Bloomberg Businessweek Makes Cash Flow Analysis Easier

Bloomberg Businessweek offers an alternative take on the analysis of cash flows, both from the business’ and the investor’s points of view. Their methodology of reporting statements of cash flows provides investors with a more natural way to analyze the ways in which cash flows from investors, into and out of business activities, and then hopefully back to investors. The result is a cash flow statement which, while not perfect, allows investors to more easily differentiate between cash flows from investors and back to investors.

Companies report their cash flows in three categories: Cash from Operations, Cash from Financing, and Cash from Investing. The sum of these three categories becomes the Net Change in Cash, which is the bottom line for cash accounting and almost impervious to manipulation. The indirect method of cash flow reporting starts with the bottom-line accrual number (i.e., net income) and adjusts those accruals into cash. The direct method, which is less common, reports the cash flows themselves.

In an Investopedia article on financial statement analysis, David Harper of Bionic Turtle makes a compelling case that the standard ways of organizing cash flow statements do not reflect the natural ways in cash flows in to and out of businesses. He surmises that because of accounting standards (i.e., GAAP) and regulations (i.e., SFAS 95), business must organize their cash flows into one of three buckets instead of following a more natural order which, for most inventory/sales based operations, flows as follows:

To summarize, Harper believes it is important for prospective investors in a company to differentiate between cash flows from investment into a company, those from operations, and ultimately those coming back to investors. Although this is possible to glean from traditional cash flow statements, the standard format does not lend itself well to this type of analysis. Therefore, Harper advises investors to reclassify as reported cash flows to reflect a more natural schema.

Reclassifying cash flows would normally be a huge inconvenience because different businesses report their cash flows differently. Also, nearly every financial data and news outlet disseminates cash flow statement information in the standard format. However, Bloomberg Businessweek actually does much of this work for you in that their site reclassifies cash flows a-la David Harper. The effect is that Businessweek has made the bottom line of the Cash Flow Statement far easier to interpret.

See the example for Samsung Electronics:

For the most part, Bloomberg’s rendition of the cash flow statement can be read like any other statement. As in typical cash flow statements, the example reports net income as a top-line item. Also, as in a typical cash flow statement done in the indirect method, depreciation/amortization/depletion is reported for comparison of EBITDA and Operating Cash Flow; this comparison allows us to adjust Net Income from an accrual to a cash based accounting method. And finally, the bottom-lines of the main ‘buckets’ (e.g., Cash from Operations, Cash from Investing, and Cash from Financing) work like they do in every other statement: the sum of which will get you to Net Change in Cash (less Foreign Exchange Rate Adjustments). However, Bloomberg make two key adjustments that can simplify our analysis of from and to whom cash flows by:

  1. Reclassifying certain types of cash flows; and,
  2. Creating additional ‘buckets’ which stand-alone in the sense that they can be used to make sensible adjustments to operating cash flow and thereby arrive at a more natural understanding of from and to whom cash flows. In this example these buckets include “Total Debt Issued”, “Total Debt Repaid”, and “Total Dividend Paid”.

For example, cash flows from operations include line items (e.g., gains/losses from sales of assets or investments) which are typically included in the investing section. While assets sales may not the core of Samsung’s business, they do reflect cash flows from business activities and are likely to recur. In the case of banks and financial institutions, we certainly need to include these kinds of flows as an operating activity.

While cash flows from investing activities loses asset and investments sales/purchases, it retains those activities, like sales of PP&E, which are not likely to recur as result of standard business operations, and therefore more like the lay-person’s concept of an “investment/divesture activity”.

Businessweek further partitions changes in debt as well a dividends paid as separate line items, items which are usually lumped together in the investments section. These are important distinctions in terms of natural cash flows to and from investors (as well as the business itself). For example, a firm can issue a lot debt which would causes the bottom line (free cash flows) to grow even though this doesn’t represent cash that can be returned to investors on any kind of long-term basis. Other financing activities stand alone because they likely represent financing from internal and/or B2B activities rather than financing to and from debt and shareholders.

Cost of debt (i.e., interest payments) is the only element missing from this picture of a company’s cash flows. This figure is usually included in the Net Income, which is reconciled in the Income Statement. Adjustment to Interest Charges are sometimes made in the Operating Cash Flows section, although I believe interest is more closely linked to capital structure and should therefore be reclassified as a Cash Flow from Financing. Businessweek, for all they got right, does not offer a convenient method by which to analyze interest in the Cash flow Statement. I believe that Operating Cash Flow before Interest Charges and after Capital Expenditures (i.e., Free Cash Flow before Interest Charges) is the closest anyone can come to an algorithmic estimate to a firm’s pure ability to churn out cash from its core operations.

Finally, we return to the bottom-line, which in any cash flow statement, is net change in cash. Except in this case, we can learn a lot more about how the company got there in a much shorter span of time.

Good work Bloomberg, and thank you David Harper!