Despite what some business execs want you to believe, cash pays the bills -- accounting earnings do not. Cash flow is much more difficult to manipulate than earnings, which makes it a better analysis tool for investors. In short, cash is king. While reading The Smartest Guys in the Room, a detailed account of the Enron downfall, I was reminded yet again why cash flow is so important.
Everybody loves Enron
One of the many, many problems at Enron was the way former president Jeff Skilling managed earnings. Skilling would ask Wall Street what earnings number it wanted him to produce. Then he would try to hit that number.
Are you kidding me?
The president of a major corporation should tell Wall Street what earnings he expects after a careful analysis of his business, not the other way around. Enron had the process completely backward.
It gets worse. Often, Enron wasn't able to meet Wall Street's lofty expectations. Rather than admit defeat, management would do whatever it took to hit its numbers, including:
- Closing unfavorable deals so the profits could be booked before the end of the quarter
- Excessively using mark-to-market accounting.
- Renegotiating or restructuring old deals to make them seem more profitable
- Delaying losses on bad deals until the next quarter
- Avoiding tax expenses through complicated financing arrangements
None of these transactions are signs of a healthy, growing business. None of these involved cold, hard cash coming in the door. Enron's "profits" were merely paper profits, most of which hurt the company's long-term financials.
Brave new world
Times have changed since the Enron scandal. Today, we have increased corporate governance and Sarbanes-Oxley regulations. But earnings manipulation still happens.
In 2004, the SEC investigated blue-chipper Coca-Cola for "channel stuffing." Channel stuffing involves shipping inventory to distribution channels ahead of schedule to inflate earnings, and it's one way to work around current accounting rules. Usually, distributors cannot sell this excess inventory and end up returning it. Acclaim Entertainment also allegedly stuffed the channels with its video games to boost revenue. Acclaim eventually filed for bankruptcy in 2004, and it now trades on the pink sheets as a penny stock.
Even when management plays by the rules, accounting earnings are subject to change. Companies as diverse as ConAgra Foods (NYSE:CAG), Nortel Networks (NYSE: NT), and Blockbuster (NYSE: BBI) have had to restate earnings recently, erasing millions of dollars in profits. As companies review their options practices, we can look forward to many more restatements.
Show me the money
Because of these earnings "discrepancies," investors should focus equally (if not more so) on the actual cash moving in and out of the business. Missing Wall Street estimates by a penny doesn't matter that much when the company is bringing in the green stuff each and every quarter.
That's why I like to see a long history of management distributing cash to shareholders through a dividend. A strong dividend policy ensures that management is committed to bringing in cash profits rather than paper profits. It ensures that real goods and services are being provided to real customers, rather than the complex (and misleading) financing arrangements of Enron.
Companies that have long histories of dividend payments are among the best performers historically. Just ask long-term shareholders of Johnson & Johnson (NYSE:JNJ), a business that has increased its dividend for the past 44 years.
The Foolish bottom line
Reading about Enron's flagrant abuse of the system shook my confidence in GAAP earnings, and I'm sure I'm not alone. It caused me to review my own investments to see if I'd been focusing too much on Wall Street's earnings game.
Sure, I like it as much as the next guy when a company I own trounces Wall Street estimates. But I like it even better when I know those earnings are quality earnings.
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This article was originally published on June 6, 2006. It has been updated. Joey Khattab owns shares of Johnson & Johnson, which is an Income Investor recommendation. Coca-Cola is an Inside Value recommendation. The Fool has a strict disclosure policy.