Evaluating the Cash Flow Quality of a Company

The cash flow statement is used to identify areas of possible earnings manipulation since OCF is viewed as less subject to manipulation relative to earnings. An analyst should check for any unusual items or items that have not been present in previous years’ reports. Generally, the analyst should make a period-to-period comparison of reports issued by a company to assess the financial reporting quality. Warning signs of misreporting include restatement of prior years’ financial statements (because of an error or recasting prior years’ financial statements because of a change in accounting policy). Furthermore, omitting some information that was previously voluntarily disclosed, or adding some items, such as a new risk disclosure, should drive an analyst to question the changes.

Moreover, the analyst should analyze the revenue quality. Recall from the previous section that most misreporting occurs in revenue recognition, as revenue is the most significant single figure on the income statement and arguably the most crucial. Improper revenue recognition affects items such as net income, receivables, and inventories on the income statement. Net income and receivables are overstated, whereas inventories are understated. Additionally, recording sales with no economic value, for example, when a customer holds goods over the end of the accounting period and subsequently returns them, inflates inventory.

Finally, the analyst should check for strategic provisioning. The management can improperly inflate and subsequently reverse restructuring charges. By so doing, the company’s income would misleadingly suggest significant improvements in performance.

Classification shifting can happen when transferring positive cash flow items from investing or financing activities to operating activities. The shift can affect investors’ analysis of a company’s cash flows and investors’ future cash flow expectations. Analysts should also be aware of flexibility in the treatment of particular items in the statement of cash flow under the different accounting standards. Under the US GAAP, interest paid, interest received, and dividends received have to be treated as operating cash flows. However, interest paid can be classified as either operating or financing cash flow under IFRS.

Moreover, interest paid and the dividend paid can be classified as either operating or investing cash flow under IFRS. An analyst examining an IFRS reporting company should look out for year-to-year changes in the classification of interest and dividends. For example, such a company could change the classification of interest paid from operating to financing. All else equal, the company’s operating cash flow would appear higher than the prior period, even if no other activities occurred in the period.

Additionally, cash flows from non-trading securities are treated as investing cash flows, while cash flows from trading securities are treated as operating cash flows. However, companies are flexible in designating investments as either trading or non-trading. Thus, managers have the opportunity to shift cash flows from one classification to another, reducing comparability across companies.

Example: Shift of Cash flows from Investing to Operating

ABC Inc. is a motor manufacturing company. Excerpts from the statement of cash flows from the financial year 2017 through 2018 are provided in Exhibit 1 and 2 as follows: We will use the information on the excerpts to analyze the impact of shifting of cash flows.

$$ \textbf{Exhibit 1: Excerpt from ABC Inc. Statement of Cash Flows Filed on 1 February 2018} $$

$$\small{\begin{array}{l|r} \textbf{Cash flows from operating activities} & \textbf{Year ended 31 December 2017}\\ \hline\text{Net earnings} & 64,032\\ \hline\text{Deferred income taxes} & 16,834\\ \hline\text{Depreciation and amortization} & 34,941\\ \hline\text{Provision for bad debts} & 19,293\\ \hline\text{Accounts receivable} & 11,307\\ \hline\text{Inventories} & 14,202\\ \hline\text{Prepaid expenses and other current assets} & 17,849\\ \hline\text{Other assets} & 15,183\\ \hline\text{Accounts payable: trade} & 17,321\\ \hline\text{Accrued expenses and other current liabilities} & 26,955\\ \hline\text{Income taxes payable} & 21,327\\ \hline\textbf{Net cash provided by operating activities} & \textbf{259,244}\\ \hline\text{Cash flows from investing activities} & {}\\ \hline\text{Purchase of property, plant, and equipment} & (15,697)\\ \hline\text{Sale (purchase) of short-term investments} & 38,985\\ \hline\textbf{Net cash used in investing activities} & \textbf{23,288}\\ \end{array}}$$

$$ \textbf{Exhibit 2: Excerpt from ABC Inc. Statement of Cash Flows Filed on 1 February 2019} $$

$$\small{\begin{array}{l|r|r} {}& {\textbf{Year ended 31}\\ \textbf{December 2018}} & {\textbf{Year ended 31}\\ \textbf{December 2017}}\\ \hline\textbf{Cash flows from operating}\\ \textbf{activities} &{} &{}\\ \hline\text{Net earnings} & 63,972 & 64,032\\ \hline\text{Deferred income taxes} & 15,391 & 16,834\\ \hline\text{Depreciation and amortization} & 40,837 & 34,941\\ \hline\text{Provision for bad debts} & 19,320 & 19,293\\ \hline\text{Short-term investments} & 46,314 & 38,985\\ \hline\text{Accounts receivable} & (66) & 17,101\\ \hline\text{Inventories} & (6,273) & 14,202\\ \hline\text{Prepaid expenses and}\\ \text{other current assets} & 15,845 & 17,849\\ \hline\text{Other assets} & 17,833 & 15,183\\ \hline\text{Accounts payable: trade} & 32,702 & 17,321\\ \hline\text{Accrued expenses and}\\ \text{other current liabilities} & 24,923 & 21,161\\ \hline\text{Income taxes payable} & 21,648 & 21,327\\ \hline\textbf{Net cash provided by}\\ \textbf{operating activities} & \textbf{292,446} & \textbf{298,229}\\ \hline\text{Cash flows from}\\ \text{investing activities} &{} &{}\\ \hline\text{Purchase of property, plant,}\\ \text{and equipment} & (24,042) & (15,697)\\ \hline\textbf{Net cash used in investing}\\ \textbf{activities} & \textbf{(24,042)} & \textbf{(15,697)}\\ \end{array}}$$

From the Exhibit 1, ABC Inc. reports operating cash flow for the year ended 31 December 2017 of \($259,244\). In Exhibit 2, the company reports operating cash flow for the same year of \($298,229\). The \($38,985\), \(($298,229 – $259,244)\) that appears in Exhibit 1 as investing cash flows from the sale (purchase) of short-term investments for the year ended 31 December 2017 has been reclassified. In Exhibit 2, this amount appears as a component of operating cash flow.

Additionally, as reported in Exhibit 2, the company’s cash flows declined by 2% from the fiscal year 2017 to the fiscal year 2018.

$$=\frac{\$292,446-\$298,229}{\$298,229}=-2\%$$

If ABC Inc. maintained the classification of its short-term investing activities, the company’s operating cash flows for the fiscal year 2018 would have been \($246,132\) thousand \((=$292,446– $46,314)\). Consequently, a decline of 5% from the fiscal year 2017 to the fiscal year 2018 would have been shown

$$=\frac{\\$246,132-\$259,244}{\$259,244}=-5\%$$

A vigilant analyst could have identified ABC’s classification shift by comparing the 2017 statement of cash flows with that of 2018.

Question

A financial analyst is evaluating the earnings quality of ABC Ltd. ABC notes indicate that its operating cash flow (OCF) has been more volatile relative to that of its peers. Additionally, ABC’s OCF has not been enough to cover capital expenditures, dividends, and debt payments. The analyst further finds out that ABC Ltd. was required to restate its previous year’s financial statements owing to its attempt to overstate sales revenue. It induced its customers to take the excess product in the previous year. Further, the customers were allowed to return purchases in the subsequent period at no penalty.

Based on ABC’s reinstatement information, it reported poor operating cash flow quality in the previous year by most likely understating:

      A. Net income.

      B. Trade receivables.

      C. Inventories.

Solution

The correct answer is C.

The items typically affected by revenue recognition issues are net income, receivables, and inventories. Overstating revenues leads to overstated net income and receivables and understated inventories.

A and B are incorrect. As mentioned above, overstating revenues results in overstated net income and receivables.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (j) Evaluate the cash flow quality of a company.