Article Source: https://blogs.baruch.cuny.edu/acc9110fall2013/
An article written by Rick Wayman that was published in the online Forbes Journal in October 2010, advocates that cash flow from operations is a better metric of a company’s financial condition. Wayman states that, “Operating cash flow is the lifeblood of a company and the most important barometer that investors have (Wayman, 2010).”
Typically, prospecting investors regardless of financial proficiency would scrutinize the net income being generated by a company. It is presumed as the straightforward determinant of a company’s efficiency and profitability. It generally provides sufficient perspective on determining if the company is making profits in an adequate scale. Although net income is an important determinant of company’s viability, there are many other factors investors’ take into consideration in weighing their investment decisions.
The article provides two main reasons why Operating Cash Flow is far superior that Net Income for investor assessment:
- Cash flow is harder to manipulate under GAAP than net income
- “Cash is king” and a company that does not generate cash over the long term is on its deathbed.
Wayman also takes into consideration that operating cash flows is often confused for EBITDA (earnings before interest taxes, depreciation, and amortization), which is actually the company’s earnings before the effects of financing and investing decisions. Moreover, it fails to include the variations in the company’s working capital.
When investors rely on net income evaluations, they usually attach assessments with EPS (Earnings per share), which have some drawbacks. Wayman contends that a company can rely in EPS alone for a narrow time. More often than not, the company will need cash to pay its liabilities from suppliers and loans from bank institutions. Despite warnings that can be attained from reviewing the operating cash flows, investors continue to be engrossed with EPS signals.
The article also contends that net income from accrual accounting sometimes become overvalued and appears more significant than operating cash flows. Wayman states that there are various occasions when cash from legitimate sales can get confined on the balance sheet; and the two most common reasons are (1) customers delay payment, hence higher receivables, (2) inventory levels rise because of low sales performance or sales returns.
Lastly, Wayman identifies the prevalence of earnings manipulation in accrual accounting. For instance, managers may overstate net income in the income statement to earn more bonuses. There are other ways to manipulate the income statement to appear more attractive to investors. In contrast, operating cash flow statement will expose such management ploys. According to Wayman, when net income is more than operating cash flows, there is something wrong with the cash cycle which can be a long-term or short-term dilemma.
In general, for the reasons stated above, investors will find it more advantageous to evaluate the operating cash flows of a company.