Investors should get into the habit of tracking cash flow from operations to see how closely it relates to net income. After all, cash pays the bills, not accounting income. Also, when you want to get a feel for financial trends, you need to go back at least three years, and five is better.
One reason we like talking about the cash flow statement is because it's so much more difficult to create financial miracles on the cash flow statement than the income statement, which means the one serves effectively as a check on the other.
Maybe a quick example will help. (Thanks to Phil Weiss for help with this.) The cash flow statement explains the changes in cash and cash equivalents from one period to another. It does this by looking at what's happened on the income statement and balance sheet. How so? It starts (in most cases) with net income, includes changes in all the balance sheet accounts, and also adds back non-cash items.
It's critical for investors to understand how the income statement, balance sheet, and cash flow statement are linked -- and how, for example, transactions flow from one to another. Here's a simple example. It doesn't reflect the nuances of accounting, but it does give you a sense of how expenses and revenues are linked across the statements.
Say Coca-Cola buys ingredients for its magic formula in one financial period. The accountant would report this transaction by decreasing cash (the money spent to buy the ingredients) and increasing assets (since the ingredients go into its inventory).
Once the ingredients are sold -- in the form of syrup to bottlers -- they begin traveling from one statement to another. As inventory (on the balance sheet) decreases, the cost of goods sold (on the income statement) increases. Proceeds from the sale, of course, are booked as revenues, and the difference between sales and cost of goods sold (minus expenses) flows to the bottom line.
Keep in mind the difference between the accrual basis of accounting and the cash basis. Items on the income statement are reported on the accrual basis, meaning revenues and expenses are booked when the transactions occur or the item is realized, not when cash is collected or paid. Items on the cash flow statement, on the other hand, represent cash inflows and outflows over time.
Now, back to Coke. In his book Financial Shenanigans, accounting sleuth Howard Schilit wrote that net income for a large, well-established company should roughly track cash from operations (CFO). Of particular concern for investors is that CFO shouldn't significantly trail net income. After all, cash pays the bills, not the accounting income reported on the income statement -- as we know from understanding the difference between accrual and cash-basis accounting. What does significantly trail mean? In a recent story for CFO Magazine Schilit says there's no rule of thumb, but we should pay attention to the relationship and watch for breaks in the trend.
There's good news and bad news for Coke, judging from the cash flow statement. The good news is that cash from operations exceeds net income by a wide measure, which indicates Coke has plenty of cash moving through the business and that it's pretty unlikely that net income overstates profitability.
The bad news brings us to another lesson for Rule Maker investors. It's worth going back a minimum of three years when reviewing financial statements to get a feel for trends, and five is better. For example, it's useful for Coke investors to compare the Q3 2000 cash flow statement with the Q3 1999 report. In it we see Coke is generating $317 million less in CFO this year than last. At the same time, a year-over-year analysis doesn't exactly make a trend, or give long-term investors a wide view of what's happening.
Go back to 1995, however, and we see that Coke's CFO has grown just 12% over the last five years, to $2.57 billion from $2.30 billion (about the same rate as sales). That's pretty disappointing. Worse than that, Coke's free cash flow has remained flat at $2 billion since 1996.
We can also see that Coke's growth is indeed slowing just by looking at its capital expenditures relative to depreciation and amortization. As a rule of thumb, a firm with higher spending on plant, property, and equipment (PP&E) than expenditures for depreciation is a growing business. Basically, it means it's buying more in the way of fixed assets than it's writing off in the way of depreciation.
In 1995, Coke spent $708 million on PP&E while depreciation and amortization expenses totaled $337 million. The gap has narrowed almost every year and, so far in 2000, depreciation and amortization expenses have slightly eclipsed capital expenditures.
This doesn't mean Coke doesn't have growth opportunities or that cash flow won't improve once the restructuring is complete. Based on this five-year trend, however, I would be much more conservative in estimating the rate of Coke's cash flow growth in the coming years. In fact, I'd be hesitant to forecast any kind of growth rate to cash flows until the company demonstrates positive movement in this direction.