LIQUIDITY, THE CASH CYCLE AND CASH FLOW - Weebly

Cash Flow 1981 – 2010 copyright protected. Barry M Frohlinger, Inc. Page 1

LIQUIDITY, THE CASH CYCLE AND

CASH FLOW Assignment:

a. Read the articles about the operating cycle and its connection to cash flow and liquidity [pages 1 – 40].


CONCEPT OF THE OPERATING CYCLE

The operations of a business can be illustrated in terms of the following four interrelated and

sequential activities: 1. Procuring inputs

� which includes raw materials, labor, and equipment 2. Using the resources

� to produce the final output 3. Selling the final output 4. Collecting payment from customers

These activities can be said to constitute the operating cycle [or asset conversion cycle1]. The length of the operating cycle is usually measured in terms of time; i.e., the time period between the point of time when inputs are obtained and the time when the final output is sold to the customers and final collection of cash.

In the course of the first three steps of the operating cycle, there is no inflow of cash and there is, in fact, a regular outflow as the inputs and services needed for the manufacturing and selling activities are obtained. It is only when cash has been collected that the cycle is complete because the next step means further acquisition of raw materials, services, etc. to start another cycle of operations. To summarize,

the operating cycle consists of a set of interrelated but distinct activities which a business performs. These activities can be used to provide a basis for estimating the financing requirements for the day-to-day workings of the enterprise because the financing requirements are determined by the physical needs of the firm's operations.

1 The accounts which are part of the asset conversion cycle [accounts receivable, inventory, and prepaids] are generally referred to as trading assets or working assets.


CONCEPT OF CASH CYCLE

Based on the concept of the operating cycle, the concept of the cash cycle has been formulated to provide a tool for analyzing and estimating the financing needs of a firm to operate the daily business.

The cash cycle is essentially the time lag between the use and the generation of the cash for the ongoing operations of the enterprise. It represents the time period that the firm is "out of cash" or "needs financing" for day to day operations. The cash cycle is the operating cycle with the inclusion of the payment period.

The payment period is the time period during which costs are not yet paid. These costs include: • the acquisition of raw materials from suppliers • services from workers • a variety of operating expenses incurred to acquire services.

This period of time provides financing for the firm because of the delay in cash outflow. In short, the cash cycle represents the total time elapsed between payment for the goods and services (i.e. utilization of cash) and the realization of the sales value of the final output (i.e. generation of cash).

The usefulness of the cash cycle as an analytical tool stems from the fact that we need to estimate the working capital requirements for the cash cycle period and the timings of such requirements for the enterprise. Normally for most companies, the "relative1" working capital requirement stays the same. Once a working capital requirement exists, it repeats in each subsequent cycle.

1 Measured by the cash cycle in days or Operating Working Capital/Sales ratio. Operating Working is often called Adjusted Working Capital or Working Investment or Non Cash Working Capital or just Working Capital.


DETERMINATION OF CASH CYCLE

The cash cycle for any enterprise depends on the length of the constituent periods; i.e., the manufacturing and inventory period, the payment period and the collection period.

Hence, any change in the cash cycle would be the consequence of any changes in one or more of these periods. Of course, at times there are compensating changes which leave the total cycle unaffected. For example, the collection period may be extended to promote sales and so in view of the larger

volume of sales to dealers and retailers, the company may reduce the inventory period. Hence, the net impact on the length of the cycle will be nil if the reduction in inventory is of the same magnitude as the increase in the days sales outstanding. The cash cycle of a business remains fairly stable even though some temporary changes may be brought about due to transitory changes in market condition.

Permanent changes in the cash cycle occur if technology changes substantially or the distribution system is revamped or trade credit practices are revised drastically. It is this stability of the cash cycle which enhances the usefulness of the concept as an analytical tool.

We know that a business needs to finance current assets like inventories (raw material, finished goods and supplies) and receivables. Is this financing need long term or short term? Some argue that the financing for "working capital" is of a short-term nature.

The first consideration must be to determine whether the investment is permanent or seasonal. Only then can the analyst determine that for most firms [except those that are seasonal, the requirement for financing of inventory and receivables is as much a long-term requirement as are fixed assets.

Since the rationale underlying an enterprise is that of a going concern; a firm must continuously acquire raw material, process them and sell them to customers. Therefore, it has to finance such activities on a continuous, ongoing and permanent basis.


CASH CYCLE MANAGEMENT

The management of the cash cycle [one element in balance sheet management] is a critical ingredient for understanding cash flow and valuation.

Read the attached, “Raiding A Company’s Hidden Cash” . As you read the following two articles please answer the following discussion questions:

Thought Questions1

1. What is a corporation’s motivation for decreasing working capital requirements?

2. Why are some key benefits to a firm for improving receivable management?

1 There are no solution notes for these thought questions. Bring your answers [they do not have to be in writing] to class.


Raiding a Company’s Hidden Cash

It's the latest in doing more with less: How many corporations can operate without operating working capital?

A fast growing number of companies are setting that audacious goal because pursuing it--even if they never attain it--unleashes efficiencies and savings that can dramatically improve corporate performance. In an era when global competition makes raising prices difficult and when companies need hefty cash flow to expand, invest in new technologies, and pay down debt, this discipline represents a managerial tool whose time has come.

Zero operating working capital isn't a fantasy. American Standard boast negative operating working capital in some of its businesses. At General Electric, CEO Jack Welch made operating working-capital reduction a corporate crusade. Whirlpool, Quaker Oats, and Campbell Soup have driven in the same direction.

Says GE's chief financial officer: "The concept not only generates cash, it also speeds up production, which helps you run your business far better." Reducing operating working capital needs yields two powerful benefits. First, every dollar freed from inventories or receivables rings up a one-time $1 contribution to cash flow. Second, the quest for zero operating working capital permanently raises earnings. Like all capital, operating working capital

costs money, so reducing it yields savings. In addition, cutting operating working capital forces companies to produce and deliver faster than the competition, enabling them to win new business and charge premium prices for filling rush orders. As inventories evaporate, warehouses disappear. Companies no longer need forklift drivers to shuttle

supplies around the factory or schedulers to plan production months in advance. During the mid 1990's Campbell Soup pared operating working capital by $80 million. It used the cash to develop new products and buy companies in Britain, Australia, and other countries. But Campbell also made an extra $50 million in profits over the next few years by lowering overtime, storage costs,

and other expenses--savings that should persist year after year. The most important discipline that zero operating working capital necessitates is speed. Many companies produce elaborate long-term forecasts of orders. They then manufacture their product weeks or months in advance, creating big inventories; eventually they fill orders from bulging stocks. Minimizing operating working capital forces organizations to demolish that system. Scrapping

forecasts, companies manufacture goods as they are ordered. The best companies start producing an auto braking system or cereal flavor after receiving an order and yet still manage to deliver just when the customer needs it. The system, known as demand flow or demand-based management, builds on the familiar idea of just-in-time inventories but is far broader. Most companies achieve just-in-time in one or two areas.

They demand daily shipments from suppliers, for example, or dispatch finished products the hour the customer wants them. But just-in-time deliveries don't guarantee efficiency. To meet the rapid schedule, many companies simply ship from huge inventories. They still manufacture weeks or months in advance.


Achieving zero operating working capital requires that every order and part move at maximum pace, never stopping. Orders streak from the processing department to the plant.

Flexible factories manufacture each product every day. Finished goods flow from the assembly line onto waiting trucks. Manufacturers press suppliers to cut inventories as well, since minimal stocks translate into lower raw materials prices to the manufacturer. Instead of cluttering plants or warehouses, parts and products hurtle through the pipeline. As velocity rises, inventory--operating working capital--dwindles. That's why operating working capital levels are

such a useful yardstick for efficiency and why, manufacturers with the least operating working in capital per dollar of sales reign as the world's best-run companies. A champ at squeezing operating working capital is American Standard, a producer of Trane air conditioners, American Standard plumbing supplies, and Wabco brakes. Not long ago it was at the brink of failure. CEO Emmanuel Kampouris salvaged the New Jersey

company by reducing operating working capital. The company had taken on $3.1 billion of expensive debt in a 1988 leveraged buy out to escape a hostile takeover by Black & Decker. Interest and principal payments of $325 million a year swallowed almost all of the company's cash flow, leaving little for capital investment. Then, in the 1990s, all three of its markets went sour. To save the company, Kampouris raided a hoard of idle cash, operating working capital.

In 1988, American Standard wallowed in over $725 million of it, 25 cents per dollar of sales. Kampouris wanted all of it. He set a goal of zero by 1996, which they achieved. He used the millions of dollars liberated to pay down debt and make capital investments. Lowered costs have raised annual operating earnings by $100 million, or 33%, since 1990. To orchestrate the comeback, Kampouris mobilized 90 factories around the globe. Plants from Britain

to Brazil wrested extraordinary reductions in inventory. In the U.S., a paragon is the Trane plant in Lexington, Kentucky. It sells over $100 million a year in large air-handling units for office buildings, restaurants, and hospitals. The units--priced at up to $50,000 are all made to order. Customizing the units is essential to winning customers, but in the past Trane never made an order

continuously from start to finish. Instead it spewed out a plethora of parts in long production runs meant to keep machines turning at full capacity. These parts spent only a few hours--or minutes on the machines but sat in mountainous inventories for weeks; certain specialized parts remained for months or years. Wheels, filters, fans, and other components littered ten acres of blacktop indoors and outdoors. Warehouses covered enough floor

space for three football fields. When an order came in, Trane needed an average of 15 days to find the components and assemble the final unit. Incredibly, despite vast inventories, Trane often didn't have or couldn't find the parts it needed. Those pulled from stocks often turned out to be damaged. Many items rusted on the blacktop or took a bang from a forklift. Paper moved as slowly as metal. Orders meandered through six departments,

including design, materials purchasing, and production planning. After each step, stacks of orders piled up in an out-box, then lumbered to the next station. Getting an order from intake to the plant took as long as ten days.


Trane has since learned to gallop. The campaign--called Project Steeplechase-snarled with order processing.

Today, representatives from order entry, design, planning, and the other functions sit side by side. Orders pass quickly from desk to desk and reach the factory floor in one to three days. Following the same principle, the plant has clustered machines needed to product modules that it combines to make final products. It can complete these units so quickly--in an average of 20 hours--that it starts producing most parts only after receiving an order.

Inventories are dwindling. Lexington kept $8 million in stocks in 1988. Today inventories are down to $5 million, despite a 30% rise in revenues. What's left is work-in-process, along with small supplies of raw materials. Instead of building a new plant, Lexington has refitted newly empty warehouse space for manufacturing. It isn't sparing the whip. Other American Standard operations do even better. A success is the once- ravaged automotive

subsidiary in Britain, Wabco UK. The main plant sits in Leeds. Its staple used to be brakes for trucks. But when the British truck market nearly vaporized in the late 1980s and early 1990s, the company responded immediately, retooling to produce new products: brakes for jeeps and vacuum pumps that route fuel in diesel cars.

Wabco UK financed its rebirth by recycling operating working capital into product development and new equipment. The gambit not only saved the company, it created a money machine. Despite Europe's weak car market in the mid 1990's, Wabco UK's sales grew. As revenues rose, operating working capital dipped below zero. Five years ago the operation used, on average, $13 million in operating working capital at any given time. Now, the figure stood at a negative $1 million. That's possible because inventories were just $2 million, and payables exceeded inventory. The pied piper of

this effort is the flamboyant managing director, Eric Nuttier. By preaching demand flow, Nuttier has achieved astonishing reductions in cycle times. In 1989 the Leeds plant took as much as three weeks to manufacture a vacuum pump. Since order processing took another week, customers had to place orders a month in advance. Today Leeds, like Lexington,

has switched to manufacturing cells that do everything from lathing to assembly in quick sequence. The result is a breakthrough in speed. Manufacturing a pump now takes just six minutes. Leeds makes all six varieties--in small quantities--every day. That means the plant can deliver quickly, which is a key to shrinking receivables.

"We deliver when our customers want the stuff, so they don't have to hold inventories," says Nuttier. "That's worth money to them." In exchange for faster service, Nuttier has persuaded customers to speed up payments. Wabco UK now collects its bills in 42 days, vs. 54 days in the late 1980s, even though sales were surging.

Nuttier lectured Jack Welch in the late 1990's on the Welch's favorite subject. Welch met with Nuttier to learn more about demand flow. Of Welch, Nuttier says, "He's an incredible character, an Oscar- winning performer. Jack asked for my working capital figures. He never heard such figures."


Nuttier exhorted Welch to reach for the stars: "I told Jack, `The only limit is your imagination.' " A fan of Kampouris, Welch dispatched GE executives to study American Standard's plants. GE didn't discover inventory reduction afresh. Since 1989 GE cut stocks from $9 to $6 billion. But Welch raised the hurdle.

He spotlighted inventory turnover as a key meter for performance. He stressed that for GE, one additional turn generated an extra $1 billion in cash, plus big savings in storage and labor. GE's chief financial officer says the company would need inventory turn of 20 [currently 10] --to achieve zero operating working capital. Can GE reach the pinnacle? A trailblazer is GE's appliance business in Louisville. Until 1990, the $6 billion-a-year division leaned on

long-term forecasts. Each month planners ran reams of data through a mainframe computer to predict appliance demand for the next 12 months. Compiling a production schedule took six weeks. Factories spent another six weeks producing models in long runs of 50,000 or more. Deliveries added two weeks. Result: Products planned in January arrived at the customer's door in May. Frequently the big roll out didn't match what customers wanted. Total demand for ranges or

dishwashers is fairly predictable, but tastes in colors and features change. By 1990 GE was saddled with $160 million of obsolete inventory. Rows of big, bulky refrigerators, then out of vogue, stood in limbo. Today GE is racing to tie production to orders. It has scrapped elaborate long-term forecasting. Four of its eight plants now make every model, every day, often in lots as small as 50. GE now plans, produces, and delivers a truckload of dishwashers in three weeks, vs. 18 weeks in

1990. Inventories have fallen from $800 million to $400 million. But the appliance group is still chasing the prize: making products to order. The rub is that many customers want deliveries in anywhere from 48 hours to a week or two, which is faster than GE can manufacture and ship. So it still has to produce goods before it receives orders, then store the ranges or dishwashers and fill orders from inventory.

Because it can manufacture more quickly than before, the operation uses shorter-term and thus more accurate forecasts. But by producing to order, it could drastically lower stocks. Its target: Make and deliver in ten days--and run a huge and growing business on trim inventories of $200 million.

GE and American Standard are far from the only hawks on operating working capital. Varity Corp. produces brake systems and components. As car makers switched to anti lock brakes, Varity's sales exploded from $600 million in 1990 to $1.2 billion in 1996. Yet operating working capital evaporated. Varity manufactured and delivered antilock systems in seven days, down from a month in 1990, matching the pace of customers' orders. The Ford plant in Lorain, Ohio, sends in new orders on Tuesday, for example, Varity then buys the parts, makes the products, and ships them to the Ford

assembly line the following Tuesday. Operating working capital in the anti lock brake operation shrunk from $70 million in 1990 to negative $18 million. [Varity is now part of TRW Automotive, which itself boasts negative operating working capital].


For Whirlpool, running lean is the ticket to growth in a competitive, low-margin industry. Whirlpool borrowed heavily in 1991 to purchase Philips's appliance business in Europe. Raising prices was impossible, so Whirlpool turned to working capital management as a source of cash to pay down

debt, build plants in Latin America, and develop now products. From 1990 to 1994 it lowered operating working capital from $1.1 billion to $900 million. In that period, fresh investments have helped buoy sales from $6 billion to $7 billion. Says chief financial officer Michael Callahan: "As sales keep growing, we'll continue cutting operating working capital. That will substantially increase cash flow." In food processing, titans are transforming their sales

strategies to conserve working capital. While such companies need less working capital than heavy manufacturers, savings can still be huge. The leaders include Campbell Soup and Quaker Oats, which are shelving the practice of "trade loading" (also called dealer dumping or channel. stuffing"). Though supermarket sales of soups and cereals are steady and predictable, production at both companies typically careened from high peaks to deep troughs.

Campbell and Quaker offered deep discounts--frequently at the end of each quarter--to maximize short-term sales and profits. By the end of each quarter, inventories were immense. Then Campbell and Quaker would ship huge stocks to customers, who actually sold the soup or cereals over weeks or even months. In addition to raising costs through huge inventories and overtime, trade loading lowered the prices Quaker received because customers demanded extra discounts in exchange for carrying big inventories.

Today Campbell and Quaker produce not to pack customers' warehouses but to smoothly replenish their shelves. They're running promotions for longer periods and spacing them throughout the fiscal year. The result is reduced working capital. Since 1990, Quaker has reduced operating working capital from 13% of sales to 6%.

A tower of progress is Quaker's plant in Shiremanstown, Pennsylvania. In 1990 the factory carried big inventories to match the quarterly push. Stocks of snacks and cereals covered a month to six weeks of orders. The credo was simple: keep the machines running full tilt. Making all nine flavors of Instant Quaker Oatmeal cereal could take as long as six weeks. Apples & Cinnamon, a hot seller, ran for a week at a time in huge batches of 25,000 boxes. Today the factory produces every flavor about once

a week. Apples & Cinnamon emerges in lots of 8,000 boxes. Producing small quantities more often carries a price: Workers have to rest the machines far more frequently than under the old system, with the machines sitting idle during the changeovers. Quaker is accelerating changeover times impressively, but workers still spent 27 more hours resetting equipment last year than under the old system, at an annual cost of $20,000. The savings in lower inventories,

however, exceed $500,000 a year. Instead of quarterly spasms, the plant simply replaces the product its customers sold the previous week. The smooth, rapid flow of deliveries has cut stocks from $12 million to $6 million. "This meant thoroughly relearning production," says plant manager Arnie Wodtke. "Until three years ago, I never thought about inventories." But then, around the globe, managers like Wodtke and

Nuttier are also achieving results they'd never dreamed of.


Methods of Measuring Performance

All firms move on cash flow, not profits. A borrower can't repay debt with profits, only cash.

As we will see, understanding the definitions, significance and drivers of cash flow are critical tools for the analyst. As an example of differing definitions, the requirements for the Statement of Cash Flow [SFAS #95], prescribe a very specific definition to Operating Cash Flow. By relying only on this accounting definition of operating cash flow, many growth companies would have to be called financially

distressed. As we will see, growing companies often cannot generate positive operating cash flows [GAAP definition - SFAS #95] as they build their business. The key is understanding the true Cash Flow measure[s] and definitions that the Equity and Debt Markets use. Even mature (and cyclical) companies may suffer Operating Cash Flow [GAAP definition] difficulties without becoming endangered.

By contrast, some companies may be regarded as financially strong because they report large, positive [GAAP] operating cash flows. This condition, however, may be the result of a decision not to reinvest in their businesses and to "harvest" the cash that mature businesses often generate late in their life cycles. Finally, some businesses may have high market equity capitalizations, but may not be attractive to the leveraged finance market.

DO NOT RELY ON AN INCORRECT MEASURE FOR ANALYZING LEVERAGABILITY [the

ability to use debt to finance the business].


How do analysts measure performance?

These are common measures of performance are:

a. Operating Profit b. Earnings Before Interest and Tax [EBIT] c. Earnings Before Interest, Tax, Depreciation and Amortization [EBITDA] d. EBIT * (1- tax rate)

e. Earnings Before Interest, Tax, Depreciation and Amortization and Rent [EBITDAR]

f. EBIT * ( 1 – tax rate) + Depreciation g. EBIT * ( 1 – tax rate) + Depreciation - ^ in Operating Working Capital h. EBIT * ( 1 – tax rate) + Depreciation - ^ in Operating Working Capital – Capital Spending

i. Net Income j. NI + Depreciation [called Funds Flow or Potential Cash Flow] k. Operating Cash Flow [GAAP definition] l. Operating Cash Flow – Capital Spending

For firms with limited debt, limited fixed and intangible assets and limited investment in operating working capital, the first four measures [a, b, c, d] and the last seven measures [f, g, h, I, j, k, l] will provide similar results. The difference between the first three measures and the last seven calculations is tax. The fifth measure [EBITDAR] is an adjustment for rent [often considered financing].

However, firms have debt, have fixed assets and have investment in operating working capital.


Review the following income statement and balance sheets for Unleveraged Company. As you

can see, this company has limited debt, limited fixed and no intangible assets and no change in operating working capital during 2009.

2009

Sales 85,350

Cost of Sales (54,315)

Depreciation (20)

OPERATING EXPENSES (28,233)

Operating Profit 2,782

Interest (8)

EARNINGS BEFORE TAX 2,774

Tax (970)

Net Income 1,804

2008

2009

Cash 50 70

Accounts Receivable 4000 4000

Inventory 3000 3000

Total Current Assets 7050 7050

Fixed Assets 400 400

Total Assets 7450 7470

Accounts Payable 2500 2500

Accruals 1500 1500

Total Current Liabilities 4000 4000

Long Term Debt 120 120

Deferred Tax 100 110

Owner's Equity 3230 3240

2009

NI 1804

Depreciation 20

Deferred Tax 10

Cash Flow from Operations 1834

Capital Spending -20

Dividend -1794

Change in Cash 20


Calculate the following [fill in the amounts, then check the next page]:

Operating Profit ________________ EBITDA ________________

EBIT _______________ EBITDA margin ________________ Calculations:

Operating Profit ______2782______

EBITDA ______2802______ EBIT _____2782______

EBITDA margin = 2802/85,350= 3.3% Note: With limited other income, you can calculate EBIT [or operating profit] top down

[Sales- Cost of Sales - Selling, General and Administrative Expenses] or bottom up [Net Income +Tax Expense + Interest Expense]. Note: For Unleveraged Company, EBIT and Operating Profit are the same because there is no other income (expense). In addition, because there is limited fixed and intangible

assets, EBIT and EBITDA are almost the same [very little depreciation expense and no amortization expense].


Assume that for Unleveraged Company, depreciation expense increases from 20 to 50.

Recalculate EBIT and EBITDA. Existing EBIT/EBITDA Proforma EBIT/EBITDA

EBIT 2782 _______________ EBITDA 2802 _______________


Existing EBIT/EBITDA Proforma EBIT/EBITDA

EBIT 2782 2752 EBITDA 2802 2802

As you can see, EBITDA is unaffected by the level of depreciation. EBITDA is not affected by

interest, tax, depreciation or amortization.

Remember, as you change interest, tax, depreciation, and amortization, the EBITDA will remain unchanged.

Similarly, if change the financial leverage of the balance sheet [change capital structure with the replacement of equity with debt], the EBIT and EBITDA will remain unchanged. Assume that for Unleveraged Company, the capital structure is changed, leading to an

increased interest expense of 300. Recalculate EBIT and EBITDA.


EBIT 2782 _______________ EBITDA 2802 _______________



EBIT 2782 ____2782_______ EBITDA 2802 ____2802_______

As you can see, changing the capital structure will have no direct impact on EBIT or EBITDA.


For unleveraged firm, calculate the following:

� Operating Profit � EBIT � EBITDA � EBIT * (1- tax rate) � EBIT * ( 1 – tax rate) + Depreciation � EBIT * ( 1 – tax rate) + Depreciation - ^ in Operating Working Capital

� EBIT * ( 1 – tax rate) + Depreciation - ^ in Operating Working Capital – Capital Spending


For unleveraged firm, calculate the following:

� Operating Profit: 2782

� EBIT: 2782

� EBITDA: 2802

� EBIT * (1- tax rate) =2782 *.65 = 1808

� EBIT * ( 1 – tax rate) + Depreciation = 1808 + 20 = 1828

� EBIT * ( 1 – tax rate) + Depreciation - ^ in Operating Working Capital =1828 – 0 = 1828

� EBIT * ( 1 – tax rate) + Depreciation - ^ in Operating Working Capital – Capital Spending = 1828 – 0 -20 = 1808


What is EBITDA?

The performance measure EBITDA (earnings before interest, taxes, depreciation, and amortization) is becoming ubiquitous in mainstream corporate America today as an alternative to traditional bottom-line-based financial yardsticks.

EBITDA supposedly gives a clearer picture of a company's operations by stripping out expenses that can distort how the business is really doing. Ebitda has existed since the 1960s but only came into vogue with the leveraged buyouts of the 1980s. It became the valuation method of choice for highly leveraged companies in

cable and media, where bona fide net profits were hard to come by. Many assume Ebitda is the same as traditional operating cash flow, which it isn't, and

saying so is a "scam," especially with big depreciation expenses. A capital intensive company isn't earning a profit, if it cannot earn the cost of wear and tear. Ebitda is an analytical technique and when used properly, is a useful tool.

But remember, it ignores

Capital Spending and Changes in Balance Sheet accounts

Interest and Tax


Now calculate the following three [after tax] measures for Unleveraged Company: Net Income _________________

Net Income + Depreciation [called funds flow] _________________ Operating Cash Flow _________________ Operating Cash Flow - Cap X _________________

Solutions:

Net Income 1804

Depreciation 20

Net Income + Depreciation [Funds Flow] 1824

Deferred Tax 10

Âccounts Receivable 0

Înventory 0

Âccounts Payable 0

Âccruals 0

Cash From Operations [GAAP] 1834

Cash From Operations [GAAP] – Cap X 1834 – 20 - 1814

You should also be able to see that EBITDA [2802] and Net Income + Depreciation [1824]

are similar except for Interest [8] and Tax [970]. EBITDA = 2802

- Interest 8 - Tax 970 NI + Depreciation = 1824

Remember, that both EBITDA and NI + Depreciation are before Depreciation and Amortization.

Also, as you can see, in this model there is no change in accounts receivable, inventory, accounts payable or accruals [called Operating Working Capital or Working Capital]. This should be case for slow growing firms. Also you should see that NI should be equal to CFO – CAPX for the firms that are in steady state [except for the deferred income tax].


VIACOM

Viacom is a diversified entertainment and publishing company with operations in four segments: (i) Networks and Broadcasting, (ii) Entertainment, (iii) Video and Music/Theme Parks, and (iv) Publishing. The Company operates MTV, SHOWTIME, NICKELODEON, NICK AT NITE, VH1 MUSIC and 17 television stations. In 2000, the Company completed of USA Networks for a pre-tax gain of approximately $1.2 billion reflected

in "Other items, net". Also in 2000, the Company completed the sale of Viacom Radio and realized an after gain of $416.4 million net of tax, reflected in “Net gain on dispositions, net of tax”.


VIACOM INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)

YEAR ENDED DECEMBER 31,

------------------------

2004 2003

---------- ----------

Revenues................................................................... $ 13,206.1 $ 12,084.2

Expenses:

Operating................................................................ 8,863.3 7,605.3

Selling, general and administrative...................................... 2,646.7 2,298.1

Restructuring charge ........................................ -- 88.9

Depreciation and amortization............................................ 943.3 817.6

Interest expense, net.................................................... 763.0 798.0

Other items, net ........................................... (1,232.9) (4.2)

---------- ----------

Earnings from continuing operations before income taxes.................... 1,222.7 480.5

Provision for income taxes................................................. (689.6) (295.5)

Equity in loss of affiliated companies, net of tax ............ (163.3) (13.0)

Minority interest.......................................................... 4.7 (1.3)

---------- ----------

Earnings from continuing operations........................................ 374.5 170.7

Discontinued Operations:

Earnings (loss) net of tax............................................... 13.9 (80.5)

Net gain on dispositions, net of tax..................................... 405.2 1,157.7

---------- ----------

Net earnings............................................................... 793.6 1,247.9

Cumulative convertible preferred stock dividend requirement................ (60.0) (60.0)

---------- ----------

Net earnings attributable to common stock.................................. $ 733.6 $ 1,187.9


VIACOM INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

(IN MILLIONS) DECEMBER 31,

-------------------

2004 2003

--------- ---------

ASSETS

Current Assets:

Cash and cash equivalents......................................................... $ 292.3 $ 209.0

Receivables .................... 2,397.7 2,153.1

Inventory ............................................................ 934.8 923.3

Theatrical and television inventory .................................. 1,317.9 1,419.1

Other current assets.............................................................. 770.8 723.8

Net assets of discontinued operations............................................. -- 289.4

--------- ---------

Total current assets.............................................................. 5,713.5 5,717.7

--------- ---------

Property and Equipment:

Land............................................................................ 452.2 466.9

Buildings....................................................................... 1,544.4 1,382.6

Capital leases.................................................................. 655.6 637.1

Equipment and other............................................................. 1,668.0 1,403.1

--------- ---------

4,320.2 3,889.7

--------- ---------

Less accumulated depreciation and amortization.................................. 1,122.5 733.9

--------- ---------

Net property and equipment.................................................... 3,197.7 3,155.8

--------- ---------

Inventory ................................................... ........ 2,650.6 2,619.4

Intangibles, at amortized cost.................................................... 14,699.6 14,894.2

Other assets...................................................................... 2,027.3 2,446.9

--------- ---------

$28,288.7 $28,834.0

--------- ---------


LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities:

Accounts payable....... ......................................................... $ 699.7 $ 808.8

Accrued expenses................................................................. 1,564.2 1,459.9

Deferred income.................................................................. 254.6 364.6

Accrued compensation............................................................. 441.7 425.7

Participants' share, residuals and royalties payable............................. 951.3 856.6

Program rights................................................................... 197.7 290.5

Income tax payable.. ............................................................ 556.3 --

Current portion of long-term debt................................................ 376.5 62.6

Net liabilities of discontinued operations.... ................................. 10.5 --

--------- ---------

Total current liabilities........................................................ 5,052.5 4,268.7

--------- ---------

Long-term debt .................................................... 7,423.0 9,855.7

Other liabilities................................................................ 2,429.6 2,123.1

Shareholders' Equity:

Convertible Preferred Stock ................... 1,200.0 1,200.0

Common Stock, par value $.01 per share .................... 3.6 3.6

Additional paid-in capital................................. .................. 10,333.1 10,242.1

Retained earnings............................................................. 2,094.6 1,361.0

Net unrealized gain on investments available for sale......................... 29.3 --

Minimum pension liability..................................................... (8.4) (7.9)

Cumulative translation adjustments............................................ (39.1) 11.3

--------- ---------

13,613.1 12,810.1

Less treasury stock .......... 229.5 223.6

--------- ---------

Total shareholders' equity.................................................. 13,383.6 12,586.5

--------- ---------

$28,288.7 $28,834.0


Calculate the following for Viacom for 2004:

EBIT ________________________ EBITDA ________________________

Year End Debt ________________________ Debt/EBITDA ________________________

Market Value of Equity ________________________ [ there were 350 million shares outstanding at December 31, 2004 at a stock price of $40].

EBITDA Margin ________________________


EBIT [use the operating profit of 752.8, do not include the other items as they are not related to the current period]

EBITDA [equals the EBIT or operating profit + depreciation is 1696.1]

Year End Debt [376.5 + 7423 = 7799.5] Debt/EBITDA [7799.5/1696.1 = 4.6]

Market Value of Equity [350 million * $40] = $14 billion EBITDA Margin = 1696.1/13206.1=12.8%


Review the balance sheets for Viacom. As you can see, there little change in accounts receivable, inventory, accounts payable or accruals from 2003 to 2004.

ASSETS

Current Assets:

Cash and cash equivalents................................................ $ 292.3 $ 209.0

Receivables .................... 2,397.7 2,153.1

Inventory ................................................... 934.8 923.3

Theatrical and television inventory ........................... 1,317.9 1,419.1

Other current assets..................................................... 770.8 723.8

Net assets of discontinued operations.................................... -- 289.4

--------- ---------

Total current assets..................................................... 5,713.5 5,717.7

Current Liabilities:

Accounts payable....... ................................................. $ 699.7 $ 808.8

Accrued expenses......................................................... 1,564.2 1,459.9

Deferred income.......................................................... 254.6 364.6

Accrued compensation..................................................... 441.7 425.7

Participants' share, residuals and royalties payable..................... 951.3 856.6

Program rights........................................................... 197.7 290.5

Income tax payable.. .................................................... 556.3 --

Current portion of long-term debt........................................ 376.5 62.6

Net liabilities of discontinued operations.... ......................... 10.5 --

--------- ---------

Total current liabilities................................................ 5,052.5 4,268.7


Review the following calculations:

Accounts Receivable + Inventory + Other Current Assets= 5421.2 5219.3

Accounts Payable + Accruals [all current liabilites except

debt and net liabilities of discontinued operations] = 4665.5 4206.1

Operating Working Capital [also called Working Investment]= 755.7 1013.2

The change in Operating Working Capital is small in 2004 [in fact, the change was a reduction].

As you can see, any increase or decrease in the balance sheet accounts of accounts receivable, inventory, accounts

payable and accruals will show up on a firm's GAAP Statement of Cash Flow. When these changes are significant, the

calculation of Net Income + Depreciation [Funds Flow] and Operating Cash Flow [GAAP] will show very different

results.

This is attributable to the change in Operating Working Capital, also called Balance Sheet Management.


Nu Horizons Electronics Corp.

Nu Horizons Electronics Corp. is engaged in the distribution of high

technology active and passive electronic components.


NU HORIZONS ELECTRONICS CORP. AND SUBSIDIARIES ----------------------------------------------

CONSOLIDATED BALANCE SHEETS

-ASSETS- February February

CURRENT ASSETS: 28, 2009 28, 2008

----------- -----------

Cash $ 4,333,669 $ 946,084

Accounts receivable-net 37,351,029 30,636,645

Inventories 44,004,890 29,764,570

Prepaid expenses and other current assets 4,837,007 2,903,269

----------- -----------

TOTAL CURRENT ASSETS 90,526,595 64,250,568

PROPERTY, PLANT AND EQUIPMENT NET 6,359,775 7,550,356

OTHER ASSETS

Costs in excess of net assets acquired-net 1,752,332 1,909,256

Other assets 1,002,726 1,073,134

----------- -----------

$99,641,428 $74,783,314

=========== ===========

-LIABILITIES AND SHAREHOLDERS' EQUITY-

------------------------------------

CURRENT LIABILITIES:

Accounts payable $12,112,365 $ 7,931,500

Accrued expenses 3,196,623 4,186,802

Current portion of long-term debt - 190,794

----------- -----------

TOTAL CURRENT LIABILITIES 15,308,988 12,309,096

LONG-TERM LIABILITIES:

Deferred income taxes 431,395 222,148

Revolving credit line 25,300,000 8,000,000

Long-term debt - 242,335

Subordinated convertible notes 7,059,000 7,059,000

----------- -----------

TOTAL LONG-TERM LIABILITIES 32,790,395 15,523,483

----------- -----------

SHAREHOLDERS' EQUITY 51,542,045 46,950,735

----------- -----------

$99,641,428 $74,783,314


NU HORIZONS ELECTRONICS CORP. AND SUBSIDIARIES ----------------------------------------------

CONSOLIDATED STATEMENTS OF INCOME

---------------------------------

FOR THE YEAR ENDED

----------------------------------------------------

FEBRUARY FEBRUARY

28, 2009 28, 2008

------------------- ------------------

NET SALES $233,325,408 $216,612,707

------------------- ------------------

COSTS AND EXPENSES:

Cost of sales 182,531,083 168,124,583

Operating expenses 40,133,422 34,873,910

Interest expense 1,723,163 1,701,092

Interest income (9,797) (8,134)

INCOME BEFORE TAXES 8,947,537 11,921,256

Provision for income taxes 3,649,546 4,847,696

------------------- -----------------

NET INCOME $ 5,297,991 $ 7,073,560


NU HORIZONS ELECTRONICS CORP. AND SUBSIDIARIES

----------------------------------------------

CONSOLIDATED STATEMENTS OF CASH FLOWS

-------------------------------------------------

FEBRUARY FEBRUARY

28, 2009 28, 2008

---------------- -------------------

RECONCILIATION OF NET INCOME TO

NET CASH FROM OPERATING

ACTIVITIES:

Net income $ 5,297,991 $ 7,073,560

Adjustments to reconcile net income to net cash

provided (used) by operating activities:

Depreciation and amortization 1,488,057 1,238,967

Bad debts 315,000 701,500

Contribution to ESOP (compensation) 139,950 139,950

Loss on sale of building 60,871 -

Changes in assets and liabilities:

(Increase) in accounts receivable (7,029,384) (1,332,963)

(Increase) decrease in inventories (14,240,320) 7,044,345

(Increase) decrease in prepaid

expenses and other current assets (1,933,738) (1,889,346)

(Increase) in other assets (80,951) (77,902)

Increase in accounts payable

and accrued expenses 3,190,686 1,964,667

Increase (decrease) in income taxes - (220,288)

(Decrease) in other current liabilities - -

(Decrease) increase in deferred taxes 209,247 106,571

Total adjustments (17,880,582) 7,675,501

---------------- -------------------

Net cash provided (used) by operating activities $(12,582,591) $14,749,061


Review the following calculations for Nu Horizons:

I] EBIT 10,670,700 [Interest Income included with the operating profit]

II] EBITDA 12,158,757

III] Year End 2009 Debt = 32,359,000

IV] Debt/EBITDA = 2.7 times

V] NI + Depreciation = 5,297,991 + 1,488,057 = 6,786,048

VI] You can see that EBITDA and Net Income + Depreciation are the same except for interest and tax.

EBITDA = 12,158,757

- Interest 1,723,163

- Tax 3,649,546

NI + Depreciation = 6,786,048

VII] GAAP Operating Cash Flow = (12,582,591)


VII] Finally, review the movement in operating working capital.

Accounts receivable-net 37,351,029 30,636,645

Inventories 44,004,890 29,764,570

Prepaid expenses and other current assets 4,837,007 2,903,269

Accounts payable $12,112,365 $ 7,931,500

Accrued expenses 3,196,623 4,186,802

[Operating] Working Capital 70,883,938 51,186,182

The 2009 change in Operating Working Capital was 19,697,756.


Finally, follow the reconciliation between EBITDA and NI + Depreciation

2009

Sales 233,325,408 Net Income 5,297,991

Cost of Sales (182,531,083) Depreciation 1,488,057

Operating Expenses (40,133,422) NI + Depreciation 6,786,048

Operating Profit 10,660,903

Interest Income 9,797

EBIT 10,670,700

Interest (1,723,163)

Earnings before Tax 8,947,537

Tax (3,649,546) the reconciliation

Net Income 5,297,991 between EBITDA and

NI + Depreciation Is

Interest and Tax

EBITDA 12,158,757

GAAP OCFlow = (12,582,591)

Finally the reconciliation between NI + Depreciation [6,786,048] and Cash From Operations [(12,582,591)]

is changes in [Operating] Working Capital.


Or as a summary, you can move from EBITDA to Cash From Operations by the following analytics:

EBITDA

- Interest expense4

- Tax

- Change in Operating Working Capital Investment5

- Other Asset/Liability changes

Cash Flow From Operations

end

4 Interest is a function of capital structure 5 Change in operating working capital is a function of balance sheet management and revenue growth

copyright 1981 – 2011 Barry M Frohlinger 38

Cash Flow, Ratio Analysis and the W.T. Grant Bankruptcy

Although they surfaced as a gusher rather than a trickle, the problems that brought the W.T.

Grant Company into bankruptcy and, ultimately, liquidation, did not develop overnight.

Whereas traditional ratio analysis of Grant's financial statements would not have revealed the

existence of many of the company's problems until 1970 or 1971, careful analysis of the

company's cash flows would have revealed impending doom as much as a decade before

the collapse. Grant's profitability, turnover and liquidity ratios had trended downward over the

10 years preceding bankruptcy. But the most striking characteristic of the company during that

decade was that it generated no cash internally. Although funds flow provided by operations

(net income + depreciation;"potential cash flow") remained fairly stable through 1973, this figure

(which is frequently referred to in the financial press as "cash flow") can be a very poor indicator

of a company's ability to generate cash in the short run. Through 1973, the W.T. Grant

Company's operations were a net user, rather than provider, of cash.

Grant's continuing inability to generate cash from operations should have provided investors

with an early signal of problems. Yet, as recently as 1973, Grant stock was selling at nearly 20

times earnings. Investors placed a much higher value on Grant's prospects than an analysis of

the company's cash flow from operations would have warranted.

The W.T. Grant Company was the nation's largest retailer when it filed for bankruptcy protection

on October 2, 1975. Only four months later, the creditors' committee voted for liquidation, and

Grant ceased to exist. The collapse of Grant is a business policy professor's dream-ambiguous

marketing strategy, personnel compensation based on questionable incentive schemes,

financially and administratively unsound credit operations, centralization versus decentralization

issues and poorly conceived and poorly executed long-range plans. Problems of this

magnitude do not develop overnight, although they often surface as a gusher rather than a

trickle.

As recently as 1973, Grant stock was selling at nearly 20 times earnings. Perhaps investors

believed that Grant would continue to prosper despite many years of consistent but lackluster

performance; after all, the company had been in existence since the turn of the century,

paying dividends regularly from 1906 until August 27, 1974. But Grant's demise should not have

come as a surprise to anyone following its fortunes closely; a careful analysis of the company's

cash flows would have revealed the impending problems as much as a decade before the

collapse.


Prior to 1971, Grant's stock had tended to perform like other variety store chain stocks.

Beginning in July 1971, however, the stock price performance of Grant and the other variety

chains parted ways. Grant's underperformed other variety store chains.

Grant's profitability, turnover, liquidity and solvency ratios over the fiscal periods between 1966

and 1975 deteriorated. The most significant deterioration in these ratios, however, occurred

during the 1970 and 1971 fiscal periods, leading the stock market's recognition of Grant's

problems by approximately one year.

The most striking characteristic of the Grant Company during the decade before its bankruptcy

was that it generated virtually no cash internally. The company simply lost its ability to derive

cash from operations. After exhausting the possibilities of its liquid resources, it had to tap

external markets for funds. As the failure to generate cash internally continued, the need for

external financing snowballed.

During the period from 1966 to 1975 funds flow correlated poorly with cash flow from

operations. The financial press frequently refers to "cash flow," defined as net income plus

depreciation. This measure may prove a very poor surrogate for the cash flow actually

generated by operations.

While Grant's net income was relatively steady through the 1973 period, operations were a net

user, rather than provider, of cash in all but two years (1968 and 1969). Even in those two years,

operations provided only insignificant amounts of cash. Grant's continuing inability to generate

cash from operations should have provided investors and creditors with an early signal of

problems. Operations were a net user of cash in eight of Grant's last 10 years between January

31 1966 and January 31. 1973, Grant's sales nearly doubled, but its earnings remained virtually

unchanged. Despite its failure to translate vastly increased sales into additional profits Grant's p-

e doubled from 10 to 20 between 1966 and 1973. Traders in Grant stock during the company's

last decade placed a higher value on Grant's prospects than an analysis of the company's

cash flow from operations would have warranted.


Survey of Operating Working Capital [Year 2009]

Acc Receivables

Days

Inventory Days Acc Payables

Days

Airlines 12 4 16

Apparel Retailers 12 54 26

Auto Parts Suppliers 53 31 47

Cable Broadcasters 23 5 28

Casino 15 2 11

Chemicals 57 47 33

Clothing Manufacturing 46 54 22

Communications

Equipment

58 32 27

Computer Hardware 52 17 41

Cosmetics 33 44 23

Home Construction 10 210 24

Household Products,

Durables

37 55 28

Restaurants 8 7 14

Software 64 1 12

Survey of Cash Cycle by Industry [Year 2009]

Operating Working

Capital/Sales

Industry Leader Industry Laggard

Airlines 0% Southwest UAL

Apparel Retailers 6% American Eagle Saks

Auto Parts Suppliers 7% Visteon Exide

Cable Broadcasters -5% Cox Cablevision

Casino 1% Argosy Caesars

Chemicals 15% Terra Sensient

Clothing Manufacturing 18% Liz Clairborne Russell

Communications

Equipment

16% Juniper JDS Unisphase

Computer Hardware 8% Apple NCR

Cosmetics 7% Avon Estee Lauder

Home Construction 44% Champion Toll Brothers

Household Products,

Durables

20% Tupperware Salton

Restaurants 0% Denny’s Cracker Barrel

Software 11% Intuit Compuware


Cash/Sales Ratio Aerospace 10%

Airlines 10%

Beverages 6%

Biotech 20%

Chemicals 8%

Communication Equipment 17%

Electric Utilities 5%

Food Retailers 1%

Food Processors 4%

Household Durables 4%

Machinery 5%

Pharmeuticals 15%

Documents

LIQUIDITY, THE CASH CYCLE AND CASH FLOW - Weebly