Some analysts focus attention on cash flow from operations, thinking it as important as, or more important than, net income as a performance measure. Interpreting cash from operations as a measure of operating performance requires considering cash flows along two dimensions: (1) their timing and (2) their classification and disclosure in the statement and related notes. Explain

Answer 1

INTERPRETATIVE ISSUES INVOLVING THE STATEMENT OF CASH FLOWS

Some analysts focus attention on cash flow from operations, thinking it as important as, or more important than, net income as a performance measure. Interpreting cash from operations as a measure of operating performance requires considering cash flows along two dimensions: (1) their timing and (2) their classification and disclosure in the statement and related notes.

TIMING OF OPERATING CASH FLOWS

Firms have some choice as to when they disburse cash. Delaying payments to suppliers and others during the last several days of an accounting period conserves cash and thereby increases cash flow from operations for that period. The cash payments during the early part of the next period reduce cash flow from operations in that period. Thus, delaying payment increases cash flow from operations during the first period but decreases cash flow from operations during the second period. The firm can repeat the process at the end of the second period—delaying payments from then to the third period—to offset the negative cash flow effects of the payments made early in the second period. A growing firm that delays payments at the end of each period reports larger cash flow from operations each period than if it had not delayed making the cash payments at the end of each period. Such a firm is, in effect, obtaining short-term financing from its suppliers. Absent contracts or other agreements that preclude delayed payments, this business practice is legal; however, sufficiently delayed payments might harm a firm's reputation or its credit rating.

CLASSIFICATION AND DISCLOSURE OF TRANSACTIONS

There are certain ambiguities in the classification of cash
flows. Many such items involve complex financial instruments. An analyst who wishes to use cash flows from operations as an indicator of performance should be aware that classification decisions can affect cash from operations, perhaps significantly.

For example, a rental library firm purchase items such as films and games for short-term rentals to customers. The useful lives of these items range from about six months to two years. Are these items inventory? If so, cash paid to acquire rental library items is an operating cash flow. Or, are the items noncurrent assets? If so, cash paid is an investing cash flow.

Prior to 2006, some firms in the rental library business chose the second alternative, classifying the cash paid for rental library purchases as an investing cash outflow. Practice has now changed, however, to classify these cash payments as part of operations. Note that the total cash paid by the firm has not changed, but cash from operations was larger under the pre-2006 classification than afterwards.

Another example is that many auto dealers finance their inventories by borrowing from banks and similar lenders, not from the auto manufacturers with conventional trade accounts payable. These
arrangements are commonly known as "floor plan financing.". Is a floor plan financing an operating cash flow, because it functions like accounts payable in financing inventories, or is it a financing cash flow? Prior to 2006, some auto retailers treated floor plan financing
like accounts payable and therefore included it in cash flows from operations. Practice has changed, however, requiring firms to classify the arrangements as financing. While total cash flows have not changed, and the classification change does not affect the substance of the financing arrangement, the change affects cash from operations.