The Statement of Cash Flows, on its face, does not always tell the whole financial story when taken as is. This is especially true if the only numbers considered are those in the Operating Cash portion of the statement, as is actually quite common. You have to look at the statement and the entire financial report, including all the statements and notes, in its entirety to determine the whole truth. Even that may not be enough, but it will be enough to clue you in to any further questions that need to be asked. Following are ways to get the whole story, even when nothing illegal is going on, so that you are not hit with any unpleasant and unnecessary surprises.
Read the Notes
So much can be “hidden” here, and though most know they should read them, often the notes are pushed to the side in the name of time. Don’t make the mistake of becoming too lazy to read the notes. Look for things that can be a red flag, such as selling A/R when it has not been done in the past, capitalization of expenses that generally are not capitalized, and a large amount of outstanding checks. Of course neither is always an indicator of an issue, but both can be a mask for poor operations. At any rate, each of these practices can cause operational cash on hand to be misleading, and neglecting to read the notes will cause the issue to remain undiscovered.
Look at the Whole Cash Flow Statement
Less seasoned investors often look only at the operating section of the cash flow statement and pay little attention to the investing and financing section. Remember the statement as a whole is what will tell the entire story. The investing and financing sections can harbor very useful information. This is where creative expense capitalization can show up, as well the classifying of inventory purchases as investment expense rather than operating expense. The repercussions of this are especially noticeable when the cases of Netflix, Inc. (NASDAQ:NFLX) and Blockbuster are taken into account. At the time it went bankrupt, Blockbuster was including DVD purchases in operating outflows. Netflix, Inc. (NASDAQ:NFLX) however, records DVD purchases as investing cash flows despite the fact they are only amortized for a year. While these expenses are accounted for in the investing section as outflow, the cash inflows generated by the DVDs are recorded as operating cash. Though legal, this can cause operating cash to be misleading to readers that look only at the operating statement.
Serial Acquisition Pattern
From 2008 to 2010 Trimble Navigation Limited (NASDAQ:TRMB) reported the highest operating cash flows in the company’s history. This was in the midst of widespread economic downturn. How could this be? They took advantage of acquisition accounting. During that time frame they acquired 22 companies. The outflows that resulted from the purchases hit the investing or financing sections of the cash flow statement, but the inventory, sales, receivables, and profits all hit the operating section, giving operating cash flow a nice boost. This is easy enough to dispel by simply subtracting capital expenditures and the cash cost of acquisitions from operating cash, resulting in the free cash flow amount.
This one is quick and dirty. Generally Accepted Accounting Principles allows for short-term investing, such as securities trading, to be included in operating cash flow. The problem is, this is not really cash from operations. As such, it should be excluded when analyzing a statement to determine how successful operations were at creating cash.
What it boils down to is it is the reader’s responsibility to understand what they are reading. These are all accounting practices that are legal, but they can be somewhat misleading at the same time. By comparing the entire current report to the previous year’s report, asking questions where significant changes have occurred, looking at the cash flow statement in full rather than just one part, and reading the notes in their entirety, any misconception can generally be cleared before uninformed decisions are made.