When cash flows should include ‘non-cash flows’

Last updated 29 February 2024

The problem with cash flow statements is that they only include cash flows. This may seem odd, given that the purpose of cash flow statements is simply to report cash movements. However, most cash flow analysis is focused on sub-totals and it is here that offsetting flows arising from non-cash transactions become important.

We explain why we believe adjustments to cash flow sub-totals are required and for which transactions you should adjust.

If you are analysing cash flows, a transaction that does not result in an actual cash flow can still matter if your focus is on a cash flow subtotal, such as free cash flow or operating cash flow. Perhaps the best example, and a particularly topical one considering the imminent change to lease accounting due to IFRS 16, is new capitalised leases.

When a company enters into a new lease there is generally no initial cash flow and hence nothing appears in the cash flow statement. Of course, there are the subsequent lease payments which, for a capitalised lease, would be split between the interest and principal repayment components. Under IFRS the interest flow is included in operating or financing according to the accounting policy selected by the company and the capital element in financing. The problem is that we do not consider this to be enough to easily obtain relevant cash flow subtotals.

Capitalising a lease is in effect two offsetting cash flows

When a new lease is capitalised, a company reports an increase in fixed assets (specifically a right of use asset) and an increase in lease obligations. The two offset and there is no cash movement. However, suppose that the company had purchased the asset with the transaction financed by debt. In that case there would have been an investing outflow for capital expenditure and a financing inflow representing the increase in borrowings. Free cash flow would therefore be reduced by the additional capital expenditure. But purchasing an asset financed by debt is economically the same (or at least very close to being the same) as a new capitalised lease and it would seem odd to report a different free cash flow metric.

In effect, capitalising a lease contract involves two cash flows that offset: a cash inflow from the new lease finance and an outflow to purchase the (right of use) fixed asset.  If you are focusing on a cash flow metric that incorporates both or neither of these ‘effective flows’, such as operating cash flow in the case of leasing, then there is not a problem. But if your focus is on a subtotal where only one of these flows would be included, such as free cash flow, then the offsetting effective flows matter a lot.

This table shows the adjustment required.

Illustration: Cash flow subtotals adjusted for effective flows from capitalised leases
Source: The Footnotes Analyst

We have seen some investors trying to correct for the lack of capital expenditure when asset purchases are financed through leasing by reclassifying the lease payments in respect of capitalised leases as an investing cash outflow. This is certainly better than making no adjustment at all, but we think it is inferior to the recognition of the offsetting effective flows themselves. The problem is one of timing. Current period lease payments do not equate to current period acquisition of assets.

Where do you find these effective flows?

Although companies do not report the ‘effective’ investing and financing flows arising from finance leases in the actual cash flow statement, IAS 7, the applicable IFRS standard, does require that significant non-cash transactions are disclosed. Ideally we would like to see these on the same page as the cash flow statement itself or at least their location clearly referenced in that statement. Unfortunately this is not always the case and you may have to search for them.

A new disclosure recently introduced by the IASB helps for those effective cash flows that involve financing. This is the requirement to reconcile the opening and closing debt position in the balance sheet.  Both the financing flows due to cash transactions and those that are non-cash, such as new finance leases, need to be identified.

Examples of other effective flows

New capitalised leases are not the only non-cash transaction for which adjustment may be required to obtain relevant cash flow sub-totals. Anything that involves offsetting flows could require adjustment. Here are some other examples:

  • Pension service costs
  • Share based payments
  • Business combinations where the consideration is non-cash
  • Reverse factoring

We may examine some of these in more detail in future Footnotes Analyst articles.

Insights for investors

  • Transactions that do not result in an actual cash flow may, in effect, comprise two offsetting flows with differing characteristics.
  • Cash flow subtotals may be incomplete and not useful for equity analysis unless certain flows arsing from ‘non-cash’ transactions are included.
  • Remember not to double count. Because non-cash transactions can have (generally) later real cash flows it is important that this real flow is classified in a consistent manner. For example, don’t included in free cash flow both the effective capital expenditure and the lease rental payments in respect of capitalised leases.
  • You only need to make an adjustment if just one side of the transaction affects the cash flow subtotal. If your cash flow subtotal includes both or neither effective flow then do nothing.

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