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Introduction to
Fundamental Analysis
- The Accounting Process
- Postulates and Principles
of Accounting
* Postulates of Accounting
* Principles of Accounting
- The Financial Statements
* The Balance Sheet
* The Income Statement
* The Cash Flow Statement
* Shareholders' Equity
Statement
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The Cash Flow Statement
The statement of cash flow reconciles the accrual
based income statement to the actual cash flow; it also pinpoints exactly
where and how cash is being generated and used.
The three components of cash flow are:
1.
Cash flow from operating activities: Operating cash flow
normally determines the value of a business. Most businesses are priced at a
multiple of current or projected operating cash flow. Operating cash flow
starts with net income, adds non-cash expenses like depreciation, and
adjusts for all other operating cash items. It reflects, among other
things:
a.
Is the company generating cash flow from operations, or is it running
deficits?
b.
Is cash being used to build inventory or receivables?
c.
Is the company generating cash by stretching its payables?
There can also be
divergences between operating cash flow and net income.
The cash flow yield
(operating cash flow ÷ net income) measures a company’s ability to generate
cash flow in relation to its net income.
2.
Cash flow from investing activities: Investing cash flow
indicates how management is investing for the future. Investing activities
normally include such items as capital expenditures (Cap X), business
acquisitions or disposals, and purchases and sales of investments.
3.
Cash flow from financing activities: Financing cash flow
reflects the details of any debt and equity financing that occurred during
the period, as well as dividends paid and treasury stock activity.
The actual parties involved
in the financing activities, however, are normally not disclosed. The
critical issue is: who is actually putting up the money to fund the
business. More disclosure is needed in the area of who is “bankrolling” an
organization. Since some of this information is available in newsletters, it
should also be available to the shareholders. Always be mindful of who are
investing alongside of you, and what are their motives?
Complaints
concerning the cash flow statement center on the complexity of the
reconciliation format. The concept of how changes in balance sheet accounts
affect cash flow is confusing. The critics additionally argue that while the
cash flow statement neatly ties together all the financial statements, and
quantifies the cash flow activities from the major business functions of the
company, it does not address the bigger picture of liquidity. Liquidity is a
company’s ability to pay its bills on time.
Investors need to “draw the connecting dots,” and tie
together a company’s credit lines, cash flow, and debt arrangements.
Projecting cash flow will alert one, in advance, to an upcoming liquidity
squeeze. Additionally, be sure to read the footnotes, and focus on whether
or not a company can meet its upcoming financial obligations. Below is the
cash flow statement for Medtronic.
Consolidated Statements of Cash Flows for
Medtronic, Inc.
(Dollars in millions)
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Medtronic, Inc.
Statements of Cash Flows |
Fiscal Yr.
2005 |
Fiscal Yr.
2004 |
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Operating
Activities: |
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Net earnings |
$1,803.9 |
$1,959.3 |
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Adjustments to
reconcile to net cash: |
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Depreciation and amortization |
463.3 |
442.6 |
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IPR&D |
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41.1 |
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Special
charges |
654.4 |
(4.8) |
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Tax benefit
from stock awards |
60.8 |
55.4 |
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Deferred income taxes |
(142.5) |
110.5 |
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Changes in op.
assets & liabilities: |
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Accounts
receivable |
(227.7) |
(171.5) |
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Inventories |
(51.3) |
127.6 |
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Prepaid
expense & other assets |
(107.3) |
(97.4) |
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A/P and accrued liabilities |
423.2 |
326.1 |
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Other
long-term liabilities |
(57.4) |
56.9 |
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Net cash
provided by
operating activities |
2,819.4 |
2,845.8 |
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Investing
Activities: |
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Acquisitions,
net of cash acquired |
(107.9) |
(30.9) |
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Purchase of
intellectual property |
(10.0) |
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Additions to
property, plant and eq. |
(452.0) |
(424.6) |
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Sales &
maturities of marketable sec. |
807.5 |
1,473.2 |
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Purchases of
marketable securities |
(1,805.3) |
(2,684.0) |
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Other investing
activities, net |
(35.2) |
15.5 |
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Net cash
used in investing activities |
(1,602.9) |
(1,650.8) |
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Medtronic, Inc.
Statements of Cash Flows |
Fiscal Yr.
2005 |
Fiscal Yr.
2004 |
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Financing
Activities: |
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Increase in
short-term borrowings |
90.0 |
(19.5) |
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Payments on
long-term debt |
(1.8) |
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Issuance of
long-term debt |
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Dividends to
shareholders |
(404.9) |
(351.5) |
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Repurchase of
common stock |
(511.0) |
(880.5) |
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Issuance of
common stock |
338.9 |
241.4 |
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Net cash
used in financing activities |
(488.8) |
(1,010.1) |
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Effect of exch.
rate changes on cash & eq. |
(89.2) |
(61.3) |
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Net change in
cash and cash equivalents |
638.5 |
123.6 |
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Cash and cash
equiv. at beg. of period |
1,593.7 |
1,470.1 |
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Cash and cash
equiv. at end of period |
$ 2,232.2 |
$ 1,593.7 |
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Supplemental
Cash Flow Information |
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Cash paid
during the year for: |
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Income
taxes |
$ 551.8 |
$ 490.9 |
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Interest |
55.1 |
56.9 |
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Cash Flow
Statistics |
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Operating
cash flow to sales: |
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Net sales |
10,054.6 |
9,087.2 |
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Net cash
provided by operating activities |
2,819.4 |
2,845.8 |
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Add back:
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IPR&D |
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41.1 |
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Special
charges |
654.4 |
(4.8) |
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Proforma
operating cash flow |
3,473.8 |
2,882.1 |
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Operating
cash flow to sales |
34.55 % |
31.72 % |
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Cash flow
yield: |
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Net Cash from
Operating Activities ÷ |
2,819.4 |
2,845.8 |
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Net Income |
1,803.9 |
1,959.3 |
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Cash flow
yield |
1.6 times |
1.5 times |
Operating cash flow
is a significant figure, as it determines how much money is available for:
1) future investments (cap x), 2) debt repayments or stock repurchases, and
3) dividends.
Lenders,
however, seem to prefer EBITDA calculations.
Many investors ask what is EBITDA or EBIT. First,
EBITDA stands for earnings before interest, taxes, depreciation and
amortization. Naturally, EBIT stands for earnings before interest and
taxes, also commonly referred to as operating income. Many bankers use these
figures instead of cash flow, as a quick calculation of a company’s leverage
capacity. It’s important for stock investors to understand this terminology,
since most banking financial covenants are based on EBITDA or EBIT ratios.
Additionally, many businesses are valued using EBITDA or EBIT multiples.
For a more detailed analysis of EBITDA, refer to the cash flow analysis
section of this book.
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Medtronic, Inc.
Debt to EBITDA Calculation
($ in millions) |
Fiscal Yr.
2005 |
Fiscal Yr.
2004 |
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Debt: |
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Short-term
borrowings |
$ 478.6 |
$ 2,358.2 |
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Long-term debt |
1,973.2 |
1.1 |
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Interest bearing
debt |
2,451.8 |
2,359.3 |
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EBITDA: |
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Earnings before
income taxes |
$ 2,543.5 |
$ 2,796.9 |
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Interest
(income) expense |
(45.1) |
(2.8) |
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Depreciation and
amortization |
463.3 |
442.6 |
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IPR&D |
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41.1 |
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Special charges |
654.4 |
(4.8) |
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Proforma
EBITDA |
3,616.1 |
3,273.0 |
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Debt to
proforma EBITDA |
.68 to 1 |
.72 to 1 |
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EBITDA
Margin: |
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Net sales |
10,054.6 |
9,087.2 |
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Proforma EBITDA |
3,616.1 |
3,273.0 |
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EBITDA Margin |
35.96 % |
36.02 % |
Next review The
Shareholders' Equity Statement |
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