Newcomers to share market investing quickly learn the near universal acclaim awarded the Price to Earnings Ratio (P/E).  As a valuation ratio, it reflects the share price the market is willing to pay for each dollar in earnings the company generates.

However, as those same newcomers continue their education they soon discover that the tools of choice for many financial professionals are not the heralded earnings ratios, but the little known cash flow ratios.  The reason is simple.  When it comes to determining the valuation of a share, the company’s cash position is more important than its stated earnings position.

Simply put, accounting standards make it easier to manipulate stated earnings than actual cash on hand.  What makes this kind of manipulation possible is accrual accounting versus cash accounting.

Cash Accounting

With cash accounting, revenues are not recorded on a company’s books until the money is in the bank.  Sales are not considered as earnings at the time a contract is signed or upon delivery of the product.  They only count when the company actually receives payment from the customer.

 

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The same principle applies to expenditures.  Cash is not deducted from the company’s ledger until the cash payment leaves the bank.

In theory, cash accounting seems like an appropriate way to keep track of a company’s financial health, since the timing of crediting a sale and debiting an expense corresponds to actual inflows and outflows of real money.  In practice, pure cash accounting can make a business look artificially bad in some months and artificially good in others.  Hence, the need for accrual accounting.

Accrual Accounting

In essence, accrual accounting allows companies to smooth out revenue and expenses over time.  Large companies use accrual accounting since it does not exclude expected future earnings from a current reporting period.  The timing in accrual accounting is the moment at which a given economic event occurs.  This varies by company, with some choosing a signed contract as the event and others the shipping of goods as the event.  Whichever is chosen, it needs to be consistent.

Now you have the big picture.  Stated earnings do not reflect cash on hand.  Contracts to purchase can be delayed or even cancelled.  There are a host of ways to manipulate earnings reported on financial statements to make a share look better.  The timing of a revenue or expense generating event can be moved from one reporting period to another.  Inventories, payables, and receivables can be overstated.

Cash Flow versus Earnings

To put this discussion into perspective, consider one of the greatest financial scandals in history – the fall of American energy giant Enron.  With the support of the most respected accounting firm in the United States at that time – Arthur Anderson – Enron routinely recorded expected earnings from projects where not even a single shovelful of dirt had been turned.  The earnings were there, but the cash wasn’t.

Cash flow information appears on one of the three principal financial statements companies are required to report – the Statement of Cash Flows.  Companies generate cash from operating activities, investing activities, or financing activities.

Operating cash flow is the true measure of a company’s health in the eyes of most seasoned financial experts.  It is revenue generated from what the company actually does – the products it sells or the services it provides.  Here is the formula for the Price to Cash Flow Ratio (P/CF), the alternative measure to the P/E:

Price to Cash Flow (P/CF) = Price Per Share (PPS)/Cash Flow Per Share

Calculating this ratio presents the same fundamental problem a retail investor has in calculating any financial ratio – what is the time frame for the numbers you use.  Clearly, to calculate P/CF you need the PPS and the net cash flow from operations as well as the total number of shares outstanding.  You can find operating cash flow on a company’s Statement of Cash Flows and the number of shares outstanding on the Statement Financial Position.

However, those statements represent the company’s position at a precise point in time – the date the annual report is released.  So what value do you use for PPS?  The price per share changes daily while companies report earnings and operating cash flow quarterly.  While it is possible to find the PPS from the day of the earnings reporting, it is cumbersome and time-consuming.

So what is the average retail investor to do?  “Professional” tools are not always available to a homeowner, but substitutes can sometimes get the job done.  Despite the fact many experts prefer the Price to Cash Flow Ratio over the Price to Earnings Ratio; the P/CF is not something you are going to find pre-calculated on one of Australia’s many financial websites.  For whatever reason, the P/E remains the Queen-Mother of financial ratios.

If you understand the basic problem inherent in relying solely on reported earnings, you can compensate.  First, make sure you go beyond the ratios appearing on your favorite financial website and read the actual financial statements.

Although you will find all three statements – the Statement of Financial Position, the Statement of Comprehensive Income, and the Statement of Cash Flows – reproduced on some sites, you are better off visiting the company’s website and reading the statements in their original form.  The statements you find there are accompanied by a “Notes” section where the accounting firm responsible for preparing the statements explains some of the assumptions they used in creating the statements.

In essence, the cash flow statement tells you where a company’s cash comes from and where it goes.  You want to see a healthy and growing cash flow from operations – the company’s basic business.  Cash flows out in certain investing activities, which you expect from a company committed to growing its business in the future.

Ideally, you would want to see a lower number in the cash flow from financing activity.  The sources here are borrowing or issuing new stock.  Both are valid and proper activities, provided the cash is raised for growth purposes.  In some cases, you can identify where cash raised from financing went right there in the investing section of the statement.  If a company borrowed or issued shares, you should be able to tell where they invested the money.

The Statement of Cash Flows is a relatively new financial statement.  Consequently, some investors ignore it in favor of the Statement of Financial Position.  However, if you believe in the statement – Cash is King – you will spend some time investigating this valuable tool.