As discussed last time, everyone (and M&A people in particular) should be a lot more concerned with cash flow than accounting profits. Not to sound like a broken record, but it really is all about cash – the size, surety, and growth of those cash flows is what you’re buying as an acquirer. And the ability to trace those cash flows through the financial statements is a critical skill in M&A, particularly as it pertains to projections and valuation matters. A piece of advice when on the corp dev buyside: You’d better understand very well i) the origins of your target’s cash flow and ii) how it is reflected in their financials.

So let’s take a look at a couple basic business activities and their related cash flow effects. You may find it enlightening…

First, a pretty simple one: What is the cash effect of increasing the depreciation of an asset by $100 and how does it flow through the financials?

1. On the income statement, if Depreciation is UP, Operating Income is DOWN by $100, therefore Net Income is DOWN by $60 (assuming 40% tax rate)
2. On the cash flow statement there are two effects – Net Income is DOWN by $60 and Depreciation is UP by $100, so the net effect (all else held constant) is that Total Cash is UP by $40;
3. On the balance sheet, Cash goes UP by $40, and Net Fixed Assets goes DOWN by $100. Total Assets, then, are DOWN by $60. On other side of the balance sheet, Retained Earnings is down by $60 via lower Net Income (as previously shown in #1), so the balance sheet balances.

Next, a slightly harder one: What is the cash effect of increasing Inventory by $100 (by paying cash), and how does it flow through the financials?

1. On the income statement, if Inventory is UP by $100 there is NO EFFECT. Recall that Inventory is only reflected on the income statement when it is sold (as Cost of Goods Sold).
2. On the cash flow statement, Cash from Operations reflects a $100 USE of cash to buy the Inventory, so total cash flow (all else held constant) is DOWN by $100;
3. On the balance sheet, there is no net effect – Cash has gone DOWN by $100 and Inventory has gone UP by $100.

Last, a slight curve ball: What is the cash effect of increasing Deferred Income Tax by $100, and how does it flow through the financials?

1. Recall that Deferred Income Tax is a difference between book and cash tax obligations.
2. On the income statement, if Deferred Income Tax is UP by $100, there is NO EFFECT. The income statement only reflects a “standard”, assumed tax rate.
3. On the cash flow statement, Deferred Income Tax is reflected as a non-cash add-back and increases cash UP by $100. On a net basis, total cash flow therefore goes UP (all else held constant) by $100;
4. On the balance sheet, Cash goes UP by $100 and the related liability for Deferred Income tax also goes UP by $100, balancing the balance sheet.

Confused (or enlightened) yet? The point here is that every business activity and event should be examined for a cash consequence. Pick any line item in the financials and trace its link to the cash account. Ignore or misunderstand this relationship at your peril, because in corporate M&A what you’re really buying (apart from strategic considerations) is cash flow. Period.

Next time I’ll discuss some basics of financial modeling and projections.

Posted by: Mory Watkins