Analyzing the Firm's Cash Flow PDF

Analyzing the Firm’s Cash Flow Cash Flow – is the primary ingredient in the financial valuation model. − From an Accounting Perspective – cash flow is summarized in a firm’s statement of cash flow. − From a Financial Perspective – firms often focus on both operating cash flow, which is used in...

Analyzing the Firm’s Cash Flow Cash Flow – is the primary ingredient in the financial valuation model. − From an Accounting Perspective – cash flow is summarized in a firm’s statement of cash flow. − From a Financial Perspective – firms often focus on both operating cash flow, which is used in managerial decision-making, and free cash flow, which is closely monitored by participants in the capital market. Depreciation – is the portion of the costs of fixed assets against annual revenues over time. − A variety of other depreciation methods are often used for reporting purposes. Depreciation for Tax Purposes – is determined by using the Modified Accelerated Costs Recovery System (MACRS). Amortization – write-off of intangible assets. Depletion – write-off natural resources. Developing the Statement of Cash Flows Statement of Cash Flows – summarizes the firm’s cash flow over a given period of time. 3 Categories of Firm’s Cash Flows: 1. Operating Cash Flows – cash flows directly related to the sale and production of the firm’s products and services. 2. Investment Cash Flows – cash flows associated with purchase and sale of both fixed assets and equity investments in other firms. 3. Financing Cash Flows – cash flows that result from debt and equity financing transactions. − Include incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to repurchase stock or pay cash dividends. Inflow and Outflows of Cash Inflows (sources) Outflows (uses) Decrease in any asset Increase in any asset Increase in any liability Decrease in any liability Net profits after taxes Net loss Depreciation and other noncash charges Dividends paid Sale of stock Repurchase or retirement of stock  Interpreting Statement of Cash Flows Statement of Cash Flows – ties the balance sheet at the beginning of the period with the balance sheet at the end of the period after considering the performance of the firm during the period through the income statement. Net Increase/Decrease in Cash – are marketable securities should be equivalent to the difference between the cash and marketable securities on the balance sheet at the beginning of the year and at the end of the year. 1. The Firm’s Operating Cash Flow (OCF) – is the cash flow a firm generates from normal operations – from the production and sale of its goods and services. − OCF may be calculated as follows: NOPAT = EBIT x ( 1 – T ) OCF = NOPAT + Depreciation OCF = [EBIT x ( 1 – T )] + Depreciation NOPAT –> Net Operating Profit After Tax EBIT –> Earnings Before Interest and Taxes T –> Tax Rate 2. Free Cash Flow (FCF) – is the amount of cash flow available to investors (creditors & owners) after the firm has met all operating needs and paid for investments in Net Fixed Assets (NFAI) and Net Current Assets (NCAI). − Thus, the firm generated adequate cash flow to cover all of its operating costs and investments and had free cash flow available to pay investors. − Formula: NAFAI = Change in Net Fixed Assets + Depriciation NCAI = Change in CA Change – in Assets and Accruals FCF = OCF – NAFAI – NACAI NFAI –> Net Fixed Assets in Investments NCAI –> Net Current Assets in Investments CA –> Current Assets  Financial Planning Process Financial Planning Process – begins with long term, or strategic, financial plans that in turn guide the formulation of short-term, or operating, plans and budgets. − 2 Key Planning Aspects of Financial Planning: 1. Cash Planning – involves the preparation of the firm’s cash budget. 2. Profit Planning – involves preparation of pro-forma statements. 1. Long Term (Strategic) Financial Plans – consider a number of financial activities: 1. Proposed Fixed Asset Investment 2. Research and Development Activity 3. Marketing and Product Development 4. Capital Structure 5. Sources of Financing − These plans are generally supported by a series of annual budgets and profit plans. 2. Short Term (Operating) Financial Plans – specify short term financial actions and anticipated impact of those actions. − Key Inputs: 1. Sales Forecast 2. Other Operating and Financial Data − Key Outputs: 1. Operating Budgets 2. The Cash Budget 3. Pro Forma Financial Statements Cash Budget/Cash Forecast – is a statement of the firm’s planned inflows and outflows of cash that is used to estimate its short-term cash requirements. − Cash Budget – is designed to cover a 1-year period, divided into smaller time intervals. − The more seasonal and uncertain a firm’s cash flows, the greater the number of intervals. Cont. / Sale Forecast – is a prediction of the sales activity during a given period, based on external and/or internal data. − The sales forecast is then used as a basis of estimating the monthly cashflows that will result from the projected sales and from outlays related to production, inventory, and sales. − The sales forecast may be based on: Analysis of External data, Internal Data, or a combination of the two. 1. External Forecast – is a sales forecast based on the relationship observed between the firm’s sales and certain key external economic indicators. 2. Internal Forecast – is a sales forecast based on a buildup or consensus of sales forecasts through the firm’s own sales channel.  Financial Instrument Financial Instruments – are assets that can be traded, or they can also be seen as packages of capital that may be traded. − Most types of financial instruments provide efficient flow and transfer of capital throughout the world’s investors. − Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. − Financial instruments may also be divided according to an asset class, which depends on whether they are Debt-Based or Equity-Based. − The Bottom Line – A financial instrument is effectively a monetary contract (real or virtual) that confers a right or claim against some counterparty in the form of a payment (checks, bearer instruments), equity ownership or dividends (stocks), debt (bonds, loans, deposit accounts), currency (forex), or derivatives (futures, forwards, options, and swaps). Financial instruments can be segmented by asset class and as Cash-Based, Securities, or Derivatives. − 2 Financial Instruments Assets Class: 1. Equity-Based Financial Instruments – rep ownership of an asset. − Securities that trade under the banner of equity-based financial instruments are most often stocks, which can be either Common Stock or Preferred Shares. − ETFs and mutual funds may also be equity-based instruments. 2. Debt-Based Financial Instruments – represent a loan made by an investor to the owner of the asset. − These are essentially loans made by an investor to the owner of the asset. − Short-Term Debt-Based Financial Instruments last for one year or less. − Securities of this kind come in the form of Treasury bills (T bills) & Commercial Paper. − 3 Bank deposits and certificates of deposit (CDs) are also technically debt-based instruments that credit depositors with interest payments. Foreign Exchange Instruments – comprise a 3rd, unique type of financial instrument. − Different subcategories of each instrument type exist, such as preferred Share Equity and Common Share Equity. Types of Financial Instrument 1. Cash Instruments – the values of cash instruments are directly influenced and determined by the markets. − These can be securities that are easily transferable. − Stocks and bonds are common examples of such instruments. − Cash instruments may also be deposits and loans agreed upon by borrowers and lenders. − Checks are an example of a cash instrument because they transmit payment from one bank account to another. 2. Derivative Instruments – Cont. – includes Stocks, Exchange-Traded Funds (ETFs), Bonds, Certificates of Deposits (CDs), Mutual Funds, Loans, and Derivatives Contacts, among others. 1. Money Market – refers to trading in every short-term debt investment. − The money market is characterized by a high degree of safety and relatively low rates of return. − It involves the purchase and sale of large volumes of very short-term debt products, such as overnight reserves or commercial paper. − An individual may invest in the money market by purchasing a money market mutual fund, buying a Treasury bill, or opening a money market account at a bank. − Money market investments are characterized by safety and liquidity, with money market fund shares targeted at $1. − Money market accounts offer higher interest rates than a normal savings account, but there are higher account minimums and limits on withdrawals. − The money market is defined as dealing in debt of less than one year. − It is primarily used by governments and corporations to keep their cash flow steady, and for investors to make a modest profit. − The Bottom Line – Money Market Accounts and Money Market Funds are considered among the safest ways to invest one's money. They also have much lower returns than other investments, often even less than inflation. Because they are so low risk, many people and businesses use money markets as a short- term investment for their cash reserves. − How Does Money Market Work? 1. Large Corporations – those with short-term cash flow needs can borrow from the market directly through their dealer. − Those with excess cash can invest. 2. Small Companies – those with excess cash can invest through money market mutual funds. Money Market Mutual Fund – is a professionally managed fund that buys money market securities on behalf of investors. 3. Individual Investors – invest through their money market bank account or money market mutual funds. 2. Capital Markets – is dedicated to the sale and purchase of long-term debt and equity instruments. − The term "Capital Markets" refers to the total of the stock and bond markets. − Capital markets are where savings & investments are channeled between suppliers & those in need. − Capital markets refer to the venues where funds are exchanged between suppliers and those who seek capital for their own use. − Capital markets are used to sell different financial instruments, including equities and debt securities. − These markets are divided into two categories: Primary and Secondary Markets. − The best-known capital markets include the Stock Market and the Bond Markets. − Capital markets are composed of the suppliers and users of funds. Suppliers – are people or institutions with capital to lend or invest and typically include banks and investors. − Those who seek capital in this market are businesses, governments, and individuals. − Suppliers in Capital Markets are typically banks and investors while those who seek Capital are businesses, governments, and individuals. − Suppliers include households (through the savings accounts they hold with banks) as well as institutions like pension and retirement funds, life insurance companies, charitable foundations, and non-financial companies that generate excess cash.