Cash is king.
Although many investors gravitate towards using net income to measure the financial performance and health of a company, operating cash flow is a far more important and objective metric. Let me tell you why.
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Whereas net income measures the profit generated by a company for a period, cash flow from operations reconciles the differences between the profit made and actual cash generated by a company’s core business activities. Such differences due are often due to depreciation, deferred tax expenses or changes in working capital.
For example, an oil & gas equipment company, ABC O&G, may report a net profit of $10 million for 2018. With a current share price of $10 and with 10 million common shares outstanding, its EPS is $1, and its price-to-earnings (PE) ratio is 10.
ABC O&G’s cash flow from operations in 2018 was $20 million after adjusting for a $10 million depreciation expense of a legacy asset. Since depreciating its legacy asset did not involve any cash outlays, the $10 million expense had no impact on cash flow and the company’s performance is actually healthier than its net income would have you believe.
In this case, using its PE ratio to judge whether ABC O&G’s share price is discounted relative to its peers may not be a good comparison. You may want to use P/CF ratios (price to cash flow) instead. P/CF ratios can be helpful in evaluating companies with consistent and predictable cash flow. Such companies can range from the telcos to utilities.
Why focus on operating cash flows? Some investors prefer it to net income because there is less room for companies to manipulate information. Standard accounting rules give companies flexibility in choosing when to report revenue and expenses. Companies can have positive net income yet still generate negative operating cash flows.
If a company’s net income is far higher than its operating cash flow, it may be a sign that the company is experiencing serious problems collecting money from its customers or that the way they report revenue is questionable. These are red flags investors must pick up when reviewing financial statements.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.