Show Me the Money -- Use the Statement of Cash Flow to Assess Corporate Risk

In a recent column, Stars, Dogs, Cash Cows and Problem Children: What's in Your Portfolio?, I said that analyzing the statement of cash flow is an important part of determining the risk of investing in individual companies.

A number of readers wrote in asking for more information. Two major components of corporate reporting -- the balance sheet and the income statement -- are covered in TSC's The Basics of Fundamental Analysis series.

To complete the picture, let's review the statements of cash flow for three companies, Anheuser-Busch BUD, Amazon.com AMZN and Revlon REV.

But first some history.

Before the mid-1980s, most investors and stock analysts thought the balance sheet and income statement provided sufficient information for decision-making.

The balance sheet provided a snapshot of financial condition (i.e., cash on hand; short- and long-term assets like accounts receivable and plant, property and equipment, and short- and long-term liabilities like accounts payable and corporate debt). The income statement summarized revenues and costs of doing business in net income and earnings per share.

The problem with the income statement is that accounting assumptions about depreciation, writedowns of goodwill and revenue recognition allow corporate management considerable leeway in generating the net income figures.

For example, in the early 1980s, Oracle ORCL aggressively recognized revenue from the sale of products that wouldn't ship for months but allowed the company to declare higher earnings in the current quarter. When the products failed to ship, Oracle was forced -- in a costly blow to shareholders -- to restate earnings.

On the other hand, Microsoft MSFT has an accounting policy of deferring some current sales to future accounting periods. This policy allows Microsoft to better match the costs of supporting a product with the revenues it generates, but it also allows the company to "smooth" earnings by controlling the recognition of that revenue.

In 1987, the Financial Accounting Standards Board (FASB), the nongovernmental organization charged with improving financial reporting standards, required companies to break out actual cash movements related to operating, investing and financing activities.

This new standard imposed a critical reality check on the income statement. A company with rapid income growth should also have dramatic increases in cash. If cash is in fact declining, there may be a problem with an accounting policy (or occasionally outright fraud) or the company may be in a higher-risk "development stage" situation.

The important information for investors is summarized in sections of the cash flow statement labeled "cash from operations," "cash from investing" and "cash from financing."

Cash from operations includes cash collected regardless of when revenues were generated or recognized and costs associated with sales and with increasing or decreasing inventories.

Cash from investment focuses on capital expenditures, such as investment in new plant, property and equipment or purchasing or divesting a stake in another company.

Cash from financing includes increases due to share offerings and debt sales or decreases due to dividend declarations, share repurchases or the retirement of debt.

TSC provides historical data, including statements of cash balance, for most U.S. companies. Simply enter a stock symbol in the Tools/Quotes box, click the "financials" tab, then click the "cash flow" tab.

Doing that for brewing giant Anheuser-Busch returns the following:

Anheuser-Busch BUD	1998	1997	1996	1995	1994
Net Income	1,233,300	1,169,200	1,189,900	642,300	1,032,100
Depreciation	738,400	683,700	611,500	573,900	517,000
Disc. Operations	0	0	18,200	233,300	-111,100
Accounting Change	0	10,000	0	0	0
Deferred Taxes	34,500	91,400	93,800	51,300	68,500
Undistrib. Earnings	-53,700	-49,900	0	0	0
Sale of Business	0	0	-33,400	0	0
Tampa Shutdown	0	0	0	112,300	0
Restructuring Charge	0	0	0	0	0
Non-Cash Work. Cap.	250,600	5,400	233,700	-262,000	-57,000
Other, Net	-27,100	-93,200	-92,800	63,800	120,000
Cash From Operations	2,176,000	1,816,600	2,020,900	1,414,900	1,569,500

The first thing you'll notice is that this company throws off a pretty healthy $1.4 billion to $2.2 billion a year. This money can be used for marketing and distribution, buying back shares, buying competitors or increasing advertising, among other things. Companies with positive cash flow from operations have many choices.

	1998	1997	1996	1995	1994
Capital Expenditure	-817,500	-1,199300	-1,084600	-952,500	-662,800
Sale of Business	0	0	116,600	0	0
Business Acquisition	-566,500	-683,300	-135,700	-82,900	-28,800
Cash From Investing	-1,384000	-1,882600	-1,103700	-1,035400	-691,600

As you might expect, Anheuser-Busch is using some cash flow to upgrade and maintain its brewery operations and is also using some of its operating cash flow to acquire other business lines.

	1998	1997	1996	1995	1994
ST Debt	0	0	0	0	0
LT Debt Increase	451,500	1,245,900	773,600	597,600	182,200
LT Debt Decrease	-63,600	-141,600	-575,100	-363,600	-106,400
Dividends Paid	-521,000	-492,600	-458,900	-429,500	-398,800
Treasury Stock	-688,800	-587,100	-770,200	-393,400	-563,000
Issued Stock Plan	107,400	95,100	113,400	159,000	49,400
Issued ESOP	0	0	0	0	0
Cash From Financing	-714,500	119,700	-917,200	-429,900	-836,600

Anheuser-Busch appears to have a stock buyback program in place (hence the expenditure of cash on treasury stock) as well as a stock option program (thus the gain of cash from the Issued Stock Plan). If you wanted to know for sure, you would review the company's actual Securities and Exchange Commission filings. The company paid out more than $521 million in dividends and also increased long-term debt by just under $400 million dollars.

The overall trend is that Anheuser-Busch is changing its debt-to-equity ratio in favor of debt, which has the benefit of increasing earnings per share faster than overall revenue growth. But it also increases the riskiness of the company.

	1998	1997	1996	1995	1994
Foreign Exch Effects	0	0	0	0	0
Net Change In Cash	77,500	53,700	0	-50,400	41,300

Overall, Anheuser-Busch is a classic "cash cow" company. Net income has increased only 19.5% over the past five years. Earnings per share have grown 111.4% over the past five years, however, as the company has reduced the number of shares outstanding. Overall, Anheuser-Busch is a fairly conservative addition to any portfolio.

What about Amazon.com?

Amazon.com AMZN	1998	1997	1996	1995	1994
Net Income	-124,546	-31,020	-6,246	-303	-52
Depreciation	9,692	3,442	296	19	5
Amortization	2,386	1,354	0	0	0
Merger/Acquisition	47,065	0	0	0	0
Non-Cash Interest	23,970	64	0	0	0
Inventories	-20,513	-8,400	-554	-17	0
Prepaid Exp./Other	-16,465	-3,034	-315	-14	0
Deposits	-293	-21	-148	0	0
Payable/Accrued Liab	78,674	30,172	2,756	99	23
Accrued Advertising	9,617	2,856	598	0	0
Other Liabilities	21,448	5,274	1,603	-16	0
Cash From Operations	31,035	687	-2,010	-232	-24

Despite losing $125 million in net income, Amazon.com had positive cash flow in the most recent year. As a "virtual" corporation, Amazon has very little depreciation. You'd have to research how a merger generated $47 million and how noncash interest generated $24 million. Some money was spent on inventories, no doubt all the new product lines Amazon introduced last year. Most interestingly, Amazon generated nearly $100 million in cash by increasing accounts payables and other liabilities -- essentially "borrowing" from suppliers. That development has to be monitored going forward.

	1998	1997	1996	1995	1994
Matur./ST Investment	332,084	4,311	0	0	0
Purch./ST Investment	-546,509	-122,385	-5,233	0	0
Capital Expenditures	-28,333	-7,603	-1,335	-52	-28
Acq./Disp. Business	-19,019	0	0	0	0
Cash From Investing	-261,777	-125,677	-6,568	-52	-28

Again, as a "virtual" corporation, Amazon made only a tiny investment in plant, property and equipment last year. A net $214 million of cash was deposited in short-term investments (most likely money market securities), which is to say that Amazon is conserving a huge cash hoard for future opportunities.

	1998	1997	1996	1995	1994
Initial Public Offer	0	49,103	0	0	0
Options/Common Issue	5,983	509	195	1,272	60
Issuance/Common	8,383	3,746	8,443	0	0
Proc./LT Debt	325,987	75,000	0	0	0
Payment/LT Debt	-78,108	-47	0	0	0
Financing Costs	-7,783	-2,309	0	0	0
Preferred Stock	0	0	0	0	0
Notes Payable, Net	0	0	0	-44	44
Cash From Financing	254,462	126,002	8,638	1,228	104

Amazon took advantage of the positive investment outlook for the Internet sector over the past two years, raising a net $380 million in stock offerings and debt issuance. It may not be so easy to issue further securities this year, but with $214 million in the bank, the company can coast for a while.

	1998	1997	1996	1995	1994
Foreign Exch Effects	-35	0	0	0	0
Net Change In Cash	23,685	1,012	60	944	52

Amazon is transitioning from "problem child" to "star" status. It's obviously a riskier investment than Anheuser-Busch, but justifiable given Amazon's triple-digit revenue growth.

Lastly, Revlon:

Revlon REV	1998	1997	1996	1995	1994
Net Income	-143,200	43,600	18,200	-41,200	-102,800
Depreciation	111,300	99,700	88,700	88,400	78,800
Disc. Ops.	64,200	-700	-400	0	0
Extraordinary Item	51,700	14,900	6,600	0	0
Sale of Fixed Assets	-8,400	-4,400	0	-2,200	0
Sale of Stock	0	0	0	0	0
Accounting Change	0	0	0	0	28,800
Receivables	-43,000	-70,000	-67,700	-44,100	-22,100
Inventories	-4,600	-16,900	-2,700	-15,100	14,100
Prepaid/Other	-11,400	400	-7,200	4,500	19,100
Accounts Payable	-49,200	17,900	9,400	10,200	23,400
Accrued/Other	52,500	-2,800	-10,000	-12,200	-22,800
Other, Net	-71,400	-73,000	-45,200	-40,400	-17,600
Restructuring Charge	0	0	0	0	0
Cash From Operations	-51,500	8,700	-10,300	-52,100	-1,100

Hmm -- a lot to worry about since basic operations are cash flow negative. Without the $51.7 million extraordinary item and $64.2 million from discontinued operations, cash flow of operations would have generated minus $167.4 million. Included in net income (as we see by double-checking the income statement) is $137.9 million in interest expense -- this company is choking to death on too much debt.

	1998	1997	1996	1995	1994
Capital Expenditures	-60,800	-52,300	-54,700	-54,300	-52,500
Acquisitions	-57,600	-40,500	-7,100	-21,200	-3,100
Sale of Assets	27,400	8,500	0	3,000	4,600
Marketable Security	0	0	0	0	0
Disc. Ops.	-17,300	-3,400	-2,700	0	0
Other, Net	0	0	0	0	0
Cash From Investing	-108,300	-87,700	-64,500	-72,500	-51,000

We see a variety of maneuverings, which used a net $108 million.

	1998	1997	1996	1995	1994
ST Borrowings	-16,300	18,000	5,800	-122,900	-5,800
LTD Issd.- 3rd Party	1,469,100	760,200	266,400	493,700	157,600
LTD Paid - 3rd Party	-1,270900	-690,200	-366,600	-236,300	-197,800
LTD Issd.- Affiliate	105,900	120,700	115,000	157,400	141,700
LTD Paid - Affiliate	-105,900	-120,200	-115,000	-151,000	-141,700
Purch./Sale of Stock	1,100	200	187,800	0	0
Debt Issuance/Other	-23,900	-4,100	-10,900	-15,700	-3,000
Business Acq.	0	0	-4,100	0	0
Parent Contributions	0	300	-500	400	0
Cash From Financing	159,100	84,900	77,900	125,600	-49,000

We see a very complicated financial structure, which raised an aggregate $159 million. We saw above that debt service cost $137.9 million last year, so, effectively, Revlon had to borrow money just to keep current.

	1998	1997	1996	1995	1994
Foreign Exch Effects	-2,000	-3,600	-900	-100	900
Net Change In Cash	-2,700	2,300	2,200	900	-100,200

Overall, Revlon would fall in the "dog" category (slow growth, negative operating cash flow) and would be best avoided for now.

Conclusions:

A company with negative operating cash flow is riskier than one with positive operating cash flow.

A company with negative net cash flow is riskier than one with positive net cash flow.

The income statement and balance sheet don't tell the whole story of corporate health. Understanding the statement of cash flow helps fill in the gaps.