Financial reporters and stock analysts obsess over earnings, but be careful about reading too much into earnings reports. Yes, earnings are profits, but they’re imprecise, slightly fudgeable little beasts that sometimes only provide an incomplete picture of how a company is doing. That’s why it’s a good idea to track a company’s cash flow along with its earnings.
For example, when many companies note a sale on their books (money expected to come in), they also estimate how much of that sale might be lost due to customers not paying or to warranty claims. If the company estimates it will need to refund 5% of its revenue and won’t collect on 1% of its invoices, then its earnings will show a dollar sale as worth 96 cents, even though first, cash hasn’t been received on the sale, second, no refund has been made, and, third, no refund has been issued.
Why on Earth would anyone call those profits? Great question. Financial statements are snapshots that describe a company’s strength and performance at a given moment of time. Investors would treat a sale differently if half of them needed to be refunded. If a company’s sales are paid for in installments, a sale will still boost the value of the company even if the money hasn’t been received yet.
That need for company estimates gives companies a bit of wiggle room to smooth earnings, so much so that, in the chief financial officer world, those estimates are called “cookie jars.” Firms can, within reason, take larger charges against earnings when profits are high and boost earnings when the company is coming up a bit short. Regulators aren’t fans of cookie jar accounting, but it’s hard to prosecute when a company can defend its reasons for reversing charges.
So what is an investor to do, since we can’t audit companies’ books? We can also look at cash flow, because that’s really what investors are concerned with. As anyone knows, cash flow can make a lot of problems disappear. Companies with cash hoards can lower prices and bankrupt competitors or expand into new product lines. They can also boost dividends to shareholders, which tends to boost the stock price along with it. That’s why I love stocks with growing dividends. Companies can also use their cash to buy back shares, which reduces the supply of shares and increases earnings per share.
It’s easy to read up on a company’s cash flow, as it’s reported along with other financial statements. Companies divide cash flow into three buckets: cash flows from financing (borrowing or lending), cash flows from investing, and cash flows from operations. The first two, financing and investing cash flows, can be affected by one-time events such as going into debt or selling a division for cash. It’s usually more useful to look for trends in operating cash flow, which is driven more by a company’s day-to-day activity.
Cash flow or earnings alone won’t tell the whole story about a company’s growth or profitability. Ideally, they’ll trend together and, the more conservative and established a company is, the more likely that will be the case. But, in a pinch, there are fewer things more lovely to an investor than a company that’s able to generate mountains of cash.
Evan R. Guido is the Founder of Aksala Wealth Advisors LLC, a 2018 Forbes Next-Gen Advisors List Member, and Financial Professional at Avantax Investment ServicesSM. Evan heads a team of retirement transition strategists for clients who consider themselves the “Millionaire Next Door.” He can be reached at 941-500-5122 or eguido@aksalawealth.com. Read more of his insights at https://finance.heraldtribune.com/category/ask-guido/. Securities offered through Avantax Investment ServicesSM, Member FINRA, SIPC. Investment advisory services offered through Avantax Advisory ServicesSM, Insurance services offered through an Avantax affiliated insurance agency. 6260 Lake Osprey Dr. Lakewood Ranch, FL 34240. The views and opinions presented in this article are those of Evan R. Guido and not of Avantax Wealth ManagementSM or its subsidiaries. Past performance does not guarantee future results. The S&P 500 is an index of 500 major, large-cap U.S. corporations. Standard & Poor's is a corporation that rates stocks and corporate and municipal bonds according to risk profiles. The S&P 500 is an index of 500 major, large-cap U.S. corporations. You cannot invest directly in an index. An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund. CDs are FDIC insured and offer a fixed rate of return. They do not necessarily protect against a rising cost of living. The FDIC insurance on CDs applies in case of insolvency of the bank, but does not protect market value. Other investments are not insured and their principal and yield may fluctuate with market conditions. Investments are subject to market risks including the potential loss of principal invested.