This passage is dedicated to simply understanding the Operating section of the Statement of Cash Flows (SCF).
Accounting at its core is a rule based science; the rules of which can be memorized. However, memorization is a terrible substitute for comprehension. Real understanding comes from recognizing the logic and context of why a rule exists instead of memorizing how to apply it.
With this in mind, there are few topics that cannot be condensed to a simple rational statement that informs the user of the rule and the logic behind why it exists.
“If you can’t explain it simply, you don’t understand it well enough.” – Albert Einstein
Accounting ‘rules’ are logical simplifications of how transactions or items should be presented to users of financial statements. The trick is to understand what should be presented and why.
Why Does the SCF Exist?
Most businesses operate under ‘accrual’ basis (as opposed to ‘cash’ basis) accounting.
One large difference between accrual and cash accounting is the existence of the ‘matching principle’ in the former. Under the matching principle, expenses are recorded when incurred, regardless of when payment is made for the associated product or service. In practice, this means that expenses are incurred when its partner revenue is recognized or when the associated service is consumed.
By utilizing the matching principle, accrual accounting financial statement users are able to make decisions using revenue and expense data that ‘match’ one another with regard to their associated costs of production.
The problem is that accrual based income statements, in isolation, do not inform the user of actual changes in a company’s cash position for a period.
This is why the SCF exists: to show the user how and why a company’s cash balances changed from the previous reporting period.
Let’s take it from the top…no, really!
At the top of any statement of cash flows (prepared under the indirect method) will be the company’s net income for the measurement period. This is where the Operating section begins.
Add Back Non-Cash Expenses
Depreciation (or Amortization)
Depreciation is the classic ‘non-cash’ expense. It is also a great example of the matching principle in action. Each capitalized asset slowly loses value and utility over time through wear-and-tear and obsolescence. Thus, depreciation was invented to allow companies to recognize this loss of value or expense as it occurs throughout the life of certain assets.
Ex: Imagine NewCo sold no shoes for the period, nor collected any money from customers. There is absolutely no ‘business’ going on within the company. Now assume NewCo owns one asset, a large mechanical press used to form shoe molds. This asset was capitalized several years ago and yearly depreciation is $100.
NewCo’s net income is ($100) however NewCo’s CFFO is $0 because yearly depreciation expense is added back to net income as a non-cash expense.
Subtract Net Increase in Working Capital
In the context of the SCF, we are primarily concerned with changes in net working capital – the period over period change in net working capital – as opposed to the net working capital figure itself.
The increase in net working capital will be subtracted from net income because a business that has increased/grown its net working capital has done so directly or indirectly by using cash.
The most common current assets relevant to CFFO are accounts receivable (AR), inventory, and prepaid expenses. As with depreciation, it’s easier to understand why the increases (decreases) in current assets are subtracted (added) from (to) the cash balance if we look at some simple examples.
Ex: NewCo again has no operations for the period. But, last period it had an AR balance of $70 and this period has a balance of $0. NewCo has collected money from a customer for a sale that was made and recognized in an earlier period. Here, it is pretty easy to see that this decrease in a current asset account should be added to CFFO because NewCo now has more cash than before.
Ex: Now suppose NewCo’s AR balance increased from $0 to $70 in this period. Here, NewCo did make a sale during the period which accounts for the increase in AR but the Company has actually financed this sale for their customer and collected $0. Because there was no cash collected, the net income of $70 must be reduced by $70 to show CFFO of $0.
The most common current liabilities relevant to CFFO are accounts payable (AP) and accrued expenses.
For current liabilities, the same logic as assets applies but to be sure you have the correct sign, think like Charlie Munger and “invert, always invert.” For example, if accrued expenses increased this period (from $0 to $20), your net expenses to be paid grew because you did not pay something. This is neither inherently good nor bad but it is a fact that your cash on-hand increased by $20 because you did not pay these expenses. Thus, your CFFO from the change in accrued expenses is +$20.
After sorting through each working capital item, you will reach a number for the net increase (decrease) in working capital. This value will be subtracted from net income and non-cash expenses to reach the CFFO.
Greater understanding of the operating section of the SCF can lead to better organizational and strategic management.