What is Cash Flow:-
Cash Flow is the true measure of a company’s profitability. It is determined by the net change in cash that enters or leaves a company in a given period.
Why Cash flow and not earnings?
Typically, institutional and individual investors value stocks based on earnings per share and the popular “PE” ratio. This is an inaccurate measure of a company’s true profitability as will be shown below. The main reason for this is the tremendous amount of leeway a company has in calculating its earnings.
The earnings figures that companies are required to report every quarter do not show a company’s true profitability. Unfortunately for the individual investor, today’s GAAP (Generally Accepted Accounting Principles) accounting methods allow a company to report an inflated version of their real profits. These methods often confuse individual investors and prevent them from gaining any real insight into the numbers. They are left to focus on single earnings per share number which can vary from company to company based on their interpretations of GAAP.
Below are some examples of how companies puff up their numbers:
Companies can set up reserves to cover the costs of non-recurring events such as restructuring. These reserves are often called cookie jars and are over-inflated by management because any cash left over after the restructuring can be counted as earnings although it has nothing to do with their operational business results.
Companies can take a special onetime write down if they mismanage their inventory. They can take an immediate “non-recurring” charge to earnings rather than allow the excess inventory to reduce their profitability over the coming quarters as it is sold below cost due to overcapacity in the market.
Companies are allowed to spread the cost of capital intensive equipment and buildings out over the expected lifetime of the item. The specific time amount is up to the company’s discretion so it is possible to make earnings look better in the short term by choosing a longer than necessary depreciation schedule.
Companies can inflate their earnings simply by claiming that they expect to make more money in their pension funds than previously expected. Their rational for doing so is if the fund grows at a higher growth rate, then less money needs to be invested in the short term to obtain the desired future level.
Companies, without real earnings will often try to pitch its pro-forma earnings which exclude nonrecurring charges that cost shareholders real money. Pro Forma results are used to show earnings that might have been achieved if a recent merger or acquisition had occurred at the beginning of a reporting period.
The cash flow statement is prepared in a similar way as balancing of our bank account check book and thus makes it much harder to manipulate than earnings.
If we examine the cash flow statement-
Cash Flow is broken down into the 3 areas-
Operating Activities-:represents all of the cash that was generated/lost from the company’s business operations.
Eg: sales of goods & services purchase of raw materials, payment of taxes, etc.
Investing Activities-:represents the net cash generated/lost from investments
Eg: purchase/sale of bonds, buildings, equipment, etc.
Financing Activities-: represents net cash generated/lost from financial activities Eg: proceeds from issuing stock, payment of dividends, payment of debts, etc.
Focus should be on Cash Flow from Operating Activities because it is the real wealth creation engine of a company. The cash it generates from its business operations is what will drive its future growth. By focusing on Cash Flows from Operating Activities we can screen out cash flows generated by selling property, issuing bonds, capital gains, or any other non-business related methods. Generating cash from non-business related activities is not necessarily bad, but is not a factor in valuing the future profit potential of the company.