Merrill Lynch is financing the business through Cash provided by financing activities – the operating activities loss is offset by increases in long-term borrowings.
1. Evaluate the cash position at year-end
Cash & cash equivalents41,346,00032,109,00014,586,000
The cash position of the firm increased by 120% in 2006 and 29% in 2007, giving the impression the firm was well capitalized. Further analysis of the cash-flow statement will prove this level of cash was not enough to support the massive losses (write-downs) incurred by the operating side of the businesses. However, the firm cannot finance negative growth; losses from operating activities can’t exceed cash-flows from financing in the long-term.
2. Evaluate the cash flow from Operations
A high divergence between net income and cash from operations equates to low quality of accruals and high quality of accruals equates to high quality of earnings. With higher quality earnings, investors have higher confidence. The divergence ratio increased from .05 to .07 from 2005 to 2007. This indicates to financial statement users that the quality of the firm’s accruals is decreasing, which may be an indicator that the firm will have financial distress in future periods.
Net earnings (loss)(7,777,000)7,499,0005,116,000
Divergence ratio (Net Income-Cash flow from operations/Average Total Assets)0.070.060.05
As you can see, the divergence ratio is increasing, which indicates that the quality of the accruals is decreasing. This undercuts investor confidence, as the earnings are considered less reliable.
The major loss in CFO was due to “Other changes in loans, notes, & mortgages held for sale,” due to major write-down in debt instruments. Of the 86.9B in changes, 23.2B of this was related to write-downs of the CDO’s, or exposure to the US sub-prime mortgage market. The CEO stated that he expects to have more write-downs in future periods; another indicator of future financial distress because operating cash flows will continue to be negatively affected, and these affects are unpredictable in nature. Other changes in loans, notes, & mortgages held for sale(86,894,000)(47,670,000) Net cash flows from operating activities(72,362,000)(39,414,000)(25,658,000)
3. Evaluate the cash flow from Investing Activities:
Cash flow from investing also includes investment security returns and a mature firm like this should be off-setting operating outflows with at least some positive inflows from investment activity. This it is an example of how the firm is acquiring financing and investing money, but are still cash flow negative in operations - which means they’d just have to keep acquiring financing to offset the investments.
Loans, notes & mortgages held for investment5,113,000(681,000)(12,977,000) Net cash flows from investing activities(7,086,000)(11,008,000)(3,938,000)
Overall, the firm shows negative cash flows from investing activities, which show the firm is still operating as a mature firm, and continuing to invest in the business.
Proceeds from the sale of discontinued operations1,250,000--
The overall proceeds from discontinued operations are positive in 2007. These are one-time events, and could indicate the business is shedding assets.
Maturities of available-for-sale securities13,362,00013,222,00025,452,000 Sales of available-for-sale securities39,327,00016,176,00036,574,000 Purchases of available-for-sale securities(58,325,000)(31,357,000)(51,283,000)
Based on the investing activities section of the cash flow statement it is clear that the largest outflow by far is $58,325 of purchases of available for sale...