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In this lesson, let’s look at the cash flow statement, because it too tells a part of the story. The cash flow statement is actually one of the best and easiest statements to understand because you can’t fake cash flow, whereas the income statement and balance sheet actually have a lot of nuances to consider and far more than I care to get into in this course. The cash flow statement reconciliation helps you bridge your understanding between the income statement and balance sheet to just focus on the cash impact of the various decisions made by senior management. Cash is the lifeblood of any business, so as an executive or directors, it behooves you to understand how cash is generated and spent.

Bear in mind the story of Enron, an infamous energy giant in the 1990’s, which showed incredible earnings each year leading up to its ultimate demise. In the very same financial statements however, the company showed negative cash flow from the underlying business. Reading the income statement in the absence of the statement of cash flow was a mistake that many people made and investors lost billions. The other aspect of the cash flow statement I like is that it’s the most visible representation of the capital allocation decisions made by the executives and the board of directors. Management is often responsible for making the operating type decisions and determining the cash used in or generated from operations. Directors often have a part to play in decisions related to investing and financing activities. Investing activities are those pertaining to an investment in or divestitures of long-term capital assets. Financing activities relate to the issuance of debt and equity instruments to raise capital or the repayment thereon, including the payment of dividends to shareholders.

The operating activities takes the income reported on the income statement and then adjusts for all the non-cash items that were included there. I’ve listed the most obvious and common non-cash expense item included on the income statement –depreciation –but what other types of expenses should you watch out for?

-Issuance of stock options, these are often non-cash.
-Amortization of financing fees paid to set up new credit facilities. These are often amortized over the term of the credit facility.
-Impairment or write down of an asset –like equipment or inventory that has spoiled or become obsolete.
-Fair value adjustments for things like hedges, investments, and foreign currency.

This section of the cash flow statement also incorporates changes in the working capital investment as these represent the real investment or release of cash from working capital. Let’s walk through the thinking.

When inventory goes up on the balance sheet, you’ll see a negative number here on the cash flow statement representing the cash that is invested to acquire or build the incremental inventory. When accounts receivable goes down on the balance sheet, you’ll see a positive number on the cash flow statement to reflect that the business collected more cash than the business recorded as sales on the income statement. And when your accounts payable goes up on the balance sheet because the business is stretching its suppliers, you will see a positive number here on the cash flow statement to reflect that the business has recorded more expenses on the income statement than it has paid for with its cash.

Operating cash flow is a truer sense of the amount of money made from operations during period. The old adage that Cash-is-King can definitely be challenged using this financial statement rather than the income statement. But before we move on, let’s connect another dot for you from a previous lesson. I’ll ask you to consider how cash from (used in) operations compares to EBITDA. After all, isn’t that what I said EBITDA was a proxy for?

Here are the differences:

-Operating cash flow is more inclusive in that it includes interest costs paid and income taxes paid.
-Operating cash flow also includes the investment in working capital that is excluded from EBITDA.
-Thus, the two metrics are not directly comparable, even though they are often used as a proxy for one another.

Let’s talk about investing activities next. When you purchase or sell capital assets or lines of business, those expenditures or proceeds get reported in this section. It’s entitled investing activities because it has to do with long-term assets such a property, plant, equipment, and investments in shares or other businesses. One thing I like to do is compare capital expenditures to the amount of depreciation. When capital spending is lower, this could be a good thing because perhaps the business doesn’t require much maintenance capital to sustain its operating capacity. When its higher, you are hoping that there is a proportional increase in sales happening and that would indicate that these expenditures were more related to growth capex than maintenance capex.

Unfortunately, the accounting rules do not require disclosure of a breakdown between the sustaining capex and the growth capex we discussed earlier, so you will need to ask about the nature of capital expended by management. Money raised or spent in this section of the cash flow statement almost always is a decision approved by the board of directors.

Finally, let’s look at the financing activities. Here is where you will find the amount of cash that is dedicated to servicing debt or raised from issuing debt. When debt is issued to raise cash, it’s a positive number. When debt is repaid, it’s a negative number to reflect the outflow of cash. Note that we are only dealing with the issuance or repayment of principal in this section. Recall that interest costs are reflected in the operating section of the cash flow statement. The financing section of the cash flow statement also shows any cash proceeds received from the injection of equity from the owner –perhaps through a share issuance or a shareholder loan. Cash flows to the owners from the business through dividends or redemptions of equity are shown as negative numbers to reflect the outflow of cash. Once again, you’ll often find in practice that every line in this section comes from a decision made by the board of directors.

The three section are added together to determine the change in the balance of cash during the period. You might think that the change in the cash is an important indicator, it really isn’t. Some companies hoard cash, others deploy it by using the free cash flow to re-invest in the business or pay down debt and equity. The important thing to remember as you read the cash flow statement is that positive numbers represent positive cash flows, i.e. cash coming into the business. Negative numbers equal cash flowing out of the business. Once you have this under your belt, the cash flow statement becomes one of the easiest and most useful statements to read.

What is important for you to understand and isn’t published on the face of the cash flow statement, is how well the business is generating what I’ve referred to as “free cash flow,” or alternatively negative free cash flow. Free cash flow represents the discretionary amount of cash that is generated from the business. Discretionary in the sense that it’s extra and not required to sustain operations. You can calculate how much free cash flow is generated by taking operating cash flow LESS maintenance capital expenditures LESS scheduled debt repayments EQUALS free cash flow. This is a really interesting number to know because this is the amount of cash that is available to reinvest and grow the business, it’s the amount that can be used to pay down debt, or pay out money to the shareholders. This is the cash flow that a board of directors often has a say in allocating.

The decisions that you, as a director, might be asked to make might include:

-Acquiring a new line of business-Investing in a new line of business.
-Paying down your debt-Paying a dividend to shareholders.
-Paying a bonus to the CEO for a job well done.
-Repurchasing some of the outstanding equity of the company to give back some capital to the owners of the business.

When free cash flow is a negative number, it implies that the business is burning cash, not generating it. That burn of cash must be financed. The first source of cash is to spend any cash on hand. The second source management has is to tighten working capital, perhaps by liquidating some inventory, collecting some receivables, or stretch payments to suppliers. After that, it’s over the board of directors to decide where the next tranche of cash will come from. Will the company issue debt by taking out a loan? Will the company issue equity by asking for shareholders to inject cash into the company? Will the board direct management to sell off pieces of the business to raise cash? Any one of these alternatives is a viable way to raise cash. When you run out of financing options, the business runs out of life and is no longer a going concern.

The going concern assumption is used by the accountant to describe a business that is able to sustain itself. When a business is no longer able to meet this assumption, interestingly that is when you will hear people talking about going concern. Auditors will add extra disclosure to their report talking about the possibility that going concern is no longer assured. You will also see note disclosure, often the very first note in the financial statements, discussing this issue. It’s a huge red flag to have this sort of disclosure in a set of financial statements and if you see it, you need to ask lots of questions to understand how the business will recover. We will come back to this disclosure when we talk about the notes to the financial statements. In our next lesson, it’s over to you. Let’s see if you can analyze a cash flow statement.

In this lesson, it’s time for you to analyze the statement of cash flow. Once again, we will return to our steel fabrication business. Let’s start with the operating activities. Look at these numbers and consider the differences between income as reported in the accounting world and operating cash flow. The difference is stark.

Review each of the lines and ask yourself two questions:
1.Is that a good thing or a bad thing from a cash flow perspective?
2.Do you understand why each line is included in the reconciliation between income and cash?

While net income has grown from $17 million to $23 million, a 32% increase; operating cash flow has gone from $8 million to $31 million, an astounding 386% improvement year over year. You’ve got to have a few questions in mind to better understand how management accomplished that feat. The increase in net income by $5 million year over year accounts for some of the improvement, but the biggest improvement comes from an improvement in managing working capital. Working capital is still a negative cash outflow of $4 million in 20X2, but that is a vast improvement over the $23 million investment that was observed in 20X1.Let’s pause for a second and consider Note 22. Note 22 includes all the non-cash items that hit the income statement that were non-cash. $15 million in adjustments is nothing to sniff at. Can you imagine what sort of things might be in here? Depreciation and amortization for sure, but let’s see what else gets included…

Whoa…that’s quite a list! Depreciation and amortization kick off the list, followed by impairments, share-based compensation, inventory allowances, gains and losses, deferred taxes, financing cost amortization, share of income from investments, and mark-to-market on derivative instruments –like a hedge of some sort for foreign currency or a commodity like steel. It’s intimidating to look at a list like this, but these should make sense when you think of each of line and are consistent with our discussion in previous lessons. This schedule highlights the differences between an accountant’s view of the world and a treasurer’s view of the world.

Let’s move down a section and talk about the investing section. Review this section and answer me this question. Which of these activities were at the discretion of the board and which were operating and at the discretion of management? The only one that was likely operating in nature was spending on the purchase of property, plant and equipment. We learned that depreciation was only $7.7 million in the operating section, so spending $17 million on capex is unclear on how much of that spend was maintenance capex and how much was growth capex. You would want to ask a question to better understand the make up of this number.

The rest of this list: the acquisition of a business, the proceeds on the sale of assets and the purchase of intangibles would all be discretionary decisions made by the company. You likely had a hand in approving those decisions as an owner, executive or director of the company. Assuming the entire $17 million of capex is maintenance in nature, what is the free cash flow before debt repayment of the business? The operating cash flow is transposed above from the previous exercise for convenience. Free cash flow is operating cash flow minus maintenance capex. Free cash flow generation in 20X2 was $14 million. A substantial improvement over the negative $4 million in 20X1. The $14 million is cash available for you to allocate at your discretion. From this section, it would appear the company spent $9 million net of proceeds from divestures on acquiring other businesses, which would account for a portion of the growth we saw back on the income statement. Let’s move onto the financing section.

The final section of the cash flow statement is the financing activities. This is where it is ultimately decided what to do with the cash that was left over or if you were short, where you got the cash from. Let’s play the same game. How much discretion do you think the owners, executive, directors had with each of the items listed in this section? Um yah, likely most of these items were probably decisions of the board. The only one that looks like it might have been mandatory is the repayment of the long-term debt. If it was a mandatory repayment, this would be subtracted from free cash flow and reduce the amount of discretionary cash available for allocation.

But the rest of the items on this list were likely decisions of the owner, executive or board. The decision to swap short-term revolving credit facilities for long-term debt. The decision to repurchase equity, which likely helped our EPS numbers that we saw back in the income statement analysis. The repurchase of the convertible debentures, which was likely done to mitigate the dilution that we also saw evidence of in the diluted EPS. And finally, dividends are always a discretionary distribution to the owners approved by the directors. The net inflows/outflows is a rather temporary phenomena and not typically something anyone focuses on. Some companies hoard cash, others are very active in deploying cash. This company appears to be very active in deploying cash. In fact, it looks to be pulling on all the levers of capital allocation –from investing in new businesses, to paying down debt, to buying back equity, to paying dividends to its owners. This is a great example of all the sorts of decision that you will be confronted with in your role. As an aside, this has been one of the top performing companies on the Toronto Stock Exchange for the previous five year period.

In this brief lesson, I want to talk about the notes to the financial statements. Yes, these are the most boring and lengthy section in the financial statements.

Consider:
-The income statement is often one page.
-The balance sheet is often one page or two pages maximum.
-The statement of cash flows is a page.
-Some companies will have a separate page showing the changes in the shareholder’s equity section.

But then there are dozens of pages that follow which are the notes to the financial statements.

I can sense the collective yawn. They all start with a few notes on the accounting policies of the business. Then each section of the financial statements will have incremental disclosure that you didn’t receive on the face of the financial statements.

Most of the time, the extra disclosure won’t be of much interest; however, here is a short list of things to watch for. First of all, if Note 1 talks about going concern, as we talked about in the last lesson, take heed. This is business tinkering on the edge of oblivion. This is an example from another company, not our steel manufacturing company because it was not a going concern. You only see this disclosure if the company in question is on the brink of failure. Pause the video for a moment and read the disclosure on the screen before you. This is the sort of red flag you want to watch for.

Second, look for anything else that might cause the business to become a going concern in the future. The most common red flags include:
1.Debt maturing in the near future, which may be difficult to refinance.
2.Any off balance sheet liabilities that the company might have to fund, the most common being a deficit in a pension plan or an environmental clean up cost.
3.Watch for any large contingencies. These are disputed issues like a lawsuit or a patent violation that could result in a large financial outflow of cash if the company loses its position.
4.The very last note can be interesting because that is where you will find subsequent events. Often you are reading financial statements that are weeks, if not months old. The subsequent event note discloses any material happenings between the date of the financial statements and the date the auditors finished their work. So if the company’s plant burned down after the year end, it would disclosed here. If the bank foreclosed on a loan, it would be disclosed here. If the company lost its largest customer and that customer was material, it would be disclosed here. You get the idea.

So, while much of the notes to the financial statements may look and feel like boilerplate disclosure, keep an eye out for these sorts of nuggets.