Tightly Manage Cash flow & Liquidity

JWI 530 Financial Management I, week4 summary, 2/3/13

This was another fabulous week of learning. I see why managing cash flow and liquidity systematically is a strategic activity.The Garmin assignment led me on an adventure, as I dug deep into corporate 10-K and 10-Q statements and am beginning to see the light and beauty of finance.

Loving this immersion into the numbers side of business.
Dr DP

JWI 530 Financial Management I, week4 summary

I. Explain the difference between information provided in various financial statements
Cash Flow Statement = Company's Cash Register
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Goal of Cash Flow Statement:
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show actual cash movements in business & document impact of corporate decisions
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Cannot be manipulated by accounting procedures
Net income can be fictitiously stated with massive growth that is imaginary

Cash is King !
Cash Flow Statement is all about "Follow the Cash !"

Cashflow statement is the crucial bridge between income statement and balance sheet
reconciles net income with physical, countable cash coming in or leaving the business
where is the cash coming from, how much stays within the business ?
Cash flow statement - pure cash system ie like Cash register receipts
Income statement - mechanics of credit to determine income ie profit

Balance sheet: Assets vs Liabilities + Equity = what firm starts out with owning and owing
Income statement: Includes cash not yet received eg. account receivables; Net Income includes IOUs
Updated Balance sheet: Shows increase in Assets/Equity from cash profit made, reduction in inventory
Cash flow statement: Shows only cash coming in and going out

Cash flow statement consists of:
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(i) operating activities: what is the net bankable "true cash profit" from operations ?
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- Follow the cash involved in firm's core business operations
- Start with net income at the top
- explain how amount in bank is different from net income reported in income statement
- positive means cash is added back to net income eg Depreciation & Amortization
(ii) investment activities: how much money was used for investments made to build the business
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- Capital expenditures (Capex)
- Other movements of cash eg. Acquisitions, short or long term portfolio investments like CDs, property sale
(iii) financing activities: what changes were made to firm's internal capital structure ?
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cash associated with dividends and stock repurchases
cash used to finance company's internal operations and investments
did the firm borrow money ? (this shows up as inflow here and inflow in debt/liabilities on balance sheet)
share repurcahses or shares sold to issue stock options

Final section
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Combines cash flows from the 3 subsections and reconciles cash balance from one period to next
how much cash was generated at end of recent year ? (restored in balance sheet)

II. When a firm reports High Margins ask "is it real? is it sustainable?"
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"is it real based on fundamental industry structure & is it sustainable through durable competitive advantage & pipeline of innovations?"

There are several scenarios under which a high margin business would raise red flags to me.
(1) Ponzi scheme - Too good to be true
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Consistently above industry average and unnaturally shows no vulnerability for years when lesser firms are falling like flies. eg. Bernie Madoff
(2) Running out of steam
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A firm can keep growing explosively for several years but run out of steam eventually without innovative growth products to sustain the torrid pace. Dell in the 1990s had this problem as it focused on being a commodity leader. Without new products and differentiation earnings dropped. Key question to ask is: can the firm keep up the pace ?
3) Accounting tricks
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Instead of showing solid growth from excellent products, a firm can shift  money around cleverly to give an illusion of high growth when under the covers it is clear that the firm has stagnated or is declining.
(4) Running out of cash
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A firm with high growth will go out of business if it cannot control its cash flow and meet payroll. Cash flow is king (JWI 530, week4, lecture1). Lou Gerster, former CEO of IBM, states that cash flow is most important for major organizations to survive (Gertstner, 2002).
(5) Cheating & Foreign Corruption Practices Act violation
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When the CEO is behaving erratically and taking the firm into unknown ventures where his family members are involved eg. Satyam computers in India. When the firm can enter easily into foreign territories while other firms that tried have failed eg. WalMart officials bribed public officials in Mexico.
Much like doubting if a super athlete with a consistently stellar and above average performance (eg. Lance Armstrong) has used performance enhancing drugs
or not, we as finance truth-seekers need to be on the look out for shady dealings by firms. We need to quickly pick up tell tale signs in the balance sheet,
 income statement, cash flow statements as explained in JWI 530 Week4, Lecture1.

When we see a firm reporting high margins, the key question to ask is "how did the firm get to high margins?".
There are genuinely great firms such as Apple and WalMart which have earned their way to a sustainable competitive advantage through an innovation pipeline
and/or relentless cost reduction.
Then there are firms like HP which were once great that seem to be struggling and wanting to show numbers without a cohesive strategy.
Such firms could bring up Flash in the pan kind of numbers that are not sustainable due to weak fundamentals.
IBM recently reported high margins but has been under criticism since the revenue actually fell.
http://www.businessweek.com/articles/2013-01-22/ibm-makes-more-money-selling-less-of-what-people-want
Is IBM getting to high margins by selling less or what customers want ?
If this is the case, are customers really not buying IBM's vision of the future ?
It is clear that high margins alone are not enough. How a firm gets to show high margins makes all the difference.

Dr Sasha's two questions - is it real and is it sustainable ?- do indeed get to the bottom of it all.
Reality check weeds out Ponzi schemes, accounting tricks and imaginary numbers.
Sustainability check gives us a view of the future based on past performance.

Fundamental determinants of profit margin include:
(a) Industry structure as illuminated by Porter's 5 forces model
(1) Competition among rivals - monopolies typically enjoy high and sustainable profit margins eg. IBM in 1960s and 70s and Microsoft in the 80s; oligopolies enjoy sustainably high margins eg. oil cartels; perfect competition leads to erosion of profit margins eg. retail with many suppliers
(2) Supplier power
(3) Buyer power
(4) Pressure from new entrants
(5) Threat of substitute products
(b) Growth phase of industry
High margins can be reaped at introduction, early user offerings, growth phase of the industry. Mature and declining industries have low to negative profit margins.
(c) PESTEL environment
Political - new political rules can make or break margins eg. tax policies
Economic - recessions lead to lower profit margins as people are buying less. In boom times, even badly run firms can show good margins, eg. real estate firms made a lot of money unyil the 2007 crash.
Social - changing social norms can affect profit margins eg. hostess twinkies went out of business due to health consciousness movement
Technological advancements can make or break profit margins eg. RIM lost big time to Apple and Android phones,
Environmental - For example, tighter EPA laws in California force the car companies to keep reducing emissions. Companies that fail to meet the standards will lose sales and margins
Legal - Change in laws can impact the bottomline eg. insider trading laws, antitrust laws

III. Tightly Manage Cash Flows & Liquidity Rigorously & Systematically, Rigby & Sweig, 2009
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Goal: Support the company's strategy,increase its thrust, Develop forward visibility to manage effectively through even a sustained period of turbulence
Healthy companies like WalMart with cash reserves have more strategic options

Managing cash flow and liquidity is a strategic - not tactical - activity
Understand cash flows to monitor strength & vulnerability of competitors, customers, vendors
Use capital and cash efficiently
Track cash flow weekly and monthly & develop integrated view
Spot patterns & drivers of variance in liquidity & how they flow through P&L statements
Predict business obstacles - peaks and valleys - buy valuable time to respond before options run out
Cash strapped = defensive actions: slash inventories, clamp down expenses, cut back compensation & benefits