Unlike the world of accrual (or accrual) accounting, cash flow is an effective way for investors to measure the financial health and operational soundness of a company. The general idea of recognizing income when it is realized or realizable can be complicated 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 the money that came in and the money that went out at a business 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 undergone some manipulation over the years. Here’s how to do this.
When looking at a cash flow statement, there are three sections the statement is divided into: operating, investing, and financing. The most important section for an investor would be the operational section because this is where you can find the money that a company is generating from its operations. Investors want to see more cash generated from the operations of a business rather than loans or equity transactions.
Unfortunately, it is not always clear where a business generates its cash from. One of the ways the company skews its operational section is by misclassifying inventory purchases. Inventory purchase costs that will eventually be sold to customers should be classified as an item in the operational section of the cash flow statement. However, some companies disagree and feel that purchasing inventory is an investment exit, which would increase operating cash flows. One should question this method of accounting because large investment outflows should not occur as part of the normal cost of running a business.
In addition to misclassifying inventory purchases, many companies capitalize some expenses, increasing the company’s bottom line. When a company capitalizes costs, it amortizes the cost of an asset gradually, in installments, rather than assuming 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 the net income or operating section. As a result, the cash flow from business operations will remain the same and will look much better than it actually is.
Companies then boost their operating cash by selling their accounts receivable. This speeds up a business’s cash collection, but also forces the business to accept less dollars than if the business had waited for customers to pay. This action can have a negative impact on the operational section of a company. Decreasing accounts receivable means that more cash has come in through the sale of accounts receivable, but this would give investors the wrong message. By speeding up collections, a business is not improving operations, it is 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 accounts payable, which would mean that no payments are made to suppliers. If these accounts payable are left open for an extended period, then a business receives free financing, which increases the operational section inaccurately.
All of these examples are ways that companies can easily manipulate their operational section. These examples give companies an opportunity to show that they have more money at their disposal for operating expenses than they actually have. For example, in 2000 Enron reported that it had an operating cash flow of more than $ 4 billion, which was actually overstated by $ 1.5 billion.
This manipulation caused the value of Enron’s shares to rise, which in turn led to Enron’s collapse. Another example in 2002, Tyco International delayed paying its executives first quarter bonuses to increase the company’s operating cash flow for the quarter. This move caused the company’s operating cash flow to erroneously increase by $ 200 million.
The above examples show how easy it is to manipulate the cash flow statement. An investor should be aware of any manipulation that may cause dishonest financial information. 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 be manipulated just as easily.