Cash flow consultant

Show stockholders the money! - Forward Observer - cash flow better indicator of value

In the wake of last year's corporate scandals, politicians tried to boost the confidence of investors by improving the so-called Generally Accepted Accounting Principles (GAAP) that public companies use to report their earnings to the Securities and Exchange Commission. They have taken a dangerously misguided approach.

As my AEI colleague Peter Wallison wrote recently, the problem with current earnings statements isn't their accuracy but their adequacy: "GAAP financial statements, even when competently audited, do not, by themselves, furnish ... reliable information to investors."

There is, however, an alternative to GAAP: It is called cash. If you run your own business, what do you truly care about? The money that comes in the door and the money that goes out the door. That movement of money is called "cash flow," and it is the classic method of figuring what an asset is worth. The value of any business is determined by the cash it will generate over its future life. Cash flow, rather than audited earnings, ought to determine value. As a saying that goes back to at least 1890 puts it, "Earnings are an opinion; cash flow is a fact."

So it's troubling that the main legislative response to the scandals (the Sarbane-Oxley law), plus new SEC measures, have concentrated on earnings-adding new rules, plugging loopholes, and forcing both auditors and corporate managers to swear up and down that the numbers are right. Instead, regulators should remind investors that earnings are only one--often misleading--way to describe the health of a business.

Take Enron. If you'd had a chance to look at its cash statements, you might have suspected something was fishy long before 2001. Between 1998 and 2000, Enron suffered an outflow of $4 billion in cash--while claiming double-digit earnings growth.

Or consider WorldCom. In a recent paper, financial consultant Richard Bassett noted that on the day before WorldCom revealed it had overstated GAAP earnings by $3.9 billion, its stock sold for just 83 cents--down from $75 in 1999. Investors had already reacted to WorldCom's dreadful cash flow, ignoring its rosy earnings reports.

The quick-and-dirty way to calculate a company's cash flow is to begin with its earnings and make adjustments. For example, add back things like depreciation that aren't cash, and subtract from revenues items that don't put money in the bank (like increases in accounts receivable). Most of this work is done for you in the "operations" portion of the "statement of cash flows" that public companies report regularly.

Of course companies need to use some of the cash they produce to make long-term investments in their business. Those capital expenditures are found under "investments" in the cash flow statement. Subtract them from the operations cash flow and you'll have a good picture of the amount of free cash that the firm has generated--money that can go to pay dividends, or buy back shares of the firm's stock, or be held on behalf of the shareholders.

Cash isn't everything--it's also important to examine earnings statements and balance sheets as well to get a three-dimensional picture of a business. But cash tells you more than anything else--which is why President Bush's proposal to end the double taxation of dividends will increase investor confidence more than any change in GAAP.

Dividends are the single best indicator of a firm's financial health--and simple to understand. A company that has paid (or, better, increased) its dividend for many years is a solid company in a good business. "The financial statements prepared under GAAP," Wallison notes, "are inherently subject to manipulation." But you can't fake dividends.

What should policymakers do? Rescinding Sarbanes-Oxley and starting over would be best, but that's not going to happen. Instead, the new chairman of the SEC should use the bully pulpit to tell investors that cash is at least as important as GAAP earnings. In short, shareholders should be saying to corporate managers, "Show me the money!"