Seeing red in rather unusual cashflow creativity

By Alan J Robb and Sue Newberry

Friday 27th February 2004

Creativity or spin in reporting company results makes things look different from what they really are.

Most attention is focused on the creative reporting of profits and balance sheet data. Cashflows too can be creatively reported. Telecom and Alliance Group have each contributed a fascinating example, apparently unnoticed by analysts.

Successful operating performance requires any company does more than make a profit. The ultimate bottom line in business involves making a profit on a transaction, turning it into cash and doing it continuously. A company that reports profits but fails to generate positive cashflows from operations has problems, just as a company with positive operating cash flows but fails to make profits also has problems.

Telecom's recent half-yearly announcement reported net earnings after tax of $365 million up 21.3% and operating cashflow of $828 million, up 6.7%. Both portray satisfactory performance.

When discussing the outcome of Australian operations, chairman Roderick Deane acknowledged losses were being made but said the company operated "on a cashflow positive basis" of about $100 million on an annualised basis.

A footnote disclosed that this $100 million is calculated as ebitda (earnings before interest, tax, depreciation and amortisation) less capex (capital expenditure). In an earlier media release Telecom had called this "indicative cashflow."

This is unlikely to be a reliable measure of operating cashflow. First, it starts with an accrual measure (ebitda), which is known to be a poor surrogate for operating cashflow (NBR, Sept 1, 2000). Then a deduction is made for capex, part of which may not have involved a cash outflow.

There is also no reason to deduct capex even were it all in cash. Such cash outflows are always investing outflows, never operating cash flows.

Telecom reported group net cashflows from operations for the past three years of $1758 million, $1351 million and $1566 million. "Indicative cash -flows" for the group would have been $1802 million or 103% of net operating cash flow, $625 million (46%) and $1716 million (110%). A variation from 46% to 110% suggests Telecom's creation is unlikely to be a reliable indicator of the cashflows from the Australian operations.

A spokesman for Telecom admitted indicative cashflow was "not the most robust number in the pack" but claimed Telecom did not compute actual cashflows for divisions.

Telecom's creativity in devising "indicative cashflows" does not result in meaningful information. It should be dropped and actual cashflows from operations reported.

Alliance Group is the creator of another cashflow horror. It has been in its reports since 1994. That year Alliance faced a profit drop from $6.4 million to only $352,000 on sales that were virtually unchanged at $791 million. Cashflow from operations fell even more, from a net inflow of $41 million to a net outflow of $68.4 million.

The chairman's review carefully avoided any reference to the $108 million deterioration in operating cashflow. Instead he drew attention to the fact that "cashflow from operations (before working capital movements)" was positive at $12.3 million compared with $17.7 million the previous year.

Cashflow from operations (before working capital movements) is not known in the relevant accounting standard, nor have I ever come across it in any cashflow literature. It seems to be an Alliance creation.

Like the Telecom example it is not a measure of actual cashflow. It is merely a subtotal in the reconciliation between net profit after tax and cash from operations.

In the accounting standard the subtotal, quite properly, does not warrant a name. It is surprising that Alliance's auditor, KPMG, allowed the description in the notes to the accounts. KPMG's own set of model financial statements do not indulge in such creative terminology.

Alan Robb and Sue Newberry are senior lecturers in accountancy at the University of Canterbury

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