Chapter 6

Reporting Cash Flows and Changes in Stockholders’ Equity

In This Chapter

Presenting the statement of cash flows in two flavors

Earning profit versus generating cash flow from profit

Reading lines and between the lines in the statement of cash flows

Offering advice and observations on cash flow

Summarizing changes in stockholders’ equity in a statement

This chapter explains the third primary financial statement reported by businesses — the statement of cash flows. (The other two are the income statement and the balance sheet, which I explain in Chapters 4 and 5.) This financial statement explains why cash flow from profit differs from bottom-line profit, and summarizes the investing and financing activities of the business during the period.

It may appear that this is an odd mix to put into one financial statement, but it actually makes sense. Earning profit (net income) generates net cash inflow (at least it should). Making profit is a primary source of cash to a business. The investing and financing transactions of a business hinge on its cash flow from profit. All sources and uses of cash hang together and should be managed in an integrated manner.

The chapter concludes with a brief — and I mean very brief — explanation of the statement of changes in stockholders’ equity. This is not a “full size” financial statement. In fact, it’s not really a financial statement at all. It’s a schedule of changes during the period in a company’s various stockholders’ equity components. When a business has a complicated ownership structure this summary is helpful to sort out what happened to its owners’ equity during the period. It pulls together all the changes in one place.

Meeting the Statement of Cash Flows

The income statement (Chapter 4) has a natural structure:

Revenue – Expenses = Profit (Net Income)

So does the balance sheet (Chapter 5):

Assets = Liabilities + Owners’ Equity

The statement of cash flows does not have an obvious natural structure. So, the accounting rule-making body had to decide on the basic format for the statement. They settled on the following structure:

± Cash Flow From Operating Activities± Cash Flow From Investing Activities± Cash Flow From Financing Activities= Cash Increase or Decrease During Period+ Beginning Cash Balance= Ending Cash Balance

The ± signs mean that the cash flow could be positive or negative. Generally the cash flow from investing activities of product businesses is negative, which means that the business spent more on new investments in long-term assets than cash received from disposals of previous investments. And, generally the cash flow from operating activities (profit-making activities) should be positive, unless the business suffered a big loss for the period that drained cash out of the business.

The three-fold classification of activities (transactions) reported in the statement of cash flows — operating, investing, and financing — are the same ones I introduce in Chapter 5, in which I explain the balance sheet. In Chapter 5, Figure 5-2 summarizes these transactions for the product company example that I continue in this chapter. It would help to read Chapter 5 before this chapter, but this chapter has all the information you need to understand the statement of cash flows.

In the example the business’s cash balance decreases $110,000 during the year. You see this decrease in the company’s balance sheets for the years ended December 31, 2012 and 2013 (see Figure 5-1). The business started the year with $2,275,000 cash and ended the year with $2,165,000. What does the balance sheet, by itself, tell you about the reasons for the cash decrease? The two-year comparative balance sheet provides some clues about the reasons for the cash decrease. However, answering such a question is not the purpose of a balance sheet.

Presenting the direct method

The statement of cash flows begins with the cash from making profit, or cash flow from operating activities, as accountants call it. Operating activities is the term that accountants have adopted for sales and expenses, which are the “operations” that a business carries out to earn profit. Furthermore, the term operating activities also includes the transactions that are coupled with sales and expenses. For example, making a sale on credit is an operating activity, and so is collecting the cash from the customer that takes place at a later time. Recording sales and expenses can be thought of as primary operating activities because they affect profit. Their associated transactions are secondary operating activities because they don’t affect profit. But they affect cash flow, which I explain in this chapter.

Figure 6-1 presents the statement of cash flows for the product business example I introduce in Chapters 4 and 5. What you see in the first section of the statement of cash flows is called the direct method for reporting cash flow from operating activities. The dollar amounts are the cash flows connected with sales and expenses. For example, the business collected $25,550,000 from customers during the year, which is the direct result of making sales. The company paid $15,025,000 for the products it sells, some of which was to increase its inventory of products awaiting sale next period.

Note: Because I use the same business example in this chapter that I use in Chapters 4 and 5, you may want to take a moment to review the 2013 income statement in Figure 4-1. And you may want to review Figure 5-2, which summarizes how the three types of activities changed its assets, liabilities, and owners’ equity accounts during the year 2013. (Go ahead, I’ll wait.)

The basic idea of the direct method is to present the sales revenue and expenses of the business on a cash basis, in contrast to the amounts reported in the income statement that are on the accrual basis for recording revenue and expenses. Rather than explain again in detail the accrual basis, I’ll just remind you that accountants record sales on credit when the sales take place even though cash is not collected from customers until sometime later. And, cash payments for expenses occur before or after the expenses are recorded. (For more information review Chapter 4.)

The cash flows you see in Figure 6-1 for revenue and expenses differ from the amounts you see in the income statement (see Figure 4-1). Herein lies a problem with the direct method. If you, a conscientious reader of the financial statements of a business, compare the revenues and expenses reported in the income statement with the cash flow amounts reported in the statement of cash flows, you might get somewhat confused. Which set of numbers is the correct one? Well, both are. The numbers in the income statement are the “true” numbers for measuring profit for the period. The numbers in the statement of cash flows are additional information for you to ponder.

Figure 6-1: The statement of cash flows, showing the direct method for presenting cash flow from operating activities.

Notice in Figure 6-1 that cash flow from operating activities for the year is $1,515,000, which is less than the company’s $1,690,000 net income for the year (refer to Figure 4-1). The accounting rule-making board thought that financial report readers would want some sort of explanation for the difference between these two important financial numbers. Therefore, the board decreed that a statement of cash flows that uses the direct method of reporting cash flow from operating liabilities should also include a reconciliation schedule that explains the difference between cash flow from operating activities and net income. Whoa! This is a lot to read.

Opting for the indirect method

Having to read both the operating activities section of the cash flow statement and a supplemental schedule gets to be rather demanding for financial statement readers. Accordingly, the accounting rule-making body decided to permit an alternative method for reporting cash flow from operating activities. The alternative method starts with net income, and then makes adjustments in order to reconcile cash flow from operating activities with net income. This alternative method is called the indirect method, which I show in Figure 6-2. The rest of the cash flow statement is not affected by which method is selected for reporting cash flow from operating activities. Compare the investing and financing activities in Figures 6-1 and 6-2; they are the same.

By the way, the adjustments to net income in the indirect method for reporting cash flow from operating activities (see Figure 6-2) constitute the supplemental schedule of changes in assets and liabilities that has to be included under the direct method. So, the indirect method kills two birds with one stone as it were: net income is adjusted to the cash flow basis, and the changes in assets and liabilities affecting cash flow are included in the statement. So, it should be no surprise to you that the vast majority of businesses use the indirect method.

Figure 6-2: The statement of cash flows, showing the indirect method for presenting cash flow from operating activities.

The indirect method for reporting cash flow from operating activities focuses on the changes during the year in the assets and liabilities that are directly associated with sales and expenses. I explain these connections between revenue and expenses and their corresponding assets and liabilities in Chapter 4. (You can trace the amounts of these changes back to Figure 5-1, which includes the start-of-year and end-of-year balances of the balance sheet accounts for the business example.)

Both the direct method and the indirect method report the same cash flow from operating activities for the period. Almost always this important financial metric for a business differs from the amount of its bottom-line profit, or net income for the same period. Why? Read on.

Dissecting the Divergence Between Cash Flow and Net Income

A positive cash flow from operating activities is the amount of cash generated by a business’s profit-making operations during the year, and does not include any other sources of cash during the year. Cash flow from operating activities depends on a business’s ability to turn profit into available cash — cash in the bank that can be used for the needs of the business. As you see in Figure 6-1 or Figure 6-2 (take your pick), the business in our example generated $1,515,000 cash from its profit-making activities in the year. As they say in New York, “That isn’t chopped liver.”

The business in our example experienced a strong growth year. Its accounts receivable and inventory increased by relatively large amounts. In fact, all its assets and liabilities intimately connected with sales and expenses increased; their ending balances are larger than their beginning balances (which are the amounts carried forward from the end of the preceding year). Of course, this may not always be the case in a growth situation; one or more assets and liabilities could decrease during the year. For flat, no-growth situations, it’s likely that there will be a mix of modest-sized increases and decreases.

The following sections explain how the asset and liability changes affect cash flow from operating activities. As a business manager, you should keep a close watch on the changes in each of your assets and liabilities and understand the cash flow effects caused by these changes. Investors and lenders should focus on the business’s ability to generate a healthy cash flow from operating activities, so they should be equally concerned about these changes. In some situations these changes can signal serious problems!

I realize that you may not be too interested in the details that I discuss in the following sections. With this in mind, at the start of each section I present the punch line. If you wish, you can just read this and move on. But the details are fascinating (well, at least to accountants).

Note: Instead of using the full phrase “cash flow from operating activities” every time, I use the shorter term “cash flow” in the following sections. All data for assets and liabilities are found in the two-year comparative balance sheet of the business (see Figure 5-1).

Accounts receivable change

Punch Line: An increase in accounts receivable hurts cash flow; a decrease helps cash flow.

The accounts receivable asset shows how much money customers who bought products on credit still owe the business; this asset is a promise of cash that the business will receive. Basically, accounts receivable is the amount of uncollected sales revenue at the end of the period. Cash does not increase until the business collects money from its customers.

The business started the year with $2.15 million and ended the year with $2.6 million in accounts receivable. The beginning balance was collected during the year, but the ending balance had not been collected at the end of the year. Thus the net effect is a shortfall in cash inflow of $450,000. The key point is that you need to keep an eye on the increase or decrease in accounts receivable from the beginning of the period to the end of the period. Here’s what to look for:

If the amount of credit sales you made during the period is greater than what you collected from customers during the period, your accounts receivable increased over the period, and you need to subtract from net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, an increase in accounts receivable hurts cash flow by the amount of the increase.

If the amount you collected from customers during the period is greater than the credit sales you made during the period, your accounts receivable decreased over the period, and you need to add to net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, a decrease in accounts receivable helps cash flow by the amount of the decrease.

In our business example, accounts receivable increased $450,000. Cash collections from sales were $450,000 less than sales revenue. Ouch! The business increased its sales substantially over the last period, so its accounts receivable increased. When credit sales increase a company’s accounts receivable generally increases about the same percent, as it did in this example. (If the business takes longer to collect its credit sales then its accounts receivable would increase even more than can be attributable to the sales increase.) In this example the higher sales revenue was good for profit but bad for cash flow.

The “lagging behind” effect of cash flow is the price of growth — business managers, lenders, and investors need to understand this point. Increasing sales without increasing accounts receivable is a happy situation for cash flow, but in the real world you usually can’t have one increase without the other.

Inventory change

Punch Line: An increase in inventory hurts cash flow; a decrease helps cash flow.

Inventory is usually the largest short-term, or current, asset of businesses that sell products. If the inventory account is greater at the end of the period than at the start of the period — because unit costs increased or because the quantity of products increased — the amount the business actually paid out in cash for inventory purchases (or for manufacturing products) is more than what the business recorded in the cost of goods sold expense for the period.

In our business example, inventory increased $725,000 from start-of-year to end-of-year. In other words, to support its higher sales levels in 2013, this business replaced the products that it sold during the year and increased its inventory by $725,000. The business had to come up with the cash to pay for this inventory increase. Basically, the business wrote checks amounting to $725,000 more than its cost of goods sold expense for the period. This step-up in its inventory level was necessary to support the higher sales level, which increased profit even though cash flow took a hit.

Prepaid expenses change

Punch Line: An increase in prepaid expenses (an asset account) hurts cash flow; a decrease helps cash flow.

A change in the prepaid expenses asset account works the same way as a change in inventory and accounts receivable, although changes in prepaid expenses are usually much smaller than changes in the other two asset accounts.

The beginning balance of prepaid expenses is charged to expense this year, but the cash of this amount was actually paid out last year. This period (the year 2013 in our example), the business paid cash for next period’s prepaid expenses, which affects this period’s cash flow but doesn’t affect net income until next period. In short, the $75,000 increase in prepaid expenses in this business example has a negative cash flow effect.

As it grows, a business needs to increase its prepaid expenses for such things as fire insurance (premiums have to be paid in advance of the insurance coverage) and its stocks of office and data processing supplies. Increases in accounts receivable, inventory, and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.

Depreciation: Real, but noncash expense

Punch Line: Recording depreciation expense decreases the book value of long-term operating (fixed) assets. There is no cash outlay when recording depreciation expense. Each year the business converts part of the total cost invested in its fixed assets into cash. It recovers this amount through cash collections from sales. The cash inflow from sales revenue “reimburses” the business for the use of its long-term operating assets as they gradually wear out over time.

The amount of depreciation expense recorded in the period is a portion of the original cost of the business’s fixed assets, most of which were bought and paid for years ago. (Chapters 4 and 5 explain more about depreciation.) Because the depreciation expense is not a cash outlay this period, the amount is added to net income to determine cash flow from operating activities (see Figure 6-2).

For measuring profit, depreciation is definitely an expense — no doubt about it. Buildings, machinery, equipment, tools, vehicles, computers, and office furniture are all on an irreversible journey to the junk heap (although buildings usually take a long time to get there). Fixed assets (except for land) have a limited, finite life of usefulness to a business; depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue.

In our example, the business recorded $775,000 depreciation expense for the year. Instead of looking at depreciation as only an expense, consider the investment-recovery cycle of fixed assets. A business invests money in its fixed assets that are then used for several or many years. Over the life of a fixed asset, a business has to recover through sales revenue the cost invested in the fixed asset (ignoring any salvage value at the end of its useful life). In a real sense, a business “sells” some of its fixed assets each period to its customers — it factors the cost of fixed assets into the sales prices that it charges its customers.

For example, when you go to a supermarket, a very small slice of the price you pay for that quart of milk goes toward the cost of the building, the shelves, the refrigeration equipment, and so on. (No wonder they charge so much!) Each period, a business recoups part of the cost invested in its fixed assets. In the example, $775,000 of sales revenue went toward reimbursing the business for the use of its fixed assets during the year.

The business in our example does not own any intangible assets and, thus, does not record any amortization expense. (See Chapter 5 for an explanation of intangible assets and amortization.) If a business does own intangible assets, the amortization expense on these assets for the year is treated the same as depreciation is treated in the statement of cash flows. In other words, the recording of amortization expense does not require cash outlay in the year being charged with the expense. The cash outlay occurred in prior periods when the business invested in intangible assets.

Changes in operating liabilities

Punch Line: An increase in a short-term operating liability helps cash flow; a decrease hurts cash flow.

The business in our example, like almost all businesses, has three basic liabilities inextricably intertwined with its expenses:

Accounts payable

Accrued expenses payable

Income tax payable

When the beginning balance of one of these liability accounts is the same as its ending balance (not too likely, of course), the business breaks even on cash flow for that liability. When the end-of-period balance is higher than the start-of-period balance, the business did not pay out as much money as was recorded as an expense in the year.

In our business example, the business disbursed $640,000 to pay off last year’s accounts payable balance. (This $640,000 was the accounts payable balance at December 31, 2012, the end of the previous fiscal year.) Its cash this year decreased $640,000 because of these payments. But this year’s ending balance sheet (at December 31, 2013) shows accounts payable of $765,000 that the business will not pay until the following year. This $765,000 amount was recorded to expense in the year 2013. So, the amount of expense was $125,000 more than the cash outlay for the year; or, in reverse, the cash outlay was $125,000 less than the expense. An increase in accounts payable benefits cash flow for the year. In other words, an increase in accounts payable has a positive cash flow effect (until the liability is paid later). An increase in accrued expenses payable or income tax payable works the same way.

In short, liability increases are favorable to cash flow — in a sense, the business ran up more on credit than it paid off. Such an increase means that the business delayed paying cash for certain things until next year. So you need to add the increases in the three liabilities to net income to determine cash flow, as you see in the statement of cash flows (refer to Figure 6-2). The business avoided cash outlays to the extent of the increases in these three liabilities. In some cases, of course, the ending balance of an operating liability may be lower than its beginning balance, which means that the business paid out more cash than the corresponding expenses for the period. In this case, the decrease is a negative cash flow factor.

Putting the cash flow pieces together

Taking into account all the adjustments to net income, the company’s cash balance increased $1,515,000 from its operating activities during the course of the year. The operating activities section in the statement of cash flows (refer to Figure 6-2) shows the stepping-stones from net income to the amount of cash flow from operating activities.

Recall that the business experienced sales growth during this period. The downside of sales growth is that assets and liabilities also grow — the business needs more inventory at the higher sales level and also has higher accounts receivable. The business’s prepaid expenses and liabilities also increased, although not nearly as much as accounts receivable and inventory. Still, the business had $1,515,000 cash at its disposal. What did the business do with this $1,515,000 of available cash? You have to look to the remainder of the cash flow statement to answer this very important question.

Sailing Through the Rest of the Statement of Cash Flows

After you get past the first section of the statement of cash flows, the remainder is a breeze. Well, to be fair, you could encounter some rough seas in the remaining two sections. But generally speaking, the information in these sections is not too difficult to understand. The last two sections of the statement report on the other sources of cash to the business and the uses the business made of its cash during the year.

Investing activities

The second section of the statement of cash flows (see Figure 6-1 or 6-2) reports the investment actions that a business’s managers took during the year. Investments are like tea leaves, which serve as indicators regarding what the future may hold for the company. Major new investments are the sure signs of expanding or modernizing the production and distribution facilities and capacity of the business. Major disposals of long-term assets and shedding off a major part of the business could be good news or bad news for the business, depending on many factors. Different investors may interpret this information differently, but all would agree that the information in this section of the cash flow statement is very important.

Certain long-lived operating assets are required for doing business. For example, Federal Express and UPS wouldn’t be terribly successful if they didn’t have airplanes and trucks for delivering packages and computers for tracking deliveries. When these assets wear out, the business needs to replace them. Also, to remain competitive, a business may need to upgrade its equipment to take advantage of the latest technology or to provide for growth. These investments in long-lived, tangible, productive assets, which are called fixed assets for short, are critical to the future of the business. In fact, these cash outlays are called capital expenditures to stress that capital is being invested for the long haul.

One of the first claims on cash flow from operating activities is for capital expenditures. Notice that the business spent $1,275,000 on fixed assets, which are referred to more formally as property, plant, and equipment in the cash flow statement (to keep the terminology consistent with account titles used in the balance sheet — the term fixed assets is rather informal).

A typical statement of cash flows doesn’t go into much detail regarding exactly what specific types of fixed assets the business purchased (or constructed): how many additional square feet of space the business acquired, how many new drill presses it bought, and so on. Some businesses do leave a clearer trail of their investments, though. For example, in the footnotes or elsewhere in their financial reports, airlines generally describe how many new aircraft of each kind were purchased to replace old equipment or to expand their fleets.

Usually, a business disposes of some of its fixed assets every year because they reached the end of their useful lives and will no longer be used. These fixed assets are sent to the junkyard, traded in on new fixed assets, or sold for relatively small amounts of money. The value of a fixed asset at the end of its useful life is called its salvage value. The disposal proceeds from selling fixed assets are reported as a source of cash in the investing activities section of the statement of cash flows. Usually, these amounts are fairly small. Also, a business may sell off fixed assets because it’s downsizing or abandoning a major segment of its business; these cash proceeds can be fairly large.

Financing activities

Note in the annual statement of cash flows for the business example (refer to Figure 6-1 or 6-2) that cash flow from operating activities is a positive $1,515,000 and the negative cash flow from investing activities is $1,275,000. The result to this point, therefore, is a net cash increase of $240,000, which would have increased the company’s cash balance this much if the business had no financing activities during the year. However, the business increased its short-term and long-term debt during the year, its owners invested additional money in the business, and it distributed some of its profit to stockholders. The third section of the cash flow statement summarizes these financing activities of the business over the period.

The managers did not have to go outside the business for the $1,515,000 cash increase generated from its operating activities for the year. Cash flow from operating activities is an internal source of money generated by the business itself, in contrast to external money that the business raises from lenders and owners. A business does not have to go hat in hand for external money when its internal cash flow is sufficient to provide for its growth. Making profit is the cash flow spigot that should always be turned on.

I should mention that a business that earns a profit could, nevertheless, have a negative cash flow from operating activities — meaning that despite posting a net income for the period, the changes in the company’s assets and liabilities cause its cash balance to decrease. In reverse, a business could report a bottom-line loss for the year, yet it could have a positive cash flow from its operating activities. The cash recovery from depreciation plus the cash benefits from decreases in its accounts receivable and inventory could be more than the amount of loss. More realistically, a loss usually leads to negative cash flow, or very little positive cash flow.

The term financing refers to a business raising capital from debt and equity sources — by borrowing money from banks and other sources willing to loan money to the business and by its owners putting additional money in the business. The term also includes the flip side — that is, making payments on debt and returning capital to owners. The term financing also includes cash distributions by the business from profit to its owners. By the way, keep in mind that interest on debt is an expense that is reported in the income statement.

Most businesses borrow money for the short term (generally defined as less than one year), as well as for longer terms (generally defined as more than one year). In other words, a typical business has both short-term and long-term debt. (Chapter 5 explains that short-term debt is presented in the current liabilities section of the balance sheet.)

The business in our example has both short-term and long-term debt. Although this is not a hard-and-fast rule, most cash flow statements report just the net increase or decrease in short-term debt, not the total amounts borrowed and total payments on short-term debt during the period. In contrast, both the total amounts of borrowing from and repayments on long-term debt during the year are generally reported in the statement of cash flows — the numbers are reported gross, instead of net.

In our example, no long-term debt was paid down during the year, but short-term debt was paid off during the year and replaced with new short-term notes payable. However, only the $100,000 net increase is reported in the cash flow statement. The business also increased its long-term debt $150,000 (refer to Figure 6-1 or 6-2)).

The financing section of the cash flow statement also reports the flow of cash between the business and its owners (stockholders of a corporation). Owners can be both a source of a business’s cash (capital invested by owners) and a use of a business’s cash (profit distributed to owners). The financing activities section of the cash flow statement reports additional capital raised from its owners, if any, as well as any capital returned to the owners. In the cash flow statement, note that the business issued additional stock shares for $150,000 during the year, and it paid a total of $750,000 cash dividends from profit to its owners.

Be an Active Reader

As a business lender or investor your job is to ask questions (at least in your own mind) when reading a financial statement. You should be an active reader, not a ho-hum passive reader, in reading the statement of cash flows. You should mull over certain questions to get full value out of the statement.

The statement of cash flows reveals what financial decisions the business’s managers made during the period. Of course, management decisions are always subject to second-guessing and criticizing, and passing judgment based on reading a financial statement isn’t totally fair because it doesn’t capture the pressures the managers faced during the period. Maybe they made the best possible decisions in the circumstances. Then again, maybe not.

One issue, in my mind, comes to the forefront when reading the company’s statement of cash flows. The business in our example (see Figure 6-1 or 6-2) distributed $750,000 cash from profit to its owners — a 44 percent payout ratio (which equals the $750,000 distribution divided by its $1,690,000 net income). In analyzing whether the payout ratio is too high, too low, or just about right, you need to look at the broader context of the business’s sources of and needs for cash.

The company’s $1,515,000 cash flow from operating activities is enough to cover the business’s $1,275,000 capital expenditures during the year and still leave $240,000 available. The business increased its total debt $250,000. Combined, these two cash sources provided $490,000 to the business. The owners also kicked in another $150,000 during the year, for a grand total of $640,000. Its cash balance did not increase this amount because the business paid out $750,000 dividends from profit to its stockholders. So, its cash balance dropped $110,000.

If I were on the board of directors of this business, I certainly would ask the chief executive why cash dividends to shareowners were not limited to $240,000 in order to avoid the increase in debt and to avert having share-owners invest additional money in the business. I would probably ask the chief executive to justify the amount of capital expenditures as well. Being an old auditor, I tend to ask tough questions and raise sensitive issues.

Recognize Shortcomings of the Depreciation Add-back Shortcut

Rather than wading through all the lines in the operating activities section of the cash flow statement (see Figure 6-2 for example), financial report readers may be tempted to take a shortcut. They simply add depreciation (and amortization, if any) to net income and call this cash flow from profit. By adding back depreciation expense to bottom-line profit you get a first cut at determining cash flow from profit. But this shortcut ignores the other factors that affect cash flow from profit, and I don’t recommend it. I have to admit, however, that this shortcut is better than nothing. Deprecation is often the largest adjustment to net income to get to cash flow. Nevertheless, the other items (changes in accounts receivable, inventory, and so on) can have major effects on cash flow and should not be overlooked.

Some small and privately owned businesses do not report a statement of cash flows — though according to current financial reporting standards that apply to all businesses they should. I’ve seen several small privately owned businesses that don’t go to the trouble of preparing this financial statement. Perhaps someday accounting standards for private and smaller businesses will waive the requirement for the cash flow statement. (I discuss developments of accounting standards for larger public versus smaller private companies in Chapter 2.) Without a cash flow statement the reader of the financial report could add back depreciation to net income to get a starting point. From there on it gets more challenging to determine cash flow from profit. Adding depreciation to net income is no more than a first step in determining cash flow from profit.

Pinning Down “Free Cash Flow”

A term has emerged in the lexicon of finance: free cash flow. This piece of language is not — I repeat, not — an officially defined term by any authoritative accounting or financial institution rule-making body. Furthermore, the term does not appear in cash flow statements reported by businesses. Rather, free cash flow is street language, and the term appears in The Wall Street Journal and The New York Times. Securities brokers and investment analysts use the term freely (pun intended). Unfortunately, the term free cash flow hasn’t settled down into one universal meaning, although most usages of the term have something to do with cash flow from operating activities.

The term free cash flow has been used to mean the following:

Net income plus depreciation expense, plus any other expense recorded during the period that does not involve the outlay of cash — such as amortization of costs of the intangible assets of a business, and other asset write-downs that don’t require cash outlay

Cash flow from operating activities as reported in the statement of cash flows, although the very use of a different term (free cash flow) suggests that a different meaning is intended

Cash flow from operating activities minus the amount spent on capital expenditures during the year (purchases or construction of property, plant, and equipment)

Earnings before interest, tax, depreciation, and amortization (EBITDA) — although this definition ignores the cash flow effects of changes in the short-term assets and liabilities directly involved in sales and expenses, and it obviously ignores that interest and income tax expenses in large part are paid in cash during the period

In the strongest possible terms, I advise you to be very clear on which definition of free cash flow a speaker or writer is using. Unfortunately, you can’t always determine what the term means even in context. Be careful out there.

One definition of free cash flow, in my view, is quite useful: cash flow from operating activities minus capital expenditures for the year. The idea is that a business needs to make capital expenditures in order to stay in business and thrive. And to make capital expenditures, the business needs cash. Only after paying for its capital expenditures does a business have “free” cash flow that it can use as it likes. In the example in this chapter, the free cash flow according to “Tracy’s” (that’s me!) definition is:

$1,515,000 cash flow from operating activities – $1,275,000 capital expenditures = $240,000 free cash flow

In many cases, cash flow from operating activities falls short of the money needed for capital expenditures. To close the gap a business has to borrow more money, persuade its owners to invest more money in the business, or dip into its cash reserve. Should a business in this situation distribute any of its profit to owners? After all, it has a cash deficit after paying for capital expenditures. But, in fact, many businesses make cash distributions from profit to their owners even when they don’t have any free cash flow (as I just defined it).

The Cash Flow Statement in the Real World: A Good Idea Gone Awry?

Being an elder statesman in accounting (at least that’s how I like to imagine myself), I remember the days before the cash flow statement was required to be included in financial reports of businesses. (Those were the days, but that’s another story.) There was constant urging to require a summary of cash flows in financial reports. Finally in 1974 the cash flow statement was made mandatory. Most financial report users, in my view, thought that this new financial statement would be quite useful and should open the door for deeper insights into the business. However, over the years I have seen serious problems develop in the actual reporting of cash flows.

Would you like to hazard a guess regarding the average number of lines in the cash flow statements of publicly owned corporations? Typically, their cash flow statements have 30 to 40 or more lines of information by my reckoning. So it takes quite a while to read the cash flow statement — more time than the average reader probably has available. Each line of information in a financial statement should be a truly useful piece of information. Too many lines baffle the reader rather than clarify the overall cash flows of the business. In reading many statements of cash flows over the years, I have to question why companies overload this financial statement with so much technical information. One could even suspect that many businesses deliberately obscure their statements of cash flows.

Also, I must say that you don’t hear a lot of feedback on the cash flow statement from principal external users of financial reports, such as business lenders and investors. I wonder how financial-report users would react if the cash flow statement were accidently omitted from a company’s annual financial report. How many would notice the missing financial statement and complain? The SEC and other regulators would take action, of course. But in my view few readers would even notice the omission. In contrast, if a business failed to include an income statement or balance sheet, it would hear from its lenders and owners, that’s for sure.

Looking Quickly at the Statement of Changes in Stockholders Equity

Larger businesses generally have more complicated ownership structures than smaller- and medium-size companies. Larger businesses are most often organized as a corporation in contrast to other forms of legal structures. (I discuss the legal organization of business in Chapter 8.) Corporations can issue more than one class of stock shares, and many do. One class may have preferences over the other class, and thus are called preferred stock. A corporation may have both voting and non-voting stock shares. Also, business corporations, believe it or not, can engage in cannibalization; they buy their own stock shares, somewhat like eating your own offspring. A corporation may not cancel the shares it has purchased. Shares of itself that are held by the business are called treasury stock.

Well, I could go on and on. But the main point is that many businesses, especially larger public companies, engage in a broad range of activities during the year involving changes in their owners’ equity components. These owners’ equity activities tend to get lost from view in a comparative balance sheet and in the statement of cash flows. Yet the activities can be very important. Therefore, the business prepares a separate statement of changes in stockholders’ equity covering the same periods as its income statements.

Here’s another point: The statement of changes in stockholders’ equity is where you find certain technical gains and losses that increase or decrease owners’ equity but that are not reported in the income statement. You have to read this summary of changes in the owners’ equity accounts to find out whether the business had any such gains or losses. Look in a column headed comprehensive income for these gains and losses, which I warn you in advance are very technical.

The general format of the statement of changes in stockholders’ equity includes columns for each class of stock, treasury stock, retained earnings, and the comprehensive income element of owners’ equity. Professional stock analysts have to pore over these statements. Average financial report readers probably quickly turn the page when they see this statement. But, it’s worth a quick glance if nothing else.

I explain more about statement of changes in stockholders’ equity in Chapter 12. At this early point in the book I simply want to alert you to the fact that many financial reports include a statement of changes in stockholders’ equity in addition to their three primary financial statements. It’s not really a full-fledged financial statement. Rather, it serves as a columnar footnote for the various owners’ equity accounts in the balance sheet.