Seeing Beyond the Income Statement and Balance Sheet

With yearend approaching I thought I would reissue of my blog dated March 20, 2013 ….

Now that the stock markets are in the spotlight and some are rethinking their investment ideas or options, it is always wise to do your own analysis of a company. Much like when you are analyzing the strength of a company from purely a business perspective, many investors fail to look beyond the highly touted earnings numbers. Actually earnings are often less trustworthy than some realize in that they are open to manipulation and can be deceiving. One area that is important and can tell you a lot about the strength of a company is the cash flow statement.

You’re looking for consistent good business practices

My suggestion is to flip past the income statement to check the cash flow and how it is moving in and out of the business. By checking the cash flow activity you can better understand whether the last batch of earnings generated the money due to consistent good business practices or simply a disguised windfall cash gusher with a “sales pitch” headline.

I strongly suggest a close look at the cash flow activity – both historically and down the road as far as can be reasonably projected. When an investor is trying to buy stocks, they should be prudent in checking on the free cash flow of a company at least once a quarter to see whether it bears any relationship to the net income headlines.

Check for Questionable Sources

Regrettably, the cash flow statement isn’t immune from dubious game playing tactics, either. That is why it is important to take a close look at the components of the cash flow from operations … to make sure that the cash flows are real and reproducible in the approaching quarters, rather than being offset by continual cash outflows that don’t appear on the income statement … such as major capital expenditures, etc. For example, cash flow based on cash net income adjustments for non-cash income statement expenses, e.g., depreciation, can generally indicate favorable results. While an increase in cash flow by delaying payments to vendors (increases accounts payable) … or by underpaying the IRS on taxes … such tactics will eventually surface to hurt an investor later. At the same time, you need to be watchful for decreasing accounts receivables, which may be ordinary in recession times, and you can only do so much to improve collections in such times. And finally, be aware of possible stock-based compensation expense going back to cash flow as possibly being questionable when a company doles out a lot of equity to employees and agrees to use cash in later periods to buyback those shares.

So when I refer to “questionable cash flow sources,” I am referring to items such as changes in taxes payable, tax benefits from stock options, and asset sales … to name a few. I’m not saying that companies listing these sources of cash flow are weak, or that they are engaging in wrongdoings, or that everything is questionable in the charts and/or graphs available are automatically bad news. However, whenever an organization is getting more than 10% of their cash from Operations that are from somewhat questionable or dubious sources, an investor should make sure to check the company’s filings and dig a bit deeper.

A Final Thought

You may be surprised at how many investors or buyers fail to closely check a companies’ cash flow. And this is a mistake … a common mistake. It is important to take time to read past the headlines or romance copy and study a filing, footnotes, etc. and then, you will be in better shape to spot potential trouble areas. Look at it as improving your odds for finding the best-valued stocks or acquisitions that provide you your best ROI.

© Phil Hoffman 2013. All rights reserved

Seeing Beyond the Income Statement and Balance Sheet

Now that the stock markets are in the spotlight and some are rethinking their investment ideas or options, it is always wise to do your own analysis of a company. Much like when you are analyzing the strength of a company from purely a business perspective, many investors fail to look beyond the highly touted earnings numbers. Actually earning are often less trustworthy than some realize in that they are open to manipulation and can be deceiving. One area that is important and can tell you a lot about the strength of a company is the cash flow statement.

You’re looking for consistent good business practices

My suggestion is to flip past the income statement to check the cash flow and how it is moving in and out of the business. By checking the cash flow activity you can better understand whether the last batch of earnings generated the money due to consistent good business practices or simply a disguised windfall cash gusher with a “sales pitch” headline.

I strongly suggest a close look at the cash flow activity – both historically and down the road as far as can be reasonably projected. When an investor is trying to buy stocks, they should be prudent in checking on the free cash flow of a company at least once a quarter to see whether it bears any relationship to the net income headlines.

Check for Questionable Sources

Regrettably, the cash flow statement isn’t immune from dubious game playing tactics, either. That is why it is important to take a close look at the components of the cash flow from operations … to make sure that the cash flows are real and reproducible in the approaching quarters, rather than being offset by continual cash outflows that don’t appear on the income statement … such as major capital expenditures, etc. For example, cash flow based on cash net income adjustments for non-cash income statement expenses, e.g., depreciation, can generally indicate favorable results. While an increase in cash flow by delaying payments to vendors (increases accounts payable) … or by underpaying the IRS on taxes … such tactics will eventually surface to hurt an investor later. At the same time, you need to be watchful for decreasing accounts receivables, which may be ordinary in recession times, and you can only do so much to improve collections in such times. And finally, be aware of possible stock-based compensation expense going back to cash flow as possibly being questionable when a company doles out a lot of equity to employees and agrees to use cash in later periods to buyback those shares.

So when I refer to “questionable cash flow sources,” I am referring to items such as changes in taxes payable, tax benefits from stock options, and asset sales … to name a few. I’m not saying that companies listing these sources of cash flow are weak, or that they are engaging in wrongdoings, or that everything is questionable in the charts and/or graphs available are automatically bad news. However, whenever an organization is getting more than 10% of their cash from Operations that are from somewhat questionable or dubious sources, an investor should make sure to check the company’s filings and dig a bit deeper.

A Final Thought

You may be surprised at how many investors or buyers fail to closely check a companies’ cash flow. And this is a mistake … a common mistake. It is important to take time to read past the headlines or romance copy and study a filing, footnotes, etc. and then, you will be in better shape to spot potential trouble areas. Look at it as improving your odds for finding the best-valued stocks or acquisitions that provide you your best ROI.

© Phil Hoffman 2013. All rights reserved