RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

The Statement of Cash Flows

by Matt Richey (TMF Verve)

ALEXANDRIA, VA (August 23, 1999)

"Cash is king."

"Follow the money."

If either of those sayings strike a chord with you, then allow me to introduce you to a friend of mine, the Statement of Cash Flows. This financial statement shows you how cash makes its way from the income statement to the balance sheet.

See, just because the income statement shows net income of, say, $10 does not mean that cash on the balance sheet will increase by $10. In our accounting system, a $10 "profit" isn't necessarily a profit at all. The problem is that we have an "accrual" accounting system, as opposed to a cash-in/cash-out system. Today, let's walk through a simple example that will show the difference between these two forms of accounting, and then we'll use that knowledge to make sense of Microsoft's (Nasdaq: MSFT) cash flow statement.

This past Friday, Lil' Jimmy's Lemonade Stand opened for business. (Jimmy's mom told him that if he really wanted that new Motley Fool Jester Cap, he'd have to save up the money on his own.) Here's what his balance sheet looked like on Friday:

Balance Sheet as of Friday August 20

ASSETS
  Cash                         $5
  Inventory (powdered lemonade)30
  Total                       $35 

LIABILITIES & EQUITY
  Interest-free loan from mom $30
  Equity                        5
  Total                       $35
  
By staking out a busy street corner where runners pass frequently, and by serving up the finest ice-cold Country Time pink lemonade, and -- most importantly -- by having a sad puppy dog look on his face, our shrewd eight-year-old proprietor made out like a bandit. A hot and sunny Saturday and Sunday worked to his advantage, allowing him to sell 100 cups at the ridiculously high price of $1 a piece (which was four times his cost -- wowzers! that's a 75% gross margin).

Being quite the little businessman, Jimmy knew that not all joggers carry cash, but instead of missing those potential sales, he allowed his suckers... er customers to pay him anytime in the next week. In fact, half of the passers-by took him up on the option to pay later.

Last night, Jimmy "closed the books." Here's what the income statement looks like on an accrual basis:

Accrual Income Statement for the Weekend of August 21-22
  Sales                      $100
- Cost of Sales                25
= Net Income                  $75
As you can see, accrual accounting allows you to count items as "sold" even if you haven't yet collected the cash from that sell. In Jimmy's case, that means he booked a "profit" of $75 even though he only collected $50 in cash (half of his sales).

Now, let's consider what things would look like if Jimmy were to account for his entrepreneurial venture on a cash basis.

Cash Income Statement for the Weekend of August 21-22
  Cash Sales                  $50
- Cost of Sales                25
= Net Income                  $25
On a cash basis, Jimmy would not record the other $50 of sales until his customers paid up. Nevertheless, as you can see, he would go ahead and record right now the full amount of his $25 of lemonade powder costs because they had been used. This type of accounting shows the true cash profit of $25.

Under the accrual system, the balance sheet would appear as follows:

Balance Sheet as of Sunday August 22
ASSETS
  Cash                        $55
  Accounts Receivable          50
  Inventory                     5
  Total                      $110 

LIABILITIES & EQUITY
  Interest-free loan from mom $30
  Equity                       80
   Total                     $110
Since Jimmy's $100 in sales was half cash and half to be paid later, cash increased by $50 and Jimmy registered the other $50 as "accounts receivable" (smart kid, eh?).

Again, all public companies use an accrual accounting system. Therefore, the important lesson to take away from the heroic tale of Jimmy, a Budding American Capitalist, is that the income statement does not tell you what's really happening inside a company. For the real story, we use the balance sheet, and for -- as Paul Harvey says -- the rest of the story, we look to the Statement of Cash Flows.

The cash flow statement is divided into three sections -- operating activities, investment activities, and financing activities. Let's walk through Microsoft's cash flow statement as an example. Here's the link:

Microsoft Statement of Cash Flows

The operating section is most important, as it allows us to follow the cash involved in a company's core business operations. Before talking about the other sections, let's look just at Microsoft's operating cash flow:
Nine Months Ended Mar. 31
                                 1998     1999
----------------------------------------------
Operations   
  Net income                    $3,133  $5,583
  Depreciation and amortization    776     514
  Write-off of acquired
    in-process technology          296       0
  Gain on sale                       0    (160)
  Unearned revenue               2,139   4,139
  Recognition of unearned revenue
    from prior periods          (1,094) (2,832)
  Other current liabilities        266     471
  Accounts receivable             (123)   (192)
  Other current assets              53    (104)
-----------------------------------------------
  Net cash from operations       5,446    7,419
  (all figures in millions)
 
Starting with net income on the top line, the cash flow statement makes adjustments to net income that "un-accrue" the effects of the income statement. A positive number means cash is being "added back" to net income where the income statement had deducted it, and vice versa for a negative number. (Notice the substantial amounts of cash that come from unearned revenue.) The bottom-line result is "net cash from operations." Think of this number as the company's true cash profit.

The next section is financing activities:
Nine Months Ended Mar. 31
                                 1998     1999
----------------------------------------------
Financing  
  Common stock issued             650    1,102
  Common stock repurchased     (1,605)  (1,527)
  Put warrant proceeds            388      757
  Preferred stock dividends       (21)     (21)
  Stock option income
    tax benefits                  910    2,238
-----------------------------------------------
  Net cash from financing         322    2,549
Cash flow from financing activities tells us the goings-on of cash associated with dividends and stock repurchases. This is probably the least significant of the three sections.

Finally, we have the investing activities:
Nine Months Ended Mar. 31
                                 1998     1999
----------------------------------------------
Investments  
  Additions to property
    and equipment                (415)    (291)
  Cash portion of WebTV
    purchase price               (190)       0
  Cash proceeds from
    sale of Softimage               0       79
  Equity investments and other  (1,756)  (1,899)
  Short-term investments        (2,952)  (5,532)
------------------------------------------------
  Net cash used for investments (5,313)  (7,643)
Investing activities is second in importance to the operating activities. Here, we see how much Microsoft spends on capital expenditures (line items in bold), or "cap ex," as it's sometimes called. These are investments that Microsoft is making for the purpose of building its business. The non-bolded items are simply "movements" of cash. For example, Microsoft takes cash out of short-term T-bills and puts it into AT&T Preferred securities. Such movements of cash aren't as significant as the cap ex items.

Below is the final portion of the cash flow statement:
Nine Months Ended Mar. 31
                                 1998     1999
----------------------------------------------
Net change in cash and
  equivalents                     455    2,325
Effect of exchange rates on cash
  and equivalents                 (51)      39
Cash and equivalents, beginning
  of period                     3,706    3,839
----------------------------------------------
Cash and equivalents,
  end of period                 4,110    6,203
Short-term investments,
  end of period                 8,212   15,558
----------------------------------------------
Cash and short-term 
  investments, end of period  $12,322  $21,761
==============================================

The final section sums the cash flows from the three sub-sections and thereby reconciles the cash balance from one period to the next. The $21,761 you see at the bottom-right is the amount of cash that exists at the end of the period, and therefore is the amount you see listed on Microsoft's balance sheet.

Okay, we've covered a lot of ground today, and I'm sure there are lots of questions. Let's meet on the Rule Maker Strategy board to discuss it.

Tomorrow, I'll build on what we've learned today and make a case for Microsoft deserving another $500 monthly investment.

Have a great night!


 




Rule Maker Portfolio

8/23/99 Closing Numbers
 Ticker   Company   Dly Pr Chg   Price 
AXP  AMER EXPRESS                 1/2   $146.38
CHV  CHEVRON CORP                 7/8   $95.94
CSCO  CISCO SYSTEMS                5/8   $65.75
DPH  DELPHI AUTOMOTIVE SYSTEMS   5/16   $18.69
EK  EASTMAN KODAK                Unch.   $74.75
GM  GENL MOTORS                  1/4   $64.38
GPS  GAP INC                      1/2   $41.75
INTC  INTEL CORP                   3   $82.94
KO  COCA-COLA CO                 Unch.   $58.81
MSFT  MICROSOFT CORP               1/16   $86.44
PFE  PFIZER, INC                  15/16   $38.88
SGP  SCHERING-PLOUGH              1/2   $54.19
TROW  T.ROWE PRICE ASSOC           9/16   $33.69
XON  EXXON CORP                   1/4   $82.81
YHOO  YAHOO INC                    1/8   $152.13

  Day Week Month Year
To Date
Since
1/5/98
Annualized
Rule Maker 2.96% 2.96% 5.29% 15.44% 45.57% 25.92%
S&P 500 1.77% 1.77% 2.37% 10.66% 39.21% 22.52%
S&P 500(DA) 1.74% 1.74% 2.34% 11.14% 40.99% 23.48%
S&P 500(DCA) n/a n/a n/a n/a 25.88% 15.17%
NASDAQ 2.69% 2.69% 3.07% 24.03% 70.60% 38.80%

 Trade Date   # Shares   Ticker   Cost/Share   Price   LT % Val Chg 
  6/23/98  68CSCO    28.784  $65.75  128.43%
  2/3/98  54MSFT    45.135  $86.44  91.51%
  5/1/98  82GPS    22.708  $41.75  83.86%
  2/13/98  52INTC    46.928  $82.94  76.73%
  2/3/98  66PFE    27.433  $38.88  41.71%
  5/26/98  18AXP    104.067  $146.38  40.66%
  3/12/98  20XON    64.335  $82.81  28.72%
  2/17/99  16YHOO    126.309  $152.13  20.44%
  3/12/98  20EK    63.148  $74.75  18.37%
  3/12/98  15CHV    83.343  $95.94  15.11%
  8/21/98  44SGP    47.993  $54.19  12.91%
  3/12/98  11DPH    17.190  $18.69  8.71%
  3/12/98  17GM    60.400  $64.38  6.58%
  2/3/98  56TROW    33.673  $33.69  0.04%
  2/27/98  27KO    69.107  $58.81  -14.90%

 Trade Date   # Shares   Ticker   Cost   Value   LT $ Val Ch 
  6/23/98  68CSCO    $1,957.28  $4,471.00  $2,513.72
  2/3/98  54MSFT    $2,437.28  $4,667.63  $2,230.35
  2/13/98  52INTC    $2,440.28  $4,312.75  $1,872.47
  5/1/98  82GPS    $1,862.06  $3,423.50  $1,561.44
  5/26/98  18AXP    $1,873.20  $2,634.75  $761.55
  2/3/98  66PFE    $1,810.58  $2,565.75  $755.18
  2/17/99  16YHOO    $2,020.95  $2,434.00  $413.05
  3/12/98  20XON    $1,286.70  $1,656.25  $369.55
  8/21/98  44SGP    $2,111.70  $2,384.25  $272.55
  3/12/98  20EK    $1,262.95  $1,495.00  $232.05
  3/12/98  15CHV    $1,250.14  $1,439.06  $188.93
  3/12/98  17GM    $1,026.80  $1,094.38  $67.57
  3/12/98  11DPH    $189.09  $205.56  $16.47
  2/3/98  56TROW    $1,885.70  $1,886.50  $0.80
  2/27/98  27KO    $1,865.89  $1,587.94  ($277.95)
  Cash: $100.80  
  Total: $36,359.12  


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.