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Author:Collins QianContributor:Chris Nelson bcCash FlowMarch 1998Copyright 1998 Bain&Company,Inc.1bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowAgenda The importance of cash flowTypes of cash flowApplicationsCash flow stepsExerciseKey takeaways2bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowAgenda The importance of cash flowTypes of cash flowApplicationsCash flow stepsExerciseKey takeaways3bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowWhat is Cash Flow?Cash flow describes the movement of cash into(sources)and out of(uses)a company.Sources of cashCompanyUses of cash$4bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowWhy Do We Care About Cash?The market value of a company is equal to the present value of its expected future cash flowsVarious stakeholders demand cashinvestors demand CASH returnssuppliers and employees require CASH compensationdebtholders demand CASH paymentsAccounting methods can be used to“manage”earnings;CASH is harder to manipulateCash is King!Cash flow is the measure of a companys strategic value.5bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowEarnings vs.Cash Flow*Some accounting decisions impact earnings,but not cashIn 1988,General Motors made at least four decisions that impacted earnings but not cashEarnings do not equal cash flow.*Earnings are also called after tax profits or net incomeSuccessful high growth companies tend to have high earnings,but low cash flow;successful low growth companies tend to have low earnings,but high cash flowAccounting DecisionExtended useful plant life from 35 to 45 year scheduleChanged the way it accounted for its pension planAdjusted its inventory valuation policyChanged the residual value assumption for cars it leasedEarnings Impact$790MM$480MM$217MM$270MMCash ImpactNoneNoneNoneNoneTotal:$1,757MMNone6bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowAgenda The importance of cash flowTypes of cash flowApplicationsCash flow stepsExerciseKey takeaways7bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowTypes of Cash Flow Net cash flow is equal to the sum of the cash flows from operating,investing,and financing activities.Operating cash flowInvesting cash flowFinancing cash flowAbility of a companys recurring operations to generate cashAbility of a companys investment decisions to generate cashHow a company funds its operationsOperating profitsDecrease in working capitalSale of fixed assetsLong-term issuance of shares Examples of sources:Operating losses Increase in working capitalPurchase of fixed assetsRepayment of loans Payment of dividends Examples of uses:8bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowOperating Cash Flow*Investing activities not related to ongoing operations(such as the purchase or sale of divisions or companies,or investments in unrelated businesses)are not included in investing cash flow.They are included in financing cash flow.Operating cash flow excludes all cash flows related to a firms capital structurecash generation ability is independent of how a firm is financedIt excludes one-time eventsthese are not related to a firms recurring operationsOperating cash flow is used to measure the strategic value of a businessfor company valuations,operating and investing cash flows are used,not financing cash flowBain is usually more interested in operating and investing*cash flow than in financing cash flowOperating cash flow measures the ability of a businesss recurring operations to generate cash.9bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowInvesting Cash FlowInvestments in ongoing operations -property,plant and equipment-are included in investing cash flowcash is used to replace assets as they wear outif a business is to grow,additional assets must be acquiredin some cases,the cash used to acquire these assets is generated from the sale of existing noncurrent assetssuch cash inflows,however,seldom cover the entire cost of asset acquisitions.Often times cash flow from operations is used to finance acquisitions,or,failing a positive operating cash flow,external financing is usedPure financing activities are not included in investing cash flow.They are included in financing cash flowpurchase or sale of divisions or companiesinvestments in unrelated businessesInvesting cash flows relating to ongoing operations are used as a measure of the strategic value of a business.Those that are purely financing/investment mechanisms are used to evaluate the financial strategy of the businessInvesting cash flow measures the use of a businesss cash for the acquisition of non-current assets.10bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowFinancing Cash FlowMajor types of financing cash flow include:debt-related transactions8changes in long-term debt8interest income and expenseequity-related transactions8changes in common and preferred stock8dividends8short-term investmentslong-term asset and liability transactions8purchase or sale of a division or company8changes in long-term liabilitiesFinancing cash flow captures all the non-operating cash changes experienced during the year,and it provides information on how a company is funding its operations.11bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStatement of Cash FlowsThe SCF is divided into three sections:operating,investing,and financingEach section shows sources and uses of funds for the accounting periodThe SCF shows the amounts fordepreciation and amortizationcapital expenditurestaxes paiddividends paidIt does not show sources and uses by business unitIt does not provide much detail for example,it does not show capital expenditures by project,nor individual equipment purchasesThe SCF is not a substitute for cash flow analysisThe statement of cash flows(SCF)found in annual reports is a good source of data for constructing cash flows,but sometimes it does not have the detail required for the analysis being done.12bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowAgenda The importance of cash flowTypes of cash flowApplicationsCash flow stepsExerciseKey takeaways13bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowApplications Bain case teams use cash flow(CF)analysis to value investments/acquisitions,to improve the health of business units,and to help companies manage their portfolios.Valuation(mergers,acquisitions)Business unit analysisPortfolio managementWhat is the cash generation potential of an investment/acquisition?What are we willing to pay(in cash)for that investment/acquisition?How healthy is a business unit?What factors have effected the business units ability to generate cash/value over time?How can the business units cash management be improved?What is the overall balance of cash users/cash generators in a clients portfolio of businesses?How does this effect the clients overall cash position/outlook?What restructuring can be done to improve this profile?CF=common denominatorCF=measuring stickCF=portfolio tool14bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowAgenda The importance of cash flowTypes of cash flowApplicationsCash flow stepsExerciseKey takeaways15bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowCash Flow Cookbook*Cash is defined as cash plus marketable securities minus short-term notes*I/S=income statement,SCF=statement of cash flows,B/S=balance sheet+/-+/-+/-=1.Profit before interest and tax(PBIT)2.Depreciation3.Other non-cash expenses/income4.Decrease/increase in working capital(excluding cash)5.Taxes paid6.Tax impact of interest income/expenseOperating cash flowBain case teams use the following cash flow cookbook:-=7.Capital expendituresInvesting cash flow+/-+/-+/-+/-+/-=8.Interest income/expense9.Tax impact of interest expense/income10.Increase/decrease in long-term debt11.Increase in outstanding stocks/shares12.Dividends13.Changes in other accountsFinancing cash flow14.Reconcile with change in cash*from Balance SheetNet cash flowSource*I/SSCF,B/S and NotesNotesB/SI/S,B/SI/SSCF,B/S and NotesI/SI/SB/SB/SSCF,B/S,and NotesB/S,I/SB/S16bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowAgenda The importance of cash flowTypes of cash flowApplicationsCash flow stepsExerciseKey takeaways17bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowExercise-Background(p.1)*This exercise is based on The Gillette Companys financial statements in 1996.Since several modifications have been made to the financial statements,the information provided hereafter should not be used to analyze Gillettes financial performance.Net SalesCost of SalesGross ProfitSG&AProfit from OperationsInterest ExpenseIncome before taxesIncome TaxesNet Income1996$9,697.7MM($3,681.7MM)$6,016.0MM($4,379.7MM)$1,636.3MM($111.3MM)$1,525.0MM($576.3MM)$948.7MMIncome Statement:The New England Razor Company*Use the following data to calculate the cash flow for The New England Razor Company:18bcBOS Copyright 1998 Bain&Company,Inc.Cash Flow*Deferred taxes can be a liability account,an asset account,or both(as is the case here).AssetsCurrent AssetsCashMarketable securitiesReceivablesInventoriesDeferred income taxes*Prepaid expensesTotal Current AssetsProperty,Plant&EquipmentLiabilities and Stockholders EquityCurrent LiabilitiesLoans payableCurrent portion of Long-Term debtAccounts payable and accrued expensesIncome taxes payableTotal Current LiabilitiesLong-Term DebtDeferred Income Taxes*Other Long-Term LiabilitiesDividends PayableStockholders EquityCommon stockAdditional Paid-in CapitalRetained EarningsTreasury stockTotal Stockholders Equity$76.9$7.0$2,724.6$1,358.2$359.3$227.2$4,753.2$5,192.0$9,945.2$656.7$14.5$1,964.9$298.6$2,934.7$1,490.4$298.9$630.2$100.1$671.4$707.0$4,168.7($1,056.2)$4,490.91995$81.6$1.6$2,290.8$1,267.6$246.8$199.3$4,087.7$4,456.6$8,544.3$634.7$26.5$1,609.8$319.4$2,590.4$1,048.4$303.4$635.1$66.7$667.1$574.8$3,704.2($1,045.8)$3,900.3$9,945.2$8,544.3Balance SheetDecember 31,1996 and 1995(in$MM)1996Exercise-Background(p.2)19bcBOS Copyright 1998 Bain&Company,Inc.Cash Flow Property,Plant and EquipmentLess accumulated depreciationNet Property,Plant,and Equipment1996(in$MM)$7,820.4$2,628.4$5,192.01995(in$MM)$6,885.0$2,428.4$4,456.6Note 1:Property,Plant and EquipmentNote 2:DividendsThe company declared dividends of$484.2MM in 1996Note 3:Sale of assetsA loss of$22MM was incurred on equipment sold during the yearThe equipment had an original cost of$244.0MM and was sold for$40.9MMExercise-Background(p.3)Notes to the financial statements are a critical source of information.20bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowOperating Cash Flow*Cash is defined as cash plus marketable securities minus short-term notes*I/S=income statement,SCF=statement of cash flows,B/S=balance sheet+/-+/-+/-=1.Profit before interest and tax(PBIT)2.Depreciation3.Other non-cash expenses/income4.Decrease/increase in working capital(excluding cash)5.Taxes paid6.Tax impact of interest income/expenseOperating cash flow-=7.Capital expendituresInvesting cash flow+/-+/-+/-+/-+/-=8.Interest income/expense9.Tax impact of interest expense/income10.Increase/decrease in long-term debt11.Increase in outstanding stocks/shares12.Dividends13.Changes in other accountsFinancing cash flow14.Reconcile with change in cash*from Balance SheetNet cash flowSource*I/SSCF,B/S and NotesNotesB/SI/S,B/SI/SI/SI/SB/SB/SB/S,I/SB/SSCF,B/S and NotesSCF,B/S and Notes21bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 1-Profit Before Interest and TaxWhere to find:Process:Comments:Income statementIt can be labeled in many different ways,including profit before interest and tax,profit from operations,operating profit,and earnings before interest and taxIf income statement is provided,pick number from income statementIf income statement is not provided,calculate profit before interest and tax:Profit before taxes-Interest income and other income(earned)+Interest expense and other expenses(incurred)-Any one-time gains included in profit before taxes+Any one-time losses included in profit before taxes=Profit before interest and tax(PBIT)The goal is to get profit before interest payments,tax payments,and extraordinary items22bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 1-Profit Before Interest and Tax-AnswerProfit before interest and tax*:$1,636.3MM1996Operating cash flow begins with profit before interest and tax.*Shown as profit from operations on The New England Razor Companys income statement23bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowSteps 2 and 3-Depreciation and Other Non-Cash Income/ExpensesWhere to find:Process:Depreciation-statement of cash flows,or calculate from Balance Sheet and NotesOther Non-Cash Income/Expenses-NotesReview assets and liabilities that are not taken into account in working capital(elements of working capital include current assets and liabilities with the exception of cash,tax items,and financing assets and liabilities(e.g.,interest and dividends payable)Ask two questions:was the item non-cash?was the item included in profit before interest and tax?If the answer to both is yes,adjust profit before interest and taxe.g.,depreciation -add back to profit before interest and taxe.g.,loss on sale of asset -add back to profit before interest and taxIf answer to either question is no,make no adjustments 24bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 2-DepreciationWhere to find:Process:Statement of cash flows,or calculate from Balance Sheet and NotesIf depreciation is provided in the statement of cash flows,pick number from thereIf not,calculate depreciation:Accumulated depreciation at year end-Accumulated depreciation at year beginning+Depreciation from sale of asset=Depreciation expense for the yearDepreciation from sale of asset:Original cost of asset-Proceeds from sale of asset-Losses incurred=Depreciation from sale of asset25bcBOS Copyright 1998 Bain&Company,Inc.Step 2-Depreciation-Answer(p.1)Depreciation from sale of asset=The original cost of asset -proceeds from sale of asset -losses incurred=$244.0MM-$40.9MM-$22.0MM=$181.1MMDepreciation expense for 1996 =Accumulated depreciation at year end-accumulated depreciation at year beginning+depreciation from sale of asset=$2,628.4MM-$2,428.4MM+$181.1MM=$381.1MMCash FlowDepreciation is a non-cash expense.Therefore,it is added to profit before interest and tax in the operating cash flow.26bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 2-Depreciation-Answer(p.2)Accumulateddepreciation(year end)Accumulateddepreciation(year beginning)Depreciation fromsale of assetsDepreciation expense$2,628.4MM($2,428.4MM)$181.1MM$381.1MM$0$500$1,000$1,500$2,000$2,500$3,000 Millions of DollarsThe depreciation expense for the year can be calculated from the balance sheet and notes.-+=27bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 3-Other Non-Cash Expenses-AnswerLoss on equipment sold during the year:$22.0MM (from Note 3)1996Other non-cash expenses are added to profit before interest and tax in the operating cash flow.28bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 4-Change in Working Capital(Excluding Cash)Where to find:Process:Balance sheetWorking capital=current assets-current liabilitiesReview each current asset and current liabilityInclude:Exclude:Cash and cash equivalentsTax itemsinclude in taxes paid calculation(Step 5)Financing assets and liabilities,such as:interest payabledividends payablecurrent portion of long-term debtOperating assets and liabilities29bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowWorking Capital Current Assets and LiabilitiesIncluded in Change in Working Capital CalculationCurrent assetscashmarketable securitiesinventoryaccounts receivablepre-paid expensesdeferred income taxes Current liabilitiesaccounts payableaccrued expensesloans payableincome taxes payablecurrent portion of long-term debtinterest payabledividends payableIncluded in cash,not working capitalIncluded in cash,not working capitalIncluded in operating cash flow,but not in working capitalIncluded in financing cash flowNot all current assets and liabilities are included in working capital.Included in operating cash flow,but not in working capitalIncluded in financing cash flowIncluded in financing cash flow30bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowCurrent Assets Changes in working capital asset items have cash flow impacts.means cash is being used to fund the businessmeans cash is being generated by the businessIncrease in non-cash working capitalDecrease in non-cash working capitalDecreases in current assets.Increases in current assets.Increase in inventoriescash spent to buy inventoriesIncrease in pre-paid expenses cash used to pre-pay billsReduction in inventoriescash generated by selling inventoriesReduction in accounts receivablecash received from customers31bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowCurrent LiabilitiesChanges in working capital liability items have cash flow impacts.means cash is being retained by the businessmeans cash is being used to fund the businessDecrease in non-cash working capitalIncrease in non-cash working capitalDecrease in current liabilities.Increases in current liabilities.Increase in accounts payablecash saved by delaying payment to suppliersIncrease in deferred tax liabilitycash saved by delaying payment of taxesDecrease in accounts payablecash paid to suppliersDecrease in accrued expensescash used to reduce accrued expenses32bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 4-Change in Working Capital-AnswerLoans payable:Receivables:Inventories:Prepaid expenses:1995($MM)$2,290.8$1,267.6$199.3$1,609.8$634.71996($MM)$2,724.6$1,358.2$227.2$1,964.9$656.7Asset or LiabilityAssetAssetAssetLiabilityLiabilityChangeIncreaseIncreaseIncreaseIncreaseIncreaseImpact on Working CapitalIncreaseIncreaseIncreaseDecreaseDecreaseImpact on Working Capital($MM)$433.8$90.6$27.9($22.0)Change in Working Capital$175.2MM$175.2MMIncreaseAccounts payable&accrued expenses:($355.1)An increase in working capital has a negative impact on operating cash flow.Increase33bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 5-Taxes PaidWhere to find:Process:Deferred taxes:Provision for income taxes-Income StatementChange in deferred income taxes-Balance SheetCurrent tax expense-Notes or calculate from Income Statement and Balance SheetIncome taxes payable-Balance Sheet+Income taxes payable(beginning of period)-Income taxes payable(end of period)Deferred taxes arise when pre-tax income reported on the income statement differs from that shown on the tax returnDeferred taxes are sometimes shown on the balance sheet as an asset and sometimes as a liability=Taxes paid Provision for income taxes+Increase in deferred income taxes asset account+Decrease in deferred income taxes liability account=Current tax expense Current tax expense34bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 5-Taxes Paid-Deferred TaxesDeferred taxes can be shown either as an asset or as a liability,or even as both(as in this exercise)When deferred taxes are shown as an asset,an increase increases taxes paid and is therefore a use of cash(negative impact on cash flow).When deferred taxes are shown as a liability,an increase decreases taxes paid and is therefore a source of cash(positive impact on cash flow)Deferred taxes are a complication to look out for in the cash flow analysis.Deferred income taxes(asset):Deferred income taxes(liability):1995($MM)1996($MM)Asset or LiabilityChangeCash Flow ImpactResult($MM)$246.8$303.4$359.3$298.9AssetLiabilityIncreaseDecreaseDecreaseDecrease($112.5)($4.5)Net result($117.0)MM35bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 5-Taxes Paid-Answer(p.1)Taxes paid is a use of cash,therefore it should be deducted from operating cash flow.Provision for income tax+Increase in deferred income taxes asset account=Current tax expense Current tax expense+Income taxes payable(beginning of year)-Income taxes payable(end of year)=$576.3MM$112.5MM$693.3MM$693.3MM$319.4MM($298.6)MM$714.1MMTaxes paid+Decrease in deferred income taxes liability account$4.5MM36bcBOS Copyright 1998 Bain&Company,Inc.Cash FlowStep 5-Taxes Paid-Answer(p.2)Provision forincome taxesChange indeferredincome taxesCurrenttax expenseIncome taxespayable(beginn
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