Book: Creative Cash Flow Reporting
Author: Charles Mulford and Eugene Comiskey
Key takeaways: This is probably my last (for foreseeable future) read on financial fine print. As luck would have it, this is one of the best books I have read on the topic. Often books on financial shenanigans focus too much on the history of the scandals and warranted but repetitive outrage on past scandals. All that is good, but if you’re not telling me how to figure things out in the future or giving me a 100-point checklist, it rather useless from a practical standpoint. This books makes no such mistakes and respects its readers with detailed and very useful analysis. Easily a must-read on the topic. And even more so because it focus on sustainable cash flow. It is often said that cash is hard to mess around with but there are so many ways to dissect cash flow into operating vs. investing or financing cash flow that it makes sense to pay attention to the true (and sustainable) operating cash flow number.
Operating or Investing Cash Flow?
- Capitalization of certain costs (software development, certain advertising etc.) is required once ethnological feasibility is reached, but this is a very subjective call and hence this measure varies a lot across companies. It is not allowed to capitalize one-time costs.
- Interest may be capitalized if the asset is being built over a long time, and reported in the cash flow as such.
Operating or Financing Cash Flow?
- Cash flow related to investments in HTM securities is investing cash flow, but trading securities will be reported as operating cash flow.
- Money coming from use of overdrafts is shown as OCF but is really bank financing.=
- Securitizing receivables can also be considered a financing transaction but will show up in OCF.
- Vendor financing: This is a case of stretching payables, or even paying of operating costs using notes payable to suppliers (even when the notes bear interest)
- Floor plan financing: Under such an arrangement, a dealer (such as an auto/RV dealer or manufactured home marketer) pledge its inventory as collateral for a loan. When the inventory is sold, the loan is paid. Though this sounds very much like a financing, it is reported under OCF. This means that even as a company build up inventory and uses cash, the loans offset the cash use and OCF decline due to working capital build is subdued.
- When companies repurchase shares primarily to offset option exercise dilution, this is reported in investing cash flow, but an argument can be made to show this as a part of the operating cash flow.
- Off-balance sheet entities can be excluded from consolidation on the financial statements when outside investors own >3% of the entity’s total capitalization (not assets). See http://www.nysscpa.org/cpajournal/2004/704/essentials/p30.htm.
Special Case: Sales and Leaseback Transaction
Let’s say an airplane with $2.5 mm book value and economic life of 10 years is being sold for $4.0 mm for a lease term of 6 years, and that the transaction is being accounted for as an operating lease. Let us say that monthly lease payment is $58.9k (I can’t fathom how they calculate it, but let’s go with it), yielding a PV of $3.4 mm (assuming 8% interest rate assumed by the lessor). The monthly rent reported will be $58.9k – $20.8k gain deferral (which is $1.5 mm gain / 72 months). Gain deferral is needed because sale value of $4 mm > PV of $3.4 mm. Now, if this were a capital lease, the lease obligation would be reported on the B/S and proceeds will be reported as financing source of cash. But given that this is an operating lease, confusion creeps in and some companies show this as a part of the operating cash flow and sometimes as a part of financing cash flow.
Special Case: Acquisitions
Liquidation of working capital of the acquired company (assuming that the buyer has better WC abilities) can aid OCF. One way to estimate the amount of working capital that a company acquired (certainly not necessarily the working capital liquidated) is to calculate the increase in WC (using B/S) and then subtract the use of WC (using C/F).
Special Topic: Taxes
Except for one proposed exception (income tax benefits related to non-qualified stock option), the cash paid are always reported as part of the operating cash flow (even if they’re related to obvious financing items such as debt refinancing). The income tax benefit related to exercise of options by holders of non-qualified options (typically company officers and employees) is accounted for in the cash flow from financing section, as this is cash received by the company in exchange for stock. Although, IF the stock price of the company is higher than the exercise price of the option, the company gets to deduct the difference between the stock price and the exercise price as a tax deduction, and currently this tax deduction is reported in the operating cash flow. The treatment of tax benefit from option expense depends on whether the firm is profitable or not; if the firm is profitable, the realization of the tax saving is immediate and is effected in the current period (tax payable is lowered by tax rate x difference between stock price and exercise price), but if the firm is not profitable, the same amount becomes the recognized benefit (though only the realized benefit portion, a lower amount due to meagre taxable book income, goes to build a DTA).
Cash Taxes =
Current Income Tax Provision (per Income Statement)
+ Increase in Deferred Income Taxes (due to difference b/w accounting and tax laws, per C/F statement)
+ Increase in Income Tax Payables (taxes incurred but not paid because tax time hasn’t arrived yet, per C/F statement)
+ Decrease in Prepaid Income Taxes (related to overpayment of income taxes [paid before they were due], per C/F statement–should be rare)
+ Increase in Income Tax Receivable (refunds/settlements not yet paid by tax agency, per C/F statement)
– Tax Benefits from Stock Award Exercises (exercise of stock options awarded in previous periods, per C/F statement)
Often there are greater delays in making tax payments / receiving if the firm has substantial profits from outside the U.S. so these firms could have greater disparities between tax accruals and tax payments (when compared to firm with strictly domestic profits).
Most often companies pay less taxes than shown on their book, but a company can be paying cash taxes larger than the book tax provision when it i going through a restructuring/asset write-downs and these charges are not yet available as deductions in their tax returns. Capital intensive companies and financial firms providing lease financing, on the other hand, continue to accumulate significant tax deferrals–the assumption is that these activities will continue to hold volume or grow, else a decline in capex/lease financing can lead to higher tax return income vs. book income. This can be be exacerbated by PP&E of short useful lives where the reversal can be large and sudden.
Liquidity and Capital Resources section of the MD&A is often a valuable source of information on non-recurring tax cash flows.
Cash Flow Items Without Income Statement Counterpart
- Outsized pension plan contributions won’t show up on the income statement but will impact the OCF.
- A cash charge related to a non-recurring income statement item from a previous period