66 Part 2 Fundamental Concepts in Financial Management
r. Net decrease in cash. The net sum of the operating activities, investing activities,
and! nancing activities is shown here. These activities resulted in a $70 million
net decrease in cash during 2008, mainly due to expenditures on new! xed
assets.
s. Cash and equivalents at the beginning of the year. Allied began the year with the
$80 million of cash, which is shown here.
t. Cash and equivalents at the end of the year. Allied ended the year with $10 million
of cash, the $80 million it started with minus the $70 million net decrease as
shown previously. Clearly, Allied’s cash position is weaker than it was at the
beginning of the year.
Allied’s statement of cash " ows should be of concern to its managers and
investors. The company was able to cover the small operating de! cit and the large
investment in! xed assets by borrowing and reducing its beginning balances of
cash and equivalents. However, that can’t continue inde! nitely. In the long run,
Section I needs to show positive operating cash " ows. In addition, we would
expect Section II to show expenditures on! xed assets that are about equal to (1) its
depreciation charges (to replace worn out! xed assets) along with (2) some addi-
tional spending to provide for growth. Section III would normally show some net
borrowing in addition to a “reasonable” amount of dividends.^10 Finally, Section IV
should show a reasonably stable cash balance from year to year. These conditions
don’t hold for Allied, so something should be done to correct the situation. We will
consider corrective actions in Chapter 4, when we analyze the! rm’s! nancial
statements.(^10) The average company pays out about one third of its earnings as dividends, but there is a great deal of
variation between companies depending on each company’s needs for retained earnings to support its growth.
We cover dividends in detail later in the text in Distributions to Shareholders: Dividends and Share Repurchases.
Pro! ts as reported on the income statement can be “mas-
saged” by changes in depreciation methods, inventory valu-
ation procedures, and so on, but “cash is cash,” so manage-
ment can’t mess with the cash # ow statement, right?
Nope—wrong. A recent article in The Wall Street Journal
described how Ford, General Motors, and several other com-
panies overstated their operating cash # ows, the most
important section of the cash # ow statement. Indeed, GM
reported more than twice as much cash from operations as it
really generated, $7.6 billion versus a true $3.5 billion. What
happened is that when GM sold cars to a dealer on credit, it
created an account receivable, which should be shown in the
“Operating Activities” section as a use of cash. However, GM
classi! ed these receivables as loans to dealers and reported
them as a! nancing activity. That decision more than dou-
bled the reported cash # ow from operations. It didn’t a" ect
the end-of-year cash balance, but it made operations look
stronger than they really were.
If Allied Foods, in Table 3-3, had done this, the $60 mil-
lion increase in receivables, which is correctly shown as a use
of cash, would have been shifted to the “Financing Activities”
section, causing Allied’s cash provided by operations to rise
from "$2.5 million to +$57.5 million. That would have made
Allied look better to investors and credit analysts, but it
would have been just smoke and mirrors.
GM’s treatment was! rst reported by Charles Mulford,
a professor at Georgia Tech. The SEC then sent GM a letter
that basically required it to change its procedures. The
company issued a statement saying that it thought at the
time that it was acting in accordance with GAAP but that it
would reclassify its accounts in the future. GM’s action was
not in the league of WorldCom’s or Enron’s fraudulent
accounting, but it does show that companies sometimes
do things to make their statements look better than they
really are.
Source: Diya Gullapalli, “Little Campus Lab Shakes Big Firms,” The Wall Street Journal, March 1, 2005, p. C3.
MASSAGING THE CASH FLOW STATEMENT