The Challenges of Dealing with the Cash Flow Statement

It’s interesting how over the years, companies make adjustments to the rules that always seem to work in their favor.  Generally, the reporting transactions are accurate and legal, but may paint a different picture of the financial health of the company.  As a lender or trusted advisor, it’s important to understand the shortcomings of the reporting system. This understanding is key to maintaining awareness of important issues that impact how cash flows through a company.  Let’s look at a few problems within the three main sections of the cash flow statement.  Cash generated from:
1) Operating
2) Investing
3) Financing activities

Understanding cash provided from operating activities is critical to comparing the financial information of like companies.  A few issues that make this difficult are the different ways certain transactions are classified.  To date, the accounting industry has largely ignored trying to make comparison but analysts have tried a couple of different measurements to level the playing field. 

One issue that makes it difficult to compare is the way interest paid and dividends paid are handled.  Interest paid is determined to be an operating activity, while dividends paid are financing activities.  Both are a form of interest on money borrowed to fund the company, yet one has a negative impact on cash flow from operations.  There are two methods currently used to overcome this challenge.  One is the use of EBITDA as a measurement and the other is earnings per share.  Accountants tend to work primarily with earnings per share because it is located on the income statement. Bankers however, lean on EBITDA. 

A growing problem for the cash flow statement is how companies are treating their receivables base.  In the past, receivables were used as collateral for borrowing and the amount borrowed was a financing activity.  The trend today is to sell receivables.  This provides two interesting advantages for companies.  First it keeps borrowing off of the balance sheet to show a better debt service coverage ratio.  Second, the proceeds from the sale of receivables are classified as an operating activity.  To an analyst, it may inaccurately inflate the cash provided from operations. 

On occasion, you’ll see employee deferred compensation on the balance sheet.  Many companies use stock options as way to pay deferred comp, which are an off the balance sheet liability when issued.  Redeeming the options it is treated as a financing activity as if it was a capital allocation.  In actuality, the true nature of the event should be an operating activity in the form of employee wages.  Again, it inflates cash from operations by reducing operating expenses, but it’s the correct way to account for the expense.

In the investing category, the rule is that only the cash amount of transactions should be shown.  This means that if a company buys another for $1 billion, but only uses $200 million in cash, the amount shown on the cash flow statement will be $200 million.  The other $800 million in debt or equity instruments will be buried in a footnote in the financial statements.  This can give the reader a false impression of the cost of the transaction.