For investors, cash flows only tell half the story

This article appears in the Fall 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Some investors place too much emphasis on cash flows, falling prey to the long-held notion that those numbers offer the best approach to evaluating equities.

That misconception generally starts with the idea that cash flows must reconcile to an audited cash balance held at a financial institution.

The alleged fraud uncovered this summer at German financial services firm Wirecard AG is only the most recent example of this notion not holding true, as €1 billion in cash turned out to not exist. It echoes the fraud at Italian dairy giant Parmalat S.p.A. in 2003, where €4 billion in supposedly verified cash was also fictitious.

Cash flows that can be fabricated from thin air are just the start of the analytical problems for investors.

Fraud isn’t required to create a cash-flow calamity. Management might push vague accounting rules to improve cash-flow results, or simply do nothing and let the lax accounting framework mislead investors all on its own.

Consider the nature of the cash-flow statement, which is created by taking accrual accounting numbers and working backward to approximate cash amounts. The key word is “approximate.” By combining the wrong starting point with the need for multiple adjustments, and injecting considerable management judgment, the ending cash flows are far from concrete or definitive.

By way of explanation, the cash-flow statement is divided into three parts: cash obtained from or used in operating, investing and financing activities.

The operations section uses net income and makes adjustments to arrive at an estimate of cash generated by operating activities. It’s the classic garbage-in, garbage-out analytical problem, because net income is derived by management making extensive judgment calls to allocate original cash flows to arbitrary periods. The cash-flow statement then tries to undo that. It’s akin to unscrambling an egg, and errors continually creep in.

Also, cash flows must be allocated to one of the three parts of the cash-flow statement and can easily be miscategorized (because of weak accounting rules, error or management being aggressive). Cash outflows that should be considered part of operating activities can be shifted to investing or financing, thereby improving performance in the areas where investors typically focus their attention.

Cash from operations can be boosted by turning receivables into long-term investments (that fall outside of capital expenditures) or through the use of reverse factoring. These techniques and others also boost free cash flow, which is frequently used by investors to measure corporate health and dividend sustainability. Yet, focusing on free cash flow means ignoring more than half the cash-flow statement. Free cash flow is the rough counterpart to adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) on the accrual side of the equation in terms of the amount of information that’s missing.

Cash flows also tend to fluctuate more than earnings, making trend analysis more difficult and arguably easier to manipulate.

With all these problems, investors shouldn’t over-focus on cash flows for the purposes of investment analysis.

The better approach, as usual with investing, is a hybrid method. It’s double the work or more, but investors can’t rely on a single flawed system. Using multiple metrics such as cash flows, earnings, EBITDA, net asset values and even management-adjusted figures provides the fullest picture. Using numerous flawed approaches may seem like multiplying the chance for mistakes, but the various methods tend to mitigate each other’s weaknesses, increasing the chance of catching something untoward or misleading in the financial statements.

Forget the investing platitudes you hear about cash flows. Cash isn’t king; sometimes, cash isn’t even cash. Investing is never that simple.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.