What Is It?
Cash Flow From Operations is the top of the thee sections within the Statement of Cash Flow found in all Financial Statement packages. Its calculation involves three steps. It starts with the reported Net Income from the Income Statement. Then it reverses out the line items on the Income Statement that measure only accounting accruals without any cash transfers (like Depreciation). Lastly, it subtracts the net increase in working capital.
Non-accountants think the statement results from measuring actual cash flows. In reality accountants line up the Balance Sheets (opening and closing) and subtract across each line.
Why Do You Care
If you are considering using CFFO in a discounted cash flow valuation model please read the Discounted Cash Flow page first. Review the measure of Comprehensive EPS to find a valid and practical alternative measure of profits and growth. That is the most important message of this web site.
Conceptual Interpretation
- There is very little new information in the CFFO Statement. It is simply the mathematical fallout from the presumptions and decisions used to prepare the Balance Sheet and Income Statement. All the problems with those are implicit in the Cash Flow.
- Note that when the value of the company’s assets shrink (a bad thing) cash flow increases (supposedly a good thing). Does that make sense to you?
- Each and every line of the cash flow statement, after Net Income, is a measure of this asset shrinking (+cash) and expanding (-cash). None of the line items exist because someone thinks “it doesn’t count”. (Doesn’t count in the measurement of … what?)
What it Misses
Purchases of operating businesses are recorded in the Investing portion of the Statement of Cash Flow. The purchase will include inventory and accounts payable, etc. But none of those show up in the CFFO section. This is a major drawback. A major question that the Statement of Cash Flow should answer is “What investments (and in what types of assets) are being made to enable our growth?”. Because all purchased working capital is buried under Investments, that answer is not available.
Another question most everyone has is “What cash taxes are paid?”. Everyone ignores the tax booked as an expense with the rational that cash taxes paid are much smaller. It would be simple for the CFFO to include a line item that reverses out the Income Statement’s accrued tax (just like it reverses Depreciation). A second line item would list the cash taxes paid. but the statement buries all that information.
Conclusion
CFFO measures nothing more than itself. There is no ‘good’ result… and none that is ‘bad’. It does not predict future success. It certainly does not measure growth or income. The financial markets are very liquid: profitable companies have no problem finding financing for good projects: lack of cash flow is not a constraint.
What it does measure, now, is the length to which management will go to manipulate any measure by which they will be judged (see Cash Truth (Not) #2).
