Many investors talk about earnings when it comes to investing. Whats the EPS? EPS Growth? What’s the revenue? What’s the profit margin?
As it turns out, earnings can be easily manipulated, while still adhering to IFRS and GAAP accounting standards.
As mentioned in Wiley’s Free Cash Flow, the “primary purpose of accrual accounting is to hide the cash flow”.
Management can adjust assumptions about bad debt allocation, depreciation and inventory obsolescence to their benefit, and not necessarily the shareholders’.
You see, much of a management’s compensation is based on PROFIT and not CASH. If they can show that profits are growing year-on-year, their bonuses grow as well. Thus, the accounting loophole allows for a bad management to keep showing healthy short-term profits while sacrificing long-term business sustainability.
The Insufficiency of the GAAP Cash Flow Statement
The GAAP Cash Flow Statement is a good place to begin discovering company cash flow, however, it is insufficient in and of itself.
According to GAAP and IFRS, there is still too much flexibility for a company to manipulate what constitutes Operating, Investing and Financing Cash Flow items.
For instance, a company might prop up an originally weak Operating Cash Flow by (prematurely) selling Accounts Receivables, or engaging in Circular Transactions with a customer.
The Answer Lies in Free Cash Flow
To detect accounting irregularities, value investors use a metric called Free Cash Flow (FCF) to factor (back) in Capital Expenditures and Changes in Net Working Capital to derive the true cash flow position of the company at that point in time.
Both CapEx and Changes in NWC are REAL cash outflows/changes that happen to a business and are material to deriving a more accurate cash flow figure.
There are many nuances of deriving FCF depending on each business’ operations. However, understanding the difference between cash flow and earnings can make a big difference to how you select and value your companies.
For more information on Wiley’s Free Cash Flow, click here.