Is This Company Really Earning Money?

It's been a rough year for many companies. Between the credit crunch and the overall economic malaise, many businesses appear to be on the verge of failure. Earning money -- any money -- in times like these is cause for celebration.

But unfortunately, not all earnings are the same. The quality, as well as the quantity, of those earnings matters a great deal. If there's real cash flow backing up those accounting profits, then you can be far more certain that they're the real deal. If the cash isn't there to back them up, then those accounting earnings are far riskier propositions.

What's wrong with cashless earnings?
At its worst, profit without cash can be the result of a company's desperate attempt to make itself look stronger than it really is. In the short run, tricks such as deferred payments and interest-free customer financing can let a company report profits even when its underlying operations are weak. In the long run, such tactics tend to backfire, because they typically merely serve to pull forward sales that would have happened in future quarters, rather than generating new revenue.

Even under less dire circumstances, when a company generates substantially less cash than it reports as earnings, it can spell trouble. When its free cash flow (defined as cash from operations minus capital expenditures) is negative, it means the company had to either borrow or tear into its reserves to fund itself for the year. That may be OK for some time, if a company is expecting rapid expansion and is investing in anticipation of that tremendous growth.

It's not a sustainable path, however. In fact, it often signals that either the company's investments are returning below its cost of capital, or that significantly deferred maintenance is finally catching up to it. Over time, especially with today's tight debt market, lenders will tire of financing supposedly profitable companies that can't come up with two dimes to rub together.

Any way you slice it, sustained periods of negative free cash flow can indicate a company that's unlikely to provide you with decent long-run investing returns.

Risky business
Take, for instance, the companies in this table:

*Defined as Cash From Operations minus Capital Expenditures.
Data from Capital IQ, a division of Standard and Poor's.

They all reported accounting profits over the past year, but not a single one of them generated sufficient cash to pay for the capital expenditures that supported those earnings.

In some cases, like Chevron, Marathon Oil, and Duke Energy, long investment lead times and high infrastructure costs make such periods of negative free cash flow occasionally inevitable. In others, like Monster Worldwide and Elan, "earnings" were driven more by one-time events like tax benefits, asset sales, and reversals of reserves for legal settlements than by actual operations.

As an investor, you have to ask yourself whether you really want your money tied up in a company that isn't pulling in enough cash to support itself. If it's a temporary condition caused by the costs of expansion, and the company ultimately turns out to be profitable, you may still have a decent chance of winding up OK when all is said and done. If, on the other hand, the company projects financial strength through earnings that aren't really there, its future will be far bleaker.

Follow the money
At Motley Fool Inside Value, we understand the importance of generating cold, hard cash when it comes to determining a company's long term prospects. Our favorite investments are the ones that produce prodigious amounts of it, regardless of what their accounting earnings may say.

If you see why cash generation is so much more important than earnings when it comes to a company's long-term financial health, then you have what it takes to join us today. If you'd like to learn more before joining, that's fine, too. Simply click here to start your 30-day no-obligation free trial to take advantage of our archives and the collective wisdom of our analysts and members.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned no shares of any of the companies mentioned in this article, but his wife owned shares of Duke Energy, which is a Motley Fool Income Investor selection. Chuck would like to thank Foolish reader Jonathan P. for suggesting the topic for this article. The Fool has a disclosure policy.