Adjusted Earnings and the importance of the Cash Flow Statement

Adjusted Earnings and the importance of the Cash Flow Statement

The Stock Market can be a confusing place with so much information to assimilate and to learn. And Wall Street doesn’t make it any easier with their lax approach to governing themselves (remember the financial mess of 2008).

A new trend is taking shape, that of ‘adjusted earnings’. Reported earnings are based on the income statement which is already filled with various estimates and assumptions of the firm’s accountants. If that wasn’t enough there is also the danger of the company manipulating its earnings to make things seem better than they actually are. With the tremendous emphasis on beating the next quarter’s earnings the senior management teams are incentivized to make their earnings seem as good as possible.

When a company uses adjusted earnings they tend to deduct anything negative from their income statements (acquisition costs, depreciation and amortization). This makes their numbers look better than they actually are. This in turn helps executives reach their incentive targets more easily to take home higher bonuses. Does any of this sound familiar? It’s the same old thing on Wall Street…the dreaded 'Greed' factor.

The DIY investor can help protect himself by putting less emphasis on reported earnings and the income statement and instead pay more attention to the cash flow statement. The cash flow statement strips away all the abstract, noncash items such as depreciation that you see on the income statement and tells you how much actual cash the company has generated.

The Cash Flow Statement is divided into three main categories as follows...

Operating Cash Flow...

This category shows operating cash flow, which in many ways is the single most important number indicating the health of a business. It tells you how much cash the company made from its business activities. This is the place to focus on as it represents the cash-generating ability of the business.

Investing Cash Flow...

Indicates the investing activities made by the company to help maintain its business.  In short anything that involves the buying or selling of the company's assets. The key line here to keep track of is the cash spent on capital investments. Companies that need a lot of capital spending can be difficult businesses to invest in as they need a lot incoming cash to help maintain their business. A good rule of thumb is to invest in companies that are the suppliers to these capital intensive companies.

Financing Cash Flow...

Involves Equity financing such stock and other forms of capital as well as Debt financing (borrowing), such as short term notes, long term loans and bonds.

And finally we come to Free Cash Flow.

When you subtract capital spending from Operating cash flow you get Free Cash Flow which is how much cash the company actually generated from its business after it paid out its expenses for running the company. Companies that have free cash flow often make good investments as they can take this cash and invest it back into their business without incurring anymore debt. If you can buy these businesses during a market downtrend when everything sells off, they can make really good investments.