When you review a company’s balance sheet or income statement, you run into a breakdown of cash flow. Ostensibly, the cash flow is the difference between how much money is generated versus how much is spent in operations. However, it isn’t always that straightforward. Companies are fully aware that investors and lenders are monitoring their cash flow statements. Accountants sometimes manipulate cash flow to make it appear higher than it otherwise should. A high cash flow is a sign of financial health. A better cash flow can result in higher ratings and lower interest rates. Companies often finance their operations by raising equity capital or through debt, and it is extremely useful to be able to present a healthy company. Study a company’s cash flow under its operating cash flow entry. This is in the cash flow statement, which is presented after the income statement and the balance sheet. Operating cash flow can be distorted in several different ways.
Changing Accounts Payable
Accountants have to determine when to recognize payments made by the company, which are recorded under accounts payable. Suppose a company writes a check and does not deduct that payable amount before the check is actually deposited, allowing the funds to be reported instead in operating cash flow as cash on hand. Another technique that a company might use involves paying overdrafts. Generally accepted accounting principles allow overdrafts to be added into accounts payable and then combined with operating cash flow, making it appear larger than it otherwise should.
Misusing Non-operating Cash
Companies sometimes generate income from operations that are not related to their normal business activity, such as trading in the securities market. These are typically short-term investments and have nothing to do with the strength of the business’s core model. If the company adds these funds into its normal cash flow, it gives the impression that it regularly generates more receivables through its standard operations than it actually does.
Receivables and Cash Flow
The working capital accounts are most directly responsible for the reporting of cash flow. Receivables increase cash flow, while accounts payable decrease cash flow. A company could artificially inflate its cash flow by accelerating the recognition of funds coming in and delay the recognition of funds leaving until the next period. This is similar to delaying the recognition of written checks. These are only short-term fixes; by accelerating receivables for the current period, the company is actually reducing them for the next period.
Selling Accounts Receivable
Companies might securitize their receivables, which means that they sell their outstanding receivables (money that is almost certain to come in but has not yet) to another company for a lump sum, which shortens the length of time that receivables are outstanding. This inflates operating cash flow figures for a short period of time. One method of dealing with potential accounting trickery is by looking at free cash flow. Free cash flow (FCF) is calculated as operating cash flow minus capital expenditures, which reveals how much cash flow is actually on hand versus how much is reported. This isn’t foolproof, but it is a popular alternative measurement.