Management of the cash flow statement

Unlike the world of accrual accounting, cash flow is an efficient way for investors to measure the financial health and operational strength of a company. The idea of ​​recognizing revenue 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 money comes from and how it is used is much more helpful to an investor. However, calculating and analyzing cash flow is not as easy as finding the difference between the money that went into and out of a company’s cash register. The difficulty arises 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 cash flow statement, 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 business generates its cash from. One way the company biases its operating section is through 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 purchasing inventory is an investment outflow, which would increase operating cash flows. One should question this method of accounting because large investments should not occur as part of the normal cost of running a business.

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 businesses 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 company’s cash flow from operations will remain the same and will look much better than it really is.

Companies then give their operating cash a boost by selling their accounts receivable. This speeds up a company’s cash collections, but it 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. Decreasing accounts receivable means more cash has come in through the sale of receivables, but this would give investors the wrong message. By speeding up collections, a business isn’t improving operations, it’s just finding another way to boost the operating section of the statement.

Another manipulation of the cash flow statement is through the 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 inaccurately increases the operating section.

All of these examples are ways that companies can easily manipulate their operations 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 having cash flow from operations of more than $4 billion, which was actually overstated by $1.5 billion.

This manipulation caused Enron’s stock to rise in value, which in turn led to Enron’s collapse. In another example in 2002, Tyco International delayed payment of its first quarter bonuses to its executives 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 above examples show how easy it is to manipulate the cash flow statement. An investor must be aware of any manipulation that may cause dishonest financial information. In conclusion, the statement of cash flows is the most useful financial statement for an investor, but just as cash easily changes hands, the statement of cash flows can be manipulated just as easily.