Financial Education

Cash flows from investing activities are those involving noncurrent capital assets used in the firm’s operations, such as property, plant, equipment (PP&E) and intangible assets. When a company invests in new long-term capacity by acquiring either PP&E or another company, the investment is a cash outflow from investing activities. Disposals of these types of assets for cash generate inflows. Accounting standards differ somewhat as to which activities can be classified as investing. For example, under IAS, some research and development expenditures can be capitalized on the balance sheet and would thus be considered investing activities. Under U.S. GAAP, research and development costs must all be expensed immediately on the income statement and appear as operating cash outflows regardless of whether the research will result in long-term benefits to the firm.

Note that the investing activities section does not necessarily provide a complete listing of all capital asset activity because only acquisitions or disposals involving cash appear here. Noncash acquisitions, such as acquisition of a building using a mortgage, are disclosed in supplemental information to the cash flow statement. Under both U.S. GAAP and IAS, a specific provision is made for these types of noncash financing and investing transactions. They are typically simultaneous, arising from an acquisition of a capital asset funded solely by incurring debt, such as the mortgage used to acquire property. Conceptually, it can be argued that a company receives cash from incurring the debt and then spends the cash on the acquisition. Nevertheless, if cash does not actually change hands, both sets of standards treat these as noncash transactions that must be disclosed separately from cash transactions. The disclosure could appear either at the end of the cash flow statement or in the notes to the statements. Another common noncash financing transaction, which is disclosed in the same manner, is the conversion of convertible debt or preferred stock into common equity.

The cash flow statement begins with the operating activities section. Operating activities generally reflect cash generated and/or paid as a result of the firm’s core business functions. This part of the cash flow statement is the cash counterpart to income from operations as reported on the income statement. As such, it provides a useful comparison and contrast to the accrual accounting measures on the income statement, potentially highlighting effects of accrual accounting assumptions. Under U.S. GAAP, this category incorporates the cash received from customers, paid to suppliers, paid for operating costs, paid for income taxes, received from interest or dividends, and paid for periodic interest costs.

While cash payments for interest are included in the operating activities section, under U.S. GAAP, dividends paid out to equity capital holders are reported in the financing section. Therefore, interest payments and dividend payments appear in different sections of the cash flow statement under U.S. GAAP. IAS handles this issue differently, allowing the reporting company the option of including both interest and/or dividends in either operating or financing activities.

In 1987, the FASB issued Statement 95 requiring the Statement of Cash Flows in its current form. International Accounting Standards mandates a cash flow statement under IAS 7 that is similar in most respects to that provided under U.S. GAAP. While not perfect, the current cash flow statement provides much meaningful information.

The cash flow statement required under U.S. GAAP or IAS presents a detailed display of what has caused the firm’s cash and cash equivalents to change throughout a reporting period. Cash equivalents include investments that are readily convertible to a specified amount of cash (in IAS, “subject to an insignificant risk of changes in value”). Under both standards, the net change in this class of assets over the reporting period is subdivided into three components: cash from operating activities, cash from investing activities, and cash from financing activities. These three components can be seen in the cash flow statement for Distribution Company above.

U.S. GAAP has fairly rigid requirements regarding which area each change in cash (or cash equivalents) falls under. IAS offers some choices for specific items. Under either IAS or U.S. GAAP, the full cash flow statement summarizes the change in cash and cash equivalents, reconciling the cash balance on the ending balance sheet to that on the beginning balance sheet. The net change is the sum of the effects of the three components—operating, investing, and financing.

In a healthy, mature firm, operating activities should support themselves; that is, sales to customers should generate enough cash to pay for inventories sold to those customers and to pay for other operating expenses required to make those sales, such as wages. Investing activities, the acquisition and disposal of the long-term assets needed for operations, could be supported using excess cash from operations. Alternatively, the funds for these investments may be acquired by issuing debt or equity. These debt and equity transactions are the firm’s financing activities.

In general, a mature firm should not need to finance operations by incurring debt or issuing stock (though such firms may still raise financing in order to change the capital structure, expand into new businesses or acquire another company.) In a new or otherwise rapidly growing firm, however, operating activities may not yet generate enough cash to support themselves without borrowing or issuing equity. But for a company to survive over the long run, its operations must support themselves. Consequently, a clear picture of how the firm is managing its cash is important to the overall understanding of a company’s financial position.

In order to comply with U.S. GAAP and IAS, however, companies must present their income statement on an accrual basis, reporting revenues when earned and expenses when incurred. The timing of when revenues are earned does not necessarily coincide with when cash is received. Likewise, the timing of when expenses are incurred does not always coincide with when the expenses are paid. Instead, the matching principle requires that revenues and their associated expenses are recognized at the same time.

When the recognition of revenue or expense differs from the cash flow timing, it results in an accrual. Common accruals include:

Many small businesses operate on a cash accounting basis. They simply keep track of cash received and cash paid out. This is known as the cash method of accounting. Under this method it can sometimes be difficult to match expenses with their associated revenues. For example, if a company purchases inventory in one year and sells it in the next, the expense will be reported in year one while the revenue will be reported in year two.

Publicly traded companies are not permitted to use the cash method under either U.S. GAAP or International Accounting Standards. However, they must present a statement of cash flows under both standards. The cash flow statement allows investors and others to compare accruals with the timing of cash flows.

This article originally appeared at Stock Market Beat and is reprinted here with the author’s permission.

Much has been made of reporting stock option compensation as an expense on the income statement. Although the current method used has its flaws, reporting an expense is more realistic than saying there is none. But little attention has been paid to the balance sheet impact of stock options. In fact, the current accounting method essentially says there is no effect (retained earnings are reduced but the same amount is added back to another line in shareholder equity with no impact on total assets, liabilities or shareholder equity.)

We believe the current method is incorrect. An option gives its holder the right to buy a share of stock from the company at a discounted price at a future date. The company is obliged to issue the share at a below-market value. This obligation, like any obligation, should be considered a liability. Only when it is redeemed should it shift from being a liability to being equity. Consider it this way: if the company issued its employees an IOU as part of their salary, it would be counted as a liability until paid. Why should options be any different, as they are in essence an IOY for a portion of the employee’s salary.

Accountants and managements would have to debate for years to determine the proper amount of liability and how to record it. Fortunately, investors can use a back-of-the-envelope approach to get a reasonable estimate. The minimum value of these options is the intrinsic value, or the difference between the current share price and the exercise price. This value understates the true liability but is easy to calculate. Like the reported expense, it may not be perfect but it is better than nothing. More sophisticated investors can simply estimate the Black-Scholes option value of all outstanding options and use that for the liability instead.

Consider the following table, which was provided by Ansys (ANSS) in their recent 10Q.

Even at the minimum valuation of the options, we can see that they represent a $137 million future liability for Ansys. Investors should adjust the balance sheet to reflect this liability by adding $137 million to liabilities and reducing shareholder equity by the same amount. Doing so will affect such ratios as debt/equity and return on equity. If you use any of those in your investment process, be sure to make this adjustment first. It will give you a truer idea of the company’s situation, especially if you are comparing it with other companies whose option issuance is much higher or lower than that of the company in question.

The following is an excerpt from Jesse Livermore’s “Reminiscensces of a Stock Operator,” which is available in our public domain library.

At all events, what was a perfect system for trading in bucket shops didn’t work in Fullerton’s office. There I was actually buying and selling stocks. The price of Sugar on the tape might be 105 and I could see a three-point drop coming. As a matter of fact, at the very moment the ticker was printing 105 on the tape the real price on the floor of the Exchange might be io4 or 103. By the time my order to sell a thousand shares got to Fullerton’s floor man to execute, the price might be still lower. I couldn’t tell at what price I had put out my thousand shares until I got a report from the clerk. When I surely would have made three thousand on the same transaction in a bucket shop I might not make a cent in a Stock Exchange house. Of course, I have taken an extreme case, but the fact remains that in A. R. Fullerton’s office the tape always talked ancient history to me, as far as my system of trading went, and I didn’t realize it.

And then, too, if my order was fairly big my own sale would tend further to depress the price. In the bucket shop I didn’t have to figure on the effect of my own trading. I lost in New York because the game was altogether different. It was not that I now was playing it legitimately that made me lose, but that I was playing it ignorantly. I have been told that I am a good reader of the tape. But reading the tape like an expert did not save me. I might have made out a great deal better if I had been on the floor myself, a room trader. In a particular crowd perhaps I might have adapted my system to the conditions immediately before me. But, of course, if I had got to operating on such a scale as I do now, for instance, the system would have equally failed me, on account of the effect of my own trading on prices.

In short, I did not know the game of stock speculation. I knew a part of it, a rather important part, which has been very valuable to me at all times. But if with all I had I still lost, what chance does the green outsider have of winning, or, rather, of cashing in?
It didn’t take me long to realise that there was something wrong with my play, but I couldn’t spot the exact trouble. There were times when my system worked beautifully, and then, all of a sudden, nothing but one swat after another. I was only twenty-two, remember; not that I was so stuck on myself that I didn’t want to know just where I was at fault, but that at that age nobody knows much of anything.

The people in the office were very nice to me. I couldn’t plunge as I wanted to because of their margin requirements, but old A. R. Fullerton and the rest of the firm were so kind to me that after six months of active trading I not only lost all I had brought and all that I had made there but I even owed the firm a few hundreds. There I was, a mere kid, who had never before been away from home, flat broke; but I knew there wasn’t anything wrong with me; only with my play. I don’t know whether I make myself plain, but I never lose my temper over the stock market. I never argue with the tape. Getting sore at the market doesn’t get you anywhere.

The details of stockholders’ or shareholders’ equity are considered important enough to warrant their own statement under both GAAP and IAS. This statement provides details of activities in the common and preferred stock accounts (including treasury stock), the retained earnings account, and changes to owners’ equity that do not appear in the income statement (other comprehensive income). These statements for AT&T are presented below.

The last section in a statement of shareholder’s equity presents comprehensive earnings (loss), which reconciles net income as reported on the income statement with other current period results that did not appear on the income statement but nonetheless affected the value of shareholders’ equity. The notion of comprehensive income is a relatively new one. Under U.S. GAAP, reporting comprehensive income has only been mandatory since 1998. Under IAS, the components are reported in the statement of equity, but a “comprehensive income” figure is not currently required but can easily be determined.

As an example, consider the reconciliation of comprehensive earnings for AT&T:

Net income appears on the income statement, and after dividends are paid out the remainder appears on the balance sheet as an addition to retained earnings. The other components, pension liability adjustments and “other” adjustments, were changes that accounting rules permit to bypass the income statement.

Examples of items that might affect comprehensive income (but not net income) include unrealized net loss from marking available-for-sale investments to market value, foreign currency translation adjustments, adjustments resulting from changes in the value of pension plan assets needed to fund pension plan liabilities, net losses on derivative activities constituting cash flow hedges and net investment hedge gains and losses.

When investors are unsure about a company’s prospects and want to evaluate them under a variety of circumstances, it can be useful to perform a sensitivity or scenario analysis. One example of such an analysis was originally published at Stock Market Beat, and is reprinted here with the author’s permission.

In previous posts we have discussed Ceradyne’s (CRDN) increased reliance on military body armor for revenue and the potential consequenses should orders flatten or, worse, decline significantly once the military has all the units it needs. In the latest quarter, military sales made up 80 per cent of CRDN’s overall business. Because the issue is so important for potential Ceradyne investors, this article conducts a sensitivity analysis on Ceradyne’s sales and earnings.

When a company increases its sales, most of the time its earnings can grow by a greater amount. This is because some of the company’s costs are fixed and do not fluctuate with the level of sales. This factor is called the operating leverage effect (OLE). According to The Analysis and Use of Financial Statements, (p. 138) OLE can be estimated as the percentage change in operating income divided by the percentage change in sales.

Looking at the last three years for Ceradyne, we find an approximate OLE of 130%, which suggests that each 10 per cent change in CRDN revenue will result in a 13 per cent change in operating income. Using that, we can now create some basic scenarios for the company. First, we will assume that 2006 results are in line with management’s guidance (which implies a 170 per cent OLE in 2006.) Given the range of OLE estimates we have seen, we will settle on 150 per cent for our analysis. From there, we will start with three scenarios for 2007:

1. Base Case: After 2006, military sales are flat as replacement units make up for the initial order fulfillment. The rest of the company can grow 15 per cent. Due to the 80/20 mix of military/other, this translates into total revenue growth of three per cent.
2. Bull Case: After 2006, military sales rise at the company-average 15 per cent per year due to technological advances the military needs or market expansion (i.e. into vehicle armor.) This would mark a total revenue growth rate of 15 per cent.
3. Bear Case: After 2006, with the initial order filled, there is a 50 per cent drop in military orders, but the remainder of the business continues to grow 15 per cent. Given the 80/20 revenue mix, this would mean an overall sales decline of 37 per cent.

For those who fear the bear case is too… well, bearish, note that the latest 10Q warns:

Based on our current backlog, we expect our shipments of ceramic body armor to be higher in fiscal year 2006 than in 2005. However, unless we receive additional orders under existing contracts or are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor will decline materially in 2007 from levels we expect to achieve in 2006.

On the other hand, the bull case is also possible. For example, Newsday recently reported that the Army is seeking a replacement design for the current body armor vest. Ceradyne could potentially win this design, although the upside to such a win is uncertain given that Ceradyne already makes the armor plating that is inserted into the current generation vest.
Finally, in Q12006, operating income more or less equaled net income. This is because the interest earned on cash was enough to offset interest paid on the company’s convertible bonds. So, after applying the 36.5 per cent tax rate we should be at a rough estimate of net income for each case. So let’s see them:

So now we have a set of three potential outcomes for Ceradyne in 2007. You can assign your own weight to each potential outcome, or play with the scenarios. But at least it should now be apparent that the $3.54 consensus estimate for 2007, and even the $3.15 to $4.27 range, are subject to a good deal of uncertainty.