It’s a question we get a lot from advisors: Can you trust the cash flow statement? The answer is no. The question usually arises after a discussion of how untrustworthy the income statement and balance sheet are. What follows is an even longer discussion about how untrustworthy the cash flow statement is.
Advisors are usually surprised. Most know accounting games can be used to fudge the income numbers, but only a minority understands how unreliable cash flow figures can be.
Most assume cash is cash because of hackneyed investment quips like “cash is a fact, profit is an opinion” or “in cash we trust” and, yes, even the inventive “cash is cash.”
To set the record straight, when it comes to the language of financial statements, nothing is what it seems. Accountants do not set the rules with investors’ needs at the top of their mind. More to the point, they don’t set rules based on the fact that investors place significant emphasis on cash from operations, and free cash flow figures.
Figures on the cash flow statement are merely adjustments of numbers that come from the income statement — the same income numbers most advisors are quick to treat with a skeptical eye.
Many of the problems that exist with the income numbers tend to leak into the cash flow statement figures, because frankly, not enough correcting adjustments can be made to bring the accrual income figures back to being anything close to actual cash flows.
Income figures are based on numerous management assumptions. In short, management estimates what expenses belong in the quarter in order to match them to their estimate of how much revenue should be recorded.
Actual cash flow figures do not match up to revenue and expense estimates. Sometimes cash comes before revenue, sometimes after; the same goes for expenses.
The period in which “cash” is recorded on the cash flow statement can be completely disconnected from actual cash flows in and out of the bank. That’s the first big miss when it comes to the cash flow statement.
The second is when it comes to categorizing cash flows. The cash flow statement is divided into three categories of cash: operating, investing and financing. The problem is that cash can be miscategorized by management, or alternatively, misinterpreted by investors.
We mentioned earlier that investors place significant emphasis on cash from operations and/or free cash flow. Unfortunately, this is akin to looking at only about one-third of the information on the cash flow statement.
A similar approach taken with the income statement would be to stop reading once you reach the gross profit line. Naturally, this can cause significant problems, since as mentioned, management has considerable ability to decide what is included in cash from operations and what is not.
In a recent article for Advisor.ca, “Shielding portfolios against the next Sino-Forest,” we looked at the potential warning signs that advisors might have seen before investing in Sino-Forest Corp., before it came under attack by a short-seller’s report and dropped as much as 93% in value before partially recovering.
One reason that all confidence in the stock collapsed was because there was no floor to the share price that could be supported by reliable cash from operations figures. At one point, the shares were trading at a fraction of 1x next year’s consensus cash flows.
And while most of those analyst estimates have now been pulled, they were unfortunately based on misleading cash flow numbers anyway. While this was something that value investors scavenging the stock probably picked up on after the fact, it went largely unnoticed before the crisis hit.
Early warning sign
We mentioned in the article that investors could have clearly identified that Sino-Forest was cash flow negative from an operational standpoint. This caught the attention of one advisor who asked us how this was apparent given the significant and growing cash from operations figures reported on the company’s cash flow statement.
On re-examination, it seems we were being too glib, and in fact, it would have been difficult for investors to identify the problem without understanding both the business of Sino-Forest, as well as the shortcomings in the accounting rules, especially as they apply to the cash flow statement.
Sino-Forest was cash-flow deficient from an operational standpoint (as we stated), despite reporting significant cash from operations in its financial statements. The paradox is the result of the way in which Sino-Forest set up its cash flow statement.
Sino-Forest treated its timber purchases as acquisitions, which flowed through the cash flow statement as cash used in investing activities. However, when the company sold the timber, the cash coming in was recorded as cash provided by operating activities. This led to positive cash from operating activities, and negative cash from investing activities.
Other companies in similar situations have been known to treat such acquisitions as cash used in acquiring inventory, which then flows through operations as a use of cash. Had Sino-Forest done this, it would have been more apparent that the company was cash-flow deficient from an operational standpoint.
As a matter of fact, since Sino-Forest switched to using IFRS effective for Q1/2011 (which it reported after the scandal broke), the company has reorganized its cash flow statement to include timber purchases as a use of cash from operations. When the company restated its Q1/2010 figures, cash from operations went from positive $51.4 million to negative $122 million (all figures USD).
It’s clear the difference in where cash flows are categorized can have a huge impact on investors’ perceptions of the health of a company. And it can’t be lost on advisors that management has significant latitude in how the cash flows are reported.
The flip side is that there is as great a risk that investors will misinterpret cash flow numbers as much as management might play games in miscategorizing them. Doubters might say sharper investors would have red-flagged Sino-Forest’s free cash flows (netting the positive cash from operations with the negative capex spending). However, the Sino-Forest example is just one of the possibilities that advisors need to keep in mind.
Most investors don’t realize that all cash taxes end up in operating cash flows, even if they relate to the sale of a property that is recorded in investing activities. This could actually end up understating cash from operations.
Conversely, it is easy to miss the fact that a company may be taking a pension contribution holiday, and that even though reported income shows an expense for the pension plan, reported cash flows might not show anything, and therefore overstate cash from operations.
Another common adjustment worth making is when a company is issuing stock options as well as buying back shares at the same time. The accrual expense of the stock options is added back to cash from operations, and therefore no cash expense is shown.
However, if the company buys back shares in order to cancel out the dilution of issuing the options, the cash used to buy back the shares is recorded in financing activities. Again, this is another example of where cash flows are essentially miscategorized because of the nuances of the accounting rules.
Cash is being spent to cancel the dilution of the stock options that are used as compensation in lieu of salary. If that’s not a use of cash for operating activities, we’re not sure what is.
Not all trash
While the cash flow statement figures are untrustworthy, it doesn’t mean they’re trash. One reliable number on the cash flow statement (outside of fraud) is the net change in cash right at the bottom of the cash flow statement.
It is the only amount that will tie into actual cash (i.e. what’s in the bank). This is what often confuses investors, and makes them believe that the cash flow statement reflects actual cash flows.
Unfortunately, the rest of the numbers on the cash flow statement are open to management judgment and assumptions, as well as flawed accounting rules. As a result, investors are at risk of misinterpreting cash flows and the health of a company.
Advisors need to treat cash flow figures with the same skepticism as income statement figures. When it comes to analysis, it is best to take both the cash flow and the income figures into consideration, and compare the two in order to identify where large discrepancies may exist. It just might be your next tipoff to something strange going on.