Investing for Survival

 Investing for Survival

Follow the cash. Most investors pay a lot of attention to how much a company earns; few investors realize how easily management can manipulate those earnings with fancy accounting. To reduce risk in the stocks you buy, keep an eye on a company’s cash flow as well as its earnings.

Your first step should be to look with a questioning eye at the non-cash, or accrual items, on the company’s financial statements. These include entries for such things as depreciation, inventory adjustments, or bad debt allowances. Cash is certain, but non-cash items such as these are anything but. Earnings can be thrown up or down by how quickly management decides to write down the value of a new factory or by how much it estimates its inventory of rotary-dial phones is really worth. The accounting industry tries to set guidelines for accruals, but management still has a lot of leeway.

For non-accountants, the easiest way to sniff out possible trouble is to compare the earnings statement with the cash flow statement—specifically the top segment of the cash flow statement, which shows “cash flow from operations.” This is the amount of cold hard cash the company’s operations are generating, before making any payouts to lenders or shareholders, or investing in new equipment. In most cases, if a company’s earnings are growing, its cash flow from operations should also be going up, since higher earnings just about always mean more cash going through the business. So what if a company says its earnings are growing, but its cash flow isn’t?  You should be very, very wary. The financial statements aren’t necessarily bogus, but you have to puzzle out how a company’s earnings can be rising without throwing off more cash.

Sometimes there is no good answer to this puzzle. Remember Sunbeam, the small-appliance maker that hired “Chainsaw Al” Dunlap to goose its business? I owned the stock in 1996 when Dunlap came on the scene. But after two earnings reports I became suspicious. “All of these restructuring efforts are improving earnings, but they’re not producing cash from operations,” I thought. “What gives?” I concluded something fishy was going on, so I sold for a nice gain. Over the next six months, the stock rose by 60%—then plunged 90% as it became clear that most of Sunbeam’s increase in earnings was the result of accounting shenanigans, not real business gains.