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Evaluating a cash flow statement.

INTRODUCTION

Auditors, finance analysts and academicians utilize the income statements and balance sheet data to derive financial ratios and assess financial performance of a firm. These ratios are generally grouped into 5 categories: 1) liquidity ratios, which include current and quick ratios, 2) asset management ratios such as total asset turnover, fixed asset turnover, inventory turnover and days sales outstanding, 3) debt management ratios, which includes total debt ratio and times interest earned, 4) profitability ratios such as profit margin, return on assets and return on equity, and finally 5) market value ratios such as market to book and price to earnings or cash flow ratios (Keown, Martin, & Petty, 2007).

The purpose of such financial performance assessment is multifold. First, the investors use it for making investment decisions. Second, management finds it useful to examine the operational and financial efficiency of the business. Third, lenders use it to evaluate the credit worthiness of the firm. Therefore, the financial analysis needs to be wide-ranging to address these diverse user needs. However, the balance sheet data are static and it provides a date-in-time perspective and the income statements report the results of operations a specific period of time. In addition, the balance sheet data are historical and the income statement does not identify any significant changes in resources that result from activities in financing and investing. Finally, the income statement utilizes the accrual-based accounting and also includes some arbitrary noncash allocations such as depreciation and amortization.

Surprisingly financial statement analyses generally include little discussion of cash flows though the statement has been required for over a decade. Academicians have also have not been emphasizing the cash flow statement. Practitioners have been using the cash flow statement primarily to validate the income statement and the balance sheet data, and to identify common accounts to the cash flow statement. The loan officers have been using cash flow ratios to monitor a firm's performance prior to the promulgation of FASB 95. Specifically, the cash flow statement complements the income and balance sheet statements, renders itself for a better liquidity analysis of a firm, facilitates financial transparency, and helps to assess a firm's cash management practices including its capacity to refinance or pay off its debt, maintain its current dividends and finance growth with new capital. The usefulness of cash flow ratios was evident in the collapse of W. T. Grant Company with negative cash flows, but with positive earnings and current ratio (Mills & Yamamura, 2000).

A cash flow is relatively difficult to cheat. Auditors should be able to reconcile the cash flow statement with the amount of cash in the bank, and should be able to detect a forged bank statement. The surge of corporate bankruptcies in the aftermath of 2008 financial crisis has convinced the business community that decisions should never be driven mainly by accounting considerations. This also led to the return of the cash-flow measures. Many investors and analysts believe that, compared to accounting measures, cash flow is free from manipulations. The cash flow measures can provide insights into the firm's ability to generate cash in the short- and long-term. Managers use the statement of cash flow, along with the cash budget, when forecasting their firm's cash positions. This wide recognition has attracted a host of techniques to develop a variety of cash flow measures (Petty & Ross, 2009).

The array of cash flow-measures can be traced to the diverse intentions of users and the economics and the complexity of the businesses. Many cash flow ratios have been developed along the lines of the traditional ratios either to make it acceptable by the user community and arguably to be useful. In most cases, the basis of the ratios is operating cash flow. That is, many of the cash flow ratios are derived by substituting cash flow from operations for the net income or the current assets in the traditional ratio analysis. If the operating cash flow is negative then any comparison of the cash flow ratios are not easy suggesting that the statement of cash flow is not valuable in isolation.

In addition, there is no common consensus among researchers on developing objective analytical tools for analyzing cash flow data, which is evident when there are almost 30 different cash flow ratios covering a wide range of industries. Therefore, it is not surprising that cash flow ratios have not yet become common practice.

Most financial analysis discussions do not provide sufficient explanation on interpretation of these ratios. In turn, it has not only led to reluctance in adopting these cash flow ratios, but also aided to maintain the status quo of the accrual-based financial ratios (Mills & Bible, 2011). Many of the cash flow ratios are ad hoc, and have been developed to mine cash flow statements for practical revelations. Although ratio analysis is a basic method of financial analysis, it is an effective approach to narrow down the financial data to a set of key relationships that draw attention to a firm's cash management related to its operations, investment and financing decisions. Of course, computations of these ratios are consequential upon intra- and inter-company comparisons at a point in time, generally at the end of the fiscal year as well as overtime also known as the trend analysis.

The purpose of this study, therefore, is to (1) utilize reported cash flow statement and derive the cash flow measures, (2) demonstrate in a meaningful way the linkages between the basic financial statements and cash-flow measures and the underlying critical variables, (3) develop a comprehensive set of cash flow-based financial ratios for improved decision making and advance the learning process, and (4) design such a framework based on economic theories and models so that it facilitates further development of analytical methods and techniques.

LITERATURE REVIEW

Mills and Yamamura (1998) argue that cash flow ratios are more reliable, and that auditors and corporate financial managers are slow to use but lenders and rating agencies have been using the cash flow ratios. They point out an internal survey of big five and other national accounting firms that their audit procedures have not changed in ways that take advantage of the information presented in the cash flow statement. They advise that the next generation of auditors need to learn how to use the cash flow statement as cash flow related measures are becoming increasingly important to the marketplace.

The cash flow ratios they find most useful fall into two general categories: ratios to test for solvency and liquidity and those that indicate the validity of a company as a going concern. In the first category of liquidity indicators, the most useful ratios are operating cash flow (OCF), funds flow coverage (FFC), cash interest coverage (ICI) and cash debt coverage (CDC). In the second category, ratios used to assess a company's strength on an ongoing basis, they recommend total free cash flow (TFC), cash flow adequacy (CFA), cash to capital expenditures and cash total debt. Auditors who employ cash flow ratios to assess corporate liquidity and viability can help their client's spot trouble in time to take corrective action.

Urbancic (2005) recommends several cash flow ratios with cash flow from operations as the numerator with or without some adjustments and one of the other accounting items from the financial statements including current liabilities or long-term debt or net income, total assets, capital expenditures, sales, total cash inflow. Albrecht (2003) and Wells (2005) point out that ratio analysis is very useful in detecting red flags for a fraud examination. Simon (2013) argues that cheating on cash is difficult and point out some of the ways a firm may play games including borrowing and showing the cash inflow from operations rather than financing. Using the translation gains, which is essentially profit made from currency movement that benefits the company to mask it as cash flow from operations. He recommends checking all the flows in and out, and asking yourself do they make sense, and how do they relate to the previous period and why the difference, if any. He advocates investigating any lumpy operational cash flow that swings from one period to another.

Carslaw and Mills (1991) demonstrate the emergence of a consciousness towards using cash flows ratios to help internal and external users of financial statements. Figlewicz and Zeller (1991) have also identified and discussed meaningful ratios based on the statement of cash flows. Schmidgall, Geller, and Ilvento (1993) further proposed nine financial ratios based on the statement of cash flows. Mills and Bible (2011) point out that several textbook authors have provided 29 different cash flow ratios. They point out that the statement of cash flow provides key information regarding liquidity, solvency and financial flexibility, and as a part of the ongoing monitoring process, loan officers have been using cash flow related ratio long before promulgation of FASB 95.

Fraser (1983) argues that cash generated from operations should receive more emphasis in financial analysis. They contend that there are variations of commonly used cash flow ratios. They conclude that most textbooks fail to provide discussion or an adequate explanation on how to interpret the ratios. They summarize that cash flow ratios have received limited acceptance to date due to the long tradition of accrual-based ratios. A lack of consensus on common definitions cash flow ratios also has slowed their acceptance. Dyckman, Davi, and Dukes (2001) argue that the cash flow statement is an indispensable complement to the balance sheet. Nikolai and Bazley (2000) point out that cash flow ratios are not generally accepted.

Spiceland and Sepe (1998) discuss 11 cash flow ratios, but provide limited interpretation of these ratios. Some of these ratios simply substitute cash flow from operations in place of net income. Hartman, Harper, Knoblett, and Reckers (2000) find that a variety of cash flow ratios exist, but there is no standard quantitative and objective method used for comparing various ratios and measures. While Skousen, Stice and Stice (2000) discuss statement of cash flow, they do not provide a consistent calculation of some of the cash flow ratios. Studies by weygandt (1998), Schmidgall, et al. (1993), Figlewicz and Zeller (1991), Carslaw and Mills (1991), and Kieso, Weygandt and Warfield (2004), Larson, Wild, and Chiappetta (2006), and Ibarra (2009) has led to grouping of cash flow ratios under four major categories: liquidity, efficiency (activity), profitability and solvency (coverage):

1. Liquidity ratios measure a company's short-run ability to pay its maturing obligations. Short-term creditors such as bankers and supplier are interested in assessing liquidity. It is affected by the timing of cash inflows and outflows along with prospects of future performance. The current ratio and acid test ratios are based on accrued data and are calculated at a particular point of time. The cash flow ratios are: Operating cash flow ratio (OCF/CL); Cash ratio (Cash/CL); Cash debt Coverage ratio (OCF- Div/total debt); and Cash interest coverage (OCF+ int. / Int.), where, OCF: operating cash flow, CL: current liabilities, Int.: interest expense, Div: Dividends.

2. Efficiency or activity refers to how productive a company is in using its assets. Common ratios based on accrual data are asset turnover, receivable turnover, and inventory turnover. Cash flow activity ratios measure a company's ability to utilize its existing assets. Using these ratios will help an analyst monitor the production of cash flow from operating activities free of the potential accrual accounting distortions. The cash flow ratios, which will measure efficiency using cash flow data are: Cash return on assets, Cash return on fixed assets, Cash reinvestment ratio, Cash turnover, and Cash balance or Days cash balance.

3. Profitability refers to a company's ability to generate an adequate to generate return on invested capital. The ratios measure a company's degree of success or failure in its operations. Income or lack of it affects the company's ability to obtain loans, its liquidity position, and its ability to grow. The ratios are: Earnings quality: OCF/net income, Cash flow from sales/sales, and Cash flow margin: OCF/total revenues.

4. Coverage or solvency refers to a company's long-run financial viability and its ability to cover long-term obligations. It measures the degree to which long-term creditors and investors are protected. The common ratios used by analysts are: Debt to total assets ratio, times interest earned and book value per share. The following cash flow ratios will measure coverage: Cash flow to long term debt, Cash dividend coverage ratio, Cash return to shareholders, and Cash flow per share.

THE STATEMENT OF CASH FLOWS

The statement of cash flows describes the flow of cash from an accounting perspective: distinguishes the sources and uses of cash, categorizes cash into operations, investment, and financing groups, and then develops the net impact on a firm's cash position. The operating cash flow is related to the core operations of the business and is the most important component of the statement. The statement of cash flows in the annual reports is generally the indirect form of this statement and delineates the reconciliation between net income and cash flows from operating activities. The net income includes both cash- and non-cash inflow and outflows, and therefore is adjusted to reflect any noncash impact from operating activities.

As a result, the cash flows from activities associated with current assets are in this operating activities section. The second section of investment activities includes cash flows associated with noncurrent assets such as purchases of property, plant and equipment (or fixed assets). Finally, the third section of financing activities includes cash flows associated with the stockholders' equity and the liabilities other than current liabilities. This classification of activities into these three sections also leads to some exceptions such as the inclusion of interest expense in the operating activities and dividend payments in the financing activities section. Although both the short-term debt and marketable securities are part of current assets, the cash flows associated with short-term debt is included in the financing activities section and those associated with short-term marketable securities are included in the investment activities section. The equation for the cash flow statement is:

[DELTA]CASH = (NI + DEP - [DELTA]AR - [DELTA]INV + [DELTA]AP + [DELTA]ACCR) + (-[DELTA]GFA - [DELTA]MS) + ([DELTA]IBD - DIV + [DELTA]CS) (1)

Where,

[DELTA]CASH: Change in cash; NI: Net income; DEP: Depreciation expense; [DELTA]AR: Change in accounts receivable; [DELTA]INV: Change in inventories; [DELTA]AP: Change in accounts payable; [DELTA]ACCR: Change in accruals; [DELTA]GFA: Change in gross fixed assets; [DELTA]MS: Change in marketable securities; [DELTA]IBD: Change in interest bearing debt; DIV: Dividend payments, and [DELTA]CS: Change in total equity. Note that [DELTA]GFA = [DELTA]NFA + DEP.

The first term in the right-hand side of the above equation represents the cash from operations in the statement of cash flows. That is,

Cash flow from operations = (NI + DEP - [DELTA]AR - [DELTA]INV + [DELTA]AP + [DELTA]ACCR), or = (NI + DEP) - [([DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR)].

This indirect statement of cash flow starts with net income and makes adjustments to reconcile net earnings to net cash provided by operating activities. For sake of simplicity, we have shown the adjustment of adding back the depreciation. However, in practice there may be similar numerous adjustments. Generally, depreciation and amortization are the largest noncash items, and in other cases the other revenues and expenses related noncash items might net out to zero.

Note that, NI = EBIT - I - T. The EBIT represents the earnings before interest and taxes, the interest expense is denoted by I, and T represents income taxes. The term [([DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR)] represent the change in current assets except cash less change in current liabilities except interest bearing short-term debt (also known as non-interest bearing current liabilities, NBCLs). For simplicity, we have shown the major current assets and liabilities accounts. In practice there may be several other current asset accounts (other than cash) and NBCLs accounts. The authors define following terms for further discussion:

[OCF.sub.SCF] = EBIT - T + DEP - I. (2)

Where [OCF.sub.SCF] stands for operating cash flows from the income statement in the statement of cash flows, and

[DELTA][NOWC.sub.SCF] = [([DELTA]AR + [DELTA]INV) - ([DELTA]AP + AACCR)]. (3)

Where, [DELTA][NOWC.sub.SCF] represents the change in net operating working capital in the statement of cash flows. Also, the term ([DELTA]AP + [DELTA]ACCR) represents the NBCLs.

The second term in the right-hand side of equation (1) is the change in gross fixed assets and marketable securities and represents the cash flow from investment activities ([CFI.sub.FCF]) in the statement of cash flows. That is, cash flow from investment activities,

[CFI.sub.SCF] = -([DELTA]GFA + [DELTA]MS). (4)

The negative sign indicates that it is a cash flow outflow to the firm. The [DELTA]GFA equals net capital spending (NCS). The gross fixed assets less accumulated depreciation (ADEP), i.e., NFA = GFA - ADEP equals the net fixed assets (NFA). For simplicity, we assume that, besides fixed assets, a firm does not have any noncurrent assets. In practice, in addition to the changes in gross fixed assets and marketable securities, there may be several other transactions that will be included in the investment activity section. Finally, the last term in the right-hand side of equation (1) is the change in interest-bearing debt less the dividends plus the change in common stock and represents the cash flow from financing activities (CFFsCF) in the statement of cash flows. That is,

[CFF.sub.SCF] = ([DELTA]IBD - DIV + [DELTA]CS). (5)

The term IBD is the sum of long- and short-term debt and bank notes. The total equity is the sum of (1) external common equity, also commonly denoted as common stock (Cs), and is the sum of common stock at par plus the paid-in capital surplus and (2) the internal common equity, which is the (cumulative) retained earnings (RE). The change in retained earnings ([DELTA]RE) is the difference between ending and beginning cumulative retained earnings in the balance sheets, and the source is the additional retained earnings (ARE) from the income statement.

The cash inflow includes the change in external common equity ([DELTA]CS), but do not include the change or additions to the retained earnings ([DELTA]RE or ARE) because the net income in the operating cash flow already includes it, i.e., NI = [DELTA]RE (or ARE) + DIV. For simplicity, we assume the firm does not have any outstanding preferred or treasury stock. In practice, there may be several other transactions that will be included in the financing activity section.

In summary, Change in cash = Cash flow from operating activities ([OCF.sub.SCF] - [DELTA][NOWC.sub.SCF]) + Cash flow from investment ([CFI.sub.SCF]) activities + Cash flow from financing activities ([CFF.sub.SCF]) (6)

This is the accounting statement of cash flows.

Free cash flow (FCF)

The FCF is also known as the free cash flow from assets (FCF) as it is derived from the deployment of assets in business activities (see Petty and Rose, 2009). The word "free" implies that the firm is free to distribute these cash flows to its creditor and shareholders thereby providing an investment perspective. This cash flow from assets is calculated as the operating cash flow less the change in net operating working capital less net capital expenditures. The FCF identifies the impact of investment in fixed assets and net operating working capital to identify the available cash flow for investors (see Deo, 2009). Our approach of carving out the free cash flow from the statement of cash flow provides an investment model of the firm, which is useful for a firm's enterprise valuation. In other words, it separates the financing and investment decisions of a firm. That is, the statement of cash flows offers an accounting perspective, and the free cash-flow measure offers a financial perspective (Kousenidis, 2006).

The cash flow to creditors is defined as interest paid less the change in interest-bearing debt. The cash flow to shareholders is defined as dividends paid less the change in external common equity. The free cash flow leads to approaches for valuation of securities and a firm, and capital investment in projects (Estridge & Lougee, 2007). It also alludes to the agency relationship between the firm's owners and its managers. Therefore it is not surprising that free cash-flow measure is the basic measure for the discounted cash-flow model deployed in capital investment projects and in the capital budgeting process including the M&A process. The annual free cash-flow measure is volatile, and as a short-term measure it is more suitable for business units of a firm that have a large asset base and less vulnerable to surges in cash associated with any individual project. We now proceed to show that the first two components of the statement of cash flows with some adjustments lead to the derivation of free cash flow (FCF). The expression for free cash flows is:

FCF = After-tax cash flows from operations - Incremental investments in operating working capital - Incremental investment in fixed assets and other-long term assets The first component is the after-tax cash flows from operations, or

[OCF.sub.FCF] = EBIT + DEP - T. (7)

It is important to note that in precise calculation of OCFFCF, the tax amount from the income statement may further be increased by the tax rate times the interest expense as the tax calculation in the income statement includes deduction of interest expense, and is therefore lower by an amount equal to tax rate times interest expense.

From equations (2) and (7),

[OCF.sub.FCF] = [OCF.sub.SCF] + I. (8)

Note the difference between the [OCF.sub.FCF] and [OCF.sub.SCF] is the latter is net of interest expense.

The second component of FCF is the additional investments in operating working capital ([DELTA][NOWC.sub.FCF]) = change in current assets - change in non-interest bearing current liabilities (NBCLs).

That is, [DELTA][NOWC.sub.FCF] = ([DELTA]CASH + [DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR). (9)

From equations (3) and (9),

[DELTA][NOWC.sub.FCF] = [DELTA][NOWC.sub.SCF] + [DELTA]CASH. (10)

That is, the difference between [DELTA][NOWC.sub.SCF] and [DELTA][NOWC.sub.FCF] is the latter includes the change in cash as part of the change in current assets.

The third component of FCF is the additional investment in fixed assets and other-long term assets, i.e., net capital spending (NCS) = [DELTA]GFA.

Therefore, the cash flow from investing activities, or

[CFI.sub.FCF] = -[DELTA]GFA. (11)

From equations (4) and (11)

[CFI.sub.FCF] = [CFI.sub.SCF] + [DELTA]MS. (12)

That is, the difference between cash flow from investing in the statement of cash flow and the free cash flow is the latter includes change in marketable securities.

Summarizing,

FCF = [OCF.sub.FCF] - [DELTA][NOWC.sub.FCF] - [CFI.sub.FCF]. (13)

Substituting in equation (13), the expressions developed for relationships among the components of FCF and SCF depicted in equations (8), (10) and (12), we get,

FCF = [[OCF.sub.SCF] + I] - [[DELTA][NOWC.sub.SCF] + [DELTA]CASH] + [[CFI.sub.SCF] + [DELTA]MS] (14)

Rearranging,

FCF = [([OCF.sub.SCF] - [DELTA][NOWC.sub.SCF]) + [CFI.sub.SCF]] + (I - [DELTA]CASH + [DELTA]MS). (15)

The first term [[OCF.sub.SCF] - [DELTA][NOWC.sub.SCF] + [CFI.sub.SCF]] represents the sum of the first two components of the statement of cash flows. Therefore, FCF can be derived from the first two components of the statement of cash flows with adjustment or addition of the last term (I - [DELTA]CASH + [DELTA]MS).

The components of FCF

Substituting in equation (13), the relationships derived in equations (7), (9) and (11), the FCF = (EBIT + DEP - T) - [([DELTA]CASH + [DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR)] - ([DELTA]GFA). (16)

Substituting NCS for [DELTA]GFA and rearranging,

FCF = (EBIT + DEP - T) - [([DELTA]CASH + [DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR)] - ([DELTA]GFA). = (EBIT - T) - [([DELTA]CASH + [DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR)] - (NCS - DEP). (17)

The first term is (EBIT - T), which represents operating profit less cash taxes paid. The second term is [([DELTA]CASH + [DELTA]AR + [DELTA]INV) - ([DELTA]AP + [DELTA]ACCR)], which is the investment made by the firm in the net working capital to support the growth in sales. It is part of the basic day-to-day working operations of the firm. The third term [NCS - DEP] represents the incremental fixed capital investment to support the long-term sales growth. So far, we have analyzed the first two components of the statement of cash flows. We now proceed to derive and discuss the Cash flow from financing activities. To that end, we first proceed to discuss the concept of change in internal cash.

Change in internal cash

Another gauge of a firm's cash position discussed in the literature (see Brealey, Myers, & Marcus, 2008) is the measure of change in internal cash. The authors of this study derive an expression for the change in internal cash measure, and then discuss its implications for the management of cash flow for a firm. If a firm plans no additional external financing, that is, [DELTA]IBD = 0 and [DELTA]CS = 0, then the change in cash on the left-hand side of the equation (1) is the change in internal cash (or the change in cash without any additional external financing). That is,

[DELTA]Internal Cash + (NI + DEP - [DELTA]AR - [DELTA]INV + [DELTA]AP+ [DELTA]ACCR) + (-[DELTA]GFA - [DELTA]MS) - (DIV). = Cash flow from operating activities + Cash flow from investment activities - Dividends paid. (18)

= ([OCF.sub.SCF] - [DELTA][NOWC.sub.SCF]) + (-[DELTA]GFA - [DELTA]MS) - (DIV). (19)

Note that net income is net of interest expense, which is consistent with the statement of cash flows. A zero or no change in internal cash implies that the firm is generating just enough cash to meet its financial obligations (resource requirements including net operating working capital and long-term capital, tax and interest, and dividends) without assuming additional debt or new equity and without drawing on a pool of funds. A positive change in internal cash allows a firm to improve its capital structure, reduce preferred equity, and pay off debt.

As Brealey, Myers, and Marcus, (2008) note, a zero or positive change helps the firm to avoid the costs of issuing new securities and can be interpreted by the investment community as a signal of higher future profits or lower risk. A positive change helps to improve a firm's cash position and its financial slack (and debt capacity). In turn, sufficient financial slack paves a path for potential lenders to see the company's debt as a safe investment and hence provide ready access to debt financing.

It also ensures that financing is quickly available for good investments. Brealey, Myers, and Marcus, (2008) point out: "In the long-run, a company's value rests more on its capital investment and operating decisions than on financing. Therefore, you want to make sure your firm has sufficient financial slack, so that financing is quickly available for good investments. Financial slack is most valuable to firms with plenty of positive-NPV growth opportunities." Therefore, assuming a firm has a sufficient cash reserve at the beginning of the year; then, in the long run, no change in internal cash should help to boost the firm's equity valuation. From equations (1) and (16), note that,

[DELTA]Cash = [DELTA]Internal Cash + [DELTA]IBD + [DELTA]CS, and (20)

[DELTA]Cash = [DELTA]Internal Cash + [DELTA]External Cash, where [DELTA]External Cash = [DELTA]IBD + [DELTA]CS. (21)

That is, a change in a firm's cash position stems from a change in its internal cash and a change in external financing from interest-bearing debt and equity. A repeated low or negative change in internal cash suggests that the firm needs to examine collectively its operations, capital programs and dividend policy.

FCF and internal/external financing

First we derive the cash flow to the investors using the FCF approach: Recall the equation (1),

[DELTA]CASH = (NI + DEP - [DELTA]AR - [DELTA]INV + [DELTA]AP + [DELTA]ACCR) + (-[DELTA]GFA - [DELTA]MS) + ([DELTA]IBD - DIV + [DELTA]CS).

Substituting, NI = EBIT - I - T + DEP, and moving ACASH to the right hand side, and I to the last term of cash flow from financing activity and subtracting it rather than adding:

0 = (EBIT - T + DEP - [DELTA]CASH - [DELTA]AR - [DELTA]INV + [DELTA]AP + [DELTA]ACCR) + (-[DELTA]GFA - [DELTA]MS) - (I - [DELTA]IBD + DIV - [DELTA]CS). (22)

But recall that the sum of the first two terms on the right hand side, (EBIT - T+ DEP - [DELTA]CASH - [DELTA]AR - [DELTA]INV + [DELTA]AP + [DELTA]ACCR) + (-[DELTA]GFA - [DELTA]MS) equals FCF. Upon this substitution, 0 = FCF - (I - [DELTA]IBD + DIV - [DELTA]CS) FCF = (I - [DELTA]IBD + DIV - [DELTA]CS). (23)

Cash flow from assets = Cash flow to the investors

If [DELTA]IBD = 0 and [DELTA]CS = 0, that is, if a firm does not engage in additional borrowing or retiring debtor issuing new or buying back its common stock. Then,

FCF = (I + DIV). (24)

The firm utilizes its FCF, which it derived from its assets and pays investors the on-going interest payments to service its debt and the promised dividend payments. The interest payments arise due to borrowing via short- and long-term debt. The interest payments are paid first prior to any dividend payments. Therefore, to make any interest payments FCF > I or (FCF/I) > 1, since the firm has other obligations to the investors such as the dividend payments, the magnitude of FCF compared to I (FCF/I) will allow the decision maker to assess the potential of the firm to meet the investors' other obligations. Alternatively, the FASB requires that the interest expense be included in the operating cash flow, and [OCF.sub.SCF] = EBIT - T + DEP - I. Therefore,

([OCF.sub.SCF])/I = (EBIT - T + DEP - I)/I = [(EBIT - T + DEP)/I] - 1. (25)

The ratios ([OCF.sub.SCF])/I or [(EBIT - T + DEP)/I] > 1 also provide insights into the potential of the firm to pay the interest payments from its operations prior to investing in net working capital and PP&E. In addition to the annual interest expense the firm may have entered into contractual obligation to retire annually a part of the debt (sinking fund). In such a case, analysts need to include the non-tax deductible sinking fund along with the interest expense.

Internal and external financing

From the equation (23), the FCF/ (I+DIV) multiple helps to assess the firm's potential to pay the annul obligations to creditors and the promised and expected payments of dividends to the preferred and common stockholders, respectively. If a firm engages in external financing or has obligations to make sinking fund payments, the ratio of FCF/IBD specifically addresses the capacity of the firm to potentially pay off all of its debt for strategic reasons without resorting to the liquidation of its assets. Of course, the analyst can further analyze the individual components and the drivers of the free cash flow from assets as discussed earlier to understand the weaknesses and suggest remedies.

From equation (6), [DELTA]CASH = [[OCF.sub.SCF]] - [[DELTA][NOWC.sub.SCF]] - [[CFI.sub.SCF]] - [[CFF.sub.SCF]]. For discussion purposes, we divide both sides by [DELTA]Sales, and get

([DELTA]CASH/Sales) = ([OCF.sub.SCF]/Sales) - ([DELTA][NOWC.sub.SCF]/Sales) - ([CFI.sub.SCF]/Sales) - ([CFF.sub.SCF]/Sales). (26)

That is, Cash created per dollar of sales = Incremental cash from operations generated per dollar less incremental investment in net operating working capital per dollar of sales less incremental investment in long-term assets per dollar of sales less incremental cash flow to investors from financing per dollar of sales. We now proceed to discuss each of the three components on the R.H.S. of above expression.

Incremental cash from operations generated per dollar of sales

Recall that [OCF.sub.SCF] = EBIT - T + DEP - I. We dissect the depreciation and interest expenses from [OCF.sub.SCF] and combine it with the capital expenditures or cash flow from investing ([CFI.sub.SCF]) and cash flow from financing ([CFF.sub.SCF]), respectively. Then the remainder term is [OCF.sub.SCF] = EBIT - T. Noting that Sales = [Sales.sub.prior year] (1 + growth rate in sales). Then the first part of the term [(EBIT - T)/sales] is (EBIT/Sales), which is the operating profit margin. So, the term incremental cash from operations created per dollar of sales may be viewed as operating profit margin generated per dollar of sales.

The EBIT is pre-interest and pretax operating profit. It is calculated as net sales less cost of goods sold and operating expenses. The cost of goods sold or procured and includes cost of production or procurement of goods and services. The operating expenses include expenses for maintaining facilities, depreciation, selling and administrative, marketing and other expenses incurred in maintaining the production, service or procurement facilities. The lower or negative cash flow from operations may be associated with start-up firms and any intermittent downturn in the economy. cash producing or cash cows mature business units may help provide cushion for the growing business units or routine cash demands of the entire firm. The cash flow from operations is the primary source and a driver of cash for a firm. For an entrenched firm, it pays for the normal outflow, payments for dividends and interest, and for the on-going replacement of fixed assets and operating working capital.

The taxes paid, T equals = EBIT times [tau], where [tau] is the cash tax rate. It represents taxes on operating profit and can be calculated as book income taxes less increase in deferred taxes. The latter arises due to the timing differences in the recognition of some revenue and expense items for book and tax purposes. The common example is the use of straight--line depreciation for book purposes and accelerated depreciation method for tax purposes.

Incremental investment in net operating working capital per dollar of sales

The term ([DELTA][NOWC.sub.SCF]/Sales) may be viewed as [1/[Sales.sub.prior year] (1 + growth rate in sales)] times (Incremental net operating working capital), and it represents incremental net operating working capital per dollar of sales. The incremental net working capital is calculated as the sales times the incremental net working capital investment rate. In turn, this rate is generally calculated as incremental net working capital investment divided by the incremental sales.

The net working capital to sales ratio is also known as net working capital intensity and these intensities differ both within industries (which may reflect different managerial decisions and level of vertical of integration), and across industries (e.g. service versus manufacturing). When intensity differs greatly from the industry average, managers should analyze the consequences for the operation's profitability, and identify the optimal level of net working capital for their industry's operations. Recall that the incremental investment in net operating working capital is the difference in incremental investment in current asses to support the sales growth net of incremental investment in non-interest bearing current liabilities. Therefore, the firm needs to examine its inventory and accounts receivable policies as well as its payment policies and its accrual process.

Incremental investment in fixed assets and long-term assets per dollar of sales

The term (Incremental capital expenditures) times [1/([Sales.sub.prior year] (1 + growth rate in sales)] represents incremental capital expenditures per dollar of sales. The capital investment is calculated as sales times the fixed capital investment rate. In turn, the fixed capital investment rate is generally calculated as incremental fixed capital expenditures in excess of the depreciation expense divided by the incremental sales.

It is a common practice to calculate incremental capital expenditures to incremental sales for one year as well as an average over a five-year period in light of the availability of data for competitors and the firm's response to the changing competitive landscape. Although a firm's fixed asset productivity may rise over time, so do the costs capital additions, because of inflationary forces. In a steady state, one may assume that these factors offset each other. As a result, the difference between capital expenditures and depreciation may approximate the cost of real growth in productive capacity. Capital expenditures serve two main purposes: to expand productive capacity commensurate with sales growth rate, and to replace existing facilities in kind. The latter expenditures also help to reduce costs and improve productivity.

Excessive investments in plant not only depress returns from operations, but also increase a firm's fixed cost burden and therefore increase its vulnerability to demand shortfalls. In effect, increasing investment in fixed assets beyond a threshold increases the fixed operations cost and thereby the level of operating risk. On way to measure the impact of investments is to measure investment intensity, the investment in plant and equipment as a percentage of output or sales. Once again, the investment intensities differ both within industries (which may reflect different managerial decisions and level of vertical integration), and across industries (which may reflect different production or process technologies). When investment intensity differs greatly from the industry average, managers should analyze the consequences for the operation's profitability, and identify the optimal; level of fixed assets (in accounting terms) for their industry's operations.

Incremental cash flow to investors from financing per dollar of sales

The incremental cash flow related to financing is the cash outflow to the firm. On the other hand, this cash flow from financing also represents the cash inflow to the investors from financing, and equals (I - [DELTA]IBD + DIV - [DELTA]CS). As a side note, the cash sales is equal to the net sales less the change in accounts receivable (Sales - [DELTA]AR). In summary, we may express the above relationships in terms of financial ratios:

[DELTA]CASH = [[Sales.sub.prior year] (1 + growth rate in sales)] times [(operating profit margin (1 - [tau]) - incremental net operating working capital intensity - incremental fixed capital intensity incremental - cash inflow to investors from financing per dollar of sales]. In dollar terms: [DELTA]CASH = [Operating profit (1 - Cash Tax Rate)] - [Incremental net operating working capital] [Incremental capital expenditures] - [Incremental cash flow to investors from financing)]. (27)

Numerical Examples

Consider the financial statements of a hypothetical firm ABC Co. shown in Tables 1 and 2. (Income statements and balance sheets for year-end 2011-2014, and cash flow statements for year-end, 2012-2014). First, we use these financial statements to perform the traditional ratio analysis (not shown here), and then to construct ABC's cash flow measures and their underlying critical variables. The authors compare the values of the financial measures in both steps with the industry averages to assess ABC's comprehensive financial performance.

The traditional ratio analysis (not shown here) yields the following observations when compared with the industry average.

--The current and quick ratios are above the industry average suggesting excessive investment in current assets.

--The relatively low debt ratio and high times interest earned ratio compared to the industry average shows a much lower level of debt.

--The turnover ratios indicate high levels of inventory and accounts receivables

--The firm is slow in paying its suppliers

--The fixed asset turnover ratio is much higher than the industry average indicating lower levels of fixed assets.

--The profitability ratios are below the industry average.

--The return on equity is much lower than the industry average and is declining each year.

--The market to book ratio is lower than the industry average.

The authors of this study now proceed to derive the values of the cash flow measures and in a stepped manner. The free cash flow is calculated in four steps; and is shown in Table 2, panels I through IV. First, using equations (2) and (8), we calculate values for the operating cash flow as defined in the statement of cash flow ([OCF.sub.SCF]), and in the expression for the free cash flow measure ([OCF.sub.FCF]) for the years 2012 to 2014.

In the second step, using equations (3) and (10), we calculate the values for the net operating working capital as defined in the statement of cash flow ([DELTA][NOWC.sub.SCF]), and in the expression for the free cash flow measure ([DELTA][NOWC.sub.FCF]) for the years 2012 to 2014. In the third step, using equation (4), we calculate the values for the cash flow related to investing as defined in the statement of cash flow ([CFI.sub.SCF]) for the years 2012 to 2014.

Finally, using equation 13, the above three components sums up to the free cash flow, the authors observe that over the three-year period of analysis though the sales are in excess of $2 billion, the free cash levels are relatively low: about $32 million in 2012, declines to $(30) million in 2013, and recovers to $28 million in 2014.

In summary, the lower level of FCF is attributed to a very high cost structure partially offset by lower long-term capital investments. The traditional ratio analysis has already identified that the firm has made excessive investment in current assets, namely accounts receivable and inventory, and it also carries a high-level of accounts payable. We now proceed to derive the values of the critical derivers of underlying the cash low measures as shown in Table 3.

--The sales growth is 5.6% in 2012, spikes to 18.9% in 2013 and reverts to 5.6% in 2014, which is below the industry average of 6.5%.

--The operating margins rover around 5% over the three-year period, and are well below the industry average of 7.1%. The traditional ratio analysis has indicated that the gross margins are somewhat lower than the industry average suggesting a higher cost of goods sold, and the net profit margins are significantly lower than the industry average revealing much higher operating expenses relative to the sales.

--The incremental net operating working capital intensities are 26.2%, 23.6% and 30.7% in 2012, 2013 and 2014 respectively, which are higher than the industry average of 16.5%. Note that the net operating working capital, which is the net of current assets and non-interest bearing current liabilities, masks the underlying excessive investments in individual accounts of receivables and inventory, which are partially offset by the higher levels of accounts payable due to slower payments to its supplier. These weaknesses were identified by the traditional ratio analysis.

--The incremental long-term capital intensities are 4.9%, 2.9% and 5.7% for the years 2012 to 2014, respectively, and are higher than the three-year average net plant intensity of 3.4%, except in 2013. A comparison of the firm's long-term capital and net plant intensities with the industry averages of 9.5% and 4.5%, respectively suggests that the firm needs to invest in property, plant and equipment to maintain or gain competitive advantage. The net plant intensity helps to assess the capital requirements over a longterm horizon, as the invested long-term capital becomes part of the gross plant, which is partially offset by depreciation or replacement in kind intensity (depreciation divided by sales). The traditional ratio analysis has identified that the lower investments in long-term capital has led to its higher fixed-asset turnover.

Table 4, panel I presents the calculation of the ratio, (FCF/(I+DIV), and the values are 2.7, (3.0) and 3.5 for the years 2012, 2013 and 2014, respectively indicating that though below the industry average of 4.1, the firm was in good financial health to service the debt in years 2012 and 2014, but not in 2013.

The values for the ratio (FCF/IBD) are 27%, (30)% and 35% in years 2012 through 2014, respectively, suggesting that in 2014 and onwards though below the industry average of 40%, should the firm decide to retire its interest-bearing debt for strategic reasons, it will take the about 3 years to pay off its entire debt using its free cash flow. Due to the lower level of debt and the lower level of interest charges, both ratios (FCF/ (I+DIV) and (FCF/IBD) mask the lower levels of FCF generated by the firm.

Finally, the Table 4, panel II represents the calculation of the changes in internal cash, and these values are $42.8, -$66.5, and -$36.6 for the years 2012, 2013 and 2014, respectively, which are well below for the industry average of the positive change in internal cash. Despite the negative cash generation by its operations, the firm continues to retire $20 million per year in long-term debt. Not surprisingly, the firm had engaged in infusion of equity capital in 2013 in the amount of $60 million, partially offsetting the effects of negative change in internal cash. The net result is the decline in cash positions to $26.5 million and $56 million in 2013 and 2014, respectively. The firm may further investigate into the calculation of the industry average, and should consider developing an industry average for the change in internal cash to sales ratio.

IMPLICATIONS

The authors have developed the cash flow-based financial ratios, which in conjunction with the traditional financial ratios provide a well-rounded approach to financial analysis. Our ratios are based on sound financial theory of the firm. Finally, our comprehensive approach to financial statement analysis should aid the decision-making makers in assessing a comprehensive financial performance of a firm.

RECOMMENDATIONS FOR FUTURE RESEARCH

Researchers could develop case studies of firms in financial distress or in bankruptcy using our methodology to evaluate their cash flow statements, and validate the usefulness of recommended cash flow-based financial rations. A firm with a complex cash flow statement would also provide an opportunity to study our techniques to identify any early warning signals about a firm's impending cash crunch.

CONCLUSIONS

The authors have recommended two measures useful in analyzing the statement of cash flow: (1) free cash flow and (2) the change in internal cash, and both are derived from the statement of cash flow. Next, we identify the critical variables or financial ratios underlying these two measures: the growth rate in sales (in combination with the prior year sales), operating profit margin, incremental net operating working capital intensity, and incremental long-term capital intensity.

The FCF measure also leads to two ratios related to financing: (1) FCF/ (I+DIV), which helps to assess the firm's potential to service the annual obligations (interest and sinking fund) to creditors and the promised and expected payments of dividends to the preferred and common stockholders, respectively, and (2) the ratio (FCF/ IBD) helps to assess the firm's financial performance related to leverage and associated risk. It also helps to estimate the number of years required to retire the debt if the firm were to do so for strategic reasons. In addition, the FCF measure allows us to separate the investment and financing decisions. The second measure, the change in internal cash helps to assess the firm's internal cash generation potential based on its operation, and identifies any need for external cash infusion.

These cash flow-based measures and ratios in combination with the traditional financial ratios derived from the income statement and balance sheet provide a holistic view of the firm's financial health. We have demonstrated the linkages between the IS and BS and cash-flow measures in a meaningful manner so as to facilitate the learning process.

Prakash Deo

University of Houston-Downtown

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Prakash Deo is an Associate Professor of finance at the University of Houston-Downtown. He has received his doctorate in corporate finance from the Ohio State University. He has over 20 years of business experience in major U.S. corporations and has held many management responsibilities, including the position of financial director. He has completed executive education at Duke and Northwestern Universities. He has published in more than 30 leading applied and pedagogical journals.
Table 1
A. Financial Statement Income Statements Ending December 31
($ million): ABC Co.

                                             2011      2012

Sales                                       1970.00   2080.00
Cost of goods sold                          1497.20   1549.60
Gross margin                                 472.80    530.40
Administrative expense                       338.80    405.60
Depreciation                                  21.60     22.80
EBIT                                         112.40    102.00
Interest                                      14.00     12.00
EBT                                           98.40     90.00
Taxes                                         39.36     36.00
Net income                                    59.04     54.00
Dividends                                      0.00      0.00
Retained earnings                             59.04     54.00

                                             2013      2014

Sales                                       2472.00   2610.00
Cost of goods sold                          1856.40   1957.60
Gross margin                                 615.60    652.40
Administrative expense                       472.20    498.60
Depreciation                                  27.20     28.80
EBIT                                         116.20    125.00
Interest                                      10.00      8.00
EBT                                          106.20    117.00
Taxes                                         42.48     46.80
Net income                                    63.72     70.20
Dividends                                      0.00      0.00
Retained earnings                             63.72     70.20

B. Balance Sheets Ending December 31 ($ million): ABC Co.

Assets                                       2011      2012

Cash                                          80.80    103.80
Receivables                                  306.40    317.80
Inventory                                    234.00    242.20
Other current assets                          11.80     12.40
Total current assets                         633.00    676.20
Gross fixed assets                            89.60    117.80
Accumulated depreciation                      24.00     46.80
Net fixed assets                              65.60     71.00
Total assets                                 698.60    747.20

LIABILITIES AND EQUITY

Accounts payable                             107.60    109.40
Short-term debt                               20.00     20.00
Accruals                                      39.40     52.00
Total current liabilities                    167.00    181.40
Long-term debt                               120.00    100.00
Common stock                                 300.00    300.00
Retained earnings                            111.60    165.60
Total liabilities and equity                 698.60    747.00

Assets                                       2013      2014

Cash                                          77.20     21.20
Receivables                                  350.20    449.60
Inventory                                    386.80    383.80
Other current assets                          14.80     15.60
Total current assets                         829.00    870.20
Gross fixed assets                           156.20    192.80
Accumulated depreciation                      74.00    102.80
Net fixed assets                              82.20     90.00
Total assets                                 911.20    960.20

LIABILITIES AND EQUITY

Accounts payable                             172.40    168.40
Short-term debt                               20.00     20.00
Accruals                                      49.40     52.20
Total current liabilities                    241.80    240.60
Long-term debt                                80.00     60.00
Common stock                                 360.00    360.00
Retained earnings                            229.20    299.60
Total liabilities and equity                 911.00    960.20

C. Cash Flow Statements Ending
December 31 ($ million): ABC Co.

Cash flows from operating activities         2011      2012

Net income                                              54.00
Depreciation                                            22.80
Less: Increase in accounts receivable                   11.40
Less: Increase in inventory                              8.20
Less: Increase in other current assets                   0.60
Add: Increase in accrued wages and taxes                12.60
Add: Increase in accounts payable                        1.80
Net cash flow from operating activities                 71.00
Cash flow from investing activities
Less: increase in gross fixed assets                    28.20
Net cash flow from investing activities                -28.20
Cash flows from financing activities
Add: Increase in short-term debt                         0.00
Add: Increase in long-term debt                        -20.0
Add: Increase in common stock                            0.00
Less: common stock dividends                             0.00
Net cash flow from                                     -20.00
  financing activities
Net change in cash and                                  22.80
  marketable securities

Cash flows from operating activities         2013      2014

Net income                                    63.80     70.00
Depreciation                                  27.20     28.80
Less: Increase in accounts receivable         32.40     99.40
Less: Increase in inventory                  144.60     -3.0
Less: Increase in other current assets         2.40      0.80
Add: Increase in accrued wages and taxes      -2.60      2.80
Add: Increase in accounts payable             63.00     -4.00
Net cash flow from operating activities      -28.00      0.40
Cash flow from investing activities
Less: increase in gross fixed assets          38.40     36.60
Net cash flow from investing activities      -38.40    -36.60
Cash flows from financing activities
Add: Increase in short-term debt               0.00      0.00
Add: Increase in long-term debt              -20.0     -20.00
Add: Increase in common stock                 60.00      0.00
Less: common stock dividends                   0.00      0.00
Net cash flow from                            40.00    -20.00
  financing activities
Net change in cash and                       -26.40    -56.20
  marketable securities

D. Changes in Balance Sheet Accounts Ending December 31
($ million): ABC Co.

Cash                                                    23.00
Receivables                                             11.40
Inventory                                                8.20
Other current assets                                     0.60
Total current assets                                    43.20
Gross fixed assets                                      28.20
Accumulated depreciation                                22.80
Net fixed assets                                         5.40
Total assets                                            48.60

LIABILITIES AND EQUITY

Accounts payable                                         1.80
Short-term debt                                          0.00
Accruals                                                12.60
Total current liabilities                               14.40
Long-term debt                                         -20.00
Common stock                                             0.00
Retained earnings                                       54.00
Total liabilities and equity                            48.40

Cash                                         -26.60    -56.00
Receivables                                   32.40     99.40
Inventory                                    144.60     -3.00
Other current assets                           2.40      0.80
Total current assets                         152.80     41.20
Gross fixed assets                            38.40     36.60
Accumulated depreciation                      27.20     28.80
Net fixed assets                              11.20      7.80
Total assets                                 164.00     49.00

LIABILITIES AND EQUITY

Accounts payable                              63.00     -4.00
Short-term debt                                0.00      0.00
Accruals                                      -2.60      2.80
Total current liabilities                     60.40     -1.20
Long-term debt                               -20.00    -20.00
Common stock                                  60.00      0.00
Retained earnings                             63.60     70.40
Total liabilities and equity                 164.00     49.20

Table 2
Calculation of FCF in four steps: ABC Co.

I. Calculations of     2012                  2013
[OCF.sub.SCF] and
[OCF.sub.FCF]

From equation (2)

[OCF.sub.SCF] = EBIT   [OCF.sub.SCF] =       [OCF.sub.SCF] =
-T + DEP -I            $102.0 - $36.0 +      $116.2 - $42.4 +
                       $22.8 - $12.0 =       $27.0 - $10.0 =
                       $76.8                 $90.9

From equation (8)

[OCF.sub.FCF] =        [OCF.sub.FCF] =       [OCF.sub.FCF] =
[OCF.sub.SCF] + I      $76.8 + $12.0 =       $90.92 + $10.0 =
                       $88.8                 $100.9

II. Calculations of    2012                  2013
[DELTA]
[NOWC.sub.SCF] and
[DELTA]
[NOWC.sub.FCF]

From equation (3)

[DELTA]                [DELTA]               [DELTA]
[NOWC.sub.SCF]         [NOWC.sub.SCF]        [NOWC.sub.SCF] =
= [(AAR + AINV +       = [($11.4 + $8.2      [($32.4 + $144.6
[DELTA]OTHERCA) -      + $0.6) - ($1.8 +     + $2.4) - ($63.0 +
([DELTA]AP             $12.6)] = $5.8        (-$2.6)] = $119.0
+[DELTA]ACCR)]

From equation (10)

[DELTA]                [DELTA]               [DELTA]
[NOWC.sub.FCF] =       [NOWC.sub.FCF] =      [NOWC.sub.FCF] =
[DELTA]                $5.8 + $23.0 =        $119.0 + (-$26.6)
[NOWC.sub.SCF] +       $28.8                 = $92.4
[DELTA]CASH

III. Calculation of    2012                  2013
[CFI.sub.SCF]

From equation (4)
[CFI.sub.SCF] =        [CFI.sub.SCF] =       [CFI.sub.SCF] =
[DELTA]GFA +           $28.2                 $38.4
[DELTA]MS

IV. Calculation of     2012                  2013
FCF

From equation (13)

FCF = [OCF.sub.FCF]    FCF = $88.8 -         FCF = $100.9 -
- [DELTA]              $28.8 - $28.2         $92.4 - $38.4 =
[NOWC.sub.FCF]         = $31.8               -$29.88
-[CFI.sub.FCF]
                       The precise           The precise
                       calculation of FCF    calculation of FCF
                       will lead exclude     will lead exclude
                       the tax deduction     the tax deduction
                       related to interest   related to interest
                       expense.              expense.

I. Calculations of     2014
[OCF.sub.SCF] and
[OCF.sub.FCF]

From equation (2)

[OCF.sub.SCF] = EBIT   [OCF.sub.SCF] =
-T + DEP -I            $125.0 - $46.8 +
                       $28.8 - $8.0 = $99.0

From equation (8)

[OCF.sub.FCF] =        [OCF.sub.FCF] =
[OCF.sub.SCF] + I      $99.0 + $8.0 =
                       $107.0

II. Calculations of    2014
[DELTA]
[NOWC.sub.SCF] and
[DELTA]
[NOWC.sub.FCF]

From equation (3)

[DELTA]                [DELTA][NOWC.sub.SCF]
[NOWC.sub.SCF]         = [($99.4 + (-$3.0)
= [(AAR + AINV +       + $0.8) -(-$4.0 +
[DELTA]OTHERCA) -      $2.8)] = $98.4
([DELTA]AP
+[DELTA]ACCR)]

From equation (10)

[DELTA]                [DELTA][NOWC.sub.FCF]
[NOWC.sub.FCF] =       = $98.4 + (-$56.0) =
[DELTA]                $42.4
[NOWC.sub.SCF] +
[DELTA]CASH

III. Calculation of    2014
[CFI.sub.SCF]

From equation (4)
[CFI.sub.SCF] =        [CFI.sub.SCF] = $36.6
[DELTA]GFA +
[DELTA]MS

IV. Calculation of     2014
FCF

From equation (13)

FCF = [OCF.sub.FCF]    FCF = $107 - $42.4 -
- [DELTA]              $36.6 = $28.0
[NOWC.sub.FCF]
-[CFI.sub.FCF]
                       The precise
                       calculation of FCF
                       of $1.6 if we
                       exclude the tax
                       deduction related to
                       interest expense.

Table 3
Calculation of critical variables underlying the
free cash flow: ABC Co.

Calculation           2012                    2013
of sales
growth rate

Sales growth rate     Sales growth rate =     Sales growth rate =
= [([Sales.sub.       [($2,080 - $1,970)/     [($2,472-$2,080)/
current yr.]/         $1,970] * 100 = 5.58%   $2,080] * 100 =
[Sales.sub.prior                              18.85%
Industry average:
6.5% yr.])/
[Sales.sub.prior
yr.]] times 100

Calculation of
operating margin

Operating Margin      Operating Margin        Operating Margin
= (Operating          = ($102.0/$2,080)       = ($116.2/$2,472)
income/sales)         * 100 = 4.90%           * 100 = 4.70%

Industry
average: 7.1%

Calculation of        2012                    2013
incremental net
operating working
capital intensity

Incremental net       ([DELTA][NOWC.sub       ([DELTA]
operating working     .FCF])/Incremental      [NOWC.sub.FCF])
capital intensity =   sales =                 /Incremental
([DELTA]              ($28.8/$110.0) *        sales = ($92.4
[NOWC.sub.FCF])/      100 = 26.18%            /$392.0) *
Incremental sales                             100 = 23.57%

Industry
average: 16.5%

Calculation of        2012                    2013
incremental long-
term capital
intensity

Incremental long/     Incremental capital     Incremental
term capital          expenditures =          capital
intensity =           $28.2 - $22.8           expenditures =
([CFI.sub.SCF]/       = $5.4                  $38.4 - $27.0
Incremental sales)                            = $11.4

Incremental capital   Incremental             Incremental
expenditures =        sales = $110.0          Sales = $392.0
Change in gross
fixed assets (or      Incremental             Incremental
change in net fixed   capital intensity       capital intensity
assets plus           = ($5.4/$110) *         = ($11.4/$392)
depreciation) less    100 = 4.91%             * 100 = 2.91%
depreciation

Industry
average: 9.5%

Calculation of        2012                    2013
plant intensity

Plant intensity       Net plant/Total         Net plant/
= Net plant/          sales = ($71.0/         Total sales =
Total sales           $2,080) *               ($82.2/$2,472) *
                      100 = 3.41%             100 = 3.33%
Industry
average: 4.5%

Calculation           2014
of sales
growth rate

Sales growth rate     Sales growth rate =
= [([Sales.sub.       [($2,610 -
current yr.]/         $2,472)/$2,472)
[Sales.sub.prior      * 100] = 5.58%
Industry average:
6.5% yr.])/
[Sales.sub.prior
yr.]] times 100

Calculation of
operating margin

Operating Margin      Operating Margin
= (Operating          = ($125/$2,610) * 100
income/sales)         = 4.79%

Industry
average: 7.1%

Calculation of        2014
incremental net
operating working
capital intensity

Incremental net       ([DELTA][NOWC.sub.FCF])/Incremental
operating working     sales
capital intensity =   = ($42.4/$138.0) * 100
([DELTA]              = 30.72%
[NOWC.sub.FCF])/
Incremental sales

Industry
average: 16.5%

Calculation of        2014
incremental long-
term capital
intensity

Incremental long/     Incremental capital
term capital          expenditures
intensity =           = $36.6 - $28.8
([CFI.sub.SCF]/       = $7.8
Incremental sales)

Incremental capital   Incremental Sales = $138
expenditures =
Change in gross       Incremental capital intensity
fixed assets (or      = ($7.8/$138) * 100
change in net fixed   = 5.65%
assets plus
depreciation) less
depreciation

Industry
average: 9.5%

Calculation of        2014
plant intensity

Plant intensity       Net plant/Total sales
= Net plant/          = ($90.0/$2,610) * 100 =
Total sales           3.49%

Industry
average: 4.5%

Table 4
Calculation of Critical Variables Underlying the
Free Cash Flow Ratios: ABC Co.

A. Calculation of the Free Cash Flow Ratios

Calculation of free         2012             2013
cash flow to
promised on expected
payments

FCF/ (I+DIV)           FCF/(I+DIV)      FCF/ (I+DIV) =
Industry average:      = $31.8/($12.0   - $29.88/($10
4.1 Times              + $0) = $2.65    + $0) = -$2.99

Calculation of free         2012             2013
cash flow to
interest bearing
debt

Free cash flow to      (FCF/IBD) =      (FCF/IBD) =
interest bearing       $31.8/($20 +     -$29.88/($20
debt = (FCF/IBD)       $100)            + $80)

Industry average:      = 26.5%          = -29.9%
40.0%

Calculation of free           2014
cash flow to
promised on expected
payments

FCF/ (I+DIV)           FCF/ (I+DIV)
Industry average:      = $28.0/($8 + $0)
4.1 Times              = $3.50

Calculation of free           2014
cash flow to
interest bearing
debt

Free cash flow to      (FCF/IBD) = $28.0
interest bearing       ($20 +
debt = (FCF/IBD)       $60)

Industry average:      = 35.0%
40.0%

B. Calculation of the Change in Internal Cash: ABC. Co.

Calculation of              2012             2013
change in
Internal cash

From equation (19)     Change in        Change in
Change in internal     internal cash    internal cash
cash = [OCF.sub.SCF]   = $76.8 -        = $90.9 -
- [DELTA]              $28.2 -          $38.4 -
[NOWC.sub.SCF]         $5.8 - 0         $119.0 - 0
-[CFI.sub.FCF] - DIV

Industry average: A    = $42.8          = - $66.5
positive change

Calculation of                2014
change in
Internal cash

From equation (19)     Change in internal
Change in internal     cash = $99.0 -
cash = [OCF.sub.SCF]   $36.6 - $98.4 - 0
- [DELTA]
[NOWC.sub.SCF]
-[CFI.sub.FCF] - DIV

Industry average: A    = - $36.6
positive change
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Article Details
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Author:Deo, Prakash
Publication:International Journal of Business, Accounting and Finance (IJBAF)
Article Type:Report
Geographic Code:1USA
Date:Mar 22, 2016
Words:10430
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