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September 18, 1998

An Investment Opinion
by Dale Wettlaufer

Cash Flow Review, Part 2

On Tuesday, we began to look at Revlon's cash flows, starting by reviewing the top to the bottom of the statement of cash flows. Before we go on, a word about the purpose of the cash flow statement. The cash flow statement reconciles the balance sheet figures shown at the beginning of a period with balance sheet figures at the end. Part of the change in resources flows through the income statement, but not all of the flows of resources can be seen on the income statement. That's how a company can "grow its way into bankruptcy" and that's why investors should not focus exclusively on earnings growth.

The cash flow statement can also be used as an alternative income statement showing what the company's cash income and outflows were for a given period. While the income statement can be full of assumptions and estimates, allowing a company to overstate or understate net income, the cash flow statement runs starkers. There is no faking the movement of resources in and out of a business, looking at it from the perspective of the cash flow statement, unless the balance sheet and the income statement are out-and-out lies. While you can get creative with the income statement, there's no room for subjectivity on the cash flow statement.

Back to Revlon. A couple of questions about why individual balance sheet amounts from one balance sheet to the next do not reconcile through individual line items in the cash flow statement. To wit, why don't the differences between these balance sheet amounts match these line items in the cash flow statement?

                                       1997     1996
Trade receivables, less allowances
of $25.9 and $24.9, respectively......$493.9 426.8
Inventories...........................349.3 281.1

Change in assets and liabilities:
Increase in trade receivables........(70.3) (67.7)
Increase in inventories...............(21.4) (5.3)

Here's why. If a company does an acquisition, which we see in the cash flow from investing activities section:

1997 1996

Acquisition of businesses,
net of cash acquired..........(60.4) (7.1)

You can't back into the actual net cash outlay for inventory by looking at period-to-period balance sheet changes. For the consideration paid by the company, it took in with the acquired corporation its assets and liabilities, including inventories. We can deduce from the period-to-period change in inventories, minus the net cash outlay for inventories shown on the balance sheet, the approximate amount of inventories taken in as part of the acquired company:

Change in inventories = $68.2 million less
Net cash outlay for inventories = $21.4 million
Inventories of acquired companies = $46.8 million.

Free Cash Flow

Free cash flow (FCF) is defined in so many different ways, correctly and incorrectly as the case might be, that one should state what one means by FCF when the term is used. Terms such as EBITDA (earnings before interest, taxes, depreciation, and amortization) and such have so bastardized the concept of free cash flow that you should define your conception of FCF if you want to be understood when using it. Free cash flow for our purposes, then, is earnings plus depreciation and amortization (of goodwill and intangibles, not of regular asset accruals) plus or minus investment. Investment is changes in working capital plus or minus capital expenditures, acquisitions, and divestitures.

In Revlon's case, cash flow from investing is straightforward enough:

                                  1997       1996
Capital expenditures............(56.5) (58.0)
Acquisition of businesses,
net of cash acquired....(60.4) (7.1)
Proceeds from the sale of
certain fixed assets.....8.5 -

Net cash used for investing
activities...(108.4) (65.1)

Now, for free cash flow, we have to deal with a big slug of "other" in the cash flow statement. This "other" appears on a regular basis in Revlon's operating cash flow statement:

                                  1997       1996
Other, net.......................(73.0) (45.8)

An investor has to decide whether these outlays represent ongoing expenses of doing business and thus reflect the company's ongoing profitability, or whether they can be disregarded in assessing the company's free cash flow. Piecing together a Ron Perelman company isn't the most fun thing in the world, so this may not be the best example for illustrating cash flow. But going through all the notes to financial statements, one can track down some of these off-income statement cash outlays. These include outlays for consolidations of facilities and restructurings taken as "extraordinary items" on past income statements. However, the presentation is not entirely clear. When a company can't present items in a clear manner and presents its second-largest cash outflow item as an "other," it's usually time to move on to a new company to look at.

But we'll stick with this one. We'll assume two scenarios, one in which the outlays are recurring and one in which they are not. The company's free cash flow, then, under the recurring scenario would very simply be net cash flow from operations minus cash used/generated in investing activities:

Net cash provided by (used for) operating activities.....$6.9


Net cash used for investing activities...(108.4) = outflow of $101.5 million

In the second scenario, we have:

Net income (loss)....................$43.6 +
Depreciation and amortization........103.8 +
Extraordinary item....................14.9 -
Gain on sale of subsidiary stock....(6.0) -
Gain on sale of certain fixed
assets, net..(4.4) -
Change in working capital.............(72) =
Net cash provided by (used for)
operating activities..$79.9


Net cash used for investing activities....(108.4) = outflow of $28.5 million

In either case, granting leniency to the "extraordinary item" and the "other" item, the company is free cash flow negative. For a small, growing company, this might be all right, but cosmetics is a pretty mature industry, and we'd like to see some free cash flows as equity investors. However, that doesn't mean the company is worth nothing. Pushing out for a day a discussion of what cash flow does for valuation, we'll look at that question on Tuesday in Part 3.


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