investment banking internship class the cash flow statement and macro

Investment Banking Internship Class

The Cash Flow Statement

and Macro

Objectives

A. Understand how to evaluate financial statement quality

B. Understand the importance of the Cash Flow Statement. Can we forecast it as well? Follow the money!

C. Understand how to write the cash flow balancing macro

A. Understand How to Evaluate Financial Statement Quality

What are quality financial statements?• A good reflection of reality

• Statements do not have gimmicks which:

• Overstate assets

• Understate liabilities (Worldcom)

• Make the firm appear stronger than it really is

• Make the firm pay more taxes than it should

Quality Balance Sheets

Quality Balance Sheets:• Use debt conservatively, so they have unused

borrowing capacity for emergencies• Tangible and intangible assets that have a market

value greater than their book value, showing that the firm has invested wisely

Concerns exist when:• Have outdated equipment, technologically inferior

assets or non-performing assets which must be written off

• Have off-balance-sheet liabilities of loan commitments or guarantees to subsidiaries which are not documented correctly (Enron)

Quality Income Statements

Quality Income Statements:• Have high quality earnings which are repeatable

and where customers are expected to continue to do business with the firm

• Use conservative accounting principles which do not overstate revenues, and which recognize revenues using the most conservative method

Concerns exist when:• Earnings are one-time non-recurring items such as

accounting charges, mergers, asset sales, etc.• Earnings recognition is not consistent with cash

flows or common sense

Quality Cash Flow Statements

Quality Cash Flow Statements:• Are accurate and cover the key areas of the

company

• Tell the story correctly, and don’t hide key information

• Show that most of the cash comes from operations

Concerns exist when:• They are generating insufficient cash for the future

• They have discontinued operations or other operations that were not successful

Questions

Any questions on quality financial statements?

B. Understand the Importance of the Cash Flow Statement. Follow the Money!

Understand the Cash Flow Statement• As an analyst, you must understand the sources and

uses of a company's cash

• Why?

• It tells how much money the company is producing by doing what it does: selling soda, writing software, etc.

• It gives a full understanding of a company's cash position on a cash basis—what they are doing and how they are doing it

• Three Key Areas:

• Operations, Financing, and Investing

Cash Flow from Operations

• Starts with net income• Makes adjustments to convert the net income

figure to a cash basis from an accrual basis• Net income doesn’t represent actual cash that’s

at a company’s disposal, but accruals• Receivables, for example, have yet to be

collected, but are considered income• Why Accrual Accounting?

• Accrual accounting is often a better reflection of economic reality than cash accounting, as it matches revenues with costs• However, cash accounting is a check.

Cash Flow from Operations (continued)

• What does it include?• Changes in working capital

• Current assets and liabilities such as receivables, inventory, and payables

• Adjustments for non-cash charges

• Depreciation, amortization, etc.

• Adjustments for non-operating gains/losses

• Investment gains, gains on sale of equipment

• On the whole, it gives us a pretty good idea what kind of cash a company is producing

Cash Flow from Investing

• What does it include?• Inflows and outflows related to the purchase or

sale of investments, property, plant, and equipment.

• Outflows relating to maintaining its equipment, expanding its plants, buying additional land, etc.

• Note: All companies invest. The question is how much! Use the historical cash flows from the historical CF statement as an indicator of future cash flows

Cash Flow from Financing

• What does it include?• Inflows and outflow related to how much the

company spent or collected from the sale or repurchase of stock, the issuance or retirement of debt, and the payment of dividends.

• In short, if the company is raising equity capital, borrowing money, or paying it back, this section will tell us so.

Putting the Cash Flow Statement to Work

• Watch:• “Net cash provided by (used in): operations,

investing, or financing”

• It's impossible to overstate the importance of these line items.

• Sum them up, and you'll know how much cash a company gained or lost over a given accounting period.

Forecasting Cash Flows

• Build a simplified Cash Flow Statement• The key is to cover every line of your Balance

Sheet

• Check on Cash: (CFO+CFF+CFI)

• Beginning Cash (end previous year)

• Ending Cash (end current year)

• Change in Cash (the cash used during the year)

• Difference: (this should add to zero)

• Note: You will have to change your cash manually in Excel (either by adding/subtracting cash or adding/subtracting long-term debt—no formulas) or write a cash flow macro

Forecasting Cash Flows (continued)

The simplified Cash Flow Statement• You do not have to forecast all 200 lines of the

historical Cash Flow Statement

• We look only at the difference between every line item of this year and last year’s balance sheet

• An increase in assets, i.e. a purchase, is a use of cash

• An increase in liabilities, i.e. more accounts payable, is a source of cash

• Make sure you include every line of the Balance Sheet


Cash Flow from Operations:• Net Profit

• Depreciation and Amortization (Historical from CFS, forecast is the difference in Accumulated Depreciation (CY-PY)

• Change in Current Assets less cash (PY-CY)

• Change in Current Liabilities (CY-PY)

• Other cash flows (calculated difference only for historical)

• Note:

• PY = Previous Year’s forecast

• CY is current year forecast


Cash Flow from Financing• Dividends Paid (from Financial Statements)

• Historical from cash flow, forecast from forecasts

• Change in Long-Term Liabilities (CY-PY)

• Change in Share. Equity – Retained Earnings (CY-PY)

• Other flows from financing (calculated difference for historical only)


Cash Flow from Investing• Change in Gross fixed assets PP&E (PY-CY)

• Change in remaining LT Assets (PY-CY)

• Other cash flows from investing (calculated difference for historical only)

• Cash flow from investing (from CFS)


Are you really forecasting the Cash Flow Statement?• No. What you are really doing is forecasting each

line item in the balance sheet and income statement

• Your cash flow statement is really just determining the impact of your assumptions regarding your balance sheet and income statement

• It is making sure your cash balances

• It is so much easier this way—take my word

Questions?

• Do we understand the cash flow statement and its implications?

• Do we understand how to forecast the cash flow statement?

C. Write the Balance Cash Flow Macro

What are macros?• Macros are analyst-written programs that perform

the same function each time Why are they helpful?

• Because you can automate your work

• It is important that you learn macros so that you can save time doing things over and over again

Balance Cash Flow Macro (continued)

What are we doing?• What you are doing is imbedding five goal seek

actions within a single macro. • The goal seek macro sets the difference between the

Assets and Liabilities and Owners Equity to zero by changing cash or debt, your plug figure.

How to we write the macro?• Record the macro, where Excel records each of your

commands, and writes the macro as you go. That is probably the easiest way to perform this activity.

• Write (or copy) the macro and change it for your company spreadsheet


How do you record the macro?• Click on Tools, Macro, Record New Macro. In

the box for Macro Name, type “Balance,” and then in the Shortcut Key hit “Shift” and type “B” and OK.

• Go to the row and column of the “Check on Balance Sheet” which shows where the balance sheet is out of balance. Click on the first cell of the “Check on Balance Sheet” row. Then click on Tools, then Goal Seek.

• The “Set Cell”, should be your difference between your assets and liabilities cell, the “To Value”, set to zero, and then in the “By changing cell” type the cell of Cash for that year. Then click OK.


After you have clicked OK, it should, through iterations, solve for cash. You are asking it to increase or decrease cash in order to make your assets equal your liabilities and owners equity. • After you have completed the first year, move

right one space and click the same Goal Seek again for each of your forecast years.


What about negative cash?

• If your cash is negative, you cannot have negative cash. In this case, you would increase long-term debt, then re-run the macro. If you continue to have negative cash, continue adding long-term debt until you get a positive cash number.

• If not, add more debt. Note: If your company had a year-end that has

passed, i.e. it is May and your company’s year-end is April, you will have 6 years of forecasts as the company is not required by the SEC to report its financial statements for 90 days after the end of the fiscal year.


The other method is to copy the macro• Go to Tools, Macro, Macro, and type in the word

“Balance,” then Create. The copy the following:• ' Keyboard Shortcut: Ctrl+Shift+B'

• Range(“o104").GoalSeek Goal:=0, ChangingCell:=Range(“o58")

• Range(“p104").GoalSeek Goal:=0, ChangingCell:=Range(“p58")

• Range(“q104").GoalSeek Goal:=0, ChangingCell:=Range(“q58")

• Range(“r104").GoalSeek Goal:=0, ChangingCell:=Range(“r58")

• Range(“s104").GoalSeek Goal:=0, ChangingCell:=Range(“s58")

Then change the range names to fit your balance sheet. In the above macro, row 92 was the difference between assets and shareholders equity and liabilities, and row 59 was the row for cash.


Why do this?

• Every time you change an assumption, you change your financial statements

• For example, when cash changes, it changes interest income, which changes net income, which changes retained earnings, which changes shareholders equity, which changes Liabilities and Shareholders Equity.

• Each time you change your financial statements you must rebalance your cash

• This macro saves lots of time.• Note that for the macro to work, you cannot have a formula

in the Cash line of your balance sheet. It must be a number.

Review of Objectives

A. Do you understand how to evaluate financial statement quality?

B. Do you understand the importance of the Cash Flow Statement. Can we forecast it as well? Follow the money!

C. Can you write the cash flow macro?

investment banking internship class the cash flow statement and macro

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