Magazine article The Journal of Lending & Credit Risk Management

Assessing the Quality of Operating Cash Flow

Magazine article The Journal of Lending & Credit Risk Management

Assessing the Quality of Operating Cash Flow

Article excerpt

The RMA Uniform Credit Analysis (UCA) direct method of computing cash flow was introduced in 1982. Since then, it has significantly changed and enhanced the credit analysis process. In fact, the UCA method has become so popular that its format has been integrated into all the major software packages for statement analysis. Nevertheless, this standard for evaluating a firm's cash flow does not clearly segregate two important sources of operating cash:

1. Gross profits and operating profits as the key contributors to earnings before interest, taxes, depreciation, amortization, and extraordinary items (EBITDA).

2. The net effect of changes in working asset efficiencies.

Collectively, these are known as the cash flow drivers.

Review of EBITDA and the Other Cash Flow Drivers

In large corporate and syndicated transactions, EBITDA continues to be one of the most important financial variables. The ratio of debt to EBITDA is often used in a performance pricing matrix in which the loan interest rate is periodically recalculated. Minimum levels of EBITDA are usually governed by a loan covenant and can further affect required levels of collateral and/or third-party support.

Purists will argue that because EBITDA is derived from the accrual-based income statement, it has no place in a direct method cash flow format like UCA. However, the importance of EBITDA to large transactions should warrant at least a modified format for analysis and monitoring purposes. Further, by isolating the income statement items that make up EBITDA, the cash flow drivers are more easily identified.

What Are the Cash Flow Drivers?

An important part of cash flow analysis is identifying the drivers, or key influences, on operating cash flow. As described in RMA's cash flow courses, this analysis involves assessing the effects of changes in the profit margins (or fundamentals) and the efficiency ratios (or swing factors).

Fundamentals are a firm's gross margin and operating margin. They are indicators of long-term economic viability and are necessary to generate consistent cash flows to repay bank debt. The operating profit closely resembles EBITDA, except for depreciation/amortization and other income/expense. So EBITDA can effectively summarize a firm's fundamental or core earnings.

Swing factors are a firm's turnover of receivables, inventory, and payables. They are indicators of short-term efficiency and management. Swing factors can create year-to-year swings in cash flow. However, they are less desirable than core earnings as long-term sources of repayment.

In most loan situations, operating cash flow is the preferred source of repayment. But within the value computed for operating cash flow, these two groups of drivers can have distinct advantages and disadvantages as the primary sources or uses of operating cash flow.

While EBITDA is not readily available in the UCA format, the other cash flow drivers are identified individually, but they are not grouped in a way that promotes effective what-if analysis. By grouping the fundamentals (and contributors to EBITDA) together, followed by the swing factors, a format emerges that is better suited to assessing the quality of these important sources of cash flow. A work sheet for calculating operating cash flow using the cash flow drivers is shown on the next page.

A New Format

Figure 1 shows the financial highlights of Sample Firm, which has experienced strong sales growth and declining margins. Based on a satisfactory level of profits and decreasing leverage, the company appears to be creditworthy. Further, operating cash flow, as measured by the key UCA line items, is sufficient to cover interest expense and current maturities of bank debt.

[TABULAR DATA OMITTED]

[TABULAR DATA FOR FIGURE 1 OMITTED]

Figure 2. Sample Firm Operating Cash Flow - UCA Format ($000s)

Period                                      1994            1995

Net sales                                 23,000          28,000
Change in accounts receivable             -2,850           1,400

Cash collected from sales                 20,150          29,400

Cost of goods sold                       -15,800         -20,000
Change in inventories                     -1,100          -1,200
Change in accounts payable                 2,800          -1,100

Cash production costs                    -14,100         -22,300
Gross cash profit                          6,050           7,100

SG&A expense (less depreciation)          -4,200          -5,500
Change in accrued expenses                    50             100
Change in prepaids                             0               0

Cash operating expenses                   -4,150          -5,400
Cash after operations                      1,900           1,700

Change in other current assets              -300            -150
Income tax expense                        -1,000            -800
Change in taxes payable                     -300              50

Net cash after operations                    300             800

Figure 2 shows the details of the UCA method used to compute operating cash flow. …

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