Chapter 9 Cash Flow Analysis

Overview and Background

We have seen how to assess the robustness and profitability of a new project through the use of NPV, IRR, payback rule and profitability index. This chapter is based upon estimation of the cash flows. The most difficult part about estimating cash flows is to determine the additional effect only. A company may have cash outflows due to labor or electricity. However, with the new project, is there a change in cash flows? This is the question being asked in this module and chapter. So the focus is on incremental cash flows due to investments, working capital and operations. Once incremental cash flows are determined, it is easy to assess whether the project should be undertaken or not by using any of the methods such as NPV or IRR.

9.1 Introduction

Cash flows have profound implications for a firm. A large firm, such as an aircraft manufacturer, may be making robust profits and yet, may not have a favorable cash flow situation just because the scale of its operations is so big. In this case, the supplier credit and buyer credit lines are huge enough to warrant significantly low amounts of cash ready at hand. On the other hand, a firm with complex international operations may face a situation in which it has a lot of cash at hand in the country of sales, such as United States, but cannot repatriate this cash to the country of manufacturing, such as Vietnam or China. Companies such as online retailers may be making razor-thin margins due to high-volume operations and sales, so they must pay close attention to their cash flows. This chapter puts the spotlight squarely on cash flows and how important cash flows are to an organization.

It is important to consider liquidity when talking about cash. A firm may choose to hold its cash balances in different forms. Therefore, it is important to understand what liquidity means. The more liquid an asset is, the easier it is to convert it into cash. Cash as defined in accounting is a collection of savings, checking balances—rather than just currency at hand. On the other hand, assets, which can be easily converted into cash, may or may not be considered cash as we defined it above. These could be short-term investments in bonds, bills, money market accounts and so on. The person/ department that deals with short-term and liquid assets of an organization is the treasury. The treasurer is responsible for ensuring that not only the firm has all its immediate payment needs met but also the firm does not have so much cash that there is a lost opportunity in short-term investments. Situations such as low and decreasing interest rate scenarios may be very good for raising short-term cash. This is because cost of borrowing is low.

As a rule of thumb, the fundamental difference between how profits are treated vis-à-vis cash lies in some key areas of the balance sheet – depreciation, amortization and assets/ liabilities that carry larger book value than market value. Stock investors typically look for these numbers, and aberrant values create red flags. As an example of this situation, a company may have a small value of profit. However, if that low profit is because of a large depreciation (the non-cash expenses that are subtracted from a company’s net income), this is not a big concern for operating cash flow. Low profit could be a problem if its current ratio, or the ability of the company to pay its short-term debts, is too small (i.e. less than 0.6, for example). This will mean that not only does the firm not have enough cash for its immediate needs, but it also does not have enough short-term assets to cover its short-term liabilities. Overall, it means the company is in a bad liquidity situation.

 

What we notice from table 9.1 of example 9.1 is that the net present value of cash flows is minus 82 million dollars meaning that the project is unprofitable if the market threshold is 15%. However, if we discount accounting profits, the net present value is positive 175 million dollars. So, while the project has a negative NPV, we can interpret it otherwise using accounting profits.

9.2 Nominal versus Real Cash flows: Effect of Inflation

The next important aspect in cash flow analysis is to remember that cash flows are spread over different periods. Therefore, inflation becomes an important factor in comparing cash flows, particularly if either cash flows being considered are over long periods, such as 15-20 years as in the case of large commercial aircraft, or when the levels of inflation are extremely volatile and risky, such as during the period 2021-22 when prices and values have fluctuated wildly. Without considering inflation, a $ 300 million aircraft in 2010 may not be comparable to a similar or lower priced variant in 2020. However, consumer price index (CPI) and inflation adjustment helps us make such a comparison. Consumer price index is the weighted average of commodity prices purchased by a representative customer in an economy. By keeping a track of consumer price index, one can compare relative price of the same or different dollar amounts intertemporally, but more importantly compare them with each other.

9.2.1 Applying the effects of inflation to nominal values

Since we have intuitively understood compound interest rates, it is straightforward to apply inflation to create real (i.e. inflation adjusted) numbers.

Let the periodic rate of inflation be a constant [latex]\pi[/latex] and cash flow available at time ‘t’ be [latex]CF_t[/latex].

Then we can represent the inflation adjusted value of [latex]CF_0[/latex] (cash flow at time t=0, i.e. right now) as [latex]CF_0[/latex]. There is no inflation adjustment for cash flow available right now, since this cash flow is available right now, and there is no inflation to contend with. We denote inflation adjusted cash flow as “real cash flow”. So the inflation adjusted cash flow at time ‘t’ would be Real [latex]CF_t[/latex]. Next, we derive the formula for real [latex]CF_t[/latex] using the compound interest formula with inflation rate \pi.

[latex]Real \; CF_1 = \frac{CF_1}{(1+\pi)}[/latex]

[latex]Real \; CF_2 = \frac{CF_2}{(1+\pi)^2}[/latex]

Here, [latex]CF_1[/latex] is the cash flow at time ‘1’ and [latex]CF_0[/latex] is the cash flow at the beginning of period one, i.e. at time zero. To extend this further to cash flow at time = 2,

Notice, how we have to use inflation adjustment to discount nominal cash flow [latex]CF_2[/latex] by two periods to bring it to t=0 and for [latex]CF_1[/latex] by one period to bring it to equivalent value in period zero.

We can generalize it to a cash flow in period ‘t’ as:

[latex]Real \; CF_t = \frac{CF_t}{(1+\pi)^t}[/latex]

9.2.2 Creating inflation adjusted interest rates

Now, let us analyze real rate with respect to nominal rate and inflation. First, let us add another feature: let nominal Cash flows that grow at a growth rate ‘g’ will be represented by

[latex]CF_1 = CF_0 \times (1+g)[/latex]

Here, [latex]CF_1[/latex] is the cash flow at time ‘1’ and [latex]CF_0[/latex] is the cash flow at the beginning of period one, i.e. at time zero. To extend this further to cash flow at time = 2,

[latex]CF_2 = CF_1 \times (1+g)^1 = CF_0 \times (1+g)^2[/latex]

Extending to cash flow at time ‘t’ (i.e. [latex]CF_t[/latex])

[latex]CF_t = CF_0 \times (1+g)^t[/latex]

Also, [latex]CF_{t+1} = CF_t \times (1+g)^1[/latex]

[latex]CF_{t+1}[/latex] is the cash flow at the end of one period following time t (i.e. at time t+1).

‘g’ is the 1-period growth rate.

Also, [latex]CF_{t+1} = CF_0 \times (1+g)^{t+1}[/latex]

Next, we understand the connection between nominal growth rate and inflation adjusted growth rate. Let ‘rgr’ be the inflation adjusted growth rate or “real growth rate” and let [latex]\pi[/latex] continue to be the inflation rate.

Now applying inflation adjustment to cash flows at periods ‘t’ and ‘t+1’,

[latex]Real \; CF_t = \frac{CF_t}{(1+\pi)^t}[/latex], (we denote this as [latex]CF_{real, t}[/latex] or [latex]CF_{infl\_adj, t}[/latex]) and

[latex]Real \; CF_{t+1} = \frac{CF_{t+1}}{(1+\pi)^{t+1}}[/latex] (we denote this as [latex]CF_{real, t+1}[/latex])

[latex]CF_{real, t+1} = \frac{CF_{real,t}}{(1+\pi)} \times (1+g)= \frac{CF_t}{(1+\pi)^{t+1}}\times(1+g) = \frac{CF_0}{(1+\pi)^{t+1}} \times (1+g)^{(t+1)}[/latex]

From above, [latex]CF_{real, t+1}= CF_0 \times \left( \frac{(1+g)^{t+1}}{(1+\pi)^{t+1}} \right)=CF_0 \times \left( \frac{1+g}{1+\pi} \right)^{t+1}[/latex]

Here, the numerator on the right-hand side is growing real cash flow at time ‘t’ by (1+g) times, but also deflating by inflation factor [latex](1+\pi)[/latex]. This factor [latex]\frac{(1+g)}{(1+\pi)}[/latex] is inflation adjusted growth rate ‘rgr’ that we defined above.

Mathematically, inflation adjusted growth rate can be defined as [latex](1+rgr) = \frac{(1+g)}{(1+\pi)}[/latex]

In other words, we can modify equation above as [latex]CF_{real, t+1} = CF_{real,t} \times (1+rgr)[/latex]

We can similarly apply this to all cash flows. We know, [latex]CF_{real, 0} = CF_0[/latex]

[latex]CF_{real, 1} = \frac{CF_1}{(1+\pi)}[/latex]

Here [latex]CF_1[/latex] is the nominal cash flow at time 1 and [latex]CF_{real, 1}[/latex] is the inflation adjusted [latex]CF_1[/latex]

[latex]CF_{real, 1} = \frac{CF_0}{(1+\pi)} \times (1+g) = CF_0 \times (1+rgr)[/latex]

[latex]CF_{real, t+1} = \frac{CF_0}{(1+\pi)^{(t+1)}} \times (1+g)^{(t+1)} = CF_0 \times (1+rgr)^{(t+1)}[/latex]

To reiterate: [latex](1+rgr)^{(t+1)} = \left( \frac{(1+g)}{(1+\pi)} \right)^{(t+1)}[/latex], which gives us

[latex](1+rgr) = \frac{(1+g)}{(1+\pi)}[/latex]

If [latex]\pi[/latex] and ‘g’ are close to zero, we can simplify this as [latex]1+rgr \approxeq 1+g - \pi[/latex] or [latex]rgr \approxeq g - \pi[/latex]

Now, we are ready to adjust real (i.e.inflation adjusted) cash flows at time ‘t+1’ in three ways:

1.The basic method is: discount nominal cash flows by nominal rate [latex]NPV = \sum_{t=0}^n \left( \frac{CF_t}{(1+r)^t} \right)[/latex]

2.If we have real cash flows, we have to discount these by the real rate. See how to obtain real rate above. Above, we calculated real growth rate of cash flows. Similarly, we can also compute real (I.e. inflation adjusted discount rate). Real discount rate [latex]rr = \left( \frac{1+r}{1+\pi} \right)[/latex]

Covert period 1 cash flow into real (inflation adjusted cash flow) [latex]\equiv CF_{1, real} = \frac{CF_1}{(1+\pi)}[/latex]

Create each real cash flow [latex]CF_{real, t} = CF_{real,t-1}\times (1+rgr)^1[/latex]

Discount these real cash flows by real rate rr as:

[latex]NPV = \sum_{t=0}^n \left( \frac{CF_{real,t}}{(1+rr)^t} \right)[/latex]

3.We still use real cash flows, but find these using an indirect method.

[latex]CF_{real, t} = CF_1 \times \frac{(1+g)^{(t-1)}}{(1+\pi)^t}[/latex]

We discount these real cash flows by real rate as above:

[latex]NPV = \sum_{t=0}^n \left( \frac{CF_{real,t}}{(1+rr)^t} \right)[/latex]

With this inflation consideration, we have to modify the understanding of cash flows that we analyzed previously all along from the moment we introduced present values. Let us discuss and apply it in an example.

In this example, let us modify the example 9.1 above and assume that the growth of cash flows is now at a rate of 15.02% instead of 10.25%.

 

We interpret from the above example that because of inflation, we would have to reject the project which otherwise seemed highly feasible. This is the reason why considering inflation is very important in finance. What seems like a feasible project is now rendered infeasible because of inflation.

9.3 Cash flows: More implications

Cash flows for a company are very important to consider from a survival perspective if the company is not profitable. In such a case, the management can at least tell their investors that notwithstanding fixed costs, the company is producing positive free cash flows. Free cash flow, also called net cash flow, arises from three factors: investments or investing cash flow; financing cash flow and operating cash flow.

Investing cash flows (also called as investment cash flows):  When a company purchases machines to produce greater output or an airline purchases aircraft to add new routes or greater frequency in existing routes or when an airline invests in a new hub as we discussed before, these actions are all investments. Cash flows associated with creating such investment is typically non-recurring and is relatively large as compared to cash flows produced from day-to-day activities, as we noticed in examples 9.1 and 9.2 above. Cash flows associated with these one-time set up costs are investment cash flows. When the life of machine or the project is over, companies generally sell such machines at whatever residual value they can receive and the cash flow from such sales is called salvage value. This cash inflow is also associated with investment cash flows.

Financing cash flows: When a company uses a bank’s loan facility or issues bonds/ debentures to borrow money, or when the company issues new shares to raise capital, the funds associated with these transactions are financing cash flows. If the loan was a term loan and was repaid, then these funds are also associated with financing cash flows. Like investment cash flows, funds associated with financing cash flows are also typically large and do not often occur regularly.

Operating cash flows: Cash flows associated with everyday activities of the firm are operating cash flows. These are the cash flows investors pay close attention to in determining future expected stock price. Operating cash flows originate from selling product and paying suppliers, servicing (interest cost) loans as well as tax obligations. Companies typically report operating cash flows quarterly and annually.

9.4 Operating Cash Flows: Three ways to get it

Most direct way to calculate operating cash flow is to subtract cash expenses from cash revenues.

OCF = cash revenue – cash expenses – tax …(9.5)

It is also the sum of profit after tax (PAT) and non-cash expenses/ write offs such as depreciation/ amortization.

OCF = PAT + depreciation …(9.6)

Another way (Indirect) to find operating cash flow is using cash revenue, cash expenses and depreciation as follows:

OCF = (revenue – cash expenses)(1-t)+Depreciation(t) …(9.7)

Here ‘t’ is the marginal tax rate (tax paid/ revenue)

Appendix A describes three different methods of obtaining operating cash flows.

Next, let us analyze operating cash flow with an example below.

In the next example, we will see what financing cash flow for the project can do to change this analysis.

However, this example is not about tax. It is about the effect of financing cash flow on NPV.

Summary and conclusion

In this chapter, a reader is exposed to the identification of cash flows from new projects. These are compared and contrasted with accounting profits for a better understanding of project profitability. These are also assessed with respect to erosion from inflation. Finally, these cash flows that arise from investments, operations and working capital are then laid out for a project to determine its feasibility. It is necessary to distinguish between the nature of cash flows in order to assess how to control these cash flows. The example in this chapter covers all these concepts as well as time value of money. One aspect that is still unresolved at the end of this chapter is how to assess the discount rate and riskiness of the project correctly. This will be covered in subsequent chapters.

References:

Ref. numbers from other airline:

LCC Avelo Airlines is investing $100 Millon its first east coast hub at New Haven Airport in Connecticut. Include modernized airport facilities, MRO, supporting staff and upgrade operations, etc.

https://www.forbes.com/sites/ericrosen/2021/05/06/new-low-cost-avelo-airlines-announces-east-coast-hub-at-new-haven/?sh=31011c7e290e

Ref. numbers from Amazon:

Amazon opened its $1.5 Billion hub in Kentucky to push speed deliveries

https://www.cnbc.com/2021/08/11/amazon-opens-1point5-billion-kentucky-air-hub-in-bid-to-speed-deliveries.html

Ref. numbers from Canadian airlines:

WestJet Group is investing in aircraft capacitiy valued more than $7 Billion to double the capacity and upgrade the facility

https://www.calgaryeconomicdevelopment.com/newsroom/westjet-announces-calgary-as-exclusive-global-connecting-hub/