unit 8 | cash flow analysis & planning

Question 1

Importance of cash flow to internal stakeholders

Answer 1

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

Question 2

Shareholders’ expectations in regard to cash flow

Answer 2

Shareholders expect management to manage cash effectively to operate the business, make interest payments, re-invest cash into the business, and pay them dividends

Question 3

Basic equation for cash flow

Answer 3

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

Question 4

Operating Activities

Answer 4

Activities related to operating the core business

Question 5

Investing Activities

Answer 5

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

Question 6

Financing Activities

Answer 6

Business activities related to raising capital

Question 7

IFRS Approach 1

Answer 7

Interest paid: Operating
Interest received: Operating
Dividends paid: Operating
Dividends paid: Operating

Question 8

IFRS Approach 2

Answer 8

Interest paid: Financing
Interest received: Investing
Dividends paid: Financing
Dividends paid: Investing

Question 9

4 Questions in Analyzing Cash Flows

Answer 9

1. What was the net change in cash during the period?
2. What were the major SOURCES of cash (i.e., big inflows, positive numbers )?
3. What were the major USES of cash (i.e., big outflows, negative numbers)?
4. What overall strengths and/or weaknesses do you see?

Question 10

Define Liquidity

Answer 10

• 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

Question 11

Current Ratio formula

Answer 11

current ratio = current assets / current liabilities

Question 12

Current Ratio definition

Answer 12

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

Question 13

Quick (Acid-Test) Ratio formula

Answer 13

current assets - inventory / current liabilities

Question 14

Quick (Acid-Test) Ratio definition

Answer 14

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

Question 15

Liquidity Ratios - Cash Conversion Cycle

Answer 15

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?

Question 16

Cash Conversion Cycle

Answer 16

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

Question 17

Inventory Turnover Ratio formula

Answer 17

inventory turnover = COGS / average inventory

Question 18

Inventory Turnover Ratio definition

Answer 18

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

Question 19

Days’ Inventory Outstanding (DIO) formula

Answer 19

DIO = 365 / inventory turnover

Question 20

Days’ Inventory Outstanding (DIO) definition

Answer 20

Tells how long (in days) it takes to sell the average level of inventory

Question 21

Accounts Receivable Turnover formula

Answer 21

A/R turnover = net credit sales / average A/R

Question 22

Accounts Receivable Turnover definition

Answer 22

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)

Question 23

Days’ Sales Outstanding (DSO) formula

Answer 23

DSO = 365 / A/R turnover

Question 24

Days’ Sales Outstanding (DSO) definition

Answer 24

Indicates how long (in days) it takes the company to collect its receivables

Question 25

Accounts Payable Turnover formula

Answer 25

A/P turnover = COGS / average A/P

Question 26

Accounts Payable Turnover definition

Answer 26

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)

Question 27

Days’ Payables Outstanding (DPO) formula

Answer 27

DPO = 365 / A/P turnover

Question 28

Days’ Payables Outstanding (DPO) definition

Answer 28

Indicates how long (in days) it takes for the company to pay off its accounts payable

Question 29

Debt Ratio formula

Answer 29

debt ratio = total liabilities / total assets

Question 30

Debt Ratio definition

Answer 30

(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

Question 31

Times-Interest-Earned (TIE) Ratio formula

Answer 31

times-interest-earned = operating income / interest expense

Question 32

Times-Interest-Earned (TIE) Ratio definition

Answer 32

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)