Heard on the Street
Cash Flow? It Isn't Always What It Seems
By Henny Sender
1,202 words
8 May 2002
The Wall Street Journal
C1
English
(Copyright (c) 2002, Dow Jones & Company, Inc.)
Cash may be king, but some princely sums reported in financial
filings are less than they appear at first blush.
Long viewed as the most reliable, least manipulated of the
financial documents filed by a company, the "statement of cash
flows" has its shortcomings, too, as Dynegy Inc. investors
recently learned. Over the years, investors have come to view
the section of the statement dubbed "cash flow from operating
activities" as a source of important insights into a company's core
business, while the document's other two sections -- one tracing
cash flow from financing activities, the other tracking
investments -- provide other key data about how the company is
run.
But late last month, the energy-services firm said that, after
discussion with the Securities and Exchange Commission, it
would revise its cash-flow statement for 2001 so that $300
million tied to a complex natural-gas trading arrangement would
be removed from the operating cash-flow section and put into
the financing section.
While the restatement doesn't change Dynegy's net income, cash
flow from operations drops by 37% as a result. Perhaps more
importantly, the restatement is a big blow to the many investors
who held on to the cash-flow statement as a beacon of truth
even as their faith in earnings figures was shattered in recent
months by everything from debate over the proliferation of pro
forma earnings to an explosion of purported one-time charges
they are told to ignore to the collapse of Enron Corp. amid
myriad alleged accounting irregularities.
"If you think operating cash flow as reported actually gives you
operating cash flow, you are kidding yourself," says Trevor
Harris, accounting analyst for Morgan Stanley & Co.
There is little question: Few things matter more than how much
cash is flowing into and out of a company. If a company's core
operations aren't generating enough cash, investors can
anticipate that the company sooner or later will need to turn to
the markets for more funds. The company will load up on either
debt (payment of which reduces earnings) or equity (which
involves undesirable dilution).
Unfortunately, accounting rules give companies plenty of
flexibility in what they include in operating cash flow and in
classifying cash flows into the operating, investing or financing
categories, according to Charles Mulford, accounting professor at
Georgia Institute of Technology and co-author of the recently
published "The Financial Numbers Game." In the Dynegy
instance, the SEC is looking into various aspects of the
accounting for the multiyear natural-gas trading arrangement.
But Mr. Mulford has compiled a list of the various ways
companies can alter operating cash flow to boost results, all
within the rules.
One common device to make cash flows look better than they
would otherwise be is for companies to sell or securitize
receivables, Mr. Mulford notes. This practice is now so
widespread that almost every company does it, according to Pat
McConnell, an accounting specialist at Bear Stearns & Co. But by
so doing, "companies are sacrificing future operating cash flows
for a one-time boost in these flows," Mr. Mulford says.
Consider TRW Inc. Earnings dropped to $68 million in 2001 from
$438 million the previous year. Operating cash flow, though,
went in the opposite direction; it rose to $1.49 billion from $1.15
billion. The improvement was largely due to $327 million the
company gained by securitizing receivables. A company
spokesman says that, in notes accompanying its financial
statements, the company made clear that the securitization
helped operating cash flow.
Meanwhile, Lear Corp.'s net income fell to $26 million in 2001
from $275 million in 2000. At the same time, operating cash
flow fell to $569 million from $753 million because the company
declined to include a sale of receivables that generated cash
flows of $261 million. "Sales of receivables and operating cash
flows are entirely separate events," says David Wajsgras, Lear's
chief financial officer. "We see sales of receivables as a low-cost
financing method; it shouldn't generate operating cash flow."
Investors should also ask themselves if an increase in operating
cash flow is the result of items that aren't likely to recur in the
future -- and hence should be discounted. For example, the rules
require companies to record tax benefits from exercising
employee stock options as part of operating cash flow. Yet
these benefits depend on how many people choose to exercise
their options and what the stock price is at the time -- variables
over which management has limited influence. That, in turn,
raises questions about the sustainability of these cash flows.
Consider the recent experience of Cisco Systems Inc. In the fiscal
year ended July 29, 2000, almost $2.5 billion of the $6.14 billion
in net cash provided by operating activities came from the tax
benefits of employee stock options. A Cisco spokeswoman
acknowledges the role played by tax benefits in the 2000 fiscal
year, but notes that by the third quarter of fiscal 2001, the tax
benefits became "much less," because employees exercise them
at their own discretion.
Companies also can adjust operating cash flow upward by
taking longer to pay their vendors, thereby increasing their
accounts payable, Mr. Mulford notes. For example, at AMR Corp.,
the parent company of American Airlines, accounts payable
increased just over 40% in 2001, to $1.78 billion from $1.27
billion in 2000, providing operating cash flow of $517 million,
Mr. Mulford notes. The increase in accounts payable made a
precious contribution since overall operating cash flow was
down sharply in 2001 -- declining to $511 million from $3.14
billion in 2000. A company spokesman says that $350 million of
the $517 million came about as a deferral of U.S. transportation
taxes and the remaining $200 million from the acquisition of the
assets of TWA.
An increase in accounts payable also helped Tower Automotive
Inc. in a difficult 2001; the company lost $268 million from
continuing operations last year, after making $16 million the
previous year. But operating cash flow looked far better in
2001, up to $514 million from $93 million in 2000, helped by a
rise in accounts payable to $369 million from $248 million the
year before.
Like American, "Tower was taking longer to pay in a difficult
year," says Mr. Mulford. Tower executives declined to comment,
as the company is in a quiet period before a stock offering. But in
its most recent annual report, the company said it was seeking
longer terms from vendors to improve its management of
working capital.
If a company isn't growing, negative cash flow can signal
unsustainable cash burn. But don't always assume that negative
cash flow is a bad thing. In fact, it can signal valuable investment
in growth. For example, over many years, Wal-Mart Stores Inc.
has produced negative cash flows, according to Mr. Harris of
Morgan Stanley, while retailing rival Kmart Corp. has had positive
cash flows. But Wal-Mart was investing heavily in its business,
and Kmart, which recently filed for Chapter 11 protection under
the bankruptcy code, wasn't.