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Flow Statement
Julie H. Hertenstein and Sharon MOMcKinnon
he cash flow statement is one of the most from the t-ash flow statement may
72
Step 2: Checking The Power healthy, growing company, we would expect
Of The Cash Flow Engine growth in operating working capital accounts
such as inventory and accounts receivable as well
The cash flow from operating activities section is as in accounts payable and other operating pay-
the cash flow engine of the company. When this ables. Obviously there can be quite a bit of vari-
engine is working effectively, it provides the cash ability in working capital accounts from period to
flows to cover the cash needs of operations. It period. Streamlining a collections policy or imple-
also provides cash necessary for routine needs, menting a Just-In-Time inventory system could
such as the replacement of worn-out equipment shrink accounts receivable or inventory in a
and the payment of dividends. There are excep- growing company. But on the average, invento-
tions, of course. Start-up companies, for example, ries, receivables, and accounts payable usually
usually have negative cash flows from operating grow in expanding companies. Beware of situa-
activities because their cash-flow engines are not tions in which all working capital accounts in-
yet up to speed. Companies in cyclical industries crease net cash from operating activities. This
might have negative operating cash flows in a likely would not happen randomly in a healthy,
“down” year; a company that has experienced an growing company. It normally results from delib-
extensive strike could also be expected to have erate management action and could indicate a
negative cash flow from operating activities. Al- company in such a cash flow crisis that managers
though occasional years of negative cash flow have been forced to raid the working capital
from operating activities do not spell disaster, on accounts to survive.
the average we should expect it to be positive. With these ground rules, let’s check Colgate-
To check the cash flow engine, first observe Palmolive’s cash flow engine. In all three years,
whether cash flow from operating activities is cash flow from operating activities is greater than
greater than zero. Also check whether it is grow- zero, reaching over $800 million in 1994. It in-
ing or shrinking. Assuming it is positive, the next creases steadily every year, unlike net income.
question is whether or not it is adequate for im- Annual depreciation is in the vicinity of $200
portant, routine expenditures. Just as we do not million each year. and the yearly dividend is also
expect a start-up company to have positive cash around $200 million. Colgate-Palmolive’s cash
flow from operating activities, we also do not flow engine is not only generating enough cash
expect a company still in a very rapid growth to cover “keeping the company whole,” it is also
phase to generate enough cash flow from operat- able to throw off around $400 million annually
ing activities to cover the investments required to for growth and investment, and the amount of
rapidly expand the firm. However, we do expect excess cash has been increasing each year.
the operations of a mature company to generate This is a powerful cash flow engine. A glance
enough cash to “keep the company whole.” This at the working capital account differences indi-
would include the amount of investment required cates that receivables, other assets, and payables
to replace those fixed assets that are used up, have grown (net) over the three years, while
worn out, or technologically obsolete as well as inventories have shrunk slightly. This picture is
cash required to pay the annual dividend share- consistent with a global company increasing its
holders have come to expect. scope through acquisitions and new product
It is difficult to know precisely how much development.
cash is required to keep the company’s fixed
assets “whole,” because the cash flow statement Step 3: Pinpointing The Good News
does not separate capital expenditures for re- And The Bad News
placement and renewal from those for expansion
and growth. However, the annual depreciation This step involves looking at the total cash flow
amount provides a very rough surrogate for the statement to find where the rest of the “good
amount of fixed assets that need to be replaced news” and “bad news” lie. What you are looking
each year. In periods when prices are rising, the for is the story the statement is trying to tell you.
cost to replace assets should be somewhat It will not come simply by divine revelation, but
greater than the cost of older assets that are be- by systematic observation of the items on the
ing depreciated. So to ensure that the firm is kept statement and their trends over the years pre-
whole and is not shrinking, we should expect the sented for your comparison.
portion of investing activities related to the pur- Begin with cash flow from investing activi-
chase of fixed assets to exceed depreciation. ties. What is this section trying to tell you? One
Important information about the cash flow systematic observation is to check whether the
engine is also revealed by examining the operat- company is generating or using cash in its invest-
ing working capital accounts. In the Colgate- ing activities. Whereas we expect positive cash
Palmolive operating activities section, these are flow from operating activities, we also expect a
shown under “cash effects of these changes.” In a healthy company to invest continually in more
ow
ing expenses in prior years and this is just the a strong positive cash flow story.
anticipated cash outflows catching up with them.
N
Moreover, the amount on the cash flow statement it’s your turn. The best way to learn
is declining each year. about cash flow statements is to study
Whether or not to chase down explanations some carefully using the four steps
for unusual or unknown items is a subjective call. described above. You may not become an expert
For example, if Colgate-Palmolive’s restructuring but you will be able to spot the big trends and
charge differences were bigger or growing, it important issues involved with the management
might be worthwhile to search for more informa- of cash in most companies.
tion. However, the “weight of the evidence” so Figure 4 provides you with the opportunity
far indicates that this issue is not particularly rel- to test your newfound skills. It is similar to the
evant in getting at the big picture. If you encoun-
ter something you do not understand, consider its
materiality. If it has a major effect on cash flow Figure 4
from operating activities, or if it ranks as one of Jones Company: Statements of Cash Flows
the major sources or uses of cash, you should For Year Ending December 31
probably search for an explanation. Otherwise it
may be more efficient to ignore it and concen- Millions of Dollu~.s 7005 1994 19%
trate on the many items you know. Cash Flow from Operating Activities
Net income (loss) S (43) $ (189) $ (134)
Now let’s summarize what we’ve learned by
Depreciation 230 271 350
examining Colgate-Palmolive’s cash flow state-
(Increase) in receivables (121) (25) (4)
ment. First, the good news. Net income has been
LIecrease in inventories i0 42 30
positive for all three years and, if we eliminate Changes in other current accounts _l& llil (12)
the effects of the accounting change, has been
steadily increasing. Operating cash flows have Net cash provided by operating activities 132 91 230
also been positive for three years; they, too, have
Cash Flow from Investing Activities
been steadily increasing. Operating cash flows
Capital Expenditures (200) (260) (310)
have significantly exceeded the sum of deprecia- Disposal of plant assets 204 200 180
tion and dividends, so Colgate-Palmolive is gen- Disposal of business segnwnt m L!
erating enough cash from operations to expand
Net cash (used in)/provided 1,);
the business. The working capital accounts are
investing activities 138 (9) (120)
growing, consistent with the expectations for a
growing business. By making capital expendi- Cash Flow from Financing Activities
tures that significantly exceed clepreciation, and Pro~ercis of long-term debt 200 450 215
also by making fairly large acquisitions, Colgate- Reductions of long-term debt (460) (480 1 (322)
Palmolive shows that it is grooming the business Dividends paid (30)
for the future. There are no large-scale sales of
Net cash used for financing activities (260) (SO) (137)
fixed assets or divestitures that indicate any
downsizing or shrinking of the business. The Increase (decrease) in cash $10 $ 52 $ (27)
company has increased its dividend payments - - -
puzzles you encountered as a child in which YOLI changed as ;I percentage of total liabilities and stock-
spot the things that are wrong with the picture. holders’ equity? For Colgate-Palrnoli\,~, the percentage
Poor Jones Company is having some rough times, of debt to tc)tal IiabiliGes and stockholders’ equity is
as illuminated by their cash flow statements for quite high and has gotten higher, from 6% in 1993 to
70% in 1994. The company‘s income alrement reveals
1993, 1994 and 1995. See how many of these
that interesr expense has almost doubled in the last
troubling developments you can identify by put- year, and ;I quick ratio analysis of “nunher of timrs
ting together the PLIZZ~ of the Cash Flow State- interest can he paid from income” shows 3 slurp de-
ment! (Some possible answers are listed at the cline from 7 time to alwut 4-l/2 times in one year.
end of the article.‘) Furthrr examination of rhe cash tlou, statement reveds
Opportunities for applying your new exper- that rhe comp;iny purchased large amounts of treasuq
tise are many. As an employee curious about stock. This helps explain why stockholders’ equity is
your company’s ability to cover your paycheck, low in comparison to total equities. \vhich may make
you can check out the health of cash flow from that 700/o dcht-to-total equity ratio more unclerstancl-
:hle.
operating activities. Or suppose you are 3 seep-
2. This contrasts \\ith minor stock repurchases that
plier \vhose customer has just announced ;I loss
companies rypically undertake to offer stock to cnl-
for the year and you are a~ondering whether to
ployees in stock option plans: in such instances, mod-
continue to extend credit. An analysis of the est treasury stock repurchases are offset by modest hut
customer’s cash 1-10~ from operating activities can comparal)le issuances of treasury stock.
provide you \vith evidence that the firm does 01 3. An accounting change is just 2 “paper decision”;
does not have strong enough cash flows from it affects the \v;iy net income is presented. hut ir does
operating ac‘tivities to pay its bills despite losses not change the tundamenral economic activity of the
on the income statement. firm. so it ciocs not affect cash receipts or c:Lsh expe”-
If you are a stockholder. you may be inter- ditures.
ested in \vhether cash flow from operating activi- -t. Some possilde :ms\Yers are: ( 1) there have lwen
losses in all three years: (2) depreciation charges have
ties is large enough to invest in the capital expen-
decreased: (3) capital expenditures :ire Irss than clepre-
ditures required to keep the company whole and ciarion; (4) capitd expenditures are less than disposals;
make it grow while still paying the dividend you (5) ;I big :iccounts receiv:lble increase needs to be
have come to expect. As an executive. you might invcstigatecl; (6) in\,entories are decreasing: (7) seg-
examine the ash flo~v statement to determine ments of the business :ire being sold off; (8) the com-
whether it is likely that all of the major sources of pany has stopped paying dividends; (9) debt needs to
cad-operating activities. issuing stock. and I,e paid off with cash flow from operations; (10) there
I2orrowing-wdl be sufficient to fund 3 major is mucli borro\ving; ( 11) there is less I>orro\ving this
expansion progl-am ~OLI plan to Ldertake. As ).ear. Are creditors trusting the comp:lny less?
your expertise increasc5, many 0dWr useful appli-
References
cations may appear to you.
The information contained in a cash flow
statement cannot repLice the information from
the traditional income statement and Mance
sheet. But it does provide v:il~lahle input for un-
derstanding the relationships between income
and its short- and long-term ability to generate
cash. 0
Notes