Net Income Over Cash Flow

Some Financial Analysts reason that using cash flow will supply a more than accurate image in determining the just value of a common stock. What gives? They ground that investors should follow where the cash is. Cash flow will track the flow of cash in and out and this is the ground business exists; to get cash.

Things are not that simple, however. Just as nett income, cash flow can be easily manipulated. Cash flow here mentions to cash flow from trading operations establish on the statement of cash flow published regularly by publicly traded companies.

Let's return a expression at the statement of cash flow for one publicly traded company, Amazon.com (AMZN) and decipher its components. We will utilize the statement of cash flow for the twelvemonth ending on 31 December 2004. Here is the beginning from Yahoo! Finance: http://finance.yahoo.com/q/cf?s=AMZN&annual

The top portion is nett income, which is self-explanatory. This is what a company earns during a clip period of time. For the clip time period earns $ 588 M. To get into the cash flow figure, we need to add depreciation expense, deduct any addition in accounts receivable and stock list and add any addition in short term liability such as as accounts payable. Sometimes, there will be some accommodations made to the nett income which will increase or lessening cash flow depending on the charge.

Now here is how companies can pull strings cash flow. This volition in consequence temporarily give an feeling that cash flow have improved markedly.

Temporarily Delaying Payment. This volition addition Accounts Collectible which in bend will better cash flow. While lone good companies can demand its providers to detain payments, all the debt eventually needs to be paid.

Demanding faster payments from customers. While an efficient aggregation is needed for a firm's survival, giving less credit to clients will ensue in them balking away. In the short term, cash flow will better owed to improved collection. In the long run, clients will travel to rivals who can offer better credit.

Keeping a tight supply of inventory. While distended stock list is wasteful, there is a certain degree of stock list that is needed to maintain a business running. Short-minded management will seek to pull strings cash flow by keeping a short supply of inventory. When you run a retail business, certain stock list is needed. It is not similar to a built-to-order company like Dell Inc. (DELL).

These three points change from one-fourth to one-fourth and twelvemonth to year. When determining just value, it is best to disregard these fluctuations and focusing on operational earnings generated by the company.

Another misleading cue from cash flow is that it adds up depreciation as the amount of cash generated from operations. While depreciation disbursal is a non-cash transaction, it is a necessary cost of doing business. For illustration a company bought a computing machine and depreciate it for five years. For the adjacent five years, the company incur a non-cash charge, which is the ground why we add depreciation disbursal to our cash flow. However, we need that computing machine for our operational purpose. Unless we halt disbursement in our capital expenditure, adding depreciation disbursal to our cash flow makes not do sense. Sure, you enjoy the benefit now. But five old age from now, you need to pass money on a new computer, which is a cash outflow.

As with other investment tools, cash flow from trading operations cannot be used independently of other ratios. Each and every financial ratio have its strengths and weaknesses. I believe that cash flow makes not reflect the true earning powerfulness of a company because of short-term fluctuations of the balance sheet and the improver of depreciation disbursal into a firm's cash flow.