A Deep Dive Into Cash Flows

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A Deep Dive Into Cash Flows

• From an academics perspective..

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The Current Credit Crisis

• The current credit crisis has
• shaken the financial markets.
• ...undermined the confidence of consumers and
  investors.
• caused access to external capital to dry up.
• sent the cost of capital soaring.
• led to a renewed focus on liquidity.
• and reminded us that CASH IS KING!

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Cash is King!

• Success is dependent upon ability to generate
  revenues and earnings, but also cash flow,
  especially free cash flow.
• Use for acquisitions, debt retirement, dividends,
  stock buybacksor at a more basic level
• LIQUIDITYto ease the minds of employees,
  customers, suppliers, creditors and investors.
• Firms with ample liquidity have outperformed
  their cash-strapped industry peers by almost 7.
• Prior to the credit crisis, cash-rich firm were
  generally underperforming.

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8 Keys to Cash Management
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Develop Accurate Cash Flow Forecasts

• Best companies get a clear picture of where they
  are headed, monitor their cash flow forecasts
  closely, and communicate this to key
  stakeholders.
• 75 of surveyed finance executives ranked
  forecasting cash flow as top priority in
  liquidity management.
• Measure and report of the accuracy of forecasts
  and use this to refine future forecasts.
• Failing to produce accurate forecasts can lead
  to
• liquidity problems.
• debt covenant violations.
• restricted or costly access to capital.
• earnings volatility.
• lower returns.

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Understand the Risks You Face

• It is imperative to understand the risks that
  influence a companys performance, as well as
  their impact on forecasts of cash flows.
• Once you understand the risks, you can take
  proactive steps to manage them.

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Understand the Risks You Face

• 62 of CFOs blame the credit crisis on risk
  managements inability to understand complex
  financial instruments.
• 75 say risk management now outranks in
  importance such issues as long- and short-term
  debt financing, relationships with financial
  institutions, pension-plan asset allocation, and
  the ability to secure equity financing.

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Understand the Risks You Face

• Only 48 of risk managers report that there is a
  formal document identifying risk management
  purpose and objectives.
• Only 38 of risk managers report that a risk
  management policy is defined and communicated
  internally.
• Only 44 report that the risk management process
  is embedded in company activity.
• And this is for companies who actually have risk
  managers!

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A Virgin Mobile Story

• Virgin Mobile CFO, John Feehan, spotted signs of
  looming bankruptcy at Circuit City and took
  action.
• Tightened billing terms
• Demanded cash payments
• Adjusted shipments daily
• RISK MANAGEMENT!
• Virgin Mobile takes a hands-on approach by
• perceiving risk management as part of our daily
  life. We dont separate it out as a separate
  function its just part of how we manage every
  aspect of our business.

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Understand the Risks You Face

• Understanding risk is a start, but then companies
  have to develop meaningful data.
• For every key performance indicator (KPI),
  companies should be tracking a key risk indicator
  (KRI).
• For example, what happens if sales are down 20?
• How will this affect cash forecasts?
• What actions will the company take in response?

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Understand the Risks You Face

• Consider communicating this information to key
  stakeholders.
• From Starbucks 4th quarter earnings release
• Starbucks believes that if it were to report a
  two percent decline in consolidated comparable
  store sales in fiscal 2009, the company would
  deliver GAAP EPS of about 0.78 per share, or
  non-GAAP EPS of approximately 0.90 per share. If
  the current environment worsens, the company
  believes even a five percent decrease in
  consolidated comparable store sales would result
  in GAAP EPS of approximately 0.68 per share, or
  non-GAAP EPS of around 0.80 per share. In the
  event of further deterioration in consumer
  spending and its associated impact on traffic,
  Starbucks believes a seven percent decline in
  consolidated same store sales would lead to GAAP
  EPS of approximately 0.59 per share, or non-GAAP
  EPS relatively flat year-over-year.

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Ensure Adequate Sources of Liquidity

• Using cash flow forecasts as a baseline, every
  company should ensure it has access to sufficient
  sources of liquidity to finance its operations
  through a downturn.
• The cheapest and most flexible source of
  liquidity is internally-generated cash.
• But given effects of financial crisis on ability
  to generate cash, firms must consider other
  options.

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Ensure Adequate Sources of Liquidity

• Consider what others are doing
• Many private and public firms are working with
  4-5 banks as opposed to 1 bank.
• Other firms are drawing down credit lines.
• Ask, do you need this credit to operate on a
  day-to-day basis?
• If not, analysts argue that this is likely to be
  seen as a black mark against managers who have
  increased leverage for no good reason.
• Many firms are seeking non-traditional sources
  of funding such as private equity.
• Some firms are accessing the corporate bond
  market.
• Last week companies raised about 7BCisco
  Systems raised 4B.
• Prior week Fannie Mae, Harley Davidson, PG, and
  others issued about 17B.

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Ensure Adequate Sources of Liquidity

• Consider what others are doing
• GM and Ford have sold businesses no longer
  central to their firms strategies.
• Target and Alcoa have cancelled plans to buy back
  shares.
• Sara Lee announced a suspension of buy back
  program, sending share price down by almost 20,
  and then re-instated program (citing the lower
  price for its stock).
• Sprint Nextel stretched out payments on bank
  debt.
• Replaced a 6B revolving credit facility with a
  4.5B loan due in 2010.
• Debt to Profit ratio increased, decreasing
  probability of violating covenants.
• Sun Microsystems cut its workforce.

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Ensure Adequate Sources of Liquidity

• Consider what others are doing
• Dow Chemical and Harley Davidson significantly
  reduced dividends.
• Dow Chemical slashed its dividend by 64 to 15
  cents from 42 cents, saving an estimated 1B.
• Harley Davidson slashed its dividend by 70 to 10
  cents from 33 cents, saving an estimated 50M for
  the quarter.
• In 2008, 62 SP 500 companies decreased dividends
  by an aggregate 40.6 billion, with 48 of the
  decreases coming from financials. Over the
  previous 5 years, only 12 dividend decreases from
  financial sector.
• Standard Poors expects 2009 SP 500 dividends
  to decline 13.3 percent, the worst decline since
  1942.
• Works out to 33B decline in dividend payments
  compared to 2008.

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Efficiency in Working Capital

• One of the best and cheapest sources of liquidity
  comes from reducing the need to finance working
  capital.
• Improvements to receivables, payables and
  inventory processes can result in lower operating
  costs, improved forecasting accuracy, and
  improved cash cycles.

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Efficiency in Working Capital

• Receivables
• Pursue collections more aggressively.
• Balance desire to limit credit exposure and drive
  cash collection against customer relationship
  management and sales growth.
• Identify customers worth keeping versus those
  that are not.
• Pitney Bowes began using a new technology to keep
  on top of its customers via automated phone calls
  to remind them of bills before they are due.

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Efficiency in Working Capital

• Inventory
• Reduce inventory in supply chain.
• Consider ways to move excess inventory.
• Must balance desire to minimize inventory with
  desire to mitigate risk of supply-chain
  disruptions (and risk of not meeting customer
  demand).
• Payables
• Negotiate new terms with suppliers.
• Must balance desirability of squeezing
  suppliers against long-term cost of damaged
  relationships.
• PG is shrinking inventory level and also
  squeezing suppliers.

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Discipline in Capital Spending

• Ensure you have a rigorous process in place for
  determining overall capital spending, allocating
  it among business lines, evaluating individual
  projects, and monitoring the efficiency of
  capital expenditures.
• Starbucks and many other firms are slamming the
  brakes on CAPEX.
• CAPEX increased 18 in 2006, but only 3 in 2007
  and declines are expected to be reported for 2008
  and 2009.
• But consider long-term effects of reduced CAPEX
  on competitiveness in marketplace.
• Decline in CAPEX can lead to a hike in reported
  tax income.
• Caused by a decrease on deferred liabilities to
  offset current liabilities.

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Seize Opportunities Created by Crisis

• The current financial crisis provides a number of
  opportunities to purchase strategic assets or to
  launch innovative products.
• The credit crisis will favor those with strong
  balance sheets buying out weaker competitors.
• Consider Warren Buffett and his purchase of key
  stakes in Goldman Sachs and General Electric on
  favorable terms.
• Also consider the purchase of Washington Mutual
  by JP Morgan Chase.
• Be fearful when others are greedy and be greedy
  only when others are fearful. Warren Buffett

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Seize Opportunities Created by Crisis

• Other firms may be building cash.
• But this can choke off investment in new
  products.
• A recession can be a great time to launch
  innovations
• Consumers are reconsidering purchase decisions.
• Marketplace is less crowded
• Easier and cheaper to create awareness of new
  product.
• During the dotcom bust Apple launched its first
  version of the iPod.
• And ten other disruptive innovations were
  launched during the same period.

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Monitor Credit Exposures

• Many companies have begun to monitor the credit
  quality of derivative counterparties, insurance
  carriers and other financial partners more
  closely.
• Thereby reducing their exposure and diversifying
  their banking relationships.
• Many companies are also investing more in
  evaluating the reliability of the links in their
  industry value chains.
• Such as providing financial assistance to
  vendors, holding excess inventory, and seeking
  alternative sources of supply.

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Communicate with Key Stakeholders

• Serious downturns stem from fear and a loss of
  trust that comes after exuberance.
• Credible external communications are critical in
  times like these.

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Communicate with Key Stakeholders

• A large body of research in social psychology
  provides evidence that individuals are less
  likely to take information at face value during
  pessimistic periods.
• Regulators will scrutinize whether both winners
  and losers are being forthcoming in their
  disclosures about liquidity and access to
  capital.
• In todays economic environment, changes to
  existing disclosures or incremental disclosures
  may be necessary to comply with the disclosure
  requirements in areas such as risks and
  uncertainties, liquidity, and credit risks, just
  to name a few, Mark Panucci, SEC Associate
  Chief Accountant

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Communicate with Key Stakeholders

• Many companies have already began to bolster
  their MDAs by providing the following types of
  information.
• Will you rely on one bank or a group of banks for
  future financing needs?
• How do you receive and plan to use cash? How may
  these change due to uncertainties in the
  marketplace?
• What is the status of short-term funds?
  Limitations? Implications if cannot be accessed?
• What factors could affect credit ratings? Debt
  agreements?

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Cash Flow Metrics

• Credit crisis requires a shift in focus to
  working capital and cash flow (making comparisons
  to peers and industry leaders).
• The largest 1,000 companies in the U.S. could
  generate an additional 491B of cash flow (4x the
  profits of the largest 10 companies), if they
  matched the Cash Conversion Efficiency of those
  in the top quartile.
• Managers and other stakeholders may find it
  informative to examine a firms prospects for
  generating cash flow as it grows revenue.

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Cash Flow Growth Profile

• Measures the capacity of a firm to generate cash
  flow as it grows revenue.
• The metric is forward looking and reports the
  amount of incremental cash flow that can be
  expected for any measured amount of growth in
  revenue.
• A firm with a positive cash flow growth profile
  will produce increasing amounts of cash flow as
  it grows.
• A firm with a negative cash flow growth profile
  will require other sources of cash to support
  growth.

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Cash Flow Growth Profile

• Two separate measures
• Core Operating Growth Profile
• Cash flow provided by operations excluding
  non-core sources of cash flow, financing costs
  and taxes.
• Reflects a combination of its operating cushion
  (operating profit before non-cash depreciation
  and amortization) and operating working capital
  requirements, as a of revenue.
• It is the amount of core operating cash flow that
  can be expected for any measured amount of growth
  in revenue under the assumption that a firms
  current mix of operating cushion and operating
  working capital remains unchanged.

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Cash Flow Growth Profile

• Two separate measures
• Free Cash Growth Profile
• Measures the capacity of the firm to generate
  free cash flow as it grows.
• Incorporates taxes and capital expenditures, two
  expenditures that are expected to grow with
  revenue.
• It is the amount of free cash flow that can be
  expected for any measured amount of growth in
  revenue under the assumption that a firms
  current mix of operating cushion, operating
  working capital, income taxes paid and capital
  expenditures, as a of revenue, remain
  unchanged.

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Cash Flow Growth Profile

• Four Examples
• Each firm operates in the Information Technology
  Services Industry
• Can you match the firm name to the cash flow
  growth profile?
• Ebay Inc (12.39 15.76B)
• Yahoo.com (12.08 16.68B)
• Google (342.70 107.82B)
• Baidu.com (122.17 4.20B)

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Are Regulators Responding?

• Questions posed to The Financial Crisis Advisory
  Group by the FASB and IASB.
• At whom should general purpose financial
  statements be primarily aimed?
• Should general purpose financial statements have
  a financial stability objective?
• With reference to fair value, should financial
  stability or pro-cyclicality be considered even
  if a loss of transparency of information would
  result?
• What principles should determine when financial
  instruments are carried at fair value and when
  change in fair value should be included in
  earnings?

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Are Regulators Responding?

• If U.S. companies are allowed or required to
  shift from reporting under U.S. GAAP to IFRS,
  what will the effect be on your firms
  financials? What will the effect be on your
  firms ability to generate cash?
• A shift to IFRS will result in more items being
  recognized at fair value.
• For financial institutions, we have already seen
  the effects during a downturn in the economy.
• What would be the effect for a troubled real
  estate firm, whose property portfolio is
  currently recorded at historical cost?

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Insights from Behavioral Finance

• Can we be counted on to make sound decisions
  under uncertainty? Are our judgments always
  rational? OR
• Are we creatures of bounded rationality, driven
  by emotions and desires? Do we confront
  uncertainty with misleading rules of thumb?
• The answers are No and Yes, respectivelyand the
  way we approach decisions under uncertainty can
  be particularly important during pessimistic
  periods.

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Insights from Behavioral Finance

• Financial managers would do well to watch out for
  five particular biases and heuristics anchoring
  and adjustment, framing, optimism,
  overconfidence, and self-serving bias.

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Anchoring and Adjustment

• People frequently form estimates by starting with
  a given, easily available reference value which
  could be arbitrary and adjusting from that
  value.
• Most common example in business schools is
  conducting a mock auction by first asking
  students to write down last 2 digits of SSN and
  then submitting a bid for an item.
• The half of the group with the higher 2-digit
  numbers bid between 60 and 120 more on the item.
• This has been extended to loan ratings (anchoring
  on current loan ratings) and internal reviews of
  forecasts or proposals (anchoring on the
  proposing groups inflated forecasts).
• Has direct implications for cash-flow forecasting
  and new capital expenditures.

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Framing

• The way a situation is presented, or framed,
  greatly influences the action taken.
• If a frame is poorly (or strategically)
  constructed, a manager may unwittingly make a
  money-losing choice.
• For example, if you have to decide whether to
  accept a special order, given fixed capacity, the
  criterion you ought to use is contribution margin
  whereas gross margin could lead to a different
  decision.
• Framing combined with loss aversion (reluctance
  to accept a sure loss) can lead managers to frame
  cost as recoverable and tempt them to continue to
  fund a failing project.

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Optimism

• Individuals systematically think that good events
  are more likely to happen to them, while bad
  events are more likely to happen to others.
• Optimism can lead to flawed and risky decisions.
• In a company with marginal investment
  opportunities, managers are likely to perceive
  the opportunities are better than they are and
  think some bad projects are good projectsleading
  to overinvestment.
• Given liquidity crunch, managers can ill-afford
  overinvestment in negative NPV projects.
• Optimism can lead managers to overestimate the
  mean of their firms cash flows.

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Overconfidence

• If you ask individuals to rate themselves as
  drivers, typically 40 say they are above
  average, 50 average, and only 10 below average.
  
• Overconfident CEOs are more prone to engage in
  MA activity.
• They are more prone to pursue risky deals, or pay
  too much, because they overestimate the returns
  they can produce from an acquisition.
• Overconfident managers have been shown to
  underestimate the volatility of their firms
  future cash flows.

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Overconfidence

• Over a period of six years, researchers collected
  7,000 observations of probability distributions
  provided by top financial executives regarding
  the stock market.
• Financial executives are miscalibrated realized
  market returns are within the executives 80
  confidence intervals only 38 of the time.
• Companies with overconfident CFOs use lower
  discount rates to value cash flows, invest more,
  use more debt, are less likely to pay dividends,
  and are more likely to repurchase shares.
• The overconfident CFOs are also committed more
  heavily to debt, particularly long-term debt,
  because they perceive future cash flows as
  relatively safe.
• Each of these actions can have exacerbated
  effects during a credit crunch.

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Self-Serving Bias

• The self-serving bias leads people to see data in
  the way they most want to see it, which may
  prompt them to take credit for successes and shun
  blame for failures.
• This can lead to overinvestment in bad
  projects.
• Can also lead to the same mistakes being made
  over and over.
• Can lead to inaccurate cash flow forecasts period
  after period after period.
• Mistakes can be extremely costly during times of
  extreme resource constraint.

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Key Takeaways

• Cash is King!
• 8 Keys to Cash Management
• Develop Accurate Cash Flow Forecasts
• Understand the Risks You Face
• Ensure Adequate Sources of Liquidity
• Efficiency in Working Capital
• Discipline in Capital Spending
• Seize Opportunities Created by Crisis
• Monitor Credit Exposures
• Communicate with Key Stakeholders
• Alternative Cash Flow Metrics
• Insights from Behavioral Finance
• Understanding how you think is important!

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If All Else Fails

• Hire a woman as CFO!
• A new research study finds that investors respond
  more favorably to certain moves by companies
  whose CFOs are women.
• The stock market reacts more favorably to both
  acquisition announcements and secondary equity
  offerings made by companies with female CFOs.
• Total growth in assets was 17 lower at companies
  with women CFOs.
• Female CFOs issued about 13 percent less debt.
• Why?
• Psychology research suggests it is due to men
  being more over-confident than women, and women
  being more risk averse than men (scrutinizing
  deals more carefully and thus making fewer poor
  decisions).

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Thank You!