The cash flow statement, in depth

The answer

The most useful half page in any annual report is the reconciliation at the top of the cash flow statement, which starts at reported profit and adjusts it, line by line, until it reaches the cash the business actually produced.

Each line in that list is 1 specific difference between the opinion and the fact. Reading it in order tells you exactly where a company's profit went.

Why this costs you money

The 3 sections of the cash flow statement, and the reason cash matters more than profit, are covered in "Why read financials, and what the three statements each answer". This article is about the traps inside the statement itself.

Here is the expensive assumption: that operating cash flow is hard to manipulate, so a company with strong operating cash flow is safe.

Operating cash flow is harder to manipulate than profit. It is not hard. There are at least 6 ways a company can raise reported operating cash without selling anything more, and all of them are legal, and most of them are disclosed somewhere other than the cash flow statement.

• Stop paying suppliers in the last month of the year.
• Arrange for a bank to pay the suppliers instead, and keep the amount inside trade payables rather than borrowings.
• Sell the receivables to a bank at a discount.
• Capitalise costs, which moves the spending from operating to investing.
• Capitalise the interest on the money borrowed to build something.
• Choose to present interest paid in the financing section rather than the operating section, where the accounting standard permits the choice.

An investor who checks only the operating cash flow subtotal will be satisfied by every one of these. An investor who reads the reconciliation and the payables note will see 4 of them immediately.

The other expensive assumption runs the other way. A young company with negative operating cash gets rejected on principle, when the negative cash is the correct result of growing inventory and receivables in a business that is working. Both mistakes come from reading the subtotal instead of the lines.

How it works

The reconciliation, line by line

Almost every company uses the indirect method, which starts at profit and works towards cash. The lines come in 4 groups, and knowing which group a line belongs to is most of the skill.

Group 1: costs that reduced profit but moved no money. Depreciation and amortisation, impairment losses, provisions created, share-based payment expense, losses on assets written off. All added back. These are not signs of quality. A large depreciation add-back means the company owns a lot of equipment, and it will have to spend money replacing it.

Group 2: items moved to another section. Finance cost is added back, because interest paid is shown separately. Interest income and dividend income are subtracted, because they belong in investing. Profit on the sale of an asset is subtracted, because the whole proceeds appear in investing. This group is where classification choices live.

Group 3: working capital movements. This is the heart of it.

• Increase in trade receivables — cash out. Customers owe more.
• Increase in inventories — cash out. Money is sitting in a warehouse.
• Increase in trade payables — cash in. The company owes suppliers more.
• Increase in other current assets, loans and advances — cash out, and this is the line to read carefully, because it is a residual category. Money lent to somebody, advances to suppliers, deposits placed. Large movements here deserve a look at the corresponding balance sheet note.

Group 4: taxes paid. Actual cash tax, which differs from the tax charge in the income statement because of timing and deferred tax.

The instruction is simple. Find the single largest line in the reconciliation and understand it. In a good year for an ordinary company it is depreciation. When it is a working capital line, that is the year's story.

Working capital: the number and the days

A working capital movement is easier to judge when converted into days.

• Receivable days = trade receivables ÷ revenue × 365.
• Inventory days = inventories ÷ cost of goods sold × 365.
• Payable days = trade payables ÷ cost of goods sold × 365.
• Cash conversion cycle = receivable days + inventory days − payable days.

The cycle is the number of days between paying for something and being paid for it. A negative cycle means customers pay before suppliers are paid, which generates cash as the business grows. Supermarkets and some online retailers work this way.

Track all 4 across 5 years. Rising receivable days with flat revenue means selling is getting harder. Rising payable days means either better bargaining or inability to pay, and only the notes distinguish them.

The classification choices that change the subtotal

Interest paid. Under Ind AS 7, a company may classify interest paid as either an operating or a financing cash flow, and must apply the choice consistently. Under US GAAP, ASC 230 requires interest paid to be an operating cash flow. So an Indian company with heavy debt can report an operating cash flow figure that has not been reduced by its interest bill, while an American company with identical economics cannot.

Always check where interest paid sits before comparing 2 companies. It is printed on the face of the statement.

Capitalised interest never appears in operating cash at all. It goes into investing, as part of the cost of the asset being built.

Lease payments moved in 2019. After Ind AS 116 and ASC 842, the repayment of lease principal is a financing cash flow, and only the interest part remains outside operating. Before the change, the entire rent payment reduced operating cash flow. So operating cash flow for retailers, airlines and hospital chains rose in that transition year without any change in the money leaving the bank. Free cash flow calculated as operating cash minus capital expenditure is not comparable across that boundary unless lease repayments are deducted too.

The 3 arrangements that hide inside working capital

Reverse factoring, also called supply chain finance. A bank pays the company's suppliers early, and the company repays the bank later. Economically this is borrowing. Presentationally, the amount often stays inside trade payables rather than borrowings, so reported debt is lower and operating cash flow is higher. Disclosure requirements have been tightened in recent years. Look for the words "supply chain finance", "vendor financing" or "channel financing" in the notes, and for payable days that rise sharply without an explanation.

Factoring or discounting of receivables. The company sells amounts owed by customers to a bank for immediate cash. Operating cash flow rises. Whether the risk actually transferred determines whether it should have been treated as borrowing. The note on financial assets says whether receivables were derecognised.

Bills payable and acceptances. In India, a supplier's bill accepted by a bank on the company's behalf may sit in trade payables or in short-term borrowings depending on the arrangement. It is debt either way.

Free cash flow, defined honestly

Free cash flow is operating cash flow minus what the company must spend to keep operating. The arguments are all about the second half.

A defensible version: operating cash flow, minus purchase of property, plant and equipment and intangibles, minus repayment of lease liabilities. If you want a stricter version for a company that grows by buying other companies, subtract acquisitions too.

Two cautions. Capital expenditure includes both maintenance spending and growth spending, and companies rarely split them, so free cash flow understates the cash a company could produce if it stopped growing. And a single year is noise. Use 5 years cumulative.

The best single quality test available: add 5 years of free cash flow, add 5 years of reported net profit, and divide the first by the second. For a healthy, mature company the ratio is usually somewhere near 1. Persistently far below 1 means reported profit is not turning into money over a full cycle, and the reason must be found.

Cash on the balance sheet is not always available cash

Check 3 things in the cash note before treating a cash pile as protection.

Restricted cash. Amounts held as margin, security for guarantees, or in escrow. It is disclosed and it is not spendable.

Where the cash sits. In a consolidated group, cash in a subsidiary with minority shareholders is not fully the parent's. Cash in a country with exchange controls may not be movable.

What sits next to it. Large cash and large debt at the same time is a question. Sometimes it is prudence. Sometimes the cash is not there, and sometimes the cash is at the parent while the debt is at a subsidiary.

What it tells you, and what it does not

It tells you where profit went. Every difference between profit and cash is named on the page.

It tells you who is funding the company. Customers, lenders or shareholders. Read the financing section as a statement about dependence.

It does not tell you whether spending was wise. A company can convert profit to cash beautifully and spend all of it on a bad acquisition.

It is not comparable across the 2019 lease transition, or between companies that classify interest differently.

It is close to meaningless for lenders. For a bank or a non-banking finance company, lending money out is an operating activity, so operating cash flow for a growing lender is deeply negative and that is normal. Use capital adequacy and asset quality instead.

The decision rule

Read the reconciliation, name the largest line, and explain it in 1 sentence. Then check where interest paid is classified.

If cumulative free cash flow over 5 years is far below cumulative reported profit, the profit is not being converted into money and you must find the reason before paying for it — unless the company is genuinely building capacity for growth, in which case operating cash before capital expenditure should still track profit closely, and the gap should be entirely in the investing section.

Try this now

Five minutes, 1 holding, its latest annual report. This is the exercise that teaches the statement.

1. Open the consolidated cash flow statement. In an Indian report it follows the profit and loss statement and the balance sheet. In a Form 10-K it is in Item 8.
2. Write down the first number: profit before tax. Then write down the last number of the first section: net cash from operating activities.
3. Now list every line between them, with its amount and its sign. There are usually 12 to 20. Do not interpret yet. Just write them down in order.
4. Circle the largest single line by absolute value, ignoring depreciation. That is the year's story. Write 1 sentence saying what it is and which direction it moved cash.
5. Find the line interest paid and note which section it sits in: operating or financing.

What you should see. Two things.

First, you now know precisely how this company got from an opinion to a fact, and you can repeat the exercise every year in about 3 minutes. Most differences will be depreciation and working capital. If the largest item after depreciation is an increase in receivables or in loans and advances, that is where the money is.

Second, if interest paid sits in financing rather than operating, then this company's headline operating cash flow has not paid for its debt. Subtract interest paid from it and use that number instead when comparing with any other company.

A useful extra 60 seconds: divide net cash from operating activities by profit before tax, for this year and the 2 previous years, and write the 3 numbers on the same line. That short series is more informative than any single ratio in this cluster.

Three real cases

1. Amazon.com, 1997 to 2003 (United States) — cash before profit, and it was real Amazon reported net losses for several years after its 1997 listing while building a business whose customers paid at the moment of purchase and whose suppliers were paid weeks later. That structure produces a negative cash conversion cycle: the money arrives before the bill is due, so growth generates cash rather than consuming it. The company's operating cash flow turned positive and stayed there well before its reported net profit did. An investor who applied a rule of "no profit, no investment" would have missed this. An investor who read the working capital lines could see that the losses and the cash position were telling different and equally true stories.

2. Carillion, 10 July 2017 to 15 January 2018 (United Kingdom) — borrowing that was reported as trade payables Carillion was a large construction and outsourcing company. On 10 July 2017 it announced a contract provision of about £845 million and its shares fell heavily. It went into compulsory liquidation on 15 January 2018. Subsequent parliamentary and regulatory examination found that the company had used an early payment facility, a form of reverse factoring, under which a bank paid its suppliers and the company repaid the bank later. Substantial amounts were classified as trade or other payables rather than as borrowings. Reported net debt was therefore lower, and reported operating cash flow higher, than the economic reality. The disclosure existed. It required reading the payables note and asking why payable days had extended.

3. Cox & Kings, June 2019 (India) — a large reported cash balance and a default on a small payment Cox & Kings was a listed travel company. In June 2019 it failed to repay commercial paper, which is short-term borrowing, and credit rating agencies moved it to default. The striking feature was that its published accounts had shown substantial cash balances shortly beforehand. Insolvency proceedings followed later that year, and subsequent forensic examination raised questions about the reality of reported receivables and cash. The general lesson is available to any reader without any special knowledge: a company that cannot make a small payment does not have the cash its balance sheet shows, or the cash is not where it can be used. Both possibilities are found by reading the cash note and the restricted cash disclosure, not the balance sheet total.

The question that resolves it

A novice looks at the cash flow statement and asks: was operating cash flow positive?

An expert looks at the same statement and asks: which line explains the difference between profit and cash this year, and is it the same line as last year?

A gap that changes its cause every year is ordinary business variation. A gap with the same cause for 3 years is a structural feature, and structural features either resolve into cash eventually or turn out never to have been profit.

What would make this wrong

If cash flow analysis reliably identified problems, companies with strong operating cash flow would not fail. Some do.

Honest limits.

Cash can be borrowed. A company can show a healthy cash balance funded entirely by short-term borrowing that must be repaid next quarter. Always read the financing section beside the operating section.

Growth legitimately consumes cash. A retailer opening stores or a manufacturer filling a new plant will show negative operating cash for years and be entirely healthy. The test is whether the consumption falls as growth slows.

A single year proves nothing. A large order shipped in the last week of the year moves receivables, and the cash arrives 45 days later, in the next report.

Some sectors do not fit the framework, particularly banks, insurers and lenders, where the statement's categories do not describe the business.

Carry this

• The reconciliation from profit to operating cash is a list of every difference between opinion and fact. Read the largest line.
• Check where interest paid is classified before comparing 2 companies.
• Over 5 years, cumulative free cash flow should be close to cumulative profit. If it is not, find out why.

Knowledge check

Related

• The income statement, in depth
• The balance sheet, in depth
• Why read financials, and what the three statements each answer
• ← Fundamental analysis, end to end