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Can a company with strong earnings still become a disastrous investment? That unfortunate outcome is highly likely if you don’t first analyse your investment target’s cash flow.
Since accrual accounting depends on management’s judgement and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. Two identical companies can have very different income statements if the two companies make different assumptions about depreciation, revenue recognition, and other factors. Hence, we must drill down into a company’s cash flow to get the most accurate sense of its financial healthiness.
There are three proxies for cash flow with which investors can measure a company’s performance: cash flow from operations, EBITDA, and free cash flow. Many new investors can get confused about the differences between them; so can some industry professionals. Here’s a quick guide to help you tell them apart and understand their importance.
Cash flow from operations
Known as CFO for short, this metric tells you exactly how much cash a company generated from regular business activities during a period.
CFO = net income + (noncash) depreciation & amortization + change in working capital
CFO is more objective than net income because it is harder to manipulate CFO than accounting profits. Many unscrupulous techniques can inflate profits, artificially increase the value of assets, or otherwise temporarily make a business look more successful than it really is. To manipulate the income statement, management can simply change how they recognize revenue or calculate depreciation (more on that later). But the ways in which a company could manipulate cash flow – such as selling its accounts receivable to someone else who’s willing to buy debts they might not be able to collect – are much more difficult, making cash flow manipulation a less attractive option for companies trying to distort their numbers.
Free cash flow
Also known as FCF, this metric subtracts capital expenditures (capex) from CFO. It represents the cash during a given period that the company could distribute to its shareholders after it’s finished spending money to build up its own business. FCF’s advantage over CFO is that it accounts for required investments in the business such as capex, which CFO ignores. Think of it as the difference between how much money you have each month before you’ve paid all your regular bills and expenses, and after.
FCF = CFO – capex
It is important to monitor free cash flow over multiple periods and compare the figures to companies within the same industry. Positive free cash flow should indicate that the company can meet its obligations, including funding its operating activities and paying dividends.
EBITDA (short for “earnings before interest, tax, depreciation, and amortization”) is a mixture of CFO, FCF, and accrual accounting. This metric somewhat shows accounting profits, but at the same time, it adjusts for one major non-cash item, which gets you a bit closer to actual cash.
EBITDA = EBIT (earnings before interest and tax) + depreciation & amortization
Depreciation and amortization attempts to account for the ways that a company’s property and equipment lose value over time – its “useful life.” But companies can use different formulas to calculate how that value is lost, and how quickly, which can change the resulting numbers. By comparing EBITDAs for two identical capital-intensive businesses, you can prevent different useful-life estimates from affecting the comparison. However, any difference in management’s revenue-recognition assumptions – for example, does a company record its revenue the moment it books a sale, or when it actually receives the money from that sale? –will still skew the picture.
EBITDA is easy to calculate, making it a widely used proxy for cash flow.
Foolish Bottom Line
Temporary differences between cash flows and the accounting-based profit as known as “net income” are normal. But a persistent divergence might suggest financial problems over time. For example, if a company is aggressively booking revenues from customers who ultimately don’t pay, you could see the high revenue growth in the past several years that isn’t actually backed up by cash receipts. When you’re attempting to measure a company’s earnings quality, always make sure you check its cash flows as well.
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