Operating Cash Flow Tricks

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Operating cash flow is the lifeblood of companies. After subtracting capital expenditures, it frees up cash for things such as paying dividends, buying back stock, new investments, and acquisitions. Conventional wisdom says it is less easily manipulated than earnings.

Or is it?

Thursday's Wall Street Journal reports that a team of forensic accounting sleuths at Georgia Institute of Technology tipped off the SEC that Caterpillar (NYSE: CAT), General Motors (NYSE: GM), Ford (NYSE: F), and others had included vendor financing receivables under investing rather than operating cash flows on the cash-flow statement.

The SEC ordered them to fix the problem and reclassify it as operating cash flow, resulting in reductions of between $503 million for Harley-Davidson (NYSE: HDI) to $14 billion for Caterpillar for the years 2002 and 2003. Interestingly, the restatement resulted in negative operating cash flow for Caterpillar during those years. The article goes on to say that other companies, such as General Electric (NYSE: GE), have cleaned up their operating cash flow sections as a result.

For those of you who don't have the cash flow statement burned into your brain like I do, the calculation of operating cash flow begins with net income and then makes adjustments for cash inflows and outflows to measure the actual cash a company generates through its operating activities. Noncash expenses such as depreciation and amortization get added back. Increases in current assets, such as accounts receivable, are deducted since it is not an actual cash inflow, but according to the accrual accounting principle it is counted as revenue.

Caterpillar and the others made loans to purchase inventory, sometimes through financial subsidiaries, to dealers, the guys who sell the tractors and cars. They then classified this money owed, or receivables, as an investing cash (out) flow. You could make a pretty good case that this is part of operations rather than part of investing on the cash-flow statement. Which the SEC has now done.

While companies' quality of earnings has often been questionable, cash flow has been considered cleaner. Is nothing sacred? Apparently not.

One quick analytical tool that bypasses the company's definition of operating cash flow on the way to free cash flow is what Tom Gardner calls structural free cash flow (net income + depreciation + amortization +/- onetime items - capital expenditures).

And while companies will continue to find ways to exploit accounting grey areas, investors will continue to find ways to "measure true profitability."

Structural free cash flow is one of the factors Tom Gardner focuses on when selecting recommendations for Motley Fool Hidden Gems. Want to know more? Take a risk-free 30-day trial.

Fool contributor Chris Cather owns none of the companies mentioned. While he is bummed out he didn't get a chance to compete in "Stock Madness 2005 , " he's hoping he'll get a bid to the NIT. In the meantime, he'll be cleaning out his locker, along with his alma mater U.Va.'s former coach, Pete Gillen, and hitting the value investing books.