CASH FLOW

Or, a lender’s best friend.

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CASH FLOW OBJECTIVES

Traditional, or EBITDA cash flow. Accrual cash flow.

Sources and uses of cash flow. FASB 95. (History of financial statements) DIRECT/INDIRECT Methods. (Top down/bottom up) UCA CASH FLOW (Uniform Credit Analysis from RMA) CONTRACTOR’s cash flow. GLOBAL cash flow.

SHORT TERM cash flow and repayment. LONG TERM cash flow and repayment. RECAP.

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CASH FLOW OBJECTIVES (Continued)

There are three types of cash flow that we are going to discuss today:

1) TRADITIONAL CASH FLOW.

2) ACCRUAL CASH FLOW. (And as a subset of accrual cash flow we will take a quick look at contractor’s cash flow).

3) GLOBAL CASH FLOW.

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TRADITIONAL CASH FLOW

What is traditional cash flow?

Traditional cash flow is often referred to as “EBITDA” or some form of “EBITDA” (EBIT, EBIDA).

“EBITDA” is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.

EBITDA cash flow is easily obtained from reviewing financial statements and spreads.

See exhibit 1 for an example of traditional cash flow.

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TRADITIONAL CASH FLOW

Traditional cash flow is a cursory review of a company’s operations. While it is a reasonable measure of profitability it has serious shortcomings as a cash flow measure.

What do you think are some of those shortcomings?

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TRADITIONAL CASH FLOW

SHORTCOMINGS INCLUDE:

1) It is a pretax measure of debt service coverage.

2) It does not consider quality of earnings or impact from dividends.

3) It does not consider fixed asset expenditures (either for maintaining or expanding operations).

4) It does not consider working capital needs or their impacts.

In general, it fails (for the most part) to incorporate the balance sheet.

TRADITIONAL CASH FLOW

OTHER CONSIDERATIONS:

Net profits do not repay loans. Sales are considered income whether or not cash

has been collected (e.g. how much of sales are A/R?) COGS may include the cost of materials that have

not yet been paid for. In essence, timing differences are not considered

when EBITDA is used.

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TRADITIONAL CASH FLOW

If traditional cash flow has so many shortcomings, why is it used?

1) EBITDA is a common language that the borrower and lender can agree upon.

2) It’s a “quick and dirty” method lenders can use while in the customer’s presence.

3) The methodology of EBITDA cash flow allows the lender to set understandable covenants that can be applied by the borrower. (i.e. application is easier).

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ACCRUAL CASH FLOW

In order to remedy the shortcomings of traditional cash flow, the lender can turn to accrual cash flow. (Typically UCA cash flow.)

Accrual cash flow allows the lender to integrate balance sheet changes with operating results.

In order to understand accrual cash flow, the lender must have a firm grasp of cash sources and uses.

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ACCRUAL CASH FLOWSOURCES AND USES The following information indicates when a cash source or use

occurs.

SOURCES USESASSETS ASSETS LIABILITIES LIABILITIES EQUITY EQUITY

Sources of funds can be summarized by the acronym DAILIE. DAILIE = Decline in Assets, Increase in Liabilities, Increase in

Equity = Sources of funds. Remember that income increases equity while expenses

decrease equity. HINT: Consider a personal loan transaction if you are ever

confused by sources and uses.

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ACCRUAL CASH FLOWMETHODS

For those of you who have been in banking a limited time, accrual cash flow is a relatively recent phenomenon, gaining in importance over the last 25 years.

History of financial statements.

FASB 95, which went into effect in 1988 is the precursor for the modern cash flow statement.

FASB 95 required that cash flow reporting be standardized to segregate cash flow into three groups: OPERATING activities, INVESTING activities and FINANCING activities.

FASB 95 also required firms to report cash flow by either the direct or indirect methods.

ACCRUAL CASH FLOWMETHODS

OPERATING ACTIVITIES – Focused on the current portion of the balance sheet and costs/expenses affecting net income.

EXAMPLES: The purchase and sale of inventory, collection of receivables, and payment of operating expenses.

INVESTING ACTIVITIES - Buying and selling of noncurrent assets. EXAMPLES: Acquire property plant or equipment, purchase a business

or invest in another company, lending money to affiliates (due from’s) or outside third parties (investments).

FINANCING ACTIVITIES – Debt and equity financing activities. EXAMPLES: Obtain loans or reduce principal on loans. Obtain additional equity capital or pay dividends.

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ACCRUAL CASH FLOWMETHODS Both cash flow methods (DIRECT AND INDIRECT) list cash flow by

operating, investing and financing activities. (see exhibits 3 & 4)

The indirect method is more cumbersome starting with net income and reconciling to cash.

The direct method provides a better breakdown of operating receipts and expenses, and is closer to what bankers use today. It starts with sales/revenues and reconciles to cash.

So which do bankers use? The answer is neither (well almost). Most banks use “UCA cash flow” developed by RMA and presented via most financial spreading software. UCA is an acronym for Uniform Credit Analysis. It is popular with bankers because it eliminates the confusion of the indirect method and it provides more cash detail than the direct method (although it closely mirrors the direct method in many ways). See exhibit 3 which reflects the UCA cash flow for the same company that we looked at earlier. On exhibit 3 calculate the UCA cash flow for 2011. We will pause here while you calculate the 2011 UCA cash flow.

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ACCRUAL CASH FLOWSUMMARY

Notice the difference between the traditional cash flow and the accrual cash flow. The difference arose from balance sheet changes. Receivables, payables and accruals were all cash uses in 2011 for this company. (Exhibits 1 AND 3.)

EBITDA equaled +$784K, while net cash after operations to service debt was a negative ($X,XXX K). The difference between the two numbers = $X,XXX K.

As a final note, the difference in cash flow of $X,XXXK does not include investing and financing activities. Investing activities consumed another $357K in cash while financing activities provided $1,022K to support the company’s cash needs.

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CONTRACTOR’S CASH FLOWA BRIEF OVERVIEWPlease refer to exhibits 5,6, and 7. FUTURE CASH INFLOW (000’S) FYE 09 FYE 10 INFO FROM?Total Contracts $9,913 $ WIP reportLess: Billed to Date $4,908 $ WIP reportRemaining to be billed $5,005 $Plus: Receivables $ 184 $ Balance sheetTotal Future Cash Flow $5,189 $

FUTURE CASH OUTFLOW (000’s)Total Estimated Costs $7,658 $ WIP reportLess: Cost incurred to date $3,708 $ WIP reportRemaining to be spent $3,950 $Plus: Accounts Payable/Accruals $ 783 $ Balance Sheet

Deferred Income Taxes $ 0 $ Balance SheetTotal Future Cash Outflow $4,733 $NET CASH INFLOW $ 456 $ OPERATIONAL OVERHEADLess: CMLTD $ 64 $ Balance SheetLess: Interest Expense $ 67 $ Inc. StatementLess: Operating Expenses $ 1,354 $ Inc. StatementTotal Additional Outlays $1,485 $ OVERHEAD COVERAGE 3.68 mths x.xx mths NCI/(op.exp/12)

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CONTRACTOR’S CASH FLOWA BRIEF OVERVIEWPlease refer to exhibits 5,6, and 7. FUTURE CASH INFLOW (000’S) FYE 09 FYE 10 INFO FROM?Total Contracts $9,913 $9,742 WIP reportLess: Billed to Date $4,908 $7,067 WIP reportRemaining to be billed $5,005 $2,675Plus: Receivables $ 184 $ 34 Balance sheetTotal Future Cash Flow $5,189 $2,709

FUTURE CASH OUTFLOW (000’s)Total Estimated Costs $7,658 $8,172 WIP reportLess: Cost incurred to date $3,708 $5,864 WIP reportRemaining to be spent $3,950 $2,308Plus: Accounts Payable/Accruals $ 783 $ 320 Balance Sheet

Deferred Income Taxes $ 0 $ 0 Balance SheetTotal Future Cash Outflow $4,733 $2,628NET CASH INFLOW $ 456 $ 81OPERATIONAL OVERHEADLess: CMLTD $ 64 $ 74 Balance SheetLess: Interest Expense $ 67 $ 91 Inc. StatementLess: Operating Expenses $ 1,354 $ 756 Inc. StatementTotal Additional Outlays $1,485 $ 921OVERHEAD COVERAGE 3.68 mths 1.05 mths NCI/(op.exp/12)

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CONTRACTOR’S CASH FLOWSUMMARY Notice that future cash inflows and outflows from the Work-In-

Progress report were weaved together with the balance sheet to derive an accrual cash flow for the contractor.

Then operating expenses were incorporated on the lower half of the contractor’s cash flow to deduct any overhead from the accrual cash flow. This is much like the operating portion of the UCA cash flow.

Please note that all non-cash expenses, such as depreciation and amortization have been removed from overhead expense.

The contractor’s cash flow should reveal to you two points: 1) what the net cash flow will be from the work currently in progress, and 2) how long that net cash flow will continue to comfortably fund the contractor’s day to day obligations.

As a final note keep in mind any cash already held on the B/S.

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CASH FLOW AND REPAYMENT

Now that we have examined the two principal methods of reviewing cash flow, we need to consider how cash flow repays loans.

Loan repayment is generally expected to occur over the short term or the long term. Therefore we should consider cash flow on the same basis.

The diagram on the next page depicts short term cash flow via the asset conversion cycle.

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SHORT TERM CASH FLOW

INVENTORY=100 DAYS

RECEIVABLES=45 DAYS

PAYABLES=45 DAYSLOC=10 DAYS

CASH

Short term cash flow cycle.

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SHORT TERM REPAYMENT Prior page the smaller circle represents trade cycle, larger circle = year.

The trade cycle on the prior page is cycling at 90 days or approximately

four times per year. This is derived by examining the components of the trade cycle:

TRADE CYCLE Inventory = 100 days Receivables = 45 days Less: Payables = 45 days Less: ST LOC = 10 days TRADE CYCLE = 90 DAYS

During the course of the trade cycle the conversion of assets (Inventory and Receivables) will provide for repayment on the line of credit. Based on the example above there is a 10-day financing need on the line of credit. This 10-day need will rise and fall as inventory and receivables expand or contract (cash too). Thus, at a time when inventory and receivables contract the line will be repaid, and when those assets expand again, the line will be drawn. When the line remains drawn for an extended period of time, it can be said that there is a permanent working capital need, which should be accomodated by term financing.

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LONG TERM CASH FLOW

90 days

90 day cycle

90 day cycle

90 day cycle

Long term cash flow cycle

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LONG TERM REPAYMENT

As seen on the previous slide the continuous conversion of assets produces long term cash flow, which can be applied to term debt repayment. While it is easier to conceive of cash flow being produced on a 90 day or annual cycle, it is ultimately being produced at all times. However, cash flow is considered and reviewed in a cyclical manner, typically on an annual basis, because it is easier for the reviewer to calculate the repayment capacity at a fixed point in time (i.e. annual basis).

The amount of cash flow produced for term debt repayment will vary by industry. For example, manufacturers or contractors will generally produce a stronger cash flow than a wholesaler or retailer with similar size revenues. This is a reflection of a particular industry’s profitability margins. (e.g. in general, the more value added the higher margins.)

LONG TERM REPAYMENT When depending on the long term repayment of a loan from a

company that produces a weak margins or has sizable term debt, your bank may take measures to better understand and monitor the cash flow cycle. For example, the bank may require an ABL audit, a borrowing base formula, financial covenants or other requirements that assure the bank of collateral value and/or the ability to be repaid.

Remember bankers are focused on revenues that are repeatable and sustainable. A gain on sale of assets is typically a one time event, but not a good sign of sustainable cash flow.

Long term repayment is typically tied to durable assets. Assets that are expected to help produce cash flow over an extended period of time.

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CASH FLOW DRIVERS

Sometimes when reviewing repayment ability, you may want to create a projection to better understand a company’s repayment ability. In order to do so, you will first have to consider cash flow drivers.

Cash flow drivers typically include the following: INCOME STATEMENT BALANCE SHEET * Sales Growth * Accounts Receivable Days * COGS (%) * Inventory Days * Operating expense (%) * Accounts Payable Days

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CASH FLOW DRIVERS

Forecasting these variables will typically provide the analyst with a good model for future repayment.

Other considerations a projection should include: 1) Expansion within fixed assets? 2) Adding financing for fixed assets or other? 3) Intercompany loans, tax changes, interest rate

changes, etc.?

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GLOBAL CASH FLOW

“Global cash flow, which is a variation of personal cash flow, blends business income and business debt service into the same model”. John Cassis (9/06) This can be done horizontally or vertically.

Horizontally: Art B. Cobb ABC CompanyCombined

Salaries/Net cash flow $50K $175K $225K Schedules B, C, D $20K N/A $20K Schedule E (R/E) $15K N/A $15K Schedule E (distr.) $100K ($100K) $ 0K Net cash flow $185K $75K $260K Mortgage debt $30K $50K $80K Installment debt $10K $20K $30K Revolving debt $2K $ 3K $5K Total debt Service $42K $73K $115K Debt Service Coverage 4.40x 1.03x 2.26x This is a simplistic model, see the vertical model attached (exhibit 8).

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RECAP EBITDA cash flow is an inadequate measure by itself, but is

also a measure that borrowers can measure for themselves. Sources & uses of cash flow provide a more accurate picture of

loan repayment. A contractor’s cash flow is an accrual based cash flow that

integrates the contractor’s current work-in-progress with their balance sheet and income statement.

Short term cash flow repayment is typically referred to as the “conversion of assets” and is repaid out of a company’s trade cycle. The lack of ability to repay short term debt from the trade cycle indicates a permanent working capital need.

Long term debt repayment is typically derived from multiple short term cash flow cycles, which produce c/f over an extended period of time. A review of cash flow drivers helps to forecast, or project, long term cash flow.

Global cash flow has become increasingly more important as banks seek to understand the cash flow dynamics between the borrower and guarantor(s).