Statement of cash flows

Way back when I was just starting in the audit profession, being able to prepare the Statement of Cash Flow was a test of mettle for us staff auditors.  We would beam with pride and accomplishment  the moment we  could successfully prepare one for the first time.  We were particularly fond of one of our audit partners then who, being recognized for his particular canny in preparing it, can pinpoint with accuracy to which  financial statement account a P1 difference was lumped in (a P1 difference, by the way is usually a rounding off difference).

A brief scanning of the articles and publications that came out after the myriad of accounting scandals in Enron, Worldcom and  similar others would show focused attention by analysts and investors alike on the statement of cash flows. 

Why the statement of cash flows?

Unlike reported earnings, cash flow allows little room for manipulation. Every company that files reports with the SEC is required to include a Statement of Cash Flows. Unless tainted by outright fraud, this statement tells the whole, basic story of cash flow: either the company has cash or it doesn’t.

However, like many things in the world of finance, the Statement of Cash Flows is not straightforward. You must understand the extent to which a company relies on the capital markets and the extent to which it relies on the cash it has itself generated. And, no matter how profitable a company may be, if it doesn’t have the cash to pay its bills, it will be in serious trouble.

What a Statement of Cash Flows is

PAS 7 defines a Statement of Cash Flows as a component of financial statements summarizing the operating, investing and financing activities of an entity.  Put simply, the Statement of Cash Flows records a company’s cash transactions (inflows and outflows) during a given period.  It has three components:  operating cash flow, investing cash flow and financing cash flow.

Cash flows from operating activities

PAS 7  defines cash flow from operating activities as  being derived primarily from the principal revenue producing activities of the entity. For the sake of illustration, let’s take the case of a sorbetero.  His operating cash flow would pertain to the cash he collects from the sale of his ice cream.  If he sold one of his ice cream carts, that would not be considered operating cash flow since selling ice cream carts is not his primary business.   

Operating cash flow  is equivalent to net income  adjusted for (1) non-cash items that either increased or decreased net income and (2) operating items that changed the value of assets and liabilities.

An example of item (1) above is depreciation expense.  Depreciation is added to income because this is an expense which reduced net income but pertains to assets that were paid for in a previous period.  It no longer involves any actual cash outlay in the current period.  In the case of our sorbetero, if his net income is P1,000, and the depreciation expense of his ice cream cart is P200, we add back the P200 to come up with operating cash flow of P1,200.

An example of item (2), meanwhile,  can be seen in the changes in accounts receivable from one accounting period to the next.  Assume our sorbetero’s accounts receivable from customers decreased from P400 to P100.  The decrease of P300 means he was able to collect P300 from customers who had bought his ice cream on credit.  This collection is no longer reflected as part of income.  It was already considered net income in the prior period.  But the cash came in during the current period.  Hence we add back the P300 decrease in accounts receivable to our sorbetero’s net income figure.  Increases in receivables may indicate collection difficulties, customers who are not creditworthy or an extension of credit terms.

An increase in inventory, on the other hand, signals that our sorbetero has spent money to purchase more ice cream to sell. If he bought the inventory on cash basis, the increase in inventory is deducted from net income. If the inventory was purchased on credit, we would see an increase in accounts payable, and the amount of the increase would be added to net income. Increasing inventory may suggest that sales are lagging  or that a business is doing a poor job predicting product demand.  It can also tip off aging inventory, which may eventually need to be written off.

Cash flows from investing activities

PAS 7 describes investing activities as cash flows derived from the acquisition and disposal of long-term assets and other investments not included in cash equivalents.  In the case of our sorbetero, cash from the sale of his ice cream cart is considered cash flow from an investing activity.  Investing cash flows should be negative for a healthy company.  In fact, signs that a company is on a downward slide would be seen in positive investing cash flow; it has stopped investing in its future.

Cash flows from financing activities

PAS 7 describes financing activities as cash flows derived from the equity capital and borrowings of the entity.  Cash outflows can mean the company is servicing debt or making dividend payments and stock repurchases, which investors might be glad to see.  Meanwhile, our sorbetero was able to borrow P1,000 from his neighbour in order to purchase the latest model ice cream cart.  He now has a P1,000 cash inflow from financing activities.

Understanding the statement of cash flows

Cash flow is much harder to manipulate than earnings for two reasons.  First, the cash flows have to reconcile with the cash balance in the statement of financial position.  Second, most ways of tweaking results involve goosing numbers, that either don’t appear in operating cash flows or reduce the operating cash flow amount.

The fact is this:  over the life of a company, cash flows and net income will be the same.  If a company starts and ends with nothing, however profitable or unprofitable it is in between, the net income and cash flows over the life of a company will end with  the same number.  All cash flow really does is compensate accrual accounting, that is, factor out non-cash transactions. 

Generally, a company’s principal industry of operation determine what is considered proper cash flow levels; comparing a company’s cash flow against its industry peers is a good way to gauge the health of its cash flow situation. A company not generating the same amount of cash as competitors is bound to lose out when times get rough.

Even a company that is shown to be profitable according to accounting standards can go under if there isn’t enough cash on hand to pay bills. Comparing amount of cash generated to outstanding debt, known as the operating cash flow ratio, illustrates the company’s ability to service its loans and interest payments. If a slight drop in a company’s quarterly cash flow would jeopardize its loan payments, that company carries more risk than a company with stronger cash flow levels.

 Take note though, that while a company that shows positive cash flow is ideal, there are also opportunities in companies that aren’t cash-flow positive yet. The statement of cash flows is simply a piece of the puzzle. So, analyzing it together with the other financial statements can give you a more  complete assessment of a company’ financial health.

Conclusion

I used the business of a simple sorbetero to illustrate the basic idea and formulas of a cash flow statement. In reality, cash flow statements range in complexity and can tell the simplest, most straightforward story like that of a sorbetero’s, as well as intricate ones involving sophisticated, sometimes seemingly convoluted financial transactions of big businesses. Cash flows have a lot of meaning embedded in them, if only one would pay close attention to what they say.

As food for thought though, I’d like to complicate matters a bit. Let’s take a glance at the cash flows of the largest superpower nation on earth today, the United States of America.  Unlike our sorbetero, who will definitely be charged of counterfeiting should he start on the idea of printing his own peso bills, the US Federal Reserve can actually manufacture cash out of thin air – a legally valid activity called “quantitative easing.”

On September 2012 the US Fed announced that it will be “creating” $40 billion per month to buy products from the US banks in an effort to stimulate the US’ sagging economy.  In 2011, the Fed was already buying 61% of total issuances of the US treasury.  This means that the money “borrowed” by the US government to finance its spending did not come from taxes on its citizens, or borrowings from creditors like China.  It was money that previously did not exist, which was instantaneously “created” by the Fed and debited to government bank accounts. 

Some expect the Fed to actually “paper over” the entire US deficit.     

To give people a more concrete grasp on the hundreds of trillions being spent by the US government, Face the Facts USA gave this analogy: 

In every second of 2011, the US government spent $114,253 while taking in only $73,043 in revenue. That means in each second, the federal government spent $41,210 that it didn’t have. We can say it is borrowing the equivalent of one brand-new luxury SUV – per second, all year long. That’s a huge pile of SUVs.

Finally, just as an exercise of your working knowledge on cash flows, try to analyze and compare the cash flows of the sorbetero and that of the US government.  If you had to choose one, which entity  would you invest in? 

Arthur Machacon is an Audit partner of Manabat Sanagustin & Co., CPAs and has more than 18 years of external audit experience covering a wide spectrum of industries.  He has also a significant experience in the audit of publicly-listed companies. 

Manabat Sanagustin & Co., CPAs, a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. This article is for general information purposes only and should not be considered as professional advice to a specific issue.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International or MS&Co. For comments or inquiries, please email [email protected] or [email protected].