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Of the three financial statements, the one that seems to trouble managers the most is the Cash Flow Statement. In the section that follows, a very basic statement is introduced. The purpose is to begin a process that will ultimately result in the reader achieving a high level of comfort with this statement. The reader shouldn't be concerned if everything about the statement isn't crystal clear. It will become increasingly so as the reader progresses through this book.

What Drives Cash Flow and Value?

In the chapters that follow, considerable time is devoted to showing why and how “value” is driven by cash flow and how to quantify it using the discounted cash flow methodology.21 Therefore, if cash flow drives value, the logical question is: What drives cash flow? More importantly, what can a manager do to increase cash flow and thereby increase value?

A careful examination of the Cash Flow Statement shown in Table 1-5 indicates that without Net Income a company doesn't generate any cash from operations other than the cash that can be squeezed out of working capital. Hence it is clear that Net Income drives Cash Flow. Also, since one of management's key tasks is to make investments that result in a future increase in earnings, it would seem logical to add investments to the list of Cash Flow drivers. However, as Table 1-5 indicates, there are other activities that impact cash flow (i.e., changes in working capital, changes in long-term debt, proceeds from the sale of equity, buybacks of equity, and dividends). A better understanding of how all of these activities impact cash flow is facilitated by a careful inspection of Table 1-5.

The next section deals with quantifying these drivers in terms of their relationship to the Income, Balance Sheet, and Cash Flow Statements and this point is intended to briefly expose the reader to the concept of Cash Flow. Everything discussed in the following section is developed in more detail in the chapters that follow, so the reader shouldn't be concerned if some of the concepts aren't crystal clear.

Defining Cash Flow

Inspection of the Cash Flow Statement (Table 1-5) indicates that Cash Flow from Operations (CFfO) is a function of Net Income, Depreciation and Amortization, whereas Cash Flow from Operating Activities (CFfOA) is comprised of Cash Flow from Operations and Changes in Current Assets and Current Liabilities. These relationships are expressed in Equations [1-44] and [1-45]:

[1-44]CFfO = NI + D & A

[1-45]CFfOA = NI + D & A ± ΔCA ± ΔCL

or

[1-46]CFfOA = NI + D & A ± ΔWC

where:

ΔWC = Change in Working Capital = ± ΔCA ± ΔCL

Since NI is the ultimate driver of Cash Flow, all Cash Flow Statements start with the current period's Net Income and then make adjustments for the impact other factors have had on the period's Cash Flow from Operations. The first step in adjusting Net Income for non-cash charges is to add back the Depreciation and Amortization that was incorporated into the Income Statement for the current period.

The reason for this is: D&A represents Depreciation and Amortization of assets purchased and paid for during a prior period and that therefore don't have any current cash impact. It should be noted that even if the asset being depreciated or amortized was purchased during the current year and still not paid for, it's D or A would still be treated as a non-cash item because the amount the Company owes the supplier is accounted for in Accounts Payable and the cash has not left the company.

The role the change in Working Capital plays in CFfOA may not be so obvious. Recall that Working Capital is defined as Current Assets – Current Liabilities, and, as shown in the preceding section, when calculating Cash Flow it is the Change in the Working Capital (ΔWC) accounts (excluding cash) between the current and prior period that is of interest. The discussion on Working Capital showed that when the Change in Current Assets increases between the Current and Prior Year this represents a use of cash and this amount has to be subtracted from CFfOA. Conversely, when the Change in Current Liabilities increases from one year to the next this represents a source of cash and this amount has to be added back to properly reflect the impact this source of cash has on the Cash Flow from Operating Activities.22

Table 1-5 also suggests that CFfOA is available for making investments in the business (Investments), “Financing Activities” (servicing/repaying debt), and paying dividends to shareholders (Dividends Paid). The following relationships can be deduced by working down the Cash Flow Statement.

Cash Flow after Investing Activities (CFaIA):

[1-47]CFaIA = CFfOA − Investments

Cash Flow after Financing Activities (CFaFA):

[1-48]CFaFA = CFaIA ± Financing Activities

Cash Flow after Dividends Paid:

[1-49]CFaDP = CFaFA − Dividends Paid

At the end of the day managers and investors alike are interested in whether the business generates or uses cash, hence the interest in the “Cash Generated (Used)” by the business, which can be expressed as:

[1-50]Cash Generated (Used) = CFfOA − Investments ± Financing

− Dividends Paid

Another way to think about this is to look at the uses of Cash Flow from Operating Activities. The uses can be expressed as follows:

[1-51]CFfOA = (CF for Investments) & (CF for Debt Holders)

& (CF for Shareholders)

Equation [1-51] says that the Cash Flow from Operating Activities caters to two constituencies. The first is shareholders. The shareholders (by virtue of the board of directors) decide how much is invested in the business to generate future cash flows, and how much, if any, is paid out in dividends. The board also decides on the capital structure of the business (debt vs. equity) and thereby obliges the company to make interest payments on debt and repay money the company has borrowed from the second constituency, the debt holders.

Investments and Cash Flow after Investing Activities

While there are numerous kinds of investments made by all companies, they broadly fall into two categories:

1. Sustaining investments: These are investments necessary to sustain or improve the company's productive asset base as part of an effort to maintain the existing stream of Net Income and Cash Flow.

2. Growth investments: Unlike the sustaining investments, growth investments are investments in new capacity, business areas, or technologies and are directed at increasing the company's rate of Revenue, Net Income, and Cash Flow growth.

Every company needs to make “sustaining investments” to stay alive. Those that don't will go into a period of decline. While it may take many years, decline, if unchecked, is ultimately terminal. Unfortunately, while sustaining investments are necessary, they usually aren't sufficient. This is because growth will ultimately slow down and demand in the company's niche or market will sooner or later stabilize or decline as the market matures. In terms of a company's value, decline is a disaster. As far as investors are concerned, when market growth or sales decline, this is quickly seen in the value of the Company's shares.

In some instances, a decline in cash flow can be avoided by cutting costs. In fact, management can increase cash flow by disinvesting in the business. However, in today's business climate, increasing cash flow by expense control doesn't work for very long. Eventually cost cutting is a dead end and the only remaining road to increasing shareholder value is growth. Growth opportunities don't just come along. A company has to be committed to investing for growth in order to get it and even then success is highly uncertain. Unlike sustaining investments, investments focused on growth inherently involve more risk. The upside is, of course, the possibility of a better return.

Making a choice between sustaining or growth investments or investing for both is not simply a matter of money. In practice it (money) frequently turns out to be the least important resource. Investments directed at growth require ideas and sometimes new technologies. Furthermore, it's not very often that a management team that is outstanding when it comes to cost control and optimizing the productive level of sustaining investments is also good at managing a company for growth. While managing the process and resources associated with putting a company on a growth track can be learned, it takes time – often lots of time and many lessons learned. In practice, most companies make both sustaining and growth investments at the same time. Successful companies have learned that each category of investment has its own prerequisites and culture and therefore staff and manage accordingly.

As far as the Cash Flow Statement is concerned there isn't any need to be concerned with the kind or category of investment but rather how investments are treated financially and the impact investments have on Cash Flow after Investing Activities (CFaIA).

Recalling that earlier in this chapter Equation [1-46] defined Cash Flow from Operating Activities (CFfOA) as:

[1-46]CFfOA = NI + D & A ± ΔWC

and that Cash Flow after Investing Activities (CFaIA) can be expressed as:

[1-47]CFaIA = CFfOA − Investments

substituting [1-46] for CFfOA in [1-47] produces an equation for CFaIA expressed in terms of operating cash flows and investments.

[1-52]CFaIA = NI + D & A ± ΔWC − Investments

Example 1-6: Calculating CFaIA and CGU

Cash Flow after Investing Activities for the company represented by the Cash Flow Statement (Table 1-5) in Year n can be determined by substituting the values for NI, D&A, ΔWC, and Investments in Equation [1-52].

CFaIA = 6,900,000 + 5,000,000 − 1,250,000 − 10,000,000 = $650,000

The CGU is calculated with the use of Equation [1-50]

[1-50]Cash Generated (Used) = CFfOA − Investments ± Financing

− Dividends Paid

Substituting values from Table 1-5 for CFfOA, Investments, Financing, and Dividends Paid the CGU is calculated to be:

Cash Generated (Used) = 10,650,000 − 10,000,000 ± 0 − 0 = $650,000

It may be helpful to look at the Cash Generated/Used from another perspective. Recall that

[1-47]CFaIA = CFfOA − Investments

Rearranging,

[1-53]CFfOA = CFaIA + Investments

Substituting the results of Equation [1-53] for CfaOA in Equation [1-50] yields

[1-54]Cash Generated (Used) = CFaOA + Investments − Investments

± Financing − Dividends Paid

or

[1-55]Cash Generated (Used) = CFaIA ± Financing − Dividends Paid

Substituting,

Cash Generated (Used) = 650,000 ± 0 − 0 = $650,000

It is worthwhile to note that since no Equity was sold to investors and no dividends were paid, the CGU is the same as the Cash Flow after Investing Activities.

So if $650,000 of Cash was generated during this period, the question is: How much cash will the company have at the end of the period? If you assume the Balance Sheet shown in Table 1-3 is the balance sheet at the end of a month (January), then the cash balance at the beginning of the next month (February) will be the same as the cash balance at the end of January, or $750,000. Then if the Cash Flow Statement shown in Table 1-5 is the statement for the month of February, the Cash Generated during February will be $650,000 and the cash balance at the end of February would be as shown in Table 1-6.23

Table 1-6 Period Cash Balances $(000)'s