The Essentials Of Corporate Cash Flow

 Courtesy : Investopedia

If a company reports earnings of $1 billion, does this mean it has this amount of cash in the bank? Not necessarily. Financial statements are based on accrual accounting, which takes into account non-cash items. It does this in an effort to best reflect the financial health of a company. However, accrual accounting may create accounting noise, which sometimes needs to be tuned out so that it's clear how much actual cash a company is generating. The statement of cash flow provides this information, and here we look at what cash flow is and how to read the cash flow statement. 

What Is Cash Flow?

 
Business is all about trade, the exchange of value between two or more parties, and cash is the asset needed for participation in the economic system. For this reason - while some industries are more cash intensive than others - no business can survive in the long run without generating positive cash flow per share for its shareholders. To have a positive cash flow, the company's long-term cash inflows need to exceed its long-term cash outflows.

An outflow of cash occurs when a company transfers funds to another party (either physically or electronically). Such a transfer could be made to pay for employees, suppliers and creditors, or to purchase long-term assets and investments, or even pay for legal expenses and lawsuit settlements. It is important to note that legal transfers of value through debt - a purchase made on credit - is not recorded as a cash outflow until the money actually leaves the company's hands.

A cash inflow is of course the exact opposite; it is any transfer of money that comes into the company's possession. Typically, the majority of a company's cash inflows are from customers, lenders (such as banks or bondholders) and investors who purchase company equity from the company. Occasionally cash flows come from sources like legal settlements or the sale of company real estate or equipment. 

Cash Flow vs Income

 
It is important to note the distinction between being profitable and having positive cash flow transactions: just because a company is bringing in cash does not mean it is making a profit (and vice versa).

For example, say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale: it would prefer to use the equipment to manufacture products and earn an operating profit. But since it cannot, the next best option is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements as well as cash flow statements, not just one or the other.

What Is the Cash Flow Statement?
There are three important parts of a company's financial statements: the balance sheet, the income statement and the cash flow statement. The balance sheet gives a one-time snapshot of a company's assets and liabilities . And the income statement indicates the business's profitability during a certain period.

The cash flow statement differs from these other financial statements because it acts as a kind of corporate checkbook that reconciles the other two statements. Simply put, the cash flow statement records the company's cash transactions (the inflows and outflows) during the given period. It shows whether all those lovely revenues booked on the income statement have actually been collected. At the same time, however, remember that the cash flow does not necessarily show all the company's expenses: not all expenses the company accrues have to be paid right away. So even though the company may have incurred liabilities it must eventually pay, expenses are not recorded as a cash outflow until they are paid (see the section "What Cash Flow Doesn't Tell Us" below).

The following is a list of the various areas of the cash flow statement and what they mean:

Cash flow from operating activities - This section measures the cash used or provided by a company's normal operations. It shows the company's ability to generate consistently positive cash flow from operations. Think of "normal operations" as the core business of the company. For example, Microsoft's normal operating activity is selling software. Cash flows from investing activities - This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement. Cash flows from financing activities - This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases, which investors might be glad to see.

When you look at a cash flow statement, the first thing you should look at is the bottom line item that says something like "net increase/decrease in cash and cash equivalents", since this line reports the overall change in the company's cash and its equivalents (the assets that can be immediately converted into cash) over the last period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the difference between the current CCE and last year's or last quarter's, you'll get this same number found at the bottom of the statement of cash flows.

In the sample Microsoft annual cash flow statement (from June 2004) shown below, we can see that the company ended up with about $9.5 billion more cash at the end of its 2003/04 fiscal year than it had at the beginning of that fiscal year (see "Net Change in Cash and Equivalents"). Digging a little deeper, we see that the company had a negative cash outflow of $2.7 billion from investment activities during the year (see "Net Cash from Investing Activities"); this is likely from the purchase of long-term investments, which have the potential to generate a profit in the future.Generally, a negative cash flow from investing activities are difficult to judge as either good or bad - these cash outflows are investments in future operations of the company (or another company); the outcome plays out over the long term. 

 

The "Net Cash from Operating Activities" reveals that Microsoft generated $14.6 billion in positive cash flow from its usual business operations - a good sign. Notice the company has had similar levels of positive operating cash flow for several years. If this number were to increase or decrease significantly in the upcoming year, it would be a signal of some underlying change in the company's ability to generate cash. 

Digging Deeper into Cash Flow

 
All companies provide cash flow statements as part of their financial statements, but cash flow (net change in cash and equivalents) can also be calculated as net income plus depreciation and other non-cash items.

Generally, a company's principal industry of operation determine what is considered proper cash flow levels; comparing a company's cash flow against its industry peers is a good way to gauge the health of its cash flow situation. A company not generating the same amount of cash as competitors is bound to lose out when times get rough.

Even a company that is shown to be profitable according to accounting standards can go under if there isn't enough cash on hand to pay bills. Comparing amount of cash generated to outstanding debt, known as the operating cash flow ratio, illustrates the company's ability to service its loans and interest payments. If a slight drop in a company's quarterly cash flow would jeopardize its loan payments, that company carries more risk than a company with stronger cash flow levels.

Unlike reported earnings, cash flow allows little room for manipulation. Every company filing reports with the Securities and Exchange Commission (SEC) is required to include a cash flow statement with its quarterly and annual reports. Unless tainted by outright fraud, this statement tells the whole story of cash flow: either the company has cash or it doesn't.

What Cash Flow Doesn't Tell Us
Cash is one of the major lubricants of business activity, but there are certain things that cash flow doesn't shed light on. For example, as we explained above, it doesn't tell us the profit earned or lost during a particular period: profitability is composed also of things that are not cash based. This is true even for numbers on the cash flow statement like "cash increase from sales minus expenses", which may sound like they are indication of profit but are not.

As it doesn't tell the whole profitability story, cash flow doesn't do a very good job of indicating the overall financial well-being of the company. Sure, the statement of cash flow indicates what the company is doing with its cash and where cash is being generated, but these do not reflect the company's entire financial condition. The cash flow statement does not account for liabilities and assets, which are recorded on the balance sheet. Furthermore accounts receivable and accounts payable, each of which can be very large for a company, are also not reflected in the cash flow statement.

In other words, the cash flow statement is a compressed version of the company's checkbook that includes a few other items that affect cash, like the financing section, which shows how much the company spent or collected from the repurchase or sale of stock, the amount of issuance or retirement of debt and the amount the company paid out in dividends.

The Bottom Line
Like so much in the world of finance, the cash flow statement is not straightforward. You must understand the extent to which a company relies on the capital markets and the extent to which it relies on the cash it has itself generated. No matter how profitable a company may be, if it doesn't have the cash to pay its bills, it will be in serious trouble.

At the same time, while investing in a company that shows positive cash flow is desirable, there are also opportunities in companies that aren't yet cash-flow positive. The cash flow statement is simply a piece of the puzzle. So, analyzing it together with the other statements can give you a more overall look at a company' financial health. Remain diligent in your analysis of a company's cash flow statement and you will be well on your way to removing the risk of one of your stocks falling victim to a cash flow crunch.

The Art Of Cutting Your Losses

One of the most enduring sayings on Wall Street is "Cut your losses short and let your winners run." Sage advice, but many investors still appear to do the opposite, selling stocks after a small gain only to watch them head higher, or holding a stock with a small loss, only to see it worsen.

No one will deliberately buy a stock they believe will go down in price and be worth less than what they paid for it. However, buying stocks that drop in value is inherent to the nature of investing. The objective, therefore, is not to avoid losses, but to minimize the losses. Realizing a capital loss before it gets out of hand separates successful investors from the rest. In this article, we'll help you stand out from the crowd and show you how to identify when you should make your move.

Reasons Investors Hold Stocks With Large Unrealized Losses

In spite of the logic for cutting losses short, many small investors are still left holding the proverbial bag. They inevitably end up with a number of stock positions with large unrealized capital losses. At best, it's "dead" money; at worst, it drops further in value and never recovers. Typically, investors believe that the reason they have so many large, unrealized losses is because they bought the stock at the wrong time or it was a matter of bad luck. Rarely do they believe it is because of their own behavioral biases.

Let's look at a few of these biases:

• Stocks Always Bounce Back - Don't They?
  A glance at a long-term chart of any major stock index will see a line that moves from the lower-left corner to the upper right. The stock market, over any long time period, will always make new highs. Knowing that the stock market will go higher, investors mistakenly assume that their stocks will eventually bounce back. However, a stock index is made up of successful companies. It is an index of winners. Those less successful stocks may have been part of an index at one time, but if they've dropped significantly in value, they will eventually be replaced by more successful companies. The indexes are always being replenished by dropping the losers and replacing them with winners. Looking at the major indexes tends to overstate the resiliency of the average stock, which does not necessarily bounce back. In fact, many companies never regain their past highs and some go bankrupt.
• Investors Do Not Like Admitting They've Made a Mistake
  By avoiding selling a stock at a loss, many investors do not have to admit to themselves that they've made a judgment error. Under the false illusion that it is not a loss until the stock is sold, they elect to continue to hold a losing position. In doing so, they avoid the regret of a bad choice. After a stock suffers a loss, many investors plan to hold onto it until it returns to its purchase price. They intend to sell the stock once they recover this paper loss. This means they will break even, and "erase" their mistake. Unfortunately, many of these same stocks will continue to slide.
• Neglect
  When stock portfolios are doing well, investors often tend to them like well-maintained gardens. They show great interest in managing their investments and harvesting the fruits of their labor. However, when their stocks are holding steady or are dropping in value, especially for long time periods, many investors lose interest. As a result, these well-maintained stock portfolios start showing signs of neglect. Rather than weeding out the losers, many investors do nothing at all. Inertia takes over and, instead of pruning their losses, they often let them grow out of control.
• Hope Springs Eternal
  Hope is the belief in the possibility of a positive outcome, even though there is some evidence to the contrary. Hope is also one of the primary theological virtues in various religious traditions. Although hope has its place in theology, it does not belong in the cold hard reality of the stock market. In spite of continuing bad news, investors will steadfastly hold onto their losing stocks, based only on the faint hope that they will at least return to the purchase price. The decision to hold is not based on rational analysis or a well-thought-out strategy; and unfortunately, wishing and hoping that a stock will go up does not make it happen.

Realizing Capital Losses

Often you just have to bite the bullet and sell your stock at a loss before those losses get bigger. The first thing to understand is that hope is not a strategy. An investor has to have a logical reason to hold a losing position. The second point is, what you paid for a stock is irrelevant to its future direction. The stock will go up or down based on forces in the stock market, the stock's underlying fundamentals and its future prospects.

Let's look at a few ways of assuring a small loss does not become "dead" money or turn into a much larger loss.

• Have an Investment Strategy
  Having a written investment strategy with a set of rules both for buying and selling stocks will provide the discipline to sell stocks before the losses blossom. The strategy could be based on fundamental, technical or quantitative factors. 
• Have Reasons to Sell a Stock
  An investor generally has quite a few reasons why he or she bought a stock, but typically no set boundaries for when to sell it. Don't let this happen to you. Set reasons to sell stocks, and sell them when these things occur. The reason could be as simple as: "Sell if bad news is released about corporate developments or a price target." 
• Would You Buy the Stock Now?
  On a regular basis, review every stock you hold and ask yourself the simple question: "If I did not own this stock, would I buy it today?" If the answer is a resounding "No", then it should be sold.

Tax-Loss Harvesting Strategies

A tax-loss harvesting strategy is used to realize capital losses on a regular basis and provides some discipline against holding losing stocks for extended time periods. To put your stock sales in a more positive light, remember that you receive tax credits that can be used to offset taxes on your capital gains.

Conclusion

Taking corrective action before your losses worsen is always a good strategy. In investing, avoiding losses entirely may not be possible; successful investors accept this and try to minimize their losses rather than avoid them. Selling a stock at a loss and receiving a tax credit is one benefit you will receive. Selling these "dogs" has another advantage too - you will not be reminded of your past mistake every time you look at your investment statement.

Top 8 Ways Companies Cook The Books

Courtesy : Investopedia


Every company maneuvers the numbers to a certain extent to achieve budgets and get bonuses. This is nothing new. But sometimes companies take the fact-fudging too far. Factors such as greed, desperation, immorality and bad judgment drive some executives to corporate fraud.
Enron, Aldelphia and WorldCom are extreme examples of companies who cooked the books. They are the few bad apples that get all the headlines. Most companies are run by ethical people. They may bend the rules, but few take the process to the extremes of Enron or WorldCom - companies that claimed billions in assets but promptly went bankrupt when their false claims were exposed. If every company used fraudulent accounting, Wall Street would be empty and we'd all be investing in government bonds. 


What can you do to protect your investments from Enron-style disasters? You need to learn the basic warning signs of earnings manipulation. While the details are usually hidden - even from the accountants - learning these money-manipulation methods will keep you alert to companies who may be cooking the books:

1. Accelerating Revenues

One way to accelerate revenue is booking lump-sum payment as current sales when services will be provided over a number of years. For example, a software service provider receives upfront payment for a four-year service contract but records the full payment as sales of only the period that the payment is received. The correct, more accurate, way is to amortize the revenue over the life of the service contract. (A recent change in accounting standards lead to a revenue boost for many companies that were required to defer revenue over several years. 

A second revenue-acceleration tactic is called "channel stuffing." Here, a manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales; however, the distributor has the right to return any unsold merchandise. Because the goods can be returned and are not guaranteed as a sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.

2. Delaying Expenses
 
AOL got in trouble for this in the early 1990s when it capitalized the costs of making and distributing its CDs. AOL viewed this marketing campaign as a long-term investment and capitalized the expense. This transferred the costs from the income statement to the balance sheet where it was going to be expensed over a period of years. The more conservative (and appropriate) treatment is to expense the cost in the period the CDs were shipped. (The balance sheet is an important tool for gaining insight into a company's operations.

3. Accelerating Expenses Preceding an Acquisition

This may sound a little counter intuitive, but before a merger is completed, the company that is being acquired will pay, possibly prepay, as many expenses as possible. Then, after the merger, the EPS growth rate of the combined entity will be easily boosted when compared to past quarters. Furthermore, the company will have already booked the expense in the previous period.

4. "Non-Recurring" Expenses

By accounting for extraordinary events, these one-time charges were meant to help us better analyze ongoing operating results. It seems, however, that some companies take one of these each year. Then a few quarters later, they "discover" they reserved too much and are able to put something back into income (see next tactic).

5. Other Income or Expense

This category can house a multitude of sins. Here companies book any "excess" reserves from prior charges (non-recurring or otherwise). This is also the place where companies can hide other expenses by netting them against other newfound income. Sources of other income include selling equipment or investments.

6. Pension Plans

If a company has a defined benefit plan, it can use some special techniques to smooth earnings. During a bull market, the company can improve earnings by reducing its pension expense. If the investments in the plan grow faster than the company's assumptions, the company could record this gain as revenue. During the late 1990s, this was done by a number of large firms, some of them blue chips.

7. Off-Balance-Sheet Items
 
A company can create separate legal entities that can house liabilities or incur expenses that the parent company does not want to have on its financial statements. Because the subsidiaries are separate legal entities that are not wholly owned by the parent, they do not have to be recorded on the parent's financial statements and are thus hidden from investors.

8. Synthetic Leases

A synthetic lease can be used to keep the cost of new building from appearing on a company's balance sheet. The lease is a long-term (five- to 10-year) agreement under which a company will pay a fixed lease expense to be in a new headquarters. At the end of the lease, the company is obligated to buy the building, but because of the nature of the lease, this liability is not included on the balance sheet. (Who said accountants were boring and uncreative?) At the time the lease was made, the company may have been in fine financial shape and the economy may have been booming; however, the ability of the company to meet this huge obligation is hard to determine until shortly before maturity (one to two years). 

The Bottom Line

If you tune into the items hidden in a company's financial statements, you may be able to spot some of the warning signs that point to earnings manipulation. This doesn't mean that the company is definitely cooking the books, but if a company makes you suspicious, that's a sure sign that you should dig deeper before making an investment.