Using Cash Flow Information The analysis of cash flows provides information that can be used along

Using Cash Flow Information The analysis of cash flows provides information that can be used along

with other financial data to help the analyst assess the financial condi- tion of a company. Consider the cash flow to debt ratio calculated using three different measures of cash flow—EBITDA, free cash flow, and cash flow from operations (from the statement of cash flows)—each com- pared with long-term debt, as shown in Exhibit 24.8 for Weirton Steel.

This example illustrates the need to understand the differences among the cash flow measures. The effect of capital expenditures in the 1988–1991 period can be seen by the difference between the free cash flow measure and the other two measures of cash flow; both EBITDA and cash flow from operations ignore capital expenditures, which were substantial outflows for this company in the earlier period.

EXHIBIT 24.8 Cash Flow to Debt Using Alternative Estimates of Cash Flow for

Weirton Steel, 1988–1996

Source: Weirton Steel’s 10-K reports, various years 19 Daniel J. McConville, “Cash Flow Ratios Gains Respect as Useful Tool for Credit

Rating,” Corporate Cashflow Magazine (January 1996), p. 18.

Cash Flow Analysis

Cash flow information may help the analyst identify companies that may encounter financial difficulties. Consider the study by Largay and Stickney that analyzed the financial statements of W.T. Grant during the 1966–1974 period preceding its bankruptcy in 1975 and ultimate liqui-

dation. 20 They noted that financial indicators such as profitability ratios, turnover ratios, and liquidity ratios showed some down trends, but provided no definite clues to the company’s impending bankruptcy.

A study of cash flows from operations, however, revealed that company operations were causing an increasing drain on cash, rather than pro- viding cash. 21 This necessitated an increased use of external financing, the required interest payments on which exacerbated the cash flow drain. Cash flow analysis clearly was a valuable tool in this case since W.T. Grant had been running a negative cash flow from operations for years. Yet none of the traditional ratios discussed above take into account the cash flow from operations. Use of the cash flow to capital expenditures ratio and the cash flow to debt ratio would have high- lighted the company’s difficulties.

More recently, Dugan and Samson examined the use of operating cash flow as an early warning signal of a company’s potential financial prob- lems. 22 The subject of the study was Allied Products Corporation because for a decade this company exhibited a significant divergence between cash flow from operations and net income. For parts of the period, net income was positive while cash flow from operations was a large negative value. In contrast to W.T. Grant that went into bankruptcy, the auditor’s report in the 1991 Annual Report of Allied Products Corporation did issue a going concern warning. Moreover, the stock traded in the range of $2 to $3 per share. There was then a turnaround of the company by 1995. In its 1995 annual report, net income increased dramatically from prior periods (to $34 million) and there was a positive cash flow from operations ($29

million). The stock traded in the $25 range by the Spring of 1996. 23 As with the W.T. Grant study, Dugan and Samson found that the economic realities of a firm are better reflected in its cash flow from operations.

20 J.A. Largay III and C.P. Stickney, “Cash Flows, Ratio Analysis and the W.T. Grant Company Bankruptcy,” Financial Analysts Journal (July/August 1980), pp. 51–54.

21 For the period investigated, a statement of changes of financial position (on a working capital basis) was required to be reported prior to 1988.

22 Michael T. Dugan and William D. Samson, “Operating Cash Flow: Early Indica- tors of Financial Difficulty and Recovery,” Journal of Financial Statement Analysis

(Summer 1996), pp. 41–50. 23 As noted for the W.T. Grant study by Largay and Stickney, cash flow from oper-

ations had to be constructed from the statement of changes in financial positions that companies were required to report prior to 1988.

FINANCIAL STATEMENT ANALYSIS

The importance of cash flow analysis in bankruptcy prediction is supported by the study by Benjamin Foster and Terry Ward, who com- pared trends in the statement of cash flows components—cash flow from operations, cash flow for investment, and cash flow for financing— between healthy companies and companies that subsequently sought

bankruptcy. 24 They observe that healthy companies tend to have rela- tively stable relations among the cash flows for the three sources, cor- recting any given year’s deviation from their norm within one year. They also observe that unhealthy companies exhibit declining cash flows from operations and financing and declining cash flows for investment one and two years prior to the bankruptcy. Further, unhealthy companies tend to expend more cash flows to financing sources than they bring in during the year prior to bankruptcy. These studies illustrate the impor- tance of examining cash flow information in assessing the financial con- dition of a company.