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Using Operating Cash Flow to Detect Earnings Problems



The relationship between earnings growth, more specifically, growth in income from continuing operations, and increases in operating cash flow is important and can provide meaningful insight into a company’s financial health. Over extended periods, the rate of growth in earnings should be commensurate with the rate of growth in operating cash flow. A lasting discrepancy in their rates of growth should be investigated in order to gain an understanding of its causes and implications.

In the short run, there may be a valid explanation for such a development. For example: seasonal factors may cause cash flow to lag earnings as actions are taken to build stocks in anticipation of increased demand. Or due to declining sales during the early stages of a downturn, a cyclical company may see operating cash flow decline as inventory levels grow before cuts in production can be made. Later, as production cuts are made and inventory levels are reduced, operating cash flow may exceed earnings. Then, during an ensuing upturn, earnings may begin to grow again at a rate that exceeds the rate of growth in cash flow as working capital accounts that were liquidated in the earlier downturn are replenished.


A fundamental change in the stage of a firm’s life cycle also can alter the relationship between operating earnings and operating cash flow. For example: a transition from start-up to growth may lead to positive earnings from losses in advance of a swing to positive operating cash flow.

Even in the absence of seasonal, cyclical, or life cycle changes, firm-specific developments may result in differences between the rate of growth in earnings and cash flow. For example: credit standards may be relaxed to boost sales. Similarly, increased amounts of inventory may be purchased to take advantage of discounts or to avoid unfilled orders.

Of course, more sinister reasons may explain an excess of earnings growth over cash flow growth. Earnings boosted by artificial means—for example, by premature or fictitious revenue recognition, by aggressive cost capitalization or extended amortization periods, by intentionally overstated assets or understated liabilities—will not be accompanied by an increase in operating cash flow.


If an imbalance between earnings and operating cash flow growth persists, and other, more benign explanations are ruled out, the sustainability of earnings can be called into question. The primary concern is that artificial accounting measures may have been used to cover up fundamental problems with a company’s operations creating what otherwise would appear to be healthy increases in earnings. Certainly the possibility of write-downs, for example, of uncollectible receivables or slow-moving inventory, or even of overstated property, plant, and equipment, increases in likelihood, suggesting that earnings declines may be in the offing.

When operating cash flow grows faster than the rate of growth in earnings, the likely explanation is that the balance sheet is being liquidated. Receivables are being collected, inventory is being sold, and prepaid expenses are being consumed without replacement. Although such developments will provide cash flow, it is also possible that asset write-downs, say of property, plant, and equipment or special liability accruals including a restructuring reserve or severance accrual, may have reduced earnings without providing cash flow.

Here again there may be reasonable explanations for such developments in the short run. Seasonal changes may call for inventory liquidation. Prudence during a cyclical downturn may suggest reductions in current assets. A change in a firm’s life cycle, this time from growth to maturity or maturity to decline, may be causing cash flow to grow faster or decline more slowly than earnings during a period of transition. Also, planned firm-specific developments, such as a tightening of credit standards or liquidation of unwanted inventory, or even a corporate restructuring, a nonrecurring event, can result in increased operating cash flow relative to earnings.

However, over an extended period, persistent operating cash flow growth in excess of earnings growth calls into question the sustainability of cash flow. Cash generated through liquidation of the balance sheet cannot be sustained. Reductions in earnings through asset write-downs or liability accruals eventually must stop. In the absence of a rebound in earnings growth relative to cash flow, the company will exhaust its supply of assets available for liquidation or write-down. Accrued liabilities will need to be paid.

Thus, after periods of high cash flow growth relative to earnings growth, it should not be surprising to see earnings growth rebound relative to cash flow. Higher earnings growth in such situations may not be a sign of developing problems but rather a return to normalcy. If earnings do not rebound, operating cash flow will eventually stop.

A truly sustainable relationship between earnings and operating cash flow requires that the two measures grow at comparable rates over the long term. When their rates of growth depart, an understanding of the causes can provide insight into how that discrepancy might be resolved. Such insight will provide guidance on the direction of future earnings and cash flow.

Our focus is on using operating cash flow, properly adjusted to reclassify certain operating items and remove nonrecurring items, to detect developing earnings problems with sufficient lead time to permit corrective action. For credit professionals with loan positions in place, such corrective action may entail a tightening of terms, including higher interest rates, a shorter repayment schedule, or added security and guarantees. It may even entail the initiation of an exit strategy. For credit decisions under consideration, a prudent course of action may be simply to avoid the opportunity altogether. For equity investors and analysts, corrective action may entail sale of securities held or the initiation of a short position.

Regardless of the objective, operating cash flow can be a powerful tool for detecting developing earnings problems. However, to better grasp the implications of departures in the growth rates of earnings and operating cash flow, an understanding of the relationship between the two must first be gained.


Relationship Between Earnings And Operating Cash Flow

The operating section of the statement of cash flows prepared in the indirect-method format, which provides a reconciliation of net income to operating cash flow, is instructive in better understanding the relationship between earnings and operating cash flow. As an example, below figure shows operating section of the statement of cash flows:
Operating Section, Statement of Cash
Years Ended April 30, 2007, 2008, and 2009 ($ millions)

                                                                            2007    2008     2009

Net income                                                          $233      $228    $245
Adjustments to reconcile net income to-
net cash provided by operations:
– Depreciation                                                         53         55        55
– Amortization                                                        11          —       —
– Deferred income taxes                                         (40)       (43)     (15)
– Other                                                                   2            3          1

Change in assets and liabilities:
– Accounts receivable                                             (9)          23        (30)
– Inventories                                                           (63)          5          2
– Other current assets                                              3            5         (4)
– Accounts payable and accrued expenses               10          15       (18)
– Accrued taxes on income                                      44         (13)       12
– Noncurrent assets and liabilities                           (12)        (29)      (5)
Net cash provided by operating activities                $232       $249    $243


Referring to the figure, it can be seen that over the three-year period presented, the above figure has reported a very stable relationship between earnings and operating cash flow. In fact, the manufacturer and marketer of distilled spirits, reported net income and operating cash flow that were almost identical in amount. Between 2007 and 2009, net income increased just over 5 percent, to $245 million from $233 million. Over that time period operating cash flow also increased by approximately 5 percent to $243 million from $232 million.

The company reported depreciation charges, which lowered net income but did not consume operating cash flow. Cash was consumed by deferred tax benefits and, more recently, increases in accounts receivable, resulting in little net difference between net income and operating cash flow.

It is noteworthy that in only one year, 2007, was there a measurable use of cash for an increase in inventory. As a manufacturer of distilled spirits and wines, the company carries inventory for considerable periods while its products age. Across the three years, 2007 through 2009, the company carried its combined inventory of all products on average for more than eight months. However, it is not the size of its inventory that would consume operating cash in any particular year, but rather the increase in that inventory. For the company, inventory levels have remained relatively stable, resulting in little year-to-year cash flow effect.

In contrast to the stable relationship between earnings and operating cash flow reported previously, consider JetStar Airways Corp. Excerpts from the company’s statement of cash flows are presented below:


Operating Section, Statement of Cash Flows,
Years Ended December 31, 2007, 2008, and 2009 ($ thousands)

                                                                     2007         2008          2009
Net income                                                  $ 38,537   $ 54,908     $103,898

Adjustments to reconcile net income to
net cash provided by operating activities:

Deferred income taxes                                    3,373        39,659       69,753
Depreciation                                                   9,972        24,730      44,133
Amortization                                                     445          2,192         6,732

Changes in certain operating assets and liabilities:

Decrease (increase) in receivables                    430           6,851      (4,047)
Increase in inventories, prepaid and other      (2,120)         (3,992)     (11,491)
Increase in air traffic liability                         23,788         45,968       37,185

Increase in accounts payable and accrued
liabilities                                                     30,894       34,734       37,335
Other                                                           5,960        11,427        2,839
Net cash provided by operating                 $111,279    $216,477    $286,337


The above figure presents the operating section of the cash flow statement for JetStar Airways. In each of the years presented, operating cash flow exceeded net income by a substantial amount. In 2009, at $286,337,000, operating cash flow was nearly three times the company’s reported net income of $103,898,000. Noncash expenses, especially deferred income tax expense and depreciation expense, were the primary reasons for the difference between net income and operating cash flow. Increases in receivables, inventories, and prepaid expenses consumed cash flow but were more than offset by substantial increases in the company’s air traffic liability, more commonly known as deferred revenue, and by increases in accounts payable and accrued liabilities.

Reporting operating cash flow that was nearly three times net income was primarily a function of the capital-intensive nature of the company’s business and the manner in which its tickets were sold. To support the rollout of its route structure, JetStar invested heavily in property, plant, and equipment. The expenditures made to purchase these assets were reported as investing uses of cash and did not weigh on operating cash flow.

However, the resulting depreciation of those assets did lower net income without reducing cash flow. In addition, through the use of accelerated methods of depreciation for tax purposes on those property, plant, and equipment accounts, the company recorded income taxes on earnings, the payment of which was postponed to future years. The resulting deferred taxes also reduced net income without reducing operating cash flow.

In terms of ticket sales, like other airlines, JetStar offered its customers discounts for early ticket purchases. When tickets were paid for in advance, the company reported the cash received as deferred revenue, referred to by them as air traffic liability. Such receipts boosted cash flow without boosting net income.

Although in each of the three years presented, the company reported significantly more operating cash flow than net income, the relationship between net income and operating cash flow was relatively stable. Between 2007 and 2009, net income increased by approximately 169 percent. During that period, operating cash flow increased by approximately 157 percent. While the two rates of growth were not identical, short-term changes in operating assets and liabilities, which can be somewhat volatile, cause these benign departures in the rates of growth of earnings and operating cash flow. Longer periods of time would be needed to determine whether departures in the rates of growth for earnings and cash flow are cause for concern.

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