Looking Past Earnings to Understand Cash Flow - dummies

Looking Past Earnings to Understand Cash Flow

By Matt Krantz, Robert R. Johnson

If you’re like many investors, you’re almost trained to maniacally devour earnings reports from companies. Every quarter, like clockwork, investors eagerly await earnings season. During the roughly three weeks of earnings season, investors wait for companies to disclose their revenue and earnings during the previous quarter.

There’s no question that earnings, which come from the company’s income statement, are very important. After all, a company’s profit and how it measured up with the same period a year before can be quite telling about the company’s trajectory. The income statement can also be revealing if the bottom line came in ahead or behind of expectations.

But investors who ignore the other financial statement and only mind the income statement are seriously shortchanging themselves. The other financial statements, especially the statement of cash flow, can be very illuminating to fully understand a company.

The statement of cash flow starts with the company’s reported profit. And then, through a series of adjustments, expenses that didn’t consume cash are added back and events that generated cash are subtracted from net income. The income statement is an agreed-upon definition of profit, but it’s somewhat up for debate in that latitude exists in many of the rules.

But when it comes to cash flow, there’s no debate: Either a dollar came into the company or it went out. This clear-cut nature of the statement of cash flows is one of its beauties.

Taking a close look at a company’s statement of cash flows is one of the best ways to truly see how a company is performing. One of the classic examples is Enron. While the company was reporting banner profits, anyone who paid attention saw that the company’s cash flow wasn’t coming from operations. When a company is reporting falling cash flow, while extolling banner profits, that’s a key warning sign that shouldn’t be ignored.