Fundamental concepts in financial analysis

Cash flows

Let’s consider, for example, the monthly account statement that individual customers receive from their bank. It is presented as a series of lines showing the various inflows and outflows of money on precise dates and in some cases the type of transaction (deposit of cheques, for instance).

Our first step is to trace the rationale for each of the entries on the statement, which could be everyday purchases, payment of a salary, automatic transfers, loan repayments or the receipt of bond coupons, to cite but a few examples.

The corresponding task for a financial manager is to reclassify company cash flows by category to draw up a cash flow document that can be used to:

• analyse past trends in cash flow (generally known as a cash flow statement1); or
• project future trends in cash flow, over a shorter or longer period (known as a cash flow budget or plan).

With this goal in mind, we will now demonstrate that cash flows can be classified as one of the following processes:

Activities that form part of the industrial and commercial life of a company:

• operating cycle;
• investment cycle.

Financing activities to fund these cycles:

• the debt cycle;
• the equity cycle.

The importance of the operating cycle

Let’s take the example of a greengrocer, who is ‘‘cashing up’’ one evening. What does he find? First, he sees how much he spent in cash at the wholesale market in the morning and then the cash proceeds from fruit and vegetable sales during the day. If we assume that the greengrocer sold all the produce he bought in the morning at a mark-up, the balance of receipts and payments for the day will deliver a cash surplus.

Unfortunately, things are usually more complicated in practice. Rarely is all the produce bought in the morning sold by the evening, especially in the case of a manufacturing business.

A company processes raw materials as part of an operating cycle, the length of which varies tremendously, from a day in the newspaper sector to 7 years in the cognac sector. There is thus a time lag between purchases of raw materials and the sale of the corresponding finished goods.

And this time lag is not the only complicating factor. It is unusual for companies to buy and sell in cash. Usually, their suppliers grant them extended payment periods, and they in turn grant their customers extended payment periods. The money received during the day does not necessarily come from sales made on the same day.

As a result of customer credit, supplier credit and the time it takes to manufacture and sell products or services, the operating cycle of each and every company spans a certain period, leading to timing differences between operating outflows and the corresponding operating inflows.

Each business has its own operating cycle of a certain length that, from a cash flow standpoint, may lead to positive or negative cash flows at different times. Operating outflows and inflows from different cycles are analysed by period, e.g., by month or by year. The balance of these flows is called operating cash flow. Operating cash flow reflects the cash flows generated by operations during a given period.

In concrete terms, operating cash flow represents the cash flow generated by the company’s day-to-day operations. Returning to our initial example of an individual looking at his bank statement, it represents the difference between the receipts and normal outgoings, such as on food, electricity and car maintenance costs.

Naturally, unless there is a major timing difference caused by some unusual circumstances (start-up period of a business, very strong growth, very strong seasonal fluctuations), the balance of operating receipts and payments should be positive.

Investment and operating outflows

Let’s return to the example of our greengrocer, who now decides to add frozen food to his business. The operating cycle will no longer be the same. The greengrocer may, for instance, begin receiving deliveries once a week only and will therefore have to run much larger inventories. Admittedly, the impact of the longer operating cycle due to much larger inventories may be offset by larger credit from his suppliers. The key point here is to recognise that the operating cycle will change. The operating cycle is different for each business and, generally speaking, the more sophisticated the end product, the longer the operating cycle. But, most importantly, before he can start up this new activity, our greengrocer needs to invest in a freezer chest.

What difference is there from solely a cash flow standpoint between this investment and operating outlays?

The outlay on the freezer chest seems to be a prerequisite. It forms the basis for a new activity, the success of which is unknown. It appears to carry higher risks and will be beneficial only if overall operating cash flow generated by the greengrocer increases. Lastly, investments are carried out from a long-term perspective and have a longer life than that of the operating cycle. Indeed, they last for several operating cycles, even if they do not last for ever given the fast pace of technological progress. This justifies the distinction, from a cash flow perspective, between operating and investment outflows.

Normal outflows, from an individual’s perspective, differ from an investment outflow in that they afford enjoyment, whereas investment represents abstinence. As we will see, this type of decision represents one of the vital underpinnings of finance. Only the very puritan-minded would take more pleasure from buying a microwave oven than from spending the same amount of money at a restaurant! One of these choices can only be an investment and the other an ordinary outflow. So what purpose do investments serve? Investment is worthwhile only if the decision to forgo normal spending, which gives instant pleasure, will subsequently lead to greater gratification.

From a cash flow standpoint, an investment is an outlay that is subsequently expected to increase operating cash flow such that overall the individual will be happy to have forsaken instant gratification. This is the definition of the return on investment (be it industrial or financial) from a cash flow standpoint.

Like the operating cycle, the investment cycle is characterised by a series of inflows and outflows. But the length of the investment cycle is far larger than the length of the operating cycle. The purpose of investment outlays (also frequently called capital expenditures) is to alter the operating cycle; e.g., to boost or enhance the cash flows that it generates.

The impact of investment outlays is spread over several operating cycles. Financially, capital expenditures are worthwhile only if inflows generated thanks to these expenditures exceed the required outflows by an amount yielding at least the return on investment expected by the investor. Note also that a company may sell some assets in which it has invested in the past. For instance, our greengrocer may decide after several years to trade in his freezer for a larger model. The proceeds would also be part of the investment cycle.

Free cash flow

Before-tax free cash flow is defined as the difference between operating cash flow and capital expenditure net of fixed assets disposals.

Operating cash flow is a concept that depends on how expenditure is classified between operating and investment outlays. Since this distinction is not always clearcut, operating cash flow is not widely used in practice, with free cash flow being far more popular. If free cash flow turns negative, additional financial resources will have to be raised to cover the company’s cash flow requirements.