Module 2 - Topic 9: Analysing an Income Statement

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0:08 In this module so far, we've looked at the various bits of
0:12 the income statement.
0:14 Now it's time to bring it all together by looking at an
0:16 income statement in its entirety.
0:19 And what questions should we ask?
0:23 So let's have a look at a recent income statement,
0:25 Woolworth's, a large supermarket business.
0:30 When you take a look at this, the first thing you should
0:31 notice is all the categories that we've talked are here,
0:36 gross profit, earnings before interest, taxes, depreciation,
0:41 and amortisation.
0:43 So that's an estimate of the cash profits of the business.
0:46 Take out the non-cash expenses, depreciation and
0:50 amortisation, and we're left with earnings
0:52 before interest in taxes.
0:54 Remember, that's a level of operating profit for the
0:57 business that's independent of how the
0:59 business is being financed.
1:02 Profit before tax takes out the interest.
1:05 Finally, profit after tax, after taxes are paid.
1:10 You'll also notice that I've structured this so we can look
1:14 at the of revenue for each of the cost and profit items.
1:19 And that makes for a much easier analysis, particularly
1:23 if we can trend this through time to see if there have been
1:26 any major changes in the structure of the income
1:30 statement or some costs increasing at greater rate
1:34 than others, and what might that mean.
1:37 It's also useful to compare this to other businesses that
1:40 are similar in size, risk, and markets in which they operate.
1:46 Try to find clones of this business to assess or
1:50 benchmark the performance against others.
1:53 Although be careful, because others might not be doing very
1:55 well as well if a business is performing poorly.
1:59 So benchmarking is always about how things are going
2:04 relative to the state of the economy and other factors.
2:08 So what things do we pick up here, with respect to
2:11 Woolworth's?
2:12 Well, the first thing you should see is its gross profit
2:16 margin is 26.2%.
2:20 So what that means is for every dollar in revenue,
2:23 Woolworth's generates gross profit of about $0.26.
2:29 Is that large or small?
2:32 Well, for a business such as Woolworth's that basically
2:36 buys stock and unsells stock, that's a pretty good return.
2:42 The next item is employee expenses, and they represent
2:48 12% percent of the revenues of Woolworth's.
2:54 Now that might seem large.
2:56 So 12%, or for every dollar in revenue, $0.12 in costs go
3:01 towards employee expenses.
3:04 But Woolworth's is also a people business.
3:06 It's a retail business, and it needs people.
3:10 So that number is not unrealistic.
3:14 Its EBITDA margin is nearly 8%.
3:20 Similarly, its EBIT, 6%.
3:24 At first sight, they might look small.
3:27 So for example, with EBIT, for every dollar in revenue,
3:32 there's just $0.06 in earnings before interest and taxes.
3:37 The margin may appear small, but remember,
3:41 this is a volume business.
3:43 So small margins, large volumes can translate into
3:47 very healthy profits.
3:50 Next, I want to refer you to EBIT and interest.
3:57 So notice that Woolworth's has lots of interest cover.
4:02 In other words, it has earnings before interest and
4:06 taxes of $3.3 billion, but only interest of $300 million.
4:13 So that's a cover of around 11 times.
4:16 And that's important in assessing financial health,
4:19 because it says Woolworth's is easily meeting its interest
4:23 expenses through its previous profit levels.
4:27 Don't forget though that there are still debt
4:29 repayments to make.
4:31 But debt repayments don't show up in an income statement.
4:34 They show up in a balance sheet and through the cash
4:37 flows of the business.
4:40 Finally, Woolworth's is generating profit after tax of
4:43 2.1, a margin of around 4%.
4:47 And as I said, while the margin might appear small on
4:50 the surface, the volumes of the business suggest this is a
4:54 very good business.
4:57 In the next topic, we'll bring everything
4:59 together for this module.
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Module 2 - Topic 10: Summing up the income statement
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0:09 In this last topic, I want to summarise the key points from
0:13 the module.
0:14 In this module we looked at profits
0:17 and the income statement.
0:19 In its most simple form, profits, we look at the
0:24 revenue of the business, we take away the expenses of the
0:28 business, and we're left with the profit of the business.
0:35 So what are the main issues that we need to consider
0:38 around each of these items?
0:40 So with revenue, the key issue is recognition.
0:46 Has the firm earned the income?
0:51 And recognise that although the firm may have earned the
0:55 income, it may not necessarily have received the cash.
1:00 And that's something we'll look at in more detail in an
1:02 upcoming module.
1:04 With expenses, the key issue for me is are they adequate?
1:11 There's a lot of pressure in businesses to cut costs.
1:18 And cutting costs will certainly improve profits in
1:22 the current period.
1:24 But we have to ask the question, how long can a firm
1:27 go on cutting costs and expect to generate income?
1:32 Costs generate income.
1:35 We need employees, we need marketing, we need raw
1:39 materials to be able to generate revenue, not only in
1:42 this period but also in future periods.
1:47 So how much costs are adequate?
1:50 We need to look at benchmarks, the structure of the business
1:54 that we're looking at, and have there been any major
1:57 changes in the different cost structures?
2:00 So if we see employee costs going up substantially,
2:03 relative to other costs, we could be concerned that the
2:07 business is paying its employees too much money.
2:10 Or we could say, this is good news, because the firm is
2:14 investing in the right people.
2:16 And the right people would generate revenues for the
2:19 business in future periods.
2:22 With respect to profits, we saw there are
2:25 many levels of profits.
2:27 The first one, gross profit.
2:29 And gross profit really tells us something about the
2:33 profitability of the products and services.
2:38 The next layer of profit, EBITDA.
2:43 That tells me something about the firm's profits rather than
2:46 just the product or service profits, because it takes into
2:50 account all those items of expenditure that turn products
2:54 and services into income.
2:57 And EBITDA is a measure of the cash profits of the firm.
3:02 Next, EBIT.
3:05 And that tells me something about the performance of the
3:07 business or the profitability of the business before we take
3:11 out any interest expenses associated with the financing
3:15 of the business.
3:17 And finally, what people call the bottom line, profits
3:20 before tax and profits after tax.
3:26 That's what's left over to pay dividends to shareholders.
3:30 If dividends are not paid to shareholders, those profits
3:33 accumulate as retained earnings in the balance sheet,
3:37 building the resilience of the firm for future periods,
3:41 providing funding to buy assets in future periods.
3:46 In the next module, we'll look a very important part of a
3:50 business, and that's the generation of cash flows
3:54 through the cash flow statement.
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Module 3 - Topic 1: The Cash Flow Statement
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0:08 Welcome to the third module in this subject.

0:11 In this module, we look at the cash flows, and specifically
0:16 the statement of cash flows.
0:19 The statement of cash flows and understanding cash flows
0:22 is critical to assessing the
0:24 financial health of a business.
0:27 We'll see that a business could be generating big
0:31 profits through time, good-looking profits, but the
0:36 business may not be generating cash.
0:40 And it's a fact that a business can survive for a
0:43 long time if it's making low profits, or even accounting
0:47 losses, provided it's generating cash.
0:51 But often the reverse is not true.
0:54 We could be making profits, but if cash is not coming into
0:56 the business, we're going to have to
0:58 rely on outside financing.
1:01 And there comes a time where outside financing, whether it
1:04 comes from banks or even from owners putting more money into
1:08 the business, there comes a time when that dries up.
1:13 So let's take a look at the idea of a cash flow statement.
1:17 Now recall from previous modules that not all
1:22 transactions involve cash.
1:24 But under an accrual accounting system, we're
1:27 required to recognise those transactions.
1:31 So we may sell some products or services, recognise the
1:35 revenue, but we've not received the cash because
1:38 we're giving credit to customers.
1:41 The cash will eventually come in, we hope.
1:43 But in the current period, we're not recording that cash
1:47 because it hasn't come in.
1:50 Then think about some expenses.
1:52 We may have purchased some products and sold them and
1:55 still not have paid for them yet.
1:57 But we must recognise the expense, cost of goods sold.
2:01 Depreciation, the wearing out of an asset, that's a true
2:05 cost to a business.
2:07 The asset will eventually have to be replaced, but no cash is
2:11 leaving the business when we recognise the
2:13 depreciation expense.
2:16 There are lots of examples of transactions that impact on
2:19 our performance, impact on our profits, impact on our balance
2:23 sheet, but they may not involve cash.
2:26 And that's the reason why we need to consider
2:28 the cash flow statement.
2:31 The cash flow statement is broken up into three main
2:34 categories.
2:36 And they are the cash that's received from the operations.
2:44 And the way to think about this is this is the cash that
2:48 the core business generates, the business doing what it
2:52 does every day, buying and selling products, providing
2:56 services to customers, so cash from the heart or
3:00 cash from the core.
3:05 The second item in the cash flow statement is cash related
3:08 to investments, or investment activities.
3:12 And if we go and buy long-term assets such as equipment that
3:19 draws cash out of the business, if we sell property
3:23 or long-term assets, that brings cash into the business,
3:28 so we must recognise that.
3:30 But that's not part of the day to day
3:31 operations of the business.
3:33 Buying new equipment, replacing depreciating
3:36 equipment, these don't happen on a day to
3:39 day basis in a business.
3:42 Finally, the cash related to financing activities.
3:47 Cash may come in because we borrowed money or cash may go
3:51 out because we've repaid debt.
3:54 Similarly, cash may come into the business because the
3:57 owners have contributed more funds.
4:00 Or cash may go out of the business because we're paying
4:03 owners' dividends or we're returning some of
4:06 the funds to owners.
4:09 If I put $1,000 in cash on the table in front of you, you
4:16 might ask the question, where did that cash come from?
4:19 It could have come from the operations, that is me doing
4:23 what I do, my earnings.
4:26 That would be very different if the cash had come from me
4:29 selling an asset.
4:31 And it depends what asset that might be.
4:34 If I'm a professional tennis player and I've just sold my
4:36 tennis rackets, I have the cash but I don't have a source
4:41 of future income without that.
4:44 And if the $1,000 came because I went and borrowed some money
4:46 from the bank, I have the cash.
4:49 But of course, I have to repay that cash at a future date and
4:53 pay interest on it.
4:55 Just to give you an idea, in the cash flow statement of a
4:59 large retail business like Woolworth's, recently the
5:03 figures were cash from operations $2.9 billion.
5:11 That's [? different ?] towards profits.
5:13 That's [? difference ?] towards revenue.
5:14 It's the cash that was generated
5:17 from the core business.
5:19 Of that, Woolworth's spent or invested $2.1 billion
5:25 developing property, buying new property, potentially
5:28 buying other firms.
5:30 Now notice I put a minus sign there.
5:32 When we're talking in a cash flow world, we can think of a
5:35 plus as cash coming into the business and a minus as cash
5:39 going out of the business.
5:42 So Woolworth's has 2.9 coming in from the core, 2.11 went
5:46 out building for the future.
5:49 And what happened with it's financing?
5:50 Well, Woolworth's actually repaid debt and paid dividends
5:56 equal to $1.5 billion.
5:58 So in that particular reporting period, we say that
6:01 Woolworth's had more cash going out then coming in.
6:06 Is that a bad thing?
6:07 Not necessarily.
6:09 The shortfall, $700 million here or $0.7 billion.
6:14 And all that means is Woolworth's
6:17 drew on its cash reserves.
6:19 And I can tell you in that particularly year, Woolworth's
6:22 had $1.5 billion in cash reserves.
6:30 So, overall a good cash flow statement.
6:35 Cash coming in from the heart of the business, cash going
6:39 out investing in the future, and Woolworth's repaying debt
6:42 or paying shareholders a healthy dividend.
6:46 In the next topic, we look at the cash from operations in
6:49 far more detail.
Module 3 - Topic 2: Operating Cash Flow
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0:09 In this topic we look at the cash flow from operations in
0:12 more detail.
0:15 The cash flow from operations is made up of three or four
0:19 main categories--
0:21 the first, cash receipts from customers.
0:25 So while revenue recognises what the business has earned,
0:30 cash receipts from customers tells us what cash the
0:33 business has actually received; cash payments to
0:36 suppliers and employees, so actual cash flows out of the
0:41 business; then interest paid or interest received in cash;
0:48 and finally, any taxes that have been paid.
0:52 So we add these numbers together.
0:54 We get the cash flow from the operations of the business or
0:58 the operational activities.
1:01 Now what do we want to see?
1:03 Well, hopefully we see it is a positive number.
1:06 That's important.
1:07 But there are circumstances where you'll see businesses
1:10 that don't have negative--
1:11 that don't have positive cash from operations.
1:14 And we need to look at the reasons for that.
1:18 What happens if we see the cash flow from operations
1:21 declining through time?
1:23 That may not be a bad thing if the business is getting
1:26 smaller and selling off assets.
1:29 So as usual, we can't look at an item in isolation to try to
1:33 gauge the financial health of a business.
1:35 We should be looking at within the context of other parts of
1:38 the operations.
1:39 So it's good to track the cash from operations back to the
1:42 size of the business, its assets, and its revenues.
1:48 What happens if we have a situation where the cash from
1:51 operations is not keeping pace with the size of the business?
1:57 And one of the things that we might look at is the
2:00 relationship between revenue and cash
2:07 receipts from customers.
2:12 And what we want to see is these two keeping pace, so the
2:17 revenue of the business rising and the cash receipts from
2:21 customers of the business rising.
2:25 But if we have a situation where the revenues of the
2:28 business are rising but the cash receipts from customers
2:33 is not rising or not keeping pace, then
2:39 there may be problems.
2:41 Revenues are increasing, but cash is not.
2:44 And this could be an indication of a firm giving
2:47 customers very long periods to pay.
2:51 And if customers have long periods to pay, and cash is
2:53 not coming into the business, usually debt is needed to
2:57 finance that gap.
2:59 Another reason why the cash flow from operations might not
3:03 be keeping pace with the rest of the business is the firm is
3:06 not taking advantage of credit available
3:08 to it with its suppliers.
3:11 If there's an opportunity to extend credit terms, we should
3:14 take it, because that's cash that remains in the business.
3:19 It can be helpful to compare the cash flow from operations
3:23 to the profit after tax of the business.
3:26 And there will be a number of reasons why these two differ.
3:30 The cash flow from operations may be higher than profits,
3:34 because it excludes a number of items that are expenses
3:38 that don't involve cash, such as depreciation.
3:43 At the same time, the cash flow from operations may be
3:46 lower than profits, because there are transactions that
3:50 are sucking cash out of the business, such as an excessive
3:53 buildup in inventory or extensive credit terms given
3:58 to customers.
3:59 Fortunately, we can see, when we look at the annual report
4:02 of a business, some of the reasons why there might be gap
4:06 from the profits the business is making and the cash flow
4:09 from its core operations.
4:13 So let's have a look at this for a big business such as
4:16 Woolworth's.
4:17 Here's some of its recent financial data.
4:21 And what I want you to notice is Woolworth's generated
4:23 profits after tax, in that particular
4:26 year, of $1.8 billion.
4:29 But it's cash from operations was much
4:32 higher, at $2.8 billion.
4:35 Now that's good news.
4:37 And why the difference?
4:39 Well, the first thing is here we're adding back expenses
4:44 that impact the non-profits and in fact which lowered
4:47 profits but in fact don't involve any cash.
4:51 So one of those is depreciation.
4:54 The cash is still in the bank account, even though an
4:57 expense is being recorded.
5:00 So that boosts the cash position of the business.
5:03 Offset against that, $400 million went out as
5:08 Woolworth's acquired inventories and
5:10 stock over the period.
5:13 That takes cash out.
5:15 But the good news is Woolworth's also was able to
5:18 take advantage of credit to customers, keeping $300
5:22 million in cash back in the business.
5:26 This reconciliation between cash flows and profits can be
5:31 very helpful in understanding how the business is operating.
5:36 And we'll refer to this in more detail in future topics.
5:41 In the next topic, let's take a look at the cash flow
5:43 related to investment activities in more detail.
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Module 3 - Topic 3: Cash Related to Investments
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0:08 In the last topic, we looked at the cash from operations of
0:11 a business.
0:12 In this topic, let's consider the cash related to investment
0:16 activities, the acquisition of long-term assets or the sale
0:21 of long-term assets.
0:23 I'd like to start with some interesting information.
0:27 If you have a look on the screen, you'll see that
0:30 Quantas, in one year, made profit of $249 million.
0:40 A year later, Quantas made a loss of $244 million.
0:47 So Quantas went from a profit to a loss.
0:51 At the same time, the cash from operations for Quantas--
0:55 remember, that's cash coming from the core--
0:58 went from positive $1,782 million to
1:07 positive $1,810 million.
1:15 So you'll see there that although a firm might be
1:22 making an accounting loss, it can still be generating large
1:28 and relatively healthy cash flows.
1:31 And that arises because not all expenses impact on cash.
1:38 Expenses impact on profit but not cash.
1:42 It also might reflect sound working capital management in
1:46 a business like Quantas, not giving excessive credit to
1:50 customers, good relationships and good
1:52 credit terms with suppliers.
1:54 They'll all help there.
1:57 It turns out that the big difference between the cash
2:00 from operations and the accounting loss is the large
2:04 cash expense depreciation and summing payment charges as
2:09 well that reflect some assets that have had to be written
2:12 down, because they weren't performing at the level that
2:14 management expected.
2:16 These are very large expenses, but they don't impact on cash,
2:21 and hence the difference between these kind of numbers.
2:25 The big difference also reflects the fact that
2:28 Quantas, with airlines, with aircraft, does have large
2:33 depreciation deductions.
2:35 And this brings us into the cash related to investment
2:38 activities.
2:39 The cash related to investment activities tells us how much
2:44 every year, in cash, the firm is spending, investing in new
2:49 plant, new equipment, new properties.
2:53 It could be replacing depreciating equipment,
2:55 replacing depreciating aircraft.
2:58 It could be buying intangible assets or investing in
3:01 intangible assets.
3:02 Or it could be investing in other firms.
3:05 So the cash from investment activities applies to
3:08 non-current assets, investments, long-term assets.
3:14 So if a business is depreciating its assets, we
3:16 want to make sure that it's investing to
3:19 replace those assets.
3:21 And the place to look is the cash flow statement, and
3:24 specifically the cash related to investment activities.
3:28 In the cash related to investment activities, you'll
3:31 see how much is being spent every year as the firm buys
3:37 new long-term assets.
3:39 And I've said previously, this is building the
3:41 firm for the future.
3:43 We can't generate revenues from the business or even cash
3:46 flows from the business unless we have great
3:49 assets behind them.
3:52 Is the company or is a firm replacing its depreciating
3:56 assets quickly enough?
3:58 One little test that can help is to take the amount of
4:03 capital expenditures that the firm is
4:07 engaging in through time--
4:09 the CAPEX is the short term for capital expenditures,
4:13 which is basically the acquisition
4:15 of long-term assets.
4:17 And compare that, through a couple of years, to the
4:21 depreciation in the profit and loss statement
4:24 or the income statement.
4:29 If you take a look at that--
4:30 if over say three or four years, this is running at
4:33 around one, that it means as assets are depreciating.
4:38 They're being replaced at a similar rate.
4:42 If it's less than one, the sign would be the firm's
4:45 depreciating the assets faster than what it's replacing them.
4:50 That may not be a bad thing, but it's certainly worthy of
4:54 further investigation.
4:56 We want to have assets in good condition, because assets
5:00 generate future income.
5:03 In the next topic, we'll look at the cash related to
5:05 financing activities.
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Module 3 - Topic 4: Cash Related to Financing
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0:09 So recall that the cash flow statement of a business is
0:11 made up of three main categories, the cash from the
0:14 core operations, the cash related to investment
0:17 activities, and the cash related to financing
0:20 activities.
0:21 In this topic we'll look more closely at the cash related to
0:25 financing activities.
0:26 And I'll show you how the cash flow statement can be used to
0:29 tell a story, probably much more than we can tell a story
0:34 by looking at a balance sheet or an income statement.
0:38 So the cash related to financing activities, this
0:41 reflects cash flows into the business, either by borrowing
0:45 money from banks or other parties or by raising funds
0:51 from the owners or shareholders.
0:53 That's cash into the business through funding.
0:56 Or it may be debt repayments, cash going out of the business
1:00 to pay off debt or to repay debt, or cash going back to
1:04 the shareholders or owners in the form of dividends or a buy
1:09 back of the equity of the business.
1:12 Now you may have heard me saying there that dividends
1:15 are included in the cash related to financing
1:18 activities.
1:20 And that's because the decision for a firm to pay a
1:23 dividend to its owners, in a sense, has
1:27 implications for financing.
1:29 If we take all of the profits of the firm this period and
1:33 pay it out as dividends to the owners, we
1:36 have no retained earnings.
1:37 And if we have no retained earnings, we have nothing to
1:40 finance growth tomorrow.
1:42 And so typically we'll have to go into the marketplace and
1:45 raise funds to finance growth.
1:48 So do you see how dividends, in a sense, are related to or
1:52 influence the financing decision of a business?
1:55 And also, dividends are discretionary.
1:57 There's no rule that says a firm has to pay a dividend to
2:00 its shareholders.
2:02 Of course, if it didn't pay a dividend to its shareholders
2:05 or owners, we might not expect them to stay around too long.
2:08 They'd probably sell their stake in the business to
2:10 somebody else.
2:12 Now let me show you how we can use the cash flow statement to
2:15 tell a story.
2:17 Suppose we have a business that pays a
2:18 dividend of $350 million.
2:22 Sounds large, but not for some large, publicly-listed firms.
2:27 And we want to ask the question, how did the firm
2:31 finance that dividend?
2:32 Where did the money come from?
2:34 And specifically, where did the cash come from to finance
2:38 that dividend?
2:39 So let's suppose that the cash flow statement of this
2:42 business, for the period that we're
2:44 measuring, tells us this.
2:47 The cash flow from the operations or operational
2:50 activities is positive $200 million.
2:55 Well, that's good, cash coming in from the core operations.
2:59 Suppose the cash flow related to investments or investment
3:03 activities turns out to be zero.
3:06 So any cash that came in from selling long-term assets has
3:10 been perfectly offset by cash going out to investing
3:14 long-term assets.
3:16 And then suppose the cash flow related to financing
3:19 activities shows a cash outflow of $230 million.
3:24 So there's the summarised cash flow statement for our
3:28 hypothetical business.
3:30 There's a deficit in cash of $30 million.
3:33 And that means this business will have had to drawn on its
3:38 cash reserves--
3:39 in other words, the money sitting in the bank account--
3:42 to be able to make that payment or to make up the
3:46 difference.
3:48 Now remember, this business paid a
3:50 dividend of $350 million.
3:55 So that means $350 million went out of the cash flow from
4:01 financing activities.
4:04 So that tells me immediately that in order for this
4:06 business to have paid that dividend, it didn't have
4:09 enough cash from operations.
4:11 It had to go into the marketplace and raise funds,
4:14 either from shareholders or perhaps from
4:17 banks and other creditors.
4:19 So how much in financing did the firm need to bring in?
4:23 Or to come up with the minus $230 here, this business
4:28 needed to borrow $120 million.
4:34 So I can conclude, by looking at the cash flow statement,
4:38 that while a dividend of $350 million is attractive, not all
4:43 of that came from the operations.
4:46 Some came from the core operations, but some also came
4:50 from outside financing.
4:52 Let's summarise that.
4:54 Here's how this firm paid its dividend of $350 million.
4:58 The cash flow from operations, $200 came from that.
5:05 For borrowings or debt, $120 came from that source or
5:14 perhaps raising funds from other shareholders.
5:17 Finally, drawing on the cash reserves of the business,
5:21 another $30 million.
5:23 That's how we ended up having enough money to pay the
5:26 dividend of $350 million.
5:31 So it's been a good performance.
5:34 Well, a firm can't keep doing this.
5:37 It can't keep borrowing money to pay dividends.
5:41 Paying high dividends makes the business look healthy.
5:44 It makes it look sound.
5:46 But remember, somebody else's money is being used to finance
5:49 this dividend.
5:50 Or perhaps the money came in from other shareholders.
5:53 And we really shouldn't expect other shareholders to finance
5:57 a dividend for the current shareholders.
6:00 Just one more thing here.
6:01 Drawing on the cash reserves is not
6:03 necessarily a bad thing.
6:05 If we have a lot of cash in the bank, it pays to give some
6:08 of that back to the shareholders if there's no
6:10 other profitable use for it.
6:12 My very last point on this, as you might recall, the cash
6:16 flow from investment activities.
6:19 We just go back with zero.
6:22 So this firm was not investing for the future.
6:25 And I just would ask the question, is the reason the
6:28 firm made no investments in non-current assets, was that
6:33 reflecting the fact that it needed to pay a
6:36 $350 million dividend?
6:39 And so it has put off some important capital expenditures
6:42 in order to satisfy shareholders
6:44 in the current period.
6:46 That's certainly a question worth asking.
6:48 So I hope you see, by this example that being able to
6:52 read a cash flow statement gives us an
6:55 x-ray into the business.
6:56 It tells us what the business did.
6:58 It helps us tell a story.
7:00 And good financial analysis is about being
7:03 able to tell a story.
7:05 In the next topic, we'll look at how the cash flow statement
7:09 can be used to tell a more complete picture of the
7:12 underlying performance of a business.
7:14 [MUSIC PLAYING]
Module 3 - Topic 4: Cash Related to Financing
File: DFHB MOD03 TOP04 v2

0:00 [MUSIC PLAYING]

0:09 So recall that the cash flow statement of a business is
0:11 made up of three main categories, the cash from the
0:14 core operations, the cash related to investment
0:17 activities, and the cash related to financing
0:20 activities.
0:21 In this topic we'll look more closely at the cash related to
0:25 financing activities.
0:26 And I'll show you how the cash flow statement can be used to
0:29 tell a story, probably much more than we can tell a story
0:34 by looking at a balance sheet or an income statement.
0:38 So the cash related to financing activities, this
0:41 reflects cash flows into the business, either by borrowing
0:45 money from banks or other parties or by raising funds
0:51 from the owners or shareholders.
0:53 That's cash into the business through funding.
0:56 Or it may be debt repayments, cash going out of the business
1:00 to pay off debt or to repay debt, or cash going back to
1:04 the shareholders or owners in the form of dividends or a buy
1:09 back of the equity of the business.
1:12 Now you may have heard me saying there that dividends
1:15 are included in the cash related to financing
1:18 activities.
1:20 And that's because the decision for a firm to pay a
1:23 dividend to its owners, in a sense, has
1:27 implications for financing.
1:29 If we take all of the profits of the firm this period and
1:33 pay it out as dividends to the owners, we
1:36 have no retained earnings.
1:37 And if we have no retained earnings, we have nothing to
1:40 finance growth tomorrow.
1:42 And so typically we'll have to go into the marketplace and
1:45 raise funds to finance growth.
1:48 So do you see how dividends, in a sense, are related to or
1:52 influence the financing decision of a business?
1:55 And also, dividends are discretionary.
1:57 There's no rule that says a firm has to pay a dividend to
2:00 its shareholders.
2:02 Of course, if it didn't pay a dividend to its shareholders
2:05 or owners, we might not expect them to stay around too long.
2:08 They'd probably sell their stake in the business to
2:10 somebody else.
2:12 Now let me show you how we can use the cash flow statement to
2:15 tell a story.
2:17 Suppose we have a business that pays a
2:18 dividend of $350 million.
2:22 Sounds large, but not for some large, publicly-listed firms.
2:27 And we want to ask the question, how did the firm
2:31 finance that dividend?
2:32 Where did the money come from?
2:34 And specifically, where did the cash come from to finance
2:38 that dividend?
2:39 So let's suppose that the cash flow statement of this
2:42 business, for the period that we're
2:44 measuring, tells us this.
2:47 The cash flow from the operations or operational
2:50 activities is positive $200 million.
2:55 Well, that's good, cash coming in from the core operations.
2:59 Suppose the cash flow related to investments or investment
3:03 activities turns out to be zero.
3:06 So any cash that came in from selling long-term assets has
3:10 been perfectly offset by cash going out to investing
3:14 long-term assets.
3:16 And then suppose the cash flow related to financing
3:19 activities shows a cash outflow of $230 million.
3:24 So there's the summarised cash flow statement for our
3:28 hypothetical business.
3:30 There's a deficit in cash of $30 million.
3:33 And that means this business will have had to drawn on its
3:38 cash reserves--
3:39 in other words, the money sitting in the bank account--
3:42 to be able to make that payment or to make up the
3:46 difference.
3:48 Now remember, this business paid a
3:50 dividend of $350 million.
3:55 So that means $350 million went out of the cash flow from
4:01 financing activities.
4:04 So that tells me immediately that in order for this
4:06 business to have paid that dividend, it didn't have
4:09 enough cash from operations.
4:11 It had to go into the marketplace and raise funds,
4:14 either from shareholders or perhaps from
4:17 banks and other creditors.
4:19 So how much in financing did the firm need to bring in?
4:23 Or to come up with the minus $230 here, this business
4:28 needed to borrow $120 million.
4:34 So I can conclude, by looking at the cash flow statement,
4:38 that while a dividend of $350 million is attractive, not all
4:43 of that came from the operations.
4:46 Some came from the core operations, but some also came
4:50 from outside financing.
4:52 Let's summarise that.
4:54 Here's how this firm paid its dividend of $350 million.
4:58 The cash flow from operations, $200 came from that.
5:05 For borrowings or debt, $120 came from that source or
5:14 perhaps raising funds from other shareholders.
5:17 Finally, drawing on the cash reserves of the business,
5:21 another $30 million.
5:23 That's how we ended up having enough money to pay the
5:26 dividend of $350 million.
5:31 So it's been a good performance.
5:34 Well, a firm can't keep doing this.
5:37 It can't keep borrowing money to pay dividends.
5:41 Paying high dividends makes the business look healthy.
5:44 It makes it look sound.
5:46 But remember, somebody else's money is being used to finance
5:49 this dividend.
5:50 Or perhaps the money came in from other shareholders.
5:53 And we really shouldn't expect other shareholders to finance
5:57 a dividend for the current shareholders.
6:00 Just one more thing here.
6:01 Drawing on the cash reserves is not
6:03 necessarily a bad thing.
6:05 If we have a lot of cash in the bank, it pays to give some
6:08 of that back to the shareholders if there's no
6:10 other profitable use for it.
6:12 My very last point on this, as you might recall, the cash
6:16 flow from investment activities.
6:19 We just go back with zero.
6:22 So this firm was not investing for the future.
6:25 And I just would ask the question, is the reason the
6:28 firm made no investments in non-current assets, was that
6:33 reflecting the fact that it needed to pay a
6:36 $350 million dividend?
6:39 And so it has put off some important capital expenditures
6:42 in order to satisfy shareholders
6:44 in the current period.
6:46 That's certainly a question worth asking.
6:48 So I hope you see, by this example that being able to
6:52 read a cash flow statement gives us an
6:55 x-ray into the business.
6:56 It tells us what the business did.
6:58 It helps us tell a story.
7:00 And good financial analysis is about being
7:03 able to tell a story.
7:05 In the next topic, we'll look at how the cash flow statement
7:09 can be used to tell a more complete picture of the
7:12 underlying performance of a business.
7:14 [MUSIC PLAYING]
Module 3 - Topic 5: Telling a cash flow story
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0:09 In the last topic, I showed you how we can use the cash
0:12 flow statement of a business to tell a story.
0:15 It gives us the underlying footprint of the business, or
0:18 an x-ray into the business.
0:20 Let's take that a step further in this topic by looking at
0:23 the actual cash flow statements and comparing them
0:26 for two firms that we focused on during these modules--
0:31 the retailer Woolworth's and the airline Qantas.
0:35 So what does this tell us about Woolworth's performance
0:37 during that period?
0:39 Well, it had $2.8 billion in cash flows coming in from the
0:44 core operations and invested $2.1 billion of that,
0:49 providing for the future.
0:51 So that leaves a surplus of $700 million.
0:54 And what did it do with that $700 million?
0:57 Well, if we look at the financing side, the cash flow
1:01 from financing activities, Woolworth's paid a dividend of
1:05 $1.3 billion.
1:08 That would make for some happy shareholders.
1:11 So it had $700 million surplus.
1:14 It paid $1.3 billion dollars as dividends.
1:18 So the difference was largely financed by a change in the
1:23 bank account of Woolworth's.
1:25 It dipped into its cash reserves.
1:27 Overall, a good performance.
1:29 It had a lot of surplus cash, $1.5 billion, so it was able
1:34 to easily make up that deficit, or that gap.
1:37 Notice, also, that Woolworth's borrowed $12.4 billion dollars
1:44 and repaid $12.8 billion dollars.
1:47 So we sometimes say that's debt refinancing.
1:50 It borrowed, or rolled over, existing debt--
1:54 it borrowed new money to pay off old money, keeping its
1:57 debt at about the same level.
2:01 Now take a look at Qantas.
2:04 A different story--
2:05 Quantas generated cash from its core
2:08 operations of $1.8 billion.
2:12 Now, that's lower than Woolworth's.
2:14 But notice that Woolworth's cash receipt from customers
2:17 was much larger than Qantas.
2:21 So actually, if we take some percentages in here, the
2:24 difference between the cash from operations, or the
2:27 percentage, I should say, of the cash from operations
2:29 relative to the cash receipts from the customers, in
2:33 Woolworth's is about 5%, whereas in
2:37 Qantas, it's about 11%--
2:43 1.8 into 16.7.
2:46 So while Qantas doesn't have as much cash coming in from
2:50 its customers, it has a very good level of cash from
2:54 operations.
2:56 And that reflects the larger margin business that Qantas is
2:59 relative to Woolworth's.
3:01 Remember Woolworth's--
3:02 lots of turnover, lots of sales, but smaller margins.
3:07 What else did Qantas do with it's money?
3:08 Well, it had $1.8 billion to invest.
3:11 And we see the number here, cash related to investment
3:14 activities, an outflow of $2.3 billion dollars.
3:18 So just like Woolworth's, Qantas invested in payments
3:23 for plants, property, and equipment.
3:26 And although Qantas has much lower level of cash receipts
3:29 from customers, you can see it's a
3:31 capital intensive business.
3:34 It's investing just as much in non-current assets, or
3:37 long-term assets, as Woolworth's does.
3:41 And that reflects the right thing to do for a business
3:44 such as Qantas that relies on aircraft in good condition.
3:50 Finally, with respect to Qantas, over on the financing
3:53 side, Qantas paid no dividend.
3:57 And partially, that was because the business didn't
3:59 make an accounting profit in that year.
4:03 So all up, Qantas made surplus cash from
4:08 operations of $1.8 billion.
4:10 It invested for the future $2.3 billion dollars.
4:14 It's short about $500 million, and it a made up the gap by
4:20 raising some funds and dipping into its cash reserves.
4:24 So two different firms, two different stories--
4:28 but stories that are relatively easy to tell when
4:32 you can read and interpret a cash flow statement.
4:36 In the next topic, I'll ask the question, what
4:39 is free cash flow?
Module 3 - Topic 6: What is Free Cash Flow?
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0:00 [MUSIC PLAYING]

0:08 In this topic, I'll explain to you the concept
0:12 of free cash flow.
0:14 Now, free cash flow doesn't appear in the financial
0:17 statements of a business.
0:18 It's something we need to extract from them.
0:21 But it's not hard to do.
0:23 And free cash flow is becoming an increasingly popular
0:27 measure in stock markets.
0:30 And the reason it's popular is it tells us how much cash over
0:36 a particular period a firm has available to pay its finances.
0:43 So how much cash is available to repay debt?
0:46 How much cash available to pay dividends to shareholders?
0:50 Or to repay some equity to shareholders?
0:54 And if there is plenty of free cash flow available to meet
0:57 debt obligations and dividend obligations, then we consider
1:01 that a firm is in a sound position.
1:05 The other key issue with respect to free cash flow is
1:10 it also takes into account any investments the firm is making
1:14 in its non-current assets.
1:16 And that's a good sign for somebody who's thinking about
1:19 the future of the business and how viable and
1:21 strong it will be.
1:23 Because we want to make sure the firm continues to invest
1:26 in its future by replacing depreciating assets, and by
1:29 buying new assets, and always investing in intangible assets
1:33 when necessary.
1:35 Building for the future.
1:37 So let's have a look at the free cash flow calculation.
1:40 And we'll have a look at it also for some of the firms
1:42 we've been examining.
1:44 So the free cash flow.
1:46 We take the cash flow from operations and we add to that
1:53 the cash flow related to investment activities.
1:57 And we end up with the free cash flow for the business for
2:01 the particular measurement period.
2:05 If a business has investments in the cash from investment
2:10 activities, then the free cash flow will be going down.
2:14 But that's not a bad thing, provided there's plenty of
2:16 cash coming in from the core operations.
2:20 So let's take a look at this for Woolworths, and we'll have
2:26 a look at this for Qantas.
2:30 So recently, Wallace had cash flow from
2:33 operations of $2.8 billion.
2:38 It invested $2.1 billion in non-current assets--
2:44 property and property development.
2:46 So that leads to free cash flow of $700 million.
2:52 Now, it turns out Woolworths paid a
2:54 dividend of $1.3 billion.
3:00 So it didn't have sufficient cash to pay that dividend.
3:03 So as we saw in a previous topic, it drew
3:06 into its cash reserves.
3:08 And what about Qantas over the same period?
3:12 Qantas generated cash from operations of $1.8 billion.
3:18 The good news is, Qantas was still
3:20 investing for the future.
3:22 $2.3 billion went out buying plant property and equipment,
3:27 essentially aircraft, leading to a deficit of $500 million.
3:35 Qantas didn't pay a dividend that year.
3:40 That was a decision of the senior executives in Qantas.
3:43 So how did it make up for this cash shortfall?
3:46 Well, we saw earlier that it borrowed at some funds and
3:50 drew on its cash reserves as well.
3:54 So the free cash flow for a business is something that we
3:56 can track over time to see how the business has been forming.
4:01 Let's do that for Woolworths.
4:03 So I have here around 10 years of recent data for Woolworths.
4:09 And he's what we see.
4:11 The cash flow from operations, the cash flow from investment
4:14 activities, leading to the free cash
4:19 flow for the business.
4:20 And when you look at the column for the free cash flow,
4:24 you'll see that in most periods, the free cash flow
4:26 for Woolworths was positive and remarkably consistent.
4:31 There were two periods here where
4:34 there were large negatives.
4:36 And the reason for those large negative free cash flows is
4:39 Woolworths was investing heavily for the future.
4:43 In fact, back at that time, Woolworths was acquiring other
4:46 businesses.
4:48 Is that a bad thing?
4:49 Not at all.
4:51 Because if we look a little bit later, we can see clearly
4:54 the cash from operations for Woolworths growing
4:57 significantly, much larger.
4:59 So these investments here produce these outcomes here.
5:04 This shows you again how cash flow statements
5:07 help me tell a story.
5:09 They present a footprint for the business and its
5:11 activities.
5:13 Woolworths free cash flow has remained remarkably
5:16 consistent.
5:17 And that's enabled Woolworths to pay a
5:19 strong and stable dividend.
5:23 In the next topic, we'll start to put into practise
5:27 everything we've covered so far in this subject.
Module 3 - Topic 7: Putting into Practice 1
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0:00 [MUSIC PLAYING]

0:08 In this topic, I'd like to start to put into practise a
0:12 lot of what we've covered and hopefully learned so far.
0:18 So I want to start by looking at the income
0:21 statement of a business.
0:23 It's a hypothetical business.
0:25 So take a look at the income statement on the screen.
0:29 Press pause, take a few minutes, jot down some points,
0:34 and then come back to me and see if my observations roughly
0:39 match yours.
1:00 So how did you go in reading the income
1:02 statement for the business?
1:05 There's not a lot we can say about it at this stage because
1:07 we can't see what it looked like last year or the preview
1:12 year, and we can't compare to other firms that are similar.
1:16 But there are some things that I've picked up and hopefully
1:19 you did too.
1:21 The first is, well, the firm's generating profit.
1:25 That's good news.
1:28 $14.8 million.
1:33 The only thing is, I can't tell whether that's enough.
1:38 Was it higher last period, and so it's falling?
1:42 Was it lower, and has it been rising?
1:45 How does it fit within the context of the economy?
1:49 Perhaps it's fallen, but every other business's profits have
1:52 been falling, and maybe this one didn't fall as much.
1:56 So do you see?
1:56 I can't look at profitability in isolation.
2:00 I do need to relate it back to the economy, competitors, and
2:05 other aspects of this firm's operations.
2:08 But I guess the good news is it is positive.
2:12 The other thing I notice is EBIT of $29 million and
2:20 interest of nearly $8 million.
2:25 That tells me that this firm is covering its interest
2:29 expense by its EBIT by a factor of around 3.7 times.
2:36 So in other words, for every dollar in interest, there's
2:38 about $3.70 in EBIT.
2:43 So it's covering its interest costs.
2:46 3 times?
2:47 4 times?
2:47 Is that enough?
2:49 Again, hard for me to tell.
2:51 It largely depends on how variable the firm's income and
2:54 hence its EBIT is.
2:56 If it was a mining company, and its cash flows and
3:00 profitability is highly variable, depending on
3:02 commodity prices, foreign exchange rates, demand in
3:06 China, then there might not be enough buffer there to be able
3:10 to make payments of interest out of
3:12 profits in future periods.
3:14 So again, I need context to be able to come to some
3:18 conclusions about the health of the business.
3:22 Its gross profit, $39 million.
3:25 That looks pretty good, but what's the
3:27 gross profit margin?
3:29 39 divided by 200 tells me the gross profit margin is around
3:37 19 and 1/2%.
3:40 That looks fine, but I have no benchmarks to compare that to.
3:44 It really does depend on what type of business this one is.
3:48 Finally, I notice, and I hope you did too, the business is
3:52 paying a dividend of $10 million.
3:54 That looks good.
3:56 But we learned in a previous topic we need to know how that
4:00 dividend was financed.
4:02 It could have come from the cash from operations, but it
4:05 may have come by the firm selling off assets or
4:09 borrowing money or some combination.
4:12 So we need to dig deeper.
4:16 Now take a few minutes to have a look at the balance sheet of
4:20 the firm over the last two periods.
4:23 Jot down some points, and let's see if we agree.
4:39 So I hope you jotted down some points after looking at the
4:41 balance sheet of the business between this
4:44 period and last period.
4:47 What did you notice?
4:48 Here are some of the things that I picked up.
4:50 First, the assets of the business have
4:53 risen from 160 to 178.
4:57 So I guess the business is growing in terms of its assets
5:00 and by $18 million.
5:03 Also, its cash has risen from $5 million to $7 million.
5:09 Good.
5:10 Assets are rising.
5:12 How did the firm finance those assets?
5:15 Well, if you look on the liabilities and equity side of
5:18 the balance sheet, we can see retained earnings went up by
5:23 $4.8 million.
5:26 So therefore, this firm, in order to finance that increase
5:29 in assets of $18 million, needed to borrow money.
5:34 And we can see here the firm's borrowed a substantial amount
5:38 of money, from $55 million debt outstanding the previous
5:42 year to $78.2 million debt outstanding this year.
5:47 So the firm has borrowed an additional $23.2 million.
5:54 You see that there's a difference there between the
5:57 funds that have been raised through retained earnings and
6:00 through debt and the growth in the assets.
6:04 And the reason for that, if you could just look in here,
6:08 the payables have gone down from $15
6:10 million to $5 million.
6:13 So, because this firm is paying back its suppliers
6:17 faster, it had to go and borrow money to make up the
6:20 difference and to finance its growth.
6:23 And again, that's an important lesson.
6:25 Credit from suppliers is very valuable to a business.
6:29 We don't want to pay our suppliers late.
6:31 That's not good for business.
6:33 It's not good for our reputation.
6:35 And it's not good from an ethical perspective.
6:37 But we do want to take advantage of as much credit
6:41 that's available to us as possible.
6:45 There are some important conclusions to draw from this.
6:47 If you take a look at the balance sheet of this
6:49 business, all of this growth has largely come by the firm
6:54 building up its current assets.
6:57 Its receivables are growing, and its inventory is growing.
7:02 The firm did buy some plant property and equipment, but
7:06 that's been completely offset by depreciation.
7:09 So what that means is that as the firm has depreciated its
7:12 assets, it's replaced them by a similar amount.
7:16 So I have here a firm that's raising a large amount of debt
7:21 to essentially finance a build up in current assets and to
7:26 make up for a decline in current liabilities.
7:30 That's an early warning sign.
7:32 It could point to inefficient management of the working
7:35 capital of the business, the day to day [? engine ?] room
7:38 in terms of the current assets, the receivables, and
7:41 the inventory, and the current liabilities, the payables.
7:47 One point for concern.
7:49 In the next topic, we'll have a look at this firm even
7:52 deeper by referring to its cash flow position.
7:55 [MUSIC PLAYING]
Module 3 - Topic 8: Putting into Practice 2
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0:08 In the last topic we were attempting to diagnose the
0:12 financial health of a hypothetical business.
0:16 And that business showed profits, the business was
0:20 paying dividends, and the assets were growing.
0:24 But we came to a conclusion that there may be some
0:26 underlying problems.
0:28 And in particular, the business had to raise a lot of
0:32 funds through debt.
0:34 Now we noticed a lot of that funding was to finance current
0:37 assets, short-term assets, finance receivables, waiting
0:42 for cash from our customers, or to finance stock which the
0:46 business hasn't sold yet.
0:49 The cash flow statement will help us get greater insight
0:54 into the performance of the business.
0:56 So have a look now on the screen at the cash flow
0:58 statement for this business.
1:00 Take a few minutes, jot down some points, and then let's
1:03 compare notes.
1:16 So did you see what I saw with his cash flow statement?
1:20 Something jumps out immediately.
1:23 And that is the cash from operations for the business is
1:27 negative, negative $1.2 million.
1:31 So this core--
1:33 the core operations of this business are sucking out more
1:36 cash than it's generating, to the tune of $1.2 million.
1:40 So you see, even though the business was profitable, $14.8
1:45 million in profits after tax, it has a negative cash from
1:49 operations.
1:51 And in a few moments we'll be able to see
1:52 what the problem is.
1:54 And no surprises, it's linked to that big buildup in current
1:58 assets, that poor management of working capital.
2:02 What did the firm do?
2:05 It was short $1.2 million.
2:07 But the cash flow statement tells us that it still
2:10 purchased $10 million in planned
2:13 property and equipment.
2:15 So if we refer back to an earlier topic, that means its
2:18 free cash flow would be minus 1.2; cash from operations,
2:26 minus 10; cash from investment activities--
2:30 so it's free cash flow--
2:32 minus 11.2.
2:35 And then notice, our firm still paid
2:37 dividends of $10 million.
2:40 So the firm's already short $11.2 million, in terms of
2:45 free cash flow.
2:46 And it's still paid a dividend of $10 million.
2:50 So the firm needed funding of at least $21.2 million.
2:58 It needed $21.2 million to finance all of its activities.
3:03 But did you notice, it borrowed $23.2 million.
3:09 So where did the extra $2 million go?
3:13 Well, the extra $2 million went into the bank account of
3:17 the business.
3:18 And so at the end the reporting period it appears to
3:21 be healthy with an increase in cash.
3:24 But by digging deeper into the cash flow statement, we are
3:27 finding a firm that has some cash flow difficulties.
3:32 So let's take a look at the reconciliation between the
3:35 profits of the business and the cash from operations to
3:39 the business to see where the source of the problems lie.
3:46 So here's the reconciliation.
3:48 So notice the business generated
3:51 profits of $14.8 million.
3:54 It's cash from operations,
3:56 unfortunately minus $1.2 million.
4:00 Why the gap?
4:02 Well, if we add back the depreciation--
4:04 remember, depreciation is a non-cash expense--
4:08 that tells us the cash profits of the
4:11 business were $24.8 million.
4:17 Where did all of that money go?
4:19 Well, here it is.
4:22 Working capital has sucked that cash back out.
4:26 The increase in receivables means we recorded revenue, but
4:31 we haven't received the cash, at least to
4:34 the tune of $10 million.
4:36 So we're waiting for our customers to pay.
4:40 The increase in inventory reflects a build up in
4:42 inventory of $6 million.
4:44 Now again, that might not be a bad thing if in the next
4:48 period the business expects a large increase in sales.
4:53 But if there's a downturn in the economy or if sales are
4:55 slow, we're caught with all of this stock.
4:58 And that stock can sink the business if it's sitting in a
5:02 warehouse, being funded with debt, and
5:05 not moving fast enough.
5:07 And finally, the business paid back its
5:10 suppliers more quickly.
5:13 Or perhaps it's suppliers weren't offering as much
5:16 credit as previously, and that could be a concern.
5:19 But either way, we interpret this $10 million was taken out
5:24 by paying back suppliers.
5:27 So I have $24.8 million in cash profits.
5:32 $26 million went out, with respect to the working capital
5:37 of the business, leaving a deficit of minus $1.2 million
5:42 in the cash from operations.
5:44 The business has some problems.
5:47 In the next topic, we'll look at the operating cash cycle
5:50 and apply it to this business and see what
5:53 inside it gives us.
Module 3 - Topic 9: Operating Cash Cycle
File: DFHB MOD03 TOP09 v2

0:08 Let's continue with our investigation of the

0:10 performance of that hypothetical firm that we
0:13 started looking at two topics ago.
0:17 We saw in the last topic that despite the firm being highly
0:20 profitable and paying a dividend and growing its
0:24 assets, the firm had negative cash from operations.
0:28 And we spotted a big build up in the current
0:32 assets of the business--
0:33 stock that wasn't moving and receivables that were
0:36 expanding, waiting for customers to pay.
0:40 And at the same time, the firm was paying back it supplies
0:43 faster, sucking cash out of the business.
0:46 The operating cash cycle of the business is a great tool.
0:50 It's easy to interpret and it can give us clues as to when a
0:54 firm is having trouble with its working capital or its
0:58 current assets less its current liabilities.
1:01 Here's what the operating cash cycle says.
1:05 Suppose out here, at this point, we buy a product and
1:15 then an amount of time passes, and
1:18 finally, we sell the product.
1:23 The amount of time between buying the product and selling
1:26 the product, we have that stock or product in inventory
1:31 on the balance sheet.
1:33 Maybe we didn't buy the product.
1:34 We might have manufactured the product.
1:36 But nonetheless, funds have been absorbed in the purchase
1:40 or the manufacture of the product.
1:43 If it was a service business, we're not manufacturing a
1:46 physical product, but we have employed people who are in the
1:49 business waiting to do work for the business.
1:52 So in a sense, there's a similar impact.
1:55 The period between buying and selling is the number of days
2:01 we have to wait while our cash is tied up in inventory.
2:07 And knowing that number and watching how that number
2:10 tracks could be very important in getting insight into the
2:14 management of working capital.
2:17 But there's more.
2:19 We sold the product at this point, but we haven't received
2:22 the cash yet.
2:24 So it may be way out here the right-hand side before we
2:28 actually receive the cash.
2:34 So do you recognise what the period between making the sale
2:37 is and receiving the cash?
2:40 Well, on the balance sheet, that's the period that our
2:43 funds are tied up in accounts receivable or receivables.
2:47 So the number of days between selling and receiving the cash
2:52 is commonly known as the days in receivables.
2:57 If we calculate the days in inventory and the days in
3:01 receivables, we come up with something called the furnace
3:05 operating cash cycle.
3:10 And we want that operating cash cycle to be as short as
3:13 possible because the longer that operating cash cycle is,
3:17 the more our funds are tied up.
3:19 And the more our funds are tied up or the longer they're
3:22 tied up, the more debt we need to make up the difference.
3:26 Or cash that could have been used elsewhere in the business
3:30 doing other profitable things is tied up supporting our
3:34 inventory and our receivables.
3:38 There's another side to this, though.
3:40 Although we might buy our product here, at this point on
3:44 the timeline, remember our suppliers may
3:48 give us some credit.
3:51 So although we buy the product here, we might actually pay
3:56 the cash here.
3:59 So this period between buying the product and paying the
4:03 cash you'll recognise is the period on the
4:07 balance sheet as payables.
4:09 And so this period in here we call the days in payables.
4:16 So the difference between the operating cash cycle and the
4:19 days in payables is really this period here--
4:25 the period between paying cash and finally receiving cash.
4:31 And this period in here between paying cash and
4:34 receiving cash represents our funding needs, or sometimes
4:39 called the funding gap.
4:43 The bigger the funding gap, the more debt that's needed to
4:46 finance the operations of the business.
4:49 If we're lazy with the management of our working
4:51 capital, the more debt the business will need and the
4:54 more interest it will have to say.
4:57 Now, in a later module, I'll come back to those actual
5:01 calculations.
5:02 But to conclude this topic, let's have a look and see what
5:05 these numbers are for the business that we've been
5:07 looking at.
5:10 So in this information here, we have the current position
5:15 for the business that we've been looking at.
5:17 So its revenue less it's cost of goods sold.
5:20 And we have the balance sheet-- the current balance
5:22 sheet for the business with cash,
5:23 receivables, and inventory.
5:25 So just its current assets.
5:27 I've also put in the previous revenue and cost of goods
5:31 sold-- something that you didn't get in the last topic--
5:34 and also it's previous balance sheet.
5:37 That's the information that we'll need to be able to
5:39 calculate the operating cash cycle and the funding gap.
5:46 Let's take a look here at what the numbers turn out to be.
5:50 So for the firm previously, its stock was
5:54 tied up for 47 days.
5:58 Having sold the product, it had to wait another 38 days
6:01 before it receives the cash.
6:03 So the operating cash cycle--
6:06 85 days.
6:09 Now, is that a long time?
6:10 Well, it depends on the business.
6:12 But what this means is it's taking almost three months
6:16 between buying a product or making a product and
6:19 eventually receiving the cash.
6:22 That will put strain on most businesses.
6:26 So in terms of the operating cash cycle, 85 days previously
6:31 and now 114 days.
6:33 We're waiting much longer to get our cash.
6:36 But we can take off the days payables, because that's the
6:38 period at which we're saving money
6:41 before we pay our suppliers.
6:44 And previously, we were paying them back within 35 days.
6:48 Now we're paying them back in only 11 days.
6:52 To net result--
6:53 a funding gap goes from 50 days, or nearly seven weeks,
6:58 to approximately 14 weeks.
7:03 Now we know why our firm needed so much debt.
7:07 We must address the poor management of working capital.
7:11 And we'll turn to issues such as this in our final module.
7:15 In the next topic, I'll sum up the main
7:18 points from this module.
Module 3 - Topic 10: Summing up the Statement of Cash
Flows
File: DFHB MOD03 TOP10 v2

0:08 So it's time for our last topic in this module.

0:11 And in this topic, I'll review the major issues around the
0:16 cash flow statement of a business
0:18 and the cash in general.
0:21 So first of all, recall the cash flow statement is made up
0:24 of three main categories.
0:27 The cash flow from the operational activities.
0:30 That's the cash that comes in from the core, the heart, the
0:34 soul of the business, the cash that reflects what it does.
0:39 And it's made up of two main items, the cash profits--
0:47 so we take out any non-cash items, like depreciation--
0:52 and the working capital of the business, the current assets
0:58 and the current liabilities.
1:00 And we've seen in previous examples the working capital
1:04 can absorb a lot of cash out of the operations if they're
1:07 not well managed.
1:09 Too much stock hurts, not enough stock hurts.
1:13 Getting the right mix is a sure sign of skilled
1:17 management.
1:18 The cash flow related to investment activities is next.
1:22 And that tells us how well the firm is
1:25 investing for the future.
1:28 What long-term assets is it buying?
1:31 Will those assets generate sufficient revenues, profits,
1:35 and cash flows in the future?
1:38 And recall that if a firm's depreciating its assets faster
1:41 than what it's investing in, there may be
1:44 problems down the track.
1:45 In fact, it could be a sign of problems even currently
1:47 because a firm's not in a position to be able to afford
1:50 to buy those new assets.
1:53 Finally, the cash flow related to financing activities.
1:58 And that tells us the cash in and out of the business
2:01 related to funding the business, so the cash that
2:05 comes in through debt or borrowings and equity and any
2:15 cash that goes out in the payment of dividends.
2:21 We can use the cash flow statement to see how dividends
2:24 are financed just by rearranging these items.
2:29 Recall, also, that the cash flow from operations and the
2:33 cash related to investment activities give me the free
2:37 cash flow of the business.
2:40 And the free cash flow of the business tells me the extent
2:43 to which the firm can meet its obligations for financing, for
2:49 its debt holders or borrowers--
2:51 or lenders, I should say--
2:53 and to the shareholders, and also meet
2:56 its dividend payments.
2:59 A couple of other quick things that we
3:00 looked at in that module.
3:04 We also took a look at the concept of the operating cash
3:07 cycle of the business.
3:10 And the operating cash cycle of the business is, how long
3:13 do we wait between buying a product or manufacturing a
3:18 product and actually receiving the cash flows?
3:23 So we look at the days in receivables and the days in
3:28 inventory, and we have the operating cash cycle.
3:32 And I will show you in a later module how to
3:35 calculate those things.
3:38 We take away from that the days in payables, so how long
3:42 it's taking us before we pay our suppliers, and we get the
3:47 funding gap of the business.
3:50 The funding gab tells us how much debts needed to be able
3:54 to support the operations of the business in terms of the
3:57 management of the business's working capital.
4:02 That concludes this topic and module, and I look forward to
4:06 seeing you in our last module which shows us how to closely
4:12 pull apart the performance of a business and reach some
4:15 conclusions about its future.