Cash-Flow Hocus-Pocus
Many investors believe that cash flow is relatively immune to accounting games that companies have used to pump up earnings, but that is not necessarily true. Indeed, companies have found many opportunities to manipulate cash flow in order to shed a more favorable light on themselves.
Much of the manipulation is aimed at pumping up cash flow from operations - the first and most scrutinized of the three sections in the Consolidated Statements of Cash Flow that follow the Income Statement and Balance Sheet in corporate financial reports. (The two other sections report on cash raised or used through investing and financing activities.)
Management has an incentive to make its operating cash flow look good. Wall Street pays a premium for the stocks of companies whose core businesses generate prodigious amounts of cash. In fact, investors often look down on companies that can raise cash only through financings, such as debt offerings, or investment-related activities such as asset sales. After all, they can't sustain themselves indefinitely that way.
If you only look at cash from operations and take it at face value, you're not getting the whole picture. Of course, it's not always obvious when companies play fast and loose with the numbers.
One way companies boost operating cash is by securitizimg - or selling - their accounts receivable. These are the bills customers owe. By selling receivables, a company speeds its cash collections, taking into its coffers immediately the cash it would normally collect in the future. (There is a drawback. To sell those receivables, the company will have to accept fewer dollars than had it waited for the customers to pay.)
This is not necessarily a problem. Selling receivables can be a legitimate cash-management strategy. If the receivable sales increase each year at the same rate as revenues, the impact on the cash-flow statement is minimal. But when a company starts or steps up a securitization program, it can create the impression that the operating cash flow in that year is better than it really is.
Companies can also keep their operating cash flow high by the way they account for outstanding checks. (When a company delays payments to creditors, its cash balances rise.) Because the checks had yet to clear, the company is able to take advantage of generally accepted accounting principles (GAAP) that allow overdrafts to be lumped into accounts payable. So instead of reducing operating cash, the large balance of outstanding checks actually inflates it.
Another dubious source of operating cash is securities trading. Although GAAP rules allow cash raised by securities sales into the operating section of the cash-flow statement, it still comes from activities unrelated to the core operations of most businesses. As such, when gauging a company's underlying health, investors should exclude it from operating cash.
Certain companies have also given operating cash flow a lift by capitalizing some expenses. This maneuver boosts the bottom line, too. Why? When a company capitalizes costs, it creates an asset on the balance sheet and writes off the costs of establishing that asset gradually, in annual installments, instead of all at once.
How can capitalization boost operating cash flow? Normally, as a company spends money to produce goods, it deducts those costs from net income and thus, operating cash flow. But when a company capitalizes certain costs - the footnotes to annual reports are a good place to discover if this is happening - cash that goes out the door is considered an investment in an asset. As such, it is recorded on the cash-flow statement as a deduction to cash flow from investing activities. While the company's overall cash - what you get by adding the numbers from all three sections of the cash-flow statement - remains the same, its cash flow from operations is untouched. As a result, its operating cash flow will look better than companies that do not capitalize.
Cash flow is as vulnerable to manipulation as net income. So before using it as a measure of financial health, you have to check for the practices that mask weak performance or produce one-time gains.
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Much of the manipulation is aimed at pumping up cash flow from operations - the first and most scrutinized of the three sections in the Consolidated Statements of Cash Flow that follow the Income Statement and Balance Sheet in corporate financial reports. (The two other sections report on cash raised or used through investing and financing activities.)
Management has an incentive to make its operating cash flow look good. Wall Street pays a premium for the stocks of companies whose core businesses generate prodigious amounts of cash. In fact, investors often look down on companies that can raise cash only through financings, such as debt offerings, or investment-related activities such as asset sales. After all, they can't sustain themselves indefinitely that way.
If you only look at cash from operations and take it at face value, you're not getting the whole picture. Of course, it's not always obvious when companies play fast and loose with the numbers.
One way companies boost operating cash is by securitizimg - or selling - their accounts receivable. These are the bills customers owe. By selling receivables, a company speeds its cash collections, taking into its coffers immediately the cash it would normally collect in the future. (There is a drawback. To sell those receivables, the company will have to accept fewer dollars than had it waited for the customers to pay.)
This is not necessarily a problem. Selling receivables can be a legitimate cash-management strategy. If the receivable sales increase each year at the same rate as revenues, the impact on the cash-flow statement is minimal. But when a company starts or steps up a securitization program, it can create the impression that the operating cash flow in that year is better than it really is.
Companies can also keep their operating cash flow high by the way they account for outstanding checks. (When a company delays payments to creditors, its cash balances rise.) Because the checks had yet to clear, the company is able to take advantage of generally accepted accounting principles (GAAP) that allow overdrafts to be lumped into accounts payable. So instead of reducing operating cash, the large balance of outstanding checks actually inflates it.
Another dubious source of operating cash is securities trading. Although GAAP rules allow cash raised by securities sales into the operating section of the cash-flow statement, it still comes from activities unrelated to the core operations of most businesses. As such, when gauging a company's underlying health, investors should exclude it from operating cash.
Certain companies have also given operating cash flow a lift by capitalizing some expenses. This maneuver boosts the bottom line, too. Why? When a company capitalizes costs, it creates an asset on the balance sheet and writes off the costs of establishing that asset gradually, in annual installments, instead of all at once.
How can capitalization boost operating cash flow? Normally, as a company spends money to produce goods, it deducts those costs from net income and thus, operating cash flow. But when a company capitalizes certain costs - the footnotes to annual reports are a good place to discover if this is happening - cash that goes out the door is considered an investment in an asset. As such, it is recorded on the cash-flow statement as a deduction to cash flow from investing activities. While the company's overall cash - what you get by adding the numbers from all three sections of the cash-flow statement - remains the same, its cash flow from operations is untouched. As a result, its operating cash flow will look better than companies that do not capitalize.
Cash flow is as vulnerable to manipulation as net income. So before using it as a measure of financial health, you have to check for the practices that mask weak performance or produce one-time gains.
* * * * *
posted by Bob Moser at
3:22 PM
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