By Hobson Hogan
Just as the proverbial third wheel, the statement of cash flows gets summarily skipped over by management. In earnings calls, CFOs spend time talking about sustainable earnings and strong balance sheets. Where is the love for the cash flow statement? Cash is king, after all.
When I was learning how to read financial statements, I too did not fully grasp and appreciate what a cash flow statement was trying to tell me. All I wanted to know was the company’s net income. Management 2101, the introductory course to accounting at Georgia Tech, was designed to teach engineers how accounting worked: T-accounts, debits and credits, the basics. I could build a cash flow statement. What’s the big deal about cash anyway? It’s easy, look at your bank statement, now read the balance. Easy. I moved on in my studies knowing what a statement of cash flows was. I just was not really sure what I was supposed to do with it.
As I matriculated through school, my assignments began to require that I create pro-forma financial models for everything from determining when to replace a pump in a refinery to coming up with a value for an entire manufacturing plant. As I began to work out these problems, it was only then that I gained an appreciation for the statement of cash flows. Positive cash flow that is greater than your investment is what drives value, not net income. Don’t get me wrong, income statements are important; they just do not paint a complete picture.
I think everyone in business wants to make their firm more valuable. The knee jerk reaction is to equate growth in revenue with increasing value. The fact of the matter is that revenue growth can destroy value, though it can take the income statement a while to pick up on it. Let’s look at two firms, Alpha Corp. and Beta Corp. Alpha is a real go-getter outfit, they have hip offices and push growth. Beta Corp. is a bit more staid and shuns the spotlight. Below is a snapshot of their performance in 2010:
REVENUE: Alpha ($10 MM) ........... Beta ($10 MM)
PRE-DISTRIBUTION MARGIN: Alpha ($1 MM) .......... Beta ($1 MM)
NET WORKING CAPITAL: Alpha ($1 MM) .......... Beta ($1 MM)
CAPITAL EXPENDITURES: Alpha ($1 MM) .......... Beta ($1 MM)
Alpha Corp. is spending $1 million on new equipment that will open up new markets and make them the darling of the industry. Beta Corp. is also spending $1 million in capital expenditures, though it is on a new accounting system that will decrease the time it takes to bill their clients and speed collections by reducing errors. For both firms, the capital expenditures will not show up on the income statement immediately. It will be parsed out through depreciation over the years. Both firms have identical new working capital, which is current assets minus current liabilities— a measure of the cash tied up in what people owe you and what you owe your vendors.
Fast forward to 2011, how did the Alpha and Beta fare?
REVENUE: Alpha ($15 MM) .......... Beta ($10 MM)
PRE-DISTRIBUTION MARGIN: Alpha ($1.5 MM) ........... Beta ($1 MM)
NET WORKING CAPITAL: Alpha ($2 MM) .......... Beta ($0.5 MM)
CAPITAL EXPENDITURES: Alpha ($0 MM) .......... Beta ($0 MM)
Looking at the Pre-distribution margin, you would say that Alpha clearly made a better decision. As Lee Corso would say, “Not so fast my friend.” The income statement does not show the whole picture.
Yes, Alpha increased their pre-distribution margin by $500,000, but what did it cost them? If your answer is $1 million, your answer is wrong. It cost Alpha $2 million, $1 million in capital expenditures and $1 million in additional working capital now invested in the business.
What about Beta? They did not make any more money, so obviously their accounting system investment was a dud— nope.
Beta just squeezed $500,000 right out of their firm without growing revenue one bit, the income statement remained the same, but cash flow increased $500,000. If 2011 is any indication of the future, Beta will be able to grow more efficiently than Alpha because the firm will require less investment in working capital for each dollar of growth.
So, what does this have to do with the cash flow statement? The income statement does not pick up on investments or collections, just the results from operations.
You need the cash flow statement to show you how well you are collecting cash, if you are paying bills too slow or fast. It gives a manager the opportunity to see exactly what cash the operations provided and exactly how much cash was invested back into the business.
This is especially important in times of growth, where it can be unclear from the income statement and balance sheet where money is coming from and how the owner’s capital is being deployed. Accountants give us all three financial statements for a reason and as a wise CFO once told me, “Net income makes you feel good about yourself, but you pay your bills with cash.”
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