UNIVERSITY OF NAIROBISCHOOL OF BUSINESS

PROGRAMME: MSC FINANCE

TOPIC: CASHFLOW ANALYSIS

IN PARTIAL FULFILLMENT OF DAC 511 IN MSC FINANCE YEAR 2013

LECTURER: MR. HERICK ONDIGO

JANUARY 2013

PRESENTED BY: GROUP FIVE

1. MIRIAM NDUNGU D63/60902/20132. MBOKA TITUS D63/79356/20123. TOM TULA KATSIVO D63/60664/20134. ABDIRAHMAN ISAAC D63/60240/20135. YVONNE MWANGI D63/60232/20136. PETER MWANGI GICHAAGA D63/60087/20137. EDWIN AGER D63/60791/20138. ANDREW MARARIA D63/61044/20139. GEORGE MUSUSDI D63/60203/201310. MOSES KIPLAGAT D63/60562/2013

TABLE OF CONTENTS

1.0 Introduction

1.1 Benefits of the statement of cash flow information

1.2 Definitions

1.3 Cash and cash equivalents

1.4 Relevance of Cash

1.5 Presentation of the statement of cash flow

1.6 Reporting cash flow from Operating Activities

1.7 Reporting cash flows from investing and financing activities

1.8 Reporting cash flows on a net basis

1.9 Foreign currency cash flows

1.10 Interest and Dividends

1.11 Income Taxes

1.12 Investments in subsidiaries, associates and joint ventures

1.13 Acquisitions and disposals of subsidiaries and other business units

1.14 Non-cash transactions

1.15 Components of cash and cash equivalents

1.16 Other disclosures

1.17 Format for Direct Method

1.18 Format for Indirect Method

2.0 Analysis and implications of Cash Flows

2.1 Limitations in Cash Flow reporting

2.2 Interpreting cash flows and net income

3.0 Analysis of Cash Flow

3.1 Inferences from analysis of cash flows

2

3.2 Alternative cash flow measures

3.3 Company and Economic conditions

3.4 Free cash flow

4.0 Specialized cash flow ratios

4.1 Cash flow adequacy ratio4.2 Cash Reinvestment ratio

5.0 Equity Method

5.1 Acquisitions of companies with stock

6.0 Postretirement benefits

7.0 Securitization of receivables

7.1 How Receivable Securitization Works

7.2 Reasons to Securitize Receivables

3

STATEMENT OF CASH FLOW IAS 7

1.0 INTRODUCTION

Objective

Information about cash flows is useful because it provides users of financial statements

the basis for assessing the ability of the company to generate cash and cash equivalents

and the needs of the company to utilize those cash flows.

To make economic decisions, users must evaluate the ability of the company to generate

cash and cash equivalents and the timing and also the degree of certainty regarding their

generation.

The objective of this Standard is to require companies to provide information about the

historical movements in cash and cash equivalents by means of a cash flow statement

which classifies cash flows during the period from operating, investing and financing

activities.

Scope

1. Companies are required to prepare a statement cash flow in accordance with the

requirements of this Standard (IAS 7) and must present it as an integral part of its

financial statements for each period financial statements are presented.

2. The Standard replaces the old IAS 7 Statement of Changes in Financial Position,

approved in July 1977.

3. Users of financial statements are interested in how the company generates and uses cash

and cash equivalents. This need is independent of the nature of the company's activities,

even when the cash could be regarded as the product of the company in question, as the

case may be of financial institutions. Basically, companies need cash for the same

reasons for that are very different activities that constitute their main source of revenue.

In fact, all of them need cash to carry out their operations, pay their obligations and

4

provide returns to their investors. Accordingly, this standard requires all companies to

present a statement of cash flows.

1.1 Benefits of the statement of cash flow information

1. The cash flow statement, when used in conjunction with the rest of the financial

statements, provides information that allows users to evaluate changes in net assets of the

company, its financial structure (including its liquidity and solvency) and their ability to

change both the amounts and dates of receipts and payments in order to adapt to changing

circumstances and opportunities that may arise. Information about cash flows is useful

for evaluating the capacity that the company has to generate cash and cash equivalents,

allowing users to develop models to assess and compare the present value of net cash

flows from different companies. It also allows comparison of information about the

performance of the operation of different companies as it eliminates the effects of using

different accounting treatments for the same transactions and economic events.

2. Often, information on historical cash flow is used as an indicator of the amount, time of

occurrence and certainty of future cash flows. It is also useful for checking the accuracy

of past assessments regarding the future flows, as well as to examine the relationship

between performance, cash flows and the net impact of price changes.

1.2 Definitions

The following terms are used in this Standard with the meanings specified below:

Cash includes both cash in hand and bank/demand deposits (including foreign

currencies) net of bank overdrafts.

Cash equivalents are short-term investments of high liquidity which are readily

convertible into certain amounts of cash subject to an insignificant risk of changes in

value.

Cash flows are inflows and outflows of cash and cash equivalents.

5

Operating activities are the main revenue-producing activities of the company and other

activities that cannot be classified as investment or financing.

Investing activities are the acquisition, disposal of long-term assets and other

investments not included in cash and cash equivalents.

Financing activities are activities that result in changes in the size and composition of

the contributed equity and borrowing of the company.

1.3 Cash and cash equivalents

The cash equivalents are held for the purpose of meeting short term cash commitments rather

than investment or similar purposes. For an investment to qualify as a cash equivalent, it must be

readily convertible to a known amount of cash and be subject to an insignificant risk of changes

in value. Therefore, an investment will qualify as a cash equivalent only when it has a short

maturity for example three months or less from the date of acquisition. Equity investments are

excluded from cash equivalents unless they are substantially equivalent to cash such as preferred

shares acquired within a short period of their maturity and with a specified redemption date.

Bank borrowings are generally regarded as financing activities. In some countries, however,

bank overdrafts which are payable on demand form an integral part of the cash and cash

equivalent management of the company. Under these circumstances, such overdrafts are

included as a component of cash and cash equivalents. A characteristic of such banking

arrangements is that the bank balance often fluctuates from being positive to overdrawn.

Cash flows exclude movements between items that constitute cash and cash equivalents because

these components are part of the cash management of the company rather than its operating,

investing or financing activities. Cash management includes the investment of excess cash in

cash equivalents.

1.4 Relevance of Cash

6

Cash is the most liquid of assets and offers a company both liquidity and flexibility. It is both the

beginning and the end of a company’s operating cycle.

Analysis of financial statements recognizes that in accrual accounting companies recognize

revenue when earned and expenses when incurred. However, cash basis accounting, revenue is

recognized when cash is received and expenses when paid in cash yet, net cash flow is the end is

the end measure of profitability i.e. it is cash, not income that ultimately repays bank borrowings,

replaces equipment, expands facilities and pays dividends.

The analysis helps in assessing the following:

Liquidity – is the nearness to cash of assets and liabilities

Solvency – is the ability to pay liabilities as and when they fall due (maturity)

Financial Flexibility – is the ability to react and adjust to opportunities and adversities.

Statements of cash flows are important to analysis and provide information to help users address

questions such as:

How much cash is generated from or used in operations?

What expenditures are made with cash from operations?

How are dividends paid when confronting an operating loss?

What is the source of cash for debt payments?

How is the increase in investments financed?

What is the source of cash for new plant assets?

Why is cash lower when income increased?

What is the use of cash received from new financing?

1.5 Presentation of the statement of cash flow

The statement of cash flow reports cash flows during the period classified as operating, investing

and financing activities. 7

A company presents its cash flows from operating, investing and financing activities in a manner

that is most appropriate to the nature of its business activities. Classification by activity provides

information that allows users to evaluate the impact of those activities on the financial position

of the company and the amount in its cash and other cash equivalents. This structure of

information can also be useful in assessing the relationship among those activities.

A single transaction can have cash flows that are classified in different ways. For example, when

repayments on a loan include principal and interest, the interest can be classified as operating

activity while the share of repayment of the principal amount is classified as a financing activity.

Operating Activities

The amount of the cash flows from operating activities is a key indicator of the extent to which

these activities have generated sufficient liquid funds to repay loans, to maintain the operating

capability of the business, pay dividends and make new investments without resorting to external

sources of funding. The information about the specific components of the cash flows from

operating activities is useful along with other information to predict future cash flows of such

activities.

Cash flows from operating activities are primarily derived from the principal revenue-producing

activities of the company. Therefore, they generally result from the transactions and other events

relevant to the determination of profits or losses. Examples of cash flows from operating

activities are as follows:

(a) Cash receipts from sales of goods and services;

(b) Cash receipts from royalties, fees, commissions and other revenue;8

(c) Cash payments to suppliers for the provision of goods and services;

(d) Cash payments to and on behalf of employees;

(e) Cash receipts and payments of insurance premium and benefits, annuities and other

liabilities arising from policies underwritten;

(f) Cash payments or refunds of income taxes, unless they can specifically be classified

within the investment or financing activities, and

(g) Cash receipts and payments under contracts held for dealing or trading purposes.

Some transactions, such as the sale of an item of property, plant and equipment can result in a

gain or loss will be included in the determination of profit or loss. However, the cash flows

arising from these transactions will be included among investment activities.

A company may hold securities or loans for dealing or trading purposes, in which case these

investments are considered similar to the stocks purchased specifically for resale. Therefore, cash

flows arising from the purchase and sale of dealing or trading securities are classified as

operating activities. In a similar way, cash advances and loans made by financial institutions are

classified as operating activities since they relate to the main revenue-producing activities of the

company.

Investing Activities

The separate disclosure of cash flows arising from investing activities is important because such

cash flows represent the extent to which expenditures have been made for resources intended to

generate future income and cash flows. Examples of cash flows from investing activities are as

follows:

i. Payment for the purchase of tangible fixed assets, intangible assets and other long

term, including payments related to capitalized development costs and work

performed by the company for its property, plant and equipment;

9

ii. Cash receipts from sales of property, plant and equipment, intangible assets and

other long-term;

iii. Payments for the purchase of tools or liabilities of capital securities issued by

other companies as well as in joint ventures (other than payments for those same

securities and instruments that are considered cash and cash equivalents, and

those are taken for dealing or trading in);

iv. Cash receipts from sales and redemption of instruments liabilities or equity

securities issued by other companies, and investments in joint ventures (other than

payments for those same securities and instruments that are considered cash and

cash equivalents, and the which are held for dealing or trading in);

v. Cash advances and loans to third parties (other than such operations by financial

companies);

vi. Charges arising from repayment of loans and advances to third parties (other than

the operations of this type made by financial institutions);

vii. Payments under forward contracts, futures, options and swap transaction, except

where such contracts are maintained on the grounds of dealing or trading routine,

or when the previous payments are classified as financing activities, and

viii. Cash receipts from forward contracts, futures, options and swap transaction,

except where such contracts are held on the grounds of dealing or trading routine,

or when the previous charges are classified as financing activities.

When a contract is accounted for as a hedge of an identifiable position, the cash flows of the

contract are classified in the same manner as the cash flows of the position being hedged.

Financing activities

The separate disclosure of cash flows arising from financing activities is important because it is

useful in predicting claims on future cash flows by providers of capital to the company.

Examples of cash flows from financing activities are as follows:

(a) Cash receipts from the issuance of shares or other equity instruments;

10

(b) Payments to owners for the purchase or redeem shares of the company;

(c) Cash receipts from the issuing debentures, loans, bonds, mortgage ballots and other funds

borrowed, either long or short term;

(d) Cash reimbursement of the funds borrowed, and

(e) Cash payments by the lessee to reduce outstanding debt from a financial lease.

1.6 Reporting cash flows from operating activities

The company must report cash flows from operating activities using either of the following

methods:

(a) Direct method, whereby major classes of gross cash receipts and gross cash payments are

disclosed, or

(b) Indirect method, whereby profit or loss is adjusted for the effects of transactions of a non-

cash nature, any deferrals or accruals of past or future operating cash receipts or

payments and items of income or expense associated with investing or financing cash

flows

NB: Both methods yield identical results except that only the presentation format differs.

Companies are encouraged to report cash flows from operating activities using the direct method.

This method provides information that may be useful in estimating future cash flows and which

is not available using the indirect method. Under the direct method, information about major

classes of gross cash receipts and gross cash payments may be obtained through one of the

following:

(a) Using the accounting records of the company, or

(b) Adjusting sales, cost of sales (interest and similar income and interest expense and other

charges for financial institutions) and other items in the income statement for:

(i.) Changes during the period in inventories and operating receivables and

payables;

(ii.) Other non-cash items, and11

(iii.) Other items for which the cash effects are investing or financing cash

flows.

In the indirect method, the net cash flow from operating activities is determined by adjusting

profit or loss for the effects of:

(a) Changes during the period in inventories and operating receivables and payables;

(b) Non-cash items such as depreciation, provisions, deferred taxes, unrealized foreign

currency gains and losses, undistributed profits of associates and minority interests, and

(c) All other items for which the cash effects are investing or financing cash flows.

Alternatively, the net cash flow from operating activities may be presented under the indirect

method by showing the items of revenue and expenses disclosed in the income statement and the

changes during the period in inventories and operating receivables and payables.

1.7 Reporting cash flows from investing and financing activities

The company must report separately on the major classes of gross cash receipts and payments

arising from investing and financing activities, except to the extent that cash flows described in

below are reported on a net basis.

1.8 Reporting cash flows on a net basis

Cash flows from the following operating, investing and financing activities may be reported on a

net basis:

(a) Cash receipts and payments on behalf of customers when the cash flows reflect the

activities of the customer rather than those of the company.

(b) Cash receipts and payments for items in which the turnover is quick, the amounts are

large and the maturities are short.

Examples of receipts and payments referred to in (a) above are as follows:

12

(a) The acceptance and repayment of the demand deposits of a bank;

(b) Funds held for customers by an investment company/bank, and

(c) Rents held for customers on behalf of, and paid over to the owners of properties.

Examples of receipts and payments referred to in (b) above include the following:

(a) Principle amounts relating to credit card customers;

(b) The purchase and sale of investments, and

(c) Other short-term borrowings, such as those which have maturity periods of three months or

less.

The following cash flows from the activities of a financial institution may be reported on a net

basis:

(a) Cash receipts and payments for the acceptance and repayment of deposits with a fixed

maturity date;

(b) The placement of deposits with and withdrawal of deposits from other financial

institutions, and

(c) Cash advances and loans made to customers and the repayment of those advances and

loans.

1.9 Foreign currency cash flows

1. Cash flows from transactions in a foreign currency shall be recorded in a company’s

functional currency by applying to the foreign currency amount the exchange rate

between the functional currency and the foreign currency at the date of the cash flow.

2. The cash flows of a foreign subsidiary shall be translated at the exchange rates between

the functional currency and foreign currency at the dates of the cash flows.

3. Cash flows denominated in a foreign currency are reported in accordance with IAS 21,

Effects of Changes in Exchange Rates. This permits the use of an exchange rate that

approximates the actual change. For example, a weighted average exchange rate for a 13

period may be used for recording foreign currency transactions or the translation of the

cash flows of a foreign subsidiary. However, IAS 21 does not permit use of the exchange

rate at the balance sheet date when translating the cash flows of a foreign subsidiary.

4. Unrealized gains and losses arising from changes in foreign currency exchange rates are

not cash flows. However, the effect of the exchange rates in the cash and cash equivalents

held or due in a foreign currency is reported in the statement of cash flows in order to

reconcile cash and cash equivalents at the beginning and end of the period. This amount

is presented separately from cash flows from operating, investing and financing activities

and includes the differences, if any, had those cash flows been reported at the end of

period exchange rates.

1.10 Interest and dividends

1. The cash flows related to interest and dividends received and paid shall each be disclosed

separately. Each shall be classified in a consistent manner from period to period as

operating, investing and financing activities.

2. The total amount of interest paid during a period is disclosed in the cash flow statement,

whether it has been recognized as an expense tin the income statement or capitalized in

accordance with IAS 23, Borrowing Costs.

3. Interest paid and interest and dividends received are classified by the financial institutions

as cash flows from operating activities. However, there is no consensus on the

classification of these cash flows in other companies. Interest paid, as well as interest and

dividends received can be classified as operating cash flows because they enter into the

determination of profit or loss. Alternatively, the interest paid and interest and dividends

received may be classified as financing cash flows and investing cash flows respectively,

because they are costs of obtaining financial resources or returns on investment.

4. Dividends paid may be classified as cash flows from financing activities, because they

represent the cost of obtaining financial resources. Alternatively, they can be classified as

components of the flows from operating activities in order to assist users to determine the

ability of a company to pay dividends out of the cash flows from operating activities.

14

1.11 Income Taxes

1. Cash flows from payments related to income tax must be disclosed separately, and should

be classified as cash flows from operating activities unless they can be specifically

identified with investing or financing activities.

2. Taxes on income arise on transactions that give rise to cash flows that are classified as

operating, investing or financing activities in the statement of cash flows. While tax

expense may be readily identifiable with investing or financing activities, the related tax

cash flows are often impracticable to identify and may arise in a different period from the

cash flows of the underlying transaction. Therefore, the taxes paid are usually classified

as cash flows from operating activities. However, when it is possible to identify the tax

cash flow with an individual transaction that give rise to payments classified as investing

or financing activities, the tax cash flow is classified as investing or financing activity as

appropriate. When the cash flows are allocated over more than one class of activity, the

total amount of taxes paid is disclosed.

1.12 Investments in subsidiaries, associates and joint ventures

1. When accounting for an investment in an associate or a subsidiary accounted for by use

of the equity or cot method, an investing company restricts its reporting in the statement

of cash flow between itself and the investee. This means, for example, to include in the

statement of cash flows and dividend and any other advance payments.

2. A company which reports its interest in a jointly controlled company using proportionate

consolidation (IAS 31 – Interests in joint ventures), includes in its consolidated statement

of cash flows its proportionate share of the jointly controlled company’s cash flows. A

company which reports such an interest using the equity method includes in its statement

of cash flow the cash flows in respect of its investments in the jointly controlled company

and its distributions and other payments or receipts between it and the jointly controlled

company.

15

1.13 Acquisitions and disposals of subsidiaries and other business units

1. The aggregate cash flows arising from acquisitions and disposals of subsidiaries and

other companies must be submitted separately and classified as investing activities.

2. The company must disclose, in aggregate in respect of both acquisitions and disposals of

subsidiaries and other companies during the period of each of the following:

(a.) The total purchase or disposal considerations;

(b.)The portion of the purchase or disposal consideration discharged by means of

cash and cash equivalents;

(c.) The amount of cash and cash equivalents in the subsidiary or business unit

acquired or disposed of, and

(d.)The amount of assets and liabilities other than cash and cash equivalents in the

subsidiary or business unit acquired or disposed of, summarized by each major

category.

3. The separate presentation of the cash flow effects of acquisitions and disposals of

subsidiaries and other business units/companies as single line items, together with the

separate disclosure of the amounts of assets and liabilities acquired or disposed of helps

to distinguish those cash flows from the cash flows arising from the other operating,

investing and financing activities. The cash flow effects of disposals are not deducted

from those of acquisitions.

4. The aggregate amount of the cash paid or received as purchase or sale consideration is

reported in the statement cash flow net of cash and cash equivalents acquired or disposed

of.

1.14 Non-cash transactions

1. Investing or financing transactions that do not require the use of cash or cash equivalents

shall be excluded from the cash flow statement. Such transactions are disclosed

16

elsewhere in the financial statements in a way that provides all the relevant information

about these investing or financing activities.

2. Many investing and financing activities do not have a direct impact on current cash

flows, although they do affect the capital and asset structure of a company. The exclusion

of non-cash transactions from the cash flow statement is consistent with the objective of a

cash flow statement as these items do not involve cash flows in the current period.

Examples of non-cash transactions are:

(a) The acquisition of assets either by assuming directly related liabilities or by

means of a finance lease;

(b) The acquisition of a company by means of an equity issue, and

(c) The conversion of debt to equity.

1.15 Components of cash and cash equivalents

1. The company should disclose the components of cash and cash equivalents, and should

present a reconciliation of the amounts in its statement of cash flow with the equivalent

items reported in the (balance sheet) Statement of Financial Position.

2. In view of the variety of cash management practices and banking arrangements around

the world and in order to comply with IAS 1 – Presentation of Financial Statements, a

company discloses the policy which it adopts in determining the composition of cash and

cash equivalents.

3. The effect of any change in the policy for determining components of cash and cash

equivalents, for example, a change in the classification of financial instruments

previously considered to be part of a company’s investment portfolio, is reported in

accordance with IAS 8 – Accounting Policies, Changes in Accounting Estimates and

Errors.

17

1.16 Other disclosures

1. A company must disclose together with a commentary by management, the amount of

significant cash and cash equivalent balances held by the company that are not available

for use by the group..

2. There are various circumstances in which cash and cash equivalent balances held by the

company are not available for use by the group. Examples include cash and cash

equivalent balances held by a subsidiary that operates in a country where exchange

controls or other legal restrictions apply when the balances are not available for general

use by the parent or the other subsidiaries.

3. Additional information may be relevant to users in understanding the financial position

and liquidity of the company. Disclosure of this information, together with a commentary

by management, is encouraged and may include:

(a) The amount of undrawn borrowing facilities that may be available for

future operating activities and to settle capital commitments, indicating

any restrictions on the use of these facilities;

(b) The aggregate amounts of cash flows from each of operating, investing

and financing activities related to interests in joint ventures reported

using proportionate consolidation;

(c) The aggregate amount of cash flows that represent increases in operating

capacity separately from those of cash flows that are required to

maintain the operating capacity; and

(d) The amount of cash flows arising from operating, investing and

financing activities of each reportable segment (IFRS 8 – Operating

Segments).

4. The separate disclosure of cash flows that represent increases in operating capacity and

cash flows that are required to maintain operating capacity is useful in enabling the user

to determine whether the company is investing adequately in the maintenance of it

operating capacity. A company that does not invest adequately in the maintenance of its

operating capacity may be prejudicing future profitability for the sake of current liquidity

and distributions to owners.

18

5. The disclosure of segmental cash flows enables users to obtain a better understanding of

the relationship between the cash flows of the company as a whole and those of the

component parts and the availability and variability of segmental cash flows.

1.17 Format for Direct Method

19

Sh. Sh. Cash flows from operating activities: Cash receipts from customers XX Cash paid to suppliers and employees (XX ) Cash generated from operations XX Income taxes paid (XX) Net cash from operating activities XX Cash flows from investing activities Dividends received XX Proceeds from sale of marketable securities XX Purchase of marketable securities (XX) Purchase of plant and equipment (XX) Proceeds from sale of equipment XX Net cash from investing activities XX Cash flows from financing activities Proceeds from issue of share capital XX Proc eeds from long term borrowing XX Interest paid (XX) Dividends paid (XX) Net cash from financing activities XX Change in cash and cash equivalents XX Add: Cash and cash equivalents at beginning of period XX Cash and cash equivalents at end of period XX

1.18 Format for Indirect Method

Effective Date

This Standard became operative for financial statements covering periods beginning on or after

1st January 1994.

20

Profit bef ore interest and income taxes

xx,xxx

Add back depreciation

xx,xxx

Add back amortization of goodwill

xx,xxx

Increase in receivables

xx,xxx

Decrease in inventories

xx,xxx

Increase in trade payables

xx,xxx

Interest expense

xx,xxx

Less Interest accrued but not yet paid

xx,xxx

Interest paid

xx,xxx

Income taxes paid

xx,xxx

Net cash from operating activities

xx,xxx

2.0 ANALYSIS IMPLICATION OF CASH FLOWS

2.1 Limitations in Cash Flow Reporting

• Some limitations of the current reporting of cash flow:

– Practice does not require separate disclosure of cash flows pertaining to either

extraordinary items or discontinued operations.

– Interest and dividends received and interest paid are classified as operating cash

flows.

– Income taxes are classified as operating cash flows.

– Removal of pretax (rather than after-tax) gains or losses on sale of plant or

investments from operating activities distorts our analysis of both operating and

investing activities.

21

2.2 Interpreting cash flows and net income

Accounting accrual, estimates, allocations, deferrals and valuations used in determining

revenues and expenses are sometimes subjective. Therefore the cash flows we can relate

the cash flows from operations to net income to assess quality-E.g. the ratio of the

operations cash flow divided by the net income should be greater.

Please note that even though we should not substitute cash flow for income.

Cash flow from operations is a broader view than the net income: Addresses the cash

demands of the revenues and expenses including.

Investing in inventories and receivables.

Financing from creditors.

This is why we analyze the changes in the operating assets and liabilities to adjust the

income statement items.

Our analysis of operations and profitability should not proceed without considering these

elements

22

NOTE:

Cash flows from operations exclude elements of revenue and expense not currently affecting

cash. But remember the analysis of profitability should not proceed without these elements.

However firms are increasingly shifting to Cash flow measures over income measures in:

Credit analysis.

Bankruptcy prediction

Assigning loan term

Earning quality assessment

Solvency forecast

Dividend expansion policies

23

3.0 ANALYSIS OF CASH FLOW

In evaluating sources and uses of cash, the analyst should focus on questions like:

Are asset replacements financed from internal or external funds?

What are the financing sources of expansion and business acquisitions?

Is the company dependent on external financing?

What are the company’s investing demands and opportunities?

What are the requirements and types of financing?

Are managerial policies (such as dividends) highly sensitive to cash flows?

• Inferences from analysis of cash flows include:

Where management committed its resources

Where it reduced investments

Where additional cash was derived from

Where claims against the company were reduced

Disposition of earnings and the investment of discretionary cash flows

The size, composition, pattern, and stability of operating cash flows

Case Analysis of Cash Flows of Campbell Soup

24

3.1 Inferences from analysis of cash flows

Inferences from analysis of cash flows include:

– Where management committed its resources

– Where it reduced investments

– Where additional cash was derived from

– Where claims against the company were reduced

– Disposition of earnings and the investment of discretionary cash flows

– The size, composition, pattern, and stability of operating cash flows

3.2 Alternative cash flow measures

Users sometimes compute net income plus depreciation and amortization as a crude proxy for

operating cash flow. One variant of this measure is the popular EBITDA (earnings before

interest, taxes, depreciation, and amortization). This measure suffers from several problems:

1. The add-back of depreciation is sometimes interpreted to mean that the expense is not

legitimate. That is incorrect. The using up of long-term depreciable assets is a real expense that

must not be ignored.

2. Some interpret the depreciation add-back to indicate that cash has been provided for the

replenishment of the long-term assets. That is also incorrect. The add-back of depreciation

expense does not generate cash. It merely zeros out the noncash expense from net income as

discussed above. Cash is provided by operating and financing activities, not by depreciation.

3. Net income plus depreciation ignores changes in working capital accounts that comprise the

remainder of net cash flows from operating activities. Yet changes in working capital accounts

often comprise a large portion of cash flows from operating activities. Examination of working

capital components provides insight into the persistence of operating cash flows as discussed in

the previous section.

Oversimplification of operating cash flows by the use of net income plus depreciation,

EBITDA, or the like, misinterprets the nature of depreciation expense and ignores valuable

information that is revealed by examination of changes in working capital accounts.

25

3.3 Company and Economic conditions

While both successful and unsuccessful companies can experience problems with cash flows

from operations, the reasons are markedly different.

We must interpret changes in operating working capital items in light of economic

circumstances.

Inflationary conditions add to the financial burdens of companies and challenges for analysis.

3.4 Free cash flow

Another definition that is widely used:

FCF = NOPAT - Change in NOA

(Net operating profits after tax (NOPAT) less the increase in net operating assets (NOA))

Positive free cash flow reflects the amount available for business activities after allowances for

financing and investing requirements to maintain productive capacity at current levels.

Growth and financial flexibility depend on adequate free cash flow. Recognize that the amount

of capital expenditures needed to maintain productive capacity is generally not disclosed,

instead, most use total capital expenditures, which is disclosed, but can include outlays for

expansion of productive capacity.

The SCF is useful in identifying misleading or erroneous operating results or expectations

SCF provides us with important clues on:

Feasibility of financing capital expenditures.

Cash sources in financing expansion.

Dependence on external financing.

Future dividend policies.

Ability in meeting debt service requirements.

Financial flexibility to unanticipated needs/opportunities.

Financial practices of management.

26

Quality of earnings.

4.0 SPECIALIZED CASH FLOW RATIOS

The following two ratios are often useful in analyzing a firm’s flow of funds.

4.1 Cash flow adequacy ratio

27

The cash flow adequacy ratio is a measure of a company’s ability to generate sufficient cash

from operations to cover capital expenditures, investments in inventories, and cash dividends. To

remove cyclical and other random influences, a three-year total is typically used in computing

this ratio. The cash flow adequacy ratio is calculated as:

Three-year sum of cash from operations

Three-year sum of capital expenditures, inventory additions, and cash dividends

Investment in other important working capital items like receivables is omitted because they are

financed primarily by short-term credit (such as growth in accounts payable). Accordingly, only

additions to inventories are included. Note in years where inventories decline, the downward

change is treated as a zero change in computing the ratio.

Proper interpretation of the cash flow adequacy ratio is important. A ratio of 1 indicates the

company exactly covered these cash needs without a need for external financing. A ratio below 1

suggests internal cash sources were insufficient to maintain dividends and current operating

growth levels. For example, a ratio of 0.87 indicates that for the three years a company’s

operating cash flows fell short of covering dividends and operating growth.

The cash flow adequacy ratio also reflects on the inflationary effects for funding requirements of

a company. As with other analyses, inferences drawn from this ratio should be supported with

further analysis and investigation.

4.2 Cash Reinvestment Ratio

The cash reinvestment ratio is a measure of the percentage of investment in assets representing

operating cash retained and reinvested in the company for both replacing assets and growth in

operations. This ratio is computed as:

Operating cash flow _ Dividends

Gross plant _ Investment _ Other assets _ Working capital

28

A reinvestment ratio in the area of 7% to 11% is generally considered satisfactory.

5.0 EQUITY METHOD INVESTMENT

Subramanyam & Wild (2009) describe this accounting method where an investor records as

income its percentage interest in the income of the investee company and records dividends

29

received as a reduction of the investment balance. This can further be understood with reference

to Cap 5 on “Analyzing Investing activities – Inter-corporate Investments”.

The portion of the undistributed earnings is therefore non-cash income and should be eliminated

from the statement of cash flows, leaving only the portion of earnings that has been received as

cash. This will be accomplished as shown below:

An example is explained below:

Suppose Vodafone owns 40% interest of Safaricom Ltd. Safaricom reports net income of KES.

100M and distributes KES. 60M as dividends. Vodafone includes KES. 40M (KES. 100M *

40%) as equity earnings on its investment in its net income and reduces its investment balance by

KES. 24M (dividends received). The KES. 16M of reported investment earnings not received in

cash must be deducted from the net income in computing net cash received from operations.

Source: Subramanyam & Wild (2009)

5.1 Acquisitions of Companies with Stock

When one company buys out another with stock, the consolidated assets and liabilities increase

together with equity accounts. It’s only changes in the balance sheet accounts that result from

cash transactions that are reported in the statement of cash flows. As a result, the balance sheet

adjustments reported to compute operating cash flows are not equal to the changes in balance

sheet accounts in themselves.

Instead, non-cash changes in the balance sheet accounts are reported in the notes to the statement

of cash flows as non-cash investing and financing activities.

6.0 POST RETIREMENT BENEFITS

Employers often provide benefits to their employees after retirement. These post- retirement

benefits come in two forms:

30

Net Income - Percentage Interest in Earnings of Investee Co. Net of dividends received

(1) Pension benefits, where the employer promises monetary benefits to the employee after

retirement, and

(2) Other post- retirement employee benefits (OPEB), where the employer provides other

(usually nonmonetary) benefits after retirement e.g. primarily health care and life insurance.

Both types of benefits pose conceptually similar challenges for accounting and analysis. Current

accounting standards require that the costs of providing postretirement benefits be recognized

when the employee is in active service, rather than when the benefits are actually paid.

The estimated present value of accrued benefits is reported as a liability for the employer.

Because of the uncertainty regarding the timing and magnitude of these benefits, postretirement

costs (and liabilities) need to be estimated based on actuarial assumptions regarding life

expectancy, employee turnover, compensation growth rates, health care costs, expected rates of

return, and interest rates.

Pensions and other postretirement benefits make up a major part of many companies’ liabilities.

We first explain the accounting for pensions and other postretirement benefits separately and

then jointly discuss disclosure requirements and analysis implications.

Pension Process

Employer

31

The employer Contributes to the plan

Pension Fund

The pension fund receives contributions and invests them in an appropriate manner

Employee

Types of Pension Funds

1) Defined benefit-specify the amount of pension benefits that the employer promises to

provide to retirees. Under defined benefit plans, the employer bears the risk of pension

fund performance

2) Defined contribution- Specify the amount of pension contributions that the employer

makes to the pension plan. In this case, the actual amount of pension benefits to retirees

depends on the pension fund performance. Under defined contribution plans, the

employee bears the risk of pension fund performance.

Analysis of defined benefit plans in the financial statements

Let’s assume an employee who is expected to retire in 15 years time and he will be paid KES

20,000.00 for 10 years after retirement assuming the discount interest rate is 8%.

a). How much does the employer need to have on the date of retirement? We also assume the

employer exactly funds the plan

F.V = 20,000.00 PVIFA 8% 10 years

F.V = 20,000.00 * 6.7132

= 134,200

b). What is the employers obligation at the start of the accumulation period that is 15 year?

P.V= F.V/(1+R)^

P.V= 134200/(1+0.08)^15

P.V= 42,305 (PENSION OBLIGATION)

c). A the start of year 2 that is end year 1 calculate employers obligation.

P.V= 134200/(1+0.08)^14

P.V= 45,690

The difference (45,690-42,305) 3,385 is Interest cost

d) Let’s assume that the employer has been making an annual contribution to the fund of KES

4,942. Because these funds are invested in the capital market, we refer to them as Plan Assets.

e). The net employer obligation now is (45,690-4,942) 40,748 which is known as funded status.

Because the obligation is more than the asset value the plan is said to be under funded.

Therefore the funded status of sh. 40,748 should appear as liability in the balance sheet. The

interest cost of KES 3,385 is shown in the income statement as interest cost.

New and Amended Disclosure Requirements for Defined Benefit Pension and

Postretirement Plans requires that employers provide the following disclosures:

A. A reconciliation of beginning and ending balances of the benefit obligation, reporting each of

the following:

• Service cost,

• Interest cost,33

• Contributions by plan participants,

• Actuarial gains and losses,

• Effects of foreign currency exchange rate changes,

• Benefits paid,

• Plan amendments,

• Effects of business combinations and divestitures, and

• Curtailments, settlements, and special termination benefits.

B. A reconciliation of beginning and ending balances of the fair value of plan assets

reporting each of the following:

• Actual return on plan assets,

• Effects of foreign currency exchange rate changes,

• Contributions by employer,

• Contributions by plan participants,

• Benefits paid,

• Effects of business combinations and divestitures, and

Settlements

CASHFLOW OF POST RETIREMENT BENEFITS

Example: General Motors Limited

CASHFLOW PRESENTATION

General Motor Disclosure about Pensions and Other Post Retirement Employee Benefits

PENSION BENEFITS OTHER BENEFITS

34

1995 1996 1995 1996

Changes in projected Benefits Obligation(PBO):

Benefit Obligation at the beginning of the year 59,752.00

70,329.0

0 36,743.00 40,862.00

Service Cost 927.00 1,208.00 617.00 668.00

Interest Cost 4,851.00 4,777.00 3,120.00 2,980.00

Amendments 89.00 3,908.00 47.00 -

Actuarial Loss (Gain) 10,093.00

(2,728.00

) 2,371.00 (1,142.00)

Termination/Settlement benefits - - 26.00 (3.00)

Benefits Paid (5,383.00)

(4,993.00

) (2,062.00) (1,978.00)

Benefit Obligation at the end of the year 70,329.00

72,501.0

0 40,862.00 41,387.00

Change in Plan Asset:

Fair Value of Plan Asset at the beginning of the

year 50,408.00

67,436.0

0 - -

Actual Return on plan Assets 12,047.00 8,035.00 - -

Employer contribution 10,364.00 817.00 - -

Benefits Paid (5,383.00)

(4,993.00

) (2,062.00) (1,978.00)

35

Plan asset at the end of the year 67,436.00

71,295.0

0

Funded Status (Plan Asset-PBO) (2,893.00)

(1,206.00

)

(40,862.00

)

(41,387.00

)

Unamortized Net (Obligation) Asset at Date of

adoption 314.00 229.00 - -

Unrecognized actuarial Loss

(13,005.00

)

(8,127.00

) 61.00 (1,124.00)

Unrecognized prior service cost (6,435.00)

(9,220.00

) (795.00) (679.00)

Adjustment for unfunded pension liabilities 12,717.00

13,157.0

0

Net prepaid Pension Asset (Liability) (9,302.00)

(5,167.00

)

(41,596.00

)

(43,190.00

)

General Motors continues to pay significant other (healthcare) benefits. The reported cost

declined over the 1995 to 1996 period but the obligation continued to grow. GM reported a large

actuarial gain in 1995 and a smaller one in 1996 due to use of a higher discount rate. In 1995,

GM reduced its assumed health care inflation rates, reducing the obligation. These benefits will

remain a drain on future cash flows and earnings.  Also note that GM's liability is highly

sensitive to the assumed health care trend rate.

The above disclosures enable users of financial statements to:

1. Evaluate the current and potential future cash flow consequences of an employer's pension and

other postretirement benefit plans,

2. Forecast benefit costs, facilitating the estimation of future reported net income, and

36

3. Assess the effect of accounting choices on reported benefit costs and earnings quality

7.0 ACCOUNTS RECEIVABLE SECURITIZATION

The securitization of receivables consists in the sale of a pool of receivables to a dedicated

vehicle that finances this purchase by issuing securities on the market. Repayment of principal

37

and payment of interest due under these securities are made with the cash flow generated by the

assigned receivables.

The assets of the dedicated vehicle consist exclusively in the pool of receivables purchased under

the securitization transaction (and the cash flow generated by the assigned receivables) and the

liabilities, in the securities issued on the market. The word "securitization" is used to describe

this transformation of receivables into securities, the securities issued by the dedicated vehicle

representing the assigned receivables.

Securitization of receivables, which involves selling a controlling interest in receivables to a

wholly-owned special purpose entity that subsequently, finances the assets through asset-backed

commercial paper or a bank loan. The structure separates the credit risk associated with the

receivables from the credit risk of the originator of the receivables, which creates an extreme

form of secured financing.

This financing alternative helps firms that have liquidity problems or are seeking additional

financial flexibility, mostly large organizations that can convert their accounts receivable into

cash at once by securitizing the receivables. A securitization can result in an extremely low

interest rate for the issuing entity, since the securities are backed by a liquid form of collateral

(the receivables).

In essence, a receivables securitization is accomplished with these steps:

1. Create a special purpose vehicle/entity (SPV/SPE);

2. Transfer selected accounts receivable into the SPV;

3. Have the SPV sell the receivables to a bank conduit;

38

4. Have the bank conduit pool the company's receivables with those from other companies,

and issue commercial paper backed by the receivables to investors;

5. Pay investors back based on cash receipts from the accounts receivable.

This process steps indicate that the securitization of accounts receivable is complex, and so is

reserved for only larger companies that can attend to the many steps. Also, the receivables

included in a pool should be widely differentiated (so there are many customers), with a low

historical record of customer defaults.

Despite the complexity, securitization is tempting for the following reasons:

Interest cost: The cost to the issuer is low, because the use of the SPV isolates the

receivables from any other risks associated with the company, typically resulting in a

high credit rating for the SPV. This credit rating must be assigned by a rating agency,

which will take into account such factors as the historical performance of the receivables

in the pool, unusually large debtor concentrations in the pool and the conservatism of the

issuing company's credit and collection policies.

Non-recordation: The debt incurred by the company is not recorded on its balance sheet,

since the debt is passing through an SPV.

Share dilution: Since no equity is being issued and the company assuming no additional

debt, the equity holders will have no dilution of their shareholding.

Working capital funding reduced: By raising funds through the sale of an asset that

already exists on the company’s statement of Financial Position and receiving cash for

receivables with a few days of an invoice being issued, a company’s working capital

funding needs are dramatically reduced. These funds can be re-deployed to finance a new

project, rather than using them to finance customer’s purchases.

The low interest cost of a receivables securitization can only be achieved and maintained if there

is considerable separation between the SPV and the company. This is accomplished by

designating the transfer of receivables to the SPV as a nonrecourse sale, where creditors of the

39

company cannot access the transferred receivables. In short, the company cannot be allowed to

regain control over any transferred receivables.

Advantages of Receivables Securitization for firms with liquidity problems or seeking additional

financial flexibility include:

a. Trade receivables vs. secured lending: In trade receivables securitization, raw payment

obligations of your customers are turned into highly liquid commercial paper issued by a

commercial paper conduit.

b. Money to you; little change to your customers: As the originating company, you set up

and sell your receivables to a subsidiary SPV, which in turn receives funding from a

commercial paper conduit. You continue to act as a "servicer" and remain the point of

contact for your customers and maintain your relationship with them.

c. A reliable cash stream:  Most such securitizations are structured as revolving facilities.

When receivables are paid, proceeds are invested in new receivables unless financial or

other triggers are hit, in which case collections pay down outstanding commercial paper. As

with a traditional revolving lending facility, you can usually draw on and repay the facility

as needed.

d. Statement of Financial Position Impact: A trade receivables securitization may be

structured as an "off-balance sheet" transaction, depending on your accounting treatment.

Repaying a secured lending facility with the proceeds from the securitization may

dramatically improve the debt-to-equity ratio on your statement of financial position.  When

a company issues additional equity or acquires additional debt, these have adverse effect on

the company’s statement of financial position as well as undesirable dilutive effects in the

case of equity. Term debts typically carry covenants that restrict the issuer’s financial

flexibility, especially around the timing of repayments. In general, companies using the

proceeds of a Receivable securitization to fund new projects and especially those that can

use a portion to pay off higher-yield debt, can expect to see positive effects n critical

statement of financial position metrics such as return on equity, return on assets and return

on capital.

40

e. Reduced risks in insolvency: Securitization reduces the commercial paper conduit’s risk of

your insolvency by isolating the receivables from your company and its operational and

business risk via a "true sale" to the SPV. Thus, the conduit can look to the creditworthiness

of your customers rather than your company itself in assessing risk.

f. Get your house in order: You will need to have historical performance data, such as

default frequency and recovery percentages and make sure receivables’ reporting is

standardized and current. This may require system changes. You also may need to

standardize and memorialize customer underwriting and collections procedures.

7.1 How Receivable Securitization Works

In general terms, securitization is a process in which an asset is sold to a Special Purpose Vehicle

(SPV), or Trust in return for immediate cash. This may be on a one-time or revolving basis. The

cash flows related to the asset (the collections in respect of the receivable sold) are combined

with credit enhancement and administrative controls within the funding facility to create

investment-grade debt securities that are tradable in the securities markets. The high credit rating

of these securities allows firms that fund through securitization to achieve very low funding

costs.

Figure 1: Overview of Receivable securitization

41

Since the securitization process results in the true sale of assets, there is generally a

corresponding removal of those assets from the Statement of Financial Position. The seller can

then realize meaningfully improved Statement of Financial Position metrics (ratios) and financial

flexibility. In addition, concurrent with the sale of receivable, the seller transfers the majority of

the associated customer credit risk to the buyer of the asset.

Receivable securitization creates a revolving fund that enables companies to:

Raise funds at reduced capital cost with much lower transaction costs

Increase financial flexibility

Increase capital efficiency

Reduce credit exposure

Increase advance rate against receivables

Dramatically accelerate cash flow

Improve financial ratios

7.2 Reasons to Securitize Receivables

Probably the most common reason to securitize receivables is to raise cash efficiently. Enhancing working capital is especially important for companies with long sales cycles and terms of sale. Given that receivables are typically the largest single asset category on the Statement of Financial Position, they are a natural choice for monetization. The securitization process generally provides small and medium-sized companies broader access to capital at a lower all-in-cost of funds. This is especially true for companies that have weaker creditworthiness than their customers do and/or companies with very well diversified customer bases. In such instances there is opportunity for credit arbitrage. A well-structured securitization can achieve an investment-grade rating even for a selling company that is not investment grade rated.

Achieving Statement of Financial Statement management objectives can be an additional reason for a company to securitize its receivables. Pursuant to certain financial engineering, sale treatment / deconsolidation can be achieved with the resulting opportunity to de-leverage through the use of proceeds to redeem outstanding debt.

42

Sellers can choose to remain anonymous or they can raise their profile in the capital markets by participating in an investment-grade issuance.

43