The Ins And Outs Of Cash Flow

These reports offer clues about companies' health

When Motorola announced on Oct. 11 that its earnings and sales would fall short of Wall Street's expectations for late 2000 and 2001, the stock plunged 19%. Investors caught in the sell-off had only themselves to blame. The statement of cash flows Motorola published on July 31 showed inventories rising much faster than sales--an imbalance that often points to softening demand for a company's products.

Sure, you've heard of the balance sheet, which notes the company's assets and liabilities. You've probably even looked at your fair share of income statements, which contain the profit and operating earnings figures Wall Streeters rely on when assessing a stock's value or a company's health. But if you really want to put the quality of a company's earnings to the test, you need to examine the cash-flow statement, too.

The cash-flow statement pulls data from the income statement and balance sheet--and adds a few new items as well. Like a corporate version of a bank statement, it tracks the cash coming into and flowing out of a corporation's coffers.

The cash-flow statement is organized into three parts. The first, "cash from operating activities," can alert you to future declines in sales and earnings by signaling when a company is having trouble selling inventory or collecting cash it is owed, among other things. The second, "cash from investing activities," gives you lots of information, from how much the company earned in the stock market to whether it's cutting back on capital expenditures. In part three, "cash from financing activities," you can discover if a company receives cash infusions from outsiders, such as banks or shareholders.

Ideally, a company's operations should generate excess cash, while its investing and financing sections show negative cash balances. Why? A self-sustaining business can pay down debt and finance new investments internally.

Now that the economy is slowing, it is more important than ever to follow this least-known of the three financial statements publicly traded companies are required to release once every three months. Indeed, while the concept of high-quality earnings seemed quaint during the Internet stock craze, it is prized now that companies are warning of earnings slowdowns.

FUTURE RISK. To see why the cash-flow statement can shine a light on earnings quality, consider the difference between the accounting rules that govern the cash-flow and income statements. Generally, companies record the revenue that drives earnings when customers receive merchandise--but before they pay. The cash-flow statement reflects how much cash is actually collected. So if earnings soar, but cash collections stall, be wary: Future earnings could be at risk of being dragged down by bad debt.

To get a feel for whether a company is playing games with its earnings, compare net income on the income statement with "cash from operating activities," which represents how much cash a company's operations generate or consume. "Generally, the closer a ratio of those two numbers is to one, the higher-quality the earnings," says David Zion, a Bear Stearns accounting analyst.

Next, compare the rates at which net income and operating cash are growing. If the two normally move in lockstep but cash now lags, "it's a terrific early warning sign," says Howard Schilit, who heads the Center for Financial Research & Analysis in Rockville, Md. Before you use this simple rule, make sure cash from operations isn't inflated. Although cash flow is harder to manipulate than earnings, it is not immune to the tricks companies use to keep their books in line with Wall Street's expectations. The gimmicks aren't illegal. But since they can't be counted on to repeat, it's important to be aware of them.

Consider Lucent Technologies. In the nine months ended June 30, it included $1 billion in tax savings in the operating part of its cash-flow statement under "tax benefit from stock options." The tax benefits from options comes when employees exercise them. For employers, that counts as compensation, which is a deductible expense. Since they never pay out any cash for this form of compensation, it's added back to cash flow. David Tice, whose Prudent Bear Fund often "shorts" stocks or seeks to profit from their declines, argues this tax benefit doesn't belong in the operating section because it's not generated by operations.

When these tax savings are excluded, Lucent's operating cash flow--already negative--declines instead of rises when compared with the same period in 1999. Lucent is not alone. This practice inflated the operating cash flow of seven of the biggest companies in the Nasdaq 100 by more than 10% in 1999, Bear Stearns says.

Once such adjustments are complete, read the cash-flow statement to see how the company makes and spends its cash. Lucent's third-quarter statement follows the standard convention of starting with net income (table).

This is followed by items that increase or reduce net income but have no impact on cash. Depreciation is the most common example. An expense that lowers net income, depreciation is an accounting technique that allows companies to spread the cost of big-ticket items over many years. The expense is recorded long after cash has been spent, so the expense must be added back to the cash flow.

At the heart of cash from operations are changes in assets and liabilities. Accounting experts pay a lot of attention to accounts receivable, representing what customers owe the company. When receivables rise at a faster pace than sales, the company may be having trouble collecting what it is owed. Since cash isn't flowing in as it should be, a rise shows up as a negative on the cash-flow statement.

BIG HIT. When inventories grow faster than sales, it might mean demand is softening. Since buying inventory requires cash, an increase here causes cash to fall. Conversely, when liabilities such as accounts payable increase, so do a company's cash balances. By delaying payments to creditors, management frees up cash. Still, this isn't necessarily good: "If accounts payable grows every year, you have to be suspicious that they are stringing out their customers," says Jack Ciesielski, author of the Analyst's Accounting Observer, a Baltimore-based publication.

In the third quarter, Lucent's receivables and inventories rose, while its accounts payable declined. The result: a $3.8 billion hit to cash. Not surprisingly, Lucent has been struggling. On Dec. 21, the company announced a reduction in fiscal fourth-quarter sales of $679 million.

Other companies experiencing deteriorating inventories and receivables include Sun Microsystems and Cisco Systems, says Bob Olstein, manager of the Olstein Financial Alert fund. Also on his watch list is Symbol Technologies.

To be sure, negative cash flow from operations isn't always bad. Because of the high costs of building a business, it's perfectly normal--even desirable--for fast-growing companies to consume more cash than they generate. Typically, such companies tide themselves over with bank loans or equity sales. In other words, they run a surplus in "financing" cash flows.

Still, if operating cash doesn't pick up, bail out. Eventually, lenders lose patience with companies whose operations hemorrhage cash. Just ask Xerox: Debt-ridden, it is raising cash the only way it can--by selling assets. When investing cash flow is positive because of asset sales, "that's usually a sick company," Schilit says. So if you have lost money on Xerox, think of this: You could have bailed out a year ago when the cash-flow statement showed receivables rising.

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