Analyzing Cash Flow

Question 1

Analyzing cash flow means what?

Answer 1

Determining if the company has sufficient high-quality sources to meet all the demands placed on its cash flow, leaving enough residual cash to repay its obligations.

Question 2

Determine cash flow quality by testing cash flow on these three points:

Answer 2

1. The source of the cash flow and its effect on margins of protection. Remember that a margin of protection for a loan is a factor that increases the likelihood the loan will be repaid.
2. The degree to which the cash flow can be sustained or repeated in future periods.
3. The degree to which the cash flow represents long-term earning power and economic viability.

Question 3

Order of Highest Quality Cash Flow

Answer 3

1) Cash Flows from Real and Sustainable Profits - improve margins of protection, are sustainable, and are the result of the company’s economic earning power.
2) Cash Flows from Efficiency Improvements and Equity Proceeds - sign of good management
3) Cash Flows from Additional Debt or from the Sale of Assets - increases leverage, can reduce profitability by adding to the interest burden, and can reduce liquidity by adding to annual principal debt service. Sale of an asset may also have benefits, but it can reduce the earning power of the company.

Question 4

To analyze the demands on cash flow, follow these five steps:

Answer 4

1. Review the cash flow statement to identify significant cash outflows for working capital, capital expenditures, dividends and distributions, and debt service.
2. Review your borrowing cause analysis to separate cash outflows caused by sales growth from those caused by declining asset efficiency and changes in trade credit activity.
3. Consider whether each demand on cash flow is a one-time, irregular event or if it is likely to be recurring.
4. Decide if the events or transactions producing demands on cash flow are within the control of management and if your appraisal of management suggests that managers are performing effectively in that area.
5. Compare historical demands with historical cash sources and expected future demands with expected future cash sources.