Cash Flow Forecasting Essential Capital Markets Books in the series: Cash Flow Forecasting Corporate Valuation Credit Risk Management Finance of International Trade Mergers and Acquisitions Portfolio Management in Practice Introduction to Project Finance Syndicated Lending Cash Flow Forecasting Edited by Andrew Fight AMSTERDAM • BOSTON • HEIDELBERG • LONDON • NEW YORK • OXFORD PARIS • SAN DIEGO • SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Butterworth-Heinemann is an imprint of Elsevier Butterworth-Heinemann is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP 30 Corporate Drive, Suite 400, Burlington, MA 01803 First published 2006 Copyright © 2006, Andrew Fight. All rights reserved. Note The materials contained in this book remain the copyrighted intellectual property of Andrew Fight, are destined for use in his consulting activities, and are to be clearly identified as copyrighted to him. Andrew Fight has asserted his right under the Copyrights, Designs, and Patents Act 1988, to be identified as author of this work, and confirms that he retains ownership of the intellectual property and rights to use these materials in his training courses and consulting activities. No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1998 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher. Permissions may be sought directly from Elsevier’s Science and Technology Rights Department in Oxford, UK: phone: (ϩ44) (0) 1865 843830; fax: (ϩ44) (0) 1865 853333; e-mail: [email protected]. You may also complete your request on-line via the Elsevier homepage (http://www.elsevier.com), by selecting ‘Customer Support’ and then ‘Obtaining Permissions’. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Control Number: 2005923901 ISBN-13: 978-0-7506-6136-2 ISBN-10: 0-7506-6136-4 For information on all Butterworth-Heinemann publications visit our website at http://books.elsevier.com Composition by Charon Tec Pvt. Ltd, Chennai, India www.charontec.com Printed and bound in Great Britain 06070809101110987654321 Contents Preface ix 1 Overview of cash flow forecasting 1 Introduction 1 What is a healthy cash flow? 3 What are the uses of cash flow forecasting? 6 2 Summary of financial statements 8 Introduction 8 The annual report and accounts 10 The profit and loss account 33 Problems with financial statements and auditors 35 Conclusion 38 3 Factors impacting financial performance 41 Introduction 41 Strategic analysis – the external environment 42 Strategic analysis – the value chain 46 Management 49 Profitability and performance 50 Asset management 54 Capital structure 58 Cash flow 63 vi Contents Cash flow forecasting 66 Corporate failure 70 4 Cash flow forecasting of financial statements 76 Why cash flow analysis? 76 Purpose of projections 79 Historical performance and variable input analysis 81 Profit and loss statement projections 86 Balance sheet projections 109 Assets 112 Liabilities 119 Completed AmaOS forecasted balance sheet 131 Cash flow projections 134 Cash flow ratio analysis 144 Sensitivity analysis 146 Protection and control in term lending 150 Conclusion 153 Chapter self-test 155 Chapter self-test answers 158 5 Cash flow forecasting of project finance 160 Introduction 160 Cash flow forecasting 163 Conclusion 171 6 Pro forma forecasts using AMADEUS electronic databases 172 Appendices 185 1 Credit rating agency rating scales 186 2 Country risk criteria 189 3 Summary of lending types 199 4 Complete AmaOS spreadsheet 200 Suggested reading 209 Glossary 210 Profitability indicators 237 Turnover and efficiency indicators 238 Contents vii Financial position indicators 239 Cash flow terms 240 Cash ratios 240 Index 243 This page intentionally left blank Preface Welcome to this book on cash flow forecasting. This book is presented in six chapters, each of which treats a specific aspect of cash flow forecasting. The individual chapters cover the following topics: ■ Overview of cash flow forecasting ■ Summary of financial statements ■ Factors impacting financial performance ■ Cash flow forecasting of financial statements ■ Cash flow forecasting of project finance ■ Pro forma forecasts using Amadeus electronic databases. It also includes appendices, suggested reading, and a glossary. This book aims to explain the background and raison d’être of cash flow forecasting as one of the techniques used in the capital markets to provide finance to companies, multinational corporations and large-scale projects. Since most large loans and project financings are structured with a view to syndication in the international capital markets, cash flow forecasting also offers the possibility of structuring financings to satisfy the particu- lar pricing, size and tenor appetites of the market. x Preface It is suggested that this book be read in conjunction with the Syndicated Lending and Introduction to Project Finance books in this series, thereby linking the structuring of the cash flow forecasting facility to the marketing issues involved in loan syndication. For newcomers to credit and financial analysis, the Credit Risk Management book in this series sets the analytical groundwork for understanding the concepts in Cash Flow Forecasting. We hope that this book Cash Flow Forecasting, in the Essential Capital Markets Series, will be informative and instructional, and an indispens- able and practical aid to persons seeking to understand this important area of banking. Andrew Fight www.andrewfight.com Chapter 1 Overview of cash flow forecasting Introduction What is cash flow forecasting? The term features prominently in the press, more specifically with respect to infrastructure, and public and private venture capital needs. The press often refers to huge projects such as building infrastructure projects like highways, the Eurotunnel, metro systems or airports. It is a technique that has been used to raise huge amounts of capital and promises to continue to do so, in both developed and developing countries, for the foreseeable future. Cash flow forecasting, however, is also useful for more mundane applica- tions. In many countries, the SME sector can account for as much as 40–50 per cent of economic activity. Small and medium-sized enterprises often require access to growth capital during their expansion phase, and the greatest single problem facing SMEs in an expansion role is insufficient liquidity. It is unfortunate that in many countries the SME sector is over- looked in the quest for more lucrative, albeit higher-risk, credit scenarios. National economic growth can also be fostered by the growth in the eco- nomic activity of SMEs, and it is therefore important to understand the techniques that can be used to provide funding to this sector. It is crucial for potential lenders to understand the financial situation, liquidity and cash flow situation of SMEs in order optimally to practise good lending principles. This book on cash flow forecasting will therefore explore some of the mechanisms used in preparing cash flow forecasts, with a view to using 2 Cash Flow Forecasting them for sensitivity analysis and designing appropriate financial struc- tures and loan covenants to protect the bank’s position in an adverse environment. Accordingly, this book will touch upon a number of issues en passant, such as the interrelations between items in a standard set of company accounts, ratio analysis, projection methodologies, debt runoff schedules, loan documentation, and the drafting of effective financial covenants in order to illustrate how to use the projections usefully. The purpose of cash flow projections after all is not to construct elab- orate mathematical models or predict the future, but rather to identify potential weaknesses in a given credit situation and point the way to adopt measures to enhance, correct or protect the bank’s exposure. Understanding the key risks and practical applications of cash flow fore- casting and how it differs from other financing techniques is critical to all the major players in large capital projects (such as commercial and investment bankers), but also other players in lending situations (such as project finance, general contractors, subcontractors, insurance com- panies, suppliers and customers). All these participants will participate into an interlocking financing structure with mutual and multiple inter- dependencies. In term lending, cash flow is the primary and usual source of loan repay- ment. The major credit issues are: ■ Will the firm’s projected cash flow – under various scenarios ranging from realistic to worst case – be sufficient to pay the interest and amortize the principal on existing long-term debt obligations? How do we measure the adequacy of cash flow to service debt, and what do we mean by a healthy cash flow? ■ Does the projected asset structure and earnings stream indicate a potential need for additional financing in the future, and is there suf- ficient cash flow