Cash flow is the amount of actual cash that flowed in or out of a firm’s bank accounts during the reporting period. Cash flow is a better gauge of a company’s profitability than reported earnings because earnings reflect a myriad of arbitrary accounting decisions while cash flow reports the real change in bank balances.

Operating cash flow reports the cash generated or used by the company’s basic operations. Free cash is operating cash flow minus capital expenditures. Companies can, and frequently do, report positive earnings when, in fact, they’ve lost money on a real cash basis.

Cash Flow Red Flags

Some companies, though cash flow positive on an annual basis, habitually burn cash during certain quarters. Therefore, it’s best to look at trailing-twelve months cash flow rather than just the last quarter. Doing that requires some extra effort because the statement of cash flow shows year-to-date totals, rather than each quarter’s results separately. So you have to subtract the previous quarter’s totals to derive the latest quarter numbers. If you don’t want to do the math, Morningstar displays the TTM operating and free cash flow totals in its Financials section. Negative cash flow and negative free cash flow, although undesirable, do not by themselves signal creative accounting or earnings manipulation and are not necessarily red flags.

COMPARING OPERATING CASH FLOW TO NET INCOME

Net income or after-tax income, the bottom line on the income statement, is the top line on the cash flow statement. Cash flow from operations is usually a larger number than net income because depreciation and amortization are subtracted from net income but not from operating cash flow.

Wal-Mart’s operating cash flow substantially exceeds its net income each year. That’s the way it’s supposed to happen. Operating cash flow usually increases in proportion to net income.

Accounts receivables and/or inventories increasing faster than sales are both red flags. If you recall the accounting math, increasing receivables and inventories also reduces operating cash flow. So less than expected operating cash flow could be a tip-off to accounting shenanigans. Recent research found that operating cash flow less than net income signals future share price underperformance, and the combination of increasing net income and decreasing operating cash flow was found to be especially significant.

Motorola managed to record 48 percent year-over-year income growth in fiscal 2000, but its operating cash flow told a different story. As of this writing, the company hasn’t seen a profitable quarter since the 2000 report.

While the research showed that the combination of increasing earnings and decreasing cash flow was especially significant, it makes sense that any company that habitually reports more net income than operating cash flow is problematic.

PolyMedica and ACT Manufacturing habitually reported operating cash flows below net income. In PolyMedica’s case, the shortfall came from direct advertising costs, which, according to GAAP, are not included on the income statement. Nevertheless, those costs were significant. For instance, in its March 2001 fiscal year, PolyMedica recorded a $31.5 million direct advertising charge against operating cash flow, more than wiping out its $22.7 million net income.

Contract manufacturer ACT’s operating cash flow shortfalls related to buildups in receivables and inventories. ACT filed bankruptcy in 2001.

Strouds had a spotty record but usually recorded cash flows higher than earnings. Strouds reported impressive earnings growth in its February 2000 fiscal year report, but it also reported its biggest ever operating cash flow deficit. Strouds filed bankruptcy in September 2000.

Comparing net income to operating cash flow is faster and easier than computing accounts receivables and inventory percentages of sales. It may not be as effective as analyzing receivables and inventories, but it looks like an efficient method for spotlighting stocks requiring detailed examination. Specifically, net income greater than operating cash flow, or net income increasing faster than operating cash flow, signals the need to analyze receivables and inventories.