Casper Van Leeuwen - Why cash flow should be a focal point

Why cash flow should be the focal point in
your financial consolidation and reporting
Contact
Casper van Leeuwen
+31 6 13 08 49 72
casper.van.leeuwen@satriun.com
WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 1

If it ain’t broke, don’t fix it. But what if it is broke?

The importance of cash flow to a business (1)
WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING
“Most companies have historically viewed profit as
king as cash as ‘free’. Only companies that make the
culture change to see cash as a measure of world-class
performance and run a tight ship make progress”
Cash is king – again: supply chain management in Aerospace and Defense,
September 2017
“Working capital can amount to as much as several
months’ worth of revenues. Cash improvements
can often be reinvested in ways that more directly
affect value creation, such as growth initiatives”
Uncovering cash and insights from working capital, July 2014
“Value may be a function of cash generation,
yet managers often focus so intently on
profitability that they give scant consideration
to the cash conversion cycle”
Transforming the culture of managing working capital, January 2018
“Capital productivity is an important and
often underused value lever in capital-
intense industries. The CFO who takes
this to heart and knows where to plug in
and how to push can make a big
difference in boosting both return on
invested capital and free cash flow”
Why capital expenditures need more CFO attention, May 2015
3

The importance of cash flow to a business (2)
“Creating shareholder value is not the same as maximizing short-term profits.”
“For value-minded executives, creating shareholder value is about maximizing a company’s
collective value to current and future shareholders, not just today’s.”
“The amount of value they create is the difference between cash inflows and the cost of the
investments made, adjusted to reflect the fact that tomorrow’s cash flows are worth less than
today’s because of the time value of money and the riskiness of future cash flows.”
4

Why cash flow is important in determining value creation
Value
Free
Cash Flow
Capital
Employed
Operating
Profit
Revenue
Operating
expenses
Income
taxes
Working
capital
PP&E and
Fixed Assets
Discount
Rate
Cost of
Capital
PP&E and
Fixed Assets
IncomeStatementBalanceSheet
Cash Flow
Statement
The value of a company is based
on its future cash flows. The
Discounted Cash Flow method
(DCF method) is regarded as the
most justifiable method to
appraise economic value. This
method considers future cash
flows adjusted for the time value
of money.
Interested? Read “Valuation”!
(Tim Koller, Marc Goedhart, David Wessels)
5

Okay, so what now?

Reorganizing the Financial Statements
“Traditional financial statements –the income statement, balance sheet, and statement of cash
flows– do not promote easy insights into operating performance and value.”
“The balance sheet mixes together operating assets, nonoperating assets, and sources of financing.
The income statement similarly combines operating profits, interest expense, the amortization of
acquired intangible assets, and other nonoperating items.”
“To prepare the financial statements for analyzing economic performance, you need to reorganize
the items on the balance sheet, income statement, and statement of cash flows.”
7

Disconnected view on financial statements
Income Statement
Sales
Cost of goods sold
Gross margin
Operating expenses
Operating profit
Other income & expenses
EBITDA
Depreciation
Amortization
EBIT
Interest income
Interest expenses
Other finance expenses
Profit before tax
Income taxes
NET PROFIT
Balance Sheet (GAAP)
Goodwill & intangible assets
Property, plant & equipment
Financial assets
Non-current assets
Inventories
Other current assets
Current assets
Assets
Equity
Non-current loans & borrowings
Non-current provisions
Deferred tax liabilities
Non-current liabilities
Trade & other current liabilities
Equity & liabilities
Cash Flow Statement
Operating profit
Change in working capital
Payments from provisions
Income taxes paid
Cash from operating activities
Investments in intangible assets
Investments in PP&E
Investments in financial assets
Cash from investing activities
Equity cash flows
Debt cash flows
Cash from financing activities
Currency effect on cash
CHANGE IN CASH
OperatingInvestingFinancing
Mixofoperating,investingandfinancingactivities
8

Balance sheet: from GAAP to Capital Employed (1)
Goodwill & intangible assets 550 Share capital 150
Property, plant & equipment 1,410 Retained earnings 1,800
Loans receivable, non-current portion 340 EQUITY 1,950
Deposits, non-current portion 410
NON-CURRENT ASSETS 2,710 Loans & borrowings, non-current portion 800
Provisions, non-current portion 280
Inventories 1,290 Deferred tax liabilities 190
Trade receivables 1,530 NON-CURRENT LIABILITIES 1,270
Loans receivable, current portion 160
Deposits, current portion 210 Trade payables 2,070
Interest receivable 40 Loans & borrowings, current portion 300
Cash & cash equivalents 860 Provisions, current portion 60
CURRENT ASSETS 4,090 Income tax liabilities 420
Accrued expenses 730
CURRENT LIABILITIES 3,580
ASSETS 6,800 EQUITY & LIABILITIES 6,800
Operating
Investing
Financing
Legend
①
Group assets and
liabilities by nature
instead of by
maturity
9

Loans receivable 500
Deposits 620
Loans & borrowings 1,100
Provisions 340
Inventories 1,290 Deferred tax liabilities 190
Trade receivables 1,530
Trade payables 2,070
Interest receivable 40
Cash & cash equivalents 860
Income tax liabilities 420
Accrued expenses 730
Operating
Investing
Financing
Legend
②
Present operating
and investing
separate from
financing activities
10

Deposits 620
Provisions -340 Loans & borrowings 1,100
Deferred tax liabilities -190
Inventories 1,290
Trade receivables 1,530
Trade payables -2,070
Cash & cash equivalents -860
Income tax liabilities -420
Accrued expenses -730
Operating
Investing
Financing
Legend
③
Group operating,
investing and
financing activities
in a logical order
11

Inventories 1,290 Share capital 150
Trade receivables 1,530 Retained earnings 1,800
Deposits 620 EQUITY 1,950
Trade payables -2,070
Accrued expenses -730 Loans & borrowings 1,100
WORKING CAPITAL 640 Cash & cash equivalents -860
NET DEBT 240
Provisions -340
Income tax liabilities -420
Deferred tax liabilities -190
Goodwill & intangible assets 550
Property, plant & equipment 1,410
CAPITAL EMPLOYED 2,190 FUNDS PROVIDED 2,190
Operating
Investing
Financing
Legend
12

Benefits of the Capital Employed presentation
Benefits of presenting the balance sheet according a Capital Employed lay out include:
• Promotes easy insights into operating performance and value
• Provides a logical view on each of operating, investing and financing activities
• Features a clear definition and presentation of working capital
• Presents net debt on the face of the balance sheet
• Provides a transparent link to a RoCE performance indicator
• Enables consistent analysis of operating performance across income statement, balance sheet and
statement of cash flows
Working capital Equity
Provisions
Taxes Loans & borrowings
Operating activities …………… Cash & cash equivalents
Investing activities Net Debt ……………
CAPITAL EMPLOYED …………… FUNDS PROVIDED ……………
13

Integrated view on financial statements
Income Statement
Sales
Cost of goods sold
Gross margin
Operating expenses
Operating profit
Other income & expenses
EBITDA
Depreciation
Amortization
EBIT
Interest income
Interest expenses
Other finance expenses
Profit before tax
Income taxes
NET PROFIT
Balance Sheet (capital employed)
Working capital assets
Working capital liabilities
Working capital
Provisions
Income tax liabilities
Goodwill
Intangible assets
Property, plant & equipment
Financial assets
CAPITAL EMPLOYED
Equity
Loans & borrowings
Cash & cash equivalents
Net debt
FUNDS PROVIDED
Cash Flow Statement
Operating profit
Change in working capital
Payments from provisions
Income taxes paid
Cash from operating activities
Investments in intangible assets
Investments in PP&E
Investments in financial assets
Cash from investing activities
Equity cash flows
Debt cash flows
Cash from financing activities
Currency effect on cash
CHANGE IN CASH
14

What does that mean to how we organize financial information?

The Satriun approach to designing a CPM data model (1 of 2)
Balance sheet
(start of period)
Balance sheet
(end of period)
Income
statement
Cash flow
statement
Balance sheet
flows
Our approach to designing a financial data model is built
around three key concepts:
• Connectivity between balance sheet, income
statement and cash flow statement, represented by
movement schedules that clearly identify the logical
relationship between non-cash movements to income
statement or other comprehensive income, and cash
movements to cash flow statement.
• Completeness of the potential transactions that can
be posted to assets, equity and liabilities, and making
sure the data model is able to digest those potential
transactions both for a single company as for the
consolidated financial statements.
• Control over the quality of the data reported by
introducing easily over 100 data quality controls that
not only enforce connectivity and completeness, but
also logical signage such as capital expenditure having
to be an increase of property, plant & equipment.

The Satriun approach to designing a CPM data model (2 of 2)
Identify balance sheet
accounts “by nature”
Classify as operating,
investing or financing
Identify recognition in
comprehensive
income
Identify / create
corresponding P&L
and equity accounts
Identify recognition in
cash flow
Create corresponding
cash flow accounts
Identify other
transaction types
(non-cash)
Identify / create
corresponding
balance sheet flows
17
Identify / create
data quality controls

Balance sheet flows – example
①
②
③
④
⑤
⑥
①
Cash relevant flow, feeds into
the indirect cash flow statement
②
Non-cash flow, represents a
reclassification between accounts
③
Non-cash flow, arising from the
financial consolidation process
④
Non-cash flow, represents amounts
posted in income statement
⑤
Non-cash flow, represents amounts
posted in income statement
⑥
Non-cash flow, arising from the
financial consolidation process
18

Opening
balance
Capital
expenditure
Assets avail.
for use
Depreciation Impairments
Translation
differences
Closing
balance
Balance sheet flows – connectivity
584 20 68 -56 -5 11 621Land and buildings
Cash Flow Statement
Income Statement
Depreciation Impairments
-56 -5
Capital
expenditure
-20
-68
11
Construction in progress
Currency translation reserve
Balance Sheet
19

Balance sheet flows and relation to non-current / current portions
To satisfy the information needs
both for the purpose of financial
statement disclosures and cash flow
reporting, balance sheet flows do
not have to be detailed by each of
the long-term (non-current) and
short-term (current) portions. For
various reasons it is more practical
to detail balance sheet flows only by
the nature of the asset or liability
rather than by the maturity of the
asset or liability.
20

Opening
balance
Additions Utilizations Releases
Change in
discount rate
Balance sheet flows – connectivity and maturity
160 23 -15 -4 -28Environmental provisions
Cash Flow Statement
Income Statement
Releases of
provisions
Change in
discount rate
4 28
Payments of
provisions
-15
140…of which long-term
Currency translation reserve
Balance Sheet Unwind of
discount
5
Translation
differences
Closing
balance
4 144
-4
20
124
20…of which short-term
Additions to
provisions
-23
Unwind of
discount
-5
21

…but what about working capital? You know, indirect method and such.

Working capital definitions
Trade working capital
• Trade working capital is the difference between current assets and current liabilities directly associated
with everyday business operations. This definition we would like to use within the application!
Working capital
• Working capital is the difference between current assets and current liabilities.
Examples of current assets and current liabilities not relevant to trade working capital
Current portion of financial assets, since this is related to investing activities
Short term loan liabilities, since this is related to financing activities
Income tax liabilities, since this is not related to everyday business operations
Accrued interest, since this is related to financing activities
①
②
③
④
23

Two ways of looking at trade working capital
Trade working capital by business stakeholder
Customers
Suppliers
Employees
Tax authorities
Trade working capital by timing of cash
Accrued amounts
Invoiced amounts
Prepaid amounts
Cash almost due
Cash not due
Cash transferred
24

Trade working capital (excl. inventories)
Stakeholders Prepaid amounts Invoiced amounts Accrued amounts
Customers Prepaid income Trade receivables Accrued income
Suppliers Prepaid expenses Trade payables Accrued expenses
Employees Employee advances Employee accruals
Tax authorities[1],[2] Prepaid taxes Tax liabilities
Others Guarantees & deposits
[1]Includes VAT, local taxes and social security
[2]Excludes income taxes as this is not a working capital measure









 


Assets, where an increase has a dampening effect
on operating cash flow
Liabilities, where an increase has a boosting effect
on operating cash flow
Accrued income, including underbilled
work in progress in project- or
construction work, is an infamous trade
working capital account. It is often the
account where fraud is detected by the
recording of non-existing revenue. It
should be closely monitored.
Legend
25

Trade working capital types of presentation
Presentation by asset/liability
Inventories
Trade receivables
Accrued income
Prepaid expenses
Employee advances
Prepaid taxes
Guarantees & deposits
Trade working capital assets
Trade payables
Prepaid income
Accrued expenses
Employee accruals
Tax liabilities
Trade working capital liabilities
Presentation by stakeholder
Inventories
Trade receivables
Accrued income
Prepaid income
Customer capital
Trade payables
Accrued expenses
Prepaid expenses
Supplier capital
Employee accruals
Employee advances
Employee capital
Tax liabilities
Prepaid taxes
Tax authority capital
Guarantees & deposits
DSO ingredients
DPO ingredients
26

Monitoring cash conversion for operating activities
Ahold Delhaize 2015 2016 2017 2018
Net sales 38,203 49,695 62,890 62,791
Operating income 1,318 1,584 2,225 2,395
Depreciation & amortization 1,035 1,456 1,859 1,816
Gain/loss on sale of non-current assets -18 -22 -47 -7
Share-based payments expenses 47 61 79 60
Adjusted operating income 2,382 3,079 4,116 4,264
Operating cash flow (excl. income taxes) 2,366 3,172 4,180 4,608
Operating Cash Conversion Ratio 99% 103% 102% 108%
Excess Cash Margin 0.0% 0.2% 0.1% 0.5%
(4,608 / 4,264) x 100% = 108%
((4,608 – 4,264) / 62,791) x 100% = 0.5%
Monitoring operating cash flow and working capital development can be achieved by introducing one or both of indicators:
• Operating Cash Conversion Ratio indicates the degree at which operating profits are converted into operating cash flows.
This ratio should be around 100%. A ratio over 100% indicates a relatively declining working capital; a ratio below 100% indicates a relatively
increasing working capital. Both situations are not sustainable in the long term.
• Excess Cash Margin indicates the degree at which operating profits and operating cash flow develop in relation to revenue.
This ratio should be around 0%. A ratio over 0% indicates a relatively declining working capital; a ratio below 0% indicates a relatively increasing
working capital. Both situations are not sustainable in the long term.

That’s all great, now give us your conclusions!

Conclusions
Why existing financial reporting is mostly broken…
• Too much focus on the income statement; a one-dimensional view on financial performance.
• A financial accounting-view of balance sheet features a lack of insight into value dynamics.
• Cash flow mostly exists in the obscurity of financial reporting and is not a true performance measure.
How do you recognize this in your own organization?
• Segmental balance sheets, perhaps with the exception of working capital, are not consistently analyzed within the
monthly management reviews.
• Cash flow statements are (mostly) prepared in Excel, and only reported for the consolidated group.
How to fix it?
• Create awareness that management accounting & reporting concepts do not apply to income statement alone!
• Define a performance management model that provides a true value-oriented view on your financial statements.
• Implement the right technology to enable both financial accounting / consolidation and management accounting /
consolidation & analysis from a single source of truth.
• Educate your colleagues to increase the understanding of balance sheet and cash flow dynamics.

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Casper Van Leeuwen - Why cash flow should be a focal point

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