This article was originally published on CoreEarnings.com
Financial Reporting is primarily focused on providing a detailed view of a firm’s earnings. The accruals concept is applied to both revenues and expenses so that only income/expenses which are earned or occurred in the period are reflected in the accounts irrespective of payments. For example, a software firm which pre-sold licenses for software which has not yet been delivered and collected payment would not recognise the sale in its accounts until the software was fully delivered.
The accruals concept is intended to provide a truer picture of a firms financial performance, however it has the drawback of earnings diverging from the cash generated by the business. The core concept is that earnings will eventually show up as cash flow.
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The issue with earnings measures such as Net Income is that they include items such as depreciation and provisions of bad debts which require estimates and so affords the business a degree of latitude in ‘managing’ its earnings. Cash Flow is a harder measure which must must backed up by movements in the firm’s cash balances which is straightforward to verify. Thus to aid the understanding of financial performance a Statement of Cash Flows is included in financial reports.
The most important item in the Cash Flow statement is the Cash Flows From Operating Activities which shows the cash generated by the firm’s core business activities. It is arrived at by starting with Operating Income and adjusting for all non-cash items. In financial analysis, capital expenditure is sometimes deducted from Cash Flow from Operating Activities to arrive at Free Cash Flow. The rationale for deducting capital expenditure is that this is a necessary recurring expense for the firm to generate its income.
There are two other balances in the Cash Flow statement – Cash Flow From Financing Activities is the cash movement associated with the financing of the business so issuance or repayment of loans as well as equity issuance will be shown in this balance. Cash Flow from Investing Activities relates to investments the firm may make in securities as well as investments in fixed assets.
Use of the Cash Flow Statement
For a business or financial analyst the primary use of the Cash Flow Statement is in determining the quality of a firm’s earnings. As noted above, a firm’s earnings should eventually be reflected in the firm’s cash flow. Thus Free Cash Flow (or Cash Flow from Operating Activities) should trend with Operating Income, note from the below chart that Apple’s Free Cash Flow closely tracks its Operating Income:
A prolonged divergence in these series could signal aggressive accounting to artificially boost Income.
Cash Flow Statement Limitations
A common misconception is that cash flow is immune from manipulation since the firm must verify the actual movement in its cash balance with bank statements. However, this is only true for the total movement in cash flow, the Cash Flow From Operating Activities balance can easily be manipulated by misclasifying items which should ordinarily be expensed. For example, WorldCom misclassified operating expenses as capital expenditure, which has the effect of removing the expense from both the Income Statement and the Cash Flow From Operating Activities, instead the amount showed up in the Cash Flow From Investing Activities which is less used by financial analysts.
Finally, note that Cash Flow is not the same as EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) although financial reports sometimes use the two the interchangeably. EBITDA still use the accruals method to arrive at the earnings figure which is then adjusted for non-cash items such as depreciation and amortization. As such EBITDA is a hybrid between a regular accrual based earnings measure and a cash based measure of earnings.