Cash flow adequacy. The third area where financial risk focuses is on cash flow, how a company generates cash to meet its obligation. Why do we need to understand cash flow adequacy? Because cash is what is paid to lenders to service and pay back debt. It is really their primary concern. Cash and cash flows are the most valuable attributes of a company, more so even than assets. There's less risk involved in lending to companies with strong operating cash flow. The key metrics that are important for credit analysts are funds from operations, operating cash flow, and discretionary cash flow. And lastly, as a reminder, once again, EBITDA is a proxy for cash, but it is not an actual cash flow. It ignores changes in working capital, Capex, and taxes. The cash flow statement ultimately measures the change in cash from one year to another. Mathematically, if you add the change in all the non-cash assets, liabilities, and equity, you would arrive at the change in cash. It is more helpful to break those changes down into the various cash flow categories. First, there are the operating activities. These are accounts that are driven by the day-to-day operations of the company. The operating cash flows are impacted by changes in retained earnings, which is the net income, as well as the operating assets and liabilities. Secondly, we have the investing activities. These cash flows measure the change in long-term assets. Lastly, we have the financing activities, which measure the change in debt in shareholders' equity accounts. To get a more realistic cash flow metric for credit, we begin with the operating cash flow. Let's start with EBITDA. One thing we need to be careful of is that if we made any adjustments to EBITDA for non-reoccurring items, and those items were actually cash expenses, we would have to back out those adjustments, add them back if they were deducted and subtract 'em if they were added. We would then need to subtract cash taxes, cash interest, subtract increases in networking capital, or add decreases in networking capital. Lastly, we would add or subtract changes in other operational assets or liabilities. If we begin with net income, we should arrive at the same result. The first thing we would need to do is add D and A, and then make any adjustments for any non-cash items to hit the income statement, like impairments or gains and losses on asset sales. Next, we would need to adjust for any non-cash interest items, if there are any, like pick debt. And then similarly, we would add or subtract the changes in operating working capital, as well as add or subtract the changes in other operational assets and liabilities. Here we would need to adjust for any non-cash taxes, such as deferred taxes.
