Accounting: Understanding the Cash Flow Statement - Rtkelz, May 24, 2010

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May 24, 2010 ¬ 9:13 amh.

Steven D Alexander

This article looks at the cash flow
statement, the final of the 3 primary financial statements that all public
companies must report to the SEC. In the first article, we covered the income
statement, and the second article looked at the balance sheet.

The
purpose of the cash flow statement. The cash flow
statement has 2 primary purposes. One, it indicates to the investor how much
cash money flowed into or out of the business over a period of time, usually a
year or a 3-month quarter. Second, it reconciles the other two financial
statements – income statement and balance sheet. For the income statement, it
reconciles the accounting assumptions with the actual cold, hard cash the
business earned. For the balance sheet, the cash flow statement shows the
differences in the level of assets or liabilities from the previous reporting
period.

One major difference between the cash
flow statement and it’s siblings is that there are no accounting assumptions or
estimations on the cash flow statement. The income statement contains many
accounting assumptions for things like depreciation and taxes. Likewise, the
balance sheet estimates the worth of acquired businesses (goodwill) and
intangibles like patents or brand names. The cash flow statement values are
very real – this is the *exact* amount of cash coming in and going out of the
business. Since creating cash from assets is the basic function of any
business, the cash flow statement has a well earned reputation amongst value
investors for being the most important of the 3 reports.

Cash flow statements are organized into
3 sections. The first, cash from operations, is the most important. This is the
section that reconciles reported net income from the income statement and adds
back non-cash costs, as well as accounting for the change in working assets
like inventory, and so forth. The second, cash from investing activities, is
where the company lists out items like capital expenditures, acquired
businesses, and purchase/sale of equity or bond holdings. The third, cash from
financing activities, is where dividend payouts, stock repurchases, cash
received from bond issues, and debt repayments are listed.

As before, we’ll look at Intel’s (INTC)
fiscal year 2007 cash flow statement, and then briefly explain each item. All
values are in millions of dollars, and parenthesis represent negative values
(cash going out). In order to keep this somewhat brief, some line items have
been grouped together.

Net Income: 6,976

Depreciation: 4,546

Share Based Compensation: 952

Asset Impairment: 564

Tax Benefit from Share Based Payments: (118)

Amortization of Intangible Assets: 252

Gains on Equity Investments: (157)

Gains on Divestitures: (21)

Deferred Taxes: (443)

Changes in Working Assets and Liabilities: 74

Net Cash from Operations: 12,625

Additions to Property, Plant, Equipment (Capital Expenditures): (5,000)

Acquisitions, Net of Cash Acquired: (76)

Purchases of Available-for-sale Investments: (11,728)

Maturities and Sales of Available-for-sale Investments: 8,011

Investments in Non-marketable Equity Instruments: (1,459)

Net Proceeds from Divestitures: 32

Other Investing Activities: 294

Net Cash from Investing Activities: (9,926)

Decrease in Short-term Debt: (39)

Proceeds from Government Grants: 160

Excess Tax Benefit from Share-based Payments: 118

Additions to Long-term Debt: 125

Proceeds from Sales of Shares to Employees: 3,052

Purchase and Retirement of Common Stock: (2,788)

Payment of Dividends: (2,618)

Net Cash from Financing Activities: (1,990)

Net Change in Cash Holdings: 709

Free Cash Flow: 8,079

Dividend Payout Ratio: 32.4%

Free Cash Flow Margin: 21.1%

Free Cash to Earnings Ratio: 181%

A brief explanation of each line item:

Net
Income. The net income line from the income statement. Cash is
reconciled against this starting point.

Depreciation.
Depreciation expenses in the income statement do not affect cash. For a
personal example, think of the depreciation in your vehicle’s value each year.
Although it diminishes your net worth by reducing the amount you could sell the
car for, it does not affect your cash holdings.

Share
Based Compensation. Tech companies like Intel often reward
employees by granting them stock or stock options. The estimated final value of
these must be expensed on the income statement, but issuing stock or options
does not require cash, so the amount expensed is added back here.

Asset
Impairment. The value of assets on the balance
sheet are in most cases estimated. Intel’s accountants decided that, due to
weak demand, the value of some assets was lower than was being carried on the
balance sheet. The resulting write-down affected the balance sheet value, but
did not affect cash holdings, so it is added back here. This line item also
contained employee severance charges that were expensed in the current period,
but not yet paid out in cash.

Tax
Benefit from Share Based Payments. When employees
exercise their stock options, the amount of profit they receive can be written
off Intel’s tax bill, as employee compensation is tax deductible. On the cash
flow statement, this value is subtracted from operating cash and added to cash
from investments as a re-classification exercise.

Amortization
of Intangible Assets. Similar to Depreciation or Asset
Impairment, Intel has set up a schedule to degrade the balance sheet value of
some of it’s intangible assets over a period of time. While this affects the
balance sheet and is counted as an expense on the income statement, it does not
affect cash and is added back in here.

Gains
on Equity Investments. As mentioned in the balance
sheet article, Intel holds equity positions in a few companies it works with,
notably VMware (VMW) and Micron (MU). Like your personal portfolio, unrealized gains and losses affect net
worth, but not cash balances. Therefore the gain recorded in the income
statement is subtracted back out here.

Deferred
Taxes. As mentioned in the balance sheet review, deferred taxes
represents over or under-estimated tax payment carry-forwards. Again, this is a
carrying account, only for tracking tax balances; changes in it are strictly
for accounting purposes and do not involve cash.

Changes
in Working Assets and Liabilities. Intel’s accounts
receivable, inventory, accounts payable, and other working capital balances
obviously fluctuate on a daily basis. Two things to look for here are accounts
receivable rising (Intel not able to collect it’s owed cash payments), and
inventory rising as a percentage of revenues. These represent weakness in Intel’s
customer base, and rising inventory is a big concern as technology products
degrade in value very quickly. Over time, this line item should work out to
about break-even. Consistent negative values here indicate poor management of
collection and demand forecasting.

Net
Cash from Operations. The sum of all of the above line
items. This is the amount of cash
Intel earned over the reported period, one of the most important pieces of data
available.

Additions
to Property, Plant, and Equipment (Capital Expenditures).
Any items the company purchases for business that have a useful life over one
year are considered “capital expenditures”. These are not expensed in the
income statement, but are charged off gradually through depreciation. For
Intel, these are things like new chip-making equipment, office furniture,
computers, and so forth.

Acquisitions,
Net of Cash Acquired. This is the cash Intel spent
purchasing other businesses.

Purchases
of Available-for-sale Investments. Cash Intel put into
purchasing equity and/or bonds for the purpose of earning a higher return.
“Available-for-sale” means these are usually done on the open market.

Maturities
and Sales of Available-for-sale Investments. The inverse
of the above. Proceeds from equity and/or bonds that matured or were sold in
the period.

Investments
in Non-marketable Equity Instruments. Cash spent for a
considerable equity investment that was done off-the-market. In this particular
case, Intel invested nearly $1.5 billion for a joint venture stake in IM Flash
Technologies.

Net
Proceeds from Divestitures. Cash received from the sale of
various assets and businesses the company no longer deemed strategic. Looking
over the 10-K, this includes optical networking components group, media and
signaling businesses, and several others.

Other
Investing Activities. The catch-all for investing-based
items that don’t fit anywhere else. These consist of a number of items spread
all over the 10-K, which I won’t list here.

Net
Cash from Investing Activities. All of the investing
based items (here, the previous 7) added together.

Decrease
in Short-term Debt. Cash Intel used to pay off some of
it’s short-term debt balances.

Proceeds
from Government Grants. There is not much detail on this
in the 10-K. Presumably Intel received a nominal amount of cash from some
government agency.

Excess
Tax Benefit from Share-based Payments. See the similar
entry under the operating cash section.

Additions
to Long-term Debt. Cash received from selling corporate
bonds.

Proceeds
from Sales of Shares to Employees. Most tech companies,
and many other companies as well, have employee share purchase programs where
employees can purchase equity at reduced prices. The amount of cash Intel’s
employees paid the company for these shares is recorded here.

Purchase
and Retirement of Common Stock. The amount Intel
spent to buy back and retire it’s own shares.

Payment
of Dividends. Just what it seems – the cash paid out
to shareholders in the form of dividends.

Net
Cash from Financing Activities. All of the financing
based items (here, the previous 7) added together.

Net
Change in Cash Holdings. Calculated as (Net Cash from
Operations + Net Cash from Investing + Net Cash from Financing). This is the
amount of cash added to or subtracted from Intel’s balance sheet during the
period. In this case, Intel increased it’s cash balance by $709 million dollars
over the fiscal year.

Free
Cash Flow. Free cash flow can be calculated two
ways. Classically it’s (Net Cash from Operations + Depreciation – Capital
Expenditures). MagicDiligence, and Joel Greenblatt in The Little Book that Beats the Market, calculate it as (Net Cash
From Operations – Depreciation). Free cash flow is the cash available for the
company to invest in growth or pay back to shareholders through share buybacks
or dividend payments. MagicDiligence uses depreciation as this is a more
accurate view of “maintenance capital expenditures”. The traditional
calculation can include capital expenditures used for growth (for example,
buying new property or buildings), which unfairly skews the free cash flow
calculation for quickly growing companies.

Dividend
Payout Ratio. Calculate as (Dividends Paid / Free
Cash Flow). This percentage shows you how much of free cash flow is being paid
out in dividends. Too high of a percentage (over 60-70%) could indicate an
unsustainable dividend.

Free
Cash Flow Margin. Calculate as (Free Cash Flow /
Revenues). This is the amount of every dollar of sales that is converted into
free cash flow. The higher the better here. Look for at least 5%. Intel’s very
high 21% figure is just another indication of the top quality nature of the
company.

Free
Cash to Earnings Ratio. Calculate as (Free Cash Flow /
Net Income). A big red flag is when this is consistently less than 100%. We
will discuss this more in the red/green flag articles.

Now, we have a working explanation of
all three financial statements that all public corporations report to the SEC.
Next, we’ll look at 10 red flags to look for when examining these statements.

Steven Alexander is the founder and
voice behind MagicDiligence (http://www.magicdiligence.com), a website
dedicated to researching stocks appearing in Joel Greenblatt’s Magic Formula
Investing screen.

Author: Steven D Alexander

Article Source: EzineArticles.com

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