27
Competitor Cash Flow Analysis
Short Description
Cash flow is often described as the "life blood" of a business. While profit is a reasonable measure of performance (due to the "matching concept" of accrual accounting), it is a very poor measure of viability. Cash flow is the prime measure of viability and also is a major determinant of operating flexibility—the ability to fund new initiatives and to defend against competitive attacks.
This chapter considers both historic and future cash flow analysis. While historic cash flow analysis adds a little to our understanding of a business, its underlying strength, and the ability of management to cope over the business cycle, it is future cash flow that is the most valid in determining viability and future flexibility. Naturally, any consideration of the future will be subject to the validity and reasonableness of the assumptions made. Hence, forecasting cash flows requires a current analysis of a business and its environment, as shown in other analytical techniques throughout this book.
Cash flow analysis is not sufficient in itself to understand a business or its competitors—it only provides a partial view of the environment. However, it can significantly enhance the overall analysis and provides a useful cross-check on the reliability of other analytic techniques.
This chapter discusses the various definitions of cash flow. It does not address the simplistic and commonly used definitions of earnings before income tax (EBIT) and earnings before deducting interest, tax, depreciation, and amortization (EBITDA). Rather, a proper analysis needs to consider the cash effects of balance sheet items—changes in working capital and capital expenditure needs.
Background
Strangely, there has been little study of cash flow analysis, certainly in comparison to the wealth of studies on profit analysis.
The "statement of cash flows" was the last of the major accounting statements to be added to firm annual reports in the early 1990s. This was largely in response to the spate of corporate disasters during the global recession. Banks and other investors had been misled by reported profits to believe that companies were viable. To highlight the difference between profit and cash flow, the statement of cash flows was added. It is the only information in the financial statements that is not based on accrual accounting. It is divided into three sections—operations, investing, and financing.
Early attempts at cash flow analysis were still largely based on accrual accounting statements. One of the first determinants of viability was deemed to be the current ratio—the ratio of current assets to current liabilities. However, even as far back as 1919, Alexander Wall found that the current ratio could be volatile and was not necessarily a good predictor of failure—its changes were driven by factors other than failure.1
Research carried out by Winaker and Smith found that the benchmarks for ratios were industry-specific; that is, adjustments needed to be made for "good" or "bad" results depending on the industry.2 So we begin to see that cash flow analysis cannot be done in isolation of a single firm; we need to benchmark and understand the industry in order to make sense of cash flow analysis.
Nonetheless, the current ratio remains one of a handful of favorite ratios used by bankers and appears in loan document covenants for both large and small firms, and across industries.
In 1966, William Beaver published a seminal paper that focused attention on cash flow, albeit still limited to accounting ratios. Beaver's preference was to use ratios that give some indication of cash flow: "Cash flow ratios offer much promise for providing ratio analysis with a unified framework."3
Following the corporate disasters of the 1991–1992 global recession, cash flow analysis gained more prominence and "Cash is King" became a popular catch cry.
Investors such as Warren Buffet (see the Berkshire-Hathaway annual reports) declared their preferences for cash flow:
"In the long run, managements stressing accounting appearance over economic substance usually achieve little of either."
"Our acquisition preferences run toward businesses that generate cash, not those that consume it . . . However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash."
At the same time, cash flow analysis (specifically, discounted cash flow (DCF) analysis) became the dominant and theoretically preferred method of valuation, gradually supplanting simplistic capitalization ratios, such as price/earnings multiples. The use of DCF analysis and "net present value" has not been as dominant as could be expected, largely because of the complexity of the analysis (and thus the scope for calculation errors) and the poor environmental analysis used to check the reasonableness of the assumptions.
However, in 2001, McKinsey and Co. published a revised document on valuing dot.com companies following the spectacular collapse of the overvalued bubble companies. The opening line to the document is, "Investment values always revert to a fundamental level based on cash flows. Get used to it."4
Most investment banks use DCF analysis as their major valuation technique for acquisitions and even theoretical share values. Several investment analysts use "long-term cash flow" as the prime determinant of a firm's value.
Finally, banks are attempting to become "cash flow lenders"; that is, the prime decision is made on whether the borrower can generate sufficient "free cash flow" to service the debt (pay the interest and meet the loan repayments).
Today, while the principles of cash flow are well recognized, the practice still has far to go. When BHP bought the Magma Copper assets in the U.S. in 1995, it paid A$3.2 billion. The value was largely based on the amount of copper reserves and the price of copper. Due diligence apparently failed to discover that Magma Copper had little in the way of copper reserves (as CRA had found earlier, when it walked away from a Magma Copper purchase). Also the copper price used in the model was at an all-time high, assisted by price manipulation by one rogue trader in Sumitomo Copper. When the copper price collapsed shortly after and the lack of copper ore became apparent, BHP wrote off more than A$2.5 billion of its investment.
Strategic Rationale and Implications
Cash flow analysis is not just about firm viability.
First, free cash flow is a major determinant of financial flexibility. Does the firm have the scope to make new investments or to take new strategic directions? Free cash flow, or at least access to further cash resources, also determines the firm's ability to undertake major investments that do not have early payback.
The classic measure of the dot.com companies when determining if their strategic plans were viable was their rate of "cash burn" and their level of cash reserves. Certainly, many of the dot.coms burned cash at unsustainable levels.
Second, free cash flow is a major strategic strength. Strong cash flow in some business units allows a firm to commit to implementing strategies in other business units.
This was recognized in a simplistic fashion in the Boston Consulting Group (BCG) matrix of stars, cash cows, problem children, and dogs.5 The idea is to have enough cash cows to support the stars through their growth (but cash negative) phase and perhaps to move problem children across to star status. However, the BCG model is over simplistic in that there are many more factors involved in determining cash flow than a reliance on market share.
Cash flow analysis provides an additional financial viewpoint of a business.
Despite the obvious link between cash flow and viability, surprisingly, historic cash flow does not show a significant correlation to failure. The difficulty lies in the ability of companies to stave off failure, at least in the short term, by falling back on sales of assets, tapping other sources of finance, and so on.
Ward, for example, argues for a cash flow theory whereby firms need to maintain cash flow stability (between operations, investing, and financing) to achieve financial health and stability. An event such as declining sales or rising costs can cause financial stress on the firm. How management responds is critical to the restoration of equilibrium.
Foster and Ward argue that an examination of the interactions between the operating, investing, and financing cash flows can indicate at what stage of financial stress the firm is in and provides information on management's actions for correction.
Certainly, examples can be found to support this assertion (see the Burns Philp case study later in this chapter). However, many more examples can be found where a firm is not in distress but where similar interactions are occurring in its cash flows.
The findings in numerous studies—by Godbee, Casey, and Bartczak, and other researchers—show that historical cash flow analysis by itself does not prove to be a good predictor of distress.
Proponents also point out that cash flow analysis is less susceptible to the manipulations of creative accounting.
Certainly, there is more scope with "creative accounting" to dress up both the "income statement" (the profit and loss statement or statement of financial performance) and the balance sheet (the statement of financial position). Capitalizing expenses, deferring expense recognition, bringing forward revenue recognition, and ignoring some accruals are just a few of the means to manipulate accrual accounts.
Cash is cash, and it is less amenable to be manipulated on the timing issues. For example, in the six months before Enron went bust, it reported an accrual profit of some US$800 million (much of which was recognition of revenue on long-term contracts that would not be realized for up to 20 years). On the other hand, operating cash flow was negative in the amount of US$1,300 million—the reality of cash versus the window dressing of profits.
This does not mean that cash flow is immune to manipulation. WorldCom demonstrated this by switching cash flows between operating and investing categories. However, the scope for manipulation is much more restricted.
Cash flow also highlights the style and goals of management. An example was the Australian firm, David Jones, when controlled by the Adsteam Group. According to all the statements and public announcements, David Jones remained a conservative, high-end retailer. However, a check of the statement of cash flows gave a very different picture. Over 70 percent of the cash flows for David Jones had nothing to do with the conservative business of retailing. The cash flows showed that most of the activity was high-risk share trading (apparently trading in shares of other members of the Adsteam Group).
The breakdown of cash flow according to operations, investing, and financing provides further detail on the sustainability of a business and its strategies.
Australian retailer Brash Holdings is an example. Founded in 1862, it floundered more than 130 years later due to a flawed strategy and operating performance. Although the operating margins (for example, sales margins) and gearing ratios were steadily deteriorating, the funds analysis stressed that the strategy was not sustainable and could not wait for improvement. (Funds analysis was the forerunner to cash analysis until the more accurately timed cash flow statements became available.)
From 1989 to 1991, the firm invested well over A$100 million in stock, equipment (shop fittings) and goodwill on acquisitions as it pursued its strategy of 30 percent per annum growth—the sole articulation of its strategy was to become the fourth-largest retailer in Australia by 1996. But where was the money coming from? Only 16 percent was coming from operations—and more than half of that was leaking out again in the form of high dividend payments. Suppliers were funding over 42 percent of the business, and debt was the other main source of funding. Such funding was only sustainable until suppliers and banks ran out of patience.
A refinement of this analysis is the "sustainable growth rate" calculation.6 Robert Higgins introduced and defined this concept in 1977. It is a measure of how fast a firm can grow its sales without blowing out its target gearing ratio. Stripped to its bare essentials, the rate is determined by four factors: the required asset level to support sales; the sales margin; how much profit is leaked out of the firm in the form of dividends; and the gearing level. To grow faster, the business must either adjust one of these parameters or inject more equity.
In the example of Brash Holdings, its deteriorating performance and high dividend payments meant the sustainable growth rate was less than 5 percent per annum. While there were some equity injections, the plummeting share price eventually cut off this source of funds. Rather than face reality, the firm continued to blow out its gearing, particularly by stretching its creditors beyond reasonable limits. Reality eventually hit.
Strengths and Advantages
Cash is cash, and cash flow analysis provides greater insight into the financial viability of a business. Further, cash flow analysis is less susceptible to the manipulations of creative accounting due to the timing issues of cash in and out of the business.
The breakdown of historic and future cash flows according to operations, investing, and financing provides detail on the sustainability of a business and its strategies, and highlights the style and goals of management.
However, future cash flow analysis is the most valid tool for assessing a firm's viability. Thus, for bankers, it is also the most valid decision-making tool for lending, especially to large corporations where security, typically, will be only 40 percent or less of the loan value.
Cash flow modeling provides a virtual laboratory model of the business and its environment—the business has a forecast of what cash surpluses or shortages will be available in future years. Some analysts now refer to such surpluses as "strategic cash flow"—it is cash surplus that can be used for new investments, returns to shareholders, or reducing liabilities.
A well-crafted cash flow forecast model not only provides a forecast of the cash flows, it allows the business situation to be tested. Typically, sensitivity analysis asks "what if" questions. What happens to cash flows if sales rise or fall by 10 percent, if collection of debt slows down, or if additional capacity is required, and so on? Several "what if" conditions combined form a scenario analysis. For example, if a new competitor enters the market or a price war breaks out, the model can calculate the effect on sales, prices, and so on, and show the resulting effects on cash flow.
As such, cash flow forecasting is one of the major tools for assessing the severity of risks. Calculation of the probability of an event occurring is a separate aspect that requires environmental and competitive assessment.
Weaknesses and Limitations
Sadly, cash flow analysis is done rarely and poorly. The main reasons for this are not conceptual, but practical. Complex future cash flow modeling is difficult, time-consuming, and prone to error.
Modeling of a major project, such as opening a large coal mine or infrastructure project, may require six months or more to research the inputs and build the model. Large models also may have thousands of lines of equations, and the scope for error is considerable, especially when running sensitivity analysis. Some organizations attempt to use audited templates, but the "one size fits all" method usually results in a behemoth of a model that mimics the human genome project—some 90 percent of it is redundant and unused.
Building a model from scratch provides much greater insight into a business, but this requires more skill and usually more time.
Finally, the validity of any model rests on the validity of the assumptions on which it is built. The old computing saying of GIGO (garbage-in, garbage-out) applies. A seemingly small difference in assumptions can have enormous ramifications.
As a consequence of the skills needed, the time and cost involved, and concerns over the scope for error, cash flow forecasting for investment or strategic purposes is not done as widely as it deserves; this is despite the ready availability of computing power and software such as Excel. Instead, we see companies and banks falling back on simple (but invalid) measures such as EBIT and EBITDA. These measures can be calculated in a matter of seconds, but they are really quite some way from the real free cash flow of a business. Even making adjustments, such as deducting capital expenditure from EBIT, does not provide much of a refinement.
Cash flow forecasts are still done in detail for liquidity planning purposes. However, despite the detail, such models are usually constructed using little more than a listing of revenues and expenses, and with limited calculation. When properly designed and used, the models can be powerful tools. For example, if there were only two major domestic airlines in a country, complex modeling of your competitor's airline could provide simulation of the effects of price movements, route changes, and even the introduction of a third airline without the expense of trial and error in the market.
Processes for Applying This Technique
The basics of cash flow analysis are not just quantitative (How much cash is there?) but also qualitative (Where is the cash coming from and going to, and is it sustainable?).
The basic cash flows in a business are depicted in Figure 27.1.
Figure 27.1 Cash flow analysis
Note that the central box of "operations" is represented in the financial statements by the income statement (statement of financial performance). While a major determinant of cash flow, it is only part of the story. Beyond operations and sales, there are another seven boxes on the diagram that also affect cash flow, and several can be larger than the operations. These boxes are represented by the balance sheet (statement of financial position). It is a reminder that we must look beyond just operations if we are to understand cash flows. Profitable companies can fail!
The diagram also highlights the inadequacy of using EBIT or EBITDA as surrogates for free cash flow.
As previously mentioned, historic cash flow analysis traditionally looks at the sources and uses of the cash. The prime delineation is provided within the statement of cash flows—operating, investing, and financing.
For an established firm, we like to see strong positive operating cash flows. In terms of risk, stable operating cash flows from year to year are desirable. A further breakdown of analysis would determine if these operating cash flows are coming from normal ongoing business operations or whether they are from one-off events.
In the case of the airline Qantas, it is in a risky industry, and its financial gearing is also high, with debt usually matching equity to give a high debt-to-equity ratio of 1:1 or 100 percent. Yet Qantas is one of the few major airlines that has maintained an investment quality credit rating. This is largely achieved by careful management of its operating cash flow. Despite issues with terrorism, wars, SARS, and other external events, Qantas can generally achieve an operating cash surplus of around A$1 billion each year.
We understand that start-up companies may have negative operating cash flow during their start-up period. Ideally, such shortfalls would be funded mostly by equity investors. To determine the viability of the start-up's business plan, we need to know the rate of their cash burn and how much cash they hold in reserve.
We also understand that growing companies, both start-ups and established firms, will generally have negative net investing cash flows. There are a few exceptions, such as Woolworths, which has limited capital needs for expansion and can fund much of its expansion in sales from the positive net working capital management it achieves. We become concerned, though, if the investment cash flows are hugely negative compared to the operating cash flows, especially if this continues for several years in a row.
Finally, we like to see a balance of funding from financing activities. If the firm is growing and needs to raise capital, both equity and debt need to grow proportionately in order to maintain a stable gearing ratio.
In the case of Qantas, it was in the middle of a major capital investment program, a number of years ago, to refurbish its fleet of aircraft. Consequently, cash flow from investing activities have been (and should continue for a few years) running negative by several billion dollars a year. Due to the difficulty in raising the share price, most of this investment has been debt funded. By 2003, Qantas' already high debt-to-equity ratio had risen from its normal 100 percent to 121 percent. By that stage, ratings agencies would have been watching it. During the next few years, Qantas changed its operational tack, slowing reinvestment in its fleet and increasing its operating cash flow surplus to nearly A$2 billion a year. The excess cash was used to repay debt. Added to retained profits, the debt ratio fell back to 100 percent in 2004 and to 86 percent in 2005. Qantas found it necessary to adjust its operating strategy to recover its financial strategy—that Qantas management was able to adjust to these needs would have been favorably viewed by the investment community.
The relevant ratios on Qantas are shown in Table 27.1.
Table 27.1
Financial Ratios for Qantas
Of course, analysis of a firm's historical cash flow is improved if it is compared, if not actually benchmarked, against its industry peers.
Future Cash Flow Analysis
Future cash flow analysis begins with building a model that is a reasonable (but not precise) approximation of the operations of the business. It is used for strategic analysis, valuation, and risk assessment. A precise model would take too long to build, would be unwieldy, and would be costly in terms of effort and time.
A part from spreadsheet modeling skills, the prime skill of the analyst is to understand the business. This will not only assist in constructing the approximation of the business, but will also help to determine the reasonableness of the assumptions. Hence, before the model can be constructed, considerable background work must go into gaining knowledge of the business and its competitive environment.
Finally, the model needs to be built with flexibility. This will include many conditional statements and links between variable factors. Otherwise, the model will not be suitable for one of its prime purposes: the conduct of sensitivity analysis.
Tip Sheet on Cash Flow Analysis
For both historic and future cash flow analysis, the key word is sustainability. Can the cash flows be sustained to pay bills and/or fund growth?
Historic Cash Flow Analysis
- Are the numbers reasonable? If you believe the numbers are "fudged" or manipulated, there is little point in spending time analyzing them. You run your eye over for anything that looks strange. This might be an unusually large number or a number that bucks the trend over the past few years or one that just seems too odd. In the case of Burns Philp, Profit after Tax was higher than Cash Flow from Operations. Since profit has large accrual items such as depreciation and amortization deducted from it, normally operating cash flow is 1.5 to 2.0 x the profit after tax figure. Further investigation of Burns Philp showed that the effective tax rate was less than 20%, suggesting that the cash flow figure was more "true" than the profit figure. (Indeed, Burns Philp was capitalizing many expenses: treating them as assets not expenses.)
Another aspect of Burns Philp was generally declining operating cash flow over the years—a very worrying sign. Then, cash flow slightly rose in 1995. But a check of the items found that the turnaround was solely from the one-off inclusion of a refund from the Superannuation Fund on the basis that the company had been overpaying for many years and had now suddenly discovered this overpayment. Back that number out of the cash flows, and the declining trend was continuing. - What is the major source of cash flow, and how steady is it over the years? For a start-up business, we expect it to make losses in the early years, and so the major source of cash flow may be equity injections.
However, once a business is established, we expect the main source of cash flow to be from operations: selling products and services to customers at a premium to what they cost to deliver. There may be odd years where major expansion or acquisition means that financing sources (debt or equity) may exceed the cash from operations, but these should be rare. - We are concerned at the use of "risky" sources of funds. In the case of retailer Brash Holdings, the major source of funds was suppliers (trade creditors), which was more than four times the cash from operations. A check of the days payable ratio showed that the creditors were being stretched out on their payment terms—a risky and short-lived strategy.
- We are also concerned if most of an expansion strategy is being debt financed. There should be a balance between debt and equity (to maintain gearing ratios). Debt financing is even more deadly if there is an overly generous dividend payout policy so that too much cash from operations is "leaked" out of the business to the shareholders. A debt-funded expansion strategy, particularly through aggressive acquisitions, is one of the highest correlating factors for corporate distress.
Future Cash Flow Analysis
- Again, sustainability is the big issue. Have the cash flows come from ongoing, sustainable operations or are they from one-off items that cannot be guaranteed? That is where Newscorp ran into difficulties in the early 1990s. The business changed from a fairly stable newspaper publisher in Australia, Britain, and America into a satellite broadcasting start-up in Britain as well as purchasing Fox movie studios, to try to establish Fox as a new TV network in America. Cash flow became volatile while costs and debt-servicing commitments remained steady.
- If presented with a cash flow forecast especially in a spreadsheet form, again you need to test if the forecast is correctly calculated before going into detailed analysis. Look for strange numbers that are unusually large or buck the trend when looking across time periods. Are the calculations correct?
- Is everything included in the forecast? A common mistake is to leave out the effect of growth on working capital needs. When Power Brewing trebled its production capacity, the spreadsheet used by its bank did not include the extra stock and debtors required to service such an expansion. This neglected some $10 million of funding needed to support the business.
- Next, with a cash flow forecast, are the assumptions reasonable? Projections always look good on paper—how many companies are going to show a declining business or cash flow? But do the assumptions tie up with the numbers today, and what can be expected going forward? Remember, you cannot reasonably have four suppliers in a market, with each claiming 60% market share.
To assess the reasonableness of assumptions, the analyst had to understand the industry, the competitors, and the business. Cash flow forecasts should not be pulled "out of thin air" but are rather the embodiment of several pieces of background analysis. - Finally, the real power of cash flow forecasts, especially in a computer spreadsheet, is sensitivity and scenario analysis. The model can be used to assess the impact of risk events. What if a competitor starts up a price war; or if a major customer defaults; or if the equipment suffers a major breakdown; and so on? Combining several of these sensitivities will develop a scenario as with Power Brewing.
Cash flow analysis is not normally complete in itself but is rather a good tool to combine several analytic techniques and to be used as a cross reference to other techniques.
Case Studies
Because this chapter has considered both historic and future cash flow analysis, a short case study on each aspect is provided next.
Historic Cash Flow Analysis: Burns Philp
Burns Philp was incorporated in 1883 and operated as a diverse group in shipping (one of the long-standing South Seas Traders), retailing, insurance, and trusteeship.
Burns Philp became involved in yeast manufacture in the 1980s when it bought a long established Australian producer, Mauri Bros. In the 1990s, Burns Philp made a series of expensive acquisitions in the herb and spice business—mainly in America, but also in Germany, the Netherlands, and Britain.
Burns Philp then encountered more severe competition than it had when it had expanded globally in yeast. There were entrenched competitors who would not (indeed, could not) yield market share to Burns Philp. McCormick Foods in particular proved to be an entrenched and determined competitor. For McCormick, defending its retail spice business was a matter of life or death.
When Burns Philp's investment in the spice business was written down by the auditors by close to A$1 billion in 1997, it nearly wiped out its entire equity. The firm was in breach of its loan covenants, and its life was only maintained by the banks not foreclosing on it.
The share price plunged from A$1.50 to just 6 cents in a matter of weeks. Most commentators focused on the sudden fall of Burns Philp. Ian Horton of the Investment and Financial Services Association was quoted in February 1998 as saying that Burns Philp was a business "going from being a very successful one to a basket case in a very short space of time." Certainly, most equity analysts and corporate investors had not realized the desperate situation of Burns Philp when they made their stock recommendations or large investments a few months earlier.
How much of Burns Philp was a surprise? The benefit of hindsight unearths the clues, but were they evident before the event? Most commentators focused on the profits and the grand international growth strategies. At least one analyst, Helen Cameron, had a different view (perhaps aided by a stint as strategy planning manager in Burns Philp). When asked well before the crash why she had left Burns Philp, she simply commented: "Look at the cash flows."
The financial statements (balance sheet, profit and loss statement, and statement of cash flows) reviewed are from 1992 to 1995. These statements cover a period of two to five years before the crash.
Objective analysis shows some issues of great concern in a supposedly strong firm. For a start, we are concerned about the reliability of the reported profit figures. The profit and tax figures for 1993 to 1995 are tabled next.
Yet the corporate tax rate in these years was over 30 percent. We can understand the actual tax rate being less than the nominal rate in some years due to timing differences with accrual accounting, but such large differences year after year lead us to suspect that the taxable profit was far less than the reported firm profit.
At least part of the explanation seemed to lie in how Burns Philp was treating slotting expenses. These were payments made to supermarkets in the U.S. just to get their spices on the supermarket shelves. It seems Burns Philp paid huge amounts (several hundred million dollars) several years in advance! Rather than treat this as an expense, they argued that under accrual accounting concepts, they should be amortized over the period in which they helped earn income. Unfortunately, the competitive reactions by McCormick meant there never were any profits.
By capitalizing these expenses, Burns Philp removed them from the profit and loss statement and instead had them treated as assets in the balance sheet. On the other hand, the cash flow was still negative—it was cash going out. The 1995 Burns Philp Annual Report states:
"Slotting fees are the upfront multi-year payments to retailers for contracts related to shelf space in supermarkets. While a traditional feature of doing business with supermarkets in the United States and some other countries, an escalation in slotting payments was used during 1994 and 1995 as a competitive reaction to our increased presence in the world spice market. This situation seems to have abated with new contracts being negotiated at more realistic levels."
"Burns Philp incurs costs ('slotting allowances') in connection with shelf space contracts for certain of its consumer food products. Where these contracts extend beyond a one-year period, the slotting allowances are deferred and amortized over the life of the contract. Costs which relate to future periods are disclosed as other assets in the balance sheet."
The cash flow statements offer more items of interest and concern. In summary form, cash flows were as follows:
The firm was obviously on a growth binge.
A more intense analysis unearths the concerns. The operating cash flows have fallen from over A$150 million to just under A$114 million. At least the 1995 results were slightly up from 1994; however, the 1995 results were "fixed up" by the old trick of looking at the superannuation fund controlled by the firm and deciding that it had made excessive payments over the years and that this should be refunded in 1995. Removal of this one-off bounty of A$20 million plunged operating cash flows below A$100 million.
The drop in the negative investing cash flows in 1995 was only due to the sale of Burns Philp's last cash cow, its BBC Hardware retail chain, for nearly A$500 million. Without this cash injection, investing cash flows would have been negative by about A$700 million. Like the superannuation fund refund, this was a one-off item that would not be there in future years.
Finally, the financing cash flows show most of the funding was coming from debt issues, as Burns Philp increased its debt levels by over A$200 million each year.
This showed a firm with declining operating cash flows despite a massive investment program that was debt funded. This was a recipe for disaster. Add some operating failures such as the spice business (plus others), and Burns Philp came close to failure.
In the end, it survived because the banks could see little value in a wind up, and the major shareholder, Graeme Hart, and a few fellow investors tried to save their investment by putting another A$300 million into the firm to try to turn it around.
Objective cash flow analysis shows the disaster in the making several years before the supposed "sudden collapse." Strategic competitor analysis would also have given some cause for alarm, but the hardest evidence was in the cash flow statements. As a leading financial commentator has said, Burns Philp's survival was dependent on the actions of Robert Lawless, CEO of McCormick Spices in the U.S. One would suspect that Lawless took one look at Burns Philp's operating cash flows, cost structures, and high gearing and decided to "put the shaft in so hard he just brought them right down."
Future Cash Flow Analysis: Power Brewing
In the early 1990s, banks were just starting to learn about becoming objective cash flow lenders. Computer-based cash flow modeling was in its infancy.
Leading Australian businessman, Alan Bond, had taken over the State of Queensland's own beer: the Castlemaine Brewery. He did the same in New South Wales with Tooheys. This followed his acquisition of the small Western Australian brewery, Swan.
In no time, Alan Bond had alienated his distributors (the pub owners) and his consumers (the drinkers). Trading terms were tightened, goodwill components in pub leases were ignored, and the packaging was changed to read brewed by Swan Brewery, Perth (Capital of Western Australia).
Bernie Power was one of the largest pub owners in Queensland and had been toying with the idea of opening a brewery. Suddenly, Alan Bond had tapped the keg of his idea. Bernie Power launched Power Brewing. It quickly claimed status as Queensland's real beer, and soon the brewery was selling at capacity with a 20 percent price premium, so keen were drinkers to avoid the Alan Bond beer brand. Power Brewing quickly achieved a 10 percent share of the Queensland market.
If you are at full capacity, the next obvious step is to triple capacity.
So, Power Brewing (by then a public company) borrowed some A$48 million from the bank to triple its capacity.
The bank developed a spreadsheet to look at future cash flows. The base case model showed generous future cash flows as tabled next. Year 1 was negative due to the capital investment in the expansion. The cash flow shown is free cash flow after all operating items and capital expenditure.
Unfortunately, the spreadsheet had an error. Working capital movements were ignored. Since the firm was tripling production and sales, working capital would also approximately treble, especially as Bernie Power offered reasonably generous payment terms to his fellow publicans. The effect was an additional negative A$10 million in the first year of expansion.
Of even greater concern was that the assumptions were simplistic and not reasonable. Prices were deemed to rise with inflation (which historically had not happened) and, even more illogically, the 20 percent price premium was expected to be maintained despite now saturating the market. Other assumptions included the plant running at 99.98 percent capacity each year and that all production would be sold.
Worse still, the model was quite inflexible, with little calculation within the model, making it very difficult to conduct a sensitivity analysis on the model.
This was regrettable. The tripling of output meant that Power Brewing was signaling to its competitors that it intended to move from 10 percent market share to 30 percent market share. At this stage, Power Brewing would need to have taken market share not just from Alan Bond's Castlemaine Brewery but also from the other rival, Fosters.
The response was foreseeable: a price war.
So how do the future cash flows look under a price war? Several sensitivity analyses are tabled next, and in the last case, we have a scenario of a fall in prices and volume, including the effect of the working capital change.
Obviously, such negative cash flows are not sustainable, especially for a fledging brewer with no operation in other markets. With the share price falling and its bank concerned, Power Brewing was happy to form a joint venture under Fosters' terms to share the new brewery. A few years later, Fosters bought the remaining half of Power Brewing.
The case shows that a well-constructed model with reasonable assumptions and sensitivity testing would have shown the strategy and business plan to be fatally flawed. Alternative strategies could have then been considered, such as stay small, form an alliance with other small regional brewers, or sell to Fosters when in a stronger bargaining position.
However, the error in the model (neglecting working capital), the unrealistic assumptions, and the lack of flexibility all led to self-delusion.
FAROUT Summary
Figure 27.2 Competitor cash flow analysis FAROUT summary
Future orientation—Medium to high. The future cash flow model is the synthesis of all techniques to look at the future.
Accuracy—Medium to high for the historic cash flow analysis. It is more accurate or at least more reliable than the other accounting statements. For future cash flow analysis, accuracy would be medium. Models require a very good understanding of the business and its environment as they often require considerable modeling and business skill.
Resource efficiency—Low.Some information can be gained from public documents, but much detail on operations requires internal analysis of the business and can require crossfunctional understanding of marketing, engineering, operations, and taxation.
Objectivity—Medium.Historic analysis is quite high. The use of many assumptions in forecasting can be influenced by political influence or "rose-colored glasses." There are tools for testing the reasonableness of assumptions, such as historic trends, engineering estimates, and break-even analysis.
Usefulness—High.Well-crafted models have enormous usefulness for strategic and business assessment and for the analysis of competitive situations and alternative strategies.
Timeliness—Low to medium. Historic cash flow analysis can be done quickly with public domain information. Complex forecasting models can take considerable time to build and use.
Related Tools and Techniques
- Competitor analysis
- Cost/benefit analysis
- Financial analysis
- Historic trend analysis
- Industry analysis
- Market forecasting
- Sustainable growth rate
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