CASH FLOW ANALYSIS

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CASH FLOW ANALYSIS

• Financial statements are like fine perfume, to be
  sniffed, not swallowed. Abraham Brilloff

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CASH FLOW TELLS A STORY

• Estimate of Future Performance
• The numbers tell the story about the what has or
  might happen. You need to clearly understand what
  the story is before you can appreciate the
  numbers or create the analysis.
• Is it fiction or non-fiction?

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ASSUMPTIONS

• We All Know What Assume Really Means.
• Create A Detailed Set Of Assumptions Before You
  Craft Your Analysis.

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GI - GO

• Make sure you have good input info. Try to use
  as much 3rd party, credible information. Go to
  the market place and get as big a data set as
  possible by working with outside parties
  brokers, cost estimators, AE team.
• Do Not Talk To Yourself In The Mirror!

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ITS A PROCESS

• Should Be Designed To Test Your Assumptions
• There Are Matters Of Fact and Matters Of Opinion
  Dont Confuse Them
• Iterative
• Decision Making Tool
• Should Lead To Management Tools.

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ESTABLISH SOURCES AND USES

• Cash From Operations
• Cash From Investment
• Cash From Financing
• Operational Cost
• Investment Costs
• Financing Costs
• Net Cash Flow
• Distribution.

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USE IT AS A TOOL
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OTHER CONSIDERATIONS

• Income Tax
• Overhead and Allocated Costs (careful about using
  this)
• Sunk Costs (careful about using this)
• Cost of Capital (equity and debt)
• Holding/Carrying Costs (property tax, insurance,
  maintenance)
• Selling Costs
• Contingency (because everything takes longer and
  costs more then you plan for).

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ADD TIME TO THE EQUATION

• Start With Single Point In Time Data Get Your
  Sources And Uses Categories Down (Relevant info)
• Develop A Schedule Of Activities
• Spread Your Data In Relation To The Schedule

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FINANCIAL MEASURES

• Most Analysis Requires Simple Measures figures
  of merit
• Establish Hurdles - acceptance criterion
• Go From Simple to More Complex
• Do Sensitivity Analysis Find Critical Elements
  For Risk Assessment Change Variables And Run
  Optimistic, Pessimistic and Likely Scenarios.

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ITERATIVE PROCESS

• First, create initial, simple analysis the
  back of the napkin. See what it will take to
  make the project work and make A go, no go
  decision. What is the probability of achieving
  the results needed to make it work. Once you
  decide to go.

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PREDICTIVE PROCESS

• Those Who Know How To Predict The Future Know
  Better
• More Is Better Then Less, Sooner Is Better Then
  Later And Always Take A Little Bit Less Sooner!
• Anything Is Possible Its A Matter Of
  Probability

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ANALYSIS TO PM

• Your Analysis Will Become Your Score Card For
  The Project. Cash Flow Projection v. Cash Flow
  Statement
• Decision Making Tool
• Project Tracking And Performance Tool

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ITIRATIVE PROCESS
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SIMPLE TO COMPLEX
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CASH FLOW ANALYSIS GOAL

• Determine Relevant Cash Flow

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RELEVANT CASH FLOW

• Requires Understanding of
• Investment income and costs and timing of both
• The market and your competitive position
• Short and long range intentions
• Financing requirements and constraints
• Working Capital needs.

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WHAT IS RELEVANT CASH FLOW

• The change in the total cash flows as a direct
  consequence of the decision to take the project
• Called incremental cash flows of the project
• Cash flows that take place regardless of the
  project are not relevant to the analysis
• Focus on Incremental Cash Flow cash flow with
  project cash flow without project
• Once we identify the projects incremental cash
  flows, we can evaluate a project based on its own
  merits
• This is known as the stand-alone principle

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DETERMINING INCREMENTAL CASH FLOWS

• Forget about sunk costs
• Include opportunity costs
• Include all indirect effects from the project
• Recognize investments in net working capital
• Beware of allocated overhead costs
• Separate investment and financing decisions.

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RISK ANALYSIS IN INVESTMENT DECISIONS

• Making Good Decisions

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FIGURES OF MERIT

• Estimate the relevant cash flows
• Calculate a figure of merit for the investment
• Compare the figure of merit to an acceptable
  criterion/hurdle.
• A figure of merit is a number summarizing an
  investments economic worth. An acceptance
  criterion is a standard of comparison.

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FIGURES OF MERIT TO CONSIDER

• Return on Investment (ROI)
• Return on Capital (ROC)
• Cash-On-Cash Return (COC)
• Break Even Point (B/E)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)

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TIME VALUE OF MONEY

• A dollar today is worth more than a dollar in
  the future
• Inflation reduces purchasing power of future
  dollars
• Uncertainty of getting receipt of a dollar in the
  future increases with time
• Opportunity costs is what you earn on the next
  best thing.

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COMPOUNDING AND DISCOUNTING

• You cant simply add-up future cash occurring
  over time at different dates
• Need to use the concept of compounding and
  discounting
• Compounding is determining future value of
  present sum (Future Value)
• Discounting is determining present value of a
  future sum (Present Value).

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Compounding Example

• 1.00 deposited at beginning of year in an
  account earning 10 interest is worth 1.10 at
  end of year. At the end of year 2 it is worth
  1.21.
• F 1(10)(1)1(1.10)1.10
• F2 1.10(10)(1.10)1(1.10)²1.21

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DISCOUNTING EXAMPLE

• You can put money in an investment earning 10
  annually and promised 1 a year from now whats
  the value of that promise today?
• P1/1(10)(1)1/1.100.909
• P21/1.10(10)(1.10)1/(1.10)²0.826

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INTEREST RATE/DISCOUNT RATE

• The Interest Rate in Present Value calculations
  is called Discount Rate
• If you already have cash on hand it is the rate
  of return you could earn on alternative
  investments, or
• If you are raising money it is the rate expected
  by investors/lenders.
• In both cases it is also known as the
  Opportunity Cost of Capital

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EQUIVALENCY

• Present value of future cash flows
• Present sum is Equivalent in value to the future
  cash flows.
• If you had that Present Sum today, you could
  transform it into the future cash flow by
  investing at the Discount Rate.

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NET PRESENT VALUE

• NPV The Present Value of future in flows minus
  the Present Value of future out flows.
• NPV is simply a measure of how much better you
  become by undertaking the investment.

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GENERAL RULES OF NPV

• NPV gt 0 accept the investment
• NPV lt 0 reject the investment
• NPV 0 investment marginal.
• Embrace positive NPV, the higher the NPV the
  better and avoid negative NPV like the plague.

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INTERNAL RATE OF RETURN

• Another figure of merit
• IRR is a close cousin to NPV
• It is the Discount Rate at which the
  investments NPV equals zero!

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CHARACTORISTICS OF IRR

• Compare to Opportunity Cost of Capital
• It is the break-even return (so, if real cost of
  capital is less - make the investment) or
• The rate at which money remaining in the
  investment grows or compounds.

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GENERAL RULES OF IRR

• Where K is the real cost of capital, then
• IRR gt K accept the investment
• IRR lt K reject the investment
• IRR K marginal investment.

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CONCLUSION

• Understand your project
• Make reasonable assumptions
• Determine relevant cash flows
• Establish appropriate criterion/hurdles
• Analyze the cash flows with figures of merit
  compared to hurdle
• Assess the quality of investment opportunity.

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WORDS OF WISDOM

• Cash flow analysis is a method of worrying before
  you spend your money instead of afterwards.