If there is any unfortunate thing about investing, it's that no investment can be made with perfect information. Not only are markets forward-looking, but accounting leaves a lot to be desired. Accounting is a science, but interpreting it is very much art. Here are a few disadvantages of income statements and cash flow statements.
Disadvantages of the income statement
In isolation, the income statement doesn't tell us all that much about a company. There are a few common pitfalls to the income statement that are worse than others, however.
1. Depreciation expenses may not reflect the true cost
Assets held on a company's balance sheet are depreciated over their useful life. Microsoft depreciates computer equipment it owns over two to three years, for example. Thus, if it purchased $100 million of computer equipment for its employees, it might take a $50 million charge for two years.
However, computer equipment often lasts much longer than two to three years, even in technology companies, so depreciation expenses may not reflect the true expense of computer equipment over time. Thus, a company may record depreciation expenses for two years for an investment that may actually last five or six years. This has the effect of understating the true earnings power of a company that makes an investment in technology.
Conversely, railroads are notorious for understated depreciation expenses, which overstates their true cash earnings power. Because assets are depreciated against their historical cost, long-term investments are depreciated against their old cost basis, while inflation leads to increasing costs of replacement.
In the 10 years from 2005 to 2015, Union Pacific reported about $15.9 billion in depreciation, while it spent $33.8 billion on capital expenditures. Some of that capital expenditure (capex) was likely spent on expanding its ability to ship goods over the rails, but much of it was simply maintenance capex -- money it had to spend just to maintain its current capacity.
Net income is a very poor way to value a railroad because depreciation reflects the expense of maintaining railroads at a historical cost, not the current cost. A railroad's net income will always be greater than the actual cash an owner could expect to take from the railroad over time.
2. Assumptions galore
For many businesses, the income statement is full of assumptions, many of which may prove to be wholly inaccurate over time.
Wal-Mart, for instance, reports sales net of expected returns. If for any reason shoppers return more product than expected, true net income could be much lower than reported.
Similarly, a bank's income in any calendar quarter includes assumptions about how many of its loans will go bad over time. If a bank expects too few loans will go bad, it will report far more income than it ultimately earns over time. Conversely, banks can assume loan losses that are too high, and thus report less income than it actually earns over periods spanning years.
Disadvantages of the cash flow statement
Unlike the income statement, which reports income on an accrual basis, the cash flow statement shows the immediate sources and uses of cash during an accounting period. It can have its own biases and disadvantages for investors.
1. Growing companies can be penalized by an analysis of the cash flow statement
Suppose a widget producer cannot keep up with demand. Its customers would order substantially more widgets if it could produce enough widgets to meet demand. It decides to embark on a project to build a new factory, which will be completed in two years.
The cash flows spent to build the factory will appear in its "capital expenditures" for the next two years, but the future cash flows earned from the factory won't be reported anywhere in its financial statements.
Thus, its reported "free cash flows" for these two years will be temporarily depressed. That appears to be a problem, and it is, but it's a very high class problem to have! Businesses could only hope that their products are so good that they cannot keep up with demand without making new investments.
2. Cash spending can be delayed
Managers can delay the payment of invoices to improve their net cash inflows from period to period. A liability that gets deferred into the future indefinitely will improve cash flows in the here and now at the expense of future cash flows at a later date.
Warren Buffett has explained this several times when talking about his various insurance businesses. Insurers take in premiums today to pay out losses in future years. The insurance companies have to show a liability for future losses, but so long as this liability is permanent and forever growing, is it truly a liability?
If you borrow money at a zero interest rate and can push off paying it indefinitely, it's really not much of a liability, is it?
Over short periods of time, most businesses can report greater cash inflows by pushing off a liability for as long as possible. This is why many analysts like to observe changes in a company's accounts payable turnover ratio. When the average life of accounts payable expands, it may just be that a company is deferring payment to suppliers to improve its cash position. Unfortunately, the cash inflow this creates isn't sustainable, and thus the short-run benefits today will be reversed in the long-run when the average life of an account payable shrinks.
If there is one takeaway, it's that financial analysis is not so much about a company's results in a single accounting period but the trends over several accounting periods. And it's important to analyze the income statement, balance sheet, and cash flow statement for every company, as what often looks "too good to be true" on the income statement is generally reconciled with a change to the balance sheet or cash flow items.
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