JDSU-MISC.--Monday July 24, 7:00 am Eastern Time
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Five Essentials for Understanding Cash Flow
By David Kathman
Is Amazon.com (Nasdaq: AMZN - news) a money-sucking pit in danger of running out of cash or a company about to start raking in the bucks? That depends.
By the looks of its income statement, Amazon appears to be in terrible shape, with more than $1 billion in net losses during its short history and no prospect of profitability any time soon. Its cash-flow statement tells a different story, though. Amazon generated positive cash flow in 1998, and although heavy spending has turned that number negative over the past year, the company expects positive cash flow by the end of 2000.
Why the difference? Net income accounts for all of a company's revenues and expenses, including some that don't represent actual cash going into or out of the company's coffers. By contrast, cash flow strips away abstractions and tells you how much cash a business is actually generating. Here are some reasons why net income and cash flow can be out of sync.
1. Depreciation and Amortization
When a company buys an asset, it has to amortize the value of that asset, or gradually subtract the asset's value from net income over a period of years, even though no cash leaves the company's pocket. Companies in capital-intensive businesses tend to incur lots of depreciation, which lowers their net incomes but doesn't affect cash flows.
One such business is cable TV, where companies have to spend a lot of money laying cable and hooking up customers. Cablevision Systems (NYSE: CVC - news), for example, posted a net loss of $800 million in 1999, largely because it logged $894 million in depreciation charges. But its cash flow was $274 million on the plus side. Such companies are usually evaluated in terms of cash flow, as depreciation has such a big effect on their net income.
2. Goodwill
Goodwill is a special kind of depreciation that occurs when one company buys another. If the acquirer pays more than the target's book value, the difference counts as goodwill and has to be amortized over a period of years just like a physical asset. Like other kinds of depreciation, goodwill is counted against earnings but doesn't affect cash flow.
The effect of goodwill can be significant. For example, Internet-service provider Earthlink (Nasdaq: ELNK - news) had positive cash flow of $44 million last year, but goodwill from its merger with Mindspring pushed it down to a net loss of $174 million. In other cases, goodwill from a lot of smaller acquisitions can add up.
Companies sometimes avoid goodwill by using an accounting method called pooling. However, the accounting authorities are planning to eliminate pooling within the next few years, so goodwill might soon become even more common.
3. One-Time Charges
Sometimes a company takes a big one-time charge that depresses net income but leaves cash flow unchanged. Such charges often stem from restructuring; if a company shuts down a factory, it has to charge the value of that factory against earnings, even though no cash has left its pocket. Coca-Cola (NYSE: KO - news) took $800 million in restructuring charges in the first quarter of 2000, for example, turning what would have been a $0.32 per share profit into a $0.02 per share loss.
In a merger, the acquiring company often takes a one-time charge for money the target company has spent on research that will never be used. Telecommunication-equipment maker JDS Uniphase (Nasdaq: JDSU - news), formed from the merger of JDS Fitel and Uniphase in 1999, took a $210 million charge for such research, resulting in a net loss of $171 million. However, the company generated $67 million in operating cash flow.
4. One-Time Gains
On the other side of the coin, sometimes a company gets a big credit that boosts net income but doesn't result in cash inflow. For example, Internet portal CNET Networks (Nasdaq: CNET - news) posted net income of $417 million in 1999, which looks impressive. But a big chunk of that came when the company traded its stake in Snap.com for a stake in NBC Internet (Nasdaq: NBCI - news). No cash changed hands, but CNET received a $324 million credit on its income statement. Overall, CNET's operating cash flow was negative, to the tune of $71 million.
A similar thing can happen when a company owns an equity stake in another company that goes public. In 1999, Qwest (NYSE: Q - news) joined with KPM Telecom (NYSE: KPN - news) to form a European high-speed data network called Kpnqwest (Nasdaq: KQIP - news). When Kpnqwest went public later that year and its stock price soared, the market value of Qwest's stake went up too, resulting in a $414 million gain. Yet Qwest received no cash; its gains were all on paper. That windfall helped Qwest record $459 million in net income for the year, even though its cash flow was negative $38 million.
5. Changes in Operating Capital
Changes in operating assets and liabilities, or changes in operating capital, can also cause a gap between cash flow and earnings. That's because there's a time lag between when a company makes something and when it sells it and between when a company sells something and when it gets paid for it. This lag shows up in the company's inventory (things made but not yet sold), accounts receivable (things sold but not yet paid for), and accounts payable (things bought but not yet paid for).
When inventories or accounts receivable rise, cash flow decreases relative to net income. Rising inventories require a company to lay out cash before it has booked revenue, and rising receivables mean a company is booking revenues before it has received the actual payment. These claims can be warning signs of trouble ahead.
For example, Lucent Technologies (NYSE: LU - news) was a hot stock in 1999, with good sales and earnings growth. But among the red flags were big changes in Lucent's operating capital that were affecting the company's cash flow. (Lucent's inventories rose $1.6 billion in 1999, and its receivables rose $3.2 billion.) As a result, the company's operating cash flow was negative $276, despite a net income of $4.8 billion. As it turned out, Lucent had some skeletons in its closet: In January 2000, it announced that its earnings would fall well short of analysts' estimates, and its stock dropped 30%.
Putting Cash Flow to Use
To put these five keys to practical use, dig into some companies' cash-flow statements and find out where their cash is coming from. Look for cash-flow statement in a company's annual report or in its 10-K and 10-Q reports.
David Kathman can be reached at david_kathman@morningstar.com.
Visit www.morningstar.com daily for in-depth analysis of stocks, funds, and sectors in the news.
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and News: Amazon Com Inc (NasdaqNM:AMZN - news)
Cablevision Systems Corp (NYSE:CVC - news)
CNET Networks Inc (NasdaqNM:CNET - news)
Coca-Cola Co (Coke) (NYSE:KO - news)
Earthlink Inc (NasdaqNM:ELNK - news)
JDS Uniphase Corp (NasdaqNM:JDSU - news)
Koninklijke KPN NV (NYSE:KPN - news)
KPNQwest NV (NasdaqNM:KQIP - news)
Lucent Technologies Inc (NYSE:LU - news)
NBC Internet Inc (NasdaqNM:NBCI - news)
Qwest Communications International Inc (NYSE:Q - news)
Related News Categories: computers, food/beverage, networking, retail, telecom |
