Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws

Chapter 4: • Explains what’s on a statement of cash flows • Discusses how to interpret the information presented Emphasizes: cash flow from operations as an analytical tool Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Company Success • Depends on firm’s ability to generate cash from operations Where to find this information? • On the statement of cash flows Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Cash Flows • Provides information about cash inflows & outflows • Prepared for three-year period • Cash flows separated by types of activities • Operating • Investing • Financing Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

The Difference Between Cash Inflows & Cash Outflows • Equals change in cash (or cash plus cash equivalents) for period Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Cash Flows from Operating Activities • The cash effects of transactions & events related to the firm’s operations • Amount of cash generated internally Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Cash Flow Statement • Begins with adjustments to net income • Converts net income (accrual basis) to cash flow from operating activities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Two Methods to Make Adjustments 1. Indirect: • Begins with net income • Adjusts for: • accruals • deferrals • non-cash items • non-operating items Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Two Methods to Make Adjustments Continued: 2. Direct: • Separately converts each item of revenue & expense on earnings statement Almost all companies use the indirect method Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Investing Activities The acquisition/disposition of: • Securities that are not cash equivalents • Productive, long-lived assets, e.g. machinery & equipment Includes lending money & collecting on loans Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financing Activities Include: • Borrowing from creditors & repaying the principal • Obtaining resources from owners • Providing owners with a return on investment, e.g. dividends Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Cash Flow from Operations • Important for analysis • Use in context of other performance measures • Evaluate trend over time Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Analyzing Cash Flow from Operations • Look at trends over time, not just one period • Compare with net income: Should track closely • Consider underlying causes of changes in cash flow operations • Be aware that companies can manipulate this number too Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Cash Flows also provides information about. . . • Cash needs from external sources • Ability to meet obligations • Effectiveness of asset management • Ability to satisfy owners through dividend payments & healthy growth Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Free Cash Flow • Widely used in analysis • Considers firm’s ability to provide cash for current operations & for expansion • No standardized measure Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Some Measures of Free Cash Flow • Cash flow from operations less capital expenditures • Cash flow from operations less capital expenditures & dividends Always look behind number to see how it is calculated Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

When evaluating Cash Flow from Operations. . . • Consider firm’s success in generating cash internally over time • Determine underlying causes for trends & fluctuations • Look at relationship between cash flow from operations & net income over time Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Do firms on the brink of bankruptcy have negative cash flow from operations? Not always You need to look behind the numbers Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Enron. . . • Had positive cash flow from operations in 2000 • Filed for bankruptcy in 2001 But . . . Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Enron. . . • Amounts fluctuated widely • Did not track with net income It is difficult to explain Enron’s adjustments to net income in calculating cash flow from operations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Global Crossing. . . • Had positive cash flow from operations before filing for bankruptcy in 2002 But. . . Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Global Crossing. . . Adjustments to net income involved: • Losses on sales of businesses • Write-downs of investments The company had large additions to long-term debt Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Kmart. . . • Had positive cash flow from operations in 2001 • Filed for bankruptcy in 2002 But. . . Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Kmart. . . Adjustments to net income involved: • Charges for store closings • Reductions in inventory from store closings Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Finally. . . Always look at underlying causes for positive or negative cash flow from operations And remember: No one piece of analysis tells the entire story Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Caution Flags • Failure to generate cash from operating activities • Large fluctuations in cash flow from operating activities over time • Net income growing faster than cash flow from operations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More Caution Flags • Net income & cash flow from operations moving in different directions • Positive cash flow from investing activities because company is selling assets to generate cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Even More Caution Flags • Positive cash flow from financing activities because company is borrowing to offset lack of internal cash • Company highlights cash flow in shareholders’ letter in same paragraph discussing falling stock price Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Yet, More Caution Flags • Adjustments to net income from changes in receivables, inventories, & payables not in line with sales • Management’s explanations of adjustments to net income obtuse or missing Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws