The Statement of Cash Flows

Here is the statement of cash flows for Clayton Homes.  It was found in the annual report for 1999.

As was discussed earlier, accountants have a certain amount of leeway with the components of earnings.  Some people have problems with the somewhat subjective nature of the accrual principle in accounting.  These people would rather see the sources of cash.  The Statement of Cash Flows helps them.

There are two ways to develop a statement of cash flows: direct and indirect.  In the direct method, all changes in cash are shown.  In the indirect method, the work of the accountants has to be undone and sources of cash determined indirectly.  The statement of cash flows is a little trickier in some respects than those discussed already.  I’ll talk about this statement in general terms.

Clearly, the long term survivability of a company will be in jeopardy if it cannot generate cash.  Many small businesses go under, not because of financing, but because of cash flow.  Companies do not have cash on hand to cover their bills.  There are many companies that “factor” receivables.  They lend money to the company based on the value of the receivables.  As you might imagine, the interest rates sometimes charged might make a credit card company blush.

Examining cash flow puts companies on an even footing.  If a company decides to lease rather than buy—that is, have leasing expenses rather than a fixed schedule of depreciation—examining cash flow can negate these accounting choices.  As mentioned earlier, the statement of cash flow might be regarded as “undoing” an accountant’s work.

Statement of Cash Flows for Clayton Homes for Fiscal Year 1999

Cash Flow from Operations 

Cash flow from operations  sounds self-explanatory and it is.  Cash flow from operations measures the ability of the company to generate cash from its operations!  Generating revenues and paying expenses.

As discussed, accountants have leeway when it comes to recognizing revenues and expenses, so earnings are consequently affected.  The goal of a cash flow analysis on operations is to undo the accrual approach—easier said than done!

The analysis starts with net income.  Remember net income (earnings) is the “bottom line” of the income statement.  We’ve now seen earnings in one form or another appear in each of the three statements so far examined.  (What’s the betting you’ll see earnings again when we hit the statement of shareholders equity?  Anyone say 100%?)  So, we start with net income—earnings—and start adding things back.

Depreciation is not a cash item.  Think about it, does depreciation, or for that matter amortization have any affect on cash?  None at all.  Depreciation is a noncash expense.  You pay for an asset, but you don’t pay out anything at all when that asset is depreciated.  Adding depreciation back in brings you closer to what the cash from operations might be.

Remember that we are concentrating on operations, so if there are any losses (or gains), things that didn’t derive from operations, these get added (or subtracted) back in.  In the Clayton Homes case, there was a gain from a sale—cash generated from something that isn’t at the core of what CMH is all about.  This gain is added right back in.

We talked earlier about an allowance for doubtful accounts—a guess at the percentage of your customers that are deadbeats!  Certain provisions for bad times reduce earnings.  Adding them back in—they’re not cash events—brings you closer to where the money is!

Notice, that we are scouring the balance sheet and income statement for items that affect cash.  Deferred income taxes do.  We’ll talk about them later.; check the index if you want to bounce to them right now.  It’s an expense but a noncash expense, so whoosh, it’s added back in.

There are some changes in accounts on the balance sheet (receivables, payables and inventories) that are non cash.  You compare the level year over year and if it changes you add (or subtract) the difference right back in.  What you’re doing is adjusting for the major changes in working capital—the money required to keep the business going from day to day.  The last three items are changes in working capital..  We’ll look at receivable, payables and inventories later.

The sum of these adjustments gives the cash provided by operations—that’s $66.15 million.  This number is lower than net income—but we haven’t finished just yet.  Clayton Homes has three other entries found in their industry.  These adjustments must be made to get net cash flow provided by operations.  This figure is now $91.72 million.

Cash Flow from Investing Activities 

Cash flow from investing activities follows next.  A company requires assets to run a business.  This part of the cash flow statement reports activities associated with such investments.  When you look at “old economy” businesses, you’ll see lots of hard assets—machines etc.  Nude economy business—whoops, I mean new economy business won’t have these sorts of assets.  You see a company like Clayton Homes which is also in financial services has hints of cash in this area.

The purchase of an asset or an investment uses up cash.  If cash is consumed, the change is negative—in parentheses.  If a company sells an asset—or in the case of Clayton Homes sells a receivable—this sale is a source of cash—a positive change.  Clayton has positive cash flow from investing activities.  In some capital intensive industries this number can be negative.  It’s negative because the company made some type of long-term investment in its asset base.  Clayton has generated cash through the sale of some assets

Cash Flow from Financing Activities 

Cash flow from financing activities is the last section in the statement.  Broadly speaking, you can view the cash flow from operations as “what went on in the income statement.”  Cash flow from investing certainly has a balance sheet sort of focus!  While cash flow from financing will seem to lean towards the statement of shareholders equity.  Of course, you know by now that each section of this statement looks at more than one other financial report.

Cash from financing looks at things like dividends (which use cash) and cash use to repurchase (or sell) stock.  The statement also examines the financing of other activities.  If the company issued some long term debt, the cash position of the company would be increased.  Clayton Homes retired debt—it used up cash in the process.  The company issued shares of stock, generating $3.6 million in cash.  It also repurchased a lot of stock, using up $81.4 million.  Later, you’ll see that when a company buys back its own shares, these shares are “put in limbo”!  When it comes to calculating EPS, only issued shares are considered.  (The issue of diluted EPS is discussed in appendix 3).

Clayton Homes has increased its overall cash position from $1.7 million last year to $2.68 million currently: an increase of $949,000.  It’s important for a company to have positive cash flow if it is to survive.

Now, we’ve looked at cash flow, so what?  Many people like to see cash flow per share (EBIT per share or EBITDA per share—that’s earnings before interest, taxes, depreciation and amortization).  Others like a flavor of cash flow not introduced here—free cash flow.  For free cash flow changes in “net working capital” are added back in.  For me the take home message is simple.  If earnings are bad, I don’t want to hear excuses.

I am reminded of a movie like Grease!  Imagine girls getting together after one of them went on a date.  They ask “was he . . .?” “did he . . .?” “was he . . .?” to each question the Olivia Newton John squirms even more and more saying “well no.”  At the very end, to defend herself, the ultimate zinger: “He has a great personality!”  To me cash flow is the personality of a company.  If you can’t say something good about earnings—let’s try cash flow.

Now, I am being a little disingenuous here—far too dismissive of cash flow.  But GAAP has a certain amount of wiggle room.  If accountants can’t make legitimate use of GAAP to present the company—through its earnings—in the best light, then perhaps its just not a great company!