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October 04 2010 | Filed Under » Fundamental Analysis, Stock Analysis, Stocks
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Operating cash flow is the lifeblood of a company and the most important barometer that investors have. Although many investors gravitate toward net income, operating cash flow is a better metric of a company's financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, "cash is king" and a company that does not generate cash over the long term is on its deathbed. Tutorial: An Introduction To Fundamental Analysis But operating cash flow doesn't mean EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows. Overview of the Statement of Cash Flows The statement of cash flows for non-financial companies consists of three main parts: Operating flows - The net cash generated from operations (net income and changes in w orking capital). Investing flows - The net result of capital expenditures, investments, acquisitions, etc. Financing flows - The net result of raising cash to fund the other flow s or repaying debt. Advertisement - Article continues below.
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By taking net income and making adjustments to reflect changes in the w orking capital accounts Unleash Your Trading Potential w ith NinjaTrader
If the payment date occurs after the close of the end of the quarter. most importantly. but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent. In extreme cases. Inventories will then move into the distribution channel and sales will be booked. and reversing charges made in prior quarters (such as restructuring reserves). the operating cash flow section shows how cash w as generated during the period. etc. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash.) The operating cash flow statement w ill catch these gimmicks. but cash may actually never be received. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important. When operating cash flow is less than net income. it will need cash to pay the piper. Because managers will generally book business in a w ay that will help them earn their bonus. Some of the more common techniques include: delaying payment to suppliers (extending payables).) and whether this situation is a short-term issue or long-term problem.usually at a discount . Some view the selling of receivables for cash . accrued earnings w ill be greater than operating cash flow because the $1 million is still in accounts receivable. such as consignment sales. a company may legitimately record a $1 million sale but. In this situation.By taking net income and making adjustments to reflect changes in the w orking capital accounts on the balance sheet (receivables. despite . suppliers and. (For more on cash flow manipulation. An example of income manipulation is called "stuffing the channel" To increase their sales. Cash is received when the customer pays (which also reduces receivables). but under GAAP it allows management a range of choices to record transactions. the $1 million in sales does not mean the company made $1 million cash. Strangely. companies have been know n to do so quite frequently during a market bubble. selling securities. (Note: While liberal return policies. it also allows for earnings manipulation. a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Try Now ! Harder to Fudge Operating Cash Flows Not only can accrual accounting give a rather provisional report of a company's profitability. Accrual Accounting vs. There are many ways that cash from legitimate sales can get trapped on the balance sheet. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows: Cash is used to make inventory. because the inventory may be returned by the customer. in accordance w ith GAAP. it is usually safe to assume that the income statement will overstate profits. investors should determine the source of the cash hemorrhage (inventories. there is something wrong w ith the cash cycle. NinjaTrader Learn to trade commodities and currenc futures High Performance Market Data For Stock Futures. For example. While this may increase sales in one quarter. While this flexibility is necessary. inventories) and other current accounts. The two most common are for customers to delay payment (resulting in a build up of receivables) and for inventory levels to rise because the product is not selling or is being returned. In some cases. the bankers. legitimately report positive EPS. it is a short-term exaggeration and ultimately "steals" sales from the follow ing periods (as inventories are sent back). because that sale allow ed the customer to pay within 30 days. Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay). there are ways for companies to temporarily boost cash flows. Cash Is King A company can only live by EPS alone for a limited time.as a way for companies to manipulate cash flows.) Cash Exaggerations While the operating cash flow statement is more difficult to manipulate. receivables. and Forex Discuss trading and investing with othe active traders Try Mirus Futures Trading Demo with MultiCharts and Zen-Fire Exclusive: Learn the "House Odds" of Investing Trade Forex and make big profits. Eventually. a company could have consecutive quarters of negative operating cash flow and. Cash Flows The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. this action may be a cash flow manipulation. are not allowed to be recorded as sales. see Cash Flow On Steroids: Why Companies Cheat. payables. Accrued earnings w ill increase.
investors are consistently hypnotized by EPS and market momentum and ignore the w arning signs. M ore f rom I nvestopedi a What Is A Cash Flow Statement? The Essentials Of Corporate Cash Flow Cash Flow On Steroids: Why Companies Cheat Free Cash Flow: Free. The Bottom Line Investors can avoid a lot of bad investments if they analyze a company's operating cash flow . Strangely. But Not Always Easy Is it possible for a company to have a positive cash flow and a negative net income? M ore f rom around the W eb 3 Things You Can Do From Home for Additional Income (Coupon Shoe Box) These 4 Companies Could Get Acquired Very Soon (Top Stock Analysts) Extrovert and Introvert Stereotypes„Busted (You Beauty) The 13-year-old CEO who invented a cure for hiccups (TheWeek) Samsung Galaxy S3: official-looking photo surfaces (uSwitch.companies who went bankrupt because they could not generate enough cash. It's not hard to do.com) Sponsored Links Dictionary Investing Markets Personal Finance Active Trading Forex Professionals FAQ Video Simulator . Tweet by Feedback Reprints Print Email R i W aym an ck No writer biography is available. but you'll need to do it. because the talking heads and analysts are all too often focused on EPS. despite all this evidence.
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