Operating Cash Flow: Better Than Net Income?
Courtesy : Investopedia
But operating cash flow doesn't mean EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working Capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.
Overview of the Statement of Cash Flows
The statement of cash flows for non-financial companies consists of three main parts:
- Operating flows - The net cash generated from operations (net income and changes in working capital).
- Investing flows - The net result of capital expenditures, investments, acquisitions, etc.
- Financing flows - The net result of raising cash to fund the other flows or repaying debt.
Accrual Accounting vs. Cash Flows
The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows:
- Cash is used to make inventory.
- Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay).
- Cash is received when the customer pays (which also reduces receivables).
For example, a company may legitimately record a $1 million sale but, because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable.
Harder to Fudge Operating Cash Flows
Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits.
An example of income manipulation is called "stuffing the channel" To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.)
The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem.
Cash Exaggerations
While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).
Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent.
Cash Is King
A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay the piper, suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs.
The Bottom Line
Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but you'll need to do it, because the talking heads and analysts are all too often focused on EPS.
Sir,
ReplyDeleteWhat is the indicator for identifying this character?
Dear Mr.VP
ReplyDeleteVery much useful information to small investors as an education. Your efforts are great with out looking any return..
with ergards
sir govt banning PET bottles use in medicine field n it has to be in glass packing...ur take on it n its imppact on POLYPLEX
ReplyDeleteSince company's major product category is different , not expecting much impact due to this reason. More than that its operations are not limited within India.
DeleteSir,
ReplyDeleteI see a ID named "VALUE-PICKS" in money control MMb , is that you sir ? can we follow there ?
That is not mine.
DeleteSir, to understand better by an example, from the below figures of a company, can I assume that they have good cash flow since net cash from operating activities is Rs.33.90 crores.
ReplyDeleteNet Profit Before Tax : 38.42 (all fig. in crores)
Net Cash From Operating Activities : 33.90
Net Cash (used in)/from Investing Activities : -39.75
Net Cash (used in)/from Financing Activities : 5.90
Net (decrease)/increase In Cash and Cash Equivalents : 0.05
Opening Cash & Cash Equivalents : 1.33
Operating Cash flow is the most important
DeleteDear VP sir,
ReplyDeleteCan u pls comment on marico kaya. Is it still a buy? As the company is cash rich. Has lot of expansion possibilities.. And company has made a turn around with 15% NP on Top line.
Well know promoters. Only listed company from its space.
I would like to know ur view on earnings going forward whether 15% NP margin can be maintained by company?
Can we invest for long term??
Disc: I already bought the stock at 300. Would like to add more.
Pls reply.
At the time of listing itself, I have expressed my positive view on this stock
DeleteI also used to focus only on EPS. This article changed my view. Thanks a lot for this write up.
ReplyDeleteSir.. Does the company release cash flow statement in every quarter with financial results statement? Where can I find these numbers?
ReplyDeleteIt is there in Annual Report
DeleteThanks Sir,
ReplyDeleteThanks for sharing you valuable information for the freshers entering the share market.... It is very useful...
I was going through Forbes Company and just checked its net cash flow .. It turned from negative to positive after 2-3 years . does that mean the company is in good health and ready for expansion .
ReplyDeleteAnyways the company had tied up with Lux International for Vaccum Cleaners and they have orders from government and Railways for purifiers and cleaning activities .
Engineering and Shipping Business is also picking up and Forbes Technosys is also doing good and has a good future ahead .
Do you find value in the stock and I have invested in it from last one year around 550 levels ..
Regards
Not tracking this company
DeleteDear VP,
ReplyDeleteyour comment on -
http://economictimes.indiatimes.com/news/economy/agriculture/foray-into-food-processing-business-kaveri-seed-promoters-plan-stake-sale/articleshow/45237225.cms
please.
thanks.
Let us hope their concentration will not divert.
DeleteDear VP
ReplyDeleteyour view on Gulshan polyols
Dear VP
ReplyDeleteyour view on Gufic Bio and Arvind Remedies
dear what is ur view on Dishman pharma and morepen labs?
ReplyDeleteNot tracking above companies
DeletePlease check morepen labs. i guess it will be a turnaround story with reduction in debts every year. and after so many yrs they have posted a profitable result. the cmp is 11.30.
DeleteDear Sir
ReplyDeleteWhat are your views on CMI FPE ? Is it a turnaround story ?
Regards
Expecting turnaround with revival in Core sector.
DeleteSir, I am not having ID but hope you will publish my query.As far i remember you were super bullish on Arrow Coated and also you are super bullish on SKM Egg products.I am holding only Arrow coated,i want to know whether i should sell some arrow coated shares and buy skm egg or not.which business you are more bullish on for the long term.I hope other readers will also be benefetted from your reply.this is my humble request to you.
ReplyDeleteBoth are good. Arrow coated already turned as a 28 bagger from recommended level .If you are not interested to take much higher level of risk , may think about selling part and investing in SKM
DeleteSir, This is some fantastic learning for us.
ReplyDeleteI request your views on two companies (a) your old recommendation - Sundaram Brake Linings. Do you see multi-bagger returns from here given that they have now put the FX swap related issues with ICICI behind them and also beacuse the auto components industry is booming. (b) Marico Kaya Enterprises - niche business, only listed entity in the space and good promoters with integrity and vision.
I hope Sundaram break will turn around in another few quarter. Don't think each and every listed company will turn as multibagger. For creating a balanced portfolio we should include stocks with different risk return ratio proportionately in our portfolio .If you are including one high risk bet ,there should be some conservative bets too.
DeleteDear VP,
ReplyDeleteShall I buy Mafatlal Industries at CMP?
Business is not growing as expected earlier , not a compelling buy
DeleteThis can make panic to the investors of Mafatlal Industries... :(
DeleteThank you sir for this wonderful article.
ReplyDelete
ReplyDeleteGILLANDERS ARBUTHNOT & CO.LTD.
1
68.95 -0.50 (-0.72%)
Dear Sir,
Would appreciate if you could give your views on GILLANDERS ARBUTHNOT & CO.LTD.
Thanks
View already given , use search option
DeleteDear VP Sir,
DeleteWhen i search it is only displaying the original post. If the name is displayed in comments it is not working using search option. Before it was working.
regards
dear vp sir
ReplyDeleterequesting your view about OPTO CIRUCITS YOUR OLD RECOMMENDATION. LOT of small investors like me waiting your valuable advice. currently it is going down from last one year but still we are hoping due to its niche skill. need your advice pls.
Later suggested to exit when debt issues started
DeleteDear Sir,
ReplyDeleteKindly advise on Nitin spinners. I felt below 3 cases interesting.
1.Increasing sales YOY.
2.Decreasing debt level
3.New capacity addition which will enhance production capacity going forward.
Not tracking it
DeleteVp sir can I buy time technoplast at CMP??
ReplyDeleteNo idea about its promoters, hence no comments
Deletesir ur take on shri renunka sugars at current price 17 for long term...though they have huge debt but ethanol card can play up...
ReplyDeleteDue to policy issues , Sugar sector is turned as a s tricky one .Both Central and Sate Govt's policies impacting.
DeleteYour views on HOV services after the sell of international stake of parent company do you think company can turnaround and is it worth holding with the agreed sales consideration. Your advise would be valuable. Thanks
ReplyDeleteNot tracking it.
DeleteVp sir I am asking these question 7th time. Want to know your view on your old recommendation nath bio gene invested at 147. Your views on the future prospective
ReplyDeleteAnswered multiple tines. No change in my previous view on this stock . Try to raise questions with a 'Name'
DeleteSir, what is your view on Binani Industries?
ReplyDeleteNot tracking it
DeleteSir can you please give your views on Harrisons Malayalam??
ReplyDeleteNegative,
DeleteWhich one one better
ReplyDeleteDeepak fertilisers
Aditya birla chemicals
Aarti industries
Plz do reply
Aditya Birla Chem recommended below Rs.90 in the following link . At current price of Rs.245 , neutral on it. Not tracking others.
Deletehttp://value-picks.blogspot.in/2012/10/aditya-birla-chemicals-better-times.html
Sir, if you can provide you valuable inputs for gulf oil corporation. Thanks
ReplyDeleteSome up side is possible.
DeleteDear VP,
ReplyDeleteWhat is your point of view on Bosch, Nestle, Britannia, LMW and Pidilite Industries?
Regards,
Nitin.
All are suitable for long term passive investors,
DeleteSir
ReplyDeleteWhat is your opinion about Simmonds Marshal ?
Subh Rao
Already expressed my positive opinion about this company @ Rs.47 , below the posting of 'Capital Trust Update' just 10 days back .Stock already gained about 25 % from that level.
DeleteRespected Sir,
ReplyDeleteI came to know about your blog and unbiased views recently, quite impressed about your service and views on various stocks. Am holding for the last 5 years 2 scripts, Kindly advise your views..
1. HMVL
2. INDIA NIPPON ELECTRICALS.
Thank you sir.
VP sir,
ReplyDeleteI am a silent watcher of your blog. Everyday, I open your blog to see the new comments and your advice. You r doing a great job. Hats off to you!
Can you please give your opinion on Multibase India, triveni turbine and praj industries.
Thanks in advance.
Regards,
afreen
Hi Sir,
ReplyDeleteAre you tracking NMDC..it is trading down trend at 140.... your call on SELL/BUY/HOLD ?
Regards
Tej