Cash Flow Analysis
21st Century Global Credit Management Tool
When the scale of Parmalat's problems emerged, Standard & Poor's
(S&P) was forced to downgrade the company's stock from investment grade by
eight notches, later abandoning a rating altogether. Investors are wondering if
the agency's other ratings are now to be trusted. (The Sunday Times
the South Sea Bubble burst in 1720 (the first great stock market crash in
England) authorities and the credit profession have been trying to protect
investors and creditors from dishonest and incompetent management. It
is beyond doubt that corporate failure is usually due either to fraud or
ineptitude. Unfortunately the method
of financial analysis and assessment adopted since the 18th century, and
continuously refined over the latter half of the 20th century, has repeatedly
failed. Thus the spectacular
corporate bankruptcies of recent memory are just the most topical in a long list
stretching over more than two hundred years.
is perhaps time to realise
that traditional financial analysis is inadequate.
methodology is undoubtedly useful in producing data for the elegant mathematical
models favoured by
investment gurus, fund managers, and credit derivative traders. However
from the point of view of protecting investors and creditors from rogue
management and overpaid dim-witted directors it is evidently useless.
banks and companies the analysis of financial statements has been a fundamental
building block of credit decision making for centuries. The
tools and techniques of financial analysis have been continuously refined.
Concurrently additional requirements have been imposed on reporting
companies, in an ongoing effort to eliminate abuses.
of these labours have
obviously failed to introduce sufficient transparency to protect investors and
creditors. Despite policing by
auditors and the authorities, cases involving abuses by management, fraud, and
reckless disregard for the interests of investors and creditors are reported
with monotonous regularity. The Parmalat
case is just the latest in a string of corporate failures that have cost
investors, pension funds, bankers and corporate creditors hundreds of millions
of Euro. All these losers relied on
traditional financial statement analysis as an essential part of their
decision-making process, before risking their money. Bearing
in mind that traditional financial statement analysis has repeatedly failed to
protect investors and creditors, one must wonder why faith remains in this
an illustration of the impotence of traditional analysis it is noted that Parmalat
group issued a 350 million Euro bond in September 2003. This
issue was rated 'investment grade' at BBB- by S&P and was underwritten by
Deutsche Bank. (Parmalat Press Release 2003.09.15)
In December 2003, a mere three months later, it was revealed that Parmalat
was bankrupt and as a result of cash shortages it had not paid dairy farmers
in northern Italy for the past six months. (The Sunday Times 2003.12.28) Therefore
the bond issue took place about three months after Parmalat commenced
defaulting on payments due to suppliers, the dairy farmers. Perhaps
if bankers and investors had paid more attention to the state of Parmalat's cash
flow, rather than concentrating on traditional financial analysis, they may have
avoided being entangled in this scandal.
has also been recounted - since the bankruptcy came to light - that analysts
repeatedly asked why Parmalat reported investing an additional 1.12
billion Euro in 'securities' while simultaneously increasing short- and
long-term debt by some 458 million Euro in 2002.
This was certainly a practice that made little business sense and a clear
signal that all was not well. Sadly
few analysts had the courage to act on this anomaly when Parmalat evaded
providing an adequate explanation.
should be understood that prior to bankruptcy the traditional financial ratios
derived from the audited balance sheet and income statement of the Parmalat group
gave comfort that, if the company imploded, analysts could plead that they did
what was expected. They all analysed
the same numbers in the traditional way and all came to the same conclusion, so
none of them will be fired. In the
it is an evident paradox that while corporate executives often prove incompetent
in managing a successful business, they have extraordinary abilities when it
comes to achieving the reporting of satisfactory financial ratios.
professional analysts are now shifting the focus of their
financial analysis away from the Balance Sheet and Income Statement, to
the Cash Flow Statement that is provided with many audited reports.
debt-issuing companies follow USA Generally Accepted Accounting Principles
(GAAP) or International Accounting Standards (IAS 7) rules, when they prepare
Cash Flow Statements. It is widely
believed that the Cash Flow Statement is not vulnerable to manipulation because
these rules have instilled a sense of confidence, since they are designed to
ensure transparency and consistency. In
fact GAAP and IAS 7 in attempting to ensure consistency often actually create
misleading results. In addition
these rules provide corporate management with several opportunities to 'legally'
manipulate the key 'Operating Cash Flow' figure.
Flow Statements are produced by the 'indirect' method in the vast majority of
cases. This method requires
companies to reconstruct or deduce the amount of cash generated by normal
business operations during a period. This
is achieved by working backwards from the Net Income figure. Net
Income is normally the result of an accrual accounting-based exercise that is
very satisfying for accountants. Sadly
it is not much use for those interested in understanding whether or not a
company will have the means to pay its debts when they fall
due. Hence it is necessary to adjust
the Net Income figure by adding and/or subtracting non-cash items in order to
establish the Operating Cash Flow for the period being reported.
indicated above, many analysts feel that the Operating Cash Flow number produced
by a company is reliable, because it is not subject to manipulation in the same
way as balance sheet and income statement numbers. It
is true that Operating Cash Flow is subject to less manipulation but unhappily
it may still be misleading. It is
necessary to analyse
and adjust any reported Operating Cash Flow (OCF) figures, in order to establish
the amount of sustainable Operating Cash Flow (sOCF) a company
could produce in the future.
management will soon realise
the new focus of analysts on the Cash Flow Statement, and those executives that
are intent on misleading investors and creditors will no doubt take steps to
deceive the unwary. Therefore it is
potentially dangerous to accept the Operating Cash Flow figure presented in any
financial report, without further analysis.
realisation has seen the recent development of the inexact science of Forensic
Cash Flow Analysis as an early 21st century tool for credit research.
investor, lender or creditor is interested in a target company's ability to
generate 'sustainable Operating Cash Flow' from which it will be
able to grow the business, pay dividends, and repay its debts when they fall
due. In this respect audited
financial statements have always suffered from the fact that they represent
income and cash generated in the past, or assets and liabilities existing at a
point of time in the past. Naturally
the real interest of analysts is in the future so analysts are not
well served by financial statement information. Analysts
need to know whether a company will have in-hand the means (the
cash) to pay its debts when they fall due in the future, that is the crucial
art of Forensic Cash Flow Analysis aims to predict the sustainable
Operating Cash Flow (sOCF), and subsequently the Free Cash Flow (FCF) and future
Liquidity of a company, based on the assumption that the future will more or
less resemble the past.
more than ever before, it is hazardous to make the assumption that the future
will resemble the past. The outcome
of any analysis on that basis must be tempered by a parallel analysis of the
relevant change drivers that could impact the target company. Combining
these two approaches can produce a useful assessment of the future Liquidity
position of a company.
is freely admitted that Forensic Cash Flow analysis is based on uncertain
information and some educated guesswork. Hence,
in the absence of the information available to company 'insiders', this approach
will offend the more meticulous accountants in the credit fraternity. Nevertheless
Forensic Cash Flow analysis does produce valuable information upon which to base
an investment or credit decision, information that is arguably more useful than
that produced by traditional analysis.
Forensic Cash Flow analysis is widely adopted in practice, it should prove to be
helpful in identifying failing companies in time to take avoiding action.
should embrace Forensic Cash Flow analysis methodology sooner rather than later.
Although they will risk the ire of those with a vested interest in
traditional financial analysis methods, and the chagrin of those meticulous
accountants among us who would rather a method produce a neat conclusion than a
Copyright 2004 R K Wells