The world “Corporation” comes from the Latin word corpus, meaning body. A corporation is made as if it’s an artificial person. Cash to a corporation is like blood to a human – flows in a cycle, facilitates the corporation’s born/growth/mature, and can be fatal if broken.
Whenever you need to assess a corporation, not only you should know what kind of a “person” they are, i.e. KYC (Know-Your-Customer), but also one step forward to know deep inside the “blood cycle” – cashflow, i.e. KYC (Know-Your-Cashflow). In a word, KYC2.
To analyze how good is such “blood cycle”, we must first find out the real interaction with the outside, i.e. Ultimate Economic Activity (UEA). Not how heart interacts with lungs (related parties to the corporation), but the real activity with the external world (Ultimate Buyers/Suppliers).
Secondly, it comes to Moody’s P.A.C.E.D. framework. Keep P.A.C.E.D., let’s start to Know Your Cashflow!
P.A.C.E.D. Framework and Cashflow Statement
Developed by Moody’s, P.A.C.E.D. stands for Profitability, Asset Cash Conversion, Capex, Equity and Debt. It’s a very useful framework to summarize any case in just 5 minutes. Following is an example cashflow statement and here’s how P.A.C.E.D. works.
1. Cash Flow from operating activities: the first section. The commonly used indirect method uses net income as a base, which comes from Profit & Loss Statement (P&L). Net income is the result of a company’s profitability: how were the sales, how was the business operating expenses and margin, etc.?
After adjusting non-cash expenses like depreciation, changes from assets are followed – Asset Cash Conversion. Here we have changes in Accounts Receivable, Accounts Payable and Inventory. The difference between the 2 balance sheets period represents cash realization. For example, AR change means a company’s customer was paying off/going to pay more than owning to the company.
2. Cash Flow from Investing Activities: the second section. It includes all the Capex – changes in the company’s equipment, assets or investments. For example, a purchase or sale of assets/properties, M&A of other companies, etc.
3. Cash Flow from Financing Activities: the third section. It includes both Equity change like the uses of cash paid to shareholders or IPO, as well as Debt change like repayment of loans or more borrowing from banks/investors. Both changes can have cash in and out at the same time.
To summarize, P.A.C.E.D. is just how we arrive at the cash flow statement – “P & A” is Operating Cash Flow, “C” is Investing Cash Flow and “E & D” is Financing Cash Flow.
How to apply P.A.C.E.D. to a company
P.A.C.E.D. framework is the anatomy of a company. It can guide you through each part of a company’s “blood cycle” and form a comprehensive assessment.
More precisely, each of P.A.C.E.D. consists of multiple key drivers that link back to a company’s business essentials, summarized below.
Your first step is to ask questions on those drivers. For example: How long can this company receive its money from suppliers/customers? Does the company have earned enough to service their debt, or need to raise more?
The second step is to find answers in a company’s financials – numbers won’t lie. We’ve prepared the related ratios (Primary and secondary ratios) for you to use together with financials to dig the information out.
Lastly, after the integration of all info, you will be rewarded a full picture of the company’s cash flow, Like the example in the following. That’s how we KYC2 – Know-Your-Cashflow!
Always remember, cash flow analysis always comes first in credit analysis! For more details using P.A.C.E.D. in the cash flow, please read this article!
Extension of P.A.C.E.D.: Integration of Company’s Life Cycle
Remember P.A.C.E.D. is all about a company’s “blood cycle” – the cashflow. However, just like a human at different stages of life (born/growing/mature/…) have different metabolism, companies at different stages of their life cycle should expect different P.A.C.E.D.
Therefore, we naturally extend the framework together with the Company’s Life Cycle for a broader & more general picture. For further information, please visit here (coming in the near future!).