Turnover is vanity, profit is sanity, but cash is reality

Making the case for revisiting companies’ cash flow statements.

• Making the statement of cash flows more relevant would be a triple win.
• For analysts, it would help us to better understand the business and forecast cash flows.
• For companies, better disclosure tends to be rewarded by the market.
• For society at large, capital markets would be more efficiently priced.

Analysts spend a lot of time scrutinising trends in turnover, profit and cash. Arguably, cash is paramount, because the fundamental question for any investor is how much to pay today in return for cash flows expected in the future. Given the importance of forecasting cash flows, one might expect the statement of cash flows to be extremely helpful. Unfortunately this is not the case. In fact, I would argue that the current accounting standard IAS 7, which prescribes how to present information in a statement of cash flows, urgently needs to be revisited to make it more relevant.

In my opinion, there are two main problems with the cash-flow statement: confusing subtotals and excessive aggregation. I would like to propose some improvements.

Confusing subtotals

Companies often use different definitions for operating, investing and financing cash flows, hindering comparability. For example, sometimes interest received is classified as an operating cash flow, and sometimes it is classified as an investing cash flow. Personally, I don’t mind what the accounting classification is; what I really need to know is where to find the information. As an analyst, I exercise my own judgement as to how much interest received should be classified as an operating cash flow on a company-by-company basis. I therefore welcome the proposals in the IASB’s (International Accounting Standards Board) Exposure Draft (ED) General Presentation and Disclosures (Primary Financial Statements) to remove optional classifications in the statement of cash flows.

A more fundamental problem is that operating, investing and financing categories are also used in the other primary statements, but they can have very different meanings. For example, in the statement of cash flows, operating cash flow is defined as post-tax, while in the statement of profit or loss, operating profit is defined as pre-tax. Why not define operating cash flow as pre-tax also, and introduce a separate tax category in the statement of cash flows? This would help investors clearly see how much profit is converted into cash. Category labels should be coherent across all the primary financial statements; it is confusing to use the same label for a different concept.

Excessive aggregation

Investors build their own derived statement of cash flows based on projected statements of profit or loss and financial positions rather than using the company’s statement of cash flows directly. This is because excessive aggregation often makes it impossible to link the numbers in the statement of cash flows to those in the other primary financial statements. Better disclosure is urgently needed to address the problem of excessive aggregation. It should be possible for an analyst to derive the statement of cash flows from the other primary statements along with the additional disclosure in the notes.

For example, depreciation, amortisation and impairment charges are often aggregated into a single number within cash flows from operations. For a traditional industrial company, this single number mostly relates to the depreciation of owned assets which is easy to understand and can be compared to capital expenditure. However, for an acquisitive high-technology company, this single number is very hard to interpret because it represents a mixture of very different items: some amortisation comes from internally generated assets and some from acquired assets; part of the deprecation comes from leased assets and part comes from owned assets. These different items need to be analysed separately. Disaggregating this single number from the outside is sometimes impossible, and when it is possible using information from the notes, it is time-consuming trying to find it. Ensuring that material information is easy to find would be helpful not only to analysts, who are under considerable time pressure when preparing for earnings calls, but also to companies, as the market rewards better transparency.

Making the case for change

Making the statement of cash flows more relevant would be a triple win: for analysts, it would help us to better understand the business and forecast cash flows; for companies, better disclosure tends to be rewarded by the market; and, for society at large, capital markets would be more efficiently priced.

Authors

Jeremy Stuber

Global analyst, valuation and accounting