Category: Cash Flow

Part 1: Firm Overview

PART A:

Texas Instruments is a manufacturer of semiconductors which it sells across the globe; generating total revenue of $15.784 billion in fiscal 2018 alone. Semiconductor products are used for a variety of purposes such as “converting and amplifying signals, interfacing with other devices, managing and distributing power, processing data, cancelling noise and improving signal resolution.” The company has two major product types: Analog and Embedded Processing. The first type, Analog, produced $10.80 billion in revenue in 2018 and consists of signal chain, power, and high-volume semiconductors. The second type, embedded processing, produced $3.55 billion in revenue in 2018 and consists of two major sections: connected microcontrollers and processors. Other products that do not fit into these segments including calculators and custom semiconductors brought in $1.43 billion in revenue in 2018. The markets for Texas instruments products by percentage of total revenue include “36% industrial, 23% personal electronics, 20% automotive, 11% communications equipment, 7% enterprise systems, and 3% other.” Texas instruments faces competition from both large-scale and small-scale companies especially in the emerging Asian sector due to an inability to monopolize within the ever-globalizing industry. As of the end of fiscal 2018 Texas instruments had 29,888 employees headed by a group of 13 executive officers with headquarters in North America, Europe, and Asia. As its name implies Texas Instruments was established in Texas in the year 1930 as an oil and gas exploration company and within two decades had become the leading innovator in semiconductor technology.

PART B:

Texas instruments capital structure is primarily composed of equity but it also utilities its debt faculties. In fiscal 2018 net income totaled $5.58 billion of which $2.555 billion was paid out in dividends and $17 million was paid out in dividend equivalents on restricted stock units. The remaining $3.008 billion from net income as well as $236 million in proceeds from accounting changes was added to retained earnings which totaled $37.906 billion. The primary use of retained earnings was stock repurchases costing $5.10 billion and capital expenditures costing $1.131 billion. $500 million was also used for the repayment of debt and $60 million was used for other financing and investing activities. $5.641 billion of retained earnings was used for the purchase of short-term investments which in turn brought in $6.708 billion in proceeds by fiscal year end providing a net profit on short-term investments of $1.607 billion. Texas instruments also had proceeds of $373 million from common stock transactions and proceeds of $9 million from the sale of assets. Proceeds of $1.50 billion came from the issuance of long-term debt; the only form of debt currently used in Texas instruments capital structure. Aside from this, Texas instruments possess a variable rate revolving credit product with a combination of investment-grad banks which allows the company to borrow up to $2.00 billion until March 2023. An important finding to note is that as of the end of fiscal 2018 this credit facility was untouched with no loan debt outstanding. Texas instruments believes it has the required funds and forecast for all its operating activities, financing activities, and investing activities for at least the next 12 months.

Part 2: Analysis of Cash Flows

Operating

The data in the cash flow graphs shown above for operating, investing, and financing activities are directly derived from Texas instruments statement of cash flows in their 2018 annual report. Upon analysis of the data we can see several changes in Texas instruments cash flows which in turn affect the companies free cash flow. Looking at the significant changes in cash flows from operating activities from years 2016-2018 we can see an increase in net income from each year to the next with net income figures of $3.595 billion, $3.682 billion, and $5.580 billion respectively; signifying an increasingly positive contribution of net income to cash flows. There is also an increase in accounts receivable being collected allowing for a positive contribution to cash flows in 2018 of $71 million as opposed to 2016 and 2017 which both had negative contributions to cash flows of -$108 million and -$7 million respectively. The biggest change to be noted is a significant positive contribution of prepaid expenses and other current assets in 2018 of $669 million as opposed to in 2016 and 2017 which had slightly negative and slightly positive contributions to cash flows of -$81 million and $76 million respectively. The only major negative contributor to cash flows from operating activities in 2018 was inventories expense which used $282 million; the purchasing of inventory gradually increased from 2016 to 2018, with 2016 and 2017 in comparison having an inventory expense of $99 million and $167 million respectively. This increase in inventory expense is due to Texas instruments intention to increase liquid assets as part of a plan to increase sales; a plan which proved successful. The combination of these factors allowed for a positive increase in net cash flows from operating activities in 2018 which had net cash flows from operating activities of $7.189 billion compared to 2016 and 2017 which had $4.614 billion and $5.363 billion respectively.

Investing

Regarding the change in net cash flows from investing activity there was a significant positive increase in 2018 which had net cash flows of -$78 million compared to 2016 and 2017 which had net cash flows of -$650 million and -$1.127 billion respectively; although the figure is still a negative number. The numerically negative factors contributing to this include a significant increase in capital expenditures which in 2018 used $1.131 billion compared to 2016 and 2017 which used $531 million and $695 million respectively. As well as a major series of purchases of short-term investments which in 2018 used $5.641 billion compared to 2016 and 2017 which used $3.503 billion and $4.555 billion respectively. This is offset by significant proceeds from short term investments of $6.708 billion compared to 2016 and 2017 which had proceeds of $3.390 billion and $4.095 billion respectively; allowing for a net profit from short-term investment activities of $1.067 billion. There was also a small proceed from the sale of assets in 2018 of $9 million which decreased from 2017 which had proceeds of $40 million; 2016 had $0 in proceeds from the sale of assets. A small expense categorized under other investments also increased from year to year with 2016, 2017, and 2018 having other investment expenses of $6 million, $12 million, and $23 million respectively.

Financing

Financing activities had a significant change in net cash flows in 2018 steaming from several major executive decisions resulting in a much greater net negative regarding cash flows from financing activities. One major decision was to repurchase stocks from Texas instruments shareholders which in 2018 accumulated a cost of $5.100 billion compared to 2016 and 2017 which had stock repurchase expenses of $2.132 billion and $2.556 billion respectively. As well as an increase in the dividends paid which in 2018 had an expense of $2.555 billion in comparison to 2016 and 2017 which had dividends paid expenses of $1.646 billion and $2.104 billion respectively. There was also a large repayment of debt expense in 2018 of $500 million which however was lower than 2016 and 2017 which had repayment of debt expenses of $1 billion and $625 million respectively; this expense is decreasing over time due to a decrease in debt outstanding. Regarding the financing activities categorized under other there was an increase in that expense from year to year with 2016, 2017 and 2018 having expenses of $3 million, $31 million, and $47 million respectively. The proceeds from financing that partially offset these expenses were the proceeds from the issuance of long-term debt which increased in from year to year with 2016, 2017, and 2018 having proceeds of $499 million, $1.099 billion, and $1.500 billion respectively. As well as proceeds from common stock transactions which although positive did slightly decrease in 2018 which had proceeds of $373 million compared to 2016 and 2017 which had proceeds of $472 million and $483 million respectively. Overall there was a significantly larger net negative in Texas instruments cash flows from financing activities in 2018 which had net cash flows of -$6.329 billion compared to 2016 and 2017 which had net cash flows of -$3.810 billion and -$3.734 billion respectively. As stated, this is primarily due to an executive decision to repurchase a significantly higher amount of company stock in comparison to previous years. Regarding net change in total cash and cash equivalents this positively increased in 2018 with net cash and cash equivalents of $782 million compared to 2016 and 2017 which had net cash and cash equivalents of $154 million and $502 million respectively; allowing for an increase in retained earnings.

Free Cash Flow

Texas instruments free cash flow increased consecutively from 2016 to 2017 to 2018; however, there was a more significant increase in 2018. Numerically Free cash flow in these years were $4.083 billion, $4.668 billion, and $6.058 billion respectively. Texas instruments defines free cash flow as “cash flow from operations less capital expenditure” (Page 2). Their strategy is to “return all free cash flow to shareholders through a combination of stock repurchases and dividends” (Page 17). This can clearly be seen in the statement of cash flows as examined above. To break the uses of free cash flow down further, it is used to pay dividends to shareholders, to repurchase stock from shareholders, to pay interest to debtholders, to repay debtholders outright, and to buy short-term investments and other nonoperating assets (Tb Pg41). Free cash flow is calculated as being equal to net operating profit after taxes less net investing in operating capital (Tb pg41) which is synonymous with the Texas instruments definition given. Looking at the figures for the years given: 2016 Free cash flow is equal to net cash flows from operations of $4.614 billion less capital expenditures of $531 million to equal $4.083 billion. 2017 Free cash flow is equal to net cash flows from operations of $5.363 billion less capital expenditures of $695 million to equal $4.668 billion. 2018 Free cash flow is equal to net cash flows from operations of $7.189 billion less capital expenditures of $1.131 billion to equal $6.058 billion. The analysis of Texas instruments net cash flows and free cash flows shows a positive increase, directly correlating to an increase in Texas instruments corporate value from the years 2016 to 2018.

The analysis of Consolidated Cash Flow Statement of Bunzl indicates that the company’s overall net cash position has increased by £31.9mn in 2010 as compared to a decline of £14.5mn in 2009. This has resulted in a cash and cash equivalent figures for 2010 and 2009 as £74.9mn and £43mn respectively (Bunzl).

These figures are further evaluated based on the changes in the cash position in relation to three set of business activities carried out by the company including operating, investing, and financing activities.

Operating Activities

The company’s net cash inflow from operating activities has declined by £25.5mn in 2010. This is mainly due to the negative changes in the working capital. Further investigation of components of working capital suggests that the company’s accounts receivables and inventory have risen sharply in 2010 by £52.7mn and £12.9mn respectively. This could suggest that the company has its cash stuck in larger inventory holding and receivables to be realized.

The company’s net profit for the year 2010 is up by £9.2mn from £216mn in 2009 which has a positive impact on the company’s cash flow from operating activities. Another element that needs to be discussed is the high levels of finance cost that the company is incurring.

Although it has decreased from £54.7mn in 2009 to £50.8mn in 2010 but still it remains at quite high levels. Examination of note 5 accompanying the financial statements clearly reflects reduction in the company’s loans and overdraft obligations but at the same time the company has incurred major loss in foreign exchange.

Further, the company has generated a financial gain on foreign exchange intercompany transactions which may need further understanding of the related party transactions comprising on loans and deposits between related companies (Bunzl).

Investing Activities:

The company’s net cash outflow from investing activities has increased by almost 387% in the year 2010. Currently, it is negative value £124.5mn in 2010 as compared to £25.7mn in 2009. This major change has been the outcome of the company’s capital investment.

The company has purchased nine other companies in the year 2010. These companies are producing hygiene, cleaning, and packaging products which are compatible with the company’s own product lines. These acquisitions are accounted for by the company in its financial statements using purchase method of accounting. Out of the total investment £34.5mn is paid for by the company for goodwill which these businesses are expected to bring with them (Bunzl).

Financing Activities

The company’s net cash outflows from financing activities are £67.7mn in 2010 as compared to £234.6mn in 2009. A major contributor to this position is the interest paid by the company for its debt obligations on both short and long term borrowing.

The company has also paid healthy total dividend of 23.35p per share in 2010 as compared to 21.55p in 2009 resulting in an outflow of £66.1mn in 2010 and £62.3mn in 2009.Further analysis indicates that the company has taken a fresh set of loans from financial institutions.

This has resulted in a positive inflow of £15.1mn in the company’s cash position despite of payback of borrowed amount by the company that resulted in a negative outflow of £131.5mn in 2009 (Bunzl).

Others

The company has also made a exchange gain of £1.8mn in 2010 as compared to a loss of £2.0mn in 2009.

Work Cited

Bunzl. Annual Report 2010. Financial. London: Bunzl Plc., 2010.

Let us start by saying that very often it is very difficult to control the flow of money even in our everyday life. Sometimes we are very surprised by the changes of our budget that happen to be absolutely uncontrolled though we always try not to neglect it. So, what can we say about the way large companies and firms control their cash flows? We are sure that it is a far more complicated process than control of our cash flow. And it is sure to be absolutely impossible without statements of cash flows.

Now we are to disclose the notion of the statement of cash flows. Our understanding of this term is the following: a cash flow statement is a financial document, a report that displays the outflow and inflow of cash during a certain period of time. It is necessary to analyze and study the cash flow statement, because it helps to assess the capability of the company very fast and the results obtained will be evident, correct and trustful. However, in case when the statement of cash flow is neglected, cash flow disclosure may be needed.

In our essay we would like to present the summary of the article by Peter Reilly who is an analyst at Deutsche Bank. His article “End exploitation and act on cash flow disclosure” has captured our attention and we have found it very informative and useful.

Reilly makes the reader interested at once, saying that he sometimes wonders “whether the highly intelligent people who set accounting standards live on the same planet …” (Reilly par. 1). That is so, because his goal as an analyst is to study the documents and reports of the companies for him to understand the real state of things there. He says: “Balance sheets are important, but tell you nothing about flows” (Reilly par. 2). Still, you have to find your way, because if you do not understand the cash flows, it means that you are absolutely ignorant of the company itself. And what is more, the worst consequence connected with poor cash flow disclosure is not inefficient capital market; it is the opportunities of the companies to present their business affairs in a very flattering light.

Reilly sets a very good example:

…under both US and international standards, companies are not required to disclose the debt at acquired companies and yet are allowed to offset the acquired cash against the acquisition price (Reilly par. 7).

Any company wanting to understate the amounts it is spending on acquisitions simply gets the management of the target company to draw down extra debt prior to consolidation (Reilly par. 8).

This example is not pure theoretical, it has been used by real companies.

We get to know that in case with cash flows details are not the subject for analysis. To make the work productive and effective standard-setters should gather with analyst and investors and study the actual set of accounts to appreciate how unsatisfactory current cash flow disclosure is.

The final part of the article presents special interest for us, because here Peter Reilly tries to define the function of the cash flow statement. He thinks that “the statement should be the bridge between the income statement and the balance sheet” (Reilly par. 15). Its main aim is to give us the missing information and to make the state of things clear.

To conclude, we want to say that we agree with the author of the article who thinks that an overhaul of the cash flow statement would be popular and would enhance the standard-setters’ reputation (Reilly par. 17).

Works Cited

Reilly, Peter. “End exploitation and cat on cash flow disclosure”. The Financial Times.Web.

Introduction

Financial statements are used in business to give a summary of the numerous operations that has taken place during a certain period of time. In most cases, they are prepared yearly, half yearly, quarterly or any such period specified in their memorandum. The financial statements include cash flow, balance sheet, and Profit and loss account. They all disclose certain information that is relevant to its users. This paper focuses on a business start up and how these financial statements mean to my business.

My Business Venture

With the world population on the rise, there has been an increase in the number of young people. They are constantly buying products for beauty purposes. There are numerous products in the market; however I wish to start herbal cosmetic business. I aim to establish the business in the town centre.

The Balance sheet

This is a statement that equates owner’s capital and liabilities on one side and long-term assets and short term assets on the other. It is an account that shows the financial strength of the business. Trading account summarises the operation gain in a business and finally Cash Flow explain the differences between opening cash and closing cash. The following is first years, trading account, Cash flow and balance-sheet:

Trading Account

Balance sheet

Cash flow Statement

Market Size

The young, the old, the well to do in the society, and the poor will be my target customers and thus my market size will not be limited to any category of customers. I will produce product to fit all the above population groups. I will not limit myself to production of women or men products but I will produce products for both genders.

Market Place

The market segment, that the marketer want to target, will influence the distribution that he is going to use. Where the customer is more likely to be found should be the place that the goods are provided. If the target customers are people who value recognition, most of them are the high class, they are more likely to be found in the shopping malls and “designer” shops. If the products are targeting the lower class, they should be distributed in the supermarket that is expected to be less expensive than the shopping mall. These are found in the area that people of a certain class live. If the target is the low class, the goods should be available in the local slum and suburbs’ shops. If the target is for the middle class, strategies should be put to persuade them to try the products. The middle class are known to be looking for something extra at the same price. There will be no harm if the products are distributed in the competitors area, efforts should be the way we display what we are offering extra¹.

Sales Forecast

With improved quality and awareness, I expect that there will be an increase in the sales value; with time the level of my company’s sales will increase drastically. I will focus on total quality management and customer satisfaction to ensure continuity in my business.

Production or Key Operations

In my business I will be involved in the manufacture of herbal beauty products and cosmetics. I will require different teams with different level of expertise and production they are generally;

• Production team – it will consist of a production manager with three assistants, they will all be professionals in cosmetics and under them there will be twenty support staff.
• Support department – the departments which will be most active are human resource, customer care, and transport department. They will all be headed by experienced managers. For a start I will have the three as the major support department, they will duplicate on some issues.

Product Cost – How much is it going to Cost You, Materials and Labour?

The price that I will charge for my products will be the total cost involved plus a 25% gross profit margin. From a broader point of view the market can be divided into three sections; the high class, the middle class, and the lower class. The high class is not interested on how expensive the product is, but the point of interest is the utility that the product is going to give. When they are buying things they are looking for something extra that can make them feel special and different. The middle class buy the common goods in the market. When they are the target group, the price should be harmonized with the competitor’s prices. When the target is the lower class, price is the determinant of the market i.e. the lower the price the better. The products can be packed in smaller quantities at “lower prices”.

Sales Plan

To introduce my new products in the market, I will use promotion as my way to get in the market. Promotions are done in the effort to either introduce a new product or increase the market segment. To engage in a promotion, the first thing to understand is the availability of the target customers. Where are they likely to be found? Are they free in the mornings, is it in the afternoon? After realizing their availability and the fact that they can give you time to sell your products then it becomes important to know the age of the market. The behaviour of the youth is that they don’t want something that feels so common, let the promotion give a different good feel on the customer. If the promotion is for the introduction of a new product, then a lot should be invested in assuring the client of better quality than that offered by the competitor. The existence of opinion leaders should be evaluated. The customers are likely to follow the opinion leaders in making their decisions. The existence of groups in the society and their matching lifestyles can also be of great use².

Usefulness of Information Provided

After the company has started operating I will prepare financial statements. In companies, to report is a statutory requirement of many governments and they should be in line with an international Accounting Standards. They are both the external users and the internal users. The external users are the government, potential investors, and the statistics analyses among others. The employees of the company require this information to determine the capability that their employer has. In the hard economic times the employees require this information to interpolate the future of the business and are able to make any adjustment that may be relevant. The shareholders need these accounts to evaluate the way the business is run. They are able to know the dividend that they are likely to get. Whenever a company is getting loan from a bank, this are the accounts that are used to evaluate the credit worthiness of the company³.

For the accounts to be of help to the users, they should be made in such a way that they are understandable by the required user.

Bibliography

Eisen, P. Accounting. New York: Barron’s Educational Series, 2007.

Gary, A. and Kotler, P. Marketing: An Introduction. New York: Prentice Hall, 2010.

Harper, S. The McGraw-Hill guide to starting your own business: a step-by-step blueprint for the first-time entrepreneur. New York: McGraw-Hill Professional, 2003.

Footnotes

1. Gary, Armstrong and Kotler, Philip. Marketing: An Introduction. New York: Prentice Hall, 2010.
2. Harper, Stephen. The McGraw-Hill guide to starting your own business: a step-by-step blueprint for the first-time entrepreneur. New York: McGraw-Hill Professional, 2003.
3. Eisen, Peter. Accounting. New York: Barron’s Educational Series, 2007.

This essay is devoted to the explanation of discounted cash flow and relative valuation techniques. Both groups of methods are illustrated with examples. While relative valuation techniques are often criticized for inconsistency, this essay tries to explain why these methods are still frequently used both by small investors and financial analysts. Additionally, the essay concludes with specific reference to common mistakes made in the valuation of security due to the irrelevancy of accounting reports.

Discounted cash flow methods

Discounted cash flow (DCF) methods are not new in human history. The ‘philosophy’ behind DCF is very simple and was known from the very earliest times of financial history: the value of assets changes across time. However, it was only in 1930 when DCF techniques were translated on modern financial language and formalized by Irwing Fisher. According to Fisher (1930): “Income is derived from capital goods. But the value of the Income is not derived from the value of the capital goods. On the contrary, the value of the capital is derived from the value of the Income.” Therefore to find out the value of capital now, one must analyze possible changes in the value of Income in the future.

When used for estimating the value of a security, DCF methods do not simply use future cash flows as current ones but consider their ‘discount’ or interest rates when converting them to current. In this way, DCF methods demonstrate two significant benefits. First, they take into account the time value of funds, reflecting the strive of investors to acquire cash as soon as possible. Cash flows discounted with interest rates produce less Income. Therefore current profit is more valuable to an investor than delayed profit. Second, they include risk premium, reflecting extra return offered to investors for the risk of not acquiring future Income at all. There are several well-known groups of DCF techniques — each of them is analyzed below.

Flows to equity approach

The flows to equity approach bases on the notion of free cash flow to equity (FCFE), which indicates how much cash will be available for payout to investors after all expenses, reinvestment, and debt repayment included. Or, expressing in a mathematical way:

FCFE = Net Income – (Capital Expenditures – Depreciation) – (Change in Non-cash Working Capital) + (New Debt Issued – Debt Repayments).

FCFE can be used for determining the value of a company and, therefore, its securities. How exactly? Damodaran (2002) answers this question: “We measure how much cash is available to be paid out to stockholders after meeting reinvestment needs and compare this amount to the amount actually returned to stockholders.” The difference between the actual payouts and hypothetical ones tells us if security is under-or overpriced.

Since we are using a discounted cash flow technique, net Income will be adjusted with the discount rate, and in the case of valuing the project, our formula calculates its net present value (NPV) as follows: NPV = Cash Flow to Levered Equity / Discount rate – Initial Investments + Debt Issued, where Cash Flow to Levered Equity = (Net Income–Debt*rate of return)*(1 – Corporate Tax). Thus, the FTE approach allows us to find the true value of a project; however estimating discount rate can be a problem.

Adjusted present value approach

The second important technique, which becomes particularly useful when time change of debt to equity ratio is essential, is called the adjusted present value approach. Simply it uses the net present value adjusting it with the present value of financial decisions made by the company. This technique can be divided into three steps: estimation of the net present value of a project, calculation of the present value of interest tax savings, and finally estimation of the probability of bankruptcy and its expected cost. The last step is the most complicated one as the cost and probability of bankruptcy cannot be calculated directly (Ehrhard and Daves, 1999).

The weighted average cost of capital approach

WACC approach shows the return a project must earn to return its stock price constant without changing assets. Illustrated by a formula: WACC = Equity/Total capital * cost of equity + Debt/Total capital * cost of debt (1 – tax rate), where Total capital = Equity + Debt (company’s assets are financed only by debt or equity). Expressed in percentage WACC shows the rate of return, which is desirable, i.e., only investments with the rate of return higher than WACC should be made. Or put it another way, WACC shows how much a company should pay to its investors.

The following example serves as an illustration for a better understanding of DCF techniques described before. Suppose we have a company that requires $5 million to invest, expecting to bring Income of $1.6 million annually. Without losing much detail, we suppose that the company’s income will remain the same forever. Additionally, the company’s required return on all (debt + equity) is 10%, and it wants to use debt of an additional $3 million with the rate of return of 8%. The corporate tax rate is at 40%.

Using the APV technique at first we will find unlevered NPV first: NPV = Income * (1 – Corporate Tax)/Rate of return – Initial Investments=1.6*(1-0.4)/0.1 – 5=1.6*0.6/0.1 – 5=$4.6 million. But our company uses additional financing from debt with an annual interest of 3*0.08=$0.24 million. The tax subsidy from this sum will amount to 0.24*0.4=$0.096 million. Therefore the present value of debt financing decisions will be 0.096/0.08=$1.2. Thus the adjusted NPV will be 4.6 + 1.2= $5.8 million. The real market value of the whole project will be 5+1.2=$6.2 million, and therefore its equity = total value – debt = 6.2 – 3 = $3.2 million.

Under FTE technique the cashflow to levered equity will amount (Income –Debt*rate of return)* (1 – Corporate Tax) = (1.6–3*0.08)*(1–0.4)=(1.6–0.24)*0.6=$0.816 million. Using the debt to equity ratio calculated previously we can find the cost of equity = total cost + debt to equity ratio * (1 – Corporate Tax) (total cost – cost of debt)=0.1 + 3/3.2*(1-0.4)*(0.1-0.08)=0.1+0.937*0.6*0.02=0.1112. Thus the cost of equity is 11.12%. Thus NPV under this approach will be calculated as: NPV = 0.816/0.1112 – 5 + 3=7.33 – 2=$5.33 million.

Finally, WACC can be easily calculated through the formula: WACC = 3.2/6.2*0.1112+(1-0.4)*3/6.2*0.08=0.0573+0.0232=0.0805. Therefore investments in this project will be beneficial under the rate of return higher than 8.05%.

Each of the provided methods has some drawbacks. Under AVP, it is often hard to determine bankruptcy costs and probability. FTE is not helpful in acquiring the required return, and under WACC, debt capacity can alter from reality.

Relative valuation methods

While discounted cash flow valuation methods determine the price of an asset by looking on its expected future cash flows, relative methods determine the price of an asset by comparing it with known prices on other assets claimed to be ‘comparable.’ Usually, relative methods are easier to use then DCF because the former ones do not hold any complex estimation, and use information readily available. Ratios used for relative valuation are numerous. However, we will look into the most widely used: price/earnings (P/E), enterprise multiple, and price/book (P/B).

The price/Earnings ratio simply reflects how much investors are willing to pay per dollar of earnings. It is calculated as market value per share divided by earnings per share. Generally, it is believed that companies with high P/E on their stocks are attractive to investors as earnings are expected to grow in the nearest future. For instance, a company trading $25 per share with earnings over the last year of $2.5 may be more perspective than stocks of another firm at a price of $60 per share and earnings of $8 over the last year, because in the first case P/E=25/2.5=10 and in the second P/E=60/8=7.5, which means that shares of the first company purchased now will bring more earnings in future. Unfortunately, P/E does not seem to be a reliable ratio: “relative P/E-ratio valuation will not be able to handle differences in the expected book return or growth of owners equity” (Skogsvik and Skogsvik, 2001).

Enterprise value (EV) is known to be an alternative to the direct market capitalization measure of a company’s value. EV is sometimes called the takeover value of a company because it includes market capitalization plus debt, minority interests, and preferred shares but excludes total cash and cash equivalents. It is considered that EV is a more accurate representation of a firm’s value, especially if a company has a diverse capital structure.

Still, the most reliable of relative ratios, according to empirical tests of Park and Lee (2003), is the price/book ratio, calculated as stock price/ (total assets – intangible assets and liabilities). Generally, this ratio shows if shares of a company are overpriced or underpriced and how much relative to other companies. For instance, if company A has a market capitalization of $50milion and has assets totaling $15million with debts of 2 million. Then P/B=50/15-2=3.85. Let us assume there is company B with a market cap of $20million, assets of $12 million, and liabilities of $1 million. Its P/B=20/12-1=1.82. It means that A-shares are overpriced in comparison to B, and B shares are underpriced when comparing it with A. Normally, this would mean that B shares are better to buy, and A shares are better to sell. However, P/B is often distorted with other side effects. For instance, the operating performance of B has significantly decreased, and its share prices have fallen down. Or, the CEO of firm A is more popular, and it has fast-growing earnings.

As can be seen, relative methods are often criticized for their inaccuracy. Still, they are widely used not only by small investors because of the simplicity of techniques but also by financial analysts combining them with DCF methods. Damodaran (2001) indicates that relative methods can be helpful in understanding the global picture of the market or one of its sectors, or indicating the presence of mistakes in the portfolio, while DCF tools are more accurate and help to determine local changes, or where those mistakes exactly are.

Of course, despite the method chosen, there is always a probability of making a mistake. While investor or financial analyst relies upon the accounting information available, the accounting reports themselves are often generators of mistakes. Here three most common problems that occurred due to accounting are described.

First, there is always a problem that exists with the calculation of a company’s growth. Since growth can be estimated by computing historical growth rates in dividends, sales, or net profits, such an approach is often too rigid and unable to reflect changes in the company or in the economy. For instance, the increase of competition in a particular business area will most likely slow down terms of growth, and even high-growth companies will not be able to keep with their historical growth rates. At the same time, stock prices of companies showing historically high growth will indicate a continuation of a high growth rate. Therefore, shareholders and investors will acquire lower returns than they would receive from investing in companies, which growth has already stabilized.

Second, estimated required return rates or risk premium could be dimmed through the insufficiency of accounting information. The estimated risk premium is often hard to calculate (Lamdin, 2002) because it has dropped significantly from the rate common to see ten years ago. While even small changes in estimating risk premium may significantly influence a portfolio, Lamdin (2002) indicates that recommended ERP oscillates from 2 to 10 percent, which shows rather wide frames for ERP.

Finally, forecasting dividends is also greatly affected by accounting information. Penman (2003) argues: “GAAP net income and earnings per share misses aspects of a firm’s operations that bear upon the valuation of shares”. Notice from exhibits 1 and 2 how earnings were generated by conservative accounting.

Conclusion

As can be seen, both discounted cash flow and relative valuation methods can be useful when applied with caution to their strengths and limitations. Being useful tools for investors and analysts DCF and relative methods are best used together in combined mode in order to receive the most comprehensive picture on the stock market.

References

1. Damodaran, A. (2002). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. 2^nd ed. Chapter 14: “Cash flow to equity discount models”. John Wiley and Sons. Web.
2. Damodaran, A. (2001). “Its all Relative: First Principles of Relative Valuation”, Working paper.
3. Ehrhard, M.C., Daves, P.R. (1999). “The Adjusted Present Value: The Combined Impact of Growth and the Tax Shield of Debt on the Cost of Capital and Systematic Risk”. Whitepaper published by Odellion Research. Web.
4. Fisher, I. (1930). Theory of Interest. The Macmillan Company, New York. Web.
5. Lamdin, D.J. (2002). “New estimates of the equity risk premium and why we need them: sharpening estimates of an important financial variable”.Business Economics, Web.
6. Park, Y.S., Lee J.-J. (2003). “An empirical study on the relevance of applying relative valuation models to investment strategies in the Japanese stock market.” Japan and the World Economy, vol. 15, issue 3, pages 331-339.
7. Penman, S.H. (2003). “Quality Accounting For Equity Analysis”. The Saxes Lectures in Accounting.
8. Skogsvik, K. and Skogsvik, S. (2001). “P/E-ratios in Relative Valuation – a Mission Impossible?” Working Paper, Stockholm School of Economics. Web.

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 Hal’s 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 Hal’s 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 Hal’s 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 entity’s 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.

Cash is king, is it not? However, having cash is not enough. What is more paramount is to develop the mechanisms of managing cash because it is the employment of such tools that makes the business successful and protects it from bankruptcy and negative influence of economic turbulence keeping it afloat. That is why it is crucial to recollect the techniques of managing cash flow in the business.

The Cash Flow Gap?

First and foremost, it is vital to realize that managing cash flow is only significant to avoid what is known as a cash flow gap, i.e. the condition of the business, in which cash outcomes exceed cash incomes (Edwards 5). It is extremely acute in the case of small businesses and start-ups. However, sometimes even big businesses face this challenge, e.g. during the times of economic turmoil. So, understanding these gaps and eliminating them are the primary objectives of cash flow management. This article will present some effective techniques for managing cash flow.

Maintaining Cash Balance

It is always paramount to maintain the balance between cash incomes and cash outcomes. This technique requires a close look at a company’s financial health. The most important thing to realize about maintaining cash balance is that an enterprise should ensure that it has enough funds to continue its operation, and it should be done daily (Moodie 20). This method is often used by small businesses because it is close to impossible to employ in the case of big companies. It is deployed through determining cash burn rate, i.e. being close to negative cash flow. This rate is easy to calculate because it equals average spending during a particular period (Edwards 6).

Down the Path of Accuracy

The easiest and most effective way to manage cash flow is to be accurate. This technique requires maintaining the quality of data, keeping precise records of all business activities, paying bills on time, and correctly addressing invoices (Moodie 21; Akalp par. 8, 10). These steps are simple to follow and are the foundation of workplace and business discipline, but their significance and efficiency cannot be underestimated because they minimize the risk of negative cash flows and the existence of cash flow gaps.

Adapting the Cash Cycle

This technique is highly individual because it implies that every company adapts the length of its cash cycle to its personal needs and interests. It means that business makes the shift from a traditional 12-month long cash cycle to longer or shorter ones to reflect the specificity of its business operations. It should be noted that the focus is made on routine activities. However, there is a set rule for deploying this method: the shorter the cycle, the better because it contributes to more accurate behavior in doing business (Edwards 8).

Thinking Long-Term

This method has two constituents. First, it points to the necessity of forecasting potential economic instability and planning the outcomes of business activities. It is necessary for mapping out expenditures and understanding the volume of resources necessary for successful operation. Second, it includes long-term lending. The idea behind this technique is to reveal as much cash as possible for dealing with current issues even though leasing and long-term lending are usually more expensive (Akalp par. 5, 15).

Conclusion

Knowing how to apply the techniques mentioned above is beneficial for doing business. Of course, they are more applicable to small businesses or start-ups because they often feel a lack of resources. However, keeping them in mind and putting them to practice is always a good idea because even big businesses can be greatly affected by the unforeseen crisis.

Works Cited

Akalp, Nellie. “How Well Are You Managing Your Business Cash Flow?” Small Business Trends. 2015. Web.

Edwards, James B. “Managing the Cash Flow Gap.” Journal of Corporate Accounting and Finance 26.1 (2014): 3-10. Print.

Moodie, Ann-Marie. “Managing Cash Flow in Tough Times.” Charter 79.9 (2008): 20-22. Print.

It could be suggested that the discounted cash flow analysis carried out in this report generates a value of Mercury Athletic Footwear that could be considered as a conservative estimation. From the analysis, it could be noted that the business is valued at $299,507 million. However, it could be argued that this valuation ignores various factors such as synergy or economies of scale that would be generated after the merger between the two companies. Furthermore, another approach to valuation could use the industry average multiple. In this case, Mercury Athletic Footwear could be valued at a higher value.

Table 1: Valuation

Table 1 indicates that the present value of expected future cash flows is $499,607.85 million. However, it could be noted that future cash flows are estimated based on a low growth rate. If the growth rate is increased, then the value of Mercury Athletic Footwear would also increase. It could be indicated that the merger between the two companies would generate positive business outcomes and synergies that could increase the growth rate and future cash flows.

The company can finance the acquisition by using two sources of funds including internal equity and debt. It is recommended that the company should complete the acquisition of Mercury Athletic Footwear by borrowing funds from debt providers. The reason is that it would help the company to utilize debt funds with low cost rather than high-cost equity. The analysis indicates that the cost of equity is 12.6%. The company should borrow funds and seek to optimize its capital structure and lower its weighted average cost of capital (WACC). The company should work on improving its debt to equity ratio value. It would help the company to increase shareholders’ confidence in its decision to acquire Mercury Athletic Footwear. Furthermore, AGI can lower its cost of funds by reinvesting its earnings. For this purpose, another valuation method i.e. Modified Internal Rate of Return (MIRR) can be used to determine the feasibility of acquisition.

The additional sources of value can be identified based on qualitative and quantitative analysis of the information regarding the targeted company and the acquirer.

The acquisition of Mercury Athletic Footwear can create business synergies. AGI can improve its asset efficiency by investing in the development of its inventory management system. The outcome of this investment would be a reduction in the number of inventory days from 61.1 days to 42.5 days. It implies that the company would be able to convert its inventory into sales faster. It would also have a positive impact on the company’s cash conversion cycle as it would generate cash for reinvestment and expansion of its business. Furthermore, it could be indicated that the merger decision would help the company to reduce its operating costs and funds tied up in its working capital.

The merger between the two companies would also assist AGI to take advantage of Mercury’s Women’s Casual Footwear product line by generating higher sales and improving its operating profit. The company is expected to experience a major shift in its sales from Mercury’s Women’s Casual Footwear product line. It could be indicated that the company experienced a decline in sales in 2005 and 2006. It is important for AGI to take initiatives to increase its sales. It is anticipated that the company would experience a sales growth of 2%. It is also expected that the merger would help AGI to recover from its current operating loss condition and earn an operating profit margin of 9%.

It could also be argued that the merger would help AGI to negotiate better terms with its suppliers and low its cost of sales. The company could experience an increase in its procurement from 20% to 40% as its sales increase. The company can achieve economies of scale and improve the efficiency of its distribution network.

Introduction

A cash flow statement is described under IAS 7 as a statement that shows the movement of funds in an organization. ¹The main purpose of preparing a cash flow statement is to provide data on all the cash inflows and outflows of a firm. It is a statement that is useful to not only the insiders but also the outsiders of the organization. Lenders and prospective lenders to the organization will be in a position to establish the status of the organization in terms of its cash flows and its ability to repay its obligations. This usually includes all the cash inflows and outflows and negates the non cash items like amortization and depreciation.

Cash flow from operating activities

This is an indirect way of preparing a cash flow statement. Since the firm got a loss, this does not represent an actual flow of cash, and so adjustments have to be made to get an actual figure for the cash outflow or inflow from operations². This will call for the addition of noncash items that had been recognized as expenses and thus had been added, for example, Amortization of surface mine development and restoration assets, which had previously been recognized as an expense yet did not include an actual out flow of funds. Another example of an item that does not involve the flow of cash is the net increase in the fair value of the assets.

The increase indicates that in the previous year, there had been a decline in the value of the assets. However, in 2008, there was an increase in the fair value of assets. This, however, does not involve an actual inflow of cash and, therefore, the need to carry out adjustments.

At the same time, we shall deduct those revenues that were recognized in the income statement, yet they did not include an actual inflow of funds. An example of this is the “Share of post-tax profit from joint ventures” that had previously been recognized as revenue. Upon the adjustments, the figure obtained is the cash used or from operating activities. There was an increase in this figure to (31,508) from (27,425). This means there was an increase in the operating costs, possibly from an increase in inflation and inefficiencies by the firm.

Cash from investing activities

This figure is used to represent the net inflows or outflows realized from investments in stocks, assets, and bonds. It will represent dividends received or paid, interest received or paid, and proceeds from the sale of any ventures by the firm. Cash inflows received will be added to the cash from operating activities while the outflows paid will be deducted from the same figure. There was a decline in the cash that was used in investing activities to 8,974) from (12,869). This is majorly attributed to the proceeds realized from the sale of a joint venture and the proceeds from the disposal of investment properties. Although there was a tremendous increase in purchase of operating property, plant and equipment, this was not substantial enough to increase the cash from investing activities.

Cash flows from financing activities

This relates to the net amounts that are utilized or received from activities that are to uphold the capital of the firm. This includes activities that affect movement of equity and debt capital. Some financing activities do not involve cash outflows or inflows and should be recorded since future payment of cash is not eliminated³. As for coal, there was a huge decline in the cash generated from financing activities.

This is attributed to the repayment of the loans and non taking of more loans. The value will have been much less save for the huge increase in net proceeds from generator loans and prepayments. At the end of the cash flow statement, cash and cash equivalents at the beginning are added to the net cash flows for the year to give a figure that is equivalent to the cash and cash equivalents at the end. ⁴Cash and Cash equivalents refer to those asset items that are easily convertible into cash. They will include among other notes receivable and marketable securities.

At the end of the adjustments, the cash and cash equivalents at the beginning when added to the net cash flows for the year will give the cash and cash equivalents at the end of the year. In the example, the cash and cash equivalents at the beginning were 42,336 and 28,766 respectively giving a total of 71,102. Having adjusted for the net receipts for the insurance premiums received, the figure for cash and their equivalents amounted to 36912.

There was a general decrease in the cash and cash equivalents from 40300 to 36912. This has the implication that the liquidity position of UK coal was at a worse position than it was in the previous year. The firm when met with current financial obligations will be in a worse position than the previous year.

The cash and cash equivalents movement has been summarized in the table below:

In conclusion, the management of cash in the organization is of great essence. As an organization UK Coal needs to not only have an effective maintenance of the flow of cash. The liquidity position of the firm is very essential in giving information to both creditors and potential lenders of the firms’ ability to repay the obligations due to them. Currently the firm seems to be in a fair position to meet its obligations since it has a positive position in terms of the cash balances.

Bibliography

Tracy, J, How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, John Wiley & Sons Publishers, New Jersey, 2007.

Jackson, S, Sawyers, R & Jenkins, G, Managerial Accounting: A Focus on Ethical Decision Making, Cengage Learning Institute, New York, 2006.

Delaney, P & Whittington, O, Wiley CPA Exam Review 2009: Financial Accounting and Reporting, John Wiley & Sons, New Jersey, 2009.

Warren, CS, Reeve, JM & Duchac, J, Managerial Accounting, South Western Cengage Learning Institute, New York, 2007.

Footnotes

1. P Delaney, & O Whittington Wiley CPA Exam Review 2009: Financial Accounting and Reporting, John Wiley & Sons, New jersey, 2009. P.616.
2. S Jackson, R Sawyers, & G Jenkins, Managerial Accounting: A Focus on Ethical Decision Making, Cengage Learning Institute, New York, 2006. P.539.
3. CS Warren, JM Reeve, & J Duchac, Managerial Accounting, South Western Cengage Learning Institute, New York, 2007. P.533.
4. J Tracy, How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, John Wiley & Sons Publishers, New Jersey, 2007. p. 90.

Effects of excess reliance on one project screening method

The problems identified in the ABC case study are not only limited to the discounted cash flow method, but also to the scoring method. The right selection of new projects is determined by the experience and judgement of all managers involved in the selection process. Just like the ABC Company, many organizations have limited experience on new projects. This implies that managers are likely to leave projects with important values when selecting new projects.

Furthermore, the input in project screening and selection may not be reliable. This can lead to some projects overrunning budgets, mismatching with the current portfolio, or getting completed after the deadline.

The Analytical Hierarchy Process (AHP) is the second screening and selection model that can lead to problems, similar to the ones identified in the case study. This model addresses the technical and management problems that are inherent in the scoring model. It supports managers in the rational selection of the best project alternatives, basing on both qualitative and quantitative criteria. The criteria and sub-criteria are hierarchically structured and ranked in the order of scores.

The AHP model helps in selecting the best alternatives and reducing new project risks. However, this model suffers from a number of drawbacks that can lead to problems, similar to the ones identified in the case study. First, a manager can end up selecting a strong project with a prohibitively high cost tag due to a bias in calculating the scores. Second, the AHP method requires full exposure of the criteria before the process begins. This implies that a potential company may prefer pursuing certain projects over others, basing on different agendas, rather than the projects’ viability or feasibility.

New projects evaluation criteria

The addition of new projects affects the project portfolio of a company. No universal criterion is used to evaluate these projects. However, the following criteria are critical for the ABC Company in adding new projects to its current portfolio. These criteria will help solve the current problems that the company is experiencing.

The first criterion is to determine the relationship between the new project and the existing project portfolio. The portfolio Matrices, scoring, and AHP, are used to evaluate this relationship.

Market penetration is the second criterion in developing new projects. These projects are evaluated, basing on their capability of attracting and maintaining customers. They can also be evaluated, basing on their increase in market penetration. In addition, the time to market the new projects or products is evaluated to measure its impact on the current marketing strategies.

Technological feasibility is the third criterion of the new project development. It involves determining the technological capabilities of a company to sustain new projects. The company should possess or have access to technological skills required in innovating and designing new products. In addition, an organization should have technological resources to help it push the new products along with the existing portfolio.

The last criterion is to evaluate the costs of developing new products or projects. Project managers should be aware of these costs. This can help in reducing costs and preventing delays due to funding constraints. The actual cost of selecting projects and opportunity costs of the foregone projects should be considered. This requires a cost-benefit analysis of the alternatives to new projects.

All these criteria should be integrated to ensure a successful project development process of an organization.

Case study demonstrated effects of poor project screening methods of project management

The ABC case study demonstrates several impacts of poor project screening methods on an organization’s ability to manage projects efficiently. The case study demonstrates that projects with strong estimated cash flows can be injurious to any company. If a company fails to manage new high cash flow projects well, the projects can turn out to be too costly and inconsistent to the existing portfolio. In addition, the ABC case study exposes dangers of excessive reliance on a single criterion, during the process of project selection. Furthermore, it shows that a successful project portfolio should be coherently constructed and managed as a whole.

In addition to the above factors, the case study shows that although financial screen models are non-subjective, they have several shortcomings. If a company excessively relies on one model, let’s say such NPV OR IRR, it will be difficult to make accurate long term estimates of new projects. The economic conditions such as inflation, interest rates, and recession may be unknown and unstable. Therefore overreliance on discounted cash flow methods may turn out to be invalid in the future, leading to problems in the ABC Case study.

The case study also demonstrates the impacts of lack of evaluation of new projects. As earlier mentioned, when new projects are added or introduced to the current portfolio without drawing their complementarity, the projects are likely to be inconsistent and mismatched. This creates project incoherence between current portfolio and the new projects. The ultimate outcome is negative project results as demonstrated in the case study. In other words, the ABC case study confirms and demonstrates the impacts of poor screening methods of management in an organization.