Category: Cash Flow

Hal is encountering a situation where it cannot meet its short-term liquidity requirements. As such, most of its cheques issued to its supplies are bouncing owing to the insufficient amounts in the bank. Cash flow is a key indicator of the financial situation of an entity as opposed to revenues statements that may contain non-cash revenues, which give a deceptive picture. In Hals case, there are a variety of reasons that are triggering the liquidity problems.

First, most of its sales are made on credit. Only 10 percent of its turnover are on cash basis. This limits the amounts of liquid funds in the entity. Furthermore, the rate at which the amounts are paid is low. This further compounds the problem that Hal is facing. Once credits sale are made, the debtor should pay up within three months. However, Hal only considers any payment of debtors as late once it exceeds ten months from the due date.

This is a lengthy period that Hal has provided. Subsequently, the debtors can delay payments for a long period without any consequences. This situation has contributed significantly to the liquidity problems in the entity since most of its funds may be held up as debtors (Coyle, 2000).

The entity also has many cash commitments. These commitments include the cash payments of the material delivered by suppliers. Additionally, it pays its employees promptly. The cash requirements in this entity are massive after its suppliers denied them credit facilities.

Subsequently, the cash requirements in the entity will outstrip Hals cash inflows. The entity also incurs a certain cost when collecting funds form cash sales. The above problems have resulted in the current liquidity problems that Hal is encountering (Nesvetailova, 2010).

Solutions

The only way to solve the above liquidity situation is by boosting Hals cash inflows. First, the entity should attempt to increase its cash remittances by encouraging cash payments. Hal can accomplish this by proposing discounts to clientele ready to transact on cash basis. By adopting such measures its can increase the proportion of its cash sales to about 15-20%.

The second measure the entity should undertake is to change the manner in which its debtors pay their debts. The entity should demand that debtors pay on a 50-30-20 basis. This will ensure that the entity has adequate funds. The remittances by the debtors have been a key cause of financial woes at Hal.

The entity should also reduce the period beyond which remittances are considered late. Currently, Hal allows ten months. Hal should reduce the period to six months. This would boost the rate of payment of its debts. Additionally, the entity should enact penalties for late payments. Instituting such policies would increase discipline in the remittance of the debts. Hal should also seek an institution that will charge lower that 2.5% for deposits made.

This is a significant margin which has reduced this entitys funds levels. Finally, the entity should negotiate better terms with the various parties it pays. Suppliers have denied them credit facilities. If Hal can negotiate fresh terms with its suppliers, then it will incur reduced cash outflows.

Hal should also review its employment policy. It should encourage permanent employees who may reduce its salaries overheads (Neely, 2002). The above details elaborate how the above entity can address the current liquidity problems that it is encountering.

References

Neely, A. (2002). Business performance measurement: Theory and practice. Cambridge: Cambridge University Press.

Nesvetailova, A. (2010). Financial alchemy in crisis: The great liquidity illusion. London: Pluto Press.

Coyle, B. (2000). Cash flow forecasting and liquidity. Chicago: Glenlake Pub. Co.

Judging upon the latest cash flow statement of Blue Apron Holdings Inc., it is appropriate to note that, in general, the companys profit has seen a decrease, albeit fairly gradual. In recent years, since 2018, its net income growth was reduced by two  starting at 49,9% in 2018 and ending at 24,4% in 2020 (MarketWatch). This is one of the main characteristics investors are advised to look at  a persistent, decreasing trend. However, this trend is incomplete without other factors, such as the depreciation of tangible assets, which can characterize a company as excellent at distributing its finances.

Subsequently, looking at Blue Aprons investing activities would be useful for a potential creditor because it gives the idea of how a company sustains and manages itself. Despite last years results in that area still not being majorly positive, the activities of most interest are net investing cash flow growth and capital expenditures growth. The first one is a good criterion of how the company manages its investments in a crisis like 2020. Although its niche is in high demand during the pandemic, the company was quite modest with its revenue growth and expenses. The capital expenditures growth, marked at -14.8%, characterized it as being a mindful decision-maker in the critical time  the company is less likely to take a risk to invest in a new opportunity (MarketWatch). Therefore, it marks it as being a stability-oriented company, which is preferable for a creditor.

The business financing activities are characterized by a similar trend of decrease or little growth, except for a few positions in the chart. A huge increase is seen in net financing cash flow, which signals a higher rate of economic activity overall  this is a positive characteristic for creditors since none of them want to lend money to a withering business. Another important point for a creditor is the companys change in long-term debt, which showed better results in the previous years, going from 194K in 2017 to 41K the next year (MarketWatch). However, this year a decrease is minimal for obvious reasons  this years results may not be as characteristic; the earlier ones have greater value for a relevant assessment.

References

Blue Apron Holdings Inc. (2021). MarketWatch, Web.

At some point, many companies are frequently required to make particular funding decisions related to specific projects for profit and further successful development. However, it is essential to analyze the expediency of investments and the possibility of the cash flows increase. Thus, planning to be involved in any new project, a company should address incremental cash flow that may be defined as the cash flow acquired by it in the case of the projects undertaking (Best, 2021). In order to evaluate incremental cash flow, a company should compare expected cash flows if it invests in a project and if it does not. The impact of the projects acceptance on other business parts cash flow should be taken into consideration as well.

At the same time, there are several concepts essential for the understanding and estimation of incremental cash flow that should be considered during its analysis. These concepts include sunk costs, opportunity costs, allocated costs, and cannibalization. Sunk costs are already incurred costs that should not be included. In turn, opportunity costs refer to missed revenue chances from a business assets. Allocated costs refer to specific projects or departments, and their inclusion in the computation is optional. Finally, cannibalization addresses the situation when a new project reduces any previously taken projects cash flows.

It goes without saying that there are multiple factors that should be considered as well in the analysis of incremental cash flow. They are changes in regulations, market trends, the companys adjustment to legal policies, and cash flow modifications on the basis of business operations. In addition, several components should be identified for incremental cash flow evaluation, including the projects timing and scale, the initial outlay, and terminal value or cost. Moreover, a company should identify its business revenue, list the projects initial costs, record business expenses, and compare the differences.

Reference

Best. (2021). Incremental cash flow: Meaning, calculations, importance, and limitations. Business Yield. Web.

Introduction

The cash flow statement is a mandatory part of a companys financial reports, it records the amounts of cash and cash equivalents entering and leaving the company. The cash flow statement analyzes the cash income and expenditures during a financial period and it has three parts which show the variations in the firms cash flows including operational, investment, and financial activities.

It examines the components such as accounts receivable, Inventory, accounts payables and credit terms, and also items that do affect the firms income for some time such as purchase of equipment, lumpsum payment of debt, bank refusal to renew or extend loan, reduction of credit by suppliers. There are two ways of analyzing a cash flow: building a cash flow analytical model or one can use concepts such as Internal Rate of Return (Clark & Maguire, 2006).

Cash Flow Activities

Operating Activities

Cash flow is obtained by making particular changes to the net income by aggregating or deducting differences in incomes, expenses and credit operations obtained from operations taking place during a particular year to the other. This is done because non-cash items are calculated into net income, assets and liabilities e.g. depreciation expenses are not cash in nature and its a value subtracted from the net value of the asset, which had earlier on been adjusted.

Adjustments in debtors accounts on the balance sheet should be shown in the cash flow. However, if the debtors accounts are decreasing, this shows that the debtors are clearing off their debts and the amount is aggregated with the total sales, if there is a decrease then the amount must be deducted from net sales because although the amounts reflect on the accounts receivables as revenue they are not cash.

Increase in stock levels implies that the firm has spent more money to buy more raw materials, thus the value of the increment in stock should be deducted from total revenues, while a decrease should be added to the total revenues. But if the goods are sold on credit, then an increase in trade receivables should be aggregated with the total revenues then shown on the balance sheet. This process will also be done for tax payables, salaries outstanding and prepaid expenses (Mclaney & Atrill, 2008).

Investing activities

This involves changes in assets and investments, with most of these changes being cash-outs due to more investments. There is also cash in when assets are sold for example selling marketable securities or disposal of assets.

Financing activities

These are changes in debts, loans, or dividends when capital is raised (for example, through sale of shares) and there is cash in and cash out when dividends are paid or payment of interests to bondholders.

Benefits of Cash Flow Statement

Cash flow statements are vital fiscal statements when appraising a companys overall monetary stability and when trying to appreciate the impact of a new economic ventures or projects on a companys investments. Investors are concerned in the cash flow because it removes all of the accounting allocations and delivers a clearer picture of the inflows and outflows of money (Mclaney & Atrill, 2009).

Inflation

Cash flow also takes into account some practical considerations such as inflation, which is a vital component in understanding whether the company has enough resources to meet its cash operating needs.

Financial Stability

The managers, financiers and various stakeholders apply cash flow statements to evaluate the financial stability of a firm. This is through calculation of various components using information from the statement. For example, net profit or loss, changes in inventory, accounts payable, accounts receivable and tax payable, through these investors can judge whether a company is financially sound.

Planning

Cash flow statements are useful in planning and managing of foreseeable financial ventures by alerting managers earlier about any changes expected in the firms operations.

Flow of Revenues

In addition, a cash flow helps newly established firms to evaluate their cash in-flow and out-flow, therefore avoid any shortage of cash running the firms activities, and also to meet the companys maturing obligation within and also meet its objectives. It preserves the goodwill of the workers and maintains their credit evaluation. It is also vital in cases of when the company is seeking additional funds to expand its operations (Atrill & Mclaney, 1994).

A cash flow gives a firm an ascertained flow of revenues no matter the external economic environment, although many corporations prefer a balanced and even inflow and outflow. With the cash flow statement, a firm can calculate a return ratio to ensure that the firm does venture in unforeseeable projects and projects invested in are making good returns.

Conclusion

A cash flow can be exemplified with a balance scale, for instance when an individual measures items, one differentiates the heavier and the lighter, this kind of flow can be shown in the cash flow statement. The cash flow statement indicates the inflow and outflow transactions, thus assisting the investor or the management identify unnecessary expenses, and revenues that are indebted (Atrill & Mclaney, 2008).

An example of a cash flow statement:

Reference List

Atrill, P. & Mclaney, E. (1994). Management accounting: an active learning approach. Malden, MA: Wiley-Blackwell.

Atrill, P. & Mclaney, E. (2008). Financial accounting for decision makers. Denver: CO Prentice Hall.

Clark, M. & Maguire, W. (2006). Business Accounting and Finance in New Zealand. New York: McGraw-Hill.

Mclaney, E, & Atrill, P. (2008). Accounting: an introduction. Denver, CO: Prentice Hall.

Mclaney, E, & Atrill, P (2009). Accounting. Redford, MI: Pearson Education, Limited.

Cash Flow Essay

Cash flow, a term often thrown around in the world of finance, is a concept that is fundamental to understanding a company’s fiscal health. At its essence, cash flow represents the movement of money into and out of a business. It’s the inflow and outflow of cash, painting a picture of how a company receives and spends its money. The following sections will show us the essential parts of cash flow in the USA and shed light on the significance of each in the American business landscape.

Operating Activities: The Heartbeat of Business

Operating activities form the foundational layer of any company’s cash flow structure. They are the transactions that reflect how a business generates its primary revenue and incurs its main expenses.

Revenue Generation

At the forefront of operating activities is revenue generation. This primarily involves:

• Sales: Money earned from selling goods or services. It’s important to note that only cash transactions (not credit sales) affect the cash flow during the period in question.
• Rent Income: For companies leasing properties, machines, or other assets.
• Royalties and Licensing: Revenue earned from granting others the right to use a company’s intellectual property.

Regular Expenses

Operating expenses represent the other side of the coin. They are costs that are directly tied to the central business activities and include:

• Wages and Salaries: Remuneration for the employees and management.
• Rent and Leases: Payments for occupying office spaces, warehouses, or any rented equipment.
• Utilities: Costs for essential electricity, water, and internet services.
• Inventory Costs: Money spent to purchase goods sold to customers.
• Taxes: Payments made to local, state, or federal tax agencies related to operational earnings.

Account Receivables and Payables

Within the realm of operating activities, one also encounters the concepts of account receivables and payables. These are critical:

• Receivables: This represents money that customers owe a business. While these don’t immediately affect cash flow (since the cash has yet to be received), they play a role in future cash flow projections.
• Payables: Payables represent money a company owes to its suppliers or vendors. These, too, will impact cash flow once payments are made.

Net Operating Cash Flow

The culmination of operating activities is net operational cash flow. By subtracting the total operating expenses from the total revenue, one can determine whether a company has a positive or negative cash flow from its primary business operations.

Operating activities play a decisive role in the vast and varied American business ecosystem. They directly influence a company’s capacity to sustain operations, fund expansions, and weather economic downturns. Recognizing the nuances of these activities provides a more transparent lens to assess the pulse of a business.

Investing Activities: Charting the Growth and Evolution

Investing activities offer insights into a company’s strategy for the future, detailing how it utilizes its cash for long-term benefits. These activities often involve large sums of money and might yield little returns. Instead, they are typically geared toward eventually bolstering the company’s growth, capacity, or efficiency.

Acquisition of Long-term Assets

Central to investing activities is the acquisition of assets that can serve the company for extended periods:

• Property, Plant, and Equipment: Purchasing or upgrading machinery, buildings, vehicles, or land. These investments usually aim to increase production capacity or improve efficiency.
• Investments in Securities: Buying stocks, bonds, or stakes in other businesses. Such actions can signify a strategic alliance, diversification, or investment to earn returns.

Sales or Disposals

Equally important are the sales or disposals of assets:

• Selling Assets: Companies might sell off old equipment, unused property, or other assets either because they’re outdated or to generate cash.
• Disposal of Business Segments: Sometimes, a company may divest itself of a particular branch or segment to streamline its operations or focus on more profitable areas.

Loans and Advances

While not the core focus, investing activities can also encompass:

• Loaning Out Money: Companies might lend money to another entity, expecting it to be returned with interest.
• Collection of Loans: The eventual collection of these loans is also classified under investing activities.

Understanding investing activities is pivotal when gauging a company’s vision for the future. A business heavily investing might be eyeing rapid growth or significant transitions, while limited investment might indicate a more cautious or maintenance-focused approach.

Financing Activities: Fueling the Enterprise Engine

Financing activities illuminate how a company sources capital, showcasing its relationship with investors and creditors. It’s about how a business is fueling its operations and growth by incurring debt or leveraging ownership.

Equity-based Transactions

Equity, representing ownership in the company, has its set of transactions:

• Issuing Stock: When a company sells its shares to raise capital, it’s an influx of cash.
• Buying Back Stock: Conversely, when a company repurchases its shares, it’s an outflow of cash, often signaling confidence in its intrinsic value.
• Payment of Dividends: When profits are distributed to shareholders, it represents an outflow of cash, underscoring a company’s profitability and commitment to returning value to its shareholders.

Debt Transactions

Borrowing is another avenue to procure capital:

• Borrowing can be through banks, bonds, or other financial instruments. The infusion of borrowed capital represents an influx of cash.
• Repayment of Debt: When a company pays back its loans or bonds, it’s an outflow of cash.

Interest Payments

While not a primary source or use of funds, the interest payments on borrowed capital also fall under financing activities.

Financing activities sketch a company’s financial strategy. Whether leaning more towards equity or debt, these choices have implications for risk, control, and financial flexibility.

Benefits of the Cash Flow Statement: Why It Matters

When income statements and balance sheets offer insights, the cash flow statement often becomes the linchpin for comprehensive financial analysis. Here’s why:

Real-time Financial Health Check

While income statements can include non-cash items, the cash flow statement focuses solely on the tangible cash inflow and outflow. This gives stakeholders a clearer picture of a company’s liquidity and ability to meet short-term obligations.

Insight into Operational Efficiency

The cash generated from operating activities reveals how proficiently a company runs its primary business operations. A consistent positive cash flow from operations indicates robust core business practices.

Understanding Investment Strategies

Investing activities, as detailed in the cash flow statement, shed light on a company’s growth strategy. Stakeholders can discern how the company is reinvesting its earnings, whether in new assets or acquisitions.

Evaluating Financial Strategies

The financing section of the statement provides transparency on a company’s financial decisions, revealing its approach towards debt, equity, and dividends. This is instrumental in assessing the risk associated with the company’s economic structure.

Future Preparedness

Companies can better forecast future cash needs by understanding where cash is coming from and where it’s being utilized. This aids in planning expansions, managing potential downturns, or capitalizing on upcoming opportunities.

Conclusion: The Power of Tracking Cash Movements

The cash flow statement, with its meticulous categorization into operating, investing, and financing activities, provides a panoramic view of a company’s financial maneuvers. It unveils the present state of affairs and offers a lens to peer into potential future scenarios. In the diverse and dynamic American business landscape, where adaptability and foresight are essential, the ability to decipher and harness the insights from a cash flow statement can be the difference between thriving and merely surviving. It’s more than just numbers; it’s a business’s financial journey narrative.

If you’re a small or medium sized business struggling with cash flow problems you are absolutely not alone, but there are steps you can take immediately to take back control of your finances. No business, large or small, wants to have to worry about where their next dollar is coming from, especially if there are plenty of payments in the pipeline that for whatever reason haven’t lobbed into your account.

Having good cash flow, especially when you’re starting out, should be fundamental to your business strategy. It means you can meet commitments such as paying staff and all those other bills while being able to plan for the future with some confidence. Conversely, wondering where exactly your next dollar’s coming from and having to constantly chase up invoices is a horrible way to have to run a business, making planning beyond a few weeks at a time almost impossible.

Yet there are ways to alleviate this type of unnecessary financial stress so you can spend your time more productively thinking about ways to grow your business. Moreover, with so much choice around in today’s globalised digital world, competition for financial products and services has never been fiercer and SMBs are no longer confined to seeking help just from banks and larger financial institutions.

First and foremost, you want to get paid as quickly and painlessly as possible, so you may want to consider a secure online payment gateway for invoices such as PayPal or Stripe. Once they’re set up, your customers only need to push a few buttons to transfer funds, as opposed to the rigmarole often involved in bank transfers. These gateways are usually straightforward and user-friendly, meaning your customers are more likely to pay their invoices more quickly and painlessly when prompted.

Additionally, have state-of-the-art accounting software installed as part of your IT ecosystem will benefit you greatly in this situation as it provides a clear and accurate picture of your financial situation immediately and what customers may be causing your cash flow issues in the first place. More importantly, it should reduce the paper work required for financing options.

There are those other times, however, when your customers just can’t pay you on time, for whatever reason, and you may have to endure a long and arduous wait for the money. It’s during these periods where services such as invoice financing can be hugely beneficial to the smooth operation of your business. Invoice finance is a type of short-term loan issued by a lender to a business customer based on an unpaid invoice or a number of unpaid invoices. With invoice financing, you set up an account with your financial institution and, once you’ve sent the invoice off to a customer, you can upload it and, once approved, receive a payment of usually 90% or more of the invoice immediately. Once the money is freed up, you’re free to spend it on any growth or investment plans you may have put on hold due to tight cash flow. Unlike other SMB loans, however, the invoice effectively acts as the collateral for the loan so there should be far less hassle involved with setting up the service in the first place and having to deal with things such as insurance as well because the lender is actually taking on the risk of the invoice not being paid, which is then reflected in the fee structure.

Finally, it pays to talk to an expert in the financial technology space that specialises in invoice financing, has an easy-to-understand fee structure, and can set you up as seamlessly and painlessly as possible. That way you’ll be well on the way to securing your ongoing cash flow, even in times of economic downturn.

Assessment

Prompt 1: Applying stakeholder theory, explain the factors that affected inventory management at DSG over the period 2013 to 2016. What impact did inventory management have on profitability?

The process of inventory management illustrates the effective approach to ensuring an entity has an appropriate amount of stock on hand to be sold, and to ensure that this stock is not held for such a time that it becomes obsolete.

From the information provided, Dick Smith Group (DSG) executed a new and ill-fated strategy, whereby they erratically purchased a significant amount of stock between 2013-2016 in line with their expansion hopes. This is further emulated in that DSG had to put on massive sales in order to move some of this excess stock and communicating this to customers that they had multiple quantities of items such as mouses and batteries etc.

Due to their poor inventory management, much of this stock did become obsolete or had to be put on sale which meant profit margins were even lower. Dick Smith were receiving rebates from the large quantities of stock that they ordered, however, we note that in proper accounting treatment, rebates are not recognised as income but as a mere offset of an expense. In this case, unfortunately, the benefit of a rebate was not enough to compensate for the costly exercise of over-ordering stock. This in turn affected the profitability of the company, raising extremely high levels of debt with the bank and suppliers and losses on written-down stock.

Stakeholder theory outlines the interconnected relationships between those with a vested interest in a company. Stakeholders range from the company executives, employees, suppliers, customers, competitors, government bodies and more.

In relation to the poor inventory management decisions made by DSG, this in turn affected a number of stakeholders. Two key stakeholders identified in the case study are: the shareholders (Pauline) and suppliers.

Pauline is greatly impacted by the affect of the inventory disaster as it was communicated in 2015 that DSG would be doing an inventory write-down. Given that they are retailers, and their main function is to sell goods, having steady inventory write-downs is not a promising sign. The outcome of this write-down was that it caused DSG share price to drop dramatically and left shareholders disgruntled and no longer trusting DSG and their capability to run a business and pay dividends. Having shareholders that are dissatisfied with the company’s performance means that they will struggle in the future to garner more shareholders, as dropping market prices suggest serious problems, and unhappy shareholders will result in a poor reputation.

Suppliers are also affected by DSG’s poor inventory management in that due to the large amounts of stock that were being ordered, this meant a significant amount would have been put on credit and repayment times were extended due to the sheer volume of supplies. Initially, this would have been welcomed by the suppliers, in that they were selling huge amounts of stock to a trusted partner. However, given the poor inventory management which eventually lead to the demise of DSG, this meant that suppliers were left in the lurch and not being paid. Given the unmodified audit opinion provided by Deloitte in 2015, this may well have lulled the suppliers into a false sense of security as they were continuing as a going concern and were expected to pay their debts when they were due. DSG requested extended credit terms from suppliers until they went into voluntary administration and then into receivership leaving significant liabilities to their suppliers being unpaid.

Prompt 2: Identify at least three (3) factors that caused the collapse of DSG and for each factor identified explain how short-term decisions resulted in shareholders losing their investment;

There were a myriad of poor decisions that lead to the demise of DSG and in turn shareholders losing their investment, however, we identify the three main aspects as being: inventory management, cash flow issues and poor choice of business strategy.

Inventory management proved to be a major contributing factor in the collapse of DSG in that the mounting expenses were not being overrun by revenue, in fact, the stock that DSG had purchased was costing them even more than expected as they had to write it down. DSG wrote down approximately $60,000,000 worth of inventory in 2015, which accounted for 20%. The product mix at DSG was described as ‘bizarre’ and they were not understanding their customers properly by stocking the products that they really wanted. The short-term decision to purchase excessive amounts of inventory before considering the costs vs. benefits meant that a company struggling financially incurred even further costs, heavily contributing to it’s demise.

Cash flow issues were another major contributing factor to DSG going into voluntary administration and then receivership. In 2015 cash flows were negative, and the rapid expansion and opening of new stores would mean further pressures on cash flows. In addition to this, given the cash flow pressures, it meant that DSG was at a point where they were breaching their debt covenants with the bank and this was almost unfixable. The cash flow issues were not dealt with in a timely manner, and due to this not being rectified when the cash flows were already negative and spending being significantly reduced, this meant that DSG were unable to pay their shareholders, the bank, and many other stakeholders involved, and ultimately, no cash resources meant they could no longer meet their current or future commitments including paying shareholders their dividends.

The third aspect that contributed to the disintegration of DSG was the business strategy it adopted. Given the rapidly changing and competitive market that is within the retail landscape, especially the innovative section that encompasses technology goods, this meant that DSG, along with other competitors were trying new and erratic business strategies to react to these changes. The changes to the business strategy meant that there were plans for rapid expansion and purchasing an unnecessarily high level of inventory (given their cash-flow position) to obtain rebates. The opening of the new stores could have been interpreted to be a mechanism to offload excess stock. Given the changes to remain competitive and profitable within the industry, this lead to impulsive decisions being without the necessary resources. Again, these desperate attempts to stay afloat meant that the company suffered drastically and shareholders lost their investment through the company’s demise.

Prompt 3: The Cash Flow Statement provides users with information relating to Operating activities, investing activities and financing activities. Explain the cash flow position of DSG and the issues that can arise from this position;

The statement of cash flows is a financial report that details the amount of cash and cash equivalents that are moving in and out of a company for the period.

The cash flow statement is made up of three different types of cash flows, these are: operating cash flows, financing cash flows and investing cash flows. Whilst these are all money entering and exiting the business, they are all classified differently and represent different information.

Operating cash flows are the day-to-day activities of the business, for DSG these include receipts from transactions, salary expenses, payments made to suppliers etc.

Investing cash flows relate to the sale or acquisition of non-current assets, and activities to do with loans from the bank.

Finally, financing activities detail the cash-related activities of the shareholders, which for DSG would be the money collected from issuing new shares or the money expensed in the form of dividends.

As detailed, in 2015 the cash flow position of DSG was ominous. Their operating and investing cash flows were negative for a third year in a row, which would be determined as being extremely concerning as this raised a significant amount of debt. The financing cash-flows were positive, meaning that the cash inflows from equity raising activities (issuing shares) were greater than the outflows (dividend payments). Whilst this is noted as a positive, given the situation, this was due to the stock price plummeting and therefore dividends being a lower payout and shareholders were keen to buy more stock at the low price as they were oblivious to what was transpiring behind closed doors.

Given the other two cash flows were showing as negative, this tells us that DSG’s expenses were continuing to exceed their revenue and that they are no longer operating in a way that is sustainable and conducive to a successful business. Although DSG reported a positive net profit for the year, this still does not discount the importance of the statement of cash flows as it does not necessarily represent free cash. The cash flow issues that DSG were facing were a key indicator of the uncertainty surrounding their future and how their drastic business strategy was not rewarding them with a positive net cash flow. Given the obligations to their shareholders, employees, banks and suppliers, a lack of cash and therefore limited liquidity would put the going concern of DSG in serious doubt.

Prompt 4: The DSG auditors provided an unmodified opinion on the DSG accounts. Identify and explain areas of risk that auditors may need to consider when auditing retailers

An unmodified audit opinion is where the auditor expresses an opinion that financial statements are presented, in all material respects, in accordance with applicable financial reporting framework. DSG was given an unmodified audit opinion for the year 2015, which signifies that Deloitte believed there were no material misstatements made in the reports prepared for their review. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

Prior to an engagement the auditor must plan the audit to reduce audit risk to an acceptably low level. During the risk assessment phase of the engagement the auditor will undertake various risk assessment procedures to ensure that appropriate attention is paid to the accounts and transactions most at risk of material misstatement. This pertains to the different environments within which the entity exists in, for DSG it is the company itself, the retail industry and the Australian economic landscape.

Given the heavy amounts of negative media attention gained by the DSG collapse, it would be recommended that auditors are aware of these risks within the retail industry going forward. There are two main risks that are relevant to the retail industry in that of inventory and cash flows.

Given DSG wrote down $60,000,000 worth of inventory in 2015 and had to resort to rapid sales to try and recover some of this inventory and avoid writing down further amounts. Unfortunately, the clearance sales generated an insufficient margin on sales to alleviate the financial pressure the business was facing. Therefore, it is strongly recommended that auditors recognise the risk of inventory write-downs and how damaging they can be to a business whose livelihood and sole function is to deliver goods.

Another major risk that needs to be appropriately accounted for is the cash flow position of retailers. Reporting negative cash flows for day-to-day operating activities and for investing activities would automatically be a red flag. Given the contextual contingencies of DSG and that this was the third year in a row some aspect of the cash flow statement were negative, this garners attention and further substantive testing. Cash flows and liquidity are imperative for businesses like DSG and other retailers, in that if they are not generating enough revenue to cover their expenses, they need to re-evaluate their business structure or engage in other restructuring activities. Ensuring that the company is liquid means that if needed, they will be able to pay their debts as and when they fall due, and remain profitable, which are the two pillars of assessment for being a going concern.

For the risk adjustment of expected cash flows, the certainty equivalent cash flows replace the risky cash flows with risk-free cashflow. The certainty equivalent is, of course, lower than the uncertain cash flow and the bigger the risk, the higher the downward adjustment. If this adjustment is made, it is also necessary to use the risk-free rate as the discount rate since the cash flows are now risk-free.

De facto, it is extraordinarily difficult to assess the probability of distress and adjust the expected cash flows, hence. Not only do we need to estimate the probability of distress each year, but we also have to keep track of the cumulative likelihood of distress as well. This is because a firm that becomes distressed in year three loses its cash flows not just in that year but also in all subsequent years.

We assume that even in distress, the firm will be able to receive the present value of expected cash flows from its assets as proceeds from the sale.

This assumption implies that the firm has the bargaining power to demand fair market values for its assets. Additionally, it can not only do this with assets in place (investments made and products already produced) but also with growth assets (products it may have been able to produce in the future). However, firms in distress do not have the power to demand such values.

In summary, distress will not have a material impact on the value if any of the following three conditions hold:

1. There is no possibility of distress because of the firm’s size, its standing, or there is a governmental guarantee.
2. Firms with profitable investments have easy access to capital markets in order to raise equity or debt capital to sustain through bad times. This ensures that firms are never forced into a distress sale.
3. The expected cash flows fully incorporate the likelihood of distress and the discount rate is adjusted for the higher risk associated with distress. As well, we assume that firms receive sale proceeds in the event of a distress sale that are equal to the present value of expected cash flows if the firm was a going concern.

However, it is likely that at least one of the three conditions do not hold. There are respectively sound arguments for that. First of all, even large, publicly-traded firms must fear the possibility of financial distress. Kahl (2001) has shown that 151 publicly traded firms in the US between 1980 and 1983 did experience financial distress. Secondly, the investment propensity has, however, risen again in recent years. Shown by McKinsey & Company, the global private equity deal volume has increased in the past decade from $0.3 trillion in 2009 by 366.67 % to $1.4 trillion in 2018. Finally, both input parameters, expected cash flows and discount rates, do not adequately consider the possibility of financial distress, as shown in the next section.

How can financial distress correctly be considered in DCF valuation?

The following section will introduce the usage of the DCF model for the valuation process of distressed firms in practice and lead on with a framework on how to sufficiently consider financial distress.

Gilson, Hotchkiss, and Ruback (2000) analyze the market value of 63 firms that have filed for bankruptcy in the United States, have emerged from their bankruptcy as public firms, are listed on one of the world’s largest stock indices (NYSE, AMEX, or Nasdaq) and have two years of cash flow projections. They then compare these market values with their estimates for the firm values derived through a DCF valuation. Their DCF model, however, differs slightly from the previously introduced DCF models. Instead of using either Dividends, Flow to Equity or Free Cash Flow, they use Capital Cash Flows as their cash flow input, which is calculated as follows:

CCF=NI+cash flow adjustments+cash and noncash interest

Where CCF is the Capital Cash Flows and NI is the Net Income. This is due to the reason that the CCF is discounted at the rate of an all-equity firm with the same risk as a leveraged firm. Since the leverage is likely to change over time, it is easier to use the CCF, wherefore, the discount rate does not have to be adapted to such changes. Nevertheless, the CCF approach results in the same PV as the FCF discounted by the WACC.

As the discount rate, they use the unlevered cost of equity, consisting of the risk-free rate, which equals the long-term Treasury bond yield for the month of the PV date, the market risk premium, which they have calculated at 7.4 % and an unlevered beta of 0.35, obtained

The results of their study show that the valuation error in the DCF method is tremendous. Defined as the ratio of estimated value to actual value (i.e., (Estimated value)⁄(Market value)), it ranges from 17.6 % to 259 %. As well, only 25 % of the estimated values are within a range of 15 % of the actual market values. These extreme deviations cannot be solely due to lack of information or strategic biases in the cash flows, as they state. But rather because the distress was not fully incorporated in the valuation process.

As now found out, financial distress has an impact on the two relevant input parameters in DCF valuation, the expected cash flows and the appropriate discount rate. In consequence, both parameters can be modified in the DCF model to reflect the effects of financial distress. The second approach to fully incorporate financial distress is to deal with financial distress separately. Both methods are introduced in a framework by Damodaran (2006) and will be further assessed in this section.

Modification of the DCF model

Adjust future cash flows

First of all, the expected cash flows must be estimated correctly, meaning that the probability of financial distress must be included. Damodaran (2006) gives a short introduction on how to do so, which will be depicted in the following section. In order to reflect the full extent of financial distress, every possible scenario with a different likelihood of financial distress would have to be considered when calculating the expected cash flow. This must be done every year, when future cash flows occur, since every future cash flow and the probability of financial distress may change from year to year. He gives the formula as follows:

〖Expected cash flow〗_t=∑_(j=1)^(j=n)▒〖π_jt*〖Cash flow〗_jt 〗

Where πjt is the probability of scenario j in period t and Cash flowjt is the certain cash flow in scenario j in period t. The sum of all scenarios then gives the expected cash flow for that period.

However, it is highly difficult to consider every possible scenario. Therefore, the formula is simplified towards only considering two scenarios. These are the going concern and the distress scenario. In the going concern scenario, expected growth rates and cash flows, which are estimated under the assumption the firm will survive, are used. IN contrast, in the distress scenario, the assumption is made that the firm is liquidated. The formula then looks like this:

〖Expected cash flow〗_t=π_(Going concern,t)*(〖Cash flow〗_(Going concern,t) )+

(1-π_(Going concern,t) )*(〖Cash flow〗_(Distress,t))

Where πGoing concern, t is the cumulative probability that the firm will continue to operate in period t. The probabilities for the distress scenario will have to be calculated subsequently for every year. Hence, we obtain:

〖Cumulative probability of survival〗_t=π_t=∏_(n=1)^(n=t)▒〖(1-π_(Distress,n))〗

Where πDistress,n is the probability of the firm becoming distressed in period t. To put this into context, a firm with the probability of distress of 30 % in period one and a probability of distress of 20 % in period two, would have a cumulative probability of surviving of:

Cumulative probability of survival over 2 periods = (1 – 0.3) * (1 – 0.2) = 0.56 or 56 %

Adjusting the future cash flows to the probability of distress is similar to the prior introduced method of the certainty equivalent cash flows. However, in this case, cash flows are not adjusted by fully cutting out the potential of risk, but rather by aiming to incorporate these risks of financial distress.

Adjust the discount rate

The second adjustment that can be made is to estimate the discount rate correctly. Usually, the cost of equity is received from using the beta of the firm and the cost of debt by using the interest rates of bonds issued by this firm. However, there is one major problem for each discount rate.

In the case of the equity discount rate, the firm’s beta is estimated by a regression analysis of the historical stock-price data over a long period of time, often between two to five years. Nevertheless, the distress of the firm’s financial situation might only occur over a concise period. Thus, the firm’s beta will not fully consider the actual financial risk of the company. To obtain a more reasonable cost of equity, there are two approaches:

Adjust the CAPM betas for distress: Often used in the case of private companies, the approach for estimating the company’s beta is to look at the levered betas of comparable firms, that are similar in size, operations, and industry. By calculating the weighted average of levered betas, a proxy for the industry average levered beta can be obtained. This proxy then has to be unlevered by using the leverage of the comparable firms. Finally, this unlevered industry average is then re-levered with the firm’s leverage. Since distressed firms often have an extraordinary high leverage, this will lead to a high levered beta as well, which considers the financial distress situation more properly. The following shows the formula for calculating the levered beta:

β_L=β_U*(1+(1-T)*L)

Where β_L is the levered beta, β_U is the unlevered beta, T is the tax rate, and L is the firm’s leverage.

Since a distressed firm does not get any tax advantages, the levered beta rises even more. With a much higher beta, the cost of equity increases and in consequence, the PV of expected cash flows is lower.

Use distress factor models: Since the fundamental CAPM formula already accounts for the systematic risk in the cost of equity, it can be extended by a distress factor to as well amount for distress risk. This would increase the cost of equity and accordingly lower the PV of expected cash flows.

The problem concerning the cost of debt is that it is solely based on promised cash flows and not on expected cash flows. This is due to the reason that in DCF valuation, the going concern assumption is made, which is why future cash flows are assumed to occur definitely. The interest rates of corporate bonds, which depict the cost of debt, are based upon these promised cash flows, whereby the yield to maturity of corporate bonds of financially distressed companies is extraordinarily high. A solution to this problem is to base the cost of debt on the firm’s bond rating. These are ratings given to bonds by private credit rating agencies, the three leading agencies being Fitch Ratings Inc., Moody’s Investors Service, and Standard & Poor’s, indicating the credit quality of the bonds. The ratings are based on the issuer’s ability to pay for bonds interest expenses and on its financial health. This solution still leads to a very high cost of debt, nonetheless lower than the yield to maturity in the case of financial distress.

Now that both, cost of equity and cost of debt, have been adjusted to the possibility of financial distress, the cost of capital, consisting of them both, must be adjusted as well. For that, the weights of respectively equity and debt must be estimated. In the initial period, the current debt to total capital ratio (i.e., Debt⁄(Total Capital)) is a reasonable selection. For distressed firms, this ratio is usually tremendously high. For every future period, the weights of equity and debt must be forecasted again, since the financial situation of the firm is likely to change with improvements in profitability. Consequently, the debt ratio is expected to shift towards lower, more reasonable levels.

According to the study by (Parsian, H & Amir, K, 2013) searched on effect of different factors on dividend payout ratio of Tehran stock exchange (TSE) registered companies. Various companies has been selected for research. They used regression panel for testing the hypothesis of f the study. This study provides us evidence and 102 companies has been selected over the time between 2005-2010. This study shows that independent variables free cash flow and profitability current ratio have negative relation with or impact on (dependent variable dividend payout ratio but independent variable have positive relationship with the dividend payout ratio(dependent variable).

According to the study of Onsae (2013) there is low correlation between investment rate and gross domestic product GDP. He hid descriptive survey to check out the relationship between investment and economic growth in Kenya and for the purpose of study he used investment, and GDP values for the period 1993 to 2012. The companies selected which was registered from Kenya National Bureau of Statistics. Data was analyzed by regression method of the annual growth rate in GDP and Investment. In this study investment is an independent variable and GDP is a dependent variable.

(Habib, 2011) has surveyed 7229 companies registered from Australian stock exchange from 1992 to 2005. He studied free cash flow, and stable profitability and opportunities for growth on stock return and test hypothesis for this purpose, he used regression method. Data was analyzed the by multiple regression methods. He realized firms with free cash flows, and high growth opportunities have a very high value price. And free cash flow has positive relationship with the stock return while profitability is short term. In this study free cash flow and profitability is independent variable and stock return is dependent variable.

(Wanja, 2011) determine the relationship between cash level and working capital like inventory, creditors, debtors in Kenyan from small to medium size enterprises (SMEs). The research has based upon survey method. 205 sample was selected population of this study SMEs. Data was analyzed from the regression model the calculated result that higher cash flow unpredictable embrace more cash and provide smooth operation and performance of the company. The independent variable is cash flow and dependent variable is companies performance.

Mango (2010) determined the effect of free cash flow on profitability of commercial banks in Kenya from 2005 to 2009. It explains the how different components of cash flow influence on profitability growth. In this study he verified banks profit determined by the profit after tax which is dependent variable and the components of cash flow (operating, investing and financing) which are independent variables. Regression method used for analyzing the data. The findings of the study specified that profit of commercial banks has been improved during the last five years. And cash flow generate from operating activities skilled the same tendency and same as cash flow (investing and financing) have been increased from last five years. Cash flow generate from the investing, and financing activities have a positive influence of the commercial banks profit while operating cash flow has negative influence.

(Kemboi, 2010) passed a descriptive survey of different firms in the capital market and a firm level data was collected from the period 2000 to 2008. Data were based upon investment equations in which debt, and cash flow were mentioned as descriptive variables. It shows the positive relationship between investment level and debt in both types of firms.

(Ahmed, H & Javid, A. 2019) held a descriptive survey In which they showed the effect of free cash flow on dividend payout of different companies. Data was collected form 320 non-financial firms registered in Karachi stock exchange in Pakistan. This study used the data from last five years 2001 to 2006. Data was analyzed the by multiple regression model and the findings that higher free cash flow has paid high dividends. In this study free cash flow is independent variable and dividend is dependent variable.

According to (ZHI Xiaoqiang, T.P, 2009) this study was held in China it shows the relationship of internal cash flow and investment expenditure, a descriptive survey method used, and data was collected from 55 banks, secondary data was used. He also used regression analysis from SPSS 20.0.It shows the opposite relationship between investment expenditures and internal cash flow between banks in China.

Gregory A, 2005)used a survey method in London and using the data of eight years of listed national companies. 67 firms were selected for this research and determine the relationship of free cash flow and performance of companies. The result shows there was an inverse relationship between free cash flow and performance of UK takeovers national firms. Free cash flow is independent variable and performance of the firms is a dependent variable.

(Opondo, M, 2004) held a study on effect of free cash flow and earnings on corporate performance of commercial banks in Kenya. 43 banks were selected for this research. Descriptive survey method was used and the result of study shows there are no any difference of free cash flow measure of performance that the expense of maintenance cannot be separated properly.

According to (Lang, P. Stulz, M & Walkling, A, 1991) there is a negative relationship between bidder return, and cash flow. 55 sample of US firms was selected for this research and seven year learning was used from 1980 to 1986. For the analysis of data Regression method was used. Cash flow is an independent variable and bidder return is and dependent variable in this research.

A research was conducted by (Ali, Ormal & Ahmad,2018). It is based on effect of free cash flow on profitability of firms. They selected small and medium listed companies of Germany. Regression method used for the analysis, and he found there is a positive relation between free cash flow and profitability of firms. The regression model clarified there in 70. 65% profitability variation (ROA) of firms. Free cash flow is independent variable and profitability are the independent variables.

According to the (Aftab and Ambreen,2016) there is positive relationship between free cash flow and profitability. They realized free cash flow and firm’s size upheld the effect of profitability of firms. They used regression and correlation models. Free cash flow, and size of firm is an independent variable and profitability are dependent variable.

According to (Ojode Christine Akuku,2014) free cash flow have positive effect on profitability. He collected data from Nairobi listed companies, and audit financial reports or financial statement. 31 companies selected for the analysis and secondary method was used and check reliability from SPSS 20.0. Free cash flow is an independent variable and profitability are dependent variable. There is positive correlation between two companies.

According to (Saqib Ali Bhatti,2012) there is positive relationship between free cash flow and profitability. He selected some dependent variable like earning per share, and its measurements which is calculated as net income divided by Common Shares. There was some independent variables gross profit ratio, financial cost, sales volume and other income means other sources of revenue. Data was collected from financial statements of different companies and quantitative method was used and it based on 2010-2014. All the variables have insignificant relationship with the profitability of different firms.

Introduction

The theory was proposed by Michael C. Jensen in an article called “Agency Costs of free cash Flow, Corporate Finance and Takeovers in 1986.”

According to this theory if a firm is efficient should pay the free cash flow to the shareholders. The firm should also give maximum value of the free cash flow to the shareholders. In the view of Jensen free cash flow is a problem rather than a good thing. When the firm has substantial free cash flow then the conflicts of interests between shareholders and management have become severe over payout policies. The problem is how to motivate managers to invest cash in cost of capital rather than waste it through organizational inefficiencies.

Free Cash Flow Theory

The theory proposed by Jensen in 1986. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. If a firm produces considerable free cash flow then the conflicts of interest over payout policies become severe between shareholders and managers.

The purpose of the development of the theory is the benefits of debt in reducing agency costs of the free cash flows. How can dividends be the substitute of debt?

• Assumptions
• Excessive free cash flow leads to over-investment.
• Managers are able to manipulate free cash flow under their control.
• There is an assumption in most previous research that second-order important relative to investment decisions are dividends.
• Earnings predictability negatively associated with surplus free cash flow.
• Earnings management practices mitigate high-quality auditors.
• The relationship between free cash flow in low growth companies and earnings management moderate by high-quality auditors.
• Opportunistic behaviour of manager positively affected by free cash flow.
• Dividend payout ratio negatively affected by free cash flow and investment opportunity set.
• Investment opportunity set positively affected by free cash flow.
• The free cash flow level can reduce by the contribution of the small size of the board of directors.
• The free cash flow level can reduce by the presence of outside director’s contributions.
• The free cash flow level reduces/increases by higher managerial ownership.
• Among Malaysian firm’s earnings are the key determinants in explaining dividends smoothing.
• The SFCF- earnings management relationship moderate by high-quality auditors.
• The investment cash flow sensitively is negatively associated with the presence of a large family shareholder.
• At moderate levels of shareholdings, the investment cash flow sensitively is positively associated with the family ownership percentage.
• Literature Support

The results in Chen et al. (2012) show that cash holdings are inversely related to leverage and credit line access. This helps to alleviate the agency problem of FCF (Jensen, 1986).

Richardson (2006) finds a positive relationship between over-investment and FCF, which is consistent with the agency cost explanation.

Apedzan Emmanuel higher et al. (2014) expects a positive coefficient of FCF. A significant impact would support our hypothesis and would also indicate that firms make use of FCF to pay dividends. This will also support Jensen (1986) that managers try to reduce agency conflict by paying dividends to shareholders out of FCFs.

Chen et al. (2007) also affirm that dividend-paying firms have higher earnings persistence than no dividend paying firms.

Previous studies document that the relation between internal funds and the investment of firms is positively significant (Devereux and Schiantarelli, 1990; Fazzari et al., 1988; Kuh and Meyer, 1959).

Pawlnaand Renneboog (2005) provides strong support for the free cash flow theory as the main source of the observed investment-cash flow sensitivity.

Harjoto and JO (2011) provide adding support that firms use governance mechanisms, along with CSR engagement, to reduce conflicts of interest between managers and non-investing stakeholders.

Cheng et al. (2014) reveal that firms with superior CSR performance have better access to capital because of reduced agency costs resulting from more effective stakeholder engagement.

Early studies such as Griffin (1988) extend the general finance literature to oil industry firms and finds supporting evidence of FCF and prove that agency problem exists in the US energy industry.

Lang and Litzenberger (1989) find that the overinvesting firms have significantly larger return associated with announcements of large dividend increases, supporting the free cash flow hypothesis.

The findings of Rozeff (1982) and Easterbrook (1984) support the free cash flow hypothesis. According to these researchers, paying greater dividends can reduce firms’ agency costs. As firms paying high dividends are financed more often by the market, they are subject to closer scrutiny.

According to Christie and Zimmerman (1991), paying out dividends is helpful for reducing free cash flow in the hands of company managers as well as reducing agency cost.

La Porta et al. (2000) found evidence that is consistent with the role of dividends in reducing the problem of agency.

Criticism

Chung et al. (2005) argue that these projects may support the self-interest of managers and may offer them a greater level of control over a firm’s resources.

Managers may thus undertake non-optimal actions such as value-destroying investments that result in increased agency costs, a reduction of firm value, and senior executives being pushed into a vulnerable situation. The worst case scenario is that managers can use opportunistic earnings management tools to inflate reported earnings for the purpose of obscuring the devastating effect of such value-destroying investments (Bukit and Iskandar, 2009; Chung et al., 2005; Rahman and Mohd-Saleh, 2008).

Chung et al (2005) argue that company managers with surplus free-cash-flow use income increasing discretionary accruals (DAC) to offset the low or negative earnings and that external monitoring is effective in deterring the manager’s opportunistic earnings management.

Accordingly, as argued by Fresard and Salva (2010), when governance mechanisms are poor, self-interested managers have the ability to use corporate resources in favour of their own interests. Excess cash enables them to take actions that benefit themselves by spending on unprofitable investments. Because cash reserves are easier to expropriate than other assets, turning excess cash into personal benefits is easier than transferring other assets to private benefits (Myers and Rajan, 1998).

Overall, Belkhir et al. (2014) argue that independent boards seem to be effective in mitigating investors’ concerns about any misallocation of funds.

Morck et al. (1988) argue that high levels of managerial ownership could lead to entrenchment, as outside shareholders find it difficult to control the actions of such managers.

Lopez-Iturriaga and Lima (2014) criticize that the dividend policy plays an important role as a disciplining mechanism in the management of companies with low growth opportunities, given that the FCF reduces by the payment of dividends that managers can use at their own discretion.

Numerous scholars argue in reducing the agency costs of FCF dividends and managerial ownership maybe substitutes. (Rozeff, 1982; Jensen et al., 1992; Lee, 2011)

Charitou and Vafeas (1998) conducted a study on the association between operating cash flows and dividend changes, given earnings and argue that a positive relationship between and dividend changes should exist due to liquidity and accruals management considerations.

Brav et al. (2005) determine that management prefers to share repurchase to dividends because it allows management to retain more control over the timing of payout. The commitment to recurring dividend payout provides a restriction on overspending that is desirable for shareholders but not for management.

Under perfect and complete markets, the pattern of dividend payouts has no effect on the firm’s value (Miller and Modigliani).

Benabou and Triole (2010) and Eccles et al. (2012) argue that high sustainability companies are more likely to establish a formal stakeholder engagement process which limits the likelihood of short-term opportunistic behaviour.

Chung et al. (2005) suspect that bias managers may not even internally project cash flows for some investments as they have for some pleasure activities or personal need that make them ignore cash and profit projections. However, they believe that poor investments will reveal themselves in the future reported profits of the company and argue that non-value-maximizing investments will eventually reduce earnings.

Gilchrist and Himmelberg (1995) criticized that Tobin’s Q has low explanatory power and is an insufficient measure of investment opportunities.

Dhrymes and Kurz (1967) argue that a stable dividend policy hampers investment through the reduction of internal capital, whereas firms with residual dividend policy first cut dividends firm investment needs.

Rubin (1990) and Lang, Stulz, and Walkling (1991) criticize that managers prefer to use any free cash flow remaining after investment negative-NPV projects to continue to invest in such projects rather than pay out dividends.

Brush, Bromiley, and Hendrickx (2000) found that growth negatively impacted by free cash flow.

While Titman et al. (2004) and Fairfield et al. (2003) found overinvestment problems with a much lower stock performance among firms.

Similarly, Dechow et al. (2008) proposed that firms with excessive free cash flow had lower future performance.

Easterbrook (1984) argued that dividends can discipline the company by issuing back to the capital market for future funds, thus allowing investors to control the company.

Vogt (1994) argues that large non-growth firms conform more to the free cash flow agency theory, whereas small-growth firms conform more to the pecking order theory.