How to use free cash flow and net income to detect creative accounting
Having different perspectives to a problem situation will result in better solutions surfacing. In other words, using multiple mental models to view the same problem situation. This is true in medicine as much as in equities investing also. Fundamental and technical investing may well be of different schools of thoughts but they actually got no conflicts.
Fundamental analysis involves looking over and analyzing the company three types of financial statements and business models while technical analysis is more towards observing and detecting price patterns and trends and developing strategies to exploit them. No amount of candlestick charting, dow theory or wave patterns can save Enron stock owners during 2001 because these tools did not tell them anything about why shares of companies eventually fall and never go up again. Conversely, the same technical analysis tools will also not tell you which companies will become the Coca Cola or Microsoft of tomorrow.
This post will mention a relatively effortless way to find out whether a company has cooked its book. It is a simple screening test for companies that you will not want to touch with a ten feet pole.
What is the cash flow statement?
In layman terms, cash flow statement listed out the exact amount of cash that enter and exit the company during the period which the financial statement is reporting. Compared to income statement and balance sheet, cash flow statement is much more difficult to cook, or that in other words, it takes more creative thinking and innovation on the part of the accountants to manipulate, for the simple reason it is based on how much cash a company has.
With the Internet, there is a relatively easy way to determine the free cash flow and net income of any listed company. What is mentioning here is most probably the first task that investment professionals do before they decide to invest or short a company’s share. When I was studying financial accounting some time ago, I recalled my tutor, an accountant by training and with a bachelor degree (honors) in accountancy, once said that how much profit the company makes is what the company CEO wants it to be. By a stroke of the pen, the entire expenses can be booked under capital expenditure and what is loss of millions can become profit of millions.
But what cannot be easily changed is the cash flow statement as it is based on the amount of cold hard cash that a company owns at the end of the day. As a result, by comparing and contrasting the income statement with the cash flow statement, one can detect the creativity exhibited by accountants working for the company. To put it simply,
If a listed company reports substantial profit on income statement but the free cash flow from cash flow statement does not paint an equally good rosy picture, then there is a warning flag.
The rationale for using free cash flow instead of operating cash flow is its more conservative, reason being that it accounts for using real cash in capital expenditure. To calculate free cash flow of any listed companies, one can use the following procedure.
1. Sourcing for the company financial data.
Go to Yahoo Finance and enter the stock ticker code. Click on Get Quotes on the right of the search box. This will brings you to the summary page of the company financial.
2. Getting into the company cash flow statements.
Under the Financial heading at the bottom left hand corner, click on Cash Flow. Take note that for the case of Yahoo Finance, there are also quarterly data available, for the latest last four quarters.
3. Calculating free cash flow required of a company.
This will be a simple arithmetic exercise; you just need two figures to determine free cash flow.
Free Cash Flow = Total Cash Flow from Operating Activities – Total Cash Flows from Investing Activities
4. Finding out the net income or net profit after taxes
Under the Financials heading at the bottom left hand corner, click on Income Statement, at the bottom of the Income Statement is the net income.
Well, after getting the figures for free cash flow and net income, one can easily estimate the quality of the business earnings but do take note that it is to be used in conjunction with other valuation models or analytical methods.
If net income > free cash flow, especially if there is significant difference, then there is a potential creative accounting and you will need to analyze the company more deeply. If all you are involved in is technical investing, you will do well to not carrying out technical trading on this company as there may be a relatively higher chance that candlestick charting, dow theory or wave patterns do not predict the outcome accurately.
If net income < free cash flow, or around the same, then relative to the above, the quality of earnings is definitely better since the company brings in around the same or more cash than what is reported as net profit.
This simple exercise saved some people from the Enron scandal, and they felt relieved that they did in the aftermath of the incident. Follow this link to Enron financial statement during the year 2000, and you will discovered that there is much more net income than free cash flows for three years running, from 1998 leading to 2000, especially by the first quarter of 2001, when free cash flow is almost doubled that of net income reported but you need to add a negative sign in front of the figure for free cash flow.
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I think it is really sad that nobody learned a lot from the enron scandal. I think now finally after the financial crisis people are starting to get it. There is a need for better and more clear laws in the financial world. Other wise we will see many more such crisis in the near future.
people should also keep up-to-date on financial news … http://rssbroadcast.com is a good source of such information