LDP 5.2 Analyzing Cash Flow

Question 1

Analyzing cash flow means

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

You can 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

Rank cash flow from most to least desirable as repayment sources or from highest to lowest quality.

Answer 3

1) Most Desirable: Cash Flows from Real and Sustainable Profits
2) Second-most Desirable: Cash Flows from Efficiency Improvements and Equity Proceeds
3) Least Desirable: Cash Flows from Additional Debt or from the Sale of Assets

Question 4

1) Most Desirable: Cash Flows from Real and Sustainable Profits

Answer 4

• These are the cash flows that improve margins of protection, are sustainable, and are the result of the company’s economic earning power.

To test cash flow’s origin from real and sustainable profit:

• Perform an account quality analysis, thereby determining that revenues are authentic and sustainable, and that expenses are authentic, appropriately recognized, and accounted for consistently.
• Estimate the portion of operating cash flow that has been provided by a company’s operating profit by adjusting operating profit for any noncash expenses.

Question 5

2) Second-most Desirable: Cash Flows from Efficiency Improvements and Equity Proceeds

Answer 5

• Improved efficiency may not be sustainable, but it is a sign of good management and enables the company to improve its return on assets while maintaining the same profit margins.

To test cash flow’s origin from efficiency improvements:
- Measure the cash impact of changes in the turnover days for accounts receivable, inventory, and accounts payable.

• Raising additional equity may not be sustainable, but it does improve the margin of protection by increasing net worth, and it provides additional resources to increase the company’s earnings capacity.

To identify equity proceeds: Review the financing cash flow’s presentation of year-to-year changes in a company’s equity accounts.

Question 6

3) Least Desirable: Cash Flows from Additional Debt or from the Sale of Assets

Answer 6

• Additional debt, while it may have benefits for the company, increases leverage, can reduce profitability by adding to the interest burden, and can reduce liquidity by adding to annual principal debt service.
• To identify cash flow from additional debt: Use the financing cash flows section

To identify cash from sale of assets: Use the investing cash flows section of the cash flow statement. Look to see if “other income” is shown on the income statement, and if so, check the Notes for details that might disclose an asset sale.

Question 7

Cash Cycle Formula

Answer 7

1) AVERAGE DAYS’ SALES IN RECEIVABLES
\+ AVERAGE DAYS’ COGS IN INVENTORY
- AVERAGE DAYS’ PURCHASES IN PAYABLES
= AVERAGE DAYS IN CASH CYCLE
(using days’ purchases in A/P)

2) AVERAGE DAYS’ SALES IN RECEIVABLES
+ AVERAGE DAYS’ COGS IN INVENTORY
- AVERAGE DAYS’ COGS IN PAYABLES
= AVERAGE DAYS IN CASH CYCLE

Question 8

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

Answer 8

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.