Lesson 4 of 10
The cash flow statement
The three sections, why the first starts from profit rather than cash, and two ways cash flow can look better than the business did.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The operating section is a reconciliation: a line-by-line account, written by the company, of every reason profit and cash disagreed this year.
- Costs that took no cash are added back, and changes in working capital are then adjusted, in either direction.
- Paying staff partly in stock lifts operating cash flow above earnings, though the cost is still real: it is paid in shares.
A cash flow statement shows where the cash came from and where it went, in three sections. The first is a line-by-line account, written by the company, of why profit and cash differed.
How share-based pay lifts operating cash flow above profit
- Net income$100
- Depreciation+$15
- Share-based compensation+$20
- Increase in receivables−$15
- Operating cash flow= $120
The three sections
Operating is the cash the business itself generated or consumed. Investing is what was spent on or received from long-lived assets: capital expenditure, acquisitions, disposals. Financing is cash exchanged with funders: debt drawn and repaid, shares issued and repurchased, dividends paid. The three, plus a line for exchange-rate effects where there is foreign cash, sum to the net change in cash, restricted cash included. That change, plus opening cash, equals the cash on the balance sheet.
Why it starts at profit
Costs that took no cash are added back first, depreciation usually the largest, because the cash left when the asset was bought. Working capital is then adjusted: a rise in receivables is subtracted, because revenue was recognised and not yet collected, and a rise in payables is added, because a cost was recognised and not yet paid. Sloan's 1996 study found that the accrual part of earnings, the middle of this reconciliation, is less persistent, less likely to recur the next year, than the cash part, and that prices behaved as though investors did not tell the two apart.
Share-based pay adds back what it also costs
ASC 718 makes share-based compensation an expense on the income statement and a non-cash add-back here. It reduces earnings and does not reduce operating cash flow. So a company that pays part of its wages in stock reports higher operating cash flow than an identical company paying entirely in cash. The reason has nothing to do with running the business better.
Two ways cash flow flatters
Operating cash flow is harder to move than profit, not impossible. Stretching payments to suppliers raises it once, in the year the terms lengthen, and the boost stops when the new terms become normal. Not replacing assets leaves operating cash flow untouched, because capital expenditure sits in investing. The figure looks healthy while capacity quietly falls, and free cash flow looks better than it is. Buffett's 1986 appendix on owner earnings subtracts the capital expenditure a business requires to hold its competitive position and unit volume, not what it happened to spend. So skimping on replacement does not flatter it.
Check yourself
Two identical companies report the same net income. One pays part of its wages in newly issued stock. What happens to its operating cash flow?
- It is unaffected
- It is higher than the company paying entirely in cash
- It is lower
Show the answer
Answer: B.
Share-based compensation is a non-cash add-back, so the cash that would have paid wages stays in the business and operating cash flow reads higher, even though the cost was real and borne by shareholders through more shares outstanding.A company's operating cash flow rises sharply for one year because it stretched payments to suppliers. What should a reader expect?
- The gain repeats automatically every year
- The gain is a timing effect that stops once the new terms become normal
- It signals higher earning power going forward
Show the answer
Answer: B.
Paying suppliers more slowly is a one-time timing shift. Once the new terms are steady, the cash flow benefit does not recur.Sloan's 1996 study found which part of earnings is less likely to recur the next year?
- The cash component
- The accrual component
- Both are equally reliable
Show the answer
Answer: B.
Sloan found that the accrual component of earnings, the non-cash adjustments and working-capital changes between profit and cash, is less persistent than the cash component, and that stock prices did not fully reflect the difference.Sources
- Sloan, The Accounting Review, 1996, on the accrual anomaly.
- Berkshire Hathaway shareholder letter, 1986, appendix on owner earnings.
- ASC 718, Compensation, Stock Compensation.
What this leaves out
- Financial companies present a cash flow statement whose operating section includes movements that would be investing or financing for anyone else, and these readings do not transfer.
- Almost every US filer uses the indirect method described here. The direct method is rare, and where it appears, a reconciliation like this one is provided separately.
- The statement says nothing about whether the cash generated was worth generating. That comparison needs a cost of capital this lesson does not supply.
- The worked examples use round invented numbers so the arithmetic can be checked by hand. Nothing here is advice about any security.