Understanding a Company’s Bottom Line

by Jason Jenkins, Investment U Research
Wednesday, January 25, 2012

Before you even think of investing in a company, you must check its make-up. The key three documents are the balance sheet, income statement and statement of cash flows. Any analyst will tell you to do this but no one really tells you what you are actually looking for.

Well each document tells a different story:

• The balance sheet is a snapshot of a company’s present condition. A list of assets with liabilities gives you the company’s equity.
• The income statement looks at their income generated minus any expenses to show if they are profitable.
• The statement of cash flow shows you the cash that “flows through the company” during a quarter or year, excluding fixed expenses. This is because cash flow tries to give a picture of the financial aspect of the activities that the company carries out.

All of the above information is helpful in judging the health of a company. However, there are specifics that money managers and analysts look at to drive their decision-making process.

Cash Proves King 

The price-to-earnings ratio is a very popular metric among amateur investors. That’s probably because it’s very easy to digest. But cash flow, and not earnings, drive economic value. Earnings – an accounting measure – represent paper profits that can be manipulated in the company’s benefit.

Here’s a good example of what can happen. Early in a company’s life it will usually lose money. When the company starts to turn a profit, it can often use those losses from previous years to cut its taxes. That can overstate current earnings and understate its forward earnings, masking the company’s real operating situation.

Thus, a savvy analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company’s growth. Cash flow is designed to focus on the operating business and not secondary costs or profits…

And take special note: Cash flow represents bankable profits that can be used to shore up balance sheets, repurchase shares, or pay dividends. These are aspects of the business that are very important in the current investing climate.

The Cable Television Example

Cash flow is most commonly used to value companies in industries that use a great deal of up-front capital expenditures and have large amortization burdens. A perfect example is Cable TV companies. They report negative earnings in their initial years of their life cycle as they put out major huge capital expenditures to build their cable networks.

But during this same time, these Cable TV companies see their cash flow grow. Net Income doesn’t paint the entire picture because huge depreciation and amortization charges cover up these companies’ ability to generate cash.

Cash flow analysis would also be used to value telecommunication companies that need to build up a network of telephony supporting infrastructure. They are in the same boat as Cable TV where they incur high fixed costs and amortization.  While building their networks, the telecommunication companies reported high negative earnings, even though, in reality, they had positive cash flows.

P/E ratios usually get all attention, but now you can see why cash flow gives you a better indication of what’s really going on with a company.

Good Investing,

Jason Jenkins

Article by Investment U