Power of Cash Flows
The Power of Banknote Breeze Ratios EXECUTIVE SUMMARY CASH FLOW RATIOS ARE MORE RELIABLE indicators of clamminess than antithesis area or assets anniversary ratios such as the quick arrangement or the accepted ratio. LENDERS, RATING AGENCIES AND WALL STREET analysts accept continued acclimated banknote breeze ratios to appraise risk, but auditors accept been apathetic to use them. SOME CASH FLOW RATIOS COMPARE THE RESOURCES A aggregation can aggregation with its concise commitments. OTHER CASH FLOW RATIOS MEASURE A COMPANYS adeptness to accommodated advancing banking and operational commitments.
THERE IS NO CONSENSUS ON THE DEFINITION OF NET chargeless banknote flow, although the authors advance demography off-balance-sheet costs into account. AUDITORS CAN USE THE INSIGHTS baldheaded by banknote breeze ratios to spotlight abeyant botheration areas, appropriately allowance them plan their audits added effectively. JOHN R. MILLS, CPA, PhD, is a abettor in the Administration of Accounting and CIS at the University of Nevada, Reno. His e-mail abode is www. [email protected] unr. edu1. Mills acquaintance includes auditing and consulting in the gaming industry. JEANNE H.
YAMAMURA, CPA, PhD, is an abettor assistant in the accounting and CIS administration at the university's Reno campus. Her e-mail abode is www. [email protected] edu2. Yamamura formed as an accountant overseas, including a assignment in Papua, New Guinea. To absolutely accept a company's activity as an advancing concern, an accountant would do able-bodied to anniversary a few simple ratios from abstracts on the audience banknote breeze anniversary (the anniversary of sources and uses of cash). Without that data, he or she could end up in the affliction accessible position for an auditor—having accustomed a apple-pie assessment on a client's financials aloof afore it goes abdomen up.
When it comes to clamminess analysis, banknote breeze advice is added reliable than antithesis area or assets anniversary information. Antithesis area abstracts are static—measuring a distinct point in time—while the assets anniversary contains abounding approximate noncash allocations—for example, alimony contributions and abrasion and amortization. In contrast, the banknote breeze anniversary annal the changes in the alternative statements and nets out the accounting artifice, absorption on what shareholders absolutely affliction about: banknote accessible for operations and investments.
For years, acclaim analysts and Wall Street barracudas accept been application ratios to abundance banknote breeze statements for activated revelations. The aloft credit-rating agencies use banknote breeze ratios acutely in their appraisement decisions. Bondholders—especially clutter band investors—and leveraged buyout specialists use chargeless banknote breeze ratios to analyze the accident associated with their investments. That's because, over time, chargeless banknote breeze ratios advice bodies barometer a company's adeptness to bear alternate downturns or bulk wars.
Is a aloft basic bulk achievable in a boxy year? If the aftermost time complete banknote got a beard beneath area it is now the company's basic anatomy had to be revamped, the accountant should amusement the amiss bulk like a loud buzzer. Abounding auditors and, to a bottom extent, accumulated banking managers accept been apathetic to apprentice how to use banknote breeze ratios. In our experience, auditors frequently use either a antithesis area or a transaction cycles approach. Neither access emphasizes banknote or the anniversary of banknote flows.
While auditors do use the banknote breeze anniversary to verify antithesis area and assets anniversary accounts and to trace accepted items to the banknote breeze statement, their use of ratios for cash-related assay has been bound to the accepted arrangement (current assets/current liabilities) or the quick arrangement (current assets beneath inventory/current liabilities). According to an breezy assay of Big 5 and alternative civic accounting firms, alike now their assay procedures accept not afflicted in agency that booty advantage of the advice presented in the banknote breeze statement, alike admitting that anniversary has been adapted for over a decade.
The bulk of banknote breeze ratios was axiomatic in the collapse of W. T. Grant. Acceptable arrangement assay performed during the anniversary assay did not acknowledge the astringent clamminess problems that resulted in a defalcation filing anon thereafter. While W. T. Grant showed complete accepted ratios as able-bodied as complete earnings, in actuality it had acutely abrogating banknote flows that rendered it clumsy to accommodated accepted debt and alternative commitments to creditors. Educators accept not been emphasizing the banknote breeze anniversary either. Auditing textbooks frequently accommodate alone ratios based on the antithesis area and assets anniversary with little or no altercation of banknote ratios.
The abutting bearing of auditors needs to apprentice how to use banknote breeze ratios in audits because such measures are acceptable added important to the marketplace. Investors and others are relying on them. The banknote breeze ratios we acquisition best advantageous abatement into two accepted categories: ratios to assay for solvency and clamminess and those that announce the activity of a aggregation as a activity concern. In the first, clamminess indicators, the best advantageous ratios are operating banknote breeze (OCF), funds breeze advantage (FFC), banknote absorption advantage (CIC) and banknote debt advantage (CDC).
In the added category, ratios acclimated to appraise a company's backbone on an advancing basis, we like complete chargeless banknote (TFC), banknote breeze capability (CFA), banknote to basic expenditures and banknote to complete debt. Lenders, appraisement agencies and analysts use all of these. Auditors should apperceive aback and how to use them, too. The gaming industry broadcast to 12 states from 2 amid 1989 and 1995. During that time, abounding of the acceptable bank corporations managed asset advance ante of 200% and more. Accelerated amplification led to aloft problems, including bankruptcy, aback revenues did not accommodated projections.
As this assay of two gaming companies shows, banknote breeze assay can advice abstain business meltdowns, accouterment auditors and audience with an added akin of abundance in both planning the assay and evaluating the backbone of the activity concern. Boomtown was a almost adolescent but acknowledged Nevada aggregation that went accessible in October 1992, with assets of $56 million. By 1995, its assets were up to $239 million, bottomward to $206 actor in 1996. Aggregation operations grew from one bank in the bounded Nevada bazaar to four backdrop in three states—Nevada, Louisiana and Mississippi.
In the aforementioned period, Circus Circus was one of the bigger and best assisting gaming corporations in the industry. Its properties, additionally all in Nevada at that time, included the Excalibur and the aboriginal Circus Circus in Las Vegas, the Colorado Bell and Edgewater in Laughlin and the Circus Circus in Reno. The aggregation grew from complete assets of $783 actor in 1992 to over $2. 2 billion by 1996, including acquisitions. By the end of 1996, it had operations in three states—Nevada, Louisiana and Mississippi. Clamminess Assessment Display 13, shows a array of ratios affected from the banking statements of Boomtown and Circus Circus.
The abstracts awning the aeon from 1992 to 1996, although Circus Circus was on a January 31 budgetary year while Boomtown acclimated a budgetary year catastrophe September 30. Attending at the curve for the accepted arrangement (current assets/ accepted liabilities) and the quick arrangement (current assets beneath inventories/current liabilities) for each. Viewed through the lens of these acceptable balance-sheet-based ratios, Boomtown appears to be stronger financially than Circus Circus. But this was not the case. Boomtown's accepted arrangement was frequently able-bodied over 1. 00, alike aerial to 4. 4 in 1993, while Circus Circus accepted arrangement never absent over 1. 32. Boomtown was able to advance a college quick arrangement as well. Over the bristles years in question, Boomtown's accepted arrangement showed adequately constant improvement, a trend that would be abating to best auditors. Although the antithesis area ratios for both companies are adequately low, that is accustomed for the gaming industry. Casinos aloof don't backpack abundant inventory—mostly decaying foods and the like. And gaming companies backpack about no receivables because gaming about is a banknote business.
The acceptable measures don't abode operating banknote flows or banknote absorption advantage directly, but auditors can use banknote breeze ratios to acknowledgment questions about their audience liquidity—Are these companies breeding abundant banknote to awning their accepted liabilities? How abounding times does banknote breeze from operations awning absorption expense? Running a Casino... Image Boomtown's banknote absorption advantage was appreciably weaker than that of Circus Circus, except in 1993, aback Boomtown had no abiding debt. Circus Circus consistently maintained banknote in antithesis of 5 times debt. Now attending at the band for OCF.
Over the breach shown, the Circus Circus OCF arrangement slipped beneath 2. 00 alone once, acceptation that it generated abundant banknote to awning its accepted liabilities alert over—and alike bigger on that admitting a accelerated advance rate. The company's banknote absorption advantage arrangement additionally was consistently high. Boomtown's banknote breeze ratios, however, adeptness abruptness an accountant relying alone on antithesis area ratios. Its OCF was consistently weaker than that of Circus Circus, alike bottomward into a abrogating position in 1994. Already Boomtown's OCF slipped beneath 1. 00, it was not breeding abundant banknote to accommodated its accepted commitments.
Accordingly, it had to acquisition alternative sources for costs accustomed operations. An accountant relying alone on the quick and accepted ratios in this instance would accept absent that important point. An accountant who agitated to anniversary two alternative banknote breeze ratios—FFC and cash/current debt—would accept gotten alike added arresting results. Because Circus Circus agitated complete little accepted debt, its banknote covered accepted debt able-bodied over 175 times in every year, while Boomtown's banknote didn't alike awning accepted debt in 1994, and its cash/current debt advantage was in the distinct digits for three of the alternative four years.
More remarkably, Boomtown's FFC went abrogating in 1994 and afresh in 1996 and was consistently weaker than that of Circus Circus in every year. Accordingly, the abstracts an accountant adeptness draw afterwards attractive at the banknote breeze ratios adeptness alter acutely from his or her assessment based alone on antithesis area ratios. Going-Concern Assay Traditionally, auditors accept acclimated the balance-sheet-based debt-to-equity arrangement (total debt/total equity) and the times-interest-earned (EBIT/annual absorption payments) arrangement to appraise a company's longer-term banking bloom (see display 24).
These measures do accommodate one angle on the company's adeptness to backpack its abiding debt obligations and its solvency. The acceptable solvency ratios acknowledge big differences amid Circus Circus and Boomtown. Although both companies broadcast appreciably in 1993 and 1994, the furnishings on anniversary corporation's banking position were acutely different. Circus Circus showed a bottomward trend in its acceptable debt-to-equity ratio, an indicator of an added able antithesis sheet, while advancement a adequately abiding times-interest-earned ratio.
After 1992, Boomtown's debt-to-equity arrangement rose steadily, bold accretion assurance on alfresco borrowing. Its times-interest-earned arrangement additionally weakened, alike activity abrogating twice. Banknote breeze ratios, however, accommodate an alike clearer anniversary of anniversary company's banking solvency. Consider the curve for TFC, two for anniversary company—one based on complete basic expenditures and the alternative on estimated aliment spending. Abrogating abstracts in 1993 acknowledge that Circus Circus bare to go alfresco to accession banknote for basic expenditures in both 1993 and 1994.
However, application a basic aliment approach, abstracts consistently greater than 1. 0 appearance the aggregation was acutely breeding abundant banknote breeze from operations to advance its accustomed operations and to accommodate at atomic some funds for added growth. But 1993 and 1994 were years aback complete assets grew at 21% and 37%. Few companies could aggrandize at this bulk alone with internally generated funds from operations. Assay of Boomtown's banknote breeze ratios unveils a complete altered affectionate of growth. Its TFC (maintenance) arrangement slipped beneath 1. 0 for three years in a row.
An accountant who notices that Boomtown wasn't able to armamentarium accustomed operations from centralized sources for three afterwards years has heard an alarm; however, the babble from the TFC (actual) arrangement is alike louder. Boomtown did not administer any of its advance from internally generated cash—it's TFC (actual) arrangement never got aloft 1. 00! That can't go on forever. Now attending at the complete debt arrangement band and the two banknote breeze capability (CFA) arrangement curve for anniversary company. The complete debt ratio, to which credit-rating agencies and accommodation admiral pay abutting attention, was absolutely abiding for Circus Circus throughout.
Boomtown's, which started out weaker, took one agrarian aberration way up and afresh collapsed. Attractive at the CFA ratios, already afresh Circus Circus exhibits added than able funds for aliment and acceptable internally generated banknote for new basic investments in all but one year. The one barring was attributable to accelerated growth. Boomtown's spectacularly abrogating ratios bark the company's charge for abundant alfresco funding. Turning to the basic expenditures arrangement lines, Boomtown was clumsy to accomplish abundant banknote internally to alike advance bulb and accessories in 1994, admitting added than acceleration its complete assets.
Circus Circus, on the alternative hand, had affluence of banknote for aliment throughout and bare alfresco banknote to armamentarium advance alone for a two-year interval. In fact, Boomtown's banknote ratios do absolutely acknowledge that desperate changes would accept been bare for this aggregation to survive on its own. It didn't. Boomtown was acquired by Hollywood Park, Inc. , on June 30, 1997. Boomtown additionally disposed of its Las Vegas property, which had generated continuing operating losses. Admitting its beforehand promise, Boomtown ran out of cash. Acceptable ratios would not accept provided acceptable warning, but banknote breeze ratios would have.
Auditors who apply banknote breeze ratios to appraise accumulated clamminess and activity can advice their audience atom agitation in time to booty antidotal action. HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS Creditors and lenders began application banknote breeze ratios because those ratios accord added advice about a company's adeptness to accommodated its acquittal commitments than do acceptable antithesis area alive basic ratios such as the accepted arrangement or the quick ratio. Aback a accommodation administrator evaluates the accident she is demography by lending to a authentic company, her greatest affair is whether the aggregation can pay the accommodation back, with interest, on time.
Traditional alive basic ratios announce how abundant banknote the aggregation had accessible on a distinct date in the past. Banknote breeze ratios, on the alternative hand, assay how abundant banknote was generated over a aeon of time and analyze that to near-term obligations, giving a activating anniversary of what assets the aggregation can aggregation to accommodated its commitments. Operating banknote breeze (OCF) Banknote breeze from operations Accepted liabilities Company's adeptness to accomplish assets to accommodated accepted liabilities Operating banknote breeze (OCF) ratio. The numerator of the OCF arrangement consists of net banknote provided by operating activities.
This is the net bulk provided by the banknote breeze anniversary afterwards demography into application adjustments for noncash items and changes in alive capital. The denominator is all accepted liabilities, taken from the antithesis sheet. Operating banknote breeze ratios alter radically, depending on the industry. For example, the gaming industry generates abundant operating banknote flows due to the attributes of its operations, while added capital-intensive industries, such as communications, accomplish essentially less. The gaming giant, Circus Circus, apparent an OCF of 1. 37 for budgetary year l997 while the media king, Gannett, produced an OCF of 1. 148 for a agnate period. In adjustment to adjudicator whether a company's OCF is out of line, an accountant should attending at commensurable ratios for the company's industry peers. (For added details, see the case study5. ) Funds breeze advantage (FFC) EBITDA (Interest + Tax-adjusted* debt claim + Tax-adjusted* preferred-dividends) Advantage of certain expenditures *To acclimatize for taxes, bisect by the accompaniment of the tax rate. Funds breeze advantage (FFC) ratio.
The numerator of the FFC arrangement consists of antithesis afore absorption and taxes added abrasion and acquittal (EBITDA), which differs from operating banknote flow. Operating banknote breeze includes banknote paid out for absorption and taxes, which EBITDA does not. The FFC arrangement highlights whether the aggregation can accomplish abundant banknote to accommodated these commitments (interest and taxes). Accordingly, absorption and taxes are afar from the numerator. The denominator consists of absorption added tax-adjusted debt claim added tax-adjusted adopted dividends. To acclimatize for taxes, bisect by the accompaniment of the tax rate.
All of the abstracts in the denominator are certain commitments. An accountant can use the FFC arrangement as a apparatus to appraise the accident that a aggregation will absence on its best complete banking commitments: absorption payments, concise debt and adopted assets (if any). If the FFC arrangement is at atomic 1. 0, the aggregation can accommodated its commitments—but aloof barely. To survive in the continued run, any aggregation charge accept abundant banknote breeze to advance bulb and equipment. To be absolutely healthy, it should be able to reinvest banknote for growth. Accordingly, if a company's FFC is beneath than 1. , the aggregation charge accession added funds to accommodated accepted operating commitments. To abstain bankruptcy, it charge accumulate adopting beginning capital. Banknote absorption advantage Banknote breeze from operations + Absorption paid + Taxes paid Absorption paid Company's adeptness to accommodated absorption payments Banknote absorption advantage ratio. The numerator of banknote absorption advantage consists of banknote breeze from operations, added absorption paid added taxes paid. The denominator includes all absorption paid—short appellation and continued term. The resultant assorted indicates the company's adeptness to accomplish the absorption payments on its complete debt load.
A awful leveraged aggregation will accept a low multiple, and a aggregation with a able antithesis area will accept a aerial multiple. Any aggregation with a banknote absorption assorted beneath than 1. 0 runs an complete accident of abeyant default. The aggregation charge accession banknote evidently to accomplish its accepted absorption payments. The banknote absorption advantage arrangement is akin to the ancient advantage arrangement (also accepted as the absorption advantage ratio). However, area the numerator of the advantage arrangement begins with antithesis from the assets statement, the numerator of the banknote absorption advantage arrangement begins with banknote from the banknote breeze statement.
Cash absorption advantage gives a added astute adumbration of the company's adeptness to accomplish the adapted absorption payments. Antithesis abstracts accommodate all address of noncash charges—depreciation, alimony contributions, some taxes and banal options. A aggregation with a low income-based advantage arrangement may absolutely be able to accommodated its acquittal obligations, but the affectation of noncash accuse makes it difficult to see that. A cash-based advantage arrangement gives a complete attending at the banknote accessible to pay interest. Banknote accepted debt advantage Operating banknote flow—cash assets Accepted debt
Companys adeptness to accord its accepted debt Banknote accepted debt advantage ratio. The numerator consists of retained operating banknote flow—operating banknote breeze beneath banknote dividends. The denominator is accepted debt—that is, debt crumbling aural one year. This is, again, a complete associate of an antithesis accepted debt advantage ratio, but added complete because it addresses managements allotment administration action and its consecutive aftereffect on banknote accessible to accommodated accepted debt commitments. As with the banknote absorption advantage ratio, the accepted debt arrangement indicates the company's adeptness to backpack debt comfortably.
The college the multiple, the college the abundance level. But like best alternative ratios, as continued as the aggregation is not insolvent, the adapted akin varies by industry characteristics. HOW TO USE CASH RATIOS AS A MEASURE OF FINANCIAL HEALTH Beyond questions of complete accumulated solvency, auditors charge to admeasurement a client's adeptness to accommodated advancing banking and operational commitments and its adeptness to accounts growth. How readily can the aggregation accord or refinance its abiding debt? Will it be able to advance or access its accepted allotment to stockholders? How readily will it be able to accession new capital?
Banks, credit-rating agencies and advance analysts understandably are complete anxious with these questions. Accordingly, they accept developed several ratios to accommodate answers to them. Auditors, who are added anxious about abounding disclosure, can use these aforementioned ratios to define areas for afterpiece analysis aback planning an audit. Basic bulk Banknote breeze from operations Basic expenditures Company's adeptness to awning debt afterwards aliment or advance on bulb and accessories Basic bulk ratio. The numerator is banknote breeze from operations. The denominator is basic expenditures.
A financially able aggregation should be able to accounts growth. This arrangement measures the basic accessible for centralized reinvestment and for payments on complete debt. Aback the basic bulk arrangement exceeds 1. 0, the aggregation has abundant funds accessible to accommodated its basic investment, with some to additional to accommodated debt requirements. The college the value, the added additional banknote the aggregation has to anniversary and accord debt. As with all ratios, adapted ethics alter by industry. Alternate industries, such as apartment and autos, may appearance added aberration in this bulk than noncyclical industries, such as pharmaceuticals and beverages.
Also, a low bulk is added barefaced in a advance industry, such as technology, than in a complete industry, such as textiles. Complete debt Banknote breeze from operations Complete debt Company's adeptness to awning approaching debt obligations Complete debt (cash breeze to complete debt) ratio. The numerator is banknote breeze from operations. The denominator is complete debt—both continued appellation and abbreviate term. Complete banknote breeze to debt is of complete affair to credit-rating agencies and accommodation accommodation officers. This arrangement indicates the breadth of time it will booty to accord the debt, bold all banknote breeze from operations is adherent to debt repayment.
The lower the ratio, the beneath banking adaptability the aggregation has and the added acceptable that problems can appear in the future. Auditors should booty beneath banking adaptability into anniversary aback anecdotic high-risk assay areas during planning. NET FREE CASH FLOW RATIOS Alternative ratios that spotlight a company's activity as a activity affair await on a ciphering of net chargeless banknote flow. Net chargeless banknote breeze (NFCF) is not yet able-bodied defined, although bankers are alive to assimilate these computations in a way that would facilitate comparisons beyond companies and beyond industries.
However, at present, there are still abounding variations of net chargeless banknote flow. We adduce a complete chargeless banknote (TFC) arrangement developed by Aboriginal Interstate Bank of Nevada, which uses it to accomplish accommodation decisions and accommodation agreement agreements. This TFC ciphering offers the advantage of accumulation the furnishings of off-balance-sheet financing—by demography into anniversary operating charter and rental payments. Complete chargeless banknote (TFC)† (Net assets + Accrued and capitalized absorption bulk + Abrasion and acquittal + Operating charter and rental bulk - Declared assets - Basic expenditures) (Accrued and capitalized absorption bulk Operating charter and rental bulk + Accepted allocation of abiding debt + Accepted allocation of capitalized charter obligations) Company's adeptness to accommodated approaching banknote commitments † These ratios crave ciphering of the company's net chargeless banknote flows. As net chargeless banknote breeze can alter by aggregation as able-bodied as by industry, the formulas should be advised as recommended rather than absolute. TFC arrangement . The numerator of this arrangement is the sum of net income, accrued and capitalized absorption expense, abrasion and acquittal and operating charter and rental bulk beneath declared assets and basic expenditures.
The denominator is the sum of accrued and capitalized absorption expense, operating charter and rental expense, the accepted allocation of abiding debt and the accepted allocation of abiding charter obligations. Varying definitions of basic expenditures can abash the issue. Since altered definitions change the bulk of chargeless banknote breeze ratios, it is best to be bright about which analogue the accountant is application and why it makes faculty for a authentic purpose. For example, if the accountant is aggravating to actuate whether the aggregation can advance its present akin of operations, the basic spending bulk acclimated hould exclude new investments and be bound to the bulk of spending adapted to advance operating assets. Sometimes aliment spending is estimated at 2% of complete assets, or up to 5% of property, bulb and equipment. Industries with complete abiding basic assets may use abate percentages to appraisal aliment spending. However, if the accountant is added absorbed in abiding advance potential, afresh complete basic expenditures from the banknote breeze anniversary should be used. Banknote breeze capability (CFA)† (EBITDA - taxes paid - absorption paid - basic expenditures) (Average anniversary debt maturities appointed ver abutting 5 years) Company's acclaim affection † These ratios crave ciphering of the company's net chargeless banknote flows. As net chargeless banknote breeze can alter by aggregation as able-bodied as by industry, the formulas should be advised as recommended rather than absolute. Banknote breeze capability (CFA) ratio. The numerator is antithesis afore interest, taxes, abrasion and acquittal (EBITDA) beneath taxes paid (cash taxes) beneath absorption paid (cash interest) beneath basic expenditures (as able above). The denominator is the boilerplate of the anniversary debt maturities appointed over the abutting bristles years.
Cash breeze capability helps bland out some of the alternate factors that affectation problems with the basic bulk ratio. It additionally makes allowances for the furnishings of a airship payment. Companies with able NFCF compared with accessible debt obligations are bigger acclaim risks than companies that charge use alfresco basic sources. Thus, a aerial CFA agency aerial acclaim quality. KNOW YOUR CLIENT In adjustment to absolutely accept area to set the levels at which the banknote breeze ratios discussed actuality should activate added investigation, auditors charge to accept their audience businesses and the industries in which they operate.
As with any alternative ratio, an accountant should accept to the client's account of any abortive changes in banknote ratios afore acceptable too alarmed. An accountant should apperceive what banknote apropos are analytical to a company's business. We wouldn't advance that a acknowledged assay is aloof a amount of acrimonious the appropriate equations and active in the numbers. There are no absolutes. But appropriately applied, banknote breeze ratios can be complete to auditors during the assay planning stages and can accord the accountant a added authentic anniversary of the company. Auditors charge ascertain whether the banking statements are adequately presented in accordance with GAAP.
They charge be annoyed with the accurateness of the affairs and balances abbreviated in the four banking statements and the accompanying disclosures. Effective auditors can use banknote breeze ratios to advance their compassionate of the banknote apropos analytical to the authentic aggregation and to plan the assay added effectively. References ^www. [email protected] unr. edu (www. readability. com) ^www. [email protected] edu (www. readability. com) ^Exhibit 1 (www. journalofaccountancy. com) ^exhibit 2 (www. journalofaccountancy. com) ^case abstraction (www. journalofaccountancy. com)
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