Cash Flow Statement: Earnings Quality 2 comments

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M investment books see the cash flow statement to be as important as the P&L statement for the investor to accurately assess the strength of the company's performance. While I feel the P&L statement is still the most important by virtue of the fact that it is what most people look at and hence makes the most impact, the cash flow statement is important in providing corroborating evidence that the performance is indeed as strong as the P&L statement suggests.

This is where the issue of earnings quality comes in. Using the Singapore reporting standard as a benchmark, the operating cash flow segment of cash flow statement effectively strips away extraordinary gains/losses to allow a clearer look at operational performance. More importantly, it establishes the cash flow that is available to the company, for purposes of financing future growth (as shown under the Investing segment), improving its balance sheet (as shown under the Financing segment through debt repayal), or finally as dividends to shareholder. This cash flow is what I normally corroborate with the operating profit shown in the P&L statement.

Under normal circumstances the growth rate of the two (operating cash flow and operating profit) over the previous year should not diverge too much. Operating cash flow, of course, adds back depreciation but this augmentation is usually cancelled out by the effects of having to invest more working capital as sales grow. Occasionally, of course, this does not happen and this is when the earnings growth as suggested by the P&L statement can be deceiving. If the receivables increase more than proportionately to earnings or revenue, a danger sign, it will immediately show up as a drastic increase in working capital and decreased operating cash flow. If inventory buildup increases more than proportionately, there is a possibility of inability to clear stocks and suggests a future drop in earnings (see Creative Technology as a case study). Generally, the lower the need to invest in working capital, the better. Dell is often quoted as having an excellent business model where it can operate with negative working capital, since it maintains a small inventory (just-in-time delivery), usually collects payment fast (since it sells direct) and due to its scale has the bargaining ability to hold back payables; all this means a strong cash flow and that's why it trades at P/Es of 30-40.

Well usually I don't use cash flow to identify a company which is doing better (in terms of cash flow) than its P&L suggests. As mentioned earlier, I'd rather use it to corroborate the P&L statement figures. The idea is to place as many strong business-related factors on my side as possible before I buy it; I would rather buy a strong company with reasonable valuation than a reasonable company with attractive valuation.