Definition and significance of cash flow

Cash flow is normally described as “profits plus non-cash charges”. The cash flow shows the amount of money that is effectively at the disposal of the company. It is one of the most important financial figures from the banker’s point of view, because of the following reasons:

-          The cash flow helps to identify the company’s sustainable core earnings.

-          It displays the amount of cash that is used (released from the company’s current operations) to sustain or to grow the business.

-          It reveals the cash which is available to service debt. This helps to calculate whether a company can “afford” a certain loan at certain terms.

-          Finally, the cash flow indicates how much cash is available from internal sources to finance long term growth.

The following table gives an overview of the sources and uses of cash as they are reflected on the balance sheet. An increase of liabilities, e.g. by enlarging debt, provides cash, just as an increase of assets, e.g. by stocking up the inventory, uses cash.

Sources and uses of cash

Cash flow forecasts

It is important to see how long it would take a company to repay its current debt, if it continuously earned the same cash flow:

So, if a firm had net debt of DM 10 m. and a gross cash flow of DM 2 m., it would take five years to repay all debt, provided the company would sustain a cash flow of at least DM 2 m. for the next five years.

A more complex calculation of debt capacity is required if one wants to know how much debt a company could service (principal and interest payments) at a given cash flow over a given period of time at a given interest rate. The Present Value (PV) of future cash flow (discounted) has to be calculated. Given continuous cash flows of DM 500,000 per annum available to service debt for the next five years, and interest rates of 10%, how much debt could this company service?

PV       =          Cash flow        +Cash flow      +Cash flow      +Cash flow      +Cash flow

1+Int.Rate       (1+R)2           (1+R)3           (1+R)4           (1+R)5

PV       =          500,000           +500,000        +500,000        +500,000        +500,000

1.1000             1.2100             1.3310            1.4641            1.6105

=          DM 1,895,395.

The company has a capacity to service debt of DM 1,895,395 over five years at an interest rate of 10 %. If the company had debts outstanding of, e.g., DM 4 m., the bank would face a refinancing risk of DM 2,104,605, that is 52.6 %.

In reality, no company has the same continuous cash flow for a number of years. Thus, it is necessary to try to forecast the future evolution of a company’s business and its impact on the balance sheet and the profit and loss account. Management must provide the bank with its assumptions of how sales, profit margins, net trading assets, asset turnover, depreciation, operating profit and so on will look in the coming years. The credit analyst must ask why the company thinks that things should go this way. In most cases, the outcome will be different from what has been planned in the previous year. Thus, it is important to examine the reasons that have led to these differences, and to adjust the business planning for the next years. Such elaborate planning can supply data about future cash flows which have to find their way into the above mentioned formula. But reality will always be different from the forecast!

Chapter E features a very detailed case study on financial planning and forecasting.

3. Worksheet: Key ratios

The financial statements reflect ability of a company’s management to manage:

-          business risk: Generate maximum profit from the minimum level of assets

-          finance risk: Finance the assets in such a way as to minimize risks to creditors

-          performance risk: Operate the company in a way as to minimize costs and maximize profits.

- Direct method;

- Indirect method.

The Direct Method is based on the information presented in the CASH accounts. It shows (1) the main sources of cash inflow and main trends in cash outflow, (2) it provides the possibility to make operational decisions on sufficiency of cash for current payments, (3) it establishes the connection between the total revenue and cash revenue for a reported (accounting) period.

In order to outline the report, Accounting Journals for the following accounts are required:

Cash on hand (account 241);

Bank accounts (account 242 and 243);

Cash equivalents (accounts 244, 245, 246).

On the debits’ side Cash Inflows are shown and the credit side reflects cash uses. The Cash Flow Statement is constructed through the summarization of debits and credits of the listed accounts, which is a simple procedure.

The Indirect Method is based on the correlation of the Net Income and the occurred changes in the Balance Sheet for a given accounting period. Any business transaction implies changes in the Assets or Liabilities side of the Balance Sheet, which is a movement of funds through the accounts of the company.

The summarized Cash Flow Statement allows the analyst to perform a sound analysis of:

- The managerial decisions quality over certain period of time;

- The size an composition of cash from operations, as well as their pattern and degree of stability

- The impact of the operating activity on the financial stability of the company.

The three following aspects of company’s activity are analyzed:

- Operating activities;

- Investment activities;

- Financial activities.

Operating Activity

Cash Flow from Operating Activities includes cash inflows and payments related to the core activity of the company (Sales, Procurements). The operating activity is the main source of cash.

Inflows from Operating Activity:

- Cash;

- Collection of accounts receivable;

- Advances received from clients;

- Sale of goods received through barter transactions;

- Other cash inflows.

Outflows from Operating Activity:

- Payments to suppliers and subcontractors;

- Salary payments;

- Taxes, Social Security, and medical insurance charges;

- Interest payments;

- Sponsoring and Social costs.

Investing Activity

Cash Flow from Investment Activities includes inflows from sales of fixed assets, as well as investments and payments for fixed assets replacement. Profitable companies usually extend their business and upgrade their production capacities, so a cash deficiency may occur in short run.

Inflows from Investing Activity:

- Disposal of fixed asset;

- Dividends related to long term investments;

- Interest received;

- Sale of daughter companies;

- Other inflows;

Outflows from Investing Activity:

- Acquisition of fixed and intangible;

- Capital investments;

- Acquisition (of other companies);

- Long-term financial investments.

Financing Activity

The Cash Flow from Financing Activities includes inflows from loans and credits, also from stock emission and payments in order to reimburse or to redemption of shares. The cash flow from financial activity should contribute to the balancing of financial needs of investment and operational activities.

Inflows from Financing Activity:

- Short-term credits and loans;

- Long-term credits and loans;

- Receipts from issuing shares;

- Subsidies;

- Other inflows.

Outflows from Financing Activity:

- Repayment of sort-term and long-term credits and loans;

- Payment of dividends;

- Redemption of shares.

Cash Flow Ratios

Minimal Cash Requirement

SPT – aggregate cash outflow from the company during a given period P – period in days

AAI – average age of inventory from the time of purchase to the time of sale (days) APR – average period of payment of accounts receivables (days)

APP – average period of payment of accounts payable (days)

Time Interval During which the Company can Operate without Cash Inflows

CF – cash funds

AR – balance of accounts receivable ADOE – average daily operational expenses

Cash Reinvestment Ratio

This ratio reflects how much cash from operational activity contributes to the replacement (renewing) of the assets and to increase of the operational level of the company. It is calculated as follows:

CFOA – Cash Flow from operational activity

D – dividends paid

LTA – long term assets

I – investments

WC – working capital

It is considered that a ratio of 8 – 10% is satisfactory, that means that operating activity of the company generates enough cash in order to meet its own investment needs.

Cash Flow Adequacy

This example shows that the operational activity does not generate enough cash to meet the necessities for increasing the operational level, thus some loans or other forms of borrowings were required.

Cash Reinvestment Ratio

It is thoroughly considered that a Cash Reinvestment Ratio of 10 – 12% positively characterizes the cash flow generating power of the company, that is the renewal of fixed assets and other components of the asset side are completed in 8 – 10 years.

- Identification of the main sources of cash gains for a given accounting period;

- To reveal the main uses of cash;

- To reveal the causes of surpluses or shortages of cash and to determine inflow sources and how they are used.

The preferred method of Cash Flow Statement Analysis is the “Common-Size” Analysis, reporting all items to one of the following bases that represent 100%:

- Net Sales;

- Total Cash Inflows;

- Net Cash Flow.

The exorbitantly detailed Statement of Cash Flow leads to dispersion of the report and reduces the potential of analysis. The Statement should present enough information in order to highlight the main items that bring significance for further analysis. The minimum analyzed period that can reveal particular trends and produce meaningful conclusions should be not less than 5 – 7 years.

The key bunch of questions to be answered through the performed Cash Flow Analysis is:

- Has the enterprise been able to finance fixed asset replacement from internally generated cash?

- How has expansion been financed?

- To what extent is the enterprise dependent on outside financing? How frequently is it required, and what form does it take?

- Sales revenue

- Net Income

- Cash Flows

The amplitude of these key indicators determines the viability of the business and at the same time reveals the major problems of it.

The funds flow and the relationship between the operational, investment, and financial activities of the company is depicted by Cash Flow Statement. The concept of Cash Flow can be generally comprehended as a Cash Reservoir, the use of which is directed by the management of the company. As cash flows into its reservoir, management has a degree of discretion as to where to direct it. This discretion depends on the amount of cash already committed to such outlays as dividends, inventory accumulation, capital expenditures, or debt repayment. The total cash inflow also depends on management’s ability to tap sources such as equity capital and debt. The noncommitted cash is referred to as Free Cash Flow.

The typical Cash Inflows for any business that contribute to the “replenishment” of the Reservoir are:

- Cash sales;

- Collection of receivables;

- Advances received from suppliers or clients;

- Disposal of fixed assets and LT investments;

- Income from investments;

- Loans and credits;

- Owners’ contribution to equity;

- Grants received;

- Miscellaneous cash inflows.

The common Cash Outflows are:

- Cash acquisitions;

- Payments to suppliers;

- Advances paid;

- Salaries, social securities, and medical insurance;

- Payment for rented facilities;

- Repairs, renewals, and maintenance;

- Taxes and penalties;

- Assets and financial investments acquisition;

- Dividends paid;

- Repayment of credits and loans;

- Sponsorships and social sphere outlays.

There are a series of differences between the Profit and Cash Flow:

Profit includes Revenues and Expenses that do not require cash as it is recognized on the Accrual Basis;

Revenues are booked on the delivery of a specific product or services irrespective to the fact that cash is collected or not;

Two categories of costs occur in the business reality:

- Cost incurred;

- Cost applied;

Income is representative for the level of Sales recorded by the company and only those Costs are applied that are linked to the production sold or services provided;

On the other hand, a part of operational costs is held in inventories or are kept in accounts for several accounting periods (prepaid expenses, depreciation, etc.);

Cash Flow is based on events that are not specific for the Profit, e.g. pay-offs of liabilities, credits applied, advances received from suppliers, payment of miscellaneous taxes, payment of dividends etc.

Except for transactions involving the raising of the money form external sources or the investment of money in long-term assets, almost all cash flows relate to, and depend on Sales. Through the analysis of Sales a range of particularities of the business are revealed:

- The past direction and trend of sales volume;

- Enterprise share of the market;

- Industry and general economic conditions;

- Productive and financial capacity;

- Competitive factors.

These factors must generally be assessed in terms of individual product lines that may be influenced by forces particular to their own markets.

The Cash Flow Management includes the following sections and covers the main aspects of the Financial Management of the company:

- Cash Flow Accounting;

- Cash Flow Analysis;

- Cash Flow Budgeting.