Rule Maker Portfolio
The Most Important Financial Statement

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (Sept. 21, 1999) --

"What's your favorite financial statement and why?"

The question was spoken quickly and with a tinge of annoyance, as my interviewer eyed me disdainfully from his cushy black leather chair. The investment banker had little time to conduct these ridiculously long interviews that are standard fare for analyst candidates.

I shifted uncomfortably in my seat and scanned my frazzled brain for the "right" answer.

"Well, of course all three financial statements should be studied in conjunction with one another, but if I had to choose just one, it would be the balance sheet because it represents the foundation upon which a business is built."

That sounded good, right? Diplomatic, intelligent, maybe even a bit Wise. But did my interview answer hold any truth whatsoever?

Well, a little. It's true that each of the three financial statements -- income statement, balance sheet, and cash flow statement -- holds certain puzzle pieces that are essential to solving the mystery of how a business makes money. The income statement tells us how much product was sold; the balance sheet shows what resources were used to run the business; and the cash flow statement reveals the actual inflows and outflows of cash.

But let's get honest. In the real world of hurried lives, precious little spare time, and information overload, we investors need a fast and dirty way to evaluate a company's financial results. We don't always have time to do a comprehensive financial analysis of all three documents. We realize that by taking a shortcut, we won't get the whole story. But that's OK because sometimes all we want are the most critical pieces of data from the most important financial statement. Is there a solution?

Yes. For investors in stocks, what really matters is cash flow. Companies are valued on the basis of how much green stuff they can throw off over the life of the enterprise. Therefore, as we evaluate a company's investment potential, we need to focus on how much cash the business is capable of spitting out. So, where can we find that info? One place -- the cash flow statement, which is published right alongside the other financial statements on a quarterly basis as part of a public company's required SEC (Securities & Exchange Commission) filings.

Follow me, and let's go dig up Microsoft's (Nasdaq: MSFT) cash flow statement.

1) Click over to quotes.fool.com, or click the "Quotes/Data" tab at the top of this page.

2) On the left side of the page, under the "Data" heading, type "MSFT," and click the "SEC Filings" button. (You should find yourself on this page.)

3) You now face a list of documents with funky form names. You're looking for the most recent "10-Q" or "10-K." As of today, the most recent is the 5/14/99 10-Q.

4) A table of contents sits before you. The most direct route to the cash flow statement is the thankfully descriptive link "Cash Flow Statement." Alternatively, if you know you'll be glancing at all three financial statements, you can click "Item 1: Financial Statements." Either way, we've arrived!

You should be looking at something like what you see below. The following is the operating portion of Microsoft's cash flow statement for the first nine months of its fiscal year which ends in June. (For a more complete explanation of the cash flow statement, click back to the 8/23/99 Rule Maker Report.)

Microsoft Cash Flow Statement
  
($ millions)                         Nine Months Ended 
                                       Mar. 31, 1999 
Operations                                   
  Net income                             $ 5,583
  Depreciation and amortization              514
  Gain on sale                              (160)
  Unearned revenue                         4,139
  Recognition of unearned revenue 
    from prior periods                    (2,832)
  Other current liabilities                  471
  Accounts receivable                       (192)
  Other current assets                      (104)
-------------------------------------------------------
  Net cash from operations                 7,419
The bottom line of this table, "net cash from operations," tells us how much cash Microsoft raked in from its software businesses. In Microsoft's case, that number is $7.41 billion. That's a nice chunk o' change over a nine-month period. Notice that the company's accounting profit, net income, is substantially less at $5.58 billion.

If you take away nothing else from this article, remember this: Net income is a fiction; cash from operations is reality.

For an investor, operating cash flow is the profit that really matters. Net income involves all sorts of distortions that muddy the waters of understanding the true cash profitability of a company.

So, you might be wondering, "Does net income have any good use?" It's a good question. The only cases where net income has any real meaning is for some mature companies like Wrigley (NYSE: WWY), which has net income that closely approximates operating cash flow. Even so, operating cash flow still stands as the true tally of a company's cash earnings.

Have I convinced you that operating cash flow is a much more meaningful figure than net income? If so, you'll follow my reasoning that the net profit margin is an inferior measure of profitability to what I call the "operating cash flow margin." This figure is analogous to the net margin, except that instead of dividing net income by revenues, the calculation is:
                               Net cash from operations
Operating Cash Flow Margin =  --------------------------
                                       Revenues
In other words, the "OCF Margin" tells us how much real cash is earned for each dollar of sales. Check out the cash profitability of our Rule Makers compared to the net margin fiction. The results might surprise you. 
               Period*   Net Margin  OCF Margin
Cisco        9 mo. 5/99     17.0%       34.5%
Microsoft    9 mo. 3/99     42.2%       56.1%
Intel        6 mo. 6/99     27.1%       30.1%
Gap          6 mo. 7/99      8.4%        6.2%
AmEx         6 mo. 6/99     11.9%       43.4%
Yahoo!       6 mo. 6/99     -4.5%       26.6%
Pfizer       6 mo. 7/99     19.8%        8.0%
Schering     6 mo. 6/99     23.4%       16.5%
T. Rowe      6 mo. 6/99     21.7%       26.8%
Coca-Cola    6 mo. 6/99     17.2%       17.9%

(*Period links go to corresponding financial statements.)
You'll notice that I listed our companies in the order of their stock performance, from best to worst. As you can see, the net margin severely underrates the true cash profitability of many of our top companies. Look at Cisco, in particular. Its net margin shows the networking giant producing 17 cents of "profit" for every dollar of sales. Not quite. In actuality, Cisco generates 34 cents -- twice as much! -- of cash earnings per dollar of sales.

For the best summary of how well a company is doing financially, be sure to study the operating portion of the cash flow statement. The best companies produce operating cash flow in excess -- sometimes well in excess -- of reported net income.

Fool on.