Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance.

John Wiley & Sons, Inc., January, 2005.

It is difficult to overstate the importance of cash flow to overall corporate financial health. Indeed, our fundamental concepts of credit quality and valuation are based on projections of cash flow. Typically these projections are of operating cash flow or a closely-related metric, free cash flow, which is operating cash flow adjusted for capital expenditures. These measures of cash are viewed as sustainable and discretionary sources that can be used for such designated purposes as debt service, reinvestment, stock buybacks, dividends and the like.

Many investors, burned by the trust they have placed in reported earnings in an era of questionable accounting have turned their focus to cash flow as the only trustworthy measure of financial performance available. One might hear such statements as,

"Cash flow is real and not subject to the vagaries of GAAP or the whims of the accountants."

"It's virtually impossible to manage cash flow."

"Profit is an opinion. Cash is a fact."

"Dividends are tangible cash, and therefore impossible to fake."

The balance in cash and the total change in cash from one period to the next are generally not prone to misstatement. These amounts are readily verifiable with banks and other institutions holding reported balances. Unfortunately however, changes in the components of total cash flow - the operating, investing, and financing components - can be reported in a misleading fashion. Typically, but not always, this is done within the boundaries of generally accepted accounting principles (GAAP) as the guidelines provide much flexibility. Increases in operating cash flow, denoting an improvement in financial performance, are offset with higher disbursements in the investing and financing sections. The net effect - with no difference in total cash flow - apparent operating performance is improved.

Creative Cash Flow Reporting and Analysis: Uncovering Sustainable Financial Performance provides a guide for adjusting cash flow to remove misreported amounts, providing a more effective analysis measure.

In an era of reduced trust in reported earnings, operating cash flow, properly adjusted, provides a useful means for identifying earnings-related reporting indiscretions. Increases in earnings obtained through questionable means will not generate operating cash flow. Consider, for example, premature or fictitious revenue. Such actions result in growing receivables but not cash. Also, steps taken to misstate inventory might boost gross profit and net income, but will not provide cash flow. Similar statements can be made about aggressive cost capitalization and other creative accounting acts. Earnings are boosted but operating cash flow, or more precisely, operating cash flow adjusted using steps described in the book, is not.

Creative Cash Flow Reporting and Analysis: Uncovering Sustainable Financial Performance demonstrates how to use adjusted operating cash flow in uncovering earnings that have been misreported using aggressive or fraudulent accounting practices.

Equities are purchased and loans are made based on the perceived ability of a company to generate cash. Cash flow analysis provides an effective look at the financial soul of a company. An important step in cash flow analysis is deciding whether current cash surpluses or shortfalls will continue. It is not unusual for companies to generate ample amounts of cash even as they slide toward extinction. In contrast, a cash shortfall may be an early sign of future success. To be effective, cash flow analysis must find the true meaning in reported cash results.

Creative Cash Flow Reporting and Analysis: Uncovering Sustainable Financial Performance provides an effective approach to cash flow analysis that focuses on the fundamental drivers of sustainable cash flow performance.

Beyond its primary objectives, the book includes certain special features, including the results of a survey of financial professionals regarding their views on cash flow reporting. It also includes the results of a study designed to adjust the cash flow statements of the S&P 100 for the years 2000, 2001, and 2002. For many companies included in this sample we found significant differences between reported and adjusted operating cash flow. Finally, to maintain a contemporary and real-world feel, the book's results are illustrated using hundreds of actual and recent company financial statements.

Creative Cash Flow Reporting and Analysis: Uncovering Sustainable Financial Performance was written for serious readers of financial statements, including equity analysts or investors, credit analysts and the credit professionals they serve, serious individual investors and professional money managers, and anyone interested in uncovering true sustainable cash flow performance.

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