unit 8 | cash flow analysis & planning Flashcards
Importance of cash flow to internal stakeholders
Internal stakeholders must monitor cash flow to understand if & when the company needs to attain additional cash from investors or banks
Management teams monitor cash flow from operating activities to determine if they are sufficient to:
- Make investments required for continued growth
- Cover financing activities such as loan repayment and/or dividend payments
Shareholders’ expectations in regard to cash flow
Shareholders expect management to manage cash effectively to operate the business, make interest payments, re-invest cash into the business, and pay them dividends
Basic equation for cash flow
Cash flow from/for operating activities
+
Net cash flow from/for investing activities
+
Net cash flow from/for financing activities
=
Net increase/decrease in cash for the period
+
Cash balance at beginning of period
+
= Cash balance at end of period
Operating Activities
Activities related to operating the core business
Investing Activities
Business activities related to purchasing or disposing of long-term assets & investments that are not cash equivalents or held for trading
Activities related to making cash advances & loans to other parties
Financing Activities
Business activities related to raising capital
IFRS Approach 1
Interest paid: Operating
Interest received: Operating
Dividends paid: Operating
Dividends paid: Operating
IFRS Approach 2
Interest paid: Financing
Interest received: Investing
Dividends paid: Financing
Dividends paid: Investing
4 Questions in Analyzing Cash Flows
- What was the net change in cash during the period?
- What were the major SOURCES of cash (i.e., big inflows, positive numbers )?
- What were the major USES of cash (i.e., big outflows, negative numbers)?
- What overall strengths and/or weaknesses do you see?
Define Liquidity
- Having cash available to run the day-to-day operations of the business
- A company’s ability to convert assets to cash
- Short-term focused → examines working capital
> Current assets - current liabilities - Indicator of company’s operating efficiency & short-term financial health
Current Ratio formula
current ratio = current assets / current liabilities
Current Ratio definition
Measures the company’s ability to pay current obligations
- “Does the company have enough resources to meet its short-term obligations?”
1.0 < → satisfactory → company has enough assets to cover all of its current obligations in the short term
1.0 > → company would run into problems if it had to repay all its current liabilities immediately
Quick (Acid-Test) Ratio formula
current assets - inventory / current liabilities
Quick (Acid-Test) Ratio definition
Measures the company’s ability to pay current obligations without selling or liquidating its inventory
- Inventory typically takes longer to turn into cash than all other current assets
- If QR is considerably lower than CR → company’s current assets are heavily comprised of inventory
> 1.0 → company can pay off all its current liabilities without having to sell any inventory
Liquidity Ratios - Cash Conversion Cycle
Tracks a company’s ability to be efficient with its working capital (answers questions below)
1. Does the company turnover (ex. sell) its inventory quickly, without hanging onto it for long periods of time? (only relevant for merchandising business)
2. Does the company collect its credit sales (ex. A/R from customers) in a timely manner?
3. Does the company pay its suppliers (ex. A/P) within the credit terms?
Cash Conversion Cycle
The number of days it takes for a company to convert inventory & sales into cash
= days in inventory + days in A/R - days in A/P
Inventory Turnover Ratio formula
inventory turnover = COGS / average inventory
Inventory Turnover Ratio definition
Measures a company’s effectiveness in selling its inventory throughout the period
- Tells how many times a company has sold its average level of inventory in a specified period
- A lower turnover is generally considered worse, but too high a turnover can signal that the company isn’t stocking enough inventory & potentially losing out on sales
Days’ Inventory Outstanding (DIO) formula
DIO = 365 / inventory turnover
Days’ Inventory Outstanding (DIO) definition
Tells how long (in days) it takes to sell the average level of inventory
Accounts Receivable Turnover formula
A/R turnover = net credit sales / average A/R
Accounts Receivable Turnover definition
Measures a company’s effectiveness in collecting its accounts receivable (revenue)
- Tells how many times a company collects its accounts receivable in a specified period
- The higher the ratio the better → the company is collecting A/R more frequently
- Too high can signal that the company’s credit terms are too aggressive (losing out on potential customers)
Days’ Sales Outstanding (DSO) formula
DSO = 365 / A/R turnover
Days’ Sales Outstanding (DSO) definition
Indicates how long (in days) it takes the company to collect its receivables
Accounts Payable Turnover formula
A/P turnover = COGS / average A/P
Accounts Payable Turnover definition
Measures the number of times a company pays its creditors in a specified period
- Higher better than lower → a company’s best interest is to collect receivables ASAP, make payments as slowly as possible (to maximize liquidity & cash on hand)
Days’ Payables Outstanding (DPO) formula
DPO = 365 / A/P turnover
Days’ Payables Outstanding (DPO) definition
Indicates how long (in days) it takes for the company to pay off its accounts payable
Debt Ratio formula
debt ratio = total liabilities / total assets
Debt Ratio definition
(Leverage ratio) measures the extent to which a company’s assets are financed by debt
- Higher ratio = higher credit risk → company financed its growth primarily with debt (w/ legal requirement to pay interest consistently & the principal eventually)
- Some company do not have easy access to equity
1 → all of company’s assets are financed by debt
0.5 → half of company’s assets are financed by debt
Times-Interest-Earned (TIE) Ratio formula
times-interest-earned = operating income / interest expense
Times-Interest-Earned (TIE) Ratio definition
Measures the number of times a company can pay its interest expense with the operating income that it generates
- The higher the better → company is capable of paying off its interest obligations through its normal operations
- Low → company isn’t generating sufficient operating income to cover its interest obligations or is carrying a large amount of debt (or paying a high cost of debt)
