This is one of a series of articles, Covering Financials, focused on financial accounting disclosures and how you as a journalist can interpret and report on them. The first four articles (see related links) introduce the financial accounting concepts utilized in this and future articles.If you have a topic you are interested in, post your request in the comments or email me at firstname.lastname@example.org.
Earnings Contrasted with Cash Flows
Rather obviously, the Statement of Income measures net income while the Statement of Cash Flows measures cash flows. Net income represents the flow of wealth to an entity and consists of revenue, gains, expenses and losses. Importantly, these two flows occur at different times. Airlines collect cash when they sell tickets to customers, but do not earn wealth (record sales revenue and earnings on the income statement) until perhaps months later, when customers fly. Cash flow precedes wealth flow in these instances. Other entities sell goods and services to customers (thus recording sales revenue and earnings on the income statement) but then do not collect cash from these customers until months later. Wealth flow precedes cash flow in these instances. Amazon’s suppliers, for example, sell goods to Amazon and Amazon pays for those goods several months later. Automobile manufacturers will readily sell you a car today and finance it over the next three to five years. Sales revenue and net income are recorded today, when you buy the car, but cash flows occur over the next three to five years. Boeing collects cash as a deposit long before it builds an airplane for a customer. Its earnings and cash flows from selling the plane may occur several years apart.
Because of income versus cash flow timing differences, many astute investors compare and contrast earnings and operating cash flows, paying particular attention to the differences between the two flows. These differences, and change in the differences, often signal changes in business operations that can help you identify interesting topics to investigate. For example, a firm may record sales revenue and earnings. However, an astute investor may realize weak and untimely cash flow from customers, thereby signaling weakening demand for a product or aggressive sales to customers less able to pay. We’ll explore examples in future articles.
Structure of the Statement of Cash Flows (SCF)
Exhibit 1 illustrates a simple SCF. Two styles of presentation exist: the ‘direct method’ and the ‘indirect method.’ We’ll focus mostly on the indirect method since almost all U.S., Canadian and European firms use this method versus the direct method used primarily by Chinese, Australian and New Zealand based entities. Referring to Exhibit 1, the structure of the indirect SCF is:
- It reconciles cash from the beginning to the end of the accounting period. That is, it accounts for all changes in cash as either cash inflows or cash outflows. At the bottom of Exhibit 1 you can see that the beginning cash is $20, the change in cash is $124 and ending cash is $144.
- Cash flows are organized into three categories: Operating, Investing and Financing. Many investors like to frame their financial statement analyses into these three categories.
Those new to the SCF almost always struggle to understand the operating section presentation. The investing and financing sections are easier to understand, so let’s discuss them first.
- The investing section line items list cash spent and cash received from investment activities. Frequently these activities are purchases and sales of property, plant and equipment (PPE) and purchases and sales of longer-term bond or equity investments. Short-term bond or equity investments are typically classified as part of an entity’s operations. Overall, each line item is either the amount of cash received or the amount of cash spent. XYZ, Inc. sold property, receiving $22 in cash and bought equipment, paying $33. The $33 may not be the total purchase price of the equipment, only the amount paid in cash. XYZ, Inc. may have financed the remainder. XYZ, Inc. didn’t purchase, or sell, any bond or equity investments during 2015.
- Like the investing section of the SCF, the financing section lists cash received or cash paid for each item. XYZ, Inc. paid $10 in dividends, for example. It received cash of $100 from issuing a bond.
- The difficulty with the SCF is interpreting the operating section. Unlike the investing or financing sections, it doesn’t list cash received, or cash paid, for each item. Instead, it reconciles Net Income to Cash from Operations, presumably to make it easier for investors to compare and contrast the income statement and cash flow statement, (although many investors disagree with this presumption). Since each line item is a reconciling item between net income and cash paid or received, line items are not cash flows. This presentation style is why many investors struggle to understand the SCF. Simply put, the operating section of the SCF doesn’t list cash flows. Let’s explore an intuitive example. First notice that XYZ, Inc. in Exhibit 1 generated net income of $25 during 2015, but generated $45 in cash from its operations. Recall that the timing of income flow and cash flows varies.
The Intuition of the SCF Operating Section
Briefly study Exhibits 2, 3 and 4 which are simplified to help us understand intuitively how the SCF operating section is presented. Exhibit 2 presents a stylized SCF operating section. Note that Net Income is $5 and Cash from Operations is $0. There is a reconciling item, Increase in Accounts Receivable, of minus $5. Exhibit 3 presents the matching statement of income. It shows $5 of Sales Revenue. Since there were no other revenues, gains, expenses or losses in this simplified example, net income is also $5. How do we interpret the income statement? The entity sold goods at a sales price of $5 and the Sales Revenue represents the wealth inflow from doing so. Now look at Exhibit 4, a partial balance sheet. It shows an asset, Accounts Receivable, of $5 at the end of this year and $0 at the end of last year. The change is an increase of $5. The receivable is an asset and represents sales to customers where the customers have yet to pay. When a customer owes Widget, Inc. money it is an asset.
With Exhibits 2, 3 and 4, we can interpret the SCF operating section. Referring to Exhibit 2, the entity earned $5 of net income. Net income represents net wealth to the firm as accountants measure it using Generally Accepted Accounting Principles (GAAP). But cash from operations is $0 because the $5 in wealth (net income) wasn’t collected yet. Therefore, the SCF subtracts the increase in Accounts Receivable. Since the cash from the $5 sale wasn’t collected yet, Accounts Receivable increased by $5 from $0 to $5. At year end, the entity is owed $5 from its customers.
Just to check your understanding, does it make sense to you that if Widget’s only activity next year is to collect the $5 of cash from customers, Widget’s 2016 SCF will look like Exhibit 5?
This post provides a short introduction to a difficult topic. In future posts, we’ll explore specific company examples and use them to better understand the statement of cash flows by comparing and contrasting cash flows with wealth flows shown on the income statement.
Steven Orpurt is a professor teaching corporate governance and sustainability in the W.P. Carey School of Business at Arizona State University.