A variety of other reporting factors can also affect the operating cash flow number so critical to a lender‘s credit decision-making process. These are summarised in Table 4.3 and discussed below.
4.6.1 Capitalised operating costs
Whether a cost is capitalised or expensed can have a major impact on reported cash flows. Nevertheless, GAAP allows managers a great deal of flexibility in deciding whether operating costs are capitalised or expensed. Clearly, if incurred costs benefit future periods, they should be capitalised and the related cash outflows reported as investing cash outflows. However, as noted previously, when companies are experiencing financial difficulties, managers may choose to capitalise rather than expense certain costs in order to overstate OCF. Several common costs that lenders may wish to scrutinise include capitalised interest costs, software development costs, customer acquisition costs, film production costs and oil exploration costs. The decision facing loan officers is whether these cash outflows are more appropriately reported as investing cash outflows or operating cash outflows.
4.6.2 Insurance reimbursements
Proceeds received from insurance settlements should be reported in the statement of cash flows according to the activity or asset class to which they relate. For example, cash receipts from insurance settlements related to long-term asset investments such as buildings and plants (such as hazard reimbursements) should be reported as investing inflows, not OCF. However, many companies ignore the reason for the insurance reimbursement and report the cash inflow as an operating activity, thereby potentially overstating OCF. Again, credit analysts must decide whether these temporary cash inflows should be included in OCF for underwriting and loan review purposes.
4. 6.3 Business acquisitions
Increases in working capital (for example, accounts receivable and inventory) are reported as uses of cash when the indirect method is used to report OCF. Conversely, working capital declines represent sources of cash. However, GAAP requires that working capital increases resulting from a business acquisition be reported as an investing activity since these assets and liabilities were purchased, not created by a company‘s operations. This creates a potential cash flow reporting problem, since GAAP also requires that the subsequent liquidation of the acquired working capital accounts be reported as an operating activity. Consequently, a company can temporarily increase OCF through an acquisition. Clearly, lenders should be alert for potential cash flow classification problems associated with major business acquisitions made by their borrowers.
4. 6.4 Vendor-related payables
Loan officers should also determine if OCF are increasing because payments on vendor payables are slowing. If a company is experiencing cash flow difficulties, it may delay payment for as long as possible; thereby receiving what is essentially a free temporary loan. GAAP requires that increases in vendor payables be reported as operating sources of funds when the indirect method is used. Therefore, postponing payment of vendors may provide a temporary boost to OCF. The result is that an increase in OCF may not be positive.
4. 6.5 Customer-provided financing
When revenue is collected in advance of being earned, the proceeds received are reported as a liability, a form of customer-provided financing. That liability, typically
referred to as deferred revenue, reflects an obligation borne by the receiving company to provide goods or services to its customers. When those goods or services are provided, the underlying revenue is earned and is reported on the income statement. That recording of revenue is offset by a reduction in deferred revenue.
Deferred revenue is the result of customer-related collections. Accordingly, collections leading to increases in the deferred revenue liability are reported as operating and not as financing sources of cash. Later, when the underlying revenue is earned, increasing revenue and reducing deferred revenue, no operating cash flow is provided. As a result, reductions in deferred revenue are reported as subtractions from net income when computing operating cash flow (Mulford and Comiskey, 2005).
4.6.6 Income tax considerations
GAAP generally requires that cash receipts or disbursements related to all taxes be reported as OCF. While this practice is appropriate for taxes related to operating activities, it is not acceptable for taxes that are incurred due to investing or financing activities. Consequently, when faced with unusual and significant tax cash inflows or outflows that are reported as operating activities, lenders should determine if they really relate to operating activities. If not, these tax cash flows should be reclassified to the investing or financing sections of the statement of cash flows. For example, tax payments related to gains on the sale of a business or buildings are better classified as investing activities.
4. 6.7 Nonrecurring operating transactions
OCF can also be affected by nonrecurring cash flow items. These are cash transactions that do not appear with any regularity, or that are very irregular in amount, and that are
not derived from the core operating activities of a company.16 Examples include restructuring cost payments, litigation settlements, merger-related charges, income tax refunds and contract termination fees. Such items should be removed from reported
OCF to obtain a more sustainable measure of OCF.