In his latest paper titled – Categorizing for Clarity, Michael Mauboussin shows how reclassifying certain items in the cash flow statement can substantially improve the description of a business, without impacting the integrity of the cash flow statement. Here’s an excerpt from the paper:
Understanding the magnitude and prospective return on investment is the principal task of a business analyst.
Financial statements are designed to contribute to this understanding. The investment analyst and academic communities tend to focus on the income statement and balance sheet. The statement of cash flows, required in the U.S. only since the late 1980s, documents the cash flows from operations, investing, and financing that can provide insight into how a business works.
The challenge is that the accounting has not kept pace with the economics. As a result, we suggest three adjustments within the statement of cash flows to better categorize activities. The first is stock-based compensation. Accounting standards prescribe adding back this expense to cash flow from operating activities, but it is better classified as equity financing and therefore should be in cash flow from financing activities.
A company making a physical investment commonly has a choice between purchasing or leasing the asset. It is an investment in either case, but a purchase and a lease show up in different parts of the statement of cash flows. We recommend reflecting all of these expenditures in cash flow from investing activities.
There has been a dramatic change in the nature of investment for companies, from tangible to intangible assets, in recent decades. Accountants place tangible investments on the balance sheet, as they have done for centuries. But investments in intangible assets are typically expensed on the income statement. This means that earnings and investments are understated absent any adjustments.
The proper measurement of the magnitude and useful life of intangible assets is a fast-growing area of research.
Our estimates suggest that intangible investments by public companies in the U.S. are more than twice those of tangible investments. The central issues are which items within selling, general, and administrative expenses are reasonably considered discretionary investments, and the length of time over which those investments should be amortized once capitalized on the balance sheet.
A final potential adjustment is to consider marketable securities as part of cash and cash equivalents. This affects cash flow from investing activities and means that the statement of cash flows is reconciling larger beginning and ending sums.
We shared a case study of Amazon for 2020 in an effort to make the concepts more concrete. The adjustments change the portrayal of the company’s finances, including a 15 percent boost in cash flow from operations and a nearly 50 percent increase in outflows associated with cash flow from investing activities. Excluding purchases of marketable securities, the adjusted cash flow from investing activities still shows a double-digit percentage gain relative to the unadjusted one.
We believe these adjustments substantially improve the description of a business. But we would add that free cash flow, defined properly, does not change at all. The main payoff from reclassifying items is a better appreciation of the cash flows in and out of the company
You can read the entire paper here:
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