How Companies Fake It (With Cash Flow)
Financial shenanigans cost shareholders billions of dollars. This is part of an ongoing series about how to spot Wall Street wrongdoing before it puts your portfolio in jeopardy. See "Is There an Enron Sitting In Your Portfolio?" and "4 Signs a Company Is Fudging Its Quarterly Results" for more.)
Cash is king. And unlike accounting inventions like "earnings per share" and "EBITDA," cash is tangible, fungible, and, heck, certain currencies are even smoke-able, I'm told.
Focusing on cash flow -- instead of the accrual based figures that Wall Street is so fond of -- is a good way for investors to measure a company's financial health and operational strength. That said, measuring a company's cash flow isn't as simple as calculating the difference between how many dollars leave a company's cash register and how many come in.
Just like with revenue and earnings, companies can use a whole range of tricks to manipulate cash flow and hoodwink investors. Savvy managers know that fancy verbiage and accounting sleight of hand can make even the poorest operating cash flow statement look like Warren Buffett's checking account.
Where's the Bacon?
The statement of cash flows is divided into three sections: operating, investing, and financing. Cash flows in and out of these sections depending on the type of activity. Here are some examples of typical inflows and outflows.
Cash Inflow (+)
Cash Outflow (-)
Profits, receivables collections
Vendor payments, marketing costs, salaries, taxes
Plant/equipment sales, investment proceeds
Capital expenditures, asset purchases, acquisitions
Bank borrowings, stock issuance
Loan repayments, stock buybacks, dividend payments
Investors and analysts care most about the operating section of the cash flow statement, and for good reason. This is where the company makes its bacon. You want to see cash generated by the company's operations, not from unsustainable sources such as equipment sales and short-term investments, or from potentially troublesome sources such as borrowing and issuing stock.
Unfortunately, it's not always 100% clear where a company is generating most of its cash from. Here's how to tell whether your stock is cash flush or penny poor.
4 Signs a Company's Pulling a Cash Flow Hustle
1. Capitalizing Normal Operating Expenses: As discussed in the previous article in the series, companies will sometimes treat normal operating expenses as an asset, and shift them to the balance sheet to be amortized (depreciated) over many years. While this boosts profits, it also boosts operating cash flow, because normal expenses (operating cash outflows) get shifted to the investing section as capital expenditures (investing cash outflows).
Red Flag: On the cash flow statement, watch for an unusually large spike in capital expenditures, with a corresponding spike in cash generated from operations. If anything looks fishy, dig further.
2. Misclassifying Inventory Purchases: The costs to acquire or produce inventory that will be sold to customers should almost always be included on the operating section of the cash flow statement. But this isn't always the case.
Take Netflix (NFLX), which Howard Schilit discusses in his classic work, Financial Shenanigans. For years, Netflix has treated its purchase of DVDs -- the essential inventory of its business -- as an investing outflow, rather than an operating outflow. This is especially curious, because most of Netflix's new DVDs are amortized over a period of just one year. Netflix's accounting treatment provides a big boost for its operating cash flows. At the time it went bankrupt last year, competitor Blockbuster had been classifying its DVD purchases as operating outflows.
Red Flag: It's up to you to decide whether Netflix's inventory accounting is proper or not, but the basic takeaway here is that you should always question large investing outflows when they appear to be part of a company's normal cost of operations.
3. Serial Acquirers: Since 2008, industrial and agricultural conglomerate Trimble Navigation (TRMB) has made no less than 22 acquisitions. You might be surprised to learn that, despite all these acquisitions, and the nasty economic downturn, Trimble reported some of the highest operating cash flow results in its history from 2008 to 2010. How is that possible? Through the magic of acquisition accounting.
When one company acquires another, it uses cash (investing outflow) from its balance sheet, or cash from borrowing (financing inflow) or from issuing shares (financing inflow). The beauty here is that all the costs to make the acquisition come out of the investing and financing sections of the cash flow statement, but all the benefits -- increased sales and profits, acquired inventory or receivables that are then sold by the parent company -- are reflected in higher cash inflows on the operating section. Companies like Trimble that make regular acquisitions can repeatedly inflate their operating cash flows simply through the magic of acquisition accounting.
Savvy investors have a way of dispelling this. Trimble may have generated operating cash flow of $495 million from 2008 to 2010, but if you subtract Trimble's capital expenditures and the cash cost of acquisitions -- a measure of Trimble's free cash flow -- it's a much more pedestrian $139 million.
Red Flag: Watch out for companies that make numerous and routine acquisitions. Pay closer attention to free cash flow (operating cash flow less capital expenditures and acquisition costs) to measure the strength of a company's operations.
4. For the Love of EBITDA: Lots of investors come across the term "EBITDA" without knowing what it means. EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a trendy accounting invention that corporate managers like to use as a proxy for their company's operating cash flow. By removing interest and taxes (which are non-operational costs) and depreciation and amortization (which are noncash accrual expenses), managers think they're presenting an appropriate and measurable metric of their company's operational prowess.
My word for EBITDA: fugetaboutit!
Interest and taxes are real cash expenses that should be accounted for. By excluding interest in particular, serial acquirers like Trimble can run up their debt to dangerous levels to acquire a bunch of bad businesses. Their EBITDA might look beautiful in the short term, but the debt and interest payments could eventually sink them. Most worryingly, EBITDA excludes changes to working capital accounts like accounts receivable and inventory, which have real cash impacts on the business.
Red Flag: Avoid companies that like to use EBITDA as a measure of their company's performance, especially if it's tied to management's compensation incentives. Stick to operating cash flow and free cash flow.More ways to spot financial shenanigans before they bring down your portfolio:
Matthew Argersinger does not own shares of any of the stocks mentioned in this article. You can click here to see his holdings and a short bio. Motley Fool newsletter services have recommended buying shares of and put options on Netflix as well as shorting Trimble Navigation.