Ordinary extraordinaries
Extraordinary items on an earnings statement are, according to accounting rules, to be tied to events that are unusual and nonrecurring. Unusual events aren’t related to typical activities of the business, at least going forward.
Nonrecurringevents aren’t expected to occur again.
Extraordinary items commonly result from business closures (“discontinued operations”) or major restatements due to changes in accounting rules. They may result from debt restructurings or other complex financial transactions.
They may result from layoffs and other employee transactions. Extraordinary items generally are notsupposed to include asset write-downs (such as receivables, inventory, or intangibles), foreign currency gains or losses, or divestitures. Some companies interpret the accounting rules and guidelines more strictly than others.
Our advice to you is to watch for extraordinary expenses that aren’t so extra- ordinary. For example, companies that routinely have some kind of write-off every year or reporting period aren’t doing as well as the investing commu- nity is being led to believe. If earnings are consistently a dollar a share each quarter with a consistent $4 write-off each year, the true value generated by the business is closer to zero than four.
The bottom line: Net income
Sales less CGS, less operating expenses, less interest and taxes, less or plus extraordinaries give you a company’s net income, sometimes referred to as income attributable to common shareholders or some similar phrase.
Net income represents the final net earnings result of the business on an accounting — not necessarily a cash — basis.
Net earnings are usually divided by the number of shares outstanding to arrive at earnings per share— the common barometer heard in nearly all financial reports. Most analysts and investors focus on diluted earnings per share, which figure in outstanding employee stock options and other equity grants beyond actual shares outstanding in the share markets.
In and Out of Pocket: Statement of Cash Flows
Earlier we mentioned the difference in timing between certain accounting transactions and related cash collections and disbursements. Build it and ship it this month and record the revenue, even though cash payments may not arrive until months later. Buy and pay for a million-dollar machine today, but expense it over its production life through depreciation. Amortize a patent and never write a check at all.
These transactions and a host of others create differences between account- ing earnings and cash measures of business activity. A business needs cash to operate. A business generating positive cash flow is much healthier than one bleeding cash and borrowing or taking cash from investors to stay afloat.
Because of noncash items, earnings statements don’t give a complete cash picture. So value investors use the statement of cash flows as a standard part of the financial statement package.
Sometimes the statement of cash flows is called “sources and uses of funds”
or something similar, although that is becoming less common. Accountants use the terms “funds” and “cash” interchangeably.
The statement of cash flow tracks cash obtained in, or used for, three sepa- rate kinds of business activity: operations, investing, and financing.
Cash flow from operations
Similar to operating income, cash flow from operations tells what cash is gen- erated from, or provided by, normal business operations, and what cash is consumed, or used inthe business. Net income from continuing operations is the starting point, to which cash adjustments are made. That net income for Simpson in 2006 is $102.5 million (see Figure 8-2).
To that figure, add (or subtract) what was called the “adjustments to recon- cile net income to net cash provided by operating activities” in the Simpson annual report (refer to Figure 6-3) or “Operating Activities: Cash Flows Provided By or Use in” section in the Figure 8-2 Yahoo! Finance summary.
The first adjustment item is depreciation, which in 2006 was $24.5 million. So far, we know that without other adjustments, $24.5 million more in cash was generated than reported as net income, because depreciation was subtracted from net income, but not from cash flow because it isn’t a cash expense. So far, so good.
After a catch-all “Adjustments to Net Income” category comes “Changes In Accounts Receivables” of $7.1 million. Because that is a positive number, it means $7.1 million in cash was generatedfor the business by receivables activities, which means — because cash is used, albeit indirectly to finance receivables — that receivables must have decreasedfor the period. Similarly, in the next line, “Changes in Liabilities,” the parentheses indicate a negative number — that is, cash was usedfor this item. This means cash was used to pay off some liabilities. Next comes the change in inventories of $34.1 million — negative — meaning that $34.1 million in cash was used to buy inventory.
It takes a while to get used to the logic: A positive number means that the item sourcedor generatedcash; a negative number means that the item used cash. And by now, it’s also apparent that cash sourcedthrough depreciation and to a lesser extent by receivables was in effect usedto buy inventory.
Finally, you arrive at a total “Total Cash Flow From Operating Activities,” a figure of $99.067 million, derived by netting the adjustments to total income.
This is a very important figure, because it shows that Simpson generated about the same amount of cash as it did income. Essentially, this is cash gen- erated by ongoing day-to-day business activities. If this amount is negative, that’s bad, because it means that the business isn’t even supporting itself on a day-to-day basis and requires an infusion of cash. If it’s positive — we’re still not out of the woods yet — capital investments may still require more cash than the business is producing. On to that question next.