Cash flow statement management

Unlike the world of accrual accounting, cash flow is an efficient way for investors to gauge a company’s financial health and operational strength. The idea of ​​recognizing income when it is realized or realizable can be tricky when an investor has to make a financial decision regarding a certain company. Whereas, having a good understanding of where the money comes from and how it is used is much more useful for an investor. However, calculating and analyzing cash flow is not as easy as finding the difference between money going in and going out of a company’s cash register. The difficulty stems from the tricks companies use to manipulate their cash flow statement. Companies often try to promote the good and hide the bad in their financial reports, which is why the cash flow statement has seen some manipulation over the years. The following explains how this is done.

When looking at a statement of cash flows, there are three sections that the statement is divided into: operating, investing, and financing. The most important section for an investor would be the operating section because this is where one can find the money that a company generates from its operations. Investors want to see more cash generated from a company’s operations rather than loans or equity transactions.

Unfortunately, it’s not always clear where a company generates its cash from. One way the company skews its operating section is through the misclassification of inventory purchases. The costs of purchasing inventory that will eventually be sold to customers should be classified as an item in the operating section of the statement of cash flows. However, some companies disagree and feel that the purchase of inventory is an investment outlet, which would increase operating cash flows. One should question this method of accounting because large investments should not occur as part of a company’s normal cost of operations.

In addition to misclassifying inventory purchases, many companies capitalize some expenses, which increases the company’s bottom line. When a company capitalizes costs, it writes off the cost of an asset gradually, in installments, rather than taking all the costs at once. This allows companies to record the cash outflow as an investing activity, because the cash outflow is considered an investment, rather than a deduction from net income or the operating section. As a result, the cash flow from the company’s operations will remain the same and will look much better than it actually is.

Companies then give their operating cash a boost by selling off their accounts receivable. This speeds up a company’s cash collections, but also forces the company to accept fewer dollars than if it had waited for customers to pay. This action can have a negative impact on the operational part of a company. The decline in accounts receivable means that you have brought in more cash through the sale of accounts receivable, but this would send investors the wrong message. By speeding up collections, a company isn’t improving operations, it’s just finding another way to boost the operational section of the statement.

Another manipulation of the cash flow statement is through accounts payable. Sometimes there is a substantial increase in the accounts payable item, which would mean that payments to suppliers are not being made. If these accounts payable are left open for a long period of time, then a company receives free financing, which imprecisely increases the operating section.

All of these examples are ways that companies can easily manipulate their operating section. These examples give companies the opportunity to demonstrate that they have more money at their disposal for operating expenses than they actually do. For example, in 2000, Enron reported that it had cash flow from operations of more than $4 billion, which was actually overestimated by $1.5 billion.

This manipulation caused Enron’s stock to rise in value, which in turn led to Enron’s collapse. As another example in 2002, Tyco International delayed paying its first quarter bonuses to its executives in order to increase the company’s operating cash flow for the quarter. This move caused the company’s operating cash flow to incorrectly increase by $200 million.

The examples above show how easy it is to manipulate the cash flow statement. An investor should be aware of any manipulation that may cause dishonest financial reporting. In conclusion, the cash flow statement is the most useful financial statement for an investor, but just as cash easily changes hands, the cash flow statement can just as easily be manipulated.