Overview
This is a most important
statement to financial analysts. A for
profit company is in business to earn cash and in the long run we would expect
accounting income to be approximately equal to cash flows. However, important timing differences can
arise naturally. Revenues can result in
immediate cash or future cash if the sale is on account. Similarly, for expenses the matching
principle results in expenses being associated to revenue or the accounting
period if a direct association to revenue cannot be established, irrespective
of when the cash flow occurs. Therefore,
over the short run accounting income will not equal cash income.
Second, net income can
be divided into two sub-components, cash income and accrual income that have a differential
impact upon future net income. The first
sub-component, cash income, has a greater persistence impact upon future
accounting income relative to the second sub-component, accounting
accruals. In addition, the latter has a
tendency to revert resulting from both natural properties (e.g., accelerated
depreciation) and income smoothing. These
properties are associated with the famous “accruals anomaly” which was first
documented by Sloan 1996. That is, these
known accounting income fundamentals are not fully reflected in the stock market’s
return behavior. As a result, there has
been much practitioner and research attention focused upon the accrual anomaly and
the cash flow statement at a macro level
ever since. This attention became the
subject of the cover story for Business Week in October 2004.
The cash flow statement in
its current form reconciles the beginning and ending period balances for “Cash
and Marketable Securities.” In 1971 US
GAAP required this type of statement to reconcile sources and uses of funds, where
funds could be defined in different ways.
Later in 1987 US GAAP required the form we see today where the fund
equals “cash and marketable securities.”
The cash flow statement is useful because the reconciliation between
opening and closing balances of this cash account is organized around three
major sets of activities: Operating,
Investing and Financing. As a result, a
user immediately gains insight into the drivers of this relatively more
permanent component of net income.
There are two ways of
presenting a cash flow statement. One
way (the most prevalent for large companies) is referred to as the indirect
method. This method is useful to
investors because it starts with Accounting Income and then undoes the accrual
components of income. This is a useful form
of presentation given the accrual anomaly described above. The second method is the direct method which
works directly with the entries that flow through the Cash account again
organized by the three major set of activities.
In a nutshell the cash
flow statement summarizes an answer to the question “how do the three major
sets of activities (operating, investing and financing) drive the change in
Cash and Marketable Securities?” In
particular, the operating activities provide insight into the more permanent
component of operating income, the investing activities provide insight into
capacity and potential growth and the financing activities provide insights
into management’s capital structure related decisions. A detailed tour of the cash flow statement
is in Chapter 2 of the online text. In the next part we examine the cash flow
statement at a micro level.
Evaluating the strength
of a company with cash flow statement information
You can see how strong a
company is performing along the three important sets of activities from the cash
flow statement in two ways: by looking at changes in the cash flow statement over
time, and by comparing the company to others (e.g. to its competitors). Let’s
look at an actual company, 1 800 FLOWERS.COM:
The above has plotted the key bottom line fields in the Cash Flow
Statement (Indirect Method): Net Income,
Net Cash Provided from Operating Activities, Net Cash Provided from Investing
Activities, and Net Cash Provided from Financing Activities. At a glance this reveals that cash from
operating activities have grown significantly – a positive, cash put into
investing activities have declined significantly and increased cash has been
applied to paying down debt. The latter
is positive in the sense of reducing financial risk.
The time period used is the last 6-months versus the corresponding
6-month period one year ago. That is, we
do not immediately see the latest quarter which would have to be pulled off
separately. But by working with the
existing disclosure we first consider closer what is driving the positive
increase in net cash inflows from operating activities? Here we need to look at the components that
make up this set of activities. Given
the large set of individual line items reported we will consider these in
subsets.
Impact of Change in Working
Capital
From the above graph it is clear that the three main working
capital components are Receivables, Inventories and Payables. Mixed results from these drivers. First, working capital is a net use of funds. The change in receivables, although better
than the previous year, remains negative.
The change in inventory is worse than the previous year’s inventory
build-up, and again remains negative.
The change in payables is positive and more positive than the previous
year indicating an expanding time taken to pay operating activities related
creditors. So overall working capital is
again a use of cash and is greater than the previous year.
Other Operating Activities
Again from left to right these other activities are adjustments to
net income. The second item from the
left is a loss adjustment for discontinued operations in the current year
versus a gain adjustment in the previous year.
Third from the left is another adjusting entry to undo the effects from
gains from the sale of discontinued operations.
Fourth and fifth from the left are the add backs from non-cash expenses
Depreciation and Amortization respectively.
Finally, the two significant contributors are from Deferred Taxes and
Stock Compensation. A little digging
into the footnotes reveals:
That is the footnote provides additional useful description of these non-cash charges. The gain that resulted from the sale of the Company’s wine fulfillment service business is subtracted from Net Income because it is a non cash adjustment. In the next section titled “Investing Activities” the cash received from this sale should show up as an addition.
Investing Activities
Overall these activities have been cut back relative to the
previous year for the same time period.
The main drivers are evident from the above. First, third from the left is the Proceeds
from Sale of Business is larger than second from the left which is Acquisitions
net of cash acquired. That is, overall
this is consistent with downsizing the scale of operations relative to a year
before. Capital expenditures have
increased (fourth from the left) which indicates that additional investment has
been allocated to the existing operations that have been retained in the
business. Other items are minor, so
overall the management has reduced the scale of operations and appears to be
focusing more heavily upon existing operations.
This is probably a positive especially if revenues are growing.
Financing Activities
To be consistent with the conclusions drawn from the investing
activities section we would expect that management is applying funds from
downsizing to reducing debt. If this is
the case then this will show up in the financing activities part of the cash
flow statement.
Consider the financing activities component of the cash flow
statement as depicted below:
The two major items above are “Proceeds from Bank Borrowings”
(second from the left) and “Repayments of Notes Payables and Bank Borrowings”
(third from the left). Overall
repayments have exceeded new borrowings and as a result the net cash from
financing is overall negative. Treasury
stock acquisitions have been minor. The
divestitures of this company appear to have simplified their borrowings to
their line of bank financing credit.
Again additional information for the above is obtained from the
footnotes using the Complete Filing tab and the Find function and this further
reveals the details associated with their line of credit financing:
Conclusions
It is clear that there is tremendous amount of information that is
learned by analyzing the cash flow statement.
This is why it is one of the most closely scrutinized by analysts
because it organizes results around the three major sets of firm
activities: operating, investing and
financing. In this lesson we analyzed
the cash flow statement at a micro level by starting with the view from above
of these three activities and then drilling down into their drivers. The result from this provides a clearer
picture of a company’s current business strategy.
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