Cash Flow Statement: Game of Cat & Mouse
Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.
Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.
Beware of the Income Statement Cheaters
Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:
- Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
- Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
- Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.
There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.
Cash Flow Statement to the Rescue
Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.
Financial Birth Certificate
As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).
The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis - especially reviewing the cash flow statement - investors (like cats) can more slyly evaluate the financial path of target companies (mice). Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Entry filed under: Accounting, Education. Tags: Accounting, balance sheet, cash flow statement, financial analysis, financial statements, free cash flow, GAAP, income statement, investing, security analysis.