Every quarter, public companies report their ‘earnings’ – but don’t let the term earnings fool you. If a company reports $1 million in earnings, it doesn’t necessarily mean it has an extra $1 million for the shareholders. Let’s take a closer look at the difference between earnings and cash flow.
The primary financial statement to understand a company’s cash flow is the Cash Flow statement, but I’ll also discuss the other two financial statements: income statement and balance sheet as well. Each of these statements play an important role in how financial information is reported, but more importantly is a company’s cash flow.
Table of Contents
Concept of Net Worth
To begin, let’s first understand the concept of net worth. The shareholders’ equity, or net worth describes what a company owns vs. what it owes. Most of the time this consists of total assets (- minus) total liabilities. If your company does well, profits increase, and the net worth increases as well.
Net worth = Assets (what it owns) – Liabilities (what it owes)
Assets
All companies own a variety of assets. Each company will vary, but typically, the Assets owned by a company comprise of:
- cash, receivables (monies owed by customers),
- physical items (inventory, finished products, raw materials, equipment, vehicles, buildings, land, etc.); and
- intangible items (patents, royalties, and other intellectual property, etc.).
Liabilities
Liabilities are the money or services owed by a company. These include money owed to suppliers (accounts payable), taxes (taxes payable), employees (wages payable), and other operational expenses. This also includes debt (loans, overdraft protection, lines of credit) that is owed to the bank in various forms of both short and long term (principal amount and interest).
The final offset of assets and liabilities gives you the actual net worth of the company or assets (- minus) liabilities.
If the total assets are more than liabilities, then the company has a positive net worth.
If the total assets are less than the liabilities, then the company has a negative net worth.
Now, when a company reports $1 million in earnings, it means that the overall net worth of the company has increased by $1 million – this is assuming none of the earned money has yet to be distributed to the owners.
Earnings = Increase or Decrease in Net Worth
BUT an increase in Net Worth doesn’t mean an increase in cash.
Example: A $0.50 increase in accounts receivable and a $0.50 decrease in payables, for instance, can increase net worth by $1 without affecting cash.
Investors
Investors expect to put money into a company that will use that money to generate more cash, and as a result, return that money back to the investors in the form of dividends or stock buybacks.
Stock buybacks increase the stock price over time – Apple is a prime example of this. But if the company is generating earnings in the form of non-cash assets like receivables, then the company will not be able to return cash dividends back to the investors.
Therefore, understanding Cash Flow is extremely important. Earnings don’t tell you how much cash was brought in and can be returned to its owners/investors.
Cash vs. Earnings
The earnings of a company are generated from the Income Statement and is typically presented as the Revenue (-minus) Costs. Both the Revenue and Costs categories contain items that are not actual cash (payables & receivables). These are the two components that make the difference in the cash vs. earnings.
To illustrate, a company that sells advertising, but does not get paid real-time for its services, but instead gets paid 45 days later. This would be considered a receivable, but also be considered revenue. It contributes to the earnings, but not directly to cash.
At the same time, this company uses 3rd party advertising consultants, and pays them at a later date. This reduces earnings. It is considered a cost on the Income Statement, but it doesn’t come from cash, but rather from payables. This is the reason there are two accounting methods created – Cash & Accrual.
This type of accounting is called Accrual Accounting – it is counted when it is ‘earned’ rather than when it is received.
It is required by GAAP (Generally Accepted Accounting Principles) that public companies state their income this way. It is counted this way in order to recognize revenue and costs in the correct period of time for financial statements (each quarter).
Accrual accounting is the fundamental reason that earnings don’t actually mean there is an increase in cash during this period. In order to understand what is happening on the Income Statement and Balance Sheet, companies are required to report a Cash Flow Statement.
Alternatively, Cash Accounting would mean that the revenues are counted when the cash is received. This is the way that most people would think about buying and selling, but that’s not the way companies report.
Accrual accounting is the fundamental reason that earnings don’t actually mean there is an increase in cash during this period. In order to understand what is happening on the Income Statement and Balance Sheet, companies are required to report a Cash Flow Statement.
Note: many small private businesses use Cash accounting methods so it’s very important to first understand which accounting method is being used. This goes for all financial statements.
Depreciation
An example of this is depreciation is referred to as a non-cash cost. The depreciation comes from assets that were paid with cash in a prior reporting period. But now the cost is reported each period for the amount of the asset that was used during the current period. For example, let’s say a company buys a truck, and it pays for it in cash. According to GAAP, a company cannot expense the entire truck the first year because it has a useful life of longer than 1 year. Instead, it breaks the expense into 6 years of separate expenses as the vehicle ‘depreciates’ over time.
The Cash Flow Statement takes all the costs, such as depreciation, that are reducing earnings on the Income Statement, but aren’t truly affecting cash. It then adds them back to earnings, to reconcile it with the cash.
Stock Based Compensation
Another example is Stock Based Compensation – when companies pay employees with stock rather than cash. It is a non-cash cost that gets added back to earnings. Remember depreciation is ‘pre-paid’, but Stock Based Compensation is different, it doesn’t decrease the company’s net worth, but dilutes the equity that owners have in the company – in the form of issuing more stock.
Non-cash items can also show up on the Revenue side as well. When the company sells an item on credit, it increases revenues, but not the actual cash. The Cash Flow Statement will subtract the non-cash revenue from earnings.
Working Capital
Credit sales are recorded as an increase in receivables in the ‘working capital’ section, rather than in the ‘funds from operations’ section.
Inventory is also included in the ‘working capital’ section.
All of these ‘working capital’ increases are then deducted from earnings in the Cash Flow Statement.
Using the same reasoning – all increases in working capital liabilities (payables) are added to earnings.
Capital Expenses (CapEx)
The original purchase of the depreciating assets is a “capital expenses” or CapEx. It’s the money spent up front.
Remember, depreciation is deducted each reporting or accounting period, but it is for something that was paid for in the past.
In other words, this is the cash that the business is investing in its operations right now that it will eventually deduct from its income in later periods. These are the investment expenses that go into the company and will lead to future revenues.
This means that every dollar that goes to CapEx, there is one less dollar to distribute to the owners.
Investors like Warren Buffett make a clear distinction between two types of CapEx:
- Maintenance CapEx requires spending money now in order to preserve future earnings. In other words, the company is handcuffed by these expenses. Now the company must use its cash to defend its future earnings rather than distributing it to the shareholders.
- Growth CapEx is cash spent to increase future earnings. The company doesn’t need to spend this money to preserve its earnings. It can now choose to invest this for the future or hold onto the cash. By holding onto the cash, it won’t hinder the earnings. A great management team will make the appropriate decision whether to take the growth path to achieve higher earnings or return the capital to the shareholders.
Let’s look at a CapEx example. Buffet’s original business with Berkshire Hathaway was a textile business. Textiles are high maintenance CapEx businesses that require large sums of money reinvested to continue business, which ultimately led to him changing the business structure. Buffett chose other types of businesses like See’s Candies that have extremely low CapEx maintenance. It generated a lot of cash every year in which he was free to extract from the business and re-invest in other companies.
Acquisitions
Another familiar way that companies look at CapEx is in the form of acquisitions. They are very similar because they take the company’s cash and use it to purchase a business that will in turn increase the growth and future cash earnings of the company, rather than slowly investing and growing the company internally.
Free Cash Flow
Free Cash Flow is the bottom line of the Cash Flow statement and essentially the cash that the company has “to use” at the end of the quarter. A company will then decide to pay down debt, return it in the form of dividends, or buybacks, or hold it for other purposes. The management team ultimately decides what is done with the money.
If there’s one thing that you get from this . . .
“Cash is a fact. Earnings are an opinion.“
The greatest companies that are managed well tend to return a lot of cash to the owners over long periods of time.
Conclusion
The Cash Flow Statement can be confusing because it requires and understanding of accounting methods, but the reality is that is provides more accurate numbers of cash going in and out of the business. My hope is that you can take away these 4 concepts when reading Cash Flow statements:
- $1 of earnings means the value of the company grew by $1, not necessary $1 in cash.
- Accrual accounting gives a more accurate picture of what’s happening in the reporting period.
- Depreciation and Capital Expenditures (CapEx) are reported in specific time periods, but have impacts on both current, and future income and expenses.
- Free Cash Flow – the bottom line of the Cash Flow Statement is the ultimate indicator of the actual cash and equivalents that the company made during the time period.
Please check out my other articles and if you have particular questions about Cash Flow statements, please feel free to ask below.
Definitions
Stock buyback (share repurchase) allows a company to re-invest in itself. The repurchased shares are absorbed by the company, reducing the number of outstanding shares on the market. Because there are fewer shares on the market, the relative ownership stake of each investor increases.
Accrual Accounting is when transactions are recorded as they occur even if the payment for that particular product or service has not been received, it is known as accrual-based accounting. This method is more appropriate in assessing the health of the organization in financial terms.
Cash Accounting refers to businesses that count transactions only after money has changed hands. These businesses won’t record income or expenses until payment is received. It doesn’t matter if the invoice has been issued, or the goods and services have been shipped. Cash accounting focuses only on money, not invoices.
Below is an example of a Cash Flow Statement and the additions/deductions for line items that result in the bottom line – Cash Flow from Operations.
