Cash Flow Statement and Ratios & Rates of Return and Profitability Analysis, Lecture notes of Corporate Finance

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Cash Flow Statement and Ratios

Session objectives Calculate solvency and leverage ratios Understand the inflows and outflows of cash throughout the year Examine funding options for an organization looking to grow

Analyzing cash flow groups Cash flow Each category of the statement of cash flows enables you to analyze the movement of funds in the company Asset management Operational management Financing strategy Asset management relates specifically to the management of investment in the company and is where commitment to growth can be seen.

• Working capital
  • Absorbing
  • Releasing
• Capital expenditure

  • amortization - <amortization

• Acquisitions Operational management refers to the operational strategy followed by an organization. - Margin management - Volume management - Operating profit Financing strategy reflects decisions made by management in relation to the ”leverage” of the company. - Debt / Equity - Long-term / Short-term - Other instruments - Interest / Dividends

Understanding debt Debt Overdraft Operating line of credit Term loans Working capital funding gap Purchase assets There are many options available when looking for debt financing:

Types of bonds Fixed rate Floating rate Zero coupon Inflation- linked Callable Convertible

• Have coupons that remain constant throughout the life of the bond
• Have coupons linked to an interest rate benchmark
• Coupon reset periodically (e.g. every 3 months)
• Pay no interest
• Trade at a discount from their value at maturity - Principal amount indexed to inflation - Interest rate is fixed, but principal and interest payments grow - The issuer has the right to repay the bond before the maturity date - Can be converted into shares of stock in the issuing company

Warrants and convertibles compared Bonds with warrants

• Tend to be more common in private placements
• The warrant can be detached
• Companies receive cash when stakeholders exercise their warrants Convertible bonds
• Convertible bonds are issued publicly
• The bond and the option are bundled together
• Bonds are exchanged for common stock

Leasing as an option Capital or Finance lease Usually longer term; most of the risks and rewards of ownership transfer to lessee Recorded on balance sheet Operating lease Usually shorter term; risks and rewards do not transfer to the lessee Recorded in income statement When an asset is leased, it remains the property of the lessor. Different accounting standards treat leases differently depending on how the lease is structured.

Leasing as an option Capital (or Finance) lease A capital of finance lease is a way to borrow funds for assets directly through the assets’ owner

Who can tap into the debt markets To raise debt financing …

• Show a history of profitability
• Have assets that can be pledged as security If a company is not yet profitable …
• Raise equity financing
• Dilute the existing shareholders to raise capital

Equity types – common shares Voting rights Ownership Residual claim A right to vote on appointments to the board of directors An equal share in earning after obligations to debt holders and preferred stockholders are met A residual claim on the business and therefore have the ultimate control of the company’s affairs Equity consists largely of common shares. Ownership of common shares normally entitles the holder to:

Retained earnings Equity Share capital Retained earnings Profit Dividends

Managing the financing of business - leverage Leverage expresses the relationship between funding provided by lenders and funding provided by shareholders. 80 20 Capital employed (100)

High leverage

Equity Long and short term debt 20 80 Capital employed (100)

Low leverage

Equity Long and short term debt

Growing the business using debt Assets Investment in assets Equity Debt Increase debt Borrow from the bank This is how you increase the leverage of the company by increasing debt rather than equity.

The benefits of leverage Leverage is effective for a number of reasons:

Reason 1

It is often very quick and inexpensive to obtain a loan or extension of a line of credit from the bank

Reason 2

A short term line of credit may be ideal for increasing inventory for a seasonal business, and a long term fixed payment loan for a significant investment in equipment to be used to increase production over a longer time period

Reason 3

By increasing debt, the current shareholders can increase the value of the company without having to reduce their share