Cash Flow Indicates Company’s Health

Published by slang August 5th, 2006 in CCC, Financial Strategy, Personal Finance

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In the Edge, Malaysia (3/8/06) there was a very interestingly article pertaining to the importance of cash flow. This is especially useful when it relates to your own personal investment. The keynotes: earnings can be easily manipulated but not cash flow & it is the key to the lock of the company’s health
Read on:
On August 2, at a luncheon talk in Kuala Lumpur on “ Identifying Potential Financial Reporting Abuses” organized by Chartered Financial Analysts (CFA) Malaysia the speaker, the principal of Sanskar Investments, Chicago-based fund manager Jay Taparia shared his insight:

Smart investors look at the cash flow statement of companies first instead of the income statement to understand the actual financial health. There were always cases of companies manipulating their accounts to make their figures “a bit rosier”;
Such manipulation was abetted by loopholes in accounting standards. The Generally Accepted Accounting Principles (GAAP) were more open for manipulation compared to simple cash accounting;
Small business accounting has always been on a cash basis and it is much harder to manipulate;
Income statements are prone to manipulation, as there are multiple ways to account for every line item on income statements;
As for revenue, it could be recognised under three different scenarios – when cash came in the door, when contract signed but no cash received and when probability that contract will be signed is high;
For instance, revenue overstatement could occur via “channel stuffing” where companies place inventory on client sites and booked them as revenue even though the cash was not received.

Interestingly, he further shared his opinion which we should try to appreciate:

As an investor and money manager, he does not use the income statement anymore and he is overly concerned about earnings per share or price-to-earnings ratios;
he preferred to use the cash flow statement as it was relatively the same each time as the corporate cheque book had to be reconciled to cash;
the bottomline is – if we see revenue and net income increase and cash flow from operations decrease, be suspicious about tomfoolery. Cold hard cash never lies.;
Investors would want to have ethical and motivated management whose main objective was to maximise cash flow and thus shareholder value alongside with their own and
Shareholder-friendliness and management who care about how their employees are treated have always paid well to shareholders.

Companies under pressure to manipulate financials are:

High growth (expectation) industries – companies under heavy pressure from competitors and shareholders – high-risk industries (for example technology and biotechnology companies;
Management under fire to short-term results (for example, first net profit, turnaround, new management team, post acquisition);
Managements that stand to gain short-term personal windfalls for “results”;
Companies inordinately dependent on high share price to support continuing operations (ability to get loans, acquisitions); and
In a market of “irrational exuberance” – any company afraid of being left behind.

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