CASH FLOWS AND THE STATEMENT OF CASH FLOWS Prior to the adoption of the statement of cash ﬂows, the information

regarding cash flows was quite limited. The first statement that addressed the issue of cash flows was the statement of financial position,

which was required starting in 1971. 3 This statement was quite limited, requiring an analysis of the sources and uses of funds in a variety of for- mats. In its earlier years of adoption, most companies provided this information using what is referred to as the working capital concept—a presentation of working capital provided and applied during the period. Over time, many companies began presenting this information using the cash concept, which is a most detailed presentation of the cash ﬂows provided by operations, investing, and ﬁnancing activities. 4

Consistent with the cash concept format of the funds flow statement, the statement of cash flows is now a required financial statement. The requirement that companies provide a statement of cash flows

applies to ﬁscal years after 1987. 5 As discussed in Chapter 2, this state- 2 For a more detailed discussion of the EBITDA measure, see Kent Eastman, “EBIT-

DA: An Overrated Tool for Cash Flow Analysis,” Commercial Lending Review (Spring 1997) p. 64.

3 APB Opinion No. 19, “Reporting Changes in Financial Position,” AICPA (New York: 1971). Prior to this APB, APB Opinion No. 3, “The Statement of Source and

Application of Funds,” AICPA (New York: 1963) encouraged, but did not require, companies to report a information regarding the changes in cash over a period (referred to as the flow of funds).

4 This change in format generally followed the recommendations of the Financial Ex- ecutives Institute and the Financial Accounting Standards Board recommendations

[ FASB Discussion Memorandum, “Conceptual Framework for Accounting and Re- porting” (Stamford: Financial Accounting Standards Board, 1974)].

5 Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows” (Stamford: Financial Accounting Standards Board, 1987).

FINANCIAL STATEMENT ANALYSIS

ment requires the company to classify cash flows into three categories, based on the activity: operating, investing, and financing. Cash flows are summarized by activity and within activity by type (e.g., asset disposi- tions are reported separately from asset acquisitions).

The reporting company may report the cash flows from operating activities on the statement of cash flows using either the direct method— reporting all cash inflows and outflows—or the indirect method—starting with net income and making adjustments for depreciation and other noncash expenses and for changes in working capital accounts. Though the direct method is recommended, it is also the most burdensome for the reporting company to prepare. Most companies report cash flows from operations using the indirect method. The indirect method has the advantage of providing the financial statement user with a reconciliation of the company’s net income with the change in cash. The indirect method produces a cash flow from operations that is similar to the estimated cash flow measure discussed previously, yet it encompasses the changes in working capital accounts that the simple measure does not. For example, Procter & Gamble’s cash flow from operating activities (taken from their 2002 statement of cash flows) is $7,742 million, which is over $1 billion more than the cash flow that we estimated earlier. 6

The classification of cash flows into the three types of activities pro- vides useful information that can be used by the analyst to see, for example, whether the company is generating sufficient cash flows from operations to sustain its current rate of growth. However, the classification of particular items is not necessarily as useful as it could be. Con- sider some of the classifications:

■ Cash flows related to interest expense are classified in operations, though they are clearly financing cash flows. ■ Income taxes are classified as operating cash flows, though taxes are affected by financing (e.g., deduction for interest expense paid on debt) and investment activities (e.g., the reduction of taxes from tax credits on investment activities).

■ Interest income and dividends received are classified as operating cash flows, though these flows are a result of investment activities.

Whether these items have a signiﬁcant affect on the analysis depends on the particular company’s situation. Procter & Gamble, for example, has very little interest and dividend income, and its interest expense of $603 million is not large relative to its earnings before interest and taxes ($6,986 million). Adjusting P&G’s cash ﬂows for the interest expense

6 Procter & Gamble’s fiscal year ends June 30, 2002.

Cash Flow Analysis

only (and related taxes) changes the complexion of its cash flows slightly to reflect greater cash flow generation from operations and less cash flow reliance on financing activities: 7

(In millions) As Reported As Adjusted

Cash ﬂow from operations

$8,134 Cash ﬂow for investing activities

(6,835) Cash ﬂow from (for) ﬁnancing activities

(195) Source: Source: Procter & Gamble 2002 Annual Report

For other companies, however, this adjustment may provide a less flattering view of cash flows. Consider Amazon.com’s fiscal year results. Interest expense to financing, along with their respective estimated tax effects, results in more reliance on cash flow from financing: 8

(In millions) As Reported As Adjusted

Cash ﬂow from operations

$(30) Cash ﬂow for investing activities

(253) Cash ﬂow from ﬁnancing activities

17 Source: Amazon.com 2001 10-K

Looking at the relation among the three cash flows in the statement gives the analyst a sense of the activities of the company. A young, fast growing company may have negative cash flows from operations, yet positive cash flows from financing activities (i.e., operations may be financed to a large part with external financing). As a company grows, it may rely to a lesser extent on external financing. The typical, mature company generates cash from operations and reinvests part or all of it back into the company. Therefore, cash flow related to operations is positive (i.e., a source of cash) and cash flow related to investing activities is negative (i.e., a use of cash). As a company matures, it may seek less financing externally and may even use cash to reduce its reliance on external financing (e.g., repay debts). We can classify companies on the basis of the pattern of their sources of cash flows, as shown in Exhibit

24.1. Though additional information is required to assess a company’s 7 The adjustment is for $603 million of interest and other financing costs, less its tax

shield (the amount that the tax bill is reduced by the interest deduction) of $211 (estimated from the average tax rate of 35% of $603): adjustment = $603 (1 − 0.35) = $392.

8 The adjustment is based on interest expense of $139 million, and a tax rate of 35%.

FINANCIAL STATEMENT ANALYSIS

financial performance and condition, examination of the sources of cash flows, especially over time, gives us a general idea of the company’s operations. P&G’s cash flow pattern is consistent with that of a mature company, whereas Amazon.com’s cash flows are consistent with those of a fast growing company that is reliant on outside funds for growth.

Martin Fridson suggests reformatting the statement of cash flows as shown in Exhibit 24.2. 9 From the basic cash flow, the nondiscretionary cash needs are subtracted resulting in a cash flow referred to as discretionary cash flow. By restructuring the statement of cash flows in this way, the analyst can see how much flexibility the company has when it must make business decisions that may adversely impact the long-run financial health of the enterprise.

For example, consider a company with a basic cash flow of $800 million and operating cash flow of $500 million. Suppose that this company pays dividends of $130 million and that its capital expenditure is $300 million. Then the discretionary cash flow for this company is $200 million found by subtracting the $300 million capital expenditure from the operating cash flow of $500 million. This means that even after maintaining a dividend payment of $130 million, its cash flow is positive. Notice that asset sales and other investing activity are not needed to generate cash to meet the dividend payments because in Exhibit 24.2 these items are subtracted after accounting for the dividend payments. In fact, if this company planned to increase its capital expenditures, an analyst can use the format in Exhibit 24.2 to assess how much that expansion can be before affecting dividends and/or increasing financing needs.

EXHIBIT 24.1 Patterns of Sources of Cash Flows

Financing Growth Externally Financing

Financial Financial

Cash Flow Internally Internally Mature Downturn Distress Downsizing

9 Martin S. Fridson, Financial Statement Analysis: A Practitioner’s Guide (New York: John Wiley & Sons, 1995).

Cash Flow Analysis

EXHIBIT 24.2 Suggested Reformatting of Cash Flow Statement to Analyze a

Company’s Flexibility

Basic cash flow Less: Increase in adjusted working capital Operating cash flow Less: Capital expenditures Discretionary cash flow Less: Dividends Less: Asset sales and other investing activities

Cash flow before financing Less: Net (increase) in long-term debt Less: Net (increase) in notes payable Less: Net purchase of company’s common stock Less: Miscellaneous

Cash flow Notes:

1. The basic cash flow includes net earnings, depreciation, and deferred income taxes, less items in net income not providing cash. 2. The increase in adjusted working capital excludes cash and payables. Source: This format was suggested by Martin S. Fridson, Financial Statement Analysis: A Practitioner’s Guide (New York: John Wiley & Sons, 1995).

Though we can classify a company based on the sources and uses of cash flows, more data are needed to put this information in perspective. What is the trend in the sources and uses of cash flows? What market, industry, or company-specific events affect the company’s cash flows? How does the company being analyzed compare with other companies in the same industry in terms of the sources and uses of funds?

Let’s take a closer look at the incremental information provided by cash ﬂows. Consider Wal-Mart Stores, Inc., which had growing sales and net income from 1988 to 2001, as summarized in Exhibit 24.3. We see that net income grew each year, with the exception of 1995, and that sales grew each year.

We get additional information by looking at the cash flows and their sources, as graphed in Exhibit 24.4. We see that the growth in Wal-Mart was supported by both internally generated funds and, to a lesser extent, through external financing. Wal-Mart’s pattern of cash flows suggests that Wal-Mart is a mature company that has become less reliant on external financing, funding most of its growth in recent years (with the exception of 1999) with internally generated funds.

FINANCIAL STATEMENT ANALYSIS

EXHIBIT 24.3 Wal-Mart Stores, Inc., Net Income and Sales, 1988–2001

Source: Wal-Mart Stores, Inc., Annual Report, various years EXHIBIT 24.4 Wal-Mart Stores, Inc., Sources of Cash Flow, 1988–2001

Source: Wal-Mart Stores, Inc., Annual Report, various years

Cash Flow Analysis

CASH FLOWS AND THE STATEMENT OF CASH FLOWS Prior to the adoption of the statement of cash ﬂows, the information