How to read and analyze a cash flow statement?
This cash flow video is a companion video to “How to read an annual report” and
“How to read an income statement”, and covers the 2017 cash flow statement of Alphabet Inc.
It is advisable to watch the income statement analysis video first, as we will build on
this income statement analysis when reviewing the cash flow statement.
As always on the Finance Storyteller channel, this video is for educational purposes only,
none of the comments in this video should be interpreted as investment advice.
As the video is for educational purposes, please do try this at home
and comment on your findings below!
In order to analyze the cash flow statement, you need to download the annual report.
In the case of Alphabet Inc, go to abc.xyz/investor, and download the 10-K PDF version.
Scroll down the table of contents of the 10-K annual report, up to item 8: financial statements
and supplementary data.
Click on the link.
You now arrive at the index to the financial statements, and the related notes.
Click on “consolidated statements of cash flows”.
Here’s the Alphabet Inc cash flow statement for the years 2015 through 2017.
It’s a lot of information, a full page in the annual report.
Let’s start at the bottom of the page, with reviewing the change in cash balance for the
three years, and then go one level deeper for the latest year 2017
by putting the high-level walk together.
After that, we go yet another level deeper by reviewing the categories
Cash From Operating Activities, Cash From Investing Activities, and Cash From Financing Activities.
That’s basically a “To Do” list that you can replicate for reviewing
the cash flow statement of any company.
Cash balance change and 2017 cash walk.
The balance of cash and cash equivalents was $18.3 billion at the start of 2015,
going down to $16.5 billion at the end of 2015.
Ending balance of 2015 is the same as the opening balance of 2016.
Cash went down by $3.6 billion in 2016 to $12.9 billion at the end of 2016.
In 2017, the cash balance went down a further $2.2 billion to $10.7 billion at the end of 2017.
So what is going on here?
Even though in absolute terms $10.7 billion is a lot of cash, should we worry about the
trend of the declining cash balance?
That’s what you can find out by going to the next level of analysis: reviewing the
cash inflows and outflows during the year.
2017 started with $12.9 billion in cash for Alphabet Inc, and ended with $10.7 billion.
A net cash outflow of $2.2 billion.
Cash from operating activities was an impressive $37.1 billion cash inflow.
Cash from investing activities was an outflow of $31.4 billion.
Cash from financing activities was an outflow of $8.3 billion.
And a more “technical” item: the effect of exchange rates on the cash balance was
a positive $400 million.
You guessed right, the next level of analysis is: what is in each of these cash flow categories.
First up: cash from operating activities or CFOA.
Alphabet Inc, like most other companies, presents CFOA using the indirect method of cash flow
reporting, which means that you start with net income (or profitability), and then make
adjustments from there to get to cash flow.
Specifically in 2017: from $12.7 billion net income to $37.1 billion CFOA.
That difference between net income and CFOA is more than $24 billion in 2017
(37.1 minus 12.7), while it was around $17 billion in 2016 (36 minus 19.5), and $10 billion in 2015
(26.6 minus 16.3).
Let’s pick the five biggest line items in 2017 to see how this indirect method works.
First off, you add back depreciation and amortization, $6.9B in 2017.
This number was deducted as a cost when net income was calculated in the profit and loss
statement, but as you do not pay depreciation and amortization to anybody (it is what we
call in finance a “non-cash expense”), you have to add back the amount if you want
to get to a cash flow based view.
Similar story for stock-based compensation expense.
This is a cost in the income statement, which lowers net income.
As the compensation is stock-based, and not cash-based, no cash is leaving the door, so
to get to a cash based view, you need to add back this number.
In the second half of the CFOA overview, changes in the balance sheet assets and liabilities
are reviewed.
The change in accounts receivable balance is a negative for cash flow.
This is a typical pattern in a fast growing company:
revenue is growing fast (in the case of Alphabet Inc 20+% per year),
and the accounts receivable balance tends to grow in line with revenue.
If accounts receivable goes up, cash goes down, hence the negative impact on cash flow
three years in a row.
Timing of booking revenue and profit are different from the timing
of booking the cash receipt from the customer.
Onward to two large contributors to cash flow in 2017, that are likely to be cash outflows
in upcoming years.
As we saw in the income statement analysis, Alphabet Inc incurred a very significant charge
in income taxes in 2017 mainly due to the one-time transition tax in the Tax Act.
This was recorded as a cost (provision for income taxes, impacting net income), but not
yet paid (no cash outflow).
The amount was deducted to calculate net income, but as the cash outflow has not happened yet,
you need to add the amount back for purposes of cash flow calculation.
Last line item to illustrate the indirect method of cash flow reporting: accrued expenses
and other liabilities.
If the amount on the balance sheet for this liability goes up, then that is a positive
for cash flow.
Let’s zoom into the detail that Alphabet Inc provides.
The December 31st 2016 and December 31st 2017 balances, as well as the main line items,
for accrued expenses and other liabilities are shown in a note to the financial statements.
The European Commission fine of $2.9 billion stands out here.
As we discussed in the income statement analysis, this is the fine that the European Commission
has announced, which Alphabet is appealing and has not paid yet.
Alphabet Inc has recorded the fine as an expense (debit) in the income statement, and the offset
(credit) to that journal entry was accrued expenses and other liabilities.
In other words, the expenses are recorded, but the settlement or payment has not occurred,
therefore it does impact net income, but does not impact cash flow yet.
Cash from investing activities.
Like with most other companies in most years, this tends to be a net cash outflow.
More specifically: a major cash outflow of $31.4 billion in 2017.
In the case of Alphabet Inc,
the purchases of property and equipment were $13.2 billion in 2017.
We will go into more detail on P&E in the upcoming video on how to read a balance sheet.
The rest of the CFIA category is mostly explained by the purchase and sale of marketable securities:
this was a net cash outflow of $18.2 billion.
So that provides the answer on the question of why cash balances keep going down year-over-year
for Alphabet Inc: they prefer to generate some interest income by converting the cash
into marketable securities.
We saw in the income statement analysis that Alphabet Inc earned $1.3 billion in interest
income in 2017, and we will review in the balance sheet analysis what makes up the portfolio
of marketable securities.
As you see, the financial statements are all connected!
Cash from financing activities.
$8.3 billion net cash outflow.
Repurchases of stock explain $4.8 billion of that, stock-based award activities $4.2 billion.
The line items related to debt are each significant amounts, but if you net the proceeds and repayments
together, it’s a net cash outflow of less than $100 million.
In the context of CFFA, the note on dividend policy in the Alphabet Inc annual report is
useful to read: “We have never declared or paid any cash dividend on our common or
capital stock.
We intend to retain any future earnings and do not expect to pay any cash dividends in
the foreseeable future.”
You could look at the dividend policy in two ways.
It’s unusual for companies as large as Alphabet Inc not to pay a cash dividend, but not unusual
for tech companies.
What I conclude in the review of Alphabet Inc’s annual report, is that there are plenty
of investments to make in current businesses, as well as other bets!
In summary: Alphabet Inc’s cash balance went down from $12.9 billion at the start
of 2017 to $10.7 billion at the end of 2017, mainly due to the cash inflow from operations
of $37.1 billion which includes some timing items due to taxes and the European Commission
fine, the cash outflow from investments of $31.4 billion for CapEx and net purchases
of marketable securities, and the cash outflow from financing of $8.3 billion due to share
buybacks and stock-based award activities.
We have succeeded in performing a high-level cash flow statement analysis of Alphabet Inc,
by focusing on five areas: cash balance change over three years, cash balance walk for 2017,
and a review of CFOA, CFIA and CFFA.
I am very interested to hear your comments, please post them below the video.
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