Cashflows question

[bob2007]

Hi, I'm new to investing and I've read according to several sources that people say cash flows are more important than earnings, because earnings can be manipulated.

I'm a 2nd year accounting student, and I find have some questions bout that arguement since cashflows can also be manipulated, if anything, possibly even easier.

The increase in debt financing / equity financing increases cashflows during the year. But that is not indicative of an imporving company. In the case wiht cashflows, it also doesn't look at amortization, which is a non cash cost allocation, but doesn't that still have effects on the earnings of the company far down the line?

[Ray Zee]

exactly . i believe a company is only worth some muliple of its average future earnings plus its hard assets. the rest is blue sky.
the earnings can be manipulated some but not over a period of years. but cash flow is also a good indictor of worth.

[adios]

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Hi, I'm new to investing and I've read according to several sources that people say cash flows are more important than earnings, because earnings can be manipulated.

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That's kind of a funny statement isn't it. Not sure what the state of GAAP rules are now (I should know). I believe they've tightened up on rules where companies had a lot of leeway in deferring revenue recognition in order to "smooth out" earnings on a multi quarter basis.

Generally speaking, I think this statement and others like it stem from the fact that often expenses on the income statement are of the non cash variety. For those that aren't adept at understanding them, they may get a different picture of a companys financial position than what really is the case.

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I'm a 2nd year accounting student, and I find have some questions bout that arguement since cashflows can also be manipulated, if anything, possibly even easier.

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Ok. The 10Q has to be examined in it's entirety.

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The increase in debt financing / equity financing increases cashflows during the year. But that is not indicative of an imporving company.

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True. Generally speaking I believe the statements regarding cash flow that you cite are really statements about free cash flow to equity. A company that has negative free cash flow to equity isn't necessarily a bad investment either.

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In the case wiht cashflows, it also doesn't look at amortization, which is a non cash cost allocation, but doesn't that still have effects on the earnings of the company far down the line?

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Generally speaking it depends on the company whether or not investors are concerned with non cash charges like this. Many companies will claim that EBITDA nunbers give a much truer picture of what is going on with their company.

Nice post.

[BadBoyBenny]

Thanks for the post Bob, it should lead to some good discussion.

I agree with most everything Adios has already said (I usually do). I would point out that the investor has to be real careful about a company’s interest expenses and liquidity if looking at EBITDA to value a company.

I have been in past posts one of those people who says they like cash flow numbers better than earnings.

However, anyone using earning or cash flow to value a stock without taking a long look at the balance sheet is just plain ignorant.

I need to make an important distinction here that I should have made in previous posts. When I talk about valuing cash flow over earnings I mean either Operating Cash Flow (OCF) or Free Cash Flow (FCF), depending on the situation. These are both a different concept than plain old cash flow and also very different from each other. I will try to be more specific in the future. If you don’t already know how to define both, you probably have no business investing in individual companies; unless of course you are into technical analysis which I don’t have much trust in.

As an accountant (or soon to be) I’m sure you know this but for other newbie’s sake I’ll give a quick definition to both.

OCF is a company’s cash from operations and excludes financing activities. It describes a company’s ability to either return money to shareholders, or expand the business through capital expenditures (like buying large machines, building new stores, etc.).

FCF is OCF minus capital expenditures and is a pretty good representation of a company’s ability to pay down debt, or return money to shareholders by paying a dividend or buying back shares. Maybe it could be used for acquisitions as well.

A reason I usually look at cash flows as a better indicator, is because posted EPS numbers, and earnings are often pro forma. Many investors (poor ones) use EPS figures from trading or finance sites that are based on a company’s pro forma numbers. Pro forma numbers to me are usually bullshit. I see twenty one-time losses excluded from pro forma numbers for every one-time gain that is excluded. This helps me identify a better “short list” when using stock screeners and making quick evaluations of companies to further investigate. I would never rely on any one number of any kind from any source as a reason to buy a stock without doing due diligence and reading the last 3 year’s 10K’s and the last 4 quarter’s 10Q’s, and doing a further study of the financial statements and management discussion contained therein. Another reason I like cash flows is that PE’s are often calculated using estimated future earnings, while P/FCF ratios are often estimated using Trailing Twelve Month numbers. So you get a more conservative estimate.

There are 2 situations I can think of off the top of my head where cash flows outpacing earnings indicate a strong business model and management that can maximize the value of their operations.

1.) Good management of payables and receivables leading to excess float that the company can use as working capital. This lets them return more money to capex or the shareholders.

2.) Earnings that are hampered by depreciation on expenditures initially funded by debt that has now been paid off. This is also true if the debt is partially paid off and is at a reasonable level of leverage and interest.