by Eric J. Fry
Cash flow is the alpine spring water of the financial world.
Pure. Crystal clear. Free of impurities and pollutants. It is "la
source" of every growing enterprise. And yet, like water, cash
flow is so basic, so unassuming, that it is easily overlooked by
investors -- particularly during exuberant financial epochs.
Saturday night revelers will toss back martinis and margaritas,
not water. But come morning, these same revelers will crave
only water, repulsed by the very thought of another martini or
margarita.
So it is in the financial markets. During the "party years" of the
stock market bubble, most investors cared little about cash
flow. Instead, they became intoxicated with New Era notions:
that revenue growth, by itself, would lead to profit growth; that
multibillion-dollar fiber-optic networks would inspire their own
demand; that "page views" would some day lead to earnings;
that options-incentivized managements would guide stocks ever
higher; and, most importantly, that Alan Greenspan's special
interest rate would always prevent a falling stock market.
Cash flow did not matter to anyone except short sellers.
Because investors did not focus on cash flow, corporations
were only too happy to bury the information in their quarterly
financial filings. During thousands of conference calls
throughout the late 1990s, thousands of CFOs acted as if
they'd never heard of cash flow. On those rare occasions when
an investor raised the issue, most CFOs would say something
like, "Uh, I don't have the information readily available. But
we're very pleased with our growth. I could have someone get
back to you on this after the call."
Instead of presenting the truth that these numbers impart,
companies devised myriad schemes for hiding or obscuring the
cash flow data. Specifically, accounting departments from
coast to coast concocted various versions of the now-infamous
"pro forma earnings" -- a calculation designed to exclude as
many expenses as possible from the reported earnings. Expert
practitioners of the pro forma charade could paint a very
pleasing picture of a company's financial health, no matter how
grim the actual cash flow trend.
Here's a hypothetical example of how pro forma earnings can
be used to mask deteriorating cash flow. Imagine for a moment
that Eric Fry is a publicly traded company. Let's say that I
make $100,000 per year. Let's further assume that my annual
expenses consist of $25,000 in taxes, $30,000 in mortgage
payments, $25,000 for food, insurance and all other
miscellaneous living expenses, plus $80,000 for a new
Porsche. As a public corporation, what is my pro forma net
income? Answer: $20,000 -- or $100,000 minus all the
expenses except for the cost of the Porsche. You see, it's
inappropriate to include the Porsche because it's a "one-time,
nonrecurring" expense and, therefore, not a true reflection of
my actual profitability.
On my quarterly conference call, I boast about my $20,000
pro forma net income and how I soundly beat the prior year's
$15,000 pro forma net income. All the sell-side analysts
applaud my "strong organic earnings growth," and fall all over
themselves to reiterate their "strong buy" recommendations.
None of the analysts asks any questions about cash flow. That
would be bad form.
The obvious irony is that my net cash flow - including the
Porsche purchase - is a NEGATIVE $60,000. I own the
Porsche, of course, and it remains an asset on my balance
sheet with a substantial value. But this particular asset -- much
like a fiber-optic network -- will gradually depreciate and will
never produce any net income for me. |
