BITS > MAY 2004

Analyzing Cash Flow -- A Peek at the Bottom Line

(Editor's note: This is the first of two articles on cash flow.)

At the end of April, I-Club-List subscribers Paul Schneider and C.H. Hodgkin got in a friendly online discussion about the importance of monitoring a company's cash flow.

Schneider, who thanks his understanding of the games accountants play with cash flow balance sheets for protecting him from several bad buys, advocated that fellow list members also learn how to recognize when cash flow isn't up to snuff.

Meanwhile Hodgkin was a little more skeptical, arguing that while cash flow is a factor, it too can be manipulated by a company intent on mischief, so a busy investor should look at other factors first.

Who's right?

Both. If managers didn't play these games, earnings would be a better indicator, but cash flow is much harder to manipulate, says Ed Ketz, an associate professor of accounting at Penn State University's Smeal College of Business and an expert on accounting fraud. So you need to look at cash flow because it's the real thing.

Why is cash flow so important? One reason is that you don't need to be an accounting genius to figure it out. Cash flow is crucial and people can look at it without performing a lot of complex calculations, says Jordan E. Goodman, author of Reading Between the Lies: How To Detect Fraud and Avoid Becoming a Victim of Wall Street's Next Scandal.

Goodman says that companies that generate excess cash flow have the potential to accomplish all kinds of good things, including:

• Raise their dividend payments.
• Repurchase company shares.
• Make strategic acquisitions.
• Ride out rough times without adopting short-term strategies to alleviate cash shortages that aren't in the long-term interest of the company.
• Be acquired because of their strong financial position.

What exactly is cash flow?

Ellis Traub explains cash flow this way: "Just as the income statement is a measure of activity over a period of time, so is a cash flow statement. This means it has a starting place and an ending place.

"Think of a company as a cigar box into which the coins are thrown when they're taken in and they're taken out to pay the expenses. You can either count the coins as they go in or you can count them when you start and when you finish. In either case, you know what happened during the time elapsed."

Here's a (only slightly) more complicated explanation:

Every quarter, a public company is required to release a cash-flow statement. It's similar to what the bank sends you each month reporting on activity in a checking account ? how many deposits you've made, how many checks you've written, fees charged, etc.

A cash-flow statement has three parts:

• Cash from operating activities, which is sales and collections.
• Cash from investing activities, which is earnings from stocks and bonds.
• Cash from financing activities, which are loans or sales of stock.

Two other basic facts about cash flow worth knowing:

Generally accepted accounting principles (GAAP) require a company to report earnings a little differently from the way most of us probably report it in our personal accounts. A company has to recognize revenue when the transaction occurs ? that is, whether it was actually paid or is still waiting, the company has to record the income.

Also, the cost of a transaction must be recognized over the same period of time that the revenue associated with the cost is generated. For instance, if a company was paid for work, the cost of materials has to be recorded as if it that money had been spent, even though the job may not have been accomplished yet.

In many cases you hope that a company's cash from operating activities is a positive number while the other two numbers -- cash from investing and financing activities -- are negative numbers. Why? An established business in good financial shape finances new investments internally and pays down debt with existing cash.

If a lot of people had been staring critically at Enron's cash flow for the last two years before the bankruptcy, they would have noticed that the cash flow from operations was negative for both those years, Ketz says. Red flags should have gone up.

Another situation that might attract an investor's attention, Ketz says, is when a company's revenues are going up while the cash flow is going down.