There's an old saying about financial reporting that goes like this: "Earnings are an opinion, but cash is a fact." In a nutshell, that saying means accountants and corporate executives can get quite good at manipulating finances to deliver a specific earnings target, but it's a lot harder to fake cold, hard cash.
Knowing that, smart investors pay attention to income statements but put their real attention on the meat of a quarterly report: the cash flow statement. Examining cash flow is a key method for discovering how well a company actually performed during whatever time frame you're looking at, rather than what its executives wanted Wall Street to see.
Lies, more lies, and accounting
A common trick used to juice up short-term earnings at the expense of long-term operational excellence is an illegal tactic known as channel stuffing. In essence, it entails a company shipping more products than its customers actually demanded, booking undeserved sales in the process. Deceiving investors so lets the company book revenue and earnings it doesn't deserve -- albeit at a cost.
Part of that cost is the fact that the tactic nearly always causes the offending company to dig an even deeper hole for itself. By stuffing the channel, the company essentially borrows sales from future quarters, thereby making future targets that much harder to meet. The result is often a cascading effect where the overstuffed channel eventually leads to a cataclysmic breakdown, such as the one that took down former pharmacy retailer PharMor a few years back.
More recently, just last year in fact, pharmaceutical company Bristol-Myers Squibb (NYSE:BMY) paid $150 million to settle charges of channel stuffing. Bristol-Myers executives were accused of lining their own pockets at the expense of shareholders by stuffing drugs into distribution channels to meet earnings targets. Illegal though it is, channel stuffing often remains an attractive stop-gap measure because it is so difficult to detect until it spirals out of control.
Digging for data
When companies engage in channel stuffing, the closest an investor will get to a telltale sign is actually found on the income statement. Ordinarily, accounts receivable and sales should move roughly in tandem. If accounts receivables spike but sales don't, that might be a sign that problems are lurking. That spike means customers haven't yet paid their bills for lots of products that have been shipped to them -- often an indication that they were given a lot of inventory they didn't yet need.
A word of caution, though: A single quarter's shift may just be a sign of a looming business slowdown, rather than a sign of maliciousness. Consider the cases of major aircraft engine supplier General Electric (NYSE:GE) in the post 9/11 air travel slowdown or networking giant Cisco Systems (NASDAQ:CSCO) as technology spending slumped after the Y2K problem had been resolved. Both had short-term jumps in receivables due to a radical slowdown in their customers' businesses. While it's never a good sign to see accounts receivable spiking in the absence of revenues to support them, a single spike alone is no guarantee of malfeasance. If the trend continues, however, the alert signal should get louder.
Cash tells the truth
Channel stuffing boosts revenue and earnings, but the cash flow statement will still tell it like it is. It'll still show you precisely how much money flowed into and out of the company and for what purpose: investing, financing, or operations. This is a primary reason why value investors like the team at Motley Fool Inside Value always look at the cash flow statement to get the real scoop. We use it to calculate something called free cash flow, which is simply the amount of cash generated by a company's operations minus its capital spending (often called "purchase of property, plant, and equipment" on the statement of cash flows).
Often, in addition to simply saying what actually happened, checking out cash flow can lead investors to uncover values that aren't apparent from earnings. Consider Inside Value lead analyst Philip Durell's recent recommendation of accounting software giant Intuit (NASDAQ:INTU). When Philip uncovered this gem, it traded for less than 15 times free cash flow. With its free cash production stronger than its reported earnings, it's a value that would have been missed by not looking at the cash flow statement. Since it was picked in the March issue of Inside Value, Intuit shares have surged by nearly 27% vs. the S&P 500's 4.2% rise as Intuit's value finally dawned on investors.
Looking for companies that produce more free cash flow than earnings is a good way to find overlooked, yet valuable, stocks that you can study further. Doing so first led me to employment and income verifier Talx (NASDAQ:TALX) late last year. It's more than doubled in just a few short months.
Where to look next?
It's not always easy to find companies that operate so much more strongly than their earnings suggest. Companies to examine include those that are completing a major expansion of their operations. At that point, cash costs (and they may be substantial) have already been paid, but earnings continue to be suppressed by depreciation costs. This gives you as an investor the opportunity to get in at that magic moment between when a company's expansion is paid for and when it realizes the benefits of its hard work. Comcast (NASDAQ:CMCSA) (NASDAQ:CMCSK) is a good example. The nation's largest cable company has just wrapped up a major -- and expensive -- network upgrade, and its free cash flow is now exceeding earnings. It's probably worth a look at this point.
Want help looking beyond the headlines to find value hidden on the cash flow statement? A 30-day free trial to Inside Value can get you started.Click hereto take the trial, and be sure to enter our "A Stock I'd Like to Own" contest. Simply tell us about any public company's stock that you'd like to own, and you could win a free subscription to Inside Value.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares in Talx and General Electric. He had no financial position in any other company mentioned here. The Fool has a disclosure policy .
