Net Income Over Cash Flow

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Some Financial Analysts argue that using cash flow will provide a more accurate picture in determining the fair value of a common stock. What gives? They reason that investors should follow where the cash is. Cash flow will track the flow of cash in and out and this is the reason business exists; to get cash.

Things are not that simple, however. Just as net income, cash flow can be easily manipulated. Cash flow here refers to cash flow from operations found on the statement of cash flow published regularly by publicly traded companies.

Let’s take a look at the statement of cash flow for one publicly traded company, (AMZN) and decipher its components. We will use the statement of cash flow for the year ending on 31 december 2004. Here is the source from Yahoo! Finance:

The top part is net income, which is self-explanatory. This is what a company earns during a period of time. For the time period earns $ 588 M. To get into the cash flow figure, we need to add depreciation expense, subtract any increase in accounts receivable and inventory and add any increase in short term liability such as accounts payable. Sometimes, there will be some adjustments made to the net income which will increase or decrease cash flow depending on the charge.

Now here is how companies can manipulate cash flow. This will in effect temporarily give an impression that cash flow has improved markedly.

Temporarily Delaying Payment. This will increase Accounts Payable which in turn will improve cash flow. While only good companies can demand its suppliers to delay payments, all the debt eventually needs to be paid.

Demanding faster payments from customers. While an efficient collection is needed for a firm’s survival, giving less credit to customers will result in them balking away. In the short term, cash flow will improve due to improved collection. In the long run, customers will go to competitors who can offer better credit.

Keeping a tight supply of inventory. While bloated inventory is wasteful, there is a certain level of inventory that is needed to keep a business running. Short-minded management will try to manipulate cash flow by keeping a short supply of inventory. When you run a retail business, certain inventory is needed. It is not similar to a built-to-order company like Dell Inc. (DELL).

These three items vary from quarter to quarter and year to year. When determining fair value, it is best to ignore these fluctuations and focus on operational earnings generated by the company.

Another misleading cue from cash flow is that it adds up depreciation as the amount of cash generated from operations. While depreciation expense is a non-cash transaction, it is a necessary cost of doing business. For example a company bought a computer and depreciate it for five years. For the next five years, the company incur a non-cash charge, which is the reason why we add depreciation expense to our cash flow. However, we need that computer for our operational purpose. Unless we stop spending in our capital expenditure, adding depreciation expense to our cash flow does not make sense. Sure, you enjoy the benefit now. But five years from now, you need to spend money on a new computer, which is a cash outflow.

As with other investing tools, cash flow from operations cannot be used independently of other ratios. Each and every financial ratio has its strengths and weaknesses. I believe that cash flow does not reflect the true earning power of a company because of short-term fluctuations of the balance sheet and the addition of depreciation expense into a firm’s cash flow.

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