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Stepan Lavrouk
Stepan Lavrouk
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What Cash Flows Can Tell You About Income

The cash flow statement offers 3 important pieces of context for the income statement

July 07, 2020

Value investors know about the three financial documents that every publicly traded company needs to produce: the balance sheet, income statement and cash flow statement. But what they might not know is that these documents can tell very different stories if viewed separately. Today, I want to discuss how the cash flow statement - which is often overlooked by investors and the financial news media - can give important context to the income statement, which is often the document most focused on.

The difference between cash and accounts receivable

Many - if not most - large companies will frequently have a situation where they book profits from sales in a given quarter, without receiving the cash payment from their counterparties. This is a completely normal occurrence - lets say an automobile manufacturer sold a fleet of cars in the last week of a quarter, but didnt receive payment from the dealership until after the quarter ended. Perhaps the sale was made on credit, or perhaps there was a delay with a bank transfer.

However, as we have discussed previously, large discrepancies between accounts receivable (as recorded on the income statement) and the actual amount of cash that is coming into the companys bank account can be a sign of potential counterparty problems, or even fraud.

Depreciation

Assets tend to degrade over time, so businesses need a way to deal with this in their filings. In our hypothetical example of the automobile manufacturer, the company may invest in a new production line and spend $50 million doing so. They now have an asset on their balance sheet worth $50 million. This piece of equipment will lose value over time (as most machinery does), so to account for this, the income statement will include a depreciation charge.

Lets say that $50 million cost is spread out across 10 years. This means that every year, there will be a $5 million depreciation charge taken out of revenues. But this obscures the fact that the real cash charge happens the minute the machinery is purchased - $50 million leaves the companys bank account. So we can see that there is a big difference between profits - which assume a gradual writedown of the machinery - and cash flows, which tell the real story.

Debt repayment

A similar situation applies to debt repayment. If a business pays off a debt, there is clearly cash changing hands. However, the income statement will not demonstrate this fact - which is logical, since loans received from a bank are not recorded as income either. But the cash position of the business has clearly changed, and that is relevant information for investors, who, after all, have a claim on the cash flows of the company.

The point of these examples is not that the income statement is not an real representation of reality and that you should only focus on cash flows; rather, it is that you need to look at all the information available to you. Only then will you be able to form an accurate picture of the business in question.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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