Wednesday, March 23, 2016

Share-based Payments - Be Careful When Studying Financial Reports

Investors studying financial statements of tech companies should pay close attention to some distorting accounting issues. In my opinion, one of such issues are the so-called "Share-based payments". Let me take Twitter as an example.

Below you will find an excerpt from the last Twitter's cash flow statement (page 67):

Please, look at the last line "Net cash provided by operating activities". It seems there is significant progress in the company's performance - Twitter has been able to generate positive and higher cash flows year over year, starting from 2013.

However, the things do not look as bright as somebody could expect. The fifth row entails "Share-based compensation expense". Because it is a non-cash issue (instead of cash payments the company issues stocks), it must be subtracted from other costs resulting in higher cash flow from operations.

However, share-based payments are definitely costs, in fact. The only difference is that these costs are not incured by the company directly but indirectly, by the company's shareholders.

My point of view is such - if the company was to pay the salaries (because share-based payments are a kind of salaries) in cash instead of payments made in shares, then its cash costs would be much higher than those reported in the cash flow statement.

Using other wording, share-based payments are hidden salaries. While many companies use this form of compensation for work, the tech companies are the leaders in using this method. Simply put, they exaggerate.

I have re-calculated Twitter's statement of cash flow from operations to show how this statement would have looked like if share-based payments were paid in cash:

Well, now it looks totally different. Instead of generating positive cash flows, Twitter would have reported negative ones.

Be careful when studying financial statements.

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