Saturday, April 18, 2015

Getting conviction: Fundamental Factors #4: Cash flows

Cash flow is the best indicator of the health of a company. It also typically has tell tale signs of what is really going on. I, of course, cannot cover this entire topic in an article but definitely can give you some pointers on where to look and a flavour of the cash flow analysis methodology:

8.        Cash flow quantity – If the cash flow from operation is on an average lower than net income it should be a huge warning sign that earnings are overstated. In some cases even when cash flow from operations is good some expense items may have been capitalized by classifying them as cash flow from investing. Now the best way to judge this is to see the delta revenue, Net income and cash flow from operations that that investing has created. Studying the cash flow from investing is also a good practice to understand the expensing and capitalization practices.

9.        Cash flow from investing – All the items in this should be new capital items. If a machine broke down and required massive expense it should be expensed as it is not a case of new capital items. If a measurement instrument broke and needed to be replaced by a new one that should be taken under cash flow from operations but as per accounting rules it needs to be capitalized. You need to adjust for this cash flow in your analysis. These ad hoc items are why depreciation is taken on the balance sheet as it hopefully evens out as long as the depreciation periods are accurately defined.

10.        Cash flow consistency – If cash flow from operations is fluctuating wildly it signals a problem. This typically happens when the financials are being managed. Such cases should be looked at carefully.

This post is a continuation of the following posts: