True confessions: one banker's inner struggle with cash flow

RMA Journal, The, June, 2003 by Thomas P. Olson

Many, many years ago, during my first training days in banking, I was asked what would best indicate a company's ability to repay a loan. Not knowing too much about financial analysis--or anything else, for that matter--I said hopefully, "Well, I guess if the company is profitable, that would be a good sign that the company can pay."

The muffled, yet snickering reaction from my teacher was riddled with such words as depreciation, amortization, capital expenditures, debt reduction, and balance sheet fluctuations. I felt a little lower than a slug.

I was informed that when intelligent bankers put all these components together, they would gleefully reach the final answer: cash flow. I continued to struggle, perplexed over this ephemeral concept.

My thoughts drifted toward a metaphorical river of money flowing downstream, with industry and businesses on the shores, pumping greenbacks into the river. Trouble is, there were irrigation channels taking some of the flow away from the river. But what the heck was it that these channels were siphoning off our river of money? Cost of goods sold, selling, general administrative expenses, and a host of other little drains were the culprits.

So, I thought, perhaps cash flow is the amount of greenbacks that ends up where the river empties into a sea of stockholders.

"In a strict sense, then," I ventured to my teacher, "cash flow is the net increase or decrease in cash remaining between two fiscal years."

"Perhaps," was the reply "In the narrowest sense, net increase or decrease certainly should be considered the ultimate determinant of cash flow; but it should be considered the result and not the cause of cash flow."

I was told that accountants know this and they now dutifully present a demonstration of the input and output factors--also known as sources and uses--in determining the changes in cash. "You've probably seen this in the back pages of audited statements," I was told. I trudged forward in my quest to understand cash flow.

Everyone needs a GEP. I sought the wise counsel of the Grand Exalted Professor, hereinafter referred to as GEP. It was reliably reported to me that if GEP didn't know the answers to these probing questions, no one would. I thought I had reached first base with the insight that cash flow started with the thing called profits. Cash flow, I assumed, equals profits; but you know what they say about that word "assume."

GEP explained that cash flow equals profits only if we're talking about an all-cash business with no depreciation. Profits alone are fine when gauging, say, the cash flow of a lemonade stand, but most businesses are a bit more complex. There's that pesky concept of depreciation, in which the wear of machinery and equipment over their expected life span has to be recognized somewhere--namely, within a profit and loss statement. For example, a $1,000 piece of equipment with a five-year life span needs to be depreciated or expensed at the rate of $200 per year.

"But wait!" I said. "There's no cash going out the door. So to arrive at cash flow, we have to add depreciation on top of income, right? And that's because the income was 'artificially' decreased earlier by that noncash expense item called depreciation."

"Artificial?" countered GEP. "Wait 'til you have to replace that equipment! Tell me then that there's no cash charge!" His comment, of course, serves as a good segue to my next mystery item.

Capital Expenditures

GEP explained that any expenditures for equipment and other capital assets need to be capitalized, which means we don't recognize the expense in the year the money was spent; rather, we amortize the expense by depreciating the asset over its estimated useful life.

"The $1,000 spent for the equipment doesn't show up anywhere on the income/expense statement," I said to GEP. "But the money sure is gone. So I guess in arriving at cash flow, we'd have to subtract this from our cash flow. Right?"

"Right," GEP said.

But at that point GEP found it amusing to confuse me all over again with the loan repayment issue. I protested, saying, "You tell me that since interest is a legitimate expense, it gets plugged in as an expense item and has thus been accounted for in the income statement. But you've got to be kidding when you tell me the principal repayment portion of the monthly payment is not expensed. Are you telling me that because the money went out the door, principal repayments of debt need to be subtracted from cash flow too?"

"Yup," replied GEP.

A flicker of light came on in my brain as I surmised to GEP that proceeds arising from new loans have to be added to cash flow. The light went from 15 watts to 25 watts as he rewarded me with "Right again."

Then I was on a roll, saying, "So, anything that doesn't pass through the income statement has to be either added or subtracted in arriving at cash flow?"

"That's the ticket," GEP responded.

Whew! Yet I was suspicious. You know that feeling you get when things are going too well? You know, the feeling that you're about to get whacked upside your head with some other imponderable? I didn't have to wait long. That's about when GEP told me something about balance sheet changes having a dramatic impact on cash flow.