How to make sense of cash flow

Cash from operations

The first point to note is that there is not a strict standard structure to the cash from operations section – UK companies can start at earnings before interest and taxes (Ebit), pre-tax profit or net income.

Because there is this flexibility in the starting point, the reconciliation between profit and cash flow varies depending on where you start:

• Start at Ebit, no need to add back tax and interest;
• Start at pre tax, no need to add back tax;
• Start at net income, you need to add back tax and interest.

To illustrate, I shall assume a start at net income, as that is the most common starting point globally. You first need to add back all the non-cash items to get to a cash flow number.

Non-cash items

Depreciation – this is a non-cash item and therefore needs to be added back. It’s important to note the difference between a capital-light company such as Apple (US:AAPL) and a capital-heavy company such as Berkshire Hathaway (US:BRK.B). The table below shows that depreciation is much more significant to the latter and this has important valuation implications, especially if the assets are long-lived.

Source: Behind the Balance Sheet from Sentieo data. All figures $mn unless stated.

Investors value capital-light businesses highly, but the more capital-intensive business tends to generate a higher operating cash flow for each pound of earnings. If the assets do not need to be replaced for a long time, the business with the higher depreciation burden may be more attractive than is generally realised.

Amortisation – like depreciation but this applies to intangible assets.

Stock-based comp – this is an add back to net income to derive cash from operations because it is a non-cash item. It is also usually treated as an add back to derive a non-GAAP earnings number. But it is a real expense and often a significant cost to the shareholder.

Gain or loss on sale of assets – if you have sold, say, a property and reported a profit on the sale, you must subtract this number, as the overall amount you sold the property for will be a receipt under cash from investing. (If you don’t exclude the profit or loss, you will be double counting.) Companies often seek to hide such property sale gains and bucket them with other items, but the keen analyst can triangulate between the cash flow and the balance sheet to derive the gain – something I explain in my How to Read a Balance Sheet course.

Provisions – the difference between the cash spend on provisions and the profit and loss (P&L) charge needs to be adjusted here, although it’s often netted off with other items. But if there is a big restructuring provision, for example, you will see that the P&L charge is added back here in year one, while the cash spend is often delayed until the following year.

Next let’s look at the adjustments that take you from a company’s net income to Ebit.

Net income to Ebit bridge

Interest – the cash spend on interest comes under cash flows from financing activities, so it has to be added back. In theory, interest should be all cash, and the numbers should match, but they often do not – for example, the unwinding of discounts. In cases where a company has a very long-term liability, that liability is discounted in the balance sheet. Each year, as you get closer to the crystallisation of the liability, the discount unwinds and notional interest is charged to the P&L. It’s not a real number and therefore has to be excluded to derive cash flows.

(This is not a bad way of thinking about the bridge between the P&L and cash flow. The P&L often includes a number of notional items. Cash, however, is real.) 

Tax – the P&L tax charge is a non-cash number and therefore needs to be added back. This is a common omission, even for professional analysts. Two points to note here: 1) the 2021 tax charge against the 2021 pre-tax profit is paid in 2022; 2) tax paid is often less than the tax charge as companies benefit from capital allowances on investment. The accounting rules dictate that the charge in the P&L is smoothed, so deferred tax is applied – for deferred, read non cash. US GAAP Cash flows often refer to the tax add back as deferred tax. I am deliberately engaging in an enormous simplification – tax, especially deferred tax, is an astonishingly complicated subject.

Balance sheet moves

The most important changes here generally relate to working capital. The cash flow is adjusted for increases or decreases in working capital and similar assets and liabilities. When a customer pays you, you receive cash and working capital is reduced – this is not shown in the P&L but is shown here in the cash flow.

A company can see a substantial change in cash flow if a customer pays in the last week of the year rather than waiting until the first week of the new year. Working capital moves can be lumpy and if a company has an unusual year-end, then there is more scope to manipulate working capital.

It’s simply good practice to persuade your customers to pay you promptly, but many major corporations take an unreasonably long time to pay suppliers. If you have a 31 December year-end (the most common timing), almost everyone wants to be paid before rather than after that date. But if you are a retailer (whose year-ends are almost never 31 December), there is more scope to finesse the reporting of working capital at the end of the year. So watch for companies with odd year-ends.

While an odd year-end gives an advantage in that working capital is likely to be lower than otherwise at the end of the period, it’s the same each year, so the cash flow benefit is restricted to the growth in working capital being lower each year than otherwise. I should also emphasise that retail stocks are not doing anything wrong, but it’s worth being aware that average cash balances may look lower than the year-end position.

Other balance sheet moves may be individually reported or may be netted.

Cash from operations then must be adjusted for tax paid to get to a cash from operations after tax.

There are a couple of issues on the definition of operating cash flow which I disagree with and are perhaps worth mentioning. For example, I don’t like the effects of IFRS 16, the recent standard on leasing which treats the cost of leases as a financing item. This is understandable as the decision to lease a truck or a shop is a financing decision, but it means that operating cash flow trends are inconsistent, especially for companies such as retailers.

Impact of IFRS 16 on Tesco Operating Cash Flow

Source: Behind the Balance Sheet from Sentieo Data

The chart shows how IFRS16 boosted Tesco’s Cash from operations – the standard made retailers look more cash generative than before.

I shall return to the treatment of leases when I cover the remainder of the cash flow statement in a future article, where I shall also talk about what’s left out of the statement – which is just as important as what’s included.