Cleaning the Cash Flow Statement

Cleaning the Cash Flow Statement

Author: Joris Kersten MSc

Kersten Corporate Finance: M&A advisory + Business Valuations @ The Netherlands. www.kerstencf.nl

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Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Categorising for clarity: Cash flow statement adjustments to improve insights. October 2021. Michael J. Mauboussin & Dan Callahan.

Introduction

A statement of cash flows classifies cash inflows and cash outflows in 3 categories:

-Cash flow from operations;

-Cash flow from investing activities;

-Cash flow from financing activities.

The cash flow statement is a relatively new accounting statement and is required in its current form since 1988.

In order to be able to analyse the cash flow statement (CFS) better, it needs to be “cleaned” on 4 components:

-Stock based compensation (SBC);

-Leases;

-Intangible investments;

-Purchases & sales of marketable securities.

Stock based compensation

Using equity to pay employees is relatively new.

For a long time Stock Based Compensation (SBC) did not show up as an expense in the income statement.

Since 2006 expensing SBC is compulsory under U.S. GAAP (U.S. general accepted accounting principles).

But even as the issue of expensing SBC on the income statement was solved in 2006, accountants still add back SBC expenses in the cash flow statement from operations.

But SBC is a legitimate expense, that should not be reversed in the CFS !

Let’s take a look at SBC in a little more detail.

Basically SBC can be seen as one number, reflecting 2 transactions:

-The company first sells shares (financing);

-And then uses the proceeds to pay employees (compensation for service).

So SBC sits correctly in the income statement (under US GAAP) since 2006.

But from the CFS, it manually needs to be removed from the cash flow from operations to the cash flow from financing activities.

Leases

A company that invests in a physical asset can generally buy it or lease it.

A lease is a contract by which the lessor agrees to let the lessee use the asset.

This for a specific period.

And in return for a periodic payment.

The assets that a company purchases show up in the cash flow statement from investing activities.

While assets that are leased are reflected in the cash flow from financing activities.

The adjustment here is to move the property and equipment acquired with leases from the cash flow statement from financing activities, into the cash flow statement from investing activities.

Intangible investments

The most significant adjustment deals with intangible investments.

Companies nowadays invest much more in intangible assets than in tangible assets.

Intangible assets include employee training, brand building, software code etc.

Tangible assets include factories, machines etc.

It is estimated that companies in the Russel 3000 made investments in intangible assets of 1.8 trillion USD in 2020. And 900 billion USD in tangible assets in 2020.

Accountants record most intangible investments in the income statement (expensing instead of capitalising).

The essential adjustment is to move them (intangible investments) to the cash flow statement from investment activities, this out of the cash flow statement from operating activities.

Because net income sits under the operating cash flow as the 1st line. And net income is influenced by "expensing".

The analytical challenge is to separate SG&A expenses into “investments”, and what is needed to maintain the business.

The split between “investment SG&A” and “maintenance SG&A” is different based on the industry and the company.

Marketable securities

A final potential adjustment in the CFS is to consider marketable securities as part of cash & cash equivalents.

This affects the cash flow from investing activities since they are then taken out from here.

And the result is that the statement of cash flows will have larger beginning and ending sums.

Hope this was useful. See you next week again with a new blog !

Best Joris

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Categorising for clarity: Cash flow statement adjustments to improve insights. October 2021. Michael J. Mauboussin & Dan Callahan.