Cash-Flow Hocus-Pocus

This seemingly simple number can be anything but straightforward

Many investors believe that cash flow is relatively immune to the accounting games that companies have used to pump up earnings. Well, no more. WorldCom's shocking disclosure on June 25 that it inflated not only its earnings but also cash flow for the past five quarters put an end to that assumption. But while the telecom carrier, now teetering on bankruptcy, will be remembered for its large-scale misrepresentation, it's not the first company to engage in such maneuvers. Indeed, companies have found "many opportunities to manipulate cash flow to shed a more favorable light on themselves," says Charles Mulford, accounting professor at Georgia Institute of Technology.

Much of the manipulation is aimed at pumping up cash flow from operations--the first and most scrutinized of the three sections in the "consolidated statements of cash flow" that follow the income statement and balance sheet in corporate financial reports. (The two other sections report on cash raised or used through investing and financing activities.)

Management has an incentive to make its operating cash flow look good: Wall Street pays a premium for the stocks of companies whose core businesses generate prodigious amounts of cash. Indeed, investors often look down on companies that can raise cash only through financings, such as debt offerings, or investment-related activities, such as asset sales. After all, they can't sustain themselves indefinitely that way.

If you only look at cash from operations and take it at face value, you're not getting the whole picture. So in this installment of The Fine Print, a series examining financial statements and other corporate documents, we focus on ferreting out cash-flow trickery. Of course, it's not always obvious when companies play fast and loose with the numbers. In the WorldCom case, for example, there's "nothing in the financial statements that would tip you off," says Doug Carmichael, accounting professor at Baruch College. In many instances, though, there are warning signals.

One way companies boost operating cash is by securitizing--or selling--their accounts receivable. These are the bills customers owe. By selling receivables, a company speeds its cash collections, taking into its coffers immediately the cash it would normally collect in the future. (There is a drawback. To sell those receivables, the company will have to accept fewer dollars than had it waited for the customers to pay.)

This is not necessarily a problem. Selling receivables can be a legitimate cash-management strategy. If the receivable sales increase each year at the same rate as revenues, the impact on the cash-flow statement is minimal. But when a company starts or steps up a securitization program, it can create the impression that the operating cash flow in that year is better than it really is.

To see why this is a problem, consider Oxford Industries, an Atlanta apparel company. In 2001, its operating cash flow more than doubled, to $74.4 million, from the year before. According to the company's cash-flow statement, the biggest boost to cash flow came from a decline in accounts receivable, which is what happens when customers pay their bills. It sounds impressive, but Oxford's footnotes reveal that the surge in cash flow was driven by an $80.5 million sale of receivables. Although you could get the notion that Oxford had improved its operations, the apparel maker actually did little more than accelerate collections. Take out the impact of this one-time boost, and Oxford's 2001 operating cash flow would have been negative.

Companies can also keep their operating cash flow high by the way they account for outstanding checks. Witness Aviall, a Dallas manufacturer of aviation parts. In 2000, Aviall showed positive operating cash of $7.7 million, up from a negative balance of $12 million in 1999. A big reason for the improvement: an increase in Aviall's accounts payable, or the amount it owed its creditors. (When a company delays payments to creditors, its cash balances rise.)

Still, in Aviall's case, much of the cash it claimed to have at its disposal was actually en route to creditors. In fact, in the first footnote in its 2000 10-K, Aviall reveals that it had already written checks for $19.7 million--or about four times the $4.87 million in its cash coffers. Because the checks had yet to clear, the company was able to take advantage of generally accepted accounting principles (GAAP) that allow overdrafts to be lumped into accounts payable. So, instead of reducing Aviall's operating cash, the large balance of outstanding checks actually inflated it.

As Aviall's creditors cashed its checks, the company's operating cash balance turned negative. In 2001, Aviall reported an operating cash-flow deficit of $93.4 million. Of course, anyone who had subtracted the rise in overdrafts in 2000 from Aviall's seemingly strong 2000 operating cash flow would have been spared this nasty surprise.

Another dubious source of operating cash is securities trading. Although GAAP rules allow cash raised by securities sales into the operating section of the cash-flow statement, it still comes from activities unrelated to the core operations of most businesses. As such, when gauging a company's underlying health, investors should exclude it from operating cash.

To see why, look at manufacturer WHX. In the first quarter of 2001, the New York City-based company's cash-flow statement showed that operations produced cash of $6.3 million. But a closer inspection reveals that $4.76 million was derived not from making steel and other products but from short-term investments and borrowings to finance more securities purchases. In a similar manner, the company's operations for the first quarter of this year would have recorded a cash deficit without a $67.3 million infusion from playing the market.

WorldCom and other companies have also given operating cash flow a lift by capitalizing some expenses. This maneuver boosts the bottom line, too. Why? When a company capitalizes costs, it creates an asset on the balance sheet and writes off the costs of creating that asset gradually, in annual installments, instead of all at once.

How can capitalization boost operating cash flow? Normally, as a company spends money to produce goods, it deducts those costs from net income and thus, operating cash flow. But when a company capitalizes certain costs--the footnotes to annual reports are a good place to discover if this is happening--cash that goes out the door is considered an investment in an asset. As such, it is recorded on the cash-flow statement as a deduction to cash flow from investing activities. While the company's overall cash--what you get by adding the numbers from all three sections of the cash-flow statement--remains the same, its cash flow from operations is untouched. As a result, its operating cash flow will look better than companies that do not capitalize.

As the WorldCom scandal has taught investors, cash flow is as vulnerable to manipulation as net income. So before using it as a measure of financial health, you have to check for the practices that mask weak performance or produce one-time gains.

By Anne Tergesen

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