Cash Is King

With more companies reporting one-time charges and pro-forma earnings, it's more important than ever to analyze companies' financial statements in-depth. Yet, some companies do not include full balance sheets when they report earnings and almost none include cash flow statements, so savvy investors need to analyze companies' 10-Q filings. Here are some tips on how to adjust the cash flow statement so it can be analyzed more easily.

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By Whitney Tilson
November 21, 2000

The financial shenanigans that companies engage in to dress up their financials never cease to amaze me. This has long been an issue at the fringe of the market, but today even the largest, most-respected companies engage in questionable -- though generally legal -- techniques to obscure problems. For example, the Lucent Technologies (NYSE: LU) debacle has been well-documented on this site (I highly recommend reading Lessons from Lucent, which might save you a lot of future pain).

You should assume that quarterly earnings reports and conference calls are companies' attempts to put their best foot forward. If things aren't going so great, management might genuinely not believe it -- the human capacity for self-delusion is remarkable -- and even if they do, they will often try to obscure it. And, if you think you can count on analysts to do anything but parrot the party line, then please contact me immediately about a bridge I have for sale.

Investors need to do some homework to dig beneath the spin that companies and analysts put out. My first stop is a wonderful quarterly filing with the SEC, the 10-Q (the year-end report is the even-more-comprehensive 10-K). In these filings, companies report all three financial statements -- the income statement, the balance sheet, and the cash flow statement -- as well as notes to these statements, management's discussion and analysis, and other miscellaneous items. (Generally, companies file their 10-Qs about a month after they report earnings -- by law, 10-Qs must be filed within 45 days of the end of the quarter -- so there have been many new filings in the past couple of weeks.)

Today, I'd like to dig into the cash flow statement, and next week I'll continue with other things to look for in a 10-Q.

The cash flow statement
When I first started investing, I focused primarily on the income statement: top- and bottom-line growth, margins, etc. Then, over time, I developed a better understanding of the balance sheet and learned the tools to analyze it, such as the Foolish Flow Ratio. But now I pay more attention to the cash flow statement than either of the other two. Why? Because cash is king -- it is the lifeblood of any business.

The cash flow statement is also less susceptible to gaming than the balance sheet and especially the income statement. For example, when companies take big one-time (so they hope) charges, the income statement in future periods can be artificially inflated. (Warren Buffett's critique of this so-called "big-bath" accounting in his 1998 annual letter, under the caption Accounting -- Part 2, is well worth reading.) But, on the cash flow statement, the one-time charge is simply added back, and costs are only accounted for to the extent that actual cash is paid.

Most importantly, in my experience changes in cash flow can be very revealing about a company's future. I can't tell you how many bad investments I've avoided by steering clear of companies in which cash flow is not rising as fast as earnings (or is declining faster than earnings). Examples include Salton (NYSE: SFP), Fossil (Nasdaq: FOSL), Staples (Nasdaq: SPLS) and Costco Wholesale (Nasdaq: COST). I have posted further information on these four companies on the Fool on the Hill discussion board).

Unfortunately, I didn't avoid one situation where weakening cash flows might have tipped me off: American Power Conversion (Nasdaq: APCC). When APC reported its Q2 earnings at the end of July, its profits met estimates, but it warned that the rest of the year would be weak and the stock fell nearly 50%. At the time, I argued in my column APC: Investor Opportunity? that the selling was likely overdone.

But shortly thereafter, APC released its 10-Q, which showed that free cash flow (cash flow from operations minus cap ex) was only $1.1 million in Q2 '00 (adjusted for a one-time payment) versus $51.5 million in Q2 '99. This warning flag was waving right in front of me, but I didn't sell because I felt that the weak cash flows were a short-term phenomenon. I'm not so sure anymore, as APC reported more disappointing earnings in Q3 and the stock plunged again. Today it is more than 70% below its July high.

When I sold the stock earlier this month (see American Power Conversion's Ugly Earnings and Goodbye Apple and American Power Conversion), I was open to the possibility of buying it back after I had realized the capital loss. But, in its recent 10-Q, cash flows were again dismal, as free cash flow was -$20.0 million versus +$56.5 million in Q3 '99. I won't buy this stock back at anything close to today's price until I see a material improvement in cash flow. As the saying goes: Fool me once, shame on you. Fool me twice, shame on me.

Adjusting the numbers on the cash flow statement
The figures reported in cash flow statements are cumulative. In other words, companies in their recent Q3 cash flow statements are reporting totals covering the first nine months of this year versus the first nine months of last year. To see what happened in Q3 by itself -- which is what I care about most -- one must subtract from the cumulative Q3 total the cumulative 6-month numbers from the Q2 cash flow statement.

There are two ways to do this: manually or using Excel. Both are a bit of a pain, but it's critical to do this every quarter (it's not necessary in Q1 of course). The manual method is simple (let's assume we're trying to find out Q3's cash flows): just write the figures from Q2 in the margin of the page with the Q3 cash flow statement. Then, take out your calculator and subtract each line of the cash flow statement from Q2 from the same line of Q3 and -- voila! -- you have the figures for Q3 only. (Click here for an example from APC's cash flow statement.)

For those of you comfortable with Excel, I recently discovered a more elegant solution. FreeEDGAR allows users to download Excel spreadsheets from company filings. So, first download the most recent cash flow statements (again, let's assume Q2 and Q3). Open both in Excel, copy the data from Q3, and paste it into the spreadsheet with the Q2 data so that the rows match up. After making sure the rows are aligned, simply create two new columns for Q3 '99 and Q3 '00 and subtract the relevant columns from one another. If this all seems like gibberish, don't worry -- a pen, paper, and a calculator work just fine.

Next week I'll continue with other things to look for in a 10-Q.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at To read his previous columns for the Motley Fool and other writings, click here.