Sunday, 27 September 2015

Look At The Operating Cash Flow Instead Of Earnings

By Shares Investment 

When a company releases their annual reports, or financial earnings, a specific part that's most looked at, is none other than earnings, or net income.

I mean, yes. It's important, because earnings affect Earnings Per Share, which affects the Price Earnings of the stock and other profitability ratios such as Return on Equity and Return on Assets.

But I'm telling you, as much as it is important for us to look at net income, it can be easily manipulated.

Too easy if you ask me.

That's because elements that make up net income can include “one off gains”, “other income” and other accounting engineering to boost this figure to beautify the income statement.

Operating cash flows however takes a stricter approach to measuring the quality of the operational profits, and it is much harder to manipulate compared to Net income.

Accrued Earnings, Not Counted In Cash Flow
Accrued earnings generally come from accrued sales, where sales are booked and accounted for in the income statement, but not yet received.

This will in turn translate to accrued earnings, which will help boost the different profitability metrics mentioned above.

The operating cash flow will flag such elements and purely take into consideration of cash actually received, so naturally, the accrued earnings will not be included, and thus more conservative as a figure.

Therefore if you see net operating cash flow lesser than net income, you need to start realising that there could be something wrong with the cash cycle, and there might be a need to look at the revenue recognition policy of the company.

Consistency In Operating Cash Flow
Apart from helping you flag the possible manipulation done to the income statement, consistency in operating cash flow, especially when it’s consistently positive and higher than the net income, will tell you that the operational earnings are of “quality”.

Also, a consistency of positive operating cash flow figures will probably help you sleep better at night.

Price To Cash Flow
For comparison purposes, you can also use price/operating cash flow (P/CF) ratio as a metric when you compare a company to its peers.

The important factor to see if the P/CF is a positive one. This will give you a quick insight to see which companies are the cash burners, and which are the better ones in your comparison.

Operating cash flow, though stricter and more conservative then net income, can still be manipulated, although a lot harder.

This is still a better number to look at compared to net income alone and can also serve as a quick metric for you to screen stocks. 

Quote for the day

“Wisdom requires an experience-based knowledge of the world (including, especially, the world of human nature). It requires mental focus, reflecting the ability to analyze and discern the most important aspects of acquired knowledge, knowing what to use and what to discard, almost on a case by case basis (put another way, it requires knowing when to follow rules, but also when the usual rules no longer apply). It requires mediating, refereeing, between the frequently conflicting inputs of emotion and reason, of narrow self-interest and broader social interest, of instant rewards or future gains.” - Stephen Hall