A Bird's-Eye Test for Profits

Investors everywhere want their companies not only to be profitable but also to grow more so over time. Yet profits are not always what they seem, and simply looking at a company's earnings on its income statement will not always tell you the true picture.

A few years ago, hedge fund manager and Fool contributor Whitney Tilson penned a series of articles showing how investors could have seen the true profitability of Lucent Technologies (NYSE:LU) -- or rather its declining state of profitability -- by comparing its free cash flow with its net income. An investor would have seen the deteriorating situation a lot sooner than waiting for the ultimate earnings surprise Lucent eventually gave. I still rely upon this series of articles when investigating companies as possible investments.

Yet to get to that bottom-line number, you've got to wade through the 10-Ks and the 10-Qs, which can often be a laborious process, particularly when you've got to adjust the figures for one-time income or expenses. A lot of times, I just want to quickly separate the wheat from the chaff, so I've come to rely upon a method that lets me get to the heart of the matter right away. If the company can pass this high-level test, I can then dig deeper; if not, I just pass on by.

Like Tilson's comparison of net income with FCF, I like to compare a company's operating cash flow with the net income it reports. A company with increasing sales will eventually lead to increasing earnings. And as earnings grow, the stock price generally follows. Conversely, if sales falter, earnings will eventually decline, and the stock price will ultimately suffer. To forestall that occurrence, management can resort to various sorts of chicanery: channel stuffing and price discounts are two such tricks.

aaiPharma (NASDAQ:AAII) was recently accused of channel stuffing. The problem with this method of forestalling the inevitable is that it leads to swelling receivables. Price cuts, on the other hand, lead to declining margins, which in turn can be masked by inflated inventory values. When inventories and receivables rise, operating cash flow takes a hit. So we ignore all of that and zero in on operating cash flows to detect a company's true situation. What we're looking for is where net income and operating income diverge: the former is increasing while the latter is decreasing.

The easiest place to do that is at Morningstar.com. As I noted last week when I looked at operating margins, the venerable mutual fund website is chock full of stock information too, and one of the best features is its 10-year financial statements. After getting your company's stock quote, click on Financial Statements from the left hand menu and then 10-Year Cash Flows. While net income is considered to be the "bottom line," it's the first line on the cash flow statement.

A look at two electronics retailers can highlight how a comparison of operating cash flows and net income can lead to superior investments. Best Buy (NYSE:BBY), a Motley Fool Stock Advisor pick, has been a fairly steady performer over the years. Circuit City (NYSE:CC), on the other hand, I characterized as the "ugly stepchild" to Best Buy when looking at its recent deal with Verizon.

Operating cash flow and net income usually (or at least should) rise together. When they don't, it could indicate accounting or other problems. As you can see above, Best Buy's operating cash flow handily exceeds its net income, as it should, and they rise and fall in tandem. Circuit City, though, is indeed ugly, reporting greater net income in two of the last five years, which should raise a red flag for investors.

The fact that Best Buy passed this high-level once-over does not render it an automatic "buy." You still need to dig further. But it would preclude me from wasting more time investigating Circuit City. You would want to investigate accounts receivable and inventories to root out the problem. Still, with so many more profitable and rewarding companies out there, why muddle through dubious ones?

Quickly comparing net income with operating cash flow is a bird's-eye examination to expedite your investing time.

Fool contributor Rich Duprey often appears befuddled when muddling through financial statements. He does not own any of the stocks mentioned in this article.