Cash Flow Statement: Game of Cat & Mouse

March 12, 2010 at 12:46 am 6 comments

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.

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Google: The Quiet Steamroller Fishy Fuld Finances – Repo 105

6 Comments Add your own

  • 1. Kevin McFadden  |  June 23, 2010 at 9:11 am

    Hi Wade,

    I read your article before and have been concentrating on Cash Flow vs. “reported” earnings. I found it really helps. (I’m a newbie at this).

    I came across a very curious case when I was researching the parent of a spinoff. The parent HLX has earnings that are abysmal to say the least, but the cash flow is strong (heavy and decreasing CAPEX spend). From what I can tell it is a debt ladened turnaround situation. I think they are doing the opposite they are depressing reported earnings. The only reference I could find to this was from Mobius:Equities (it just so happened that I was reading the chapter at the exact time I was doing my research on DVR).

    I’ve heard reference to this as “kitchen sinking” the balance sheet – I think this reference is for a one time shot, this case seems to be prolonged.

    Any thoughts on why they would do this?
    Per Mobius – this is done to pay debt without paying taxes. This sounds reasonable, I just don’t know if this is the case.
    Additionally the CEO is buying heavily after talking down the company short term??? Possibly an “unethical” move?

    Some background for reference on HLX, they have gone through a CEO cycle. The original CEO was demoted to chairman, the new one made a large acquisition (adding the massive debt and subsequent writedown), the market crashed with the ensuing refinancing troubles, and they brought back the old CEO to fix things. From what I’ve seen of the old/present CEO, he ran the company well for years before this. P.S. If you’ve watched any of the BP mess, this is one of the companies hired to help with the spill. Search Q4000 or Helix Producer 1 if your interested in the backstory.

    Thanks, KJM

    • 2. sidoxia  |  June 23, 2010 at 5:45 pm

      Hi Kevin:

      Thanks for the comments. “Kitchen Sinking” often refers to recognizing large expenses/costs all at one time on the income statement, with the thought process being in the future you will recognize fewer expenses. By using this strategy, the assumption is profits will therefore look rosier in the future. Without doing further research on HLX it is tough for me to say whether prior expenses recognized by HLX were legitimate or overstated.

      Per the recent 10K of HLX, the company actually burned significant cash in ’07 & ’08, and another $8 mil in ’09. In Q1 of ’10 they burned another $50 million approximately. So as you alluded to in your comments, this appears to be a turnaround situation. Although the company has burned significant amounts of cash, the stock is trading at about an 18% discount to its book value on March 31, 2010 (the equity on its balance sheet). From my perspective, this is more of a balance sheet play than a cash flow play.
      Companies like HLX that operate in extremely cyclical industries are more difficult to value with cash flows, especially if they are using significant debt, so it’s important to look at mid-cycle earnings/cash flows (a so-called average) to come up with reasonable valuation estimates. Companies like HLX can have substantial price sensitivity for their services based on prices of the underlying commodities they indirectly service.

      A lot of moving parts, but I hope that helps. There is no silver bullet valuation metric for analyzing any company, but I’m a firm believer that cash flow is one of the most important ones.


  • 3. Kevin McFadden  |  June 23, 2010 at 8:13 pm

    Thanks Wade,

    Sorry I should have added this – the main writedowns were depreciation and goodwill (1B in GW in 2 yrs). It looked like paper losses with some legitimate writedowns of oil and gas properties. There were also accounting recognitions and one time events related to insurance and other misc. numbers for apx 100M. This looks like it depressed “earnings”

    The cash burn was from the development of a major oil property – they spent apx 1.5B on this property and related infrastructure and the production rig since 2006. (in addition to 2 other ships they built). It basically is time to collect on all the spending. The property is ready to produce as of a few weeks ago – but it was temporarily upended when BP contracted them to move their rig to the spill site to process the outflow. I figured the oil field will produce 250-300M per year in revenue (3-5yrs lifespan decreasing after 2yrs). In addition there are 2 other field that recently came on line. The company predicts 200M total of CAPEX spend for 2010. This should be lower on an annual basis after the projects are completed by summer. Cost of production is apx 30% of revenue and depreciation is 40% (the paper loss).

    They are an oil construction and production company that is getting rid of the oil assets – they will produce these fields and use the cash to pay the debt. I was wondering how you would look at cash flow in a situation like this? They will not be replacing reserves so I’m calculating that the depreciation of assets is really an enhanced cash conversion and just a paper loss.

    I’m guessing that the cash flow is immaterial as valuation in this case (as it is a situation that won’t sustain) and as you said it should be treated as an asset play, looking at the assets more like a timed payment like a bond.

    Someone sent me the Raymond James report – they have FCF at 450M for 2010+2011 and ValueLine has CF at 6.20 per share for the same period. I’m guessing this should just be added back as cash (or more “correctly”paid debt).

    I thinking that I should have picked an easier one to start with, ha ha.

    Thanks again, KJM

    • 4. sidoxia  |  June 25, 2010 at 12:34 am


      Glad to see you are doing your homework! You are right about HLX…it sounds like there are a lot of balls up in the air. From my experience these small/midcap energy production-service companies are quite volatile and speculative. If you invest in this company, you are likely to make a lot of money or lose a lot of money (likely not in between).

      Having said that, if you can gain comfort and conviction in a $450m FCF number for next year, then you are likely to do quite well in this stock. The price of crude will obviously also have something to do with the cash flow realized as well. That is another difficult aspect of the HLX story to forecast.

      If I were you, I would keep researching the company and digging through the financial models in hopes of better understanding the cash flow dynamics to unfold in the next 12-24 months. The more you research, the better you will be prepared to deal with upcoming volatility.

      Regardless, I like your ambition. Keep up the good work….Wade

  • […] and cash flow statement – those that have followed me know the extreme importance I place on the cash flows of a business. In general a good start is to create common size financial statements for the income statement […]

  • 6. Kevin McFadden  |  June 26, 2010 at 6:15 pm

    Thanks again Wade,

    I wasn’t to worried about the cash flow too much they are hedged apx 60% at $75 bbl. (FCF was for 2010 and 2011 though) Of course without production for the one field they may be over hedged, I have no idea what that entails. I figure that they must have something worked out with BP if that happens.

    Surprisingly enough, my biggest concern isn’t the debt, it was dilution. There are a lot of covenants, and I haven’t quite deciphered all of the language yet. (possibility of over 10% when the stock hits ~38, not a large concern yet – haha).

    I’ve actually researched this for a while (months) – I was following Pabrai’s advice of diving in to a stock when you find something interesting. My “something” was footnote 16 on the 2009 10K.

    I guess the market is either crazy as usual or I’m in over my head. I guess I had to find out someway – a learning experience either way. If I lose on it, I’ll just chalk it up to “tuition” in the value investing school.

    In case your interested, I recently watched a video and haven’t seen one much better. I don’t know if your familiar with Li Lu, he is the guy Bruce Greenwald uses to invest, he has some interesting comments regarding Chinese stocks.

    The link is at the bottom of the page – from “Schloss Archives for Value Investing” at Columbia Business School. (it’s a whole class, apx 3 hrs – just in case you ever get bored).

    Thanks again for everything,


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