Dimension 4 - Cash Flow Flashcards
What are the differences between direct and indirect cash flow?
- Direct cash flow is known as the “top down” approach, while the indirect cash flow is known as the “bottom up” approach.
- Direct cash flow starts with the “top line” on the income statement (Net Sales) whereas the indirect cash flow starts with the “bottom” line on the income statement (Net Income).
- Direct cash flow starts with the income statement (Net Sales) and methodically adjusts the corresponding balance sheet accounts
- Direct cash flow breaks out interest expense. Interest expense in the indirect cash flow is included in the net income figure, so you can’t tell how comfortably the company can pay its interest.
- CPLTD is broken out as a claim against the operating cash flows of a company in the direct method. The indirect method combines CPLTD with other changes in long-term debt to arrive at a “net” number for an increase or decrease in long-term debt. It is not as easy to determine from the indirect method how maturing long-term debt has been financed, either from new long-term debt or from operating cash flow.
- The direct cash flow statement does not include net income. Thus, it is harder to determine the sustainable profitability and, ultimately, the long-term debt-service capacity of your customer.
Cash from Sales
That portion of the present year’s sales collected in the present year, plus any amounts from previous years’ sales collected during the present year.
Cash Production Costs
Cash expended during the present year to produce goods for sale (manufacturer) or to acquire merchandise (wholesaler or retailer). In the case of a manufacturing company, this figure may be adjusted for depreciation as well as for changes in inventory, accounts payable, and other payables.
Gross Cash Profit
= Cash from sales - Cash production costs.
Cash Operating Expenses
Actual cash spent during the present year for selling, general, and administrative expenses. SG&A will be adjusted for depreciation as well as for changes in prepaid and accrued expenses.
Cash after Operations
= Gross cash profit - Cash operating expenses
Net Cash after Operations
= Cash after operations +/- Miscellaneous
items +/-Income taxes paid.
Cash remaining after adjusting cash after operations to reflect net cash outlays (or inflows) arising from changes in income taxes and in miscellaneous assets and liabilities. It is the amount of cash available for servicing interest on bank debt. Investigate large miscellaneous sources and uses of funds.
Net Cash Income
Computed by deducting financing costs (interest, dividends, or withdrawals) from net cash after operations.
Cash after Debt Amortization (CADA)
= Net cash income – Current maturities of long-term.
If, after this deduction, there is still a positive figure, it could mean that a company has been able to generate sufficient cash from its internal operations to meet all its current obligations to its debt holders, including interest and principal payments on your institution’s debt. If the figure is negative, your customer must resort to external sources of financing to meet these obligations and make any capital expenditures.
Financing Requirements or Surplus
Computed by subtracting fixed-asset purchases and expenditures for long-term investments from cash after debt amortization. This measures either the magnitude of external financing needed or the cash generated in excess of all needs of the business.
Calculated Change in Cash
“External financing” refers to the provision of additional cash to a company from new debt or equity. This entry will result in an excess or shortfall of cash after adjusting the financing requirement or surplus by the amount of any external financing.
Actual Change in Cash
This represents the change in the cash account on the balance sheet from the preceding year’s to that of the current year. The change in cash includes changes in other cash equivalent accounts, such as marketable securities classified as current assets.
Cash flow sources important to you are:
- Those that are sustainable and reasonably predictable over the ensuing three to five years.
- Those that increase your margin of protection and indicate your customer’s economic viability.
TYPES OF CASH FLOW
- The most desirable cash flows are those from authentic and repeatable revenues and related noncash expenses. They are the cash flows that improve margins of protection because they are repeatable
- The second most desirable sources are improvements in asset efficiency and the proceeds of additional equity.
- The least desirable sources are flows from additional debt or from the sale of assets. Additional debt, while it may have benefits for your customer, increases leverage,
Three Levels of Cash Flow Analysis
• Analyzing Operating Cash Flows
- Cash flow derived from earnings is dependent on business fundamentals, whereas the cash cycle is driven by swing factors.
- Positive operating cash flow can be attributable to strong profit margins (fundamentals).
- Changes in the swing factors reflect a company’s ability to manage its working capital assets.
- Analyzing Investing Cash Flows
- Analyzing Financing Cash Flows
CASH FLOW RATIO ANALYSIS
1) Cash Margin Ratio
- Direct Cash Flow - Compute by dividing gross cash profit by net sales.
Cash Gross Profit / Net Cash from Sales
2) Cash Coverage Ratio
a) Indirect Cash Flow
Net income + Depreciation + Amortization / CPLTD
b) Direct Cash Flow
Net Cash after Operations / Financing Costs + CPLTD
-Addresses the question of whether the borrower is able to meet its debt obligations, both principal and interest, as well as any dividend payments, from internally generated cash.
Sales Growth
Sales Year 2 – Sales Year 1 / Sales Year 1
Gross Profit Margin
Gross Profit / Net Sales
Operating Expense Percent
Operating Expense /
Net Sales
Operating Profit Margin
Operating Income / Net Sales
Types of Business Fundementals
- Sales growth
- Gross profit margin
- Operating expense percent
- Operating profit margin
- Net Profit Margin
Types of Swing Factors
- A/R days outstanding
- Inventory days outstanding
- A/P days outstanding
A/R days outstanding
Accounts Receivable x 365 /
Net Sales
The result is the average number of days from sale of goods to collection of the resulting receivables.
Inventory days outstanding
Inventory x 365 /
Cost of Goods Sold (including depreciation)
This measurement demonstrates efficiencies in the way a company buys its raw materials and processes these raw materials and how quickly it can sell the resulting finished goods.
A/P days outstanding
AP x 365 / COGS (or Purchases)
Three Sections of Cash Flow
DIRECT METHOD:
1) Cash from operating activities or how the company made it:
Net sales to net cash income
2) Cash for investing activities or
how the company spent it:
Long-term debt reduction to net
change in long-term
investments
3) Cash from financing activities
or how the company financed
the difference:
Financing/surplus to actual
change in cash difference
Sources of Cash
Revenues
Decreases in asset
Increase in liability
Increase in equity
Uses of Cash
Expenses
Increase in asset
Decrease in liability
Decrease in equity
Accrual to Cash Flow Statement
- Delete all non-cash entries from income statement.
- Modify all income statement entries by year-to-year changes in related balance sheet items.
- Include spending not present in income statement (CapEx, principal payments, dividends).
- Separate internal and external sources of cash.
Capital Expenditures (CapEx)
- Two types of capital expenditures: maintenance
(routine repairs and replacement) and discretionary (increase production capacity or major equipment purchase).
- Method for calculating CapEx is to add the annual depreciation charge to the change in net fixed assets from one year to the next.
UCA Direct vs. FASB Indirect Cash Flow
- UCA direct cash flow starts with “top line” of income statement (net sales) while FASB indirect cash flow starts with “bottom line” of income
statement (net income).
- Direct cash flow includes the entire income statement, and adjusts corresponding balance sheet accounts.
- Indirect method focuses on differences between net income and net cash flow from operations.
- Direct cash flow isolates interest expense; indirect cash flow includes it in net income.
- CPLTD is broken out in direct method; included in long-term debt in indirect method.
- Direct method does not include net income; indirect method starts with it.
In summary,
- Direct cash flow derives net cash provided by operations from the components of operating cash receipts and disbursements.
- Indirect cash flow derives net cash provided by operations by adjusting net income for revenue and expense items not resultingfrom cash transactions.
UCA Direct Cash Flow Highlights
The UCA Direct Cash Flow statement does not include net income which makes it more difficult to determine sustainable profitability and, ultimately, the long-term debt service capability of the borrower.
- UCA Direct Cash Flow does, however, highlight which changes in working capital assets are affecting cash flow generated from operations.
- Therefore, some short-term lenders may prefer the UCA Direct method.
FASB Indirect Cash Flow Highlights
- The FASB Indirect method does not clearly show where cash came from and where it went—only adjustments to accrual based net income are shown.
- FASB Indirect combines CPLTD with other changes in term debt making it difficult to determine how maturing term debt was financed (either from new long-term debt or operating
cash flow).
- In addition, interest expense in the FASB
Indirect method is included in the net income figure so that it is not easy to tell how comfortably a company can pay its interest.
- However, the FASB Indirect method does show the cash effect of overall balance sheet changes and includes net income which makes it easier to determine sustainable profitability and, ultimately,
long-term debt service capability.
- As a result, some long-term lenders may
prefer the FASB Indirect Cash Flow
Method.
Gross cash margin
= Gross cash profits/ Cash from sales.
Cash coverage ratio
= Net cash after operations / Financing costs +
CMLTD.
