Cash flow

It can be used ...

* to determine problems with liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.

* to generate project rate of returns. The time of cash flows into and out of projects are inputs to models like internal rate of return and net present value.

* to measure income or growth of a business when it is believed that accrual accounting rules do not represent economic realities. Alternately, the cash flow can be used to 'validate' the net income generated by accrual accounting.

Cash flows can be classified by ...

1. Operational cash flows: Cash received or expended as a result of the company's core business activities.

2. Investment cash flows: Cash received or expended by making capital expenditures that will benefit the business for many years (e.g. the purchase of new machinery), investments or acquisitions.

3. Financing cash flows: Cash received or expended as a result of financial activities, such as receiving or paying loans, issuing or repurchasing stock, and paying dividends

All three together are necessary to reconcile the beginning cash balance to the ending cash balance.

Operating cash flow as proxy for income

Because of the politics involved in the formation of accounting standards (GAAP), many investors have lost faith in the published income statements. One way to by-pass them is to use cash flows instead. The feeling is that

* Cash flows cannot be fudged. This presumption is shown to be wrong by the following section.

* Cash liquidity is necessary for survival. This is true, and even more true for businesses with limited access to financing.

* Cash is tangible proof of income. The problem with this concept is that cash can be received as profit on a sale ... but also as proceeds from the sale of an asset with no profit. One asset is simply exchanged for another. This reality is expressed by non-cash expenses like depreciation, amortization and depletion. Capital assets wear out in the process of being used to generate sales. Part of the proceeds from the sale is a return of capital not income. The cash replaces the reduction in the asset's value.

Not withstanding the problems with GAAP, the growth of a business is better measured by Net Income than by Cash from Operations.

Dangers of isolating Operating cash flow

When analysts and the media refer to 'cash flow' they are most likely referring only to #1 above: "Operating Cash Flow". There are problems with isolating only this third of flows because business can easily manipulate the classification. Here are some ways the business can increase 'Operating' cash flow without changing the economic realities of the business.

* Sales - Sell the receivables to a factor for instant cash

* Inventory - Don't pay your suppliers for an additional few weeks at period end

* Sales Commissions - Management can create a separate (but unrelated) company to do the work. The book of business can then be purchased quarterly as an investment

* Wages - Pay compensation with stock options

* Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work

* Equipment Leases - Buy it

* Rent - Buy the property (sale and lease back if you like)

* Oil Exploration costs - Replace reserves by buying another company's

* Research&Development - Wait for the product to be proven by a start-up lab. Then buy the lab

* Consulting Fees - Pay in shares from treasury since usually to related parties

* Interest - Issue convertible debt where the conversion rate changes with the unpaid interest

* Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.

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