Increase (Decrease) In Accumulated Other Comprehensive Income

A rare item (personally, I have never seen one before). Accumulated Other Comprehensive Income is an entry that is generally found in the shareholders' equity section of the balance sheet. Accumulated other comprehensive income is used to sum up unrealized gains and losses because those items have not been settled. This account can include unrealized gains and losses from investments held by the firm, company pension funds and foreign currency transactions.

In an unlikely event that you encounter this item, you will need to bring in an experienced auditor to figure out the exact economic meaning of this item and how it affects the corporate cash flows.

Net Capital Expenditures

Net Capital Expenditures is functionally the same thing as your Investment in Operating Working Capital, only referring to capital (long-term) rather than current operating assets.

In order to maximize their sales, capital-intensive companies have to constantly invest into upgrading or replacing their existing equipment. Net Capital Expenditures is exactly the amount of such investment over the time period. Net of accumulated depreciation, of course.

Therefore, your fundamental objective in managing your Net Capital Expenditures (NCE) is exactly the same as in managing your OWC. It is to optimize the latter to maximize the difference between your Gross Cash Flow and your NCE. Which, as usual, will require (1) solid methodology; (2) efficient business process; (3) efficient tools and (4) highly experienced and competent personnel.

    

Companies that are not capital intensive, usually do not have to worry about this item. 

Investment in Capitalized Operating Leases (or, more accurately, ‘in Capital Leases’) is functionally identical to Net Capital Expenditures, only structured as a capital lease and not a purchase. Therefore, it must be analyzed and managed in exactly the same way.

Investments in Intangibles and Goodwill is also functionally identical to Net Capital Expenditures, only it covers intangible, rather than tangible, operating assets. Therefore, it must be analyzed and managed in exactly the same way. 

Investment in Operating Working Capital

Your working capital (WC) is a difference between your current assets and current liabilities. I will cover WC in the section on financial ratios. Operating Working Capital is (no surprise here) the operating component of your WC.

On the asset side, it includes pretty much everything with the exclusion of prepaid expenses and ‘other’ current assets not related to your company operations; on the liabilities side, however, it includes only accounts payable and accruals directly caused by your operations. Thus excluding current portion of long-term-debt, short-term capital lease obligations, etc.

By definition, both asset and liability components of our OWC include only non-interest-bearing items (interest-bearing are a part of financing, not operating activities).

‘Investment in Operating Working Capital’ means that as your sales are recorded and reposted on your P&L on the accruals basis, some of them end up increasing your working capital (if not properly offset by appropriate current liabilities). And thus decreasing your cash flow. Which means that you have to subtract your Investment in Operating Working Capital from your Gross Cash Flow.

Your Investment in Operating Working Capital is, indeed, an investment. To maximize your sales (and thus your Gross Cash Flow) you must offer appropriate customer credit terms. Which result in inevitable increase in your OWC.

Therefore, your fundamental objective in managing your OWC is to optimize the latter to maximize the difference between your Gross Cash Flow and the increase in your OWC. Which, as usual, will require (1) solid methodology; (2) efficient business process; (3) efficient tools and (4) highly experienced and competent personnel.  

Gross Cash Flow

Gross Cash Flow is NOPLAT adjusted for depreciation and amortization. D&A is a non-cash ‘expense’; therefore, to calculate cash flow, you need to add it back together to your operating system, already adjusted for taxes.

Obviously, you need to maximize your Gross Cash Flow, which requires maximization of sales and optimization of expenses. In other words, you need to be careful not to cut ‘meat’ with the ‘fat’. Therefore, you must differentiate between investments and waste when analyzing your expenses.  

Cash Flow Statement

Cash Flow Statement (aka ‘statement of cash flows’ or CFS) is used to calculate and report cash flows into and out of business. As financial value is determined by cash flows (free cash flows, to be more precise), CFS is by far the most important financial statement for a financial analysis. P&L and balance sheet are important, too, but only to the extent how changes in balance sheet and P&L accounts affect corporate cash flows.

Unlike P&L and balance sheet, CFS can be prepared using either direct or indirect method (i.e., in direct or indirect form). The direct method of preparing CFS results in a more easily understood report; however, the indirect method is substantially more convenient for building financial valuation models, because it focuses more on cash flows while the direct method is more concerned with changes in corporate cash position.

Direct Method

Direct method for preparing a CFS breaks corporate cash flows into operating, investing and financing activities. Each of these flows can be either positive (cash inflow) or negative (cash outflow).

Sum of these flows gives the net increase or decrease in the amount of cash in corporate bank accounts, which is then added to cash at the beginning of the financial year to yield cash at the end of financial year. Often ‘cash equivalents’ are added to ‘cash’ which is a bit misleading, because ‘cash equivalents’ are marketable securities and spending cash on these instruments is actually a financing activity.

Indirect Method

With indirect method, CFS calculates two cash flows: (1) free cash flow that is used in financial valuation model for a business entity prepared using the discounted cash flows (DCF) method; and (2) cash flow available to investors. ‘Investors’ in this particular context refer to holders both of corporate stock (investors proper) and holders of the long-term debt of the company (i.e., creditors).

Cash flow available to investors has a dual purpose in this CFS. It (1) indicates how the cash flow generated by the firm's assets are distributed to the debt holders and equity holders and (2) is used to balance the CFS, making sure that it is done correctly. Which is another major advantage of indirect method.

This ‘balancing of the model’ becomes possible because cash flow available to investors is calculated twice (two ways): from operating and financing activities

Oh, and FAS 95 (standard for cash flow reporting issued by FASB as part of GAAP) requires a supplementary report similar to the indirect method if a company chooses to use the direct method. Which makes the indirect method almost universally used.

For all these reasons, in this guide I will cover only the indirect form of CFS. 

Financial Statements Analysis Methodology

You fundamental business management objective is two-fold: (1) maximize financial and aggregate value of your company and (2) transform your company into a powerful money-making machine that will operate at maximum performance (and, therefore, generate the maximum amount of financial and aggregate value) at all times. Obviously, these objectives are closely interrelated.

No less obviously, your financial statements analysis (FSA) is only as good and valuable as it helps you achieve these two fundamental objectives.

On the surface, your FSA deals with just numbers. Numbers that appear in corresponding accounts on your financial statements plus your key financial ratios. But it is just the surface, or a ‘front-end’. Front-end of the issue (object) that needs to be analyzed and optimized. The object that yields the value at the front-end.

The object in question can be your accounting receivable management system or an investment project financed by your bank loan or a piece of equipment (also an investment project, by the way) financed by a long-term note payable and the like.

More specifically:  

Your front-end – the numbers. The values of items on your financial statements (which are actually your financial KPI). Which need to be optimized (not all KPI values must be maximized).

Your back-end systems (such as your A/R management system that I mentioned). Such system typically includes (1) description; (2) methodology; (3) process; (4) tools; (5) in-house personnel and might also include (6) external providers of goods or services, such as a collection agency in the case of A/R management. This system, obviously, needs to be optimized to maximize its efficiency.

Your back-end projects such as the ones that I mentioned. These projects must generate the maximum amount of financial value measured by their financial KPI (NPV and IRR). They need (1) financial model; (2) operational plan; (3) business plan; (4) all relevant project-related corporate documentation and (5) project managers and personnel. Obviously, you will need to maximize financial value generated by each project.

To make a valuable contribution to achieving your fundamental business management objectives, you must analyze and optimize both front- and back-end. And to do it in the right way:

The numbers on financial statements. You deal with these KPI like with any other KPI – look at their current and historic values – benchmark, planned and actual; analyze KPI dynamics, develop conclusions; write recommendations and comments and develop and implement financial and operational plans for optimizing KPI values.  

Your key tool for analyzing your financial KPI are the dedicated KPI scorecards – KPIS – which are a part of both the CBA Toolkit and the by far more functionally rich Comprehensive Business Analysis Workbench (CBAW).

The back-end systems and objects. You thoroughly document them; analyze them using the appropriate CBA questions; develop conclusions; write recommendations and comments and develop and implement financial and operational plans for optimizing these systems and objects.

With objects you always have a choice of use ‘as is’, use for a different purpose (not with all objects); upgrade or sell/lease out. With loans and other debt instruments there is almost always an option of refinancing.

Obviously, you must always make a choice based on thorough financial analysis of available options using solid financial models and supporting documentation. 

Questions for Analyzing Your Balance Sheet Items

1.      How well does your capital structure conform to the matching principle between your assets and liabilities/capital?

2.      How optimal is your capital structure in terms of your WACC?

3.      How optimal is the amount of cash in your bank accounts in terms of risk/return?

4.      How solid is your cash management methodology?

5.      How efficient is your cash management process?

6.      How efficient are your cash management tools?

7.      How competent is your cash management personnel?

8.      How optimal is your cash/equivalents (marketable securities) ratio?

9.      How optimal is your marketable securities portfolio (in terms of risk/return)?

10.  How optimal is your balance between cash/credit/prepayment sales?

11.  How optimal is your portfolio of accounts receivable (in terms of duration)?

12.  How efficient is your system for performing customer credit checks?

13.  How efficient is your system for calculating credit scores?

14.  How comprehensive is your customer database?

15.  How solid is your A/R management methodology?

16.  How efficient is your A/R management process?

17.  How efficient are your A/R management tools?

18.  How competent is your A/R management personnel?

19.  How competent is your A/R collection agency?

20.  How efficient are your relationships with your A/R collection agency?

21.  How solid is your inventory management methodology?

22.  How optimal is your methodology for inventory costs allocation?

23.  How efficient is your inventory management process?

24.  How competent is your inventory management personnel?

25.  How efficient are your inventory management tools?

26.  How competent is your inventory management personnel?

27.  How efficient is your method and process for evaluating prepayment/purchase on credit choice?

28.  How efficient is your Short-Term Notes Payable management system?

29.  How efficient is your system for maximizing financial value of your PPE (equipment, buildings and land)?

30.  How optimal are your depreciation and amortization schedules from tax benefits standpoint?

31.  How efficient is your system for putting together (determining terms and conditions) of your long-term notes receivable?

32.  How efficient is your system for monitoring and managing your long-term notes receivable?

33.  How efficient are your long-term investments from operational standpoint?

34.  How solid is your A/P management methodology?

35.  How efficient is your A/P management process?

36.  How efficient are your A/P management tools?

37.  How competent is your A/P management personnel?

38.  How solid is your methodology for estimating your employee pension funding?

39.  How efficient is your process for estimating your employee pension funding?

40.  How solid are your tools for estimating your employee pension funding?

41.  How competent are your actuaries?

42.  How efficient is our employee benefit system in terms of generating an incremental financial value compared to motivation system that includes no benefits?

43.  How much incremental financial value does each new benefit add?

44.  How optimal is your equity structure (in terms of various types of securities)?

45.  How optimal are terms, conditions and other features of each security issue?

46.  How efficient are your procedures for dealing with your treasury stock?