importance of the cash flow statement: it’s like mushrooms

why project a cash flow statement?

While I was in graduate school, I spent a year in Germany studying at Eberhard Karls University in Tübingen.  Before school started I lived for a while with a German family.  Every Saturday morning we would roam the local woods in search of the mushrooms that would comprise one or two of our meals during the following week.  Since I had no clue what I was doing, my hosts would scrutinize any mushrooms I found very carefully to make sure they weren’t poisonous.

One type, the death cap–which I never stumbled across–still stands vividly in my mind.  According to my family and to public service announcements on tv, not only was this mushroom deadly, but the first symptoms of its effects only developed after the poisoning was too far advanced to be treated.

There’s an analog to this situation in the investment world.  These are cases where the financial results of past management actions narrow the scope of future possible outcomes to the point where one or two become highly probable–if not unavoidable. In these cases, management is never going to spell out the constraints it it working under.  Nevertheless, the current financial condition probably makes their future actions very highly predictable.

Projecting a cash flow statement for such a company is the way to uncover and evaluate.  (An analyst should do this for every company under coverage.  In my experience, most don’t.  In “mushroom” cases, however, the cash flow statement is crucial.)


a toy company

In the early Nineties I was following–and for a while owned shares in–a small publicly owned toy company.  It earned, say, $10 million annually.  One year it had a surprisingly successful spring-driven flying toy doll for girls.  The following year it decided to make a similar toy for boys, with a martial theme and a stronger spring.  As I recall, the firm decided to spend $40 million on materials and labor for this toy (a real roll of the dice at 4x total corporate earnings).  It got the money through trade financing and borrowing from its bank.  The risk was especially high, since all the manufacturing had to be done at one time, in preparation for the yearend holiday selling season.  On the other hand, the prior year’s toy had been a smash hit; the firm really understood the boy market and felt this one would be, as well.

Soon after the toy was on the shelves of toy stores, the company began to get reports that the combination of a strong spring and curious young boys was resulting in severe eye injuries to users.  The government mandated a recall.  The $20 million in profits the company had envisioned was up in smoke.  The inventory that had cost $40 million to make was now worth close to zero.

Do the math.  At most $10 million in earnings from other toys vs. $40 million in short-term financing needing to be repaid = no way out.

the Mets

The New York Times published a recent article on the Mets’ finances, titled “For Mets, Vast Debt and Not a Lot of Time.”  There isn’t enough publicly available information to draw a firm conclusion, but if the figures in the article are correct, the Mets don’t have much wiggle room.  The current club drive to lower the total player salary bill may be the only real option it has.  Specifically,

Sources of funds:

The Mets lost $70 million (I’m presuming that this is a pre-tax figure, but this isn’t clear) last season, with a player payroll of about $150 million.  Let’s say the actual pre-tax cash outflow was $30 million.

If we make the (optimistic) assumption that ticket sales and concession revenue in 2012 is constant with 2011, then lowering payroll to $100 million will result in a pre-tax loss of $20 million for 2012.  Cash flow should be positive, at about $20 million.

2013 cash inflow = $40 million ?

2014 cash inflow = $50 million ?

Uses of funds:

repayment of $25 million to Major League Baseball, now overdue

repayment of $40 million Bank of America bridge loan

repayment of $430 million team loan in 2014.

If, again, the NYT figures are correct and the cash inflow numbers I’ve made up for 2012-14 are anywhere close, the Mets won’t be able to make much of a dent in the 2014 principal repayment requirement.  It seems to me that dealing with the $430 million that comes due in three years is the major management issue.

What I’ve written above is just the bare bones.  The Mets are attempting to find outside investors who are willing to accept having no say in the running of the organization.  Suit by the Madoff trustee is pending.  And, of course, there’s the tangled relationship between the Mets and SNY, the Wilpon-controlled cable network to which the club has sold broadcast rights.


Eastman Kodak has been supporting its ongoing turnaround through outside financing and asset sales.   Looking at the cash flow statement for the past couple of years and projecting it forward for the next few will be highly instructive.

Current market worries about Italy’s sovereign debt also have a cash flow basis.   The issue is the current high cost of refinancing maturing debt.  Unlike the previous corporate instances, Italy’s new government has much greater scope for initiating reforms that can change market perceptions quickly.  And perceptions, rather than the amount of outstanding debt (which is typically the corporate issue), are the main concern here.  Still, projecting sources and uses of funds forward for several years will give a much clearer grasp on the issues than simply watching current yields.







Sony/Samsung LCD jv restructuring: a study in cash flow vs. earnings

the Sony/Samsung LCD-making joint venture

On Monday Sony and Samsung announced a restructuring of the joint venture they entered into during 2004 to manufacture large liquid crystal displays for televisions.

The joint venture developed out of Sony’s dire need of LCD manufacturing capacity (it had badly underestimated how quickly flat panels would replace traditional CRTs) and Samsung’s desire to achieve economies of scale and its hope for technology transfer.  But after seven years, in a world awash in LCD-making factories, and given Samsung’s technological dominance over Sony, the jv had outlived its usefulness.

I haven’t looked at Sony carefully for years.  My overall impression continues to be that the firm is a mess.  But that’s not what I want to write about.

terms of the jv restructuring

The essentials of the recasting of the LCD joint venture are:

–Samsung will buy out Sony’s interest (50% minus one share) for around $950 million in cash,

–Sony agrees to buy LCDs from Samsung (no details of the arrangement given),

–Sony will record a loss of $850 million on the sale, implying its ownership interest is being carried on the balance sheet as worth $1.8 billion, and

–Sony expects to save about $160 million a quarter–a combination of savings on LCD purchases and being freed of the need to make new investments in the jv.

earnings and cash flow implications for Sony


The writeoff of its 2004 investment will depress Sony’s March 2012 earnings by $850 million.  The $950 million payment will be treated as a return of capital and won’t show on the income statement.

If we assume that the jv is simply breaking even, which is probably much too optimistic, there will be no effect, positive or negative, on future eps for Sony from its dissolution.  To the degree that the jv is loss-making, that red ink will disappear from the income statement.

cash flow

Here’s where the significant positive impact comes.  The transaction turns a loss-making asset into significant positive cash flow.

First, of course, Sony takes in $950 million in cash early next year, an amount equal to roughly 5% of the company’s market cap.

Second, it avoids having an outflow of money that it estimates at $160 million per quarter.  In other words, Sony enhances its cash flow by that amount.

Two positives from this:

–Sony can reallocate the cash saved to more productive activities, and

–my quick perusal of Sony’s most recent form 6-K (on page 18) suggests that the $160 million a quarter the jv was using up is virtually all the cash flow Sony is currently generating.

my point

This kind of transaction is a staple of value investing, where a loss-making asset that earnings-oriented investors regard as worthless is sold–and thereby is shown to have substantially more value than the market has realized.  In the case of larger sales or smaller companies, transactions like these can be transformative.

cash flow per share and earnings per share as valuation metrics (ll): cash flow per share

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  This has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend capital on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip of a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you’ve got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ve be unable to pry the company out of the hands of current management.

cash flow per share and earnings per share as valuation metrics (l): earnings per share

two types of investors, two toolboxes

In the US and increasingly in the rest of the world, investors tend to fall into two psychological types:

growth investors (like me) are dreamers.  We buy stocks based on the belief that future profit growth will be strong enough to make the stock rise in price.  Our mantra is:  better eps than expected for longer than expected.  We typically buy stock in well-managed, industry-leading companies and use projected future eps as our main tool.

value investors (the more venerable [read: older] school)are pragmatists.  They buy stocks on the idea that they are undervalued based on what one can see in the here and now–the earning power of today’s well-understood businesses + the value of assets on the balance sheets.  They are happy to buy a mediocre company whose stock is trading on the mistaken belief that the firm is truly wretched.  They often have an eye to change of control.  They use both cash flow per share and eps as tools.


Looking at earnings per share growth is, I think, pretty straightforward conceptually.  Earnings go up, the stock goes along for the ride.  The problem is that forecasting earnings with a reasonable degree of accuracy  even twelve months ahead is much more difficult than you’d imagine.  The evidence is that as a group even professional securities analysts, with lots of information at their fingertips and unparalleled access to company managements, fail at doing this.

One issue is that company managements understand the Wall Street game:  show surprisingly strong earnings and you’ll look like a genius and your stock (your stock options, too) will go up a lot.  So they pressure analysts to understate earnings.  Analysts, too, since their livelihood depends on investor interest in the stocks they cover, sometimes become like home town radio announcers for “their” industry and fail to notice trouble developing.

For growth investors, cash flow per share doesn’t come up in discussion very much.  For me–and I spent a little more than half my career in value shops)–three instances where  cash flow is important stand out:

–An emerging company has spent a lot on creating the infrastructure it needs to launch its products/ services, but they haven’t caught on yet.  The firm is showing small profits, or maybe losses at present.  This situation often creates the opportunity for significant operating leverage (large profit increases from small increases in sales).  So if you can find a convincing reason that the company will be successful, it is probably a very interesting investment.

–A more established company has persistently high cash flow but small profits.  This means cash flow consists mostly of depreciation.  Put another way, the company continues to make capital investments but then spends most of its time just trying to recover its (poorly conceived) outlays.  Value investors are drawn to this kind of firm like moths to a flame–thinking that either the board of directors, shareholders or activist investors will force changes.  Growth investors, in contrast, run away as fast as they can.

–A company has two divisions, one of which provides all the growth.  This happens more often than you might think.  In fact, WYNN (which I own) is in just this position.  Macau operations provide all the profits.  To my (growth investor) mind, a situation like this can provide very good performance.  That’s provided you can convince yourself that the second division–Las Vegas, in this case–won’t turn into a black hole of losses that devours the profitable division. This is where cash flow comes in as analytic tool.

As an investor, it’s not good but it is acceptable that the second division is losing money.  But it’s a great comfort if the division is in the black on a cash flow basis, as WYNN is in Nevada.  Operating leverage can be a worry if there’s a significant chance it can turn negative.  But it can be a longer-term plus, if you think there’s a bigger chance operating leverage can eventually turn positive.

That’s it for today.  Tomorrow, cash flow per share and value investors.

cash flow

cash flow

Yesterday’s post probably contained more than you will ever need to know about depreciation.  Today’s topic is cash flow.  Tomorrow’s will be a discussion of whether cash flow or net profits is a better indicator to use in evaluating a stock.

four possible sources

What makes cash flow important is that it is a broader measure of a company’s ability to generate money from operations year after year than net profit is.  Professional investors normally consider four sources of funds in calculating cash flow. They are:

–net profit

–depreciation and amortization (which is essentially depreciation under another name)

–deferred taxes

–changes in working capital.

The four items should be found either in a company’s cash flow reconciliation statement or in the footnotes to the balance sheet.   In the US, all are contained in the “cash flows from operating activities” section of the cash flow statement.

I stick with two

Not everyone uses all four items.  There’s universal agreement (or as near as you can get in any human endeavor) that a cash flow calculation should include net profit + depreciation and amortization.  The question is whether to include the other two. And the issue is whether they provide a recurring source of cash.  My own opinion is, except in heavily government subsidized industries like mineral extraction where taxes always seem to be deferred, to exclude both deferred taxes and changed in working capital.

The worry about deferred taxes is that they arise from differences in the timing of when the tax expense is shown on the financial reports to shareholders and when the cash is ultimately paid to the tax authority.  So they often reverse themselves in relatively short order.

How can this happen?  One main reason is that governments often give companies a tax incentive to invest by allowing them to take rapid depreciation deductions.  In most countries (Japan is the only exception I can think of) financial reports use straight line depreciation, which slows and smooths the depreciation deduction.

An example:  For a $1000 item with a 5-year life and no salvage value, where government allows double declining balance depreciation, the yearly deprecation expense for taxes vs. for financial reporting looks like this:

tax     400     240     120     120     120

fin      200     200     200     200     200

Δ        200      40      (80)     (80)    (80).

Let’s assume (to keep things simple) that there are no other differences between the tax books and the financial reporting accounts.  If so, in year 1 the financial reporting accounts will deduct 200 from revenue for depreciation vs. 400 on the tax books.  Therefore, the report to shareholders will show pre-tax income that’s 200 higher than the tax books will show to the government.

What to do about the 200 in “phantom” income on the financial reporting books.  Not to worry, the financial reporting accountants will make a tax provision of 70 (assuming a 35% corporate tax rate) for the “extra” income.   They will label the 70 as deferred taxes and establish a balance sheet entry to hold the phantom tax payment.  They will also enter the 70 as a positive cash flow from operations on the consolidated cash flow statement, to show that the 70 hasn’t actually been paid to the tax authority.  (I’m not making this up.  This is what they do.  Don’t ask me why.)

In year 2, the procedure is similar to that of year 1, but the amount is 14.

In year 3, the depreciation deduction for financial reporting purposes is higher than that for the tax authority, so more actual taxes–an extra 28 per year–are paid.  Financial reporting accountants handle this by reversing their prior procedure–subtracting 28 in deferred taxes each year from the balance sheet, the tax entry on the income statement and the cash flow statement.

The details–bizarre as they are–aren’t so important.  The point to remember is that unless a company is continually investing, the deferred tax additions to cash flow will soon reverse themselves.  So they can’t be counted on as recurring sources of cash flow.

The other iffy item, in my view, is changes in working capital. There are negative working capital businesses.   Public utilities, restaurants, and hotels are examples.  Their customers pay for the companies’ products either in advance or very quickly after using them.  The companies, on the other hand, pay their suppliers only with a time lag, say, 30 days after delivery.  So such companies enjoy a “float” equal to perhaps 20 days worth of sales.  As long as sales are increasing, this “float” not only persists–it gets bigger!  The increase in payables minus receivables shows up on the cash flow statement as cash coming in from operations.  The amounts can be very large.

This isn’t exactly risk-free money, however. If sales begin to contract, so too will payables–meaning the company will have to return part of the float it has enjoyed from its suppliers.  And it better have the cash to be able to do so.  This is my reason for not counting working capital changes either.

(One other note about working capital, which I really consider a separate item for analysis.  There are firms whose market position is weak enough that their suppliers don’t give them much trade credit and they are also compelled to finance their customers’ purchases for long periods of time.  The worst I ever recall seeing was the Japanese sporting good company, Mizuno, which in the Eighties was giving its customers two years to pay.  In order for the company’s sales to grow, this trade financing–a use of corporate funds–had to grow as well.)

cash flow vs. free cash flow

Analysts often try to distinguish between (gross) cash flow as described above and (net or) free cash flow.  The latter is what’s left from profits + depreciation after all corporate calls on that cash have been satisfied.  These calls are generally:

–capital expenditure, i.e. reinvestment in maintaining and expanding plant and equipment

–working capital needs

–repayment of debt

–dividends to shareholders.

sounds good, but a somewhat nebulous concept

Although the concept of free cash flow is clear, arriving at a practical figure–especially when analyzing the company as an acquisition target–is a lot murkier than it might sound.  First of all, if you or I were acquiring a company, we probably wouldn’t pay dividends any more (we’d cancel our jet rentals and ride around on the corporate plane instead; we might have the company “invest” in a golf course in a resort area, too–and inspect it frequently).

We might think that the current owners’ capital spending plans were too aggressive or wasteful.  In either case, we could pare them back.  We might also think that the firm’s working capital management is very inefficient.  And we might feel we could refinance existing debt at a more favorable rate.

the unenviable case of utilities

However fuzzy the actual calculation may be,  we can probably best see what the distinction wants to highlight by considering a (highly simplified) public utility, like a local gas or electric distribution company.  Regulators in most countries grant such utilities a maximum allowable profit that’s calculated as a percentage of the utility’s net (meaning still undepreciated) plant and equipment.

Let’s say the allowable return is 5% and the net plant and equipment is 1000.  In the first year, the company is permitted to achieve a profit of 50.  During that year, the company records depreciation expense of 25.  Cash flow is therefore 75.

But starting out in year 2, absent any new building, the net plant is only 975.  Therefore the maximum allowable profit is 48.75–a fall of 2.5%.  In order to keep profits flat from year to year, the utility has to reinvest its depreciation to get the net plant back up to the prior year’s level.  To have, say, a 2.5% profit increase, the utility has to make its net plant grow by that amount–meaning it has to reinvest depreciation + another 25 (half its profit) back into the business.

This is the ultimate case of a company whose cash flow is not free.  Looking at the utility sections of stock services like Value Line, which calculate cash flow and price/cash flow ratios will show you what stunningly low multiples of cash flow pure utilities trade at.  The fact that most of the cash has to be plowed back into the business just to keep the ship afloat is the reason why.

That’s it for today.