1986 8.8% 6.4% 1.51 8.1% 0.9% 0.65 1.9%
1987 11.6% 7.4% 1.52 9.8% 2.7% 0.69 4.7%
1988 13.5% 8.2% 1.42 10.0% 3.7% 0.93 5.9%
1989 12.5% 8.1% 1.40 9.5% 2.9% 1.03 5.3%
1990 10.4% 7.1% 1.42 8.3% 1.9% 1.06 3.3%
1991 6.5% 5.7% 1.41 6.3% 0.1% 1.01 ÔÇ“0.5%
1992 3.1% 3.9% 1.49 4.2% ÔÇ“1.3% 1.03 ÔÇ“4.0%
1993 6.8% 4.9% 1.51 5.9% 0.8% 1.00 ÔÇ“0.2%
1994 12.9% 6.7% 1.57 9.1% 4.0% 0.92 6.3%
1995 11.7% 6.3% 1.58 8.5% 3.3% 0.93 4.8%
1996 13.7% 7.1% 1.56 9.7% 4.7% 0.85 7.6%
1997 12.9% 6.7% 1.55 9.1% 4.2% 0.88 6.9%
1998 13.7% 7.0% 1.45 8.9% 4.4% 0.93 7.9%
Average 11.2% 6.7% 1.56 9.0% 2.7% 0.80 4.6%
Source: Financial statement data for all non´¬ünancial companies publicly traded in the U.S., listed in the Compustat ´¬üles.
CASH FLOW ANALYSIS
Ratio analysis discussed above focused on analyzing a ´¬ürmÔÇ™s income statement (net
pro´¬üt margin analysis) or its balance sheet (asset turnover and ´¬ünancial leverage). The
analyst can get further insights into the ´¬ürmÔÇ™s operating, investing, and ´¬ünancing policies
by examining its cash ´¬‚ows. Cash ´¬‚ow analysis also provides an indication of the quality
of the information in the ´¬ürmÔÇ™s income statement and balance sheet. As before, we will
illustrate the concepts discussed in this section using NordstromÔÇ™s and TJXÔÇ™s cash ´¬‚ows.
Cash Flow and Funds Flow Statements
All U.S. companies are required to include a statement of cash ´¬‚ows in their ´¬ünancial
statements under Statement of Financial Accounts Standard No. 95 (SFAS 95). In the
9-23 Part 2 Business Analysis and Valuation Tools
reported cash ´¬‚ow statement, ´¬ürms classify their cash ´¬‚ows into three categories: cash
´¬‚ow from operations, cash ´¬‚ow related to investments, and cash ´¬‚ow related to ´¬ünancing
activities. Cash ´¬‚ow from operations is the cash generated by the ´¬ürm from the sale of
goods and services after paying for the cost of inputs and operations. Cash ´¬‚ow related
to investment activities shows the cash paid for capital expenditures, intercorporate in-
vestments, acquisitions, and cash received from the sales of long-term assets. Cash ´¬‚ow
related to ´¬ünancing activities shows the cash raised from (or paid to) the ´¬ürmÔÇ™s stock-
holders and debt holders.
Firms use two cash ´¬‚ow statement formats: the direct format and the indirect format.
The key difference between the two formats is the way they report cash ´¬‚ow from oper-
ating activities. In the direct cash ´¬‚ow format, which is used by only a small number of
´¬ürms in practice, operating cash receipts and disbursements are reported directly. In the
indirect format, ´¬ürms derive their operating cash ´¬‚ows by making adjustments to net in-
come. Because the indirect format links the cash ´¬‚ow statement with the ´¬ürmÔÇ™s income
statement and balance sheet, many analysts and managers ´¬ünd this format more useful.
As a result, the FASB required ´¬ürms using the direct format to report operating cash
´¬‚ows in the indirect format as well.
Recall from Chapter 3 that net income differs from operating cash ´¬‚ows because rev-
enues and expenses are measured on an accrual basis. There are two types of accruals
embedded in net income. First, there are current accruals like credit sales and unpaid ex-
penses. Current accruals result in changes in a ´¬ürmÔÇ™s current assets (such as accounts re-
ceivable, inventory, prepaid expenses) and current liabilities (such as accounts payable
and accrued liabilities). The second type of accruals included in the income statement is
noncurrent accruals such as depreciation, deferred taxes, and equity income from uncon-
solidated subsidiaries. To derive cash ´¬‚ow from operations from net income, adjust-
ments have to be made for both these types of accruals. In addition, adjustments have to
be made for nonoperating gains included in net income such as pro´¬üts from asset sales.
Most ´¬ürms outside the U.S. report a funds ´¬‚ow statement rather than a cash ´¬‚ow
statement of the type described above. Prior to SFAS 95, U.S. ´¬ürms also reported a sim-
ilar statement. Funds ´¬‚ow statements show working capital ´¬‚ows, not cash ´¬‚ows. It is
useful for analysts to know how to convert a funds ´¬‚ow statement into a cash ´¬‚ow
Funds ´¬‚ow statements typically provide information on a ´¬ürmÔÇ™s working capital from
operations, de´¬üned as net income adjusted for noncurrent accruals, and gains from the
sale of long-term assets. As discussed above, cash ´¬‚ow from operations essentially in-
volves a third adjustment, the adjustment for current accruals. Thus, it is relatively
straightforward to convert working capital from operations to cash ´¬‚ow from operations
by making the relevant adjustments for current accruals related to operations.
Information on current accruals can be obtained by examining changes in a ´¬ürmÔÇ™s
current assets and current liabilities Typically, operating accruals represent changes in
all the current asset accounts other than cash and cash equivalents, and changes in all the
current liabilities other than notes payable and the current portion of long-term debt.9
Cash from operations can be calculated as:
340 Financial Analysis
Working capital from operations
Ôł’ Increase (or + decrease) in accounts receivable
Ôł’ Increase (or + decrease) in inventory
Ôł’ Increase (or + decrease) in other current assets excluding cash and cash equivalents
+ Increase (or Ôł’ decrease) in accounts payable
+ Increase (or Ôł’ decrease) in other current liabilities excluding debt.
Funds ´¬‚ow statements also often do not classify investment and ´¬ünancing ´¬‚ows. In
such a case, the analyst has to classify the line items in the funds ´¬‚ow statement into
these two categories by evaluating the nature of the business transactions that give rise
to the ´¬‚ow represented by the line items.
Analyzing Cash Flow Information
Cash ´¬‚ow analysis can be used to address a variety of questions regarding a ´¬ürmÔÇ™s cash
ÔÇó How strong is the firmÔÇ™s internal cash flow generation? Is the cash flow from oper-
ations positive or negative? If it is negative, why? Is it because the company is
growing? Is it because its operations are unprofitable? Or is it having difficulty
managing its working capital properly?
ÔÇó Does the company have the ability to meet its short-term financial obligations, such
as interest payments, from its operating cash flow? Can it continue to meet these
obligations without reducing its operating flexibility?
ÔÇó How much cash did the company invest in growth? Are these investments consis-
tent with its business strategy? Did the company use internal cash flow to finance
growth, or did it rely on external financing?
ÔÇó Did the company pay dividends from internal free cash flow, or did it have to rely
on external financing? If the company had to fund its dividends from external
sources, is the companyÔÇ™s dividend policy sustainable?
ÔÇó What type of external financing does the company rely on? Equity, short-term debt,
or long-term debt? Is the financing consistent with the companyÔÇ™s overall business
ÔÇó Does the company have excess cash flow after making capital investments? Is it a
long-term trend? What plans does management have to deploy the free cash flow?
While the information in reported cash ´¬‚ow statements can be used to answer the
above questions directly in the case of some ´¬ürms, it may not be easy to do so always
for a number of reasons. First, even though SFAS 95 provides broad guidelines on the
format of a cash ´¬‚ow statement, there is still signi´¬ücant variation across ´¬ürms in how
cash ´¬‚ow data are disclosed. Therefore, to facilitate a systematic analysis and compari-
son across ´¬ürms, analysts often recast the information in the cash ´¬‚ow statement using
their own cash ´¬‚ow model. Second, ´¬ürms include interest expense and interest income
9-25 Part 2 Business Analysis and Valuation Tools
in computing their cash ´¬‚ow from operating activities. However, these two items are not
strictly related to a ´¬ürmÔÇ™s operations. Interest expense is a function of ´¬ünancial leverage,
and interest income is derived from ´¬ünancial assets rather than operating assets. There-
fore, it is useful to restate the cash ´¬‚ow statement to take this into account.
Analysts use a number of different approaches to restate the cash ´¬‚ow data. One such
model is shown in Table 9-11. This presents cash ´¬‚ow from operations in two stages.
The ´¬ürst step computes cash ´¬‚ow from operations before operating working capital in-
vestments. In computing this cash ´¬‚ow, the model excludes interest expense and interest
income. To compute this number starting with a ´¬ürmÔÇ™s net income, an analyst adds back
three types of items: (1) after-tax net interest expense because this is a ´¬ünancing item
that will be considered later, (2) nonoperating gains or losses typically arising out of as-
set disposals or asset write-offs because these items are investment related and will be
considered later, and (3) long-term operating accruals such as depreciation and deferred
taxes because these are noncash operating charges.
Several factors affect a ´¬ürmÔÇ™s ability to generate positive cash ´¬‚ow from operations.
Healthy ´¬ürms that are in a steady state should generate more cash from their customers
than they spend on operating expenses. In contrast, growing ´¬ürms, especially those in-
vesting cash in research and development, advertising and marketing, or building an or-
ganization to sustain future growth, may experience negative operating cash ´¬‚ow. FirmsÔÇ™
working capital management also affects whether they generate positive cash ´¬‚ow from
operations. Firms in the growing stage typically invest some cash ´¬‚ow in operating
working capital items like accounts receivable, inventories, and accounts payable. Net
investments in working capital are a function of ´¬ürmsÔÇ™ credit policies (accounts receiv-
able), payment policies (payables, prepaid expenses, and accrued liabilities), and ex-
pected growth in sales (inventories). Thus, in interpreting ´¬ürmsÔÇ™ cash ´¬‚ow from
operations after working capital, it is important to keep in mind their growth strategy,
industry characteristics, and credit policies.
The cash ´¬‚ow analysis model next focuses on cash ´¬‚ows related to long-term invest-
ments. These investments take the form of capital expenditures, intercorporate invest-
ments, and mergers and acquisitions. Any positive operating cash ´¬‚ow after making
operating working capital investments allows the ´¬ürm to pursue long-term growth
opportunities. If the ´¬ürmÔÇ™s operating cash ´¬‚ows after working capital investments are not
suf´¬ücient to ´¬ünance its long-term investments, it has to rely on external ´¬ünancing to fund
its growth. Such ´¬ürms have less ´¬‚exibility to pursue long-term investments than those that
can fund their growth internally. There are both costs and bene´¬üts from being able to fund
growth internally. The cost is that managers can use the internally generated free cash ´¬‚ow
to fund unpro´¬ütable investments; such wasteful capital expenditures are less likely if man-
agers are forced to rely on external capital suppliers. Reliance on external capital markets
may make it dif´¬ücult for managers to undertake long-term risky investments if it is not easy
to communicate to the capital markets the bene´¬üts from such investments.
Any excess cash ´¬‚ow after these long-term investments is free cash ´¬‚ow that is avail-
able for both debt holders and equity holders. Payments to debt holders include interest
payments and principal payments. Firms with negative free cash ´¬‚ow have to borrow
342 Financial Analysis
Table 9-11 Cash Flow Analysis
Nordstrom Nordstrom TJX1
Line Item 1998 1997 1998
Net income (dollars in millions) 206.7 186.2 420.6
After-tax net interest expense (income) 30.6 22.3 1.1
Nonoperating losses (gains) ÔÇ” ÔÇ” 6.0
Long-term operating accruals 186.7 156.9 139.3
Operating cash ´¬‚ow before working
capital investments 424.0 365.4 567.0
Net (investments in) or liquidation of operating
working capital 199.1 (45.0) 73.3
Operating cash ´¬‚ow before investment in
long-term assets 623.1 320.4 640.3
Net (investment in) or liquidation of operating
long-term assets (259.3) (257.7) (198.3)
Free cash ´¬‚ow available to debt and equity 363.8 62.7 442
After-tax net interest (expense) or income (30.6) (22.3) (1.1)
Net debt (repayment) or issuance 258.1 140.4 (23.4)
Free cash ´¬‚ow available to equity 591.3 180.8 417.5
Dividend (payments) (44.1) (41.2) (38.1)
Net stock (repurchase) or issuance (330.6) (143.1) (322.6)
Net increase (decrease) in cash balance 216.6 (3.5) 56.8
additional funds to meet their interest and debt repayment obligations, or cut some of
their investments in working capital or long-term investments, or issue additional equity.
This situation is clearly ´¬ünancially risky for the ´¬ürm.
Cash ´¬‚ow after payments to debt holders is free cash ´¬‚ow available to equity holders.
Payments to equity holders consist of dividend payments and stock repurchases. If ´¬ürms
pay dividends despite negative free cash ´¬‚ow to equity holders, they are borrowing
money to pay dividends. While this may be feasible in the short term, it is not prudent
for a ´¬ürm to pay dividends to equity holders unless it has a positive free cash ´¬‚ow on a
sustained basis. On the other hand, ´¬ürms that have a large free cash ´¬‚ow after debt pay-
ments run the risk of wasting that money on unproductive investments to pursue growth
for its own sake. An analyst, therefore, should carefully examine the investment plans of
The model in Table 9-11 suggests that the analyst should focus on a number of cash
´¬‚ow measures: (1) cash ´¬‚ow from operations before investment in working capital and
interest payments, to examine whether or not the ´¬ürm is able to generate a cash surplus
from its operations, (2) cash ´¬‚ow from operations after investment in working capital, to
assess how the ´¬ürmÔÇ™s working capital is being managed and whether or not it has the
´¬‚exibility to invest in long-term assets for future growth, (3) free cash ´¬‚ow available to
9-27 Part 2 Business Analysis and Valuation Tools
debt and equity holders, to assess a ´¬ürmÔÇ™s ability to meet its interest and principal pay-
ments, and (4) free cash ´¬‚ow available to equity holders, to assess the ´¬ürmÔÇ™s ´¬ünancial
ability to sustain its dividend policy and to identify potential agency problems from ex-
cess free cash ´¬‚ow. These measures have to be evaluated in the context of the companyÔÇ™s
business, its growth strategy, and its ´¬ünancial policies. Further, changes in these mea-
sures from year to year provide valuable information on the stability of the cash ´¬‚ow
dynamics of the ´¬ürm.
Key Analysis Questions
The cash ´¬‚ow model in Table 9-11 can be also used to assess a ´¬ürmÔÇ™s earnings