Understanding the Cash Flow Statement

This article looks at the cash flow statement, the final of the 3 primary financial statements that all public companies must report to the SEC. In the first article, we covered the income statement, and the second article looked at the balance sheet.

The purpose of the cash flow statement. The cash flow statement has 2 primary purposes. One, it indicates to the investor how much cash money flowed into or out of the business over a period of time, usually a year or a 3-month quarter. Second, it reconciles the other two financial statements – income statement and balance sheet. For the income statement, it reconciles the accounting assumptions with the actual cold, hard cash the business earned. For the balance sheet, the cash flow statement shows the differences in the level of assets or liabilities from the previous reporting period.

One major difference between the cash flow statement and it’s siblings is that there are no accounting assumptions or estimations on the cash flow statement. The income statement contains many accounting assumptions for things like depreciation and taxes. Likewise, the balance sheet estimates the worth of acquired businesses (goodwill) and intangibles like patents or brand names. The cash flow statement values are very real – this is the *exact* amount of cash coming in and going out of the business. Since creating cash from assets is the basic function of any business, the cash flow statement has a well earned reputation amongst value investors for being the most important of the 3 reports.

Cash flow statements are organized into 3 sections. The first, cash from operations, is the most important. This is the section that reconciles reported net income from the income statement and adds back non-cash costs, as well as accounting for the change in working assets like inventory, and so forth. The second, cash from investing activities, is where the company lists out items like capital expenditures, acquired businesses, and purchase/sale of equity or bond holdings. The third, cash from financing activities, is where dividend payouts, stock repurchases, cash received from bond issues, and debt repayments are listed.

As before, we’ll look at Intel’s (INTC) fiscal year 2007 cash flow statement, and then briefly explain each item. All values are in millions of dollars, and parenthesis represent negative values (cash going out). In order to keep this somewhat brief, some line items have been grouped together.

Net Income: 6,976
Depreciation: 4,546
Share Based Compensation: 952
Asset Impairment: 564
Tax Benefit from Share Based Payments: (118)
Amortization of Intangible Assets: 252
Gains on Equity Investments: (157)
Gains on Divestitures: (21)
Deferred Taxes: (443)
Changes in Working Assets and Liabilities: 74
Net Cash from Operations: 12,625
Additions to Property, Plant, Equipment (Capital Expenditures): (5,000)
Acquisitions, Net of Cash Acquired: (76)
Purchases of Available-for-sale Investments: (11,728)
Maturities and Sales of Available-for-sale Investments: 8,011
Investments in Non-marketable Equity Instruments: (1,459)
Net Proceeds from Divestitures: 32
Other Investing Activities: 294
Net Cash from Investing Activities: (9,926)
Decrease in Short-term Debt: (39)
Proceeds from Government Grants: 160
Excess Tax Benefit from Share-based Payments: 118
Additions to Long-term Debt: 125
Proceeds from Sales of Shares to Employees: 3,052
Purchase and Retirement of Common Stock: (2,788)
Payment of Dividends: (2,618)
Net Cash from Financing Activities: (1,990)
Net Change in Cash Holdings: 709
Free Cash Flow: 8,079
Dividend Payout Ratio: 32.4%
Free Cash Flow Margin: 21.1%
Free Cash to Earnings Ratio: 181%

A brief explanation of each line item:

Net Income. The net income line from the income statement. Cash is reconciled against this starting point.

Depreciation. Depreciation expenses in the income statement do not affect cash. For a personal example, think of the depreciation in your vehicle’s value each year. Although it diminishes your net worth by reducing the amount you could sell the car for, it does not affect your cash holdings.

Share Based Compensation. Tech companies like Intel often reward employees by granting them stock or stock options. The estimated final value of these must be expensed on the income statement, but issuing stock or options does not require cash, so the amount expensed is added back here.

Asset Impairment. The value of assets on the balance sheet are in most cases estimated. Intel’s accountants decided that, due to weak demand, the value of some assets was lower than was being carried on the balance sheet. The resulting write-down affected the balance sheet value, but did not affect cash holdings, so it is added back here. This line item also contained employee severance charges that were expensed in the current period, but not yet paid out in cash.

Tax Benefit from Share Based Payments. When employees exercise their stock options, the amount of profit they receive can be written off Intel’s tax bill, as employee compensation is tax deductible. On the cash flow statement, this value is subtracted from operating cash and added to cash from investments as a re-classification exercise.

Amortization of Intangible Assets. Similar to Depreciation or Asset Impairment, Intel has set up a schedule to degrade the balance sheet value of some of it’s intangible assets over a period of time. While this affects the balance sheet and is counted as an expense on the income statement, it does not affect cash and is added back in here.

Gains on Equity Investments. As mentioned in the balance sheet article, Intel holds equity positions in a few companies it works with, notably VMware (VMW) and Micron (MU). Like your personal portfolio, unrealized gains and losses affect net worth, but not cash balances. Therefore the gain recorded in the income statement is subtracted back out here.

Deferred Taxes. As mentioned in the balance sheet review, deferred taxes represents over or under-estimated tax payment carry-forwards. Again, this is a carrying account, only for tracking tax balances; changes in it are strictly for accounting purposes and do not involve cash.

Changes in Working Assets and Liabilities. Intel’s accounts receivable, inventory, accounts payable, and other working capital balances obviously fluctuate on a daily basis. Two things to look for here are accounts receivable rising (Intel not able to collect it’s owed cash payments), and inventory rising as a percentage of revenues. These represent weakness in Intel’s customer base, and rising inventory is a big concern as technology products degrade in value very quickly. Over time, this line item should work out to about break-even. Consistent negative values here indicate poor management of collection and demand forecasting.

Net Cash from Operations. The sum of all of the above line items. This is the amount of cash Intel earned over the reported period, one of the most important pieces of data available.

Additions to Property, Plant, and Equipment (Capital Expenditures). Any items the company purchases for business that have a useful life over one year are considered “capital expenditures”. These are not expensed in the income statement, but are charged off gradually through depreciation. For Intel, these are things like new chip-making equipment, office furniture, computers, and so forth.

Acquisitions, Net of Cash Acquired. This is the cash Intel spent purchasing other businesses.

Purchases of Available-for-sale Investments. Cash Intel put into purchasing equity and/or bonds for the purpose of earning a higher return. “Available-for-sale” means these are usually done on the open market.

Maturities and Sales of Available-for-sale Investments. The inverse of the above. Proceeds from equity and/or bonds that matured or were sold in the period.

Investments in Non-marketable Equity Instruments. Cash spent for a considerable equity investment that was done off-the-market. In this particular case, Intel invested nearly $1.5 billion for a joint venture stake in IM Flash Technologies.

Net Proceeds from Divestitures. Cash received from the sale of various assets and businesses the company no longer deemed strategic. Looking over the 10-K, this includes optical networking components group, media and signaling businesses, and several others.

Other Investing Activities. The catch-all for investing-based items that don’t fit anywhere else. These consist of a number of items spread all over the 10-K, which I won’t list here.

Net Cash from Investing Activities. All of the investing based items (here, the previous 7) added together.

Decrease in Short-term Debt. Cash Intel used to pay off some of it’s short-term debt balances.

Proceeds from Government Grants. There is not much detail on this in the 10-K. Presumably Intel received a nominal amount of cash from some government agency.

Excess Tax Benefit from Share-based Payments. See the similar entry under the operating cash section.

Additions to Long-term Debt. Cash received from selling corporate bonds.

Proceeds from Sales of Shares to Employees. Most tech companies, and many other companies as well, have employee share purchase programs where employees can purchase equity at reduced prices. The amount of cash Intel’s employees paid the company for these shares is recorded here.

Purchase and Retirement of Common Stock. The amount Intel spent to buy back and retire it’s own shares.

Payment of Dividends. Just what it seems – the cash paid out to shareholders in the form of dividends.

Net Cash from Financing Activities. All of the financing based items (here, the previous 7) added together.

Net Change in Cash Holdings. Calculated as (Net Cash from Operations + Net Cash from Investing + Net Cash from Financing). This is the amount of cash added to or subtracted from Intel’s balance sheet during the period. In this case, Intel increased it’s cash balance by $709 million dollars over the fiscal year.

Free Cash Flow. Free cash flow can be calculated two ways. Classically it’s (Net Cash from Operations + Depreciation – Capital Expenditures). MagicDiligence, and Joel Greenblatt in The Little Book that Beats the Market, calculate it as (Net Cash From Operations – Depreciation). Free cash flow is the cash available for the company to invest in growth or pay back to shareholders through share buybacks or dividend payments. MagicDiligence uses depreciation as this is a more accurate view of “maintenance capital expenditures”. The traditional calculation can include capital expenditures used for growth (for example, buying new property or buildings), which unfairly skews the free cash flow calculation for quickly growing companies.

Dividend Payout Ratio. Calculate as (Dividends Paid / Free Cash Flow). This percentage shows you how much of free cash flow is being paid out in dividends. Too high of a percentage (over 60-70%) could indicate an unsustainable dividend.

Free Cash Flow Margin. Calculate as (Free Cash Flow / Revenues). This is the amount of every dollar of sales that is converted into free cash flow. The higher the better here. Look for at least 5%. Intel’s very high 21% figure is just another indication of the top quality nature of the company.

Free Cash to Earnings Ratio. Calculate as (Free Cash Flow / Net Income). A big red flag is when this is consistently less than 100%. We will discuss this more in the red/green flag articles.

Now, we have a working explanation of all three financial statements that all public corporations report to the SEC. Next, we’ll look at 10 red flags to look for when examining these statements.

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Moneydance – A Cross-Platform Personal Finance Manager

I have to admit, I am a software junkie. I like good software that works as it should and does it’s job with a minimum of effort on my part. When I first started using a computer at home, one of the first things I started looking for was a software program that would manage my finances and allow me to keep up with what I spend. It is essential for me because although I do not have a lot of different finances to keep up with, I need all the help I can get. I began using Microsoft Money and while I actually like the way it operated, it did have it’s drawbacks. Chief among them is the very obtrusive advertisements and the fact that Microsoft Money (you pick the year) would not open a perfectly good money file that had been opened even once in the next year’s version of Money. I can see that being the case every once in a while, when the file format has to change for whatever reason, but to do it every year is a bit over the top. The next program I used was AceMoney and I used it until I converted from Windows XP to Linux almost two years ago.

When I started using Linux, I knew I could use AceMoney on my Linux system, as long as I installed Wine, which allows Windows applications to run on Linux, but I chose not to do so. I preferred to us a program that was designed to run on Linux itself. After doing some research online, I decided to take advantage of a free trial offered by Moneydance, an open source, cross-platform personal finance manager for Windows, Linux, and Mac OS. It took a bit of playing around with the software before I was used to the way it does things, but after I did, I had no problem purchasing the full version for $29.99. In my opinion, it is well worth the price.

As with any software program there are pros and cons to using it. Everyone likes to do things differently and every personal finance manager does things it’s own way, at least a little. One of the main things I do not like about Moneydance is the way it installs on my Mepis system. Actually, I think that has more to do with me getting used to doing things the Linux way, so that really isn’t a complaint. Once installed, Moneydance is relatively easy to use. It opens up to the home page and there are a variety of items you can have showing up there. You can see from the screenshot below that mine is pretty simple. I do not have stocks or bonds, but you can show stock quotes if you want. Just add an investment account and then add the stocks from your portfolio into that account.

One of the things I really like about the way the home page is set up is the transaction reminders, both the list and the calendar. It is very easy to tell what items I have due, coming up or even overdue. It is also very easy to add new reminders by clicking on the link at the top. The great thing about the reminders is that you can use them for transactions or just a general reminder. The transactions can be set up to be entered automatically or just to remind the user to enter them manually.Overall, the home page of Moneydance is very usable and it can be edited to add or remove items that you do or do not need or want. As you can see, I display my checking account, as well as both of my credit card accounts on the left side. That allows me to see at a quick glance what I have in my accounts.

As with any personal finance manger, the main heart of the program lies in it’s register or ledger. That’s where the bulk of the work is done in the program and that is where I spend most of my time, entering transactions and reconciling with my bank account. It is in the register that I had to learn to do things a little differently than I was used to doing. For example, there is no keyboard shortcut to mark a transaction cleared or reconciled. You can do so by right clicking on the transaction and choosing it from the context menu and while it gets the job done, I find it a bit cumbersome to do. However, there is another way to accomplish this that works very well and after getting used to it, I find it much easier to reconcile the register with my online bank statement.

You can see in the screenshot to the right that there is an Actions link at the top left of the register screen. Clicking on it drops down a menu with a reconcile action. Choosing that brings up a dialog that lists the beginning statement balance and asks me to enter the ending statement balance, which is basically the target balance that I need to finish up with. Before I get to this point, I have already looked at my online bank statement and have that figure noted. Once that is entered, Moneydance brings up a small window that lists all of my transactions that are not cleared or reconciled. That window can be positioned directly over the Firefox tab containing my bank statement and from there, I can use the mouse to mark the transactions cleared and see how my register balance matches up with the bank statement. I can see very quickly if there is a mistake in the register, without ever opening the bank statement I receive in the mail.

I have found that using this small window actually speeds up my work in making sure the transactions are correct and the online bank statement and my register balance are correct. It saves me a lot of time and effort by not having to alt+tab back and forth between windows. As I said, it took me a while to get used to doing things that way, but once I did, it makes clearing a lot of transactions much easier and faster. I am pretty set in my ways, but this is one thing I have learned to do differently and glad I did.

Another feature I find very useful is the way Moneydance can backup my money file with no action from me, after the initial setup is performed. I make daily backups in a folder on a completely separate partition and Moneydance takes care of the rest. Trust me, the backups have saved my bacon more than once and even if I don’t have a hardware problem, it really came in handy when I installed SimplyMepis 8. It was a snap to load my backup file and have all of my data at hand. I have found it is essential to keep backups and Moneydance gives you a variety of options to choose from.

There is one other thing that I found to be a bit different from most other personal finance programs I have used and that is the way Moneydance treats accounts and categories the same. I am no accountant, but that is evidently the way most actual accounting software It’s called the double entry method and while I don’t understand it completely, it basically links the different accounts to each other. In KMyMoney and other personal finance managers, you can set up a transfer from one account to another by calling it a transfer. In Moneydance, I had to choose the account in the category section of the transaction in order to get the changes to register in both accounts. Once I got past the difference, it’s a piece of cake.

As with most personal finance managers, Moneydance remembers the transactions and will complete them automatically for you. If I enter a transaction to Aldi’s to purchase groceries, it remembers that and until I tell differently, all transactions to Aldi’s will be entered into the “Food:Groceries” category. That comes in very handy and I can set up a reoccuring transaction by right clicking on the transaction line and telling Moneydance to “Memorize” the transaction. Very quick and very easy to do. I suppose I could say that Moneydance is very intelligent in the register and the way it handles the transactions.

I could go on and on about the features of the program, but this article is already longer than I had anticipated. Suffice it to say that I am quite pleased with Moneydance. Yes, there are things that I would like to see changed. For example, the only way to hide past transactions in the register is to archive them, but I have found that the number of transactions in the register doesn’t seem to slow the program down, so I am living with that. It’s just a matter of personal preference in that regard. The documentation could also be a little more thorough, but I have worked past that as well. If you are looking for an easy to use personal finance manager, I would urge you to give Moneydance a try. I don’t think you will be disappointed.

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