In this session, we will work with the Cash Flow Statement of Office Depot and see what the numbers tell us. Office Depot is a retailer of office supplies in the US market.
Remember that the statement shows what the firm’s beginning and ending cash balances are and what activities have been performed throughout the year to result in those balances. We have taken the figures from 1997 to 1999 for the purpose of comparison.
The cash flows from Operating Activities of Office Depot are given below. We are going to deal with each of the three sections – operating, financing and investing activities – separately.
All figures in ‘000
| Operating Activities | 1997 | 1998 | 1999 |
| Cash received from customers | $8,017,406 | $8,928,519 | $10,205,532 |
| Cash paid to suppliers | (7,416,925) | (8,119,219) | (9,739,616) |
| Interest received | 5,611 | 23,972 | 31,865 |
| Interest paid | (4,166) | (3,625) | (6,472) |
| Income taxes paid | (140,831) | (151,032) | (118,157) |
| Net Cash Inflow (outflow) from operating activities | 461,095 | 678,615 | 373,152 |
We can see that net cash flows from Operating Activities were positive for all three years, which means that the firm experienced more inflows than outflows. As credit analysts we are concerned about whether the operating activities have generated enough cash to pay off interest. We can see that the interest figure is adequately covered even though net cash from operating activities declined in 1999 as compared to 1998.
All figures in ‘000
| Investing Activities | 1997 | 1998 | 1999 |
| Purchase of investment securities | 0 | (36,697) | (154,364) |
| Proceeds from maturity or sale of investment securities | 20,030 | 44,260 | 114,141 |
| Investment in unconsolidated joint ventures | (22,464) | (40,475) | (1,606) |
| Purchase of remaining ownership interest in joint ventures | 0 | (27,680) | (21,629) |
| Capital expenditure | (156,869) | (233,089) | (396,008) |
| Proceeds from sale of property & equipment | 4,127 | 22,364 | 7,922 |
| Net cash used in Investing activities | (155,176) | (271,317) | (451,544) |
As cash is flowing out of the company when investments are made, most of the figures written above are shown as outflows. Detailed information about investments is usually available in the notes of the cash flow statement.
Net cash outflows have been higher in 1999. Compared to 1998, outflows from investing activities shot up by $ 180 million. The two major contributors (also the largest changes) were ‘Purchase of Investment Securities’ and “Capital Expenditure’.
All figures in ‘000
| Financing Activities | 1997 | 1998 | 1999 |
| Proceeds from exercise of stock option | $19,959 | $64,237 | $59,082 |
| Repurchase of common stock for treasury | 0 | 0 | (501,006) |
| Proceeds from issuance of long term debt | 0 | 0 | 42,841 |
| Payments on long- and short-term borrowing | (151,888) | (2,490) | (6,766) |
| Net cash (used) in Financing activities | (131,929) | 61,747 | (405,849) |
Financing activities revolve around obtaining cash to finance the rest of the activities of the firm. We can see that Office Depot has issued long-term debt, and has received payment for the exercising stock options. The outflows that the company has experienced are ‘Repurchase of Common Stock’ (the company bought back its shares) and ‘Payment on Long-term and Short-term Borrowing’. As outflows have been more in value than the inflows in 1997 and 1999, the net cash flow from financing activities is negative.
Notice that cash used in financing activities has increased considerably in 1999. It was positive a year earlier.
The analyst must learn to differentiate between one-time outflows or inflows that lead to positive or negative effects on the cash position of the firm. For example, in the financing activities of Office Depot a loan was made only in 1999, which led to an inflow of $42.8 million. No such loans were made in either 1997 or 1998. So, while studying the cash flow position of a firm, an analyst should be able to identify consistency in the source of cash inflows (and outflows), which can be depended upon for loan repayments.
All figures in ‘000
| 1997 | 1998 | 1999 | |
| Increase (decrease) in cash equivalents | $173,990 | $469,045 | ($484,241) |
| Effect of exchange rate changes | (1,939) | (4,381) | (1,516) |
| Net increase (decrease) in cash equivalents | 172,051 | 464,664 | (485,757) |
The beginning balance of cash is then adjusted to make allowance for this overall change in cash flows during the year to arrive at the ending balance of cash.
All figures in ‘000
| 1997 | 1998 | 1999 | |
| Cash and Cash equivalents at beginning of year | $67,826 | $239,877 | $704,541 |
| Net increase (decrease) in cash equivalents | 172,051 | 464,664 | (485,757) |
| Cash an Cash equivalents at end of year | $239,877 | $704,541 | $218,784 |
For a credit analyst, the cash flow statement highlights the major sources and uses of cash. The analyst can see from where cash is flowing into the company and whether it is being put to good use. The most important question that needs to be answered is whether inflows and outflows of cash are timed & matched properly or not.
Concept Title: Analyzing Cash Flow Statement – Example II – Will and Can Inc
When a cash flow statement is presented to a bank, how can a bank assess if net cash flows are strong enough to support the additional financial charges that the business wants to take up? It all depends on what the numbers in the cash flow statements tell the banker. He must learn to differentiate between a rise in cash flows that has resulted from an extraordinary situation and one that has resulted from efficient operations. He must look for steady and consistent sources of cash.
We will work with an example using the data from two corporate customers Will Inc and Can Inc.
Consistency
A credit analyst has to focus on whether inflows of cash have resulted from one-time events, like sale of assets, issue of new equity etc, or whether the firm has been managing its cash position in a consistent manner through its operations.
Will Inc. shows ending cash balances for 3 years as follows:
| Will Inc | 1996 | 1997 | 1998 |
| Ending Cash Balance | $24,000 | $34,000 | $44,000 |
Can Inc. is another firm in the same industry that has the following ending cash balances
| Can Inc | 1996 | 1997 | 1998 |
| Ending Cash Balance | $24,000 | $28,000 | $35,000 |
Apparently, the cash balances of Will Inc. show a higher growth in the cash position of a firm. But a break down by operations, investment and financing cash flows will reveal that from 1996 to 1999 Will has consistently sold off its earlier investments in short and long-term securities purchased earlier. You now want to dig a little deeper
The health of cash flows can be determined by comparing cash flows to the overall earning situation of a firm. We know that the cash balance of a company can be derived from the figure that is available for Operating Income. So, the figure or value of operating and gross income, when compared on a yearly basis, can provide the analyst with an idea of the firm’s earning situation. Together, cash flows and earnings give the analyst a good idea about how strong a company’s projected cash position will be.
The Gross and Operating Profit Margins that are available to us for 1996 to 1998 are as follows.
| Will Inc | 1996 | 1997 | 1998 |
| Gross Profit Margin | 8% | 9.6% | 11.5% |
| Operating Profit Margin | 4% | 4.8% | 5.4% |
| Can Inc | 1996 | 1997 | 1998 |
| Gross Profit Margin | 12% | 14% | 16% |
| Operating Profit Margin | 8% | 9.8% | 11.1% |
Both these businesses are operating in the same industry and environment. However, we can see that the profit situation of Can is much stronger than that of Will, which is in line with the conclusion that we had reached about Will’s cash position earlier on.
Seasonality or Cyclicality of Cash Flows
It is also important for a credit analyst to determine the existence of seasonal variations in cash flows of a business. Say Will and Can do not operate in the same industry. Both companies presently hold no debt in their books. Will is in the sugar cane industry, while Can produces ice cream.
Sugarcane production starts in November and lasts for 4 months till February. So, major operational cash flows for Will Inc occur in the last three and first three months of the year. Can produces and sells ice cream throughout the year and as a result from operating activities flows into the company steadily throughout the year. There is some minor seasonal variation, but not as strong as the sugarcane industry or Will Inc. Seasonality in cash flows increases the risk associated with Will as compared to Can.
Will has had the following cash flows in the last four quarters of 1999.
Note: We are considering operating cash flows only to simplify the explanation. Total cash flows can also be analyzed in the same way.
| Will Inc. | Qtr. 1 | Qtr. 2 | Qtr. 3 | Qtr. 3 |
| Net Cash Flows from operating activities | $8,000 | $41,000 | $41,000 | $10,000 |
Can, on the other hand, has had stable cash flows throughout the year. So, Can’s cash flows for the same period look something like this.
| Can Inc. | Qtr. 1 | Qtr. 2 | Qtr. 3 | Qtr. 3 |
| Net Cash Flows from operating activities | $24,000 | $25,000 | $26,000 | $25,000 |
Since both companies have no debt, interest expense can be ignored while calculating net cash flows. Net cash flow, if compared at the end of the year, is the same for both firms ($100,000). However, the bank prefers to receive quarterly interest payments of $10,000. If it has a choice between Will Inc and Can Inc, who will it lend to? The bank will certainly be concerned about how Will Inc can cover $10,000 in interest payments from operational cash flows in Quarter 2 and 3.
Say the cash flows given above occurred in normal financial conditions. What if the economy goes into recession? Customers would be willing to buy less, so there would be less cash inflows. Let’s say both companies decide to maintain the same production levels (hence, outflows would be the same). As a result, both the firms would have the following net cash flows from operating activities, without an allowance for interest expense.
| Will Inc. | Qtr. 1 | Qtr. 2 | Qtr. 3 | Qtr. 3 |
| Net Cash Flows from operating activities | $6,000 | $10,000 | $10,000 | $6,000 |
| Can Inc. | Qtr. 1 | Qtr. 2 | Qtr. 3 | Qtr. 3 |
| Net Cash Flows from operating activities | $12,000 | $8,000 | $12,000 | $8,000 |
Under conditions of stress, both Will Inc and Can Inc will not generate enough cash flows to service the $10,000 quarterly interest. Would you still lend to Can Inc?
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