How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

Chapter 16. IMPACT OF GROWTH AND DECLINE ON CASH FLOW

Setting the Stage for Cash Flow Analysis

Chapter 13 explains how to get from net income (the bottom line of the income statement) to the cash flow yield from net income (in the first section of the statement of cash flows). Cash flow can be higher or lower than net income for the period. Why? There are three main reasons: (1) depreciation (and any other noncash expenses and losses recorded in the year), (2) changes in operating assets, and (3) changes in operating liabilities.

1. Depreciation (and Other Noncash Expenses and Losses): Sales revenue reimburses a business for the expenses it incurs in making sales. Profit is the margin of sales revenue in excess of expenses. One expense is depreciation. A business records depreciation expense each period by writing down the cost balance of its property, plant, and equipment (except land). There is no cash outlay in recording this expense. Therefore, depreciation is an "add back" to net income for determining cash flow.

   In addition to depreciation, a business may record other noncash expenses and losses. For example, a company may record amortization expense to recognize the loss of value of its intangible assets. Or, a business may record an uninsured loss that occurred during the year. Neither asset write down involves a decrease in cash. Therefore, amortization expense and asset write-down losses are added back to net income (just like depreciation).

2. Operating Assets: Changes in a company's ...