Cash Flow Statement Analysis

  1. INTRODUCTION

Recall from the article on the income statement that a company will recognize revenue regardless of when payment is received.  For example, a company may sell a product and receive a promise of future payment (receivable) in lieu of a cash receipt.  Likewise, a company will recognize an expense regardless of when cash is paid.  For example, a company may purchase inventory and in exchange provide the vendor with a promise to pay in the future (payable).  Because of these timing differences between recognition and cash transfers (known as accruals), the income statement does not show the company’s cash receipts and cash disbursements.

The cash flow statement, in contrast, shows the total cash receipt and cash disbursements for all the company’s transactions over a period.  The cash flow statement shows the total change in the cash and equivalents amount on the balance sheet over a corresponding period.

  1. FORMAT OF THE CASH FLOW STATEMENT

Under U.S. GAAP, companies are required to present the cash flow statement using the indirect methodi.  However, companies may also present the cash flow statement using the direct method.  With either method of presentation, the cash flow statement must breakdown cash flows into operating, investing, or financing.

2.1.  Direct Method

Under the direct method, the operating section of the cash flow statement is broken down such that each income statement category is adjusted for its related accrualsii.  Because of the increased detail, the direct method offers financial statement users a more in-depth presentation of the company’s sources and uses of major operating categories.  The direct method cash flow presentation is often considered the cash-basis income statement.

U.S. GAAP requires companies electing to use the direct method to at a minimum present cash sources and uses in the following categories: (1) cash collected from customers, (2) interest and dividends received, (3) other operating cash receipts, (4) cash paid to employees and suppliers, (5) interest paid, (6) income taxes, and (7) other cash payments.

2.2.  Indirect Method

The indirect method presents operating cash flow indirectly by reconciling net income to operating cash flow.  The presentation of the indirect method begins by adding back noncash expenses, such as depreciation, amortization, and employee stock-option expense.  Then, the statement presents the cash impact of changes in current assets and current liabilities: Increases in current assets represent a use of cash and are subtracted from net income; decreases in current assets are a source of cash and are added to net income; increases in current liabilities are a source of cash, and are added to net income; decreases in current liabilities are a use of cash, and are subtracted from net income.

Because current U.S. GAAP requires companies to use the indirect method, regardless of the use of the direct method, most U.S. public companies present their cash flow statement using only the indirect method.

  1. SECTIONS OF THE CASH FLOW STATEMENT

3.1.  Cash Flow from Operations (Operating Cash Flow)

Operating cash flow represents a company’s cash inflows and cash outflows realized as a result of transactions from the company’s normal business operations.  The operating cash flow section is the first section presented in the cash flow statement.  Operating cash flow is the most important source of cash flow.  A company producing insufficient operating cash flow will be unable to invest in growth, service debt, or pay dividends to shareholders.

Common sources of operating cash flow are cash from sales and collection of accounts receivable.  Common uses of cash flow are cash payments from inventory, cash payments for operating expenses, and reduction in payables.

As mentioned above, increases in current assets represents a use of cash.  Likewise, decreases in current assets represents a source of cash.  For example, an increase in the carrying value of accounts receivable means that a company has recognized more sales than the cash received from customers, while a decrease in accounts receivable means that a company’s cash collections exceeded reported sales.

Increases in current liabilities represents a source of cash, while decreases in current liabilities represents a use of cash.  For example, a decrease in accounts payable means the company’s payments to suppliers has exceeded its credit purchases, while an increase in accounts payable means the company’s input purchases is greater than the cash paid to suppliers.  The collective impact of changes in current assets and current liabilities is the period’s change in working capital (current assets – current liabilities).  An increase in working capital for a reporting period is a use of cash, while a decrease in working capital is a source of cash.

3.2.  Cash Flow from Investing (Investing Cash Flow)

Investing cash flow represents cash inflows and outflows arising from the purchase or sale of long-term assets.  Examples of sources of investing cash flow are the sale of equipment and real estate.  Examples of uses of investing cash flow include the purchase of equipment, real estate, and intangible assets.

The direct purchase of assets in the investing section is known as capital expenditures.  These activities are presented in a separate item on the statement from cash used for acquisitions, which are the outlays used to acquire companies.

3.3.  Cash Flow from Financing (Financing Cash Flow)

Financing Cash Flows represents cash inflows and outflows relating to a company obtaining and paying capital.  Essentially, this section of the cash flow statements showing any cash transactions with the company’s owners and creditors.

Examples of sources of financing cash flow include the cash proceeds from the issuance of equity and cash proceeds from the issuance of debt.  Examples of uses of financing cash flow include cash payments used to repurchase stock, the payment of cash dividends, and the repayment of long-term debt.

  1. RECONCILING THE CASH FLOW STATEMENT WITH THE INCOME STATEMENT AND BALANCE SHEET

Not all changes in asset and liability accounts are caused by accruals; thus, not all changes in these accounts will correspond with the cash flow statement.

4.1.  Asset Write-Offs

Assets are “written-down” when management determines the asset’s value to be impaired.  Inventory write-offs, for example, will reduce ending inventory balances in a way that will not correspond with the cash flow statement.  In other words, inventory changes over a period will reflect recognized impairments in addition to inventory purchases and costs of goods sold.  Likewise, increases in the provision for bad debt will reduce the carrying amount of receivables in a way that will not correspond with the cash flow statement.

4.2.  Translation Adjustments on Assets and Liabilities Held by Foreign Subsidiaries

U.S. companies with operations in foreign countries will transact in currencies different from the U.S. dollar.  However, these companies must present all figures in the financial statements in U.S. dollars.

Current accounting standards specifies two methods of translating accounts in foreign operations: the current rate method and the temporal methodiii.

With the temporal method, balance sheet carrying amounts for monetary assets and liabilities (those assets and liabilities whose settlement amounts are fixed and determinable in the company’s reporting currency) will reflect exchange rates from the prior balance sheet date.  With the current rate method, balance sheet carrying amounts for both monetary and non-monetary assets and liabilities will reflect exchange rate changes from the prior balance sheet date.  An increase or decrease in the historical transaction currency relative to the reporting currency will lead to an increase or decrease in the ending value of certain assets or liabilities which will not correspond with the cash flow statement.

4.3.  Acquisitions

If the reporting company acquires another company during the period, the ending balances of current asset account and liability accounts will reflect the accounts of the acquired subsidiaries and will thus not correspond with the cash flow statement.

Also, capital expenditures reported on the cash flow statement will reflect only cash outflows made to acquire property directly.  Property acquired as part of a business acquisition are classified as acquisitions, not capital expenditures.

  1. CASH FLOW REPORTING UNDER IFRS

5.1.  Presentation

Despite similarities in the presentation of the cash flow statement, several significant differences exist between cash flow reporting under U.S. GAAP and cash flow reporting under IFRSiv.

The major difference in the cash flow statement presentation between the two standards is that IFRS does not require presentation of the indirect method if the direct method is used.  Under U.S. GAAP, companies must present the indirect method as a separate disclose even when the direct method is used.

5.2.  Transactions

Under IFRS certain transactions may be reported in a different section of the cash flow statement than is reported under U.S. GAAP.

Bank overdrafts are very short-term borrowings which fund a bank overdraft.  Under U.S. GAAP, such overdraft funding is reported in the financing section of the cash flow statement.  Under IFRS, however, bank overdrafts are part of cash and equivalents and not a financing mechanism.

Interest received and interest paid are classified within the operating section of the cash flow statement under U.S. GAAP.  Under IFRS, interest received may be recorded in the operating section or the investing section of the cash flow statement.  Similarly, under IFRS interest paid may be recorded in the operating section or the financing section of the cash flow statement.

Dividends received are classified within the operation section of the cash flow statement under U.S. GAAP, while under IFRS dividends received are classified as either operating or investing cash flows.  Dividends paid are classified as financing cash flow under U.S. GAAP, while under IFRS dividends paid are classified as either operating or financing cash flows.

The last major difference between U.S. GAAP and IFRS cash flow transaction classifications is regarding taxes paid. Under U.S. GAAP, taxes paid are always classified in the operating section of the cash flow statement.  Under IFRS, taxes paid are generally classified as an operating cash flow.  However, IFRS allows for any portion of taxes paid which can be attributed to an investing or financing activity can be allocated to those categories.

SOURCES

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer.

Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

 

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International Financial  

                  Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

 

Subramanyam, K.R. Financial Statement Analysis, 11th ed. New York: McGraw-Hill, 2014.

i ASC Topic 230

ii The investment and financing sections are the same for both methods.

iii I will discuss foreign currency translations in more depth in a future article.  I merely provide a brief overview here.

iv IAS 7

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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