Valuation Tutor Lesson: Understanding the Cash Flow Statement at a Micro Level


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:

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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