Being Wary of Cash Flow Manipulation by Companies – Financial Health
Companies want to project themselves as being in good financial health. So you need to check whether the reported cash flow is actually what it is.
Stock trading and investing is all about selecting stocks to invest in. Selecting companies requires checking various aspects of their operation. Primarily, you need to know the financial health of these particular companies. That’s where cash flow comes in.
This Investopedia article explains that a cash flow breakdown is the most important part of reviewing the income statement or balance sheet of a company. The cash flow basically depicts the difference between the money being generated and the money the company spends on its operations. But the article also reminds that cash flows can be distorted or manipulated. Since companies are totally aware of the fact that lenders and investors would be checking out this information as a sign of their financial health, they get their accountants to manipulate their cash flow so that it appears higher than it actually is.
Why Is Cash Flow Manipulated?
When the cash flow appears positive, the company is able to get lower rates of interest for loans and higher ratings. This helps companies since they often pay for their business operations by taking loans or raising equity capital. They want to project themselves as healthy companies. So you need to be able to figure out the true nature of a company’s cash flow, beyond what it seeks to project.
You must check the cash flow of a company under the operating cash flow entry. You find this in the company’s cash flow statement, after the presentation of income statement and balance sheet.
How Is Cash Flow Distorted?
Let’s look at some of the ways the operating cash flow is distorted as reported by Investopedia:
- As you may know, cash flow reporting is directly influenced by working capital accounts. Receivables raise the cash flow. The opposite situation is accounts payable that decreases the cash flow. A simple way to get the cash flow reporting manipulated is by advancing the recognition of receivables and delaying the recognition of accounts payable till the next period. But these techniques would eventually unravel in the next period because accelerating receivables for the present period would reduce them in the next period. Delaying accounts payable would also accumulate them for the successive period.
- Another method of manipulating cash flow reporting is by changing the accounts payable. Accountants need to figure out when payments by the company can be recognized. A company, having written the check, does not deduct the amount payable before the actual deposition of the check, but allows the amount to be reported as cash on hand under the operating cash flow section.
- Adding overdrafts to the accounts payable is another technique. This is then combined with the operating cash flow which then appears bigger than it should.
- Companies can also include income generated from activities not directly connected to their usual business activity. While these activities do generate income, they are usually short-term investments, such as securities market trading. As a result, they are not an indication of the strength of the business. Adding the income from these non-core activities gives investors and lenders the idea that the company is actually generating more receivables from its usual, core business operations, while it’s the non-core, short-term activities that are contributing a significant amount to that.
Always Check the Free Cash Flow
Always remember that there is a way to counter the accounting trickery companies could potentially employ. Check the free cash flow (FCF). The FCF is calculated by subtracting capital expenditures from the operating cash flow. That shows how much of the cash flow is really available and how much is actually being reported, though this calculation isn’t always reliable.
Being able to select good companies based on their cash flows is important to this investment strategy. Keeping costs down and being able to trade those stocks that are attractive on both the long and short side is important as well. It is also highly important to have a broker that is easy to use, inexpensive and reliable.