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Alex Morris
Alex Morris

Security Analysis: The Cash Flow Statement

May 08, 2011 | About:

In Warren Buffett’s 1986 shareholder letter, he discussed a concept known as owner’s earnings. Here is what he had to say:

"These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess — and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes — both for investors in buying stocks and for managers in buying entire businesses.”

I’m currently working on a comprehensive guide to income statement analysis (as laid out by Ben Graham), which should help us with this exercise; however, choosing which “certain other non-cash charges” (like Buffett’s items 1-4 from above) to include is unclear. This article will look at Ben Graham’s discussion on Cash Flow Analysis in "Security Analysis", which should shed some light on this subject.

Graham suggests following the cash-to-cash cycle of the typical business in order to understand the cash flow concept; this starts with sales (or accounts receivable), which “can be used as the first approximation of the actual cash received from operations.” This progression can be generally followed through the revenues and expenses in the income statement. Importantly, as noted by Graham, “the primary use of the funds statement [cash flow statement] is to confirm or deny, over time, the amounts shown in the income statement.” By taking the numbers in an accrual basis on the income statement and adjusting them to a cash basis, we can create a cash basis income statement, which is a better measurement for the equity investor in valuation than GAAP earnings.

Graham suggests that the investor starts by calculating operating cash flow, which can be compared with operating income; operating cash flow is calculated as such:

(1) Revenues

(-/+) Increase/Decrease in Account Receivable

+ Interest Income

- Noncash Interest income

+ Amortization of Bond Premium

+ Dividends from Equity Investments

+ Foreign Currency Gain


(2) SG&A expenses


(+/-) Increase/Decrease in Inventories

(-/+) Increase/Decrease in Account Payable

(+/-) Increase/Decrease in Prepaid Expenses

(-/+) Increase/Decrease in Accrued Liabilities

(+/-) Increase/Decrease in Other Noncash, Nontax Current Assets

+ Cash Foreign Currency Translation Loss


Where net cash flow from operations (before interest/income taxes) = (1) INFLOWS – (2) OUTFLOWS

After adjusting for interest costs and income tax expense, we are left with cash flows from operations that can be used for dividends/repurchases, capex, and debt repayment.

For investing activities, Graham suggests simply taking purchases of plant and equipment and subtracting dispositions to calculate to investment. In regards to capital expenditures, Graham says little that can help us to breakdown the capex issue of maintenance versus growth — he suggests asking, “Did the capital expenditure improve earnings power, hold it at the original level, or were they so inadequate as to permit earning power to decline?” However, this does little to answer the question of what amount is representative of an increase in the capital base, instead answering how effective it was. As Buffett notes, this number must be a guess; as always, the intelligent investor errs to the conservative side with his/her estimate of this figure.

Financing activities, such as retirement of debt, are self-explanatory and immediate uses of cash; from here, we can sum up the line items and calculate the cash flow for the period as such:

Cash flows from operations – investments – financing – dividends paid = net increase in cash/equivalents

As Graham notes, “Ideally, this number will turn out to be precisely equal to the change in cash and equivalent shown on the balance sheet, but that seldom happens.” He suggests that income estimated from cash flows should be the sum of the increase in cash items, dividends paid, growth capex, and other increases in working capital, less net financing. Using the framework laid out in "Security Analysis" can help the investor cover all adjustments that might be needed to achieve cash numbers from an accrual basis, which are “more reliable numbers, more understandable numbers.”

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.5/5 (22 votes)


Pirot - 6 years ago    Report SPAM
Great article Alex. You're young, smart and passionate - a triple threat!
Alex Morris
Alex Morris - 6 years ago    Report SPAM
Thank you Pirot, your kind words are much appreciated.
John Emerson
John Emerson - 6 years ago    Report SPAM
As I have aged I haved leaned more on cash flow statements to make sense of earnings. That said I am continually amazed at the continued reliance that most investors place upon accural earnings. It is the net income not the free cash flow that devastates stocks in the short term. When they miss, no one examines the cash flow statement and exclaims, well it was not really that bad, rather they sell the miss and lambast the management. That short-term thinking directly supports earnings embellishment by management teams.

I think the most important point was distinguishing between maintance capex vs growth capex, the former is an expense the latter is an investment, at least philosophically. Almost no one breaks these two down and rarely pays them any heed. Listen to conference calls, almost never is the question asked to management. If one is focusing upon earnings growth and really attempting to break down the earnings power of a business in the long term, the practice is imperative. However almost always as Montier has pointed out, growth projections are overly optimistic and people generally overpay for the anticipated growth. Personally I do not think that most analysts understand the companies they follow well enough to project future earnings and they rely heavily on management guidance. It is such a useless game, so much energy wasted on such a nonproductive system, but so important to the Cramers of the world.

All this leads me back to a focus on the assets rather than the earnings, it is a simplier and a much safer approach. During times of inflation I try to focus on discounts to replacement value and look for long assets built in preinflationary dollars which encourage assimilation rather than competition. During deflationary times, it is all about the current assets since the replacement values are dropping and it becomes cheaper to built than assimilate. I frequently do not give a hoot about current earnings or calculating future earnings power if I can purchase the assets of a company at a small percentage of their current replacement costs. So long as the business is still relevant, the earnings will eventually return or the company will be bought out or taken private. Almost anyone can be a successful asset-based investor if they retrain their thinking but very few can be successful business evaluators in terms of handicapping future earnings power. Alas, that never stops them from trying.

I appreciate your attempts to discuss accounting and finacial concepts in your articles, although I have found out over the years that relatively few readers are much interested in discussing such concepts. I hope that does not discourage you from attempting to educate the masses.

Alex Morris
Alex Morris - 6 years ago    Report SPAM

As always, appreciate your insightful comments! You keep me learning, which is all I can ask for.

As you noted, there are relatively few readers that are interested in the steps for breaking down an income statement, especially when EPS numbers are right there for you. To me, that means less competition for equities that are not readily understood; I'm not going to complain about that! :)
Uashraf - 5 years ago    Report SPAM
Thank you for your article. I have recently joined investing community. I have no experience in accounting or investing but from my little expierence, one thing which bothers me is my lack to make real meaning of statements. So if you keep writing articles like this , it will beneficial esp with examples. Do you have suggestion for specific book?

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