Get A Handle On The Ebb And Flow Of Money

Foreword from ShareInvestor

This article “Get A Handle On The Ebb And Flow Of Money” by Cai Haoxiang was first published in The Business Times on 24 Jun 2013 and is reproduced in this blog in its entirety.

Gain valuable insights when you decipher a firm’s cash flow statement, says CAI HAOXIANG

LAST week, we looked at how to read and analyse the balance sheet. The balance sheet is an integral part of a company’s financial statements. It allows the investor to evaluate the financial stability of a company by giving an idea of what its assets and liabilities are.

We have also examined the role of the income statement. It tells investors how much money the company made and what its major costs were in the last financial period.

This week, our focus is on the cash flow statement. This is the third major item in a company’s financial statements that investors should scrutinise.

It can also be the most confusing.

One area of confusion is the difference between the income statement and the cash flow statement.

The income statement tells you how much money you made. The cash flow statement also gives you a sense of how much money was made, but it focuses on the ebb and flow of cash.

To understand this difference, we have to go to the heart of financial accounting.

Money Flows

When a company brings in money by conducting ordinary business activities, the money earned is classified as revenue on the income statement. For example, if I run a home appliance shop and sell a washing machine to you today for $1,000, I would record $1,000 as revenue.

But this does not mean that I get $1,000 in cash today. You might pay me $200 as a deposit first and come to my shop next week to pay the remainder when you collect the washing machine. You might not have $1,000 straightaway but sign an agreement saying that you will pay me $100 a month for the next 10 months. Or you might pay me a lump sum of $1,000 three months from now.

Revenue is typically recorded when it is clear that I will get some clearly-defined economic benefit from a sale that was made. It does not matter when the payment is made.

If I sell 1,000 washing machines today and everybody decides to pay me three months from now, I will have recorded $1 million in revenue, assuming everybody is creditworthy. But I will have nothing in the bank this month.

But let’s say my costs are $800 per machine and I will make a profit of $200 for every machine I sell.

When I sell 1,000 machines today, assuming this is the only transaction I will make this month, I will record June revenue of $1 million. I then spend the whole of tomorrow producing all these 1,000 machines.

My June expenses will thus be $800,000, and my June profit $200,000.

But this profit is only on paper, because I have not received any money yet and everybody can only pay three months later. Because I will not get any cash till September, my cash flow this month is actually negative – I have spent $800,000 making the washing machines but have not got any money back in return.

Tracking Cash Movements

How is this flow of money reflected on the cash flow statement?

Many cash flow statements are prepared using what is called the indirect method. This means that the statement starts with a measure of profit for the time period first.

Then, a series of adjustments are made before one arrives at the net increase or decrease in cash.

In our washing machine example, if I had to prepare my cash flow statement for June, I will start with profit of $200,000.

I will then consider how much money customers owe me. This is known as receivables, explained in last week’s piece on the balance sheet.

Receivables are an asset because it is money that is due to the company.

By selling $1 million worth of washing machines today, and given that all customers are not paying me yet, I will record an increase of $1 million in receivables.

To get net cash flow, I deduct the increase in receivables from net profit. This is known as an adjustment made under working capital. By deducting $1 million from $200,000, we get -$800,000. This was the amount of cash that flowed out from my bank account this month.

Going Backwards

This is the part that confuses people. Under the indirect method, everything is worked out backwards.

If customers owe you more this year compared to last year, your assets will increase as receivables increase. But when you think about this in terms of cash, it is not a good thing because you actually have less cash to use. If you owe your suppliers less this year, your liabilities will decrease as payables decrease.

But in terms of cash, it is also not a good thing, because it means you have less cash to play around with. The relevant adjustment here is to deduct the decrease in payables.

Let us plunge into a real world example now. Given that timing is everything, it is perhaps appropriate to use the cash flow statement of homegrown watch retailer The Hour Glass, which has been listed on the Singapore Exchange since 1988.

Its cash flow statement in its unaudited results for the year ended March 31, 2013 has three parts: Operating activities, investing activities, and financing activities.

Note that the first line on the statement starts with “profit before taxation”. We thus know that this statement was prepared using the indirect method, and we have to work backwards and make various adjustments.

The Hour Glass recorded $65.9 million of profit before taxation in its latest full year results. There are eight items to be adjusted for, before we get “operating cash flow before changes in working capital”.

A major item on every company’s accounts is known as depreciation. Car owners will understand what this means.

You buy a $200,000 lean, mean and powerful machine today, but 10 years from now it might only have scrap value of $5,000 if you’re lucky.

This means the car decreases in value – depreciates – at an average of $19,500 a year.

Similarly, company assets like machines, furniture and equipment, leasehold property and motor vehicles decrease in value every year. The extent of the depreciation is estimated using various assumptions.

Depreciation is an expense on the income statement. If we look at The Hour Glass’ latest income statement, we see that it has recorded $5.9 million as “depreciation of property, plant and equipment”.

This amount is an expense, meaning it is deducted from revenue to get profit before taxation.

But there were no cash movements. You do not lose money in the bank every month just because your car loses a thousand dollars of value. This is just an accounting measure and is not reflective of how much cash you actually have.

In the cash flow statement, we thus add depreciation back to arrive at how much cash we actually made.

Other Operating Cash Flow Adjustments

Cash flow from operating activities, the section we are in, describes the cash flow from the company’s day-to-day activities in the pursuit of revenue.

But there are some items accounted for in “profit before taxation” which, strictly speaking, have nothing to do with the company’s day-to-day activities.

These items are included in “other income” on the company’s income statement in this case, below “revenue”. They include interest income, a fair value gain on investment properties, and a net gain on disposal of property, plant and equipment.

They boosted profit before taxation, but they are not part of operating activities. This income should thus be deducted to get a better sense of how much cash was contributed by operating activities.

Working Capital Adjustments

We are now at “operating cash flows before changes in working capital”. Working capital refers to the cash the company shuffles around between paying its suppliers, increasing inventory, and collecting money from customers.

We see five items to be adjusted for. This includes deducting the increase in receivables and deducting the decrease in payables we talked about earlier.

A major item that was deducted from operating cash flows was “increase in stocks” of $36.6 million. The Hour Glass had been adding to its inventory pile as it expanded its retail network.

Because more money was spent on increasing inventory, this is subtracted from cash flow, even though this would be an increase in current assets.

After adjusting for changes in working capital, our journey into backwards-land ends. Phew.

We deduct income taxes and interest payments made, add interest received, and get net cash flows from operating activities of $12.9 million.

Investing And Financing Activities

We are now at the second half of the page. We have figured out the cash that the company made from operating activities.

Now, we examine the cash flows spent on investing and financing activities. From now on, things are more straightforward. Expenditure is deducted, and gains are added. A major item under investing activities is usually the purchase of factory equipment. We see that the company spent a significantly higher amount on “purchase of property, plant and equipment” in the full year to March 31 – $9.6 million compared to $3.9 million a year ago.

Financing activities refer to things to do with borrowing money, paying dividends to shareholders, and paying back debts. Here, we see that the company borrowed $41.2 million, a cash inflow, and paid back $2.6 million of debt, a cash outflow. It also paid out $14.1 million worth of dividends on ordinary shares.

We finally get to the line called “net increase in cash and cash equivalents”. This shows how much money the company added or deducted from its bank account.

In this case, the company started out with $53.7 million. Throughout the year, which ended on March 31, the company made $12.9 million from operating activities, spent $10.6 million in investing activities, and gained $24.1 million from financing activities.

The end result is a $26.5 million increase in cash and cash equivalents. Add that to the cash it had from the previous financial year, and The Hour Glass now has $79.5 million in the bank as at March 31, 2013.