November 6, 2019 9

How to read a cash flow statement: Alphabet Inc case study

How to read a cash flow statement: Alphabet Inc case study


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. Thank you for watching! If you enjoyed this explanation of how to
read a cash flow statement and how to perform a cash flow statement analysis, then please
give it a thumbs up! On this end screen, there are a few suggestions
of videos you can watch next. Please subscribe to the Finance Storyteller
YouTube channel! Thank you.

9 Replies to “How to read a cash flow statement: Alphabet Inc case study”

  • P k says:

    Hi there, if the company generated 37.1bln CFO how dos they made investiments of 94bln? Where the Money came from?

  • P k says:

    What about the provision that they in the PL?

  • Kenneth Beard says:

    Philip, at about 3:40 you mention that most companies use the "indirect method" of Cash Flow reporting. Could you please comment briefly on this? What alternatives exist, how do they work, are there advantages / disadvantages and does is make a material difference as they should all always "balance back"? This topic of Cash Flow has always been more challenging to follow but your structured approach with clear explanation and supporting slides really make it easier to follow. I am analyzing a company of interest to test my comprehension of the application of this knowledge as well as learn about this company so I did the hi-level Cash Flow walk and it worked. In my example there were small absolute differences but I recognized that they corresponded to two line items (for adjustments "in assets accordance with IFRS5" which helped me to reconcile perfectly.

  • NONIT TIWARI says:

    Hii

  • Shivkumar Kalyanaraman says:

    Is repurchases of capital stock returning money to shareholders (i thought that was treasury stock)? If not – what is it trying to achieve? Something to do with stock options ? But there is another line item there above it on stock based compensation…

  • Sabin Tee says:

    so glad i found your channel, everything is super helpful for my accounting classes

  • NICOLAS SUAREZ says:

    GREAT, I loved it, great job,

  • angelo senlob says:

    bravo. I am learning a lot. Good method. Saluti e auguri

  • angelo senlob says:

    if you want to do it really GREAT, for us students, do the same for different sample COMPANIES from differents sectors/industries ….thank you in advance.

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