The Finance Gem 💎 Week #74: Cash Flow and CEOs

THIS WEEK’S ISSUE AT A GLANCE

1. This issue’s finance Gems 💎 vote your favorite at the end of the newsletter.

• How to Analyze a Cash Flow Statement in 10 Simple Steps

• Liquidity vs. Solvency

• The 5 Types of Cash Flow

• The CEO Checklist

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THIS WEEK’S FINANCE GEMS

1. How to Analyze a Cash Flow Statement in 10 Simple Steps

1️⃣ Start with Net Income

🎯 Examine the P&L first because that is where indirect cash flow statements start

🎯 Understand the sustainability and reliability of earnings by examining the revenue and expenses that drive Net Income

2️⃣ Non-Cash Adjustments

🎯 Review adjustments for non-cash items like depreciation, amortization, and stock-based compensation.

🎯 These adjustments reconcile net income to the cash generated from operations.

3️⃣ Working Capital Changes

🎯 Analyze changes in working capital components such as accounts receivable, inventory, and accounts payable.

🎯 Significant changes could indicate operational efficiency or inefficiency.

4️⃣ Cash Flow from Operating Activities (CFO)

🎯 Evaluate the cash generated from core business operations.

🎯 Consistently positive CFO indicates a company’s ability to generate sufficient cash to maintain and grow its operations. Negative CFO should be evaluated depending on context and trends.

🎯 Compare CFO with Net Income over time because a consistent divergence could signal accounting manipulation, unsustainable working capital growing pains, or quality of earnings issues

5️⃣ Cash Flow from Investing Activities (Capital Expenditures and others)

🎯 Check the amount spent on acquiring or improving physical assets.

🎯 High CapEx could mean future growth or just future high maintenance costs.

🎯 Beyond CapEx, large other outflows might suggest growth strategies or diversification.

6️⃣ Financing Activities

🎯 Examine cash flows from financing, including debt issuance/repayment and equity transactions including raises/ distributions.

🎯 This reveals how a company funds its operations and returns value to shareholders.

🎯 Regular dividends can indicate financial stability as long as funded from operating cash flows.

7️⃣ Net Cash Flow

🎯 Assess the net increase or decrease in cash to understand if the company’s cash position improved or worsened.

8️⃣ Free Cash Flow (FCF)

🎯 Calculate FCF (CFO - CapEx) as a key indicator of a company's ability to generate cash after funding both operations and capital expenditures.

🎯 Look for a positive value but assess in context of the company’s financing cash flows and investment + distribution needs

9️⃣ Cash Flow Trends

🎯 Look for trends in the cash flow statement over multiple periods as patterns can reveal cash flow sustainability

🎯 Compare the company’s cash flow metrics with industry peers and historical trends. This contextual analysis helps in understanding the company’s performance relative to its competitors.

🔟 Debt & Taxes

🎯 Assess the company's ability to cover its principal debt payment obligations using cash from operations (CFO).

🎯 Similarly, evaluate how the company is able to manage its interest and tax payments, as these are other key cash outflows.

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2. Liquidity vs. Solvency

80% of people confuse Liquidity and Solvency.⤵️

Want to guess what happens next?

Their cash flow suffers.

Their business suffers.

Their careers suffer.

Here’s what you need to remember:

▶️ Liquidity impacts your today

▶️ Solvency impacts your tomorrow.

They serve different functions and have different implications.

Understanding how they are different can save your company from a liquidity crunch, from insolvency, or even from bankruptcy.

Here are 4 critical differences between solvency and liquidity you need to know:

1️⃣ They have different time horizons:

↳ Liquidity: Short-term; usually focused on a 12-month period, ensuring you can meet immediate financial obligations.

↳ Solvency: Long-term; spans years, ensuring your company has the required runway ahead to remain a viable business.

2️⃣ They use different financial KPIs:

↳ Liquidity uses balance-sheet-centric, emphasizing short-term health.

Examples: Current Ratio, Quick Ratio, and Cash Ratio.

↳ Solvency uses metrics that cross the income statement and balance sheet, examining long-term viability.

Examples: Debt-to-Equity Ratio, Interest Coverage Ratio, Funded Debt to EBIT, Fixed Charge Coverage Ratio

3️⃣ They monitor different underlying business concerns:

↳ Liquidity is a timing issue testing for enough cash or easily convertible assets to cover immediate liabilities

↳ Solvency is a mix of profitability and cash flow measuring if your business model is sustainable in the long run

4️⃣ They come with different consequences when ignored

↳ Liquidity: Expect a cash crunch, operational setbacks, and tarnished creditworthiness.

If it continues beyond the current operating cycle and requires debt working capital financing, it may convert into a solvency problem, where not enough assets will be available to fund future payment obligations

↳ Solvency: Expect risk of bankruptcy, investor mistrust, and long-term failure.

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3. The 5 Types of Cash Flows

1️⃣ Operating cash flow

⚫ Represents the net cash generated by your company's core operations

⚫ Calculated by adjusting Net Income for non-cash items & changes in net working capital assets.

⚫ Used to assess:

>> your company's financial health

>> your company's ability to meet its financial obligations

>> your company’s ability to generate sufficient cash to fund ongoing business operations

>> trends in how the business generates cash

2️⃣ Investing cash flow

⚫ Represents the net cash generated by your company's investments in long-term assets such as property, plant and equipment (PPE) as well as securities investments.

⚫ Calculated by totaling the net investments over the period (purchases less sales )

⚫ Used to assess:

>> your company's investment decisions

>> your company's ability to generate returns from its investments

3️⃣ Financing cash flow

⚫ Represents the cash generated by your company's net debt and/or equity activity.

⚫ Calculated by totaling debt and equity proceeds and payouts over the period.

⚫ Used to assess:

>> your company's financing choices and risk profile

>> your company's ability to raise capital

4️⃣ Free Cash Flow to Firm (FCFF or Unlevered Cash Flow)

⚫ Represents the cash remaining in your business after accounting for cash outflows that support product sales and operations (product costs + operating expenses + working capital) and cash outflows that maintain the capital asset base (capital expenditures).

⚫ Calculated by adjusting after tax EBIT for non cash expenses and income, and for investments in fixed and capital assets

⚫ Used to assess:

>> your company's financial strength and ability to generate sufficient cash for growth and reinvestment

>> your company's value based on the discounted cash flow (DCF) valuation.

5️⃣ Free Cash Flow to Equity (FCFE or Levered Cash Flow)

⚫ Represents the cash remaining in your business after accounting for all business expenses, investments in working capital assets, investments in fixed assets, and also all debt obligations.

⚫ Calculated by adjusting Operating Cash Flow for after tax interest expense, investments in capital assets and net debt payments.

⚫ Cash flow available to be used for investments, dividend payments, returns of capital, additional debt repayments, or acquisitions, but skewed by new debt raises.

⚫ Used to assess:

>> your company's ability to generate cash for distributions to shareholders holders

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4. The CEO Checklist

It’s hard being a CEO

Every decision impacts finances,

Team morale, stakeholder satisfaction.

And to succeed, you’ll need a skilled CFO.

And you’ll need to master Strategic Management.

Here are 15 important areas for CEOs to focus on, to help you measure progress and performance:

1. Vision and Strategy Development

🎯Design the future, align with the strategic vision, and craft long-term strategies for achieving objectives.

2. Leadership and Organizational Culture

🎯Cultivate a positive and productive corporate culture.

3. Financial Oversight

🎯 Manage the company’s financial health.

4. Corporate Governance

🎯 Uphold the highest governance standards.

5. Risk Assessment

🎯 Identify potential risks and establish mitigation systems.

6. Operational Excellence

🎯 Streamline operations, enhance efficiency, and encourage innovation.

7. Talent Optimization

🎯 Ensure the right individuals are in appropriate roles to drive the strategic plan effectively.

8. Customer-Centric Approach

🎯 Instill a customer-focused mindset to meet customer requirements.

9. Investor Relations

🎯 Maintain robust and transparent relationships with investors, shareholders, and financial analysts.

10. Brand Integrity

🎯 Serve as the company’s face and ensure actions positively impact the brand.

11. Innovation and Technology

🎯 Cultivate an innovation-oriented culture to stay ahead of technological advancements.

12. Sustainability and Social Responsibility

🎯 Aim to reconcile profit drivers with ethical and sustainable business practices.

13. Stakeholder Engagement

🎯 Skillfully manage relationships with diverse stakeholders.

14. Mergers and Acquisitions

🎯 Assess growth opportunities through mergers, acquisitions, partnerships, or joint ventures and ensure their effective execution.

15. Business Continuity and Succession Planning

🎯 Create and execute a comprehensive business continuity plan for sustained success.

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