For the Investor
By Marc Siegel, FASB Member

Giving the Cash Flow Statement Its Due


There continues to be plenty of discussion in the financial reporting and investor communities about the proliferation of non-GAAP information, particularly around pro forma earnings. Many companies and analysts adjust reported net income for noncash items in order to arrive at a figure that’s “closer to cash.” We also often hear that metrics like EBITDA (earnings before interest, taxes, depreciation, and amortization) can be better proxies for “cash flow.”
Perhaps it’s time to highlight the GAAP-based cash flow statement and how it can be used and how it might be improved.

In one of my prior columns, I addressed non-GAAP metrics more generally, but there appears to be a recurring view that companies and their investors need to have better communication about cash flow. Perhaps it’s time to highlight the GAAP-based cash flow statement and how it can be used and how it might be improved.

In the book, Creative Cash Flow Reporting, Drs. Charles Mulford and Eugene Comiskey state right up front, “[i]t is hard to overstate the importance of operating cash flow and its closely related, carefully watched, and loosely defined metric, free cash flow, to fundamental measures of debt-service capacity and firm valuation.” The book goes on to describe how to critically analyze the cash flow statement in order to ascertain the sustainable cash-generating capacity of a company.

In my former position as an analyst, I spent a lot of time poring over the cash flow statement. It provides another dimension of the performance of a company. It is only by analyzing something in multiple dimensions that one gets a true sense of it. For example, it is far different to see a picture of One World Trade Center than to stand before it and strain your neck looking up.

There are many ways to use the cash flow statement. Comparing operating earnings growth to operating and free cash growth was one of the first steps in my analysis of a company’s performance. Seeing different trends over time in these two metrics was a red flag.

The cash flow statement also could be used to see cash flow impacts of items, which many consider to be noncash.

For example, in my experience, many companies use stock options for employee compensation, but subtract the related expense when arriving at their pro forma earnings. The theory is that this compensation is noncash and therefore shouldn’t be included in a discounted cash flow analysis to value the business.

However, many of the companies who have these option programs for their employees also are concerned about the dilutive effect options have on the reported earnings per share of the company. As such, they actively buy back shares in order to offset the dilutive effect of options exercises.

Because any cash used to buy back shares is not available to invest in research and development or for other investing opportunities, there is a real cash impact of the program and that impact should be included in an analysis of free cash flow. (As a reminder, these cash outflows for share buybacks are found in the financing section of the cash flow statement.)

There are drawbacks to the cash flow statement for sure. Anyone who analyzes or prepares financial statements for banks will say that the cash flow statement does not provide any particular insights into a financial institution. Furthermore, in part because the accounting requirements mostly provide principles about how cash flows should be classified between operating, investing, and financing, there can be and often is some significant diversity in practice around these classifications, which can make comparisons from one company to another more difficult.
The EITF is attempting to clarify how, in nine different specific situations, a company should think about the question of classifying cash flows.

The Emerging Issues Task Force (EITF) has taken on a project to help alleviate some of this diversity. The EITF is attempting to clarify how, in nine different specific situations, a company should think about the question of classifying cash flows. Some of the areas being addressed include:
  • The cash payment made by a bond issuer to settle a zero-coupon bond
  • Proceeds from corporate-owned or bank-owned life insurance and proceeds from the settlement of an insurance claim
  • Transfers between restricted and unrestricted cash and cash flows that directly affect restricted cash
  • Contingent consideration payments made after a business combination
  • Distributions received from equity investments, and
  • Debt prepayment or extinguishment costs.
The cash flow statement is one of the basic financial statements for good reasons. It provides a completely different perspective for the investor in understanding the performance and financial position of a company.
Hopefully investors will find the cash flow statement even more impactful in their analysis after the EITF concludes its project.

It is also in many ways a direct reflection of the objective of financial reporting as described in Chapter 1 of FASB Concepts Statement 8, which states that “…investors’, lenders’, and other creditors’ expectations about returns depend on their assessment of the amount, timing, and uncertainty of…future net cash inflows to the entity.”

While many companies and investors look at various “proxies” for cash flows, the cash flow statement is an audited, generally accepted statement that almost all companies provide. Hopefully investors will find the cash flow statement even more impactful in their analysis after the EITF concludes its project.