Introduction to Corporate Finance

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Definitions or explanations of important

key terms are located in the margin for

quick reference.

Finance in practice boxes show you

examples of corporate finance within

international organisations.

2: Financial Statement and Cash Flow Analysis

39

Next, we convert this operating cash flow to free cash flow (FCF). To do so, we deduct the company’s

net investments (denoted by delta, the ‘change’ symbol: ∆) in fixed and current assets from operating cash

flow, as shown in the following equation:

Eq. 2.4 FCF = OCF – ∆FA – ∆WC

where

∆ FA = change in gross fixed assets

∆WC = change in working capital

= ∆CA – ∆A/P – ∆accruals

where

∆CA = change in current assets

∆A/P = change in accounts payable

∆accruals = change in accrued expenses

Spontaneous current liability changes occur automatically with changes in sales. They must therefore

be deducted from current assets in order to find the net change in working capital investment. From the

preceding calculation, we know that GPC’s OCF in 2016 was $1657 million. Using GPC’s 2015 and

2016 balance sheets (Table 2.1), we can calculate the changes in gross fixed assets, current assets,

accounts payable and accruals between 2015 and 2016:

∆FA = $9,920 – $9,024 = $896

∆CA = $2,879 – $2,150 = $729

∆A/P = $1,697 – $2,150 = $393

∆accruals = $440 – $379 – $61

∆WC = $729 – $393 – $61 = $275

Substituting these values into Equation 2.4 yields the following expression:

FCF = $1,657 – $896 – $275

= $486

The first line of this FCF calculation

shows that, after subtracting $896

million in fixed asset investment and

$275 million in current asset investment

net of accounts payable and accruals from

its OCF of $1,657, GPC had free cash

flow in 2016 of $486 million available to

pay its investors. We will use free cash

flow in Chapter 5 to estimate the value of

a company. At this point, suffice it to say

that FCF is an important measure of cash flow used by corporate finance professionals.

Inflows and Outflows of Cash

Table 2.4 classifies the basic inflows and outflows of cash for companies (assuming all other things are

held constant). For example, a $1,000 increase in accounts payable would be an inflow of cash. A $2,500

increase in inventory would be an outflow of cash.

TABLE 2.4 THE INFLOWS AND OUTFLOWS OF

CORPORATE CASH

Inflows Outflows

Decrease in any asset Increase in any asset

Increase in any liability Decrease in any liability

Net income (profit after tax) Net loss

Depreciation and other non-cash charges Dividends paid

Sale of ordinary or preferred shares Repurchase or retirement of shares

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You can analyse the practical applications of

concepts in the examples.

Key equations are highlighted where they

appear in the text.

finance in practice

example

22

PART 1: INTROdUCTION

suppliers and creditors? A company’s shareholders are sometimes called its that they can exert claims only on the company’s cash flows that remain after all other claimants, such as residual claimants, meaning

customers, employees, suppliers, creditors and governments, are satisfied in full. It may help to visualise a queue with all the company’s stakeholders standing in line to receive their share of the company’s cash

flows. Shareholders stand at the end of this line. If the company cannot pay its employees, suppliers,

creditors and the tax authorities, then shareholders receive nothing. Shareholders earn a return on their investment only after all other stakeholders’ claims have been met. In other words, maximising

shareholder returns usually implies that the company must also satisfy customers, employees, suppliers, creditors and other stakeholders first.

residual claimantsCorporate investors – typically,

ordinary shareholders – who have the right to receive cash

flows after all other claimants have been satisfied in full

finance in practice

VIEWS ON CORPORATE GOALS AND STAKEHOLDER GROUPS

Although the perspective of maximising shareholder value has enjoyed widespread acceptance in

Australia, the US and the UK, it has not been universally embraced by companies from other

countries. However, the chart below, which reports results from a survey of chief financial officers (CFOs)

conducted during the global financial crisis, reveals a strong tilt toward shareholder wealth maximisation

among companies in Europe and Asia as well as in North America. The survey asked CFOs to rank

the importance of shareholders compared to other stakeholders. A score of 0 means that the CFO

believes that companies should focus exclusively on shareholders, and a score of 100 means that

the CFO focuses exclusively on other stakeholder groups. A score of 50 would mean that the CFO

rates shareholders and other stakeholders as being equally important. On average, it is clear that CFOs

from around the world place more emphasis on shareholders than on other stakeholders.

Shareholdersonly Other stakeholders(not shareholders)

(^0) 0–10
10
20
30
40
11–30 31–50 51–70 71–100
On whose behalf should a company be run?
Per cent
North America Europe Asia
Source: Duke University CFO magazine ‘Global Business Outlook’ survey. Conducted Spring 2010.
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44
PArT 1: INTrODuCTION
The quick ratio provides a better measure of overall liquidity only when a company’s inventory cannot
be easily converted into cash. If inventory is liquid, then the current ratio is a preferred measure. Because
GPC’s inventory is mostly petroleum and refined products that can be readily converted into cash, the
company’s managers will probably focus on the current ratio.
2-3c ACTIVITY rATIOS
Activity ratios measure the speed with which the company converts various accounts into sales or cash.
Analysts use activity ratios as guides to assess how efficiently the company manages its assets and its
accounts payable.
Inventory turnover provides a measure of how quickly a company sells its goods. Here is the calculation
for GPC’s 2016 inventory turnover ratio:
Inventoryturnover==CostInveofgoodntorssyold$8,519$615= 13 .8 5
In the numerator we used cost of goods sold, rather than sales, because companies value inventory
at cost on their balance sheets. Note also that, in the denominator, we use the ending inventory
balance of $615. If inventories are growing over time or exhibit seasonal patterns, analysts sometimes
use the average level of inventory throughout the year, rather than the ending balance, to calculate
this ratio.
The resulting turnover of 13.85 indicates that the company basically sells out its inventory 13.85
times each year, or slightly more than once per month. This value is most meaningful when compared
with that of other companies in the same industry or with the company’s past inventory turnover. An
inventory turnover of 20.0 is not unusual for a grocery store, whereas a common inventory turnover
for an aircraft manufacturer is 4.0. GPC’s inventory turnover is in line with those for other oil and gas
companies, and it is slightly above the company’s own historic norms.
We can easily convert inventory turnover into an average age of inventory by dividing the turnover figure
into 365 (the number of days in a year). For GPC, the average age of inventory is 26.4 days (365 ÷ 13.85),
meaning that GPC’s inventory balance turns over about every 26 days.
thinking cap question
What are some advantages for
financial analysts of using ratios, rather than absolute numbers
in dollars, when comparing
different companies
activity ratiosA measure of the speed with
which a company converts various accounts into sales
or cash
inventory turnoverA measure of how quickly a
company sells its goods
Inventory ratios, like most other financial ratios, vary a
great deal from one industry to another. For example, on 30 June 2014, Woolworths Ltd, a supermarket
retail operation, reported inventory of $4.69 billion
and cost of goods sold of $44.5 billion. This implies an inventory turnover ratio for Woolworths of about
9.49, and an average age of inventory of about 38.5 days. With the limited shelf life of retail groceries, its
primary product, Woolworths cannot afford to hold inventory too long.
Cochlear Ltd, the Australian manufacturer of ear In contrast, for the year ended 30 June 2014,
implant devices, reported cost of goods sold of
$248.3 million and inventory of $128.6 million. Cochlear’s inventory turnover ratio is thus 1.93,
and its average age of inventory is about 189
days.Clearly, the differences in these inventory ratios
reflect differences in the economic circumstances of the industries. Apparently, groceries lose their value
much faster than do ear implants.
Source: Income, Cochlear Limited and its controlled entities for the year ended 30 June Cochlear Annual Report 2014: A Hearing Life, Statement of Comprehensive

2014. Available at http://www.cochlear.com

example

average age of inventoryA measure of inventory

turnover, calculated by dividing the turnover figure into 365,

the number of days in a year

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