Contrary to popular opinion, a company’s statement of cash flows is not sacred and is susceptible to manipulation. Under accrual-based accounting, revenue is recorded when it is earned, not when cash is received. Expenses are also charged once benefits are received, not when actual payment occurs.
The cash flow statement is split into three parts – cash flow from operating activities, cash flow from financing and cash flow from investing. According to Schilit, there are three types of cash flow shenanigans:
- Shifting cash flow from financing activities into cash flow from operations
- Shifting operating cash outflows somewhere else
- Boosting operating cash flows using unsustainable activities
This is illustrated in the Figure below.
1. Shifting cash flow from financing activities into cash flow from operations
The title of the subheading says it all. This happens when a company incorrectly classifies non-operating cash flow as an operating cash flow. Delphi corporation counted a bank loan as cash flow from operations, classing the loan as a sale of inventory to the bank when it was just posting collateral for a loan. The red flag here was managements focus on pro forma metrics in which the company’s self-defined ‘operating cash flow’ was much higher than the already inflated cash flow from operations. Any time management choses to focus on a non-GAAP metric that is much higher than its GAAP equivalent, this could be a red flag.
A company could also sell its accounts receivables to a bank or third party and receive a cash payment in return. In the US, this is called ‘Factoring’. If the sale is to a third party for the purpose of creating a new financial instrument, this is called ‘Securitisation’. Cash gained from sale of receivables is recorded as cash flow from operations. This is a method for companies to bring forward future operating cash flows and can be used to mask a bad financial year. Of course, this has the effect of depressing future cash flow from operations, unless the process is carried out again which is obviously unsustainable. Again, the magnitude and frequency of such a move is what matters. If the sale of receivables generates a large portion of a company’s cash flow from operations, this could be a red flag.
When a company sells its accounts receivable, it can be done under a ‘recourse’ or ‘nonrecourse’ arrangement. In a recourse arrangement, the risk of customer default remains with the company selling its receivables. In a nonrecourse arrangement, the opposite is the case and the company transfers the risk to the buyer of the receivables.
2. Shifting operating cash outflows somewhere else
Boomerang transactions occur when a company sells something to a customer, while simultaneously buying back an identical item from the customer it just sold to. In order to make the transaction look beneficial to the perpetrator of this scheme, the cash outflow from the purchase is recorded under ‘cash flow from investing activities’ while the cash inflow from the sale is recorded as under operating cash flows. This happened with Global Crossing during the dotcom bubble and significantly boosted its operating cash flows.
Improperly capitalising operating costs also shifts cash outflows into cash flow from investing activities thereby boosting operating cash flows. Aggressive capitalisation of operating costs can be spotted by researching peers in the same industry to see what is normal and what isn’t. Also, any sudden change to capitalise a large operational cost that has historically been expensed could be a red flag. Free cash flow will also be reduced if normal operating cash outflows are classed as capital expenditures.
3. Boosting operating cash flows using unsustainable activities
An increase in account payable means payments to suppliers are being stretched. This is not necessarily a bad thing but a large increase in payables may not be sustainable. If the business is deteriorating and the only source of ‘growth’ is through delayed payables, this is a red flag. An increase in the Days Payable Outstanding (DPO) means the company is stretching payments to suppliers.
Other unsustainable, one-time activities can also boost cash flow from operations. As ever, you are looking for large contributions to the operating cash flows that are not ‘normal’. A sale of a large subsidiary isn’t ‘normal’ unless the parent company is in liquidation and continually selling off parts of its businesses. It is important to read the footnotes of all recent annual and quarterly reports and go through the recent earnings transcript to understand the assumptions made in calculating different items on the cash flow statement.