Credit history statement of cash flows

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Credit History
Lenders like to see that a firm has borrowed in the past and successfully repaid the loans. Young firms sometimes shy away from borrowing to avoid constraints that such borrowing may impose. However, such firms often find that an inadequate credit history precludes them from borrowing later when they need to do so. On the other hand, developing a poor credit history early on can doom a firm to failure because of the difficulty of overcoming initial impressions

Statement of Cash Flows
An examination of a firm’s statement of cash flows for the most recent three or four years will indicate whether a firm is experiencing potential cash flow problems.  Some of the indicators of potential cash flow problems, if observed for several years in a row, include:

•  Growth in accounts receivable and inventories exceed the growth rate in sales.
• Increases in accounts payable or other liabilities routinely exceed the increase in inventories or sales.
•  Persistent negative cash flow from operations exist because of net losses or substantial increases in net working capital (current assets minus current liabilities).
•  Capital expenditures substantially exceed cash flow from operations. Although you should expect such an excess for a rapidly growing, capital-intensive firm, the negative excess cash flow (cash flow from operations minus capital expenditures) indicates a firm’s continuing need for external financing to sustain that growth.
•  Reductions in capital expenditures occur over time. Although such reductions conserve cash in the near term, they might signal that a firm expects declines in future sales, earnings, and operating cash flows.
• Sales of marketable securities are in excess of purchases of marketable securities. Such sales provide cash immediately but might signal the inability of a firm’s operations to provide adequate cash flow to finance working capital and longterm investments. Such sales, however, may not indicate cash flow problems if the firm temporarily invested excess cash that it now plans to use to make a corporate acquisition or to acquire fixed assets.
•  A reduction or elimination of dividend payments or stock repurchases occurs. Although such actions conserve cash in the near term, dividend reductions or omissions and cessation of share repurchase plans can provide a negative signal about a firm’s future prospects.
• Available (previously established) revolving lines of credit are fully utilized. Full utilization of letters of credit might suggest that a firm’s cash flows have become insufficient for operating purposes

Although none of these indicators by themselves represents conclusive evidence of cash flow problems, they do signal the need to obtain explanations from management to see whether an emerging cash flow problem does exist. Just as analysts must understand a firm’s industry and strategy to effectively analyze profitability, lenders mustfollow the same analysis steps.

Cash Flow Financial Ratios
Previous sections of this chapter discussed two cash flow ratios that may signal a cash flow problem: (1) operating cash flow to current liabilities ratio and (2) operating cash flow to total liabilities ratio

Cash Flows in Projected Financial Statements
Projected financial statements represent forecasted income statements, balance sheets, and statements of cash flows for some number of years in the future. Lenders may   require potential borrowers to prepare such statements (which are rarely made publiclyavailable) to demonstrate the borrower’s ability to repay the loan with interest as it comes due. A credit analyst privy to such forecasts should question each of the important assumptions (such as sales growth, cost structure, or capital expenditures plans) underlying these projected financial statements.

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