Fahmi Ben Abdelkader 10/10/2017 6:04 PM 1. The Investment Cycle and the Free Cash Flow The Financing Cycle

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1 Financial Statement Analysis Section 2. Classifying Company Cash Flows: the Operating Cycle is of critical importance Students version Fahmi Ben Abdelkader 10/10/2017 6:04 PM 1 Overview of Cash Flows Cash flows from operating activities: Net cash flows from primary operating activities Cash flows from investment activities: Cash flows from investments in (or disposal of) noncurrent assets (plants, machines, office equipments, etc.) Cash flows from financing activities: Cash flows due to repayment of debt or raising of new debt, payment of dividends (repurchasing own shares) and share issues 2

2 Cash is vital: the example of Swissair s bankruptcy Lacking Cash, Swissair Grounds All Its Flights By ELIZABETH OLSON OCT. 3, Swissair abruptly stopped flying today because it lacked cash to pay for jet fuel and landing fees and feared that its planes would be seized by creditors at foreign airports. At least two planes were seized, at Heathrow Airport near London, though one was later released. 3 Cash is vital Only a French company on three pay suppliers on time (2015 June 11 - bourse.lesechos.fr). In France, a quarter of corporate defaults is due to late payment Beyond a delay of 30 days, the probability of default is multiplied by almost 6 4

3 The Cash Conversion Cycle (CCC) The operating cycle is characterized by a time lag between the positive and negative cash flows deriving from the length of the production process (which varies from business to business) and the commercial policy (customer and supplier credit). Source: Berk & DeMarzo (2011), Corporate Finance. Pearson Capital is needed to finance the cash conversion cycle: the Net Working Capital 5 The Cash Conversion Cycle (CCC) : measuring Working Capital Needs Net Working Capital is cash required in the short term to run the business It reflects the time lag between operating cash outflows and inflows Working Capital Needs = Inventory + Accounts receivable Accounts Payable Example: Nike Inc. Balance Sheet for 2013 (in $ million) Assets Liabilities Current assets: Current liabilities Inventory 3,434 Accounts payable 3,730 Accounts receivable 3,425 6,859 +3,129 The firm incurred $6,859 M to build inventories and deliver finished products : incurred expenses (from suppliers) 6

4 Measuring Working Capital Needs: a basic example You have just started a new business: consulting in strategy. Assume that you have already one consulting mission which will provide a revenue of Assume also that you have only one type of charges, for example: rental charges for the office which cost 2000 per quarter. 1. Customer credit & pay cash Cash at t 0 Balance Sheet at t 0 Inflows Assets Outflows Receivable Liabilities Payable Balance Net Working Capital = 2. Customer credit & supplier credit Inflows Assets Liabilities Outflows Receivable Payable Balance Net Working Capital = 3. Sell cash & supplier credit Inflows Assets Liabilities Outflows Receivable Payable Balance Net Working Capital = 7 Net Working Capital Needs over time Working Capital needs are devourer of cash An increase in Working Capital always reflects poor performance. True False 8

5 Working Capital Needs in days worth of sales Working Capital can be expressed in terms of the number of days worth of sales: Working Capital Needs Working Capital Needs Days = Inventory + Accounts receivable Accounts Payable Working Capital Needs Days = Inventory Days = Accounts Receivable Days = Inventory Accounts receivable Accounts Payable Accounts Payable Days = Working Capital Needs Days How long will it take to consume inventory? How long does it take to get paid? How long does it take to pay suppliers? How many days of sales do we need to carry to run the business? 9 Working Capital Needs in days worth of sales Working Capital can be expressed in terms of the number of days worth of sales: Working Capital Needs Working Capital Needs Days = Inventory + Accounts receivable Accounts Payable Working Capital Needs Days = Example: Nike Inc. and Dell for 2013 (in $ million) Inventory Days = Accounts Receivable Days = Inventory Accounts receivable Accounts Payable Accounts Payable Days = Working Capital Needs Days Nike Dell 10

6 Working Capital Needs in days worth of sales or the Cash Conversion Cycle 11 Working Capital and industry Working Capital in Various Industries (2012) 12

7 Working Capital and industry Working Capital in Various Industries (2009) 13 Working Capital and cash conversion performance Cash-Rich companies: the example of Apple and Microsoft With a $145 billion cash hoard, Apple could acquire Facebook, Hewlett- Packard and Yahoo. Put another way, it could buy every office building and retail space in New York, according to city estimates. The New York Times, APRIL 30, 2013, In 2004, Microsoft stunned financial markets by announcing plans to pay the largest single cash dividend payment in history, a one-time dividend of 32$ billion, or 3$ per share Since then, Microsoft has purchased over 100$ billion in shares, and raised its quarterly dividend 8 times September 17, 2013 Microsoft s board had approved a new $40 billion stock buyback program 14

8 Working Capital and cash conversion performance Apple isn t really sitting on $216 billion in cash Published: Jan 27, :50 a.m., By JEREMYC. OWENS Apple s reserves are mostly overseas and in long-term securities Apple has about $16.7 billion in cash and equivalents on its balance sheet. The majority of the assets included in its reserve is stashed in long-term marketable securities, meaning Apple plans to let those funds roughly $177.7 billion accrue interest for more than a year. More importantly, almost all of Apple s cash and securities are stashed overseas, proceeds from sales outside the United States that Apple will not bring back because it would then have to pay U.S. taxes. Cook has expressly said Apple does not plan to sacrifice roughly 40% of that stash in order to bring the proceeds home 15 Working Capital Over Time Working Capital Needs Nike Inc. from 2011 to Working Capital Needs ($ million) +2,594 +3,061 +3,129 Inventory (Days of sales) Accounts Receivable (Days of sales) Accounts Payable (Days of sales) Working Capital Needs (Days of sales) Working Capital Needs Vodafone from 2011 to Working Capital Needs ($ million) -4,902-4,006 Inventory (Days of sales) 4 4 Accounts Receivable (Days of sales) Accounts Payable (Days of sales) Working Capital Needs (Days of sales) See Appendix - Days Outstanding over the world (by country and by industry) 16

9 Working Capital Needs: the bottom line The Working Capital needs are necessary expenses, essential to run the business and to fund its daily operations The Working Capital is not a potential need, but a compulsory investment The evolution of the Working Capital depends on : The evolution of sales The length of the operating cycle The evolution of the Cash Conversion Cycle: credit terms from suppliers, average collection period, inventory turnover Any reduction in Working Capital needs generates a positive free cash flow that increases the firm value Efficiently managing working capital will maximize firm value 17 Managing Working Capital Objective : reduce capital invested in the operating cycle without altering the proper functioning of the firm + negotiate optimal credit terms + pay on the latest day allowed - Stretching accounts payable may be costly WCN = Inventory + Accounts receivable Accounts Payable (-) Excessive inventory uses cash: Acquisition costs, order costs, carrying costs (storage space, insurance taxes, opportunity costs, etc.) (+) benefits of holding inventory: avoid stock-outs, seasonality factors + Determining the credit policy: establishing credit standards, credit terms and a collection policy + Monitoring Accounts receivable - Cost of monitoring and collection 18

10 Managing Working Capital Corporate Finance B&DM: Chap 26 - Working Capital Managment 19 What is the difference between investment and operating outflows? Like the operating cycle, the investment cycle is characterized by a series of inflows and outflows. But the length of the investment cycle is far larger than the length of the operating cycle. Investments are carried out from a long-term perspective and their impact is spread over several operating cycles Investments involve higher risks: they will be beneficial only if overall generated operating cash flow increases (a certain Return On Investment) Investments impact the operating cycle New inventory, new credit terms from suppliers, The purpose of investments outflows - or Capital Expenditure - is to enhance operating cash flows 20

11 The Free Cash Flow Operating inflows - Operating outflows (I) Cash from Operating activities Cash generated during the year Investment inflows - Investment outflows (II) Cash from Investment activities Cash needed to maintain or develop the production equipment (I) + (II) = Free Cash Flow Free Cash Flow > 0 : cash flow generated by a firm s activities covers its operating and investment needs (it may be used to pay dividend or to pay down debt) Free Cash Flow < 0 : additional financial resources will have to be raised to cover the company s capital requirements 21 The Free Cash Flow A common and generally accepted definition: FCF = Cash flow from operating activities + Cash From Investing Activities Alternative measures of FCF: Free Cash Flows to the Firm (FCFF) FCFF = EBIT * (1- t) + Noncash charges (D&A) Increase in Working capital - Capex Free Cash Flows to the equity (FCFE) FCFE = Net income + Noncash charges (D&A) Increase in Working capital - Capex + Net Borrowing See also section 6. Accrual-based Versus Cash-Flow-based performance measures 22

12 The Free Cash Flow Quick check question Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: Free Cash Flow = +1,960,000 +2,413, , How does Working Capital impact Free Cash Flow and firm value? Problem The projected net income and free cash flows next year for Criteo S.A. are: Net income 20,000 + Depreciation +5,000 - Increase in Working capital -1,000 - Capital expenditures -5,000 Free Cash Flow +19,000 The company expects capital expenditures and depreciation to continue to offset each others, and for both net income and increase in working capital to grow at 4% per year. The opportunity cost of capital is 12%. What is the current value of the firm? ,000 ( 1 4% ) 19,000 * + 19,000 *( 1 4% ) 2 + ( ) 3 19,000 * 1 + 4% 24

13 How does Working Capital impact Free Cash Flow and firm value? Problem The projected net income and free cash flows next year for Emerald City Paints are: Net income 20,000 + Depreciation +5,000 - Increase in Working capital -1, Capital expenditures -5,000 Free Cash Flow +19, ,200 If the company were able to reduce its annual increase in working capital by 20% by managing its WC more efficiently without adversely affecting any other part of the business, what would be the effect on the firm s value? ,200 ( 1 4% ) 19,200 * + 19,200 *( 1 4% ) 2 + ( ) 3 19,200 * 1 + 4% 25 The financing cycle is the flip-side of the investment and operating cycles When a company s free cash flow is negative, the company covers its funding shortfall through its financing cycle by raising capital. Financial inflows: equity or debt Financial outflows: dividends, share repurchase, capital repayments, interest payments, etc. As future cash flows are uncertain, a distinction has to be made between a firm s commitments regarding capital providers: Equity holders: (+) decision-making powers and control (voting rights) (+) entitled to benefits generated by the business (-) risk: uncertain revenues and no possible repayment obligations Debt holders: (+) predetermined fixed income and certain revenues, regardless of the firm s performance (+) do not take part in the venture s risk (except for default risk) (-) lower revenue and opportunity costs 26

14 The financing cycle is the flip-side of the investment and operating cycles Quick check question Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: 27 The financing cycle is the flip-side of the investment and operating cycles Scenario I Scenario II The operating cycle Cash from operating activities Cash from operating activities Cash shortfall The investment cycle Cash from Investment activities Cash surplus Cash from Investment activities Free cash Flow FCF > 0 FCF < 0 The financing cycle Paying debt interests Paying dividends Decrease in borrowings Raising capital : Increase in equity Or Increase in borrowings Cash surplus > Or < 0 > Or < 0 28

15 Operating versus financing activities In calculating financial ratios which intend to measure a firm s profitability, it is beneficial to separate operations and investments in operations from financing activities In financial statements, the distinction between operating items and financial items is not always easy to make due to several factors: The definition of operations is not clear-cut The specifications in the income statement and the balance sheet do not clearly distinguish between operating and financing activities Which activities included in operations depend on the business model and the characteristics of the firm? Items that are sometimes categorised as belonging to operations may at other times be classified as belonging to financing. 29 Concept Check and Critical Thinking 1. What is the difference between a firm s cash cycle and operating cycle? 2. How will a firm s cash cycle be affected if (i) the firm increases its inventory, all else being equal? (ii) the firm begins to take the discounts offered by its suppliers, all else being equal? 3. What are the costs of stretching accounts payable? 4. What factors determine working capital variation over time? 5. Does an increase in a firm s working capital needs necessarily mean that the firm is managing its operating cycle poorly? 6. How does working capital impact a firm s value? 30

16 FAQ. Net Working Capital or Working capital needs? There are several denominations for Net Working Capital: Net Operating Working Capital (OWC) Working Capital Requirements (WCR) Working capital needs 31 FAQ. Net Working Capital : should we include other current assets and other current liabilities? Please note that you should include other operating assets (which are expected to be converted in cash in less than one year) and other operating liabilities (which are due in less than one year) when computing net working capital. Otherwise, the equation Capital employed = Invested Capital may not be effective. Examples of other operating assets: prepayments, deferred tax assets, and other trade receivables Examples of other operating and accrued liabilities: tax payables, social security, salaries due to employees, deferred tax liabilities, prepayments, etc. Net Working capital = Inventories + Accounts Receivable (including other receivables) Accounts Payable (including other operating liabilities) 32

17 Working Capital and opportunity cost Costly Working Capital for a project (Example 26.1 B&DM, p.889) Although the company receives back all of its investment in working capital, it loses the time value of money on this cash 33 Appendix- A substantial increase in Payable days (DSO), the example of Yahoo! Inventory days (DIO) Receivable days (DSO) Payable Days (DPO) = Net Operating Working Capital days worth of sales Since it had an income taxes payable related to sale of Alibaba Group ADSs of $3,282 million, after 2014, this income taxes payable remained to be zero, so its payable days returned to a normal level. The acquisition of 40% of the Chinese online retail company Alibaba for $ 1 bn. in 2005 was a great success for Yahoo!. When Alibaba had its IPO in 2014, Yahoo! sold 140 m. shares worth $9.4 billion (pre tax). Yahoo! still holds 380 m. shares (15%) of Alibaba, which contributes positively to the economic success of the company. 34

18 B2B or B2C? Impact on receivables Receivables are decreasing gradually, resulting from the operational transformation Nike is leading and the growing network of its own managed concept stores. 35 Zodiac : Profit warning February 25, 2016 Zodiac Shares Plunge on Delayed Recovery, Miss on Margin Target The stock slumped 21 percent to euros at 10:35 a.m. in Paris, giving the company a market value of 4.4 billion euros ($5 billion). The intraday drop of 26 percent was the biggest since Jan. 4, Zodiac Aerospace shares plunged the most in more than 17 years after saying a restructuring meant to halt delays in delivering airliner seats will take longer than estimated, the latest in a series of setbacks that have dented management s credibility. Zodiac, a key supplier to both Airbus Group SE and Boeing Co., has failed to meet schedules over the last two years after it took on more work than it was capable of handling. Its difficulties meant delays for airlines taking new planes from both manufacturers. Airbus Chief Executive Officer Fabrice Bregier said in January he had banned the supplier from bidding for work on its new A330neo. 36

19 Appendix- Days Outstanding 37 Appendix- Days Outstanding (DSO) 38

20 Appendix- Days Outstanding (DSO) 39 FAQ. What possible increases Net Working Capital? Question- What possible increases Net Working Capital? Student s answer- Besides increase in inventory and short term assets OR paying off short term debts OR both, could I also say that it may be because a Business sold more? Because in that case, "A/c receivables" entry would increase. not necessarily. Selling more doesn't mean that my clients will pay on credit (which will increase A/c Receivables in that case). If they pay cash for example, it would not increase receivables nor the net working capital Nevertheless, if Net sales increased (in accrual terms), Receivables in days worth of sales would decrease (all else being equal) Accounts receivable Accounts Receivable Days = 40