Posts tagged ‘cash flow statement’
Cash Flow Statement: Game of Cat & Mouse
Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.
Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.
Beware of the Income Statement Cheaters
Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:
- Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
- Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
- Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.
There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.
Cash Flow Statement to the Rescue
Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.
Financial Birth Certificate
As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).
The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis – especially reviewing the cash flow statement – investors (like cats) can more slyly evaluate the financial path of target companies (mice). Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Financial Statements: Monetary X-Rays for Decision Makers
Virtually everyone has been to a doctor’s office or hospital, and at some point gotten an x-ray. Typically, multiple x-rays are taken to give the doctor adequate data for determining a patient’s health and well-being. For example, a dentist will take numerous views in searching for disease and cavities, above and below the surface of the mouth. When it comes to financial markets, the same diagnostic principles apply to securities analysis. But rather than x-rays, we have financial statements. The income statement, balance sheet, and cash flow statement provide analysts multiple angles for making a proper company diagnosis. Each financial statement provides the user a unique perspective, and together, the statements paint a more complete picture into the financial condition of a company. In the coming weeks (and months), I will take a deeper dive into the world of financial statement analysis.
Financial Statement Reporting
What is the purpose of financial statement analysis?
“The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.” -Howard Schilit (author of Financial Shenanigans)
Sounds simple and pure in its aim, but as we will find out, there can be more to financial statements than meets the eye (see also EPS Tricks of the Trade). In order to profit (and protect oneself), financial statement users need to read between the lines.
The Bookkeeper Police
Policing the integrity of the financial bookkeeping process are the FASB (Financial Accounting Standards Board) – the entity behind the creation of GAAP (Generally Accepted Accounting Principles) – and the SEC (Securities and Exchange Commission). Unfortunately the goals of management (maximize wealth and shareholder value) do not always align with the objectives of financial statement users (accuracy and transparency). As we found out from the case of Bernie Madoff, investors cannot always rely on the SEC for law enforcement. A deep-rooted foundation in financial statement analysis mixed in with some common sense may protect you from some major financial pitfalls.
Why are Financial Statements so Important?
Transparency of Capital Markets: Our capitalistic society is based on the trust and transparency of available financial information, so key decision makers can make informed decisions. In many emerging markets, standards are more lax and well-versed decisions are more difficult to make. Ultimately, if you believe in free markets, money migrates to where it is treated best. Reliable and transparent financial systems build investor confidence and make our system work. When companies like AIG and Enron have complex derivatives and opaque off balance sheet structures that are not clearly disclosed, then investors and key decision makers are at a disadvantage. The companies generally suffer as well, since investors afford lower valuations for complex organizations.
Investment Bankers / Sell Side Research: Investment bankers rely heavily on financial statements when determining the suitability of corporate marriage. A company cannot be bought or sold without determining an agreed-upon valuation. Financial statements help bankers establish an appropriate price for transactions.
Competitors: We live in a dog eat dog world. Assessing the strength and effectiveness of various competitor initiatives can lead to better decision making. For example, one can simply compare the revenue growth rates of two companies to determine who is gaining market share. In tough times like now, an analyst can look at items such as debt load on the balance sheet or cash generation on the cash flow statement to determine how a company is positioned to weather a potential cash crunch.
Employment/Compensation: Astute financial analysis by job seekers can lead to tremendous insights into a company’s financial condition. The process can also trigger shrewd questions to bounce back at the interviewers. Executives can also look at financial and proxy statements to uncover compensation practices of a company.
Fraud/Inaccuracies: The SEC and other regulatory agencies need tools to hunt down the bad guys and notify those stretching the letter of the law. The SEC and FASB are supposed to act as the industry financial cops. Our trust in these institutions took a deep hit when these organizations failed to catch the corrupt actions of Bernie Madoff, despite the multiple times outsiders waved red flags to the SEC.
IRS/Tax Collection: Uncle Sam wants to collect his revenue, especially in these times of large and expanding deficits. Verifying and auditing the correctness of a company’s tax liabilities can ensure correct tax revenues are accumulated.
Bankers/Creditors: Banks are becoming even more tight-fisted these days, and in order to provide loans to borrowers, financial statements become a key component of the loan equation.
Internal Finance Staff & Consultants: Chief Financial Officers and corporate finance department professionals need financial statements to steer strategy in the right direction. Many companies develop a six sigma type of approach whereby margin and cash flow improvements are targeted. In that vein, internal and external benchmarking can highlight areas of strengths and weaknesses.
For many, financial statement analysis is not the sexiest endeavor. However, I think when properly applied, the process engenders clearer and more confident decision-making. A doctor feels much the same way upon reviewing a set of accurate x-rays and making an informed patient diagnosis. Do yourself a favor and don’t ignore the financial statement components. With appropriate financial analysis, I am confident you can make healthy investment decisions too.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in AIG or other securities mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
How to Make Money in Stocks Using Cash Flows
There you are in front of your computer screen, and lo and behold you notice one of your top 10 positions is down -11% (let’s call it ticker: ABC). With sweaty palms and blood rushing from your head, you manage to click with trembling hands on the ticker symbol that will imminently deliver the dreadful news. A competitor (ticker: XYZ) just pre-announced negative quarterly earnings results, and an investment bank, Silverman Sax, has decided to downgrade ABC on fears of a negative spill-over effect. What do you do now? Sell immediately on the cockroach theory – seeing one piece of bad news may mean there are many more dreadful pieces of information lurking behind the scenes? Or, should you back up the truck to take advantage of a massive buying opportunity?
Thank goodness to our good friend, cash flow, which can help supply answers to these crucial questions. Without an ability to value the shares of stock, any decision to buy or sell will be purely based on gut-based emotions. Many Wall Street analysts follow this lemming based analysis when whipping around their ratings (see The Yuppie Bounce & the Lemming Leap). As I talk about in my book, How I Managed $20,000,000,000.00 by Age 32, I strongly believe successful investing requires a healthy balance between the art and the science. Using instinct to tap into critical experience acknowledges the importance of the artistic aspects of investing. Unfortunately, I know few (actually zero) investors that have successfully invested over the long-run by solely relying on their gut.
A winning investment strategy, I argue, includes a systematic, disciplined approach with objective quantitative measures to help guide decision making. For me, the science I depend on includes a substantial reliance on cash flow analysis (See Cash Flow Components Here). What I also like to call this tool is my cash register. Any business you look at will have cash coming into the register, and cash going out of it. Based on the capital needs, cash availability, and growth projects, money will furthermore be flowing in and out of the cash register. By studying these cash flow components, we gain a much clearer lens into the vitality of a business and can quickly identify the choke points.
ACCOUNTING GAMES
The other financial statements definitely shed additional light on the fitness of a company as well, but the income statement, in particular, is subject to a lot more potential manipulation. Since the management teams have more discretion in how GAAP (Generally Accepted Accounting Principles) is applied to the income statement, multiple levers can be pulled by the executives to make results look shinier than reality. For example, simply extending the useful life of an asset (e.g., a factory, building, computer, etc.) will have no impact on a company’s cash flow, yet it will instantaneously and magically raise a companies’ earnings out of thin air…voila!
“Stuffing the channel” is another manipulation strategy that can accelerate revenue recognition for a company. For example, let’s assume Company X ships goods to a distributor, Company Y, for the exclusive purpose of recognizing sales. Company X wins because they just increased their sales, Company Y wins because they have more inventory on hand (even if there is no immediate plan for the distributor to pay for that inventory), and the investor gets “hoodwinked” because they are presented artificially inflated sales and income results.
JOINT STRATEGY
These are but just a few examples of why it’s important to use the cash flow statement in conjunction with the income statement to get a truer picture of a company’s valuation and “quality of earnings.” If you don’t believe me, then check out the work done by reputable academics (Konan Chan, Narasimhan Jegadeesh, Louis Chan, and Josef Lakonishok) that show negative differentials between accounting earnings and cash flow are significantly predictive of future stock price performance (Read more).
So the next time a holding craters (or sky-rockets), take an accounting on the state of the company’s cash flows before making any rash decisions to buy or sell. By doing a thorough cash flow analysis, you’ll be well on your way to racking up gains into your cash register.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
Investing Caffeine 
