Sales and Cash Flow as Key Indicators

Sometimes, accounting can obscure the truth. Public companies are required to provide transparent information about their performance so that investors can make the best possible investment decisions and stock holders can know what is actually happening to their investment. But what may be transparent to one analyst might be opaque to another because of the interpretation and method of collection of the data used to provide financial reports. For example, there are a myriad of expenses between Revenue and profit or loss. Sometimes an expense is not really an expense-like depreciation, which is counted as an expense (and sometimes a large one) but does not incur a real expenditure of cash. Sometimes, expenses can be accelerated or differed. How does this effect transparency? Sometimes some of these extraordinary expenses are handled in different ways by different companies. And sometimes, the “numbers” between the top line (sales revenue) and the bottom line (profit or loss) can be manipulated by the very collectors of the data.

Professional financial analysts understand these possible distortions to “the real picture” and they may use differing financial measures to help make the best possible investment decisions. As an experienced Investment manager and CFA (Chartered Financial Analyst), I favor using Revenue and Cash Flow to help give a better picture of what is really happening within a company. The simple logic is that instead of relying on the “bottom-line” with all the possible interpretations of expenses that can affect the outcome of profit or loss, many professionals prefer to look at cash flow. If you can gather information on the inflow and outflow of all monies into and out of the company, you can get a much clearer picture of how the company is actually performing.

What Are the Components of Cash Flow?

Typically, all public companies produce a Cash Flow Statement, which shows the sources and uses of cash moving into and out of the company for a specified period of time. Cash Flow has three components:

Operating Cash Flow. Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It comes from sales of the product or service of the business, and because it is generated internally, it is under the control of management.

Investing Cash Flow. Investing cash flow is generated internally from non-operating activities.

Financing Cash Flow. Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, the issuance of stock, and the payment of dividends are some examples.

Positive Cash Flow

If cash inflow exceeds outflow, a company has a positive cash flow. A positive cash flow is a good sign of financial health, but it is by no means the only measure but perhaps the most basic.

Because of this simplicity, many professional money managers feel that cash flow ratios are a better measurement of a stock’s value than the popular price earnings ratio (P/E). P/E represents the ratio of the stock’s price to its earnings per share (EPS). It is an important metric, if for no other reason because so many people think it is. Analysts normally use two primary measurements of cash flow to get an idea about a company’s valuation.

The price to cash flow is determined by dividing the stock’s price by cash flow per share. The reason many prefer this measurement is the use of cash flow instead of net income, which can become distorted by interpretations of expense and income.

Cash flow is a company’s net income with the depreciation and amortization charges added back in. These charges, which reduce net income, do not represent outlays of cash so they artificially reduce the company’s reported cash. Since these expenses don’t involve actual cash, the company has more cash than the net income figure indicates. Analysts divide the current price by the free cash flow per share and the result describes the value the market places on the company’s ability to generate cash.

Importance of Revenue

Most company mangers ask the questions: what should we do to make the company more financially viable in the future? The answer could be to reduce costs, to increase revenue, to consider changes in demand and in the costs of inputs, or a combination of all three. All of these questions involve the company’s ability to generate income and its abilities to control costs. Therefore, what’s happening with revenue is of vital importance. As a matter of fact, over the years, it seems that generating revenues has become even more important than profitability. That’s one reason the Dotcom bubble burst in the 90′s. Too much focus on revenue can be misleading but when considered in context with profitability (or the ability to generate positive cash flow) Revenue is a major indicator of a company’s capabilities to meet market acceptance. But Revenue without positive cash flow can become a concern and this can be a common situation with many of the new technology companies (like the current run on solar related companies) as they penetrate new markets. It doesn’t rule them out but it takes a trained eye to see which companies will make it over the long run.

In conclusion, a good financial analyst understands not only what the financial reports are saying but also how the information is collected and what is the best way to use information to present the most credible picture of exactly what is happening within a company. After all, it’s garbage-in and garbage-out.

William Hutchens is a Chartered Financial Analyst (CFA) and President of Hutchens Investment Management based in Concord, New Hampshire. A twenty five-year veteran of the markets, Mr. Hutchens accepts all questions concerning investing or portfolio management. You can contact him at http://www.hutchco.net

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