Podcast Transcript

Today we will be talking about a company’s Cash Flow and how to calculate it by using the Cash Flow Statement. We will also look at earnings as reported on the Income Statement. We will compare the two figures to understand the difference between Cash Flow and Earnings. I will also provide a run down on the difference between the Income Statement and Cash Flow Statement. A final point we will be covering is Owner Earnings, this is another earnings figure used by Warren Buffett when he calculates the Intrinsic Value of a business.

To value a business we first need to know how much money the business is making. This doesn’t mean Gross Sales or Revenue but is the actual money a business will keep after all expenses and taxes have been paid. We can calculate this value from either the Income Statement or the Cash Flow Statement. Both these statements ideally will have the same end result, which is to illustrate how much money a business makes and what expenses it must incur to make this money. The difference between the two is that the Cash Flow Statement records transactions only when money has actually changed hands and the Income Statement will record a transaction at the point of sale, regardless if the customer paid cash or added it to their credit account. For example, if we have a bakery and two people buy a loaf of bread and one pays with cash and the other uses credit, which is basically adding the purchase to an account to pay at a later date, both these transactions will be recorded on the Income Statement, but the Cash Flow Statement will only record the cash transaction, ignoring the purchase made by credit. Not until the outstanding credit account has been paid will the transaction finally be recorded on the Cash Flow Statement.

Expenses are also recorded in a similar way as income. Using the bakery example again, say today the bakery made 100 loaves of bread, the cost to buy the ingredients to make the bread can be accounted for differently on each statement. The Cash Flow Statement will record the expense at the time of purchase, provided the bakery paid upfront using cash. The Income statement however, will record the cost of the flour on the balance sheet as an asset, and then each time someone buys a loaf of bread a portion of that asset will be expensed on the Income Statement, reducing the value of the asset. This expense is to account for the flour used to make that loaf of bread.

You can see that eventually, both statements will end up with the same amount of revenue and expenses over time. The difference between the two is timing. The Income Statement presents sales and expenses more smoothly by utilising the Balance Sheet to slowly expense the flour after each purchase. Whereas the Cash Flow Statement is less worried about looking good and is more concerned about presenting what is actually taking place in terms of the transaction of money between buyers and sellers.

To help illustrate, let’s look at a theoretical week at the bakery. On Monday the bakery pays $70 cash to a supplier to buy enough flour to make 700 loaves of bread for the week, selling 100 loaves a day. Half of these daily sales is paid for with cash and the other is paid for utilising a credit account which will be settled at the end of the week. Each loaf costs $2.00. Now let’s compare this week using both the Income Statement method and the Cash Flow Statement method. Starting with the Cash Flow Statement, on Monday we will have a deduction of $70 to pay for the flour which will be used to make the 700 loaves of bread for the week. We will also have a daily income of $100 from the 50 customers who paid using cash, resulting in $30 profit for the day. Tuesday through to Saturday will see $100 profit each day, this comes from the 50 customers who paid cash for their loaf of bread. On Sunday we will again see $100 from the 50 cash paying customers, but in addition, we will receive $700 cash which has come from settling the credit account, resulting in $800 for the day. So the week looked something like this; Monday $30 net profit, Tuesday $100, Wednesday $100, Thursday $100, Friday $100, Saturday $100 and Sunday $800, with a weekly total of $1,330 profit. You can see that the money received has been rather lumpy, caused by the initial expense on Monday to buy the flour and then on Sunday with the large inflow of cash received to settle the credit account.

The Income Statement has been designed to try and smooth this out. As stated earlier, the cost to buy the flour will sit on the Balance Sheet as an asset and then as each loaf is sold a proportion of the flour asset will be expensed. So if we are able to produce 700 loaves of bread with $70 of flour, this means that about 10 cents worth of flour is used for each loaf. If we sell 100 loaves a day this is $10 of flour a day deducted as an expense on the Income Statement. We will record revenue when a sale takes place, regardless if it was paid for by cash or credit. This will result in recording income of $200 a day for the sale of 100 loaves at $2.00 each. So, for each day of the week, we will record an income of $200 and an expense of $10 for the flour, resulting in $190 profit each day and a total of $1,330 for the week.

You can see that the end result is the same with $1,330 profit for the week, but the two statements provide a different story on how the profit was recorded. The Income Statement provided a smooth $190 profit each day, whereas the Cash Flow Statement was much more lumpy, seeing less profit on the Monday to account for the flour expense and then a large inflow of cash on the Sunday from the settlement of the credit account.

When it comes to calculating Intrinsic Value it may be a little confusing as to which Cash Flow or Earnings figure to use. Given that the company’s Cash Flow, as calculated using the Cash Flow Statement and its Earnings, as calculated using the Income Statement, should theoretically be the same, why differentiate the two? This is because due to the nature of recognising a sale on the Income Statement at the point of sale rather than when cash changes hands, known as accrual accounting, the profit assigned to the Income Statement is much more susceptible to manipulation, often with the target to overstate the profits made by the business. This can be achieved in many ways such as recording a sale sooner than appropriate or holding back expenses, both of which will result in a short term boost to the reported earnings.

The Cash Flow Statement isn’t free from manipulation either. Given there are three sections on the Cash Flow Statement; Cash Flow from Operations, Cash Flow From Investing and Cash Flow from Financing, managers can inappropriately allocate funds to either of these sections with the aim to boost Operating Cash Flow. Operating Cash Flow, which is taken from the Cash Flow Statement, is what we use to calculate the Free Cash Flow figure that is used to value a business. To further explain, I will shortly run through the different sections found on a Cash Flow Statement.

I would first just like to reiterate why we need to utilise the two Cash Flow and Earnings figures. Cash Flow which is taken from the Cash Flow Statement, as opposed to Earnings obtained from the Income Statement, is harder to manipulate and is considered a more accurate representation of a company’s performance. For this reason It is usually a more concervative measure of the business’s performance as well. It is still important however, to pay attention to the reported Earnings as it will offer a good basis to start from when calculating the latest Free Cash Flow figure which will be used to calculate the Intrinsic Value of the business. This is because if a business has just spent a heap of money upgrading its equipment, this will be reflected at a much greater scale on the Cash Flow Statement when compared to the Income Statement. So you could run the risk of undervaluing the business if electing to use the latest Free Cash Flow figure which has seen a large reduction due to a significant recent Capital Expense. We will talk more about Capital Expense shortly.

Another important point to mention is that it pays to compare Cash Flow and Earnings over time. This is because if the Earnings begin to outpace the Cash Flow by any great extent, it could be a warning sign that management is being too aggressive when recording revenue.

Now, getting back to the Cash Flow Statement, Cash Flow from Operations is a place to record transactions directly related to the normal operation of the business. So continuing with the bakery example, we will record both the sale of bread and the cost of flour in the Cash Flow from Operations section with the result being Operating Cash Flow. This means that the bakery produces $1,330 of Operating Cash Flow each week.

The Cash Flow from Investing section is where the company will record any purchase or sale of property, plant and equipment used to run the business, plus any other investments that it may make, for example it could buy a bakery in the next town to expand its network and generate more revenue. The purchase of property, plant and equipment includes items required to operate the business, such as an oven to bake the bread and a van to deliver it to customers. Land purchased by the bakery is also included under the Cash Flow from Investing section.

Cash Flow from Financing is where a business will record any money received from taking on a loan or issuing debt to bond holders. It will also record any repayments to reduce this debt. Dividends paid to owners are also recorded in this section as money leaving the business.

Now we have a basic idea of the different sections of the Cash Flow Statement and the understanding that Operating Cash Flow is what investors first look at when calculating the Free Cash Flow used to value a company, we can see that some managers may be tempted to look for ways to increase Operating Cash Flow. An example could include inappropriately allocating an expense such as the purchase of flour under the Cash Flow from Investing section, resulting in an increase to Operating Cash Flow as the flour expense has been removed from the Operating section to the the Investing section on the Cash Flow Statement.

You will find I have a checklist in my Value Investing Spreadsheet that will help investors to find any manipulation that may be attempted by management. I have a link to download this spreadsheet and checklist in the show notes. https://growthwithvalue.com/tools/

To further clarify the Income Statement and Cash Flow Statement we should also look at capital expenses, also known as CAPEX. There are two basic forms of CAPEX, investing and maintenance. Investing CAPEX is when a business will purchase something to expand its operations such as a second bakery or additional ovens and delivery cars. Maintenance CAPEX is an expense to maintain existing property, plant and equipment. This can include maintaining the delivery vans or servicing the oven to ensure it operates at the correct temperature. This type of expense is seen as a necessity because without it the business and its assets will deteriorate.

Like with sales and operating expenses, capital expenses are recorded differently on the Income Statement when compared to the Cash Flow Statement. On the Income Statement, if a new oven is purchased, this will sit on the Balance Sheet as an asset and, like the flour, it will be expensed over time. In this case the expense is called depreciation and different types of assets will have different periods of depreciation depending on their expected useful life. Just like with expensing the flour over its life of 700 loaves of bread, the cost of a new oven will also be expensed over its expected life at which point a new oven will have to be purchased and the cycle starts again. Depreciation is deducted from the profit generated by the business over time resulting in a gradual expense with the aim to keep the reported earnings more stable.

On the Cash Flow Statement however, the purchase of a new oven will fall under Cash Flow from Investing and will not have any effect on the Operating Cash Flow. It is allocated as a lump sum expense and not spread out over time like on the Income Statement. Given this scenario, it will become obvious that there will now be a discrepancy between the Net Profit, as seen on the Income Statement and the Operating Cash Flow, as seen on the Cash Flow Statement. The difference being that Net Profit will now be lower due to the depreciation expense of the new oven, which is not included when calculating Operating Cash Flow.

This is where Free Cash Flow comes in. Free Cash Flow is calculated as Operating Cash Flow minus Capital Expense. By deducting the Capital Expense from Operating Cash Flow we will end up with a figure similar to Net Profit which now includes the cost of the oven. Again, due to the timing differences between the two statements, the year in which the oven was purchased will have a lower Free Cash Flow figure when compared to Net Profit, but this difference will be made up over the life of the oven.

Considering all this you may be wondering why we don’t just use Net Profit instead of worrying about the Cash Flow Statement and calculating Free Cash Flow. It is basically because Cash Flow is a more true representation of the business and is less susceptible to manipulation. However, I opt to use an average of both when I calculate the Intrinsic Value of a business, by using Earnings per Share I can help reduce the effect seen by lumpy Free Cash Flow, conversely, by using Free Cash Flow I will be utilising a more conservative number in my analysis.

I would also like to add that I include Owner Earnings as well as Free Cash Flow and Earnings per Share. Owner Earnings is a calculation that can also be undertaken using data which can be found in the Financial Statements. It is a term coined by Warren Buffett and is used to determine the actual cash that can be taken from the business and paid out to the shareholder (owner), hence the name, Owner Earnings. It is very similar to the Free Cash Flow figure explained earlier. The formula for Owner Earnings as outlined by Warren Buffett is:

Owner Earnings = Net Income + Depreciation and Amortisation +/- Other Non Cash Charges – Annual Maintenance Expense +/- Changes in Working Capital

A more simplified and perhaps more easily acquired version which will provide a similar value is:

Owner Earnings = Net Profit – Capital Expenditure + Depreciation and Amortisation

Owner Earnings is not a reportable figure and you will not find it on a Financial Report, so you will need to calculate it yourself if you wish to use it. You can also find it on GuruFocus, a site which provides vast amounts of data and 30 years worth of financial reports, they also include many of the great Value Investors’ formulae within their historical financial data. I have a link in the show notes to the website.

https://www.gurufocus.com

In summary, we have Earnings per Share, which comes from the Income Statement, it utilises accrual accounting to present a more consistent earnings figure but is more susceptible to manipulation. Next we have Free Cash Flow which is derived from the Cash Flow Statement and is calculated as Operating Cash Flow minus Capital Expense. This figure will be much more lumpy and inconsistent and is best viewed as a long term trend, but it is less susceptible to manipulation. Finally, we briefly discussed Owner Earnings, a formula coined by Warren Buffett used to calculate the money that a shareholder can expect to receive from the business. It requires some more complicated calculations utilising figures from both the Income Statement and Balance Sheet.

From these three earnings figures, I use a weighted average as my Cash Flow figure used to calculate the Intrinsic Value of a business. I generally have a stronger weighting towards Free Cash Flow, followed by Owner Earnings and then Earnings per Share. The result is the Cash Flow figure I use to calculate the Intrinsic Value of a company.