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The Statement of Cash Flows
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This statement is the true touchstone for corporate value creation because it shows how much cash a company is generating from year to year—and cash is what counts (see Figure 5.-15). In fact, I would almost recommend that you look at the statement of cash flows first when evaluating a company to see how much cash it's throwing off, then look at the balance sheet to test the firmness of its financial foundation, and only then look at the income statement to check out margins and such.

Figure 5.14 Dell and Hewlett-Packard's partial income statements. Source: Dell/Hewlett-Packard SEC filings.

The cash flow statement strips away all the abstract, noncash items such as depreciation that you see on the income statement and tells you how much actual cash the company has generated. Many of the items on this statement are also found on either the income statement or the balance sheet, but here they're rearranged to highlight the cash generated and how it relates to reported earnings. The cash flow statement is divided into three parts: cash flows from operating activities, from investing activities, and from financing activities.

The "cash flows from operating activities" section comes first and it tells you how much cash the company generated from its business. This is the area to focus most of your attention on because it's the cash-generating power of the business that we're most interested in. Dell's statement of cash flows is on page 70 so you can follow along (see Figure J.16).

Net Income

This figure is simply taken from the income statement. All the items below it are added to or subtracted from net income to get the end result, "net cash provided by operating activities." In Dell's case, we start with the same $2.1 billion that was reported on the income statement.

Figure 5.15 ACME Corporation's cash flow statement. Source: Morningstar, Inc.

Figure 5.15 (Continued).

Depreciation and Amortization

This is not a cash charge—remember, Mike didn't have to pay anyone just because his grilling tongs started to wear out—so we need to add it back to net income. In Dell's case, we add back $211 million.

Tax Benefit from Employee Stock Plans

When an employee exercises stock options, the employer gets to deduct the gain received by the employee against its corporate income. (Employee compensation is generally tax deductible.) Because the result is a lower tax bill, we need to add back the tax benefit to the already-taxed net income. Be wary of this line item—if it's large relative to total operating cash flow and the company's stock has been zooming upwards, you shouldn't count on this cash being around in the future. When the shares sink, fewer employees "will exer­cise their options, and the company will receive a smaller cash tax benefit. As you can see, Dell's tax benefit from stock option exercises dropped in half between 2001 and 2OO2 and sunk again in 2003. Over the same time period, Dell's stock wasn't such a hot performer—and that's not a coincidence.

Figure 5.16 Dell's partial cash flow statement. Source: Dell SEC filings.

Changes in Working Capital

Remember when Mike let some folks buy hot dogs on credit and owed money to the grocer for those extra buns? Both of those actions affected working capital, and they'd be accounted for here. If a company is owed more money by customers this year than it was last year, accounts receivable increase and cash flow decreases; if it owes more money to suppliers, accounts payable increase and so does cash flow. Finally, if a firm pumps more money into inventory that doesn't sell, cash flow decreases. Remember, inventory ties up capital.

In Dell's case, we need to go back to the balance sheet to see where the Si.2 billion entry for the line item came from (see Figure 5.17).

Figure 5.17 Dell's current assets. Source: Dell SEC filings.

As you can see, accounts receivable increased from $2,269 billion to $2,586 billion, which ate up $317 million ($2,586 minus $2,269) because Dell's customers owed it more money at the end of fiscal 2003 than they did at the end of fiscal 2OO2. In addition, inventory increased a bit from $278 million to $306 million, which also used up cash because Dell increased the amount of capital it had tied up in inventory. Meanwhile, accounts payable increased from $5,075 billion to $5,989 billion, which means that Dell owed $914 million more to its suppliers at the end of 2003 than it did at the end of 2OO2—and that meant more cash in Dell's pocket (see Figure 5.18).

Figure 5.18 Dell's current liabilities. Source: Dell SEC filings.

So, we have $914 million in cash generated by an increase in accounts payable, minus the $317 million increase in accounts receivable, minus the $28 million change in inventory, which gives us $569 million in cash flow. Add in the $500 million increase in "accrued and other"—mainly warranties and employee bonuses that Dell may have to pay out in the future—as well as some other odds and ends detailed on the bowels of the financial filings, and you "wind up with the $1,220 billion in "changes in operating working capital" that you see on Dell's cash flow statement.

You don't need to go through all of this every time you look at a statement of cash flows because everything gets neatly netted out for you in the "net cash provided by operating activities" line. But because the "changes in working capital" entry is often the biggest cause of differences between net income and operating cash flow, this is an area that you'll want to pay attention to—hence our detailed analysis.

One-Time Charges

Remember these? Dell didn't have any, but H-P did (see Figure 5.19). Because most of these charges were noncash charges—that is, H-P didn't write a check made out to someone named Restructuring—they need to be added back when figuring cash flow (similar to depreciation, which is also noncash).

Net Cash Provided by Operating Activities

This is your holy grail for figuring out "whether a company is generating cash.

Also known as operating cash flow, it's the result of adding or subtracting the previous items from net income. It doesn't replace net income, but if you don't look at it in addition to net income, you're not getting the full picture because the two can often tell very different stories.

Now we arrive at the second portion of the statement of cash flows, the "cash flow from investing activities" section. These are activities that involve acquiring or disposing of PP&E, corporate acquisitions, and any sales or purchases of investments.

Capital Expenditures

This figure represents money spent on items that last a long time, such as PP&E—basically, anything needed to keep the business running and growing at its current rate. Operating cash flow minus capital expenditures equals free cash flow, or the amount of cash the company generates after investing in its business. We can see in Figure 5.20 that Dell spent $305 million on cap ex.

Investment Proceeds

Companies often take some of their excess cash and invest it in bonds or stocks in an effort to get a better return than they could in a basic savings account. This number tells us how much money the company has made (or lost) on such investments. As you can see in Figure 5.20, Dell invested $8.7 billion of its cash in securities of one sort or another (purchases) and received $7.7 billion from previous investments that either reached maturity or were sold (maturities and sales).

Figure 5.20 Dell's partial cash flaw statement. Source: Dell SEC filings.

Dividends Paid

Unlike many line items, this one is just what it sounds like. You can see that H-P paid a total of $801 million in dividends in 2OO2 (see Figure 5.21).

Issuance/Purchase of Common Stock

This is an important number to look at because it indicates how a company is financing Its activities. Rapidly growing companies often issue large amounts of new stock, which can dilute the value of existing shares but which also give the company cash for expansion. Slower growing companies that generate a lot of free cash flow tend to buy back significant amounts of their own stock, though companies that issue many stock options to their employees also buy back stock to minimize dilution.

You can see this kind of buyback activity in Figure 5.22 of Dell's financial statements printed to the right. Under "purchase of common stock," note that Dell spent $2.3 billion repurchasing its own stock, and on the income statement, you can see that the number of diluted shares outstanding fell about 3 percent, from 2.726 billion to 2.644 billion. Although share repurchases are generally a shareholder-friendly use of excess cash—after all, the fewer shares outstanding, the larger the piece of the company that each shareholder owns—

Figure 5.21 Hewlett-Packard's partial cash flow statement. Source/Hewlett-Packard SEC filings.

Figure 5.22 Dell's partial cash flaw statement. Source: Dell SEC filings.

you have to view share buybacks with caution when they come from firms such as Dell that grant large numbers of stock options. Firms that grant their employees a ton of options and then spend corporate cash on repurchases are essentially selling shares to their employees at low prices and buying it back on the open market at much higher prices, which is not the best use of capital.

Issuance/Repayments of Debt

This number tells you whether the company has borrowed money or repaid money it previously borrowed. In Figure 5.23, you can see that H-P received $2.5 billion from bondholders in exchange for some long-term debt and paid off $2.4 billion in short-term debt. You can see these two entries on the lines

Figure 5.23 Hewlett-Packard's partial cashflow statement. Source: Hewlett-Packard SEC filings.

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