Financial management and analysis phần 9 ppsx

810 FINANCIAL STATEMENT ANALYSIS The basic difference between NFCF and free cash flow is that the financing expenses—interest and, in some cases dividends—are deducted. If preferred dividends are perceived as nondiscretionary—that is, investors come to expect the dividends—dividends may be included with the interest commitment to arrive at net free cash flow. Otherwise, dividends are deducted from net free cash flow to produce cash flow. Another difference is that NFCF does not consider changes in working capital in the analysis. Further, cash taxes are deducted to arrive at net free cash flow. Cash taxes is the income tax expense restated to reflect the actual cash flow related to this obligation, rather than the accrued expense for the period. Cash taxes are the income tax expense (from the income state- ment) adjusted for the change in deferred income taxes (from the bal- ance sheets). 15 For Procter & Gamble in 2002, In the case of Procter & Gamble for 2002, The free cash flow amount per this calculation differs from the $5,785 that we calculated earlier for two reasons: Changes in working capital and the deduction of taxes on operating earnings were not considered. Net cash flow gives the analyst an idea of the unconstrained cash flow of the company. This cash flow measure may be useful from a cred- itor’s perspective in terms of evaluating the company’s ability to fund additional debt. From a shareholder’s perspective, net cash flow (i.e., net Income tax expense $2,031 Deduct increase in deferred income tax (389) Cash taxes $1,642 15 Cash taxes require taking the tax expense and either increasing this to reflect any decrease in deferred taxes (that is, the payment this period of tax expense recorded in a prior period) or decreasing this amount to reflect any increase in deferred taxes (that is, the deferment of some of the tax expense). EBIT $6,986 Add depreciation and amortization 1,693 Earnings before interest, taxes, depreciation, and amortization $8,679 Deduct capital expenditures (1,679) Free cash flow $7,000 Deduct interest (603) Deduct cash taxes (1,642) Net free cash flow $4,755 Deduct cash common dividends (2,095) Net cash flow $2,660 24-Cash Flows Page 810 Wednesday, April 30, 2003 12:15 PM Cash Flow Analysis 811 free cash flow net of dividends) may be an appropriate measure because this represents the cash flow that is reinvested in the company. THE USEFULNESS OF CASH FLOWS IN FINANCIAL ANALYSIS The usefulness of cash flows for financial analysis depends on whether cash flows provide unique information or provide information in a man- ner that is more accessible or convenient for the analyst. The cash flow information provided in the statement of cash flows, for example, is not necessarily unique because most, if not all, of the information is avail- able through analysis of the balance sheet and income statement. What the statement does provide is a classification scheme that presents infor- mation in a manner that is easier to use and, perhaps, more illustrative of the company’s financial position. An analysis of cash flows and the sources of cash flows can reveal information to the analyst, including: ■ The sources of financing the company’s capital spending. Does the com- pany generate internally (i.e., from operations) a portion or all of the funds needed for its investment activities? If a company cannot gener- ate cash flow from operations, this may indicate problems up ahead. Reliance on external financing (e.g., equity or debt issuance) may indi- cate a company’s inability of to sustain itself over time. ■ The company’s dependence on borrowing. Does the company rely heavily on borrowing that may result in difficulty in satisfying future debt ser- vice? ■ The quality of earnings. Large and growing differences between income and cash flows suggests a low quality of earnings. Consider financial results of OEA, Inc., a manufacturer of propel- lants and pyrotechnic devices (such as those used in air bags), as pre- sented in Exhibit 24.6. 16 As we can see in this exhibit, both operating income and net income are growing over time, with a slight interruption of this growth in 1992. We can take off the “rose-colored glasses” of income and look at cash flows to get a much different picture of the company, as shown in Exhibit 24.7. As we can see in this exhibit, the growth in investment expenditures has continued over time, yet the company is less able to generate funds from operations; in fact, in 1997 OEA relied entirely on external financing. This difficulty is associated with the recent concerns over air bags, the reengineering of air bags, and 16 OEA, Inc. was acquired in 2000 by Autoliv Inc. 24-Cash Flows Page 811 Wednesday, April 30, 2003 12:15 PM 812 FINANCIAL STATEMENT ANALYSIS OEA’s heavy reliance on the airbags for its revenues (80%). OEA’s recent financial challenges are not reflected in the income figures, but are detected with an analysis of the sources of cash flows. Ratio Analysis One use of cash flow information is in ratio analysis, much like we did in Chapter 4 primarily with the balance sheet and income statement infor- mation. In that chapter we used a cash flow-based ratio, the cash flow interest coverage ratio, as a measure of financial risk. There are a number of other cash flow-based ratios that the analyst may find useful in evaluat- ing the operating performance and financial condition of a company. A useful ratio to help further assess a company’s cash flow is the cash flow to capital expenditures ratio, or capital expenditures coverage ratio: 17 EXHIBIT 24.6 OEA Inc., Operating and Net Income 1988–1997 Source: OEA, Inc., Annual Reports, various years 17 The cash flow measure in the numerator should be one that has not already re- moved capital expenditures; for example, including free cash flow in the numerator would be inappropriate. Cash flow to capital expenditures Cash flow Capital expenditures = 24-Cash Flows Page 812 Wednesday, April 30, 2003 12:15 PM Cash Flow Analysis 813 EXHIBIT 24.7 OEA, Inc., Sources of Cash Flows, 1988-1997 Source: OEA, Inc., Annual Reports, various years This ratio gives the analyst information about the financial flexibil- ity of the company and is particularly useful for capital-intensive firms and utilities. 18 The larger the ratio, the greater the financial flexibility. The analyst, however, must carefully examine the reasons why this ratio may be changing over time and why it might be out of line with compa- rable firms in the industry. For example, a declining ratio can be inter- preted in two ways. First, the firm may eventually have difficulty adding to capacity via capital expenditures without the need to borrow funds. The second interpretation is that the firm may have gone through a period of major capital expansion and therefore it will take time for rev- enues to be generated that will increase the cash flow from operations to bring the ratio to some normal long-run level. Another useful cash flow ratio is the cash flow to debt ratio: where debt can be represented as total debt, long-term debt, or a debt measure that captures a specific range of maturity (e.g., debt maturing in 5 years). This ratio gives a measure of a company’s ability to meet maturing debt obligations. A more specific formulation of this ratio is Fitch’s CFAR 18 Fridson, Financial Statement Analysis, p. 173. Cash flow to debt Cash flow Debt = 24-Cash Flows Page 813 Wednesday, April 30, 2003 12:15 PM 814 FINANCIAL STATEMENT ANALYSIS ratio, which compares a company’s 3-year average net free cash flow to its maturing debt over the next five years. 19 By comparing the company’s average net free cash flow to the expected obligations in the near term (i.e., five years), this ratio provides information on the company’s credit quality. Using Cash Flow Information The analysis of cash flows provides information that can be used along with other financial data to help the analyst assess the financial condi- tion of a company. Consider the cash flow to debt ratio calculated using three different measures of cash flow—EBITDA, free cash flow, and cash flow from operations (from the statement of cash flows)—each com- pared with long-term debt, as shown in Exhibit 24.8 for Weirton Steel. This example illustrates the need to understand the differences among the cash flow measures. The effect of capital expenditures in the 1988–1991 period can be seen by the difference between the free cash flow measure and the other two measures of cash flow; both EBITDA and cash flow from operations ignore capital expenditures, which were substantial outflows for this company in the earlier period. EXHIBIT 24.8 Cash Flow to Debt Using Alternative Estimates of Cash Flow for Weirton Steel, 1988–1996 Source: Weirton Steel’s 10-K reports, various years 19 Daniel J. McConville, “Cash Flow Ratios Gains Respect as Useful Tool for Credit Rating,” Corporate Cashflow Magazine (January 1996), p. 18. 24-Cash Flows Page 814 Wednesday, April 30, 2003 12:15 PM Cash Flow Analysis 815 Cash flow information may help the analyst identify companies that may encounter financial difficulties. Consider the study by Largay and Stickney that analyzed the financial statements of W.T. Grant during the 1966–1974 period preceding its bankruptcy in 1975 and ultimate liqui- dation. 20 They noted that financial indicators such as profitability ratios, turnover ratios, and liquidity ratios showed some down trends, but provided no definite clues to the company’s impending bankruptcy. A study of cash flows from operations, however, revealed that company operations were causing an increasing drain on cash, rather than pro- viding cash. 21 This necessitated an increased use of external financing, the required interest payments on which exacerbated the cash flow drain. Cash flow analysis clearly was a valuable tool in this case since W.T. Grant had been running a negative cash flow from operations for years. Yet none of the traditional ratios discussed above take into account the cash flow from operations. Use of the cash flow to capital expenditures ratio and the cash flow to debt ratio would have high- lighted the company’s difficulties. More recently, Dugan and Samson examined the use of operating cash flow as an early warning signal of a company’s potential financial prob- lems. 22 The subject of the study was Allied Products Corporation because for a decade this company exhibited a significant divergence between cash flow from operations and net income. For parts of the period, net income was positive while cash flow from operations was a large negative value. In contrast to W.T. Grant that went into bankruptcy, the auditor’s report in the 1991 Annual Report of Allied Products Corporation did issue a going concern warning. Moreover, the stock traded in the range of $2 to $3 per share. There was then a turnaround of the company by 1995. In its 1995 annual report, net income increased dramatically from prior periods (to $34 million) and there was a positive cash flow from operations ($29 million). The stock traded in the $25 range by the Spring of 1996. 23 As with the W.T. Grant study, Dugan and Samson found that the economic realities of a firm are better reflected in its cash flow from operations. 20 J.A. Largay III and C.P. Stickney, “Cash Flows, Ratio Analysis and the W.T. Grant Company Bankruptcy,” Financial Analysts Journal (July/August 1980), pp. 51–54. 21 For the period investigated, a statement of changes of financial position (on a working capital basis) was required to be reported prior to 1988. 22 Michael T. Dugan and William D. Samson, “Operating Cash Flow: Early Indica- tors of Financial Difficulty and Recovery,” Journal of Financial Statement Analysis (Summer 1996), pp. 41–50. 23 As noted for the W.T. Grant study by Largay and Stickney, cash flow from oper- ations had to be constructed from the statement of changes in financial positions that companies were required to report prior to 1988. 24-Cash Flows Page 815 Wednesday, April 30, 2003 12:15 PM 816 FINANCIAL STATEMENT ANALYSIS The importance of cash flow analysis in bankruptcy prediction is supported by the study by Benjamin Foster and Terry Ward, who com- pared trends in the statement of cash flows components—cash flow from operations, cash flow for investment, and cash flow for financing— between healthy companies and companies that subsequently sought bankruptcy. 24 They observe that healthy companies tend to have rela- tively stable relations among the cash flows for the three sources, cor- recting any given year’s deviation from their norm within one year. They also observe that unhealthy companies exhibit declining cash flows from operations and financing and declining cash flows for investment one and two years prior to the bankruptcy. Further, unhealthy companies tend to expend more cash flows to financing sources than they bring in during the year prior to bankruptcy. These studies illustrate the impor- tance of examining cash flow information in assessing the financial con- dition of a company. SUMMARY ■ The term “cash flow” has many meanings and the analyst’s challenge is to determine the cash flow definition and calculation that is appropri- ate. ■ The simplest calculation of cash flow is the sum of net income and non- cash expenses. This measure, however, does not consider other sources and uses of cash during the period. ■ The statement of cash flows provides a useful breakdown of the sources of cash flows: operating activities, investing activities, and financing activities. Though attention is generally focused on the cash flows from operations, the analyst must also examine what the com- pany does with the cash flows (i.e., investing or paying off financing obligations) and what are the sources of invested funds (i.e., operations versus externally financing). ■ Minor adjustments can be made to the items classified in the statement of cash flows to improve the classification. ■ The analyst can examine different patterns of cash flows to get a gen- eral idea of the activities of the company. For example, a company whose only source of cash flow is from investing activities, suggesting the sale of property or equipment, may be experiencing financial dis- tress. 24 Benjamin P. Foster and Terry J. Ward, “Using Cash Flow Trends to Identify Risks of Bankruptcy,” The CPA Journal (September 1997), p. 60. 24-Cash Flows Page 816 Wednesday, April 30, 2003 12:15 PM Cash Flow Analysis 817 ■ Free cash flow is a company’s cash flow that remains after making cap- ital investments that maintain the company’s current rate of growth. It is not possible to calculate free cash flow precisely, resulting in many different variations in calculations of this measure. ■ A company that generates free cash flow is not necessarily performing well or poorly; the existence of free cash flow must be taken in context with other financial data and information on the company. ■ One of the variations in the calculation of a cash flow measure is net free cash flow, which is, essentially, free cash flow less any financing obligations. This is a measure of the funds available to service addi- tional obligations to suppliers of capital. QUESTIONS 1. A temporary downturn in a company’s fortunes may be suggested by the presence of a negative operating cash flow and positive cash flows from investing and financing activities. Explain how these cash flows may suggest a temporary financial problem. 2. Classify each of the following according to the statement of cash flow activity (i.e., operating, investing, or financing): a. Cash received from the issuance of bonds b. Cash dividends paid c. Cash from the sale of equipment d. Cash paid for treasury stock e. Cash received from the sale of inventory 3. Classify each of the following companies as mature, growing, or downsizing based on these cash flows: 4. Consider the following statement: “Companies that consistently generate free cash flows are good performing companies that will do quite well in the future.” Is this statement true? Explain. 5. Explain briefly what is meant by cash flow, discretionary cash flow, free cash flow, and net free cash flow. What are the distinguishing characteristics of each of these measures? Company Cash Flow from Operations Cash Flow from (for) Investing Activities Cash Flow from (for) Financing Activities A $550,345,890 $(300,532,400) $(232,221,891) B $33,114,893 $(145,231,879) $120,133,155 C $2,900,311 $3,000,200 $(5,444,656) D $1,918,777 $(5,506,990) $3,899,231 24-Cash Flows Page 817 Wednesday, April 30, 2003 12:15 PM 818 FINANCIAL STATEMENT ANALYSIS 6. The following are adjustments to net income to arrive at cash flow from operations from Kmart’s 1997 Consolidated Statement of Cash Flows: ■ Asset impairment charges ■ Cash used for store restructuring and other charges ■ Decrease in other long-term liabilities ■ Cash used for discontinued operations ■ Loss on disposal of discontinued operations Support the classification of these items as adjustments to arrive at cash flows from operations or suggest and support a reclassification to either the cash flows for investing or cash flows from financing. 7. Calculate the amount of free cash flow for Gap Inc., for the year ended January 31, 1998. State any assumptions that you make in your calculations. Gap Inc., Statement of Cash Flows, in thousands CASH FLOWS FROM OPERATING ACTIVITIES Net earnings $53,901 Adjustments to reconcile net earnings to net cash provided by operat- ing activities Depreciation and amortization 269,706 Tax benefit from exercise of stock options by employees and from vest- ing of restricted stock 23,682 Deferred income taxes (13,706) Change in operating assets and liabilities Merchandise inventory (156,091) Prepaid expenses and other (44,736) Accounts payable 63,532 Accrued expenses 107,365 Income taxes payable (8,214) Deferred lease credits and other long-term liabilities 69,212 Net cash provided by operating activities $844,651 CASH FLOWS FROM INVESTING ACTIVITIES Net maturity (purchase) of short-term investments 174,709 Net purchase of long-term investments (2,939) Net purchase of property and equipment (465,843) Acquisition of lease rights and other assets 19,779 Net cash used for investing activities (313,852) 24-Cash Flows Page 818 Wednesday, April 30, 2003 12:15 PM Cash Flow Analysis 819 Gap Inc., Income Statement, in thousands CASH FLOWS FROM FINANCING ACTIVITIES Net increase in notes payable 44,462 Net issuance of long-term debt 495,890 Issuance of common stock 30,653 Net purchase of treasury stock (593,142) Cash dividends paid (79,503) Net cash used for financing activities (101,640) Net sales $6,507825 Costs and expenses Cost of goods sold and occupancy expenses 4,021,541 Operating expenses 1,635,017 Net interest income (2,975) Earnings before income taxes $842,242 Income taxes 320,341 Net earnings $533,901 24-Cash Flows Page 819 Wednesday, April 30, 2003 12:15 PM [...]... countries that engage in European economic and political activities In February 199 2, the Treaty on European Union of 199 2 established that monetary union would take place by January 199 9 The treaty, also called the Maastricht Treaty because its terms were agreed to at the European Council meeting in Maastricht (Netherlands) in December 199 1, called for a single currency and monetary policy for member countries... new investors and achieving comparable, if not, cheaper financing.” A managing director of Sears 5 Victoria Keefe, “Companies Issue Overseas for Diverse Reasons,” Corporate Financing Week (November 25, 199 1, Special Supplement), pp.1 and 9 International Financial Management 841 Roebuck stated that the company “has a long-standing policy of diversifying geographical [funding] sources and instruments... U.S securities law and other requirements imposed by the Securities and Exchange Commission A non-Japanese 3 R.L Benke, Jr and J.D Edwards, Transfer Pricing: Techniques and Uses (New York: National Association of Accountants, 198 0) 838 SELECTED TOPICS IN FINANCIAL MANAGEMENT corporation that seeks to offer securities in Japan, for example, must comply with Japanese securities law and regulations imposed... denominated in U.S dollars and pay dividends in them The holder of an ADR does not have voting or preemptive rights 9 “Why Corporations Gain from Foreign Equity Listings,” p 40 H Kent Baker, “Why U.S Companies List on the London, Frankfurt and Tokyo Stock Exchanges,” The Journal of International Securities Markets (Autumn 199 2), pp 2 19- 227 10 844 SELECTED TOPICS IN FINANCIAL MANAGEMENT ADRs can arise...PART Seven Selected Topics in Financial Management CHAPTER 25 International Financial Management inancial management decisions of most firms are not confined to domestic borders Many financing and investment decisions involve economies and firms outside a firm’s own domestic borders either directly, through international transactions,... trucks and aircraft), chemicals, and grain products, which relate to the vast capital investment in the heavy industries (e.g., steel production) and the acreage devoted to farm products The chief import of the United States is petroleum because of the diminished U.S oil reserves combined with the strong demand for fuel and petroleum-based products (e.g., plastics) International Financial Management. .. Financial Management EXHIBIT 25.2 United States’ Exports and Imports, 191 9–2001 in Real Dollars Panel a: Exports and Imports Panel b: Net Trade Balance Source: Federal Reserve Bank of St Louis 825 826 SELECTED TOPICS IN FINANCIAL MANAGEMENT Many advocate free trade, which is trading among countries without barriers such as export or import quotas and tariffs (taxes on imported goods) The benefits of free... trade barriers and to enhance economic cooperation A January 199 4 agreement eliminated trade barriers between the EU and the EFTA by creating the European Economic Area, and creating the largest free trading area in the world The North American Free Trade Agreement (NAFTA) is a pact among Canada, Mexico, and the United States for the gradual removal of trade barriers for most goods produced and sold in... & United Kingdom United States Japan 9 10 General Electric Toyota Motor Source: www.fortune.com, 2002 Global 500 Revenues (Millions of $ U.S.) $2 19, 812 191 ,581 177,260 174,218 162,412 138,718 136, 897 135,211 125 ,91 3 120,814 828 SELECTED TOPICS IN FINANCIAL MANAGEMENT ■ To achieve production efficiency By shifting operations to other, lower-cost nations, a company can reduce its operating costs ■ To gain... access to patents and other developments that ensure its competitiveness both domestically and internationally The many changes in the world political economy have enhanced opportunities These changes include changes in domestic laws and regulations, such as increased import quotas and the reduction in regulations on banking activities, and changes outside the United States, such as NAFTA and the European . (for) Financing Activities A $550,345, 890 $(300,532,400) $(232,221, 891 ) B $33,114, 893 $(145,231,8 79) $120,133,155 C $2 ,90 0,311 $3,000,200 $(5,444,656) D $1 ,91 8,777 $(5,506 ,99 0) $3, 899 ,231 24-Cash Flows Page. prior to 198 8. 22 Michael T. Dugan and William D. Samson, “Operating Cash Flow: Early Indica- tors of Financial Difficulty and Recovery,” Journal of Financial Statement Analysis (Summer 199 6), pp tax expense). EBIT $6 ,98 6 Add depreciation and amortization 1, 693 Earnings before interest, taxes, depreciation, and amortization $8,6 79 Deduct capital expenditures (1,6 79) Free cash flow $7,000 Deduct