1. Operating revenues

Operating receipts should correspond to sales for the same period, but they differ because:

• customers may be granted a payment period; and/or
• payments of invoices from the previous period may be received during the current period.

As a result, operating receipts are equal to sales only if sales are immediately paid in cash. Otherwise, they generate a change in trade receivables.

2. Changes in inventories of finished goods and work in progress

As we have already seen in by-nature income statements, the difference between production and sales is adjusted for through changes in inventories of finished goods and work in progress.¹ But this is merely an accounting entry, to deduct from operating costs those costs that do not correspond to products sold. It has no impact from a cash standpoint.² As a result, changes in inventories need to be reversed in a cash flow analysis.

3. Operating costs

Operating costs differ from operating payments in the same way as operating revenues differ from operating receipts. Operating payments are the same as operating costs for a given period only when adjusted for:

• timing differences arising from the company’s payment terms (credit granted by its suppliers, etc.);
• the fact that some purchases are not used during the same period. The difference between purchases made and purchases used is adjusted for through change in inventories of raw materials.

These timing differences give rise to:

• changes in trade payables in the first case;
• discrepancies between raw materials used and purchases made, which are equal to change in inventories of raw materials and goods for resale.

The total amount of the timing differences between operating revenues and costs and between operating receipts and payments can thus be summarised as follows for by-nature and by-function income statements:

Astute readers will have noticed that the items in the central column of the above table are the components of the change in operating working capital between two periods, as defined in Chapter 4.

Over a given period, the change in operating working capital represents a need for, or a source of, financing that must be added to or subtracted from the other financing requirements or resources.

If positive, it represents a financing requirement and we refer to an increase in operating working capital. If negative, it represents a source of funds and we refer to a reduction in operating working capital.

The change in working capital merely represents a straightforward timing difference between the balance of operating cash flows (operating cash flow) and the wealth created by the operating cycle (EBITDA). As we shall see, it is important to remember that timing differences may not necessarily be small, of limited importance, short or negligible in any way.

4. Capital expenditure

Capital expenditures³ lead to a change in what the company owns without any immediate increase or decrease in its wealth. Consequently, they are not shown directly on the income statement. Conversely, capital expenditures have a direct impact on the cash flow statement.

A company’s capital expenditure process leads to both cash outflows that do not diminish its wealth at all and the accounting recognition of impairment in the purchased assets through depreciation and amortisation that does not reflect any cash outflows.

Accordingly, there is no direct link between cash flow and net income for the capital expenditure process, as we knew already.

5. Financing

Financing is, by its very nature, a cycle that is specific to inflows and outflows. Sources of financing (new borrowings, capital increases, etc.) do not appear on the income statement, which shows only the remuneration paid on some of these resources, i.e. interest on borrowings but not dividends on equity.⁴

Outflows representing a return on sources of financing may be analysed as either costs (i.e. interest) or a distribution of wealth created by the company among its equity capital providers (i.e. dividends).

To keep things simple, assuming that there are no timing differences between the recognition of a cost and the corresponding cash outflow, a distinction needs to be drawn between:

• interest payments on debt financing (financial expense) and income tax, which affect the company’s cash position and its earnings;
• the remuneration paid to equity capital providers (dividends), which affects the company’s cash position and earnings transferred to reserves;
• new borrowings and repayment of borrowings, capital increases and share ­buy-backs,⁵ which affect its cash position, but have no impact on earnings.

Lastly, corporate income tax represents a charge that appears on the income statement and a cash payment to the state which, though it may not provide any financing to the company, provides it with a range of free services and entitlements, e.g. police, education, roads, etc. It is worth mentioning that corporate income tax is not always paid as soon as it becomes a cost, thus creating another time lag between a cost and its payment.

We can now finish off our table and walk through from earnings to decrease in net debt:

FROM THE INCOME STATEMENT . . . TO THE CASH FLOW STATEMENT

1. From net income to cash flow

As we have just seen, depreciation, amortisation, impairment losses on fixed assets and provisions are non-cash costs that have no impact on a company’s cash position. From a cash flow standpoint, they are no different from net income.

These two items form the company’s cash flow, which accountants allocate between net income on the one hand and depreciation, amortisation and impairment losses on the other hand, according to the relevant accounting and tax legislation.

The simplicity of the cash flow statement shown in Chapter 2 was probably evident to our readers, but it would not fail to shock traditional accountants, who would find it hard to accept that financial expense should be placed on a par with repayments of borrowings. Raising debt to pay financial expense is not the same as replacing one debt with another. The former makes the company poorer, whereas the latter constitutes liability management.

As a result, traditionalists have managed to establish the concept of cash flow. We need to point out that we would advise computing cash flow before any capital gains (or losses) on asset disposals and before non-recurring items, simply because they are non-recurrent items. Cash flow is only relevant in a cash flow statement if it is not made artificially volatile by inclusion of non-recurring items.

Cash flow is not as pure a concept as EBITDA. That said, a direct link may be established between these two concepts by deriving cash flow from the income statement using the top-down method:

or the bottom-up method:

Cash flow is influenced by the same accounting policies as EBITDA. Likewise, it is not affected by the accounting policies applied to tangible and intangible fixed assets.

Note that the calculation method differs slightly for consolidated accounts,⁶ since the contribution to consolidated net profit made by equity-accounted income is replaced by the dividend payment received. This is attributable to the fact that the parent company does not actually receive the earnings of an associate company since it does not control it, but merely receives a dividend.

Furthermore, cash flow is calculated at group level without taking into account minority interests. This seems logical, since the parent company has control of and allocates the cash flows of its fully-consolidated subsidiaries even if they are not fully owned. In the cash flow statement, minority interests in the controlled subsidiaries are reflected only through the dividend payments that they receive.

Lastly, readers should beware of cash flow as there are nearly as many definitions of cash flow as there are companies in the world!

The preceding definition is widely used, but frequently free cash flows, cash flow from operating activities and operating cash flow are simply called “cash flow” by some professionals. So it is safest to check which cash flow they are talking about.

2. From cash flow to cash flow from operating activities

In Chapter 2 we introduced the concept of cash flow from operating activities, which is not the same as cash flow.

To go from cash flow to cash flow from operating activities, we need to adjust for the timing differences in cash flows linked to the operating cycle.

This gives us the following equation:

Note that the term “operating activities” is used here in a fairly broad sense, since it includes financial expense and corporate income tax.

3. Other movements in cash

We have now isolated the movements in cash deriving from the operating cycle, so we can proceed to allocate the other movements to the investment and financing cycles.

The investment cycle includes:

• capital expenditures (acquisitions of tangible and intangible assets);
• disposals of fixed assets, i.e. the price at which fixed assets are sold and not any capital gains or losses (which do not represent cash flows);
• changes in long-term investments (i.e. financial assets).

Where appropriate, we may also factor in the impact of timing differences in cash flows generated by this cycle, notably non-operating working capital (e.g. amount owed to a supplier of a fixed asset).

The financing cycle includes:

• capital increases in cash, the payment of dividends (i.e. payment out of the previous year’s net profit) and share buy-backs;
• change in net debt resulting from the repayment of (short-, medium- and long-term) borrowings, new borrowings, changes in marketable securities (short-term investments) and changes in cash and equivalents.

This brings us back to the cash flow statement in Chapter 2, but using the indirect method, which starts with net income and classifies cash flows by cycle (i.e. operating, investing or financing activities; see next page).

In practice, most companies publish a cash flow statement that starts with net income and moves down to changes in “cash and equivalents” or change in “cash”, a poorly defined concept since certain companies include marketable securities while others deduct bank overdrafts and short-term borrowings.

Net debt reflects the level of indebtedness of a company much better than cash and cash equivalents or than cash and cash equivalents minus short-term borrowings, since the latter are only a portion of the debt position of a company. On the one hand, one can infer relevant conclusions from changes in the net debt position of a company. On the other hand, changes in cash and cash equivalents are rarely relevant as it is so easy to increase cash on the balance sheet at the closing date: simply get into long-term debt and put the proceeds in a bank account! Cash on the balance sheet has increased but net debt is still the same.

CASH FLOW STATEMENT FOR ARCELORMITTAL ($M)

As we will see in Chapter 35, net debt is managed globally and looking at only one side (cash and cash equivalents and marketable securities) is therefore of little interest.