DECEMBER 2002

Statement of Cash Flows

Understanding Income Statements, Balance Sheets and Cash Flow Statements

by Diane Graese

Learn how to use an annual report's financial statements in this workshop. Diane Graese describes how to use the balance sheet, income statement, cash flow statement, and MD&A (Management Discussion and Analysis.)

The workshop uses the 1998 Diebold, Inc. online annual report as an example. You may review the complete report online if you would like to prepare for the discussion that follows.

Introduction

Welcome to the Better Investing School Financial Statements Workshop. The workshop consists of four individual sessions.

Session #1 presented a brief history of financial statements and Generally Accepted Accounting Principles (GAAP). Session #2 covered the Balance Sheet. Session #3 discussed the Income Statement. This session will cover the Statement of Cash Flow.

Workshop Resources

The workshop uses the 1998 Diebold, Inc. online annual report as an example. We thank Diebold for permission to duplicate selected financial statements for workshop illustrations. The four annual report sections for this workshop are:

• MD&A - Management's Discussion and Analysis of Financial Condition and Results of Operations
• Balance Sheet (Consolidated Balance Sheet)
• Income Statement (Consolidated Income Statement)
• Cash Flows (Consolidated Statement of Cash Flows)

I will cite information in the illustrations as the workshop progresses. Selected lines on the financial statements have been highlighted in yellow to identify references used in the workshop sessions. Similarly, text in the MD&A illustration in a bold blue font identifies material referred to in the workshop.

Please note that the workshop illustrations taken from the Diebold annual report present dollars in thousands except per share amounts. However the text of the workshop sessions will present dollars in their full unit value i.e. $42,540,000 rather than $42,540 as in the financial statement illustration.

Statement of Cash Flows - An Introduction

Some History

Why is it you haven't heard more about the Statement of Cash Flow? Because, it is a very recent invention. It has only been a required financial statement in its current form since 1988.

The statement of cash flow is an outgrowth of statements first required in the 1960s and refined in the 1970s. The goal was an explanation of changes in balance sheet accounts which were not the result of transactions recorded in the income statement. Early versions used terms like Funds, Resources, and Working Capital.

The New Math?

It was also during this period that new theories of finance like discounted cash flow were being popularized. Leveraged buyouts were the rage. Michael Millken spread the virtues of junk debt financing which relied heavily on the cash which could be generated from operations. For these technical financial wizards, earnings no longer mattered.

New transactions forced accountants to issue rules at a fast and furious pace. The new accounting rules often involved calculations which moved revenues and expenses away from cash equivalency.

A dollar of revenue no longer implied an immediate dollar of cash. Thus, the QUALITY of earnings became a concern.

Earnings which correlate with cash are high quality earnings. Earnings which do not correlate require analysis.

The Statement of Cash Flow (SCF)

The SCF requires all monetary transactions of a business to be presented in one of three categories: operations, investing, or financing.

The SCF normally begins with NET INCOME as presented in the Income Statement and ends with CASH as presented on the Balance Sheet. Thus, this statement is said to bridge the other two financial statements.

The Big Picture

When I read the SCF, I perform three quick tests. Follow along with the Diebold statement of cash flow.

1. Did CASH increase or decrease during the period? The answer sets the focus of the rest of the review. If cash increased, I'm happy and can be less critical. If cash decreased, I want to know why. Diebold's cash increased $22,244,000 in 1998.

2. I also check the balance sheet to see if the company has current marketable securities which are often temporary investments of cash. I combine securities and cash to compare with the similar balance in the prior year. If this year is higher than last year, I'm happy. If this year is lower, temporary securities were sold to raise cash. Now I need to find out why.

On Diebold's balance sheet, the 1998 sum of Cash and cash equivalents ($42,540,000) plus Short-term investments ($37,433,000) equals $79,973,000. This is an increase of $23,204,000 over the comparable data for 1997. This is good news.

3. Back to the SCF. I compare NET INCOME to NET CASH PROVIDED BY OPERATING ACTIVITIES (CFO). CFO is the first subtotal in the statement. If CFO is approximately equal to or greater than net income, I'm happy. For the three years presented, Diebold's CFO fits this picture.

Positive answers to these three questions make me happy -- I like this picture. Negative answers force me to look for explanations. If cash didn't increase, it is either because it was spent or revenues weren't collected.

Investing Activities - Part One

This section of the Statement of Cash Flow shows cash spent on long-term investments and received from the sale of non-operating assets. Acquiring companies and purchasing fixed assets are typical INVESTING activities.

A manufacturer cannot increase sales volume without sufficient plant capacity to produce product. Look at the three year trend of capital expenditures. Is it increasing, decreasing or staying about the same? Large differences in spending levels will be discussed in the Management's Discussion and Analysis (MD&A).

Diebold has capital expenditures slightly over $30,000,000 in both 1998 and 1996. In 1997, expenditures were almost double at $67,722,000. Read MD&A to find out why.

Investing Activities - Part Two

If this statement section includes a line for Proceeds from Sales, it quickly highlights changes in the business or company assets. These changes may influence your estimates of future revenue and earnings growth.

It is also a clue to look for gains or losses in the income statement which you many want to treat as unusual. The amounts may not be on a separate income statement line, but you can read MD&A to find them.

If an acquisition has occurred, you may need to revise your estimates of future revenues and earnings. At a minimum, you will want to determine how the company paid for the purchase.

Financing Activities

This SCF section shows transactions between the company and its lenders and owners. It shows debt issuances and repayment, stock issuances and repurchases, and dividends paid to shareholders.

Reducing debt, repurchasing shares or paying dividends are good reasons to spend cash. Increasing cash by issuing stock or debt begs the question WHY. It is either to finance an investment or raise funds for operations.

The answer can be found in Management's Discussion and Analysis (MD&A): Financial Condition. As you gain more experience, you will often be able to see the reason right away on this statement.

Over the three years presented, Diebold's primary financing activity is payment of dividends. The $20,800,000 Proceeds from long-term borrowings in 1997 is the issuance of bonds to pay for the three new plants included in capital expenditures in the same year.

Operating Activities - The Big Picture

Operating activities are the primary business of the company. Recall that I pursue detailed examination of this SCF section only when Cash from Operating Activities (CFO) is negative or significantly less than Net Income.

The details are often not as significant as the cash flow trend for the three years presented. In any one year there could be numerous reasons for negative CFO. It may be easiest to call Investor Relations and ask for the reasons.

Continuing CFO which is negative or less than net income will constrain growth. In that case, growth will only be achieved through the issuance of additional debt or equity.

Note that Diebold generates significant cash from operations so I don't need to explore the fine print -- I already like this picture.

The Details

Since many companies do not provide such a pretty picture, I will point out a few highlights of the detail in this section.

This statement section might be more easily understood if it were presented in the DIRECT method (an allowable, but infrequently used option under Generally Accepted Accounting Principles.)

The statement would begin:

Cash collected on account of sales (no matter when they were recorded as revenue.)

Cash paid to purchase inventory (no matter whether or not it was sold.)

But this wouldn't correlate earnings to cash. Therefore, most companies use the INDIRECT method which starts the statement with Net Income. ADJUSTMENTS then convert net income to cash provided or used. The key to understanding the detail in this section is to remember you are looking at adjustments.

Non-Operating Transactions

This section of the SCF presents cash from OPERATIONS. Anything not related to operations has to be adjusted -- eliminated and presented elsewhere.

Gains from the sale of a division or long-term asset are subtracted from net income and losses are added back to arrive at CFO. The proceeds from sale will appear in the statement section on investing activities.

Non-Cash Transactions

This section of the SCF presents CASH from operations. Anything which is non-cash must be adjusted. DEPRECIATION is the most common non-cash expense. It is an allocation of a portion of the cost of fixed assets used to generate revenue. (Cash was used when the fixed assets were purchased -- an investing activity.)

Other accounting rules require a portion of the purchase price of certain assets (such as goodwill which was discussed in Session #3) to be AMORTIZED -- recognized in the income statement over a period of time.

Both depreciation and amortization expenses are added back to net income to arrive at CFO.

This section of the SCF also adjusts for OPERATING increases and decreases in the value of current assets and liabilities. One cannot simply assume it is the difference between the balances presented on the balance sheet. The change in value as a result of acquisitions, dispositions, foreign exchange rates, and other non-operating transactions will be presented in other statement sections.

When CFO is negative, watch for receivables and inventory which are increasing significantly faster than sales. This is common for many growing companies but it can also be a sign of future trouble.

Financial Statements - Conclusion

The Statement of Cash Flow can be used to analyze the QUALITY of earnings. It also explains how business growth is being financed.

Financial statements are useful tools. They often represent a starting point for analysis rather than an end in themselves. I use financial statements to confirm my assessments of the information presented in the summarized detail I use to prepare my Stock Selection Guides. Reading management's discussion and analysis makes me feel more confident in my judgments. This concludes our session on using Financial Statements to form judgments during our stock studies.

Diane Graese

Session # 4 - Questions and Answers

Zeydy Ortiz: This workshop is giving me a better understanding of the financial statements. It is fascinating to me to learn the history behind them. I have some questions about the statement of cash flows. I am not sure how to use this statement in my evaluation of a company. How can changes in the cash flows "influence your estimates of future revenue and earnings growth?"

Diane: The exact quote is: "If this statement section includes a line for Proceeds from Sales, it quickly highlights changes in the business or company assets. These changes may influence your estimates of future revenue and earnings growth."

The relevant point is that the company has sold a revenue producing asset. This asset no longer exists. If it was a division of the business, the revenues and earnings (or losses) from this division will no longer exist in the future. If the division was a money-loser, this could be good news for future earnings. If it was a money-maker, you will have to remove those earnings from your future estimates. In either case, future revenues will be lower without a new revenue source.

Current year earnings will likely have some profits or losses from the sale. You may need to adjust current year earnings figures. You don't want to project future earnings growth off a figure which includes a one-time sale.

Zeydy: "Earnings which correlate with cash are high quality earnings. Earnings which do not correlate require analysis." What do you mean by the correlation of earnings with cash?

Diane: The complete text is, "A dollar of revenue no longer implied an immediate dollar of cash... Earnings which correlate with cash are high quality earnings." To most people, a sale occurs when you trade currency for a product. I'll give you $1 to buy a glass of lemonade. Done deal. Sale = cash in the hand of the seller. What if I agree to buy your machine, but I'm going to pay you in monthly installments over 3 years? Well, you sold the machine and have a receivable from me. But what happens if I fall short on one of my payments? Do you get the machine back? The financing aspects of this transaction muddy the waters as to whether this is a sale or a lease transaction.

If you report this transaction as a sale, you will record lots of profit. But you won't see the cash until I make the monthly payments. Thus you should be interested in whether reported revenue is generating cash (high quality earnings) or receivables.

Zeydy: "1. Did CASH increase or decrease during the period? The answer sets the focus of the rest of the review. If cash increased, I'm happy and can be less critical. If cash decreased, I want to know why." What would differ if cash decreased? For example, I am looking at Home Depot's Cash Flow statement where they had $172 million in 1998 and now have only $62 million. The biggest difference is capital expenditures. According to the notes, the company is building new stores. How would that affect my evaluation of the statements and the company?

Diane: I did not look at the Home Depot financials. Assuming your statements are correct, here are some thoughts for you.

The company spent part of your money to build these new stores. Do you think that was a good use of cash?

The company is using it's own cash to build these stores. It doesn't have to borrow money. Hmmmm....

How many new stores did they build this year? What kind of revenues does the average store have? What does this mean for future revenues?

How many stores did they build last year? Does it appear they have enough cash flow to build A LOT more stores in the future? Will they have to borrow money in the future to pay for new stores? Future interest expense would lower pre-tax income.

Does this information help you better visualize future operations of the company?

To paraphrase an old nursery rhyme: Zeydy, Zeydy... How will your company grow? Cash and borrowing capacity create room to take advantage of opportunity. I like to feel that management can afford to do whatever they need to grow the company.

Zeydy: "3. Back to the SCF. I compare NET INCOME to NET CASH PROVIDED BY OPERATING ACTIVITIES (CFO). CFO is the first subtotal in the statement. If CFO is approximately equal to or greater than net income, I'm happy. For the three years presented, Diebold's CFO fits this picture." Do you do this by "eyeballing" the figures or do you have a percentage up or down?

Diane: Eyeball. Remember, I am looking for a trend and trying to get a broad sense of what is happening.

Zeydy: "Negative answers force me to look for explanations. If cash didn't increase, it is either because it was spent or revenues weren't collected." After I find out the cause for the negative answer, what do I do with that knowledge? Also, how do you find out if revenues were not collected?

Diane: In Sessions #4, we look at how management is spending shareholder's money and we looked at other ways in which management uses cash. When you know where the cash went, how do you react? Were your feelings positive or negative? Or undecided?

Zeydy: Also, how do you find out if revenues were not collected?

Diane: If I didn't receive cash right away, I must have recorded a receivable-- basically an IOU. Receivables are assets on the balance sheet.

Nancy Isaacs: "In this session, we will discuss the Statement of Cash Flow" This is great, Diane. Finally something concrete to do with the Statement of Cash Flows. Let's see if I can summarize your suggestions:

1. Did CASH increase or decrease during the period?

If cash increased, I'm happy and can be less critical. (This information can be derived from either the balance sheet (line 1) or the Statement of Cash Flows (last line). If cash decreased, I want to know why.

2. Combine lines 1 and 2 of the balance sheet (Cash and cash equivalents + Short-term investments) and compare with the similar combined balance in the prior year. If this year is higher than last year, I'm happy. If this year is lower, temporary securities were sold to raise cash. Now I need to find out why.

3. Compare Net Income to Net Cash Provided by Operating Activities. If CFO is approximately equal to or greater than net income, I'm happy.

4. Negative answers to the above three questions force me to look for explanations. If cash didn't increase, it is either because it was spent or revenues weren't collected.

5. Investing Activities:

A. Look at the three year trend of capital expenditures. Is it increasing, decreasing or staying about the same? For large differences in spending levels, find explanations in the the Management's Discussion and Analysis (MD&A).

B. Check for a line for Proceeds from Sales. Unusual Gain? Check Income Statement and MD&A.

C. Check for any acquisitions here. Possibly revise estimates of future revenues and earnings. Determine how the company paid for the purchase ... cash, debt, issued shares?

Diane: A beautifully accurate summary... But one point needs clarification. In: "B. Check for a line for Proceeds from Sales. Unusual Gain? Check Income Statement and MD&A." Sometimes the gain is a loss. Proceeds from a sale is what you got when you sold the item. It is cash in your hands. A gain or loss is determined by reference to your cost. The gain or loss will appear on the income statement (on a separate line if it is large enough.)

Nancy Isaacs: In your reply to Zeydy you stated: "Thus you should be interested in whether reported revenue is generating cash (high quality earnings) or receivables." And I guess that's what you're talking about when you say that net cash provided by operating activities should be equal to or greater than net income. Receivables could be the culprit if it weren't. Just thinking out loud (Grin).

Diane: Yes, growing receivables are one reason cash from operations may be less than net income.

Rip West: Maybe I'm just old-fashioned and maybe I'm just out of it, but I do have a little trouble with the 'new math' and the emphasis on cash. You say... "1. Did CASH increase or decrease during the period? The answer sets the focus of the rest of the review. If cash increased, I'm happy and can be less critical. If cash decreased, I want to know why." But if a company is suffering a reversal in its operations, it is likely that receivables and inventory are being converted to cash, which looks good, but is actually a real cause for alarm. We used to audit some large construction firms and the only time that their balance sheets looked strong was when they didn't have any work. Conversely, if a company is growing, it is tying up more cash in inventory and receivables, so a comparison of its cash from year to year gives a negative appearance when in reality the company is doing quite nicely.

None of this should be construed as taking anything away from your fine workshop, but I am concerned that members of this list could make an entirely false conclusion from a simplistic comparison of cash from year to year.

Diane: As I said in my conclusion, we must focus on why we look at these financial statements in the first place. Most likely it is one of two reasons: (1)I own the stock. I have updated my SSG and am now reviewing the events of the last year. (2) I am thinking about buying this stock and have completed an SSG using summarized data. I am now seeking to validate the numbers and my assumptions.

In either case, I'm not viewing any single piece of information in a vacuum. I'm old fashioned, too. I like my earnings to be supported by cash. And even though I trust management, I still want to see how they are spending my cash. Your early points are completely correct. Diebold's cash from operations in 1998 looks incredibly good compared to net income. But as you indicate, it has an extra kicker because of lower 4Q 1998 sales than in 4Q 1997 resulting in lower receivable and inventory levels.

This is another reason I suggest focusing on the three year trend. Despite rising sales, receivables and inventory in 1996 and 1997, Diebold was still able to maintain cash from operations approximately equal to net income.

On the other hand, growing receivables and inventories will use cash. But now I must look at the ratio of the increase to the ratio of the increase in sales. (I use quarterly sales and cost of sales figures to analyze receivable and inventory turnovers.) If the ratios are in line, fine.

It's a little extra work. But every piece of information has to be viewed in the right context. Thanks for your question and reminder.

Bob Prouty: You wrote: "When CFO is negative, watch for receivables and inventory which are increasing significantly faster than sales. This is common for many growing companies but it can also be a sign of future trouble." I have found this to be true in my own investing. In fact, I am convinced that rising receivables, and/or inventories are an extremely important part of the 5% (or 20%) that investors should be concerned about that is NOT represented on the SSG. The dilemma has been in determining WHEN it is a sign of future trouble, and when it is simply normal growth.

Are there some specific guidelines you use or some percent of increase in these two items that would warn you of this "future trouble"? Safeskin is a classic example of a small company that got into big trouble about six months after the accounts Receivables increased by 60%, and Inventory increased by about one third. In the meantime sales were increasing about 20%.

Diane: I think you answered your own question: Receivables up 60%, Inventories up 30%, Sales up 20%. Hmmmmmm... What's wrong with this picture? My recollection is Safeskin was pushing sales and building inventories in anticipation of moving production from one plant to another. It is possible they offered delayed payment terms to companies who bought big quantities-- thus explaining the big increase in receivables. The trouble was in the next quarter when the sales dried up. If this is correct, I view this as a temporary, probably self-correcting issue.

The easiest thing to do would be to call investor relations and ask them to explain. First I do some homework so I am better prepared when I make the call. I use the Statement of Cash Flow to determine whether the company has recently acquired another company. The balance sheet would include the receivables and inventories of the acquired company but revenues will only include sales of the acquired company from the acquisition date. This date should be in MD&A or the footnotes.

I consider whether there are any possible new products about to hit the market which might explain the build-up of inventory. And I recheck my calculations. I compare receivables to fourth quarter sales and inventory to fourth quarter cost of sales ... at both year-end dates. The quarterly figures are available in the annual report or the 4Q press release.

Now I can listen to Investor Relations and decide if the explanations make sense. I don't use specific guidelines. I just try to find logical explanations for relationships which seem out of line.

Return to Financial Statements Workshop

Diane Graese was formerly an officer of the Computer Group Advisory Board and a director for the BetterInvesting Las Vegas Chapter. She is an active member of i-club-list and the BetterIinvesting Community at Compuserve. Diane is well known for her seminars on cash flow and interpreting financial statements. Contact Diane at dmg1031@aol.com.