In The End: Cash Flow Matters Most

July 17th, 2007

There are plenty of great formulas for the value investor; P/E ratio, PEG, EBITDA, EPS, Price/Book, Price/Sales, Profit Margins, ROE, ROA and a whole bunch of others.  The formulas are mostly valuation and profitability formulas to help investors decide what a company should be worth and whether it is ‘cheap’ or not.  There is a fundamental flaw with the way most value investors use the formulas.  They use these formulas (and perhaps a few others) to make the decision about whether to invest at the current share price.  This may not be a good idea and here is why.  Almost every formula listed above (with a few exceptions) can be completely altered by ‘creative’ accounting:

• Example: Price/Book is essentially Share Price Divided by Book Value.  This may not be the most useful ratio as Book Value is greatly influenced by the amount of amortization of assets.  Often times amortizing a building is nothing but a ‘fake’ depreciation of an asset that is actually increasing in value.  This will help understate the book value of the corporation.
• Example: Price/Earnings is another formula that can be influenced by accounting in many ways, such as depreciation.  This will lower the income tax the corporation must pay at the end of the year, but it also can make the company appear to have a lower profit when it might not.  The opposite can also occur to raise the profits so management gets their hefty bonus.
• Accounting Policy Changes: Next time you are looking through an Annual Report, go read some of the fine print.  Often times the company will have some accounting policies they are changing.  This is part of the creative accounting game.  Read it carefully as the earnings from year to year might not be completely based on the company making more money, but on some fundamental accounting changes.  These changes can make it difficult to compare yearly performance and alter the results to help give management that big bonus.

Yes, Generally Accepted Accounting Principles (GAAP) is a great idea and I’m glad we have the rules in place.  It allows us to look at our capital markets and be able to determine with some understanding and level of safety, how the accounting statements work.  But due to all the ways accounting statements can be altered, it should not be the only thing an investor is investigating.  With that said, there is one accounting statement that is more important than most investors realize.  The Statement of Cash Flows is perhaps the most important statement… even more important than the Income Statement! 

My accounting professor used to tell us the Statement of Cash Flows is the most important and under-utilized by investors.  You can’t run a business if you run out of money.  Everyone has heard stories of companies that are actually making money, but are forced to declare bankruptcy due to cash flow problems and running out of money. 

Another reason cash flow is so important is it shows how much money the company is really able to keep and, in the end, re-invest in growth of the corporate entity, or to use in issuing dividends to the investors.  Businesses are in the business to make money, and hopefully be able to keep some of it for re-investment or dividends.  When a business is showing it has the ability to make and keep cash, it will be able to use that cash.  Cash is king in business.  My favorite part of the Cash Flow Statement is “Total Cash Flow From Operating Activities”.  This will tell you if the company is really making money based on operations.

Entry Filed under: Articles