Cash Flow Analysis and Forecasting ForothertitlesintheWileyFinanceseries pleaseseewww.wiley.com/finance Cash Flow Analysis and Forecasting The Definitive Guide to Understanding and Using Published Cash Flow Data Timothy D.H. Jury A John Wiley & Sons, Ltd., Publication Thiseditionfirstpublished2012 ©2012TimothyD.H.Jury RegisteredOffice JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussex,PO198SQ, UnitedKingdom Fordetailsofourglobaleditorialoffices,forcustomerservicesandforinformationabouthowto applyforpermissiontoreusethecopyrightmaterialinthisbookpleaseseeourwebsiteat www.wiley.com. Therightoftheauthortobeidentifiedastheauthorofthisworkhasbeenassertedinaccordancewith theCopyright,DesignsandPatentsAct1988. 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Setin10/12ptTimesbyAptaraInc.,NewDelhi,India PrintedinGreatBritainbyTJInternationalLtd,Padstow,Cornwall,UK Tomymotherandfather, brotherandsistersforalwaysbeingthere Contents Introduction ix SECTIONONE HISTORICCASHFLOWANALYSIS 1 UnderstandingHowCashFlowsinaBusiness 3 2 UnderstandingCashFlowsProperly 21 3 Start-up,Growth,Mature,Decline 47 4 RestatingtheCashFlowsofaRealBusiness 59 5 RestatingUSGAAPCashFlows 83 6 AnalysingtheCashFlowsofMatureBusinesses 99 7 AnalysingtheCashFlowsofGrowthBusinesses 135 8 GrowthandMature–FurtherAnalysisIssues 153 9 AnalysingtheCashFlowsofStart-upBusinesses 171 10 AnalysingtheCashFlowsofDeclineBusinesses 179 11 WhattodoaboutBadCashFlows 185 12 CashVersusProfitasaMeasureofPerformance 191 viii Contents 13 CashFlowAnalysisandCreditRisk 201 14 CashFlowAnalysisandPerformanceMeasurement 215 15 AnalysingDirectCashFlowStatements 223 16 GeneratingaCashFlowSummaryfromProfitandLossAccount andBalanceSheetData 231 17 SummarisingHistoricFreeCashFlow 247 SECTIONTWO FORECASTINGCASHFLOWS 18 Introduction 255 19 SpreadsheetRisk 263 20 GoodPracticeSpreadsheetDevelopment 275 21 TheUseofAssumptionsinSpreadsheetModels 295 Index 305 Introduction This book is the definitive guide to cash flow analysis. It is designed to be the definitivefirstreferenceonallaspectsofhistoriccashflowanalysis.Italsoprovides anincisiveoverviewoftheriskstobemanagedinpreparingcashflowforecasts. Ithasbeenwrittenfromacashflow-centricpointofview.Otherfinancialand analyticalinformationisintroducedwhenever relevant tosupporttheprocessof cashflowanalysis. Thisbookisdesignedforpeopletryingtounderstandandanalysecashflows, probablyinaprofessionalcontext.Whilstitcontainssometheoreticalcontent,the primaryobjectiveistoofferapracticalhandbookofcashflowanalysis. Ideally, it should first be read like a novel and then dipped into chapter-by- chapterasrequired;adetailedguidetothecontentsofeachchapterfollowsthis introduction.Muchoftheinformationinthebookhasbeenlaidouttofacilitate directreferencefromtheindex;alsoallowingittobeusedasapurereferencetext. Considerable effort has been expended to make the book as user friendly as possible.Ithasbeendesignedtoberelevantandusefulbothtopersonswhoare coming to cash flows for the first time, and to those who are more experienced intheperilsoffinancialstatementanalysis!Ihavepaidparticularattentiontothe needs of those who are not native English speakers. I have tried to keep the use ofEnglishasclearandconciseaspossiblewhilstavoidingtheuseofunnecessary complexity. Whilstthebook iswrittenprimarilyforthoseemployed asfinancial analysts, Ihaveidentifiedfourothermajorusergroupswhoseneedsarespecificallydealt withindifferentsectionsofthebook.Theyare: • Novicesinfinancialanalysisandotherpersonsnewto,orrelativelyunfamiliar with, cash flows in general and their analysis in particular, in all fields of endeavour,whowishtoimprovetheirunderstandingofcashflow. x Introduction • Bankers, credit analysts and others involved in business lending and the man- agementofcreditexposuresandcreditrisk. • Investors, fund managers and credit analysts involved in taking investment decisions. • Entrepreneurs, managers and business people involved in controlling business entities. Theguidetothebook,whichfollowsthisintroduction,providesanindication of the content of each chapter and its relevance to different users. For example, personswhohavenodesiretoactuallyperformtheanalysisofthecashflowsof a business themselves, but who still wish to understand cash flow, will initially gainlittlefromChapters4and5astheyarewrittenforpersonswhoareseeking topracticallyapplythetechniquefortherestatementofpublishedcashflows. THELOGICOFTHEBOOKDESIGN Years of experience as a financial trainer have taught me that people acquire technicalknowledgeinaveryrandomwayfromavarietyofsourcesastheycome across information relevant to their needs. This sometimes results in a partial, incompleteandofteninaccurateunderstandingoftheparticularsubjectinissue. Asatrainerandauthormyobjectiveistoorganisetheinformationrelevanttoa subjectortaskinalogicalandstructuredwaytofacilitateandeasetheassimilation process.ThemetaphorIliketouseisthatofajigsaw.Myaudienceswilltypically havemanyofthepiecesofthejigsawalreadyintheirpossession;however,until I facilitate the process of assimilation they have not previously assembled the piecesintoacompletepicture.WhenworkingasatrainernotonlydoIassistin completingthejigsaw,Ialsoprovidethemissingpieces,whicharedifferentfor eachparticipant! Forthisreasonthebookhasbeenorganisedintospecificblocksofknowledge. Itcanbereadsequentially.Itcanalsobeusedasareferencetoprovideanswers tospecificqueriesandproblemsbydippingintotherelevantpartofthebook. COMPLEXITY The word complex is regularly misused to mean difficult, or beyond the users present comprehension. When things labelled complex are analysed it often be- comesclearthatwhatisactuallymeantisthereisalotofinformationtoassimilate before comprehension of the whole can be gained. The information itself is not particularlydemandingtocomprehend;thereis,however,alotofit!Writingcom- puter software or learning a musical instrument or foreign language are typical examples. Introduction xi Mystrategyforthistypeofassimilationproblemistochoptheinformationup into lots of little bits that are sufficiently elemental that they can be adequately digestedbythepersonseekingtoassimilatethewholeareaofknowledgeandthen buildtheknowledgeinapyramidformbyaddingblocksandlayersinanordered way.ThisistheapproachIhavetakeninwritingthisbook. THEUSEOFCASESTUDIESINTHEBOOK Once the initial chapters have introduced the concepts upon which the analysis of cash flows rely, the book includes a number of case studies that illustrate the useofthetechniqueforcashflowanalysisoffered.Mostofthesecasesarebased on financial information taken from the accounting statements of real business entities.Iprefertodothisbecausethereisthennochallengeastotherealityof businessbehaviour.IfIcreatefictionalcasesforthebookthereisariskuserswill questionmyconclusionsaboutthemandcashflowanalysisingeneralonthebasis that the examples are fictionalised and therefore do not represent a reasonable representationofbusinessreality. However, this inevitably results in problems with dates! The question of how todealwithdatesinthebookisonethathasvexedmesignificantly.Theproblem for the publisher and I is that the book will soon appear dated if we show the yearsfromwhichthecasestudiesweretakenintheoriginal.Usersmaywrongly assumethemessageandcontentofthebookissomehowlessrelevantbecausethe materialusedtoillustratethelogicofthetechniqueofferedisageing. Thelogicofthecashflowanalysistechniqueofferedinthebookisessentially timeless,itshouldworkvirtuallyanywhereandanytimefinancialinformationis available to perform the analysis. For this reason I have partially disguised the originaldatesofthematerialusedtoillustratethecases.Thetimelineofmostof thecasestudiesofferedisincidental;theexamplesaretheretoillustratetheuse andbenefitsofthecashflowanalysistechniquethatisthebasisofthisbook. Experienced analysts will know that in performing any business analysis the economic context in which the company operates is sometimes highly relevant. Matterssuchasinflation,interestratesandthestateoftheeconomymayaffectthe conclusionsdrawnabouttherelativeperformanceofabusiness.Forthisreason, in a small number of cases and where the context of the example warrants it, I haveleftthedatesastheywereoriginally.Thisallowsthereadertoputthecase intothecontextoftheeconomicconditionsprevailingatthetime. Considerableefforthasbeenexpendedtokeepthevariousexamples,tablesand otherinformationbothnumericallyandfactuallycorrect,however,itisinevitable in a work of this length that, despite our best efforts, errors may still creep into print.Pleasedonothesitatetobringthesetomyattention,tofurtherimprovethe bookasitdevelops.