Statement of cash flows

(Conclusion)

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 percent 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].