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February 10, 2001

What Cash Flow? Which Earnings?

Last week we began our discussion of the different methods of evaluating a company's results of operations. (Earnings, EBITDA or Cash Flow -- Which Is Most Important? - Street Wise, Feb.3) We showed why simply looking at reported earnings is not always enough to get a true picture of how a company is doing. We also explained how EBITDA is derived and for what it is most appropriately used. This week we'll talk about different reported earnings figures that get tossed about, and different cash flow figures. A company's earnings release nowadays often refers to its cash earnings or operating earnings before one-time items, and other methods of measuring their results. The guidelines below will show you how and when to use these figures. I'll do a lot of explaining, but at the end, I'll simplify it all into a few short rules for you.


When you hear analysts talk about earnings estimates for a company, you're almost always hearing what they call "operating earnings." They also sometimes use "cash earnings." I won't get into all the different ways some of these terms get used; it would make you nuts. (It makes me nuts.) I'll just go with how they are most often used. Cash earnings is a term that means earnings calculated without deducting amortization of goodwill. Operating earnings is a term that usually means earnings that exclude goodwill and "one-time items" such as write-offs for restructuring, mergers, etc., and gains from the sale of investments or assets.

Goodwill, to refresh your memory, is a term used to denote the portion of a price paid for a company that is above the determinable price of its assets. For example, if you buy a pizzeria in which the equipment and building are worth $100,000, but you pay $150,000 for the business, $50,000 is allocated to goodwill. Goodwill represents the intangible value of a company's reputation, contacts, customers, etc. These are things that can't be quantified, but are certainly of value. Some financial columnists make a big deal about a company having a lot of goodwill on its books. The lead columnist of a very popular financial weekly often writes stories of this sort acting as if he has uncovered some great scandal.

The fact is that goodwill means nothing in and of itself. Amortizing goodwill makes an attempt at answering the question of whether or not a company made a good investment or whether it overpaid when it bought another company. That question is best answered, however, simply by calculating a company's return on assets after the acquisition. If company A returned an average of 10% on its assets for a number of years before the acquisition, but returned only 7% in the years following the acquisition, it's probably because it made a bad deal. If its return increased, it probably made a good deal. In fact, tracking ROA over a number of years is a good idea even if a company doesn't make acquisitions. Beware if the percentage return goes steadily down.

The Financial Standards Accounting Board (FASB) has recently recognized the flaw in its handling of goodwill amortization. It is in the process of changing policy to allow companies to use cash earnings in the future.

Incidentally, unlike amortization of goodwill, depreciation usually represents a real expense, since a depreciated asset usually needs to be replaced. So, ignoring depreciation is not a valid way to compute cash earnings.

Analysts' use of "operating earnings" usually makes sense, but not always. The purpose of this calculation it is to get an idea of the general trend of a business without the "bumps" of one-time items. That's okay, as long as these one-time items are the exception rather than the rule. Some companies, however, are constantly restructuring or writing-off assets because they can't get their act together. If you see that a company has significant restructuring charges or write-offs year after year, it would be foolish to evaluate it as if those losses wouldn't be repeated. You need to look at several years of earnings statements to make this judgement. That's something you should always do anyway.

On the Subject of Cash Flow

I explained last week how most analysts wrongly equate EBITDA with operating cash flow. I want to elaborate a little more on how the term "cash flow" gets bandied about. Analysts often talk about "free cash flow." This is supposed to represent the cash generated by a company from its normal operations, less its ongoing capital investment needs. It is most useful in determining the value of companies in capital-intensive industries, such as oil and gas production.

There are variations of how free cash flow is calculated, and the ongoing "needs" of a company are somewhat subjective. The most important thing to question when someone presents this number is whether or not it was generated from the actual cash flow statement, or whether it was backed out of the earnings statement like EBITDA. If it was backed-out, you should compare the operating cash flow statement against reported earnings to make sure the earnings aren't questionable. If the comparison looks okay, then it's also okay to accept the the free cash flow figure. Properly calculated free cash flow is a better measure for evaluating the ongoing earning capability of a capital intensive company than EBITDA is, simply because it takes into account depreciation and interest expense, which EBITDA ignores.

I'll now summarize what we've learned in the last two weeks into a few rules.

Rule 1 Always compare a company's operating cash flow to its reported earnings. If operating cash flow is noticeably below reported earnings be wary of the validity of the reported earnings. Note that operating cash flow figure is not used by itself; it is used to check the integrity of reported earnings. (See Follow the Money to Find the Phonies - Street Wise, Jan. 13)

Rule 2 Cash earnings (which exclude amortization expense) is a useful measure of a company's performance if the company has a lot of goodwill on its books. (See the corrolary to this rule at the bottom of this list.)

Rule 3 Operating earnings is a more useful measure of a company's performance if it has occassional significant one-time gains or write-offs. If a company habitually has signifcant one-time items, net income or cash earnings present a more accurate picture of its operations.

Rule 4 Free cash flow is most useful in comparing the values of companies in capital intensive industries. Check a company's reported earnings against its operating cash flow statement before accepting the "free cash flow" figures.

Rule 5 EBITDA is useful for determining how much money a company is generating that can be used to pay down debt. It is also useful in determining a company's value as a takeover target. Check a company's reported earnings against its operating cash flow statement before accepting its EBITDA figures.

Corollary to rule 2 To determine how well a company invests in acquisitions, compare a company's return on assets (without amortizing goodwill) a few years before and a few years after acquisitions. Compare the return on assets (ROA) before taxes are deducted. (See the glossary for a definition of ROA.)


That's it for cracking the books for now. I look forward to speaking with you again next week.


Copyright 2001 by Jack Adamo. All rights reserved.