Cash-Flow Statements

by Phil Weiss

TOWACO, NJ (Oct. 6, 1998) -- In June, I wrote the first three parts of a series on how to read financial statements:

1. Pfizer's Income Statement

2. Pfizer's Assets

3. Pfizer's Liabilities

In those reports I discussed Pfizer's (NYSE: PFE) income statement and balance sheet with a focus on what's important to us as Cash-King investors. Now, over the next two nights, I'm going to finish up that series with a discussion of the Consolidated Statement of Cash Flows.

Once again, I plan to use Pfizer's statements, which are available from the company's website (Pfizer's Cash-Flow Statement). If you have a copy of our Pfilly's annual report in tow, the Statement of Cash Flows appears on page 44. I encourage you to have this statement in front of you while reading this column.

For many beginning investors the Cash-Flow Statement is the financial statement to ignore, because of its apparent complexity. However, it really is one of the more important reports, and I also believe it's fairly easy to grasp, once you have a little guidance. I say this even though here we've outlined a way to invest using just the income statement and balance sheet. But it's pretty clear that while the terms found in the Flow Ratio are evident on the balance sheet, their underlying concepts really come from the Cash-Flow Statement.

Okay, let's get to the numbers. Disclaimer up-front: This sort of cataloging of items on financial statements can be less interesting to read than the ingredient listings on a packet of rice cakes. I apologize. Today's report is mostly medicine with little sugar. But bear with me -- I hope you'll find it worth a few minutes of labor in the end. As the resident accountant in the C-K group, I figure I'm allowed to take a shot at this kind of stuff once in awhile.

The first section of the Cash-Flow Statement calculates the "Net Cash Provided by Operating Activities." Operating activities are those that are part of the company's everyday business. They don't include such items as restructuring charges or the material sales of assets. Anything that's an extraordinary one-time gain or loss doesn't appear in this category -- only work from daily operations.

The starting point for this portion of the Cash-Flow Statement is net income as reported on the income statement. Next, any expenses that don't result in an actual outlay of cash are then added back to this number. Remember, we're following the flow of cash here, so any expenses that don't have to be paid are considered positives. In Pfizer's case, this means that we add back depreciation expenses and deferred taxes.

The rest of the "Operating Activity" portion of this statement is made up of changes in current assets and liabilities (i.e., the items that make up our Flow Ratio). The statement reflects the difference between the results at the last marking period compared to today's circumstance. Warning! Warning! We're going to work through some numbers here to explain this. Let's look at accounts receivable. A quick glance at Pfizer's balance sheet shows us that the 1996 year-end balance was $2,252 and the 1997 year-end balance was $2,527. This is an increase of $275 (million). But, the Cash-Flow Statement shows a change of $503 (million).

Why the difference? I actually phoned up the investor relations department at Pfizer to get an answer. The difference was attributable to foreign currency fluctuation. The discrepancy is the result of Pfizer's foreign affiliates translating results at different exchange rates. For Cash-Flow Statement purposes, the same exchange rate is applied to the beginning and ending balance to make an apples to apples comparison. Exchange differences from the conversion of all assets and liabilities are then summarized in one line at the bottom of the Cash Flow Statement, listed as the "Effect of Exchange Rate Changes on Cash and Cash Equivalents."

Sounds obscure, but it's pretty simple. The Net Cash from Operating Activities represents the flows of cash through the business from the last market period to this marking period. In Pfizer's case, there had to be some exchange-rate calculations to account for their foreign business. To hammer home one example of that flow of cash, while Pfizer's accounts receivable increased, the increase is shown as a negative number in the Cash-Flow Statement. That's because for cash flow purposes an increase in announced but uncollected sales is viewed as a use of cash rather than a source of it.

If you think about the Flow Ratio for a second, the reasoning here is quite similar. In the Flow Ratio, we divide current assets less cash by current liabilities. So, the more receivables a company has, the higher its Flow Ratio is. We penalize companies when their receivables increase. The same penalty is applied on the Cash-Flow Statement.

The rest of the current assets and liabilities are treated the same as accounts receivable. The only difference between assets and liabilities is that increases in assets are treated as uses of cash while increases in liabilities are treated as sources of cash. Is that clear? I hope so. It's the backbone of the philosophy behind our Flow Ratio, and it's core to understanding a Cash-Flow Statement. If you have any questions, I'm prepared to answer them in our C-K Strategy Folder on the Web.

Now, once we've finished working through the changes in current assets and liabilities we're left with net cash provided by operating activities. This figure puts us very close to defining a term that you've certainly come across in valuing companies. It's a principle based on something called free cash flow. Alas, that's a topic for tomorrow. I'm going to stop here for tonight.

If you have any questions, please post them to our Cash-King Strategies Folder linked above.

Have a Foolish evening,

Phil Weiss

Cash-King Strategy Folder
Cash-King Companies Folder

10/06/98 Close

Stock  Change    Bid 
 AXP   -1 3/4   70.75 
 CHV   -1 15/16 87.00 
 CSCO  -2 1/8   46.19 
 KO    +1 9/16  63.00 
 GPS   +2 5/16  51.56 
 EK    +1 5/16  76.19 
 XON   +  7/8   75.75 
 GM    -2 3/8   51.38 
 INTC  -  15/16 79.63 
 MSFT  -3 9/16  97.63 
 PFE   -5 1/4   89.38 
 SGP   -1 13/16 97.63 
 TROW  -1 1/4   26.13 
                 Day     Month    Year    History 
         C-K      -1.54%  -6.97%  -1.73%  -1.73% 
         S&P:     -0.40%  -3.19%  -2.13%  -2.13% 
         NASDAQ:  -1.68% -10.80%  -9.33%  -9.33% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   24 Microsoft     78.27     97.63    24.73% 
     2/3/98   22 Pfizer        82.30     89.38     8.60% 
    8/21/98   22 Schering-P    95.99     97.63     1.71% 
     5/1/98   37 Gap Inc.      51.09     51.56     0.92% 
    2/13/98   22 Intel         84.67     79.63    -5.96% 
    2/27/98   27 Coca-Cola     69.11     63.00    -8.84% 
    6/23/98 34.5 Cisco Syst    57.56     46.19   -19.76% 
     2/6/98   56 T. Rowe Pr    33.67     26.13   -22.42% 
    5/26/98   18 AmExpress    104.07     70.75   -32.01% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     76.19    20.65% 
    3/12/98   20 Exxon         64.34     75.75    17.74% 
    3/12/98   15 Chevron       83.34     87.00     4.39% 
    3/12/98   17 General Mo    72.41     51.38   -29.05% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   24 Microsoft   1878.45   2343.00   $464.55 
     2/3/98   22 Pfizer      1810.58   1966.25   $155.67 
    8/21/98   22 Schering-P   2111.7   2147.75    $36.05 
     5/1/98   37 Gap Inc.    1890.33   1907.81    $17.48 
    2/13/98   22 Intel       1862.83   1751.75  -$111.08 
    2/27/98   27 Coca-Cola   1865.89   1701.00  -$164.89 
    6/23/98 34.5 Cisco Syst  1985.95   1593.47  -$392.48 
     2/6/98   56 T. Rowe Pr  1885.70   1463.00  -$422.70 
    5/26/98   18 AmExpress   1873.20   1273.50  -$599.70 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1523.75   $260.80 
    3/12/98   20 Exxon       1286.70   1515.00   $228.30 
    3/12/98   15 Chevron     1250.14   1305.00    $54.86 
    3/12/98   17 General Mo  1230.89    873.38  -$357.52 
                               CASH     $48.07 
                              TOTAL  $21412.73 
 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio. $2,000 will be added every six months.

*The year for the S&P and Nasdaq is as of 02/03/98


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