,
Financial Warnings (New York: John Wiley & Sons, 1996).
3 Blockbuster, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 63.
5 Pharmacy Buying Association, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, Item 8.
6 Changes in accumulated other comprehensive income could be due to any number of items, including the effects of foreign currency movements on balance sheet accounts when the current-rate method is applied, changes in the fair value of investments classified as available for sale, adjustments for underfunded pension plans, and changes in the fair value of certain derivatives, especially those accounted for as cash flow hedges. An allocation of a change in accumulated other comprehensive income to various affected line items on the cash flow analysis statement should be made when the cause of the change can be identified. Often, however, no such allocation can be made. For example, foreign currency movements can affect virtually all accounts on the financial statements. Information on the effects of foreign currency movements on various accounts typically is not presented, making an allocation of the change in accumulated other comprehensive income impractical.
7 In Chapter 7, we present a sustainable cash flow worksheet that is designed to adjust reported operating cash flow by reclassifying certain operating items and by removing nonrecurring items. Adjustments for nonrecurring items are presented in layers depending on the extent to which each item is perceived as being nonrecurring. In preparing the cash flow analysis statement, no provisions are made for a layering of nonrecurring items. Thus, decisions must be made on which nonrecurring items to remove.
8 Where possible, deferred tax assets and liabilities related to discontinued operations, extraordinary items, the cumulative effect of changes in accounting principle, and accumulated other comprehensive income should be moved to those sections of the cash flow analysis statement.
9 Depreciation and amortization expense lower asset book values but provide no cash inflow. Accordingly, they should be combined with the change in property, plant, and equipment as an offsetting use of cash. Any gains generated by the sale of property, plant, and equipment should be recorded in the capital expenditures line as a source of cash while losses on sale should be recorded as a use of cash.
10 The current portion of long-term debt and capital leases reported as a use of cash in the debt-service section of the cash flow analysis statement also must be reported as a source of long-term debt financing or capital lease financing, respectively.
11 The assumption here is that the loss carryforwards were recognized and realized in the same time period.
12 To put operating working capital to revenue of 27 percent into perspective, consider that 27 percent of revenue translates into an operating working capital turnover ratio of 3.7 times (1/27 percent). A turnover ratio of 3.7 converts into an operating working capital days statistic of approximately 99 days. At 99 days, a company could take 30 days to collect operating receivables, 90 days to sell inventory, and 21 days to settle operating payables, yielding operating working capital days of 99 (30 + 90 - 21). However, while calculating inventory days and operating payables days in a more traditional manner based on cost of revenue and not revenue would change the calculations, the general observations remain intact. Kellogg Co. is one firm that makes reference to improvements in its management of working capital as a percent of revenue. Refer to Kellogg Co. annual report, December 31, 2002, p. 18.
13 Robert Mondavi Corp., Form 10-K annual report to the Securities and Exchange Commission, June 30, 2003, pp. 9 and 11.
