Harry-
Accounting. That's how.
Here's a brief (incomplete) lesson on cash flow vs. net income.
To calculate operating cash flow, compare 2 periods (such as Q1 to Q2):
Q2 Net income + increase in cash & equivalents from Q1 + Q2 depreciation and amortization + the difference in current liabilities - the difference in accounts receivable and inventory = operating cash flow.
Explanation:
Net income deducts certain non-cash expenses, such as depreciation and amortization. Therefore, all other things being equal, cash flow is actually higher than reported income (income + D & A).
Increases in cash & equivalents (and short term investments) are obviously additive to cash flow (or rather, they are clear evidence of cash flow).
If the company is paying its bills (lowering its payables and current liabilities), it is spending cash. Therefore, decreasing current liabilities generally corresponds to decreasing cash flow.
If the company records a sale (and records the corresponding income), it is counting that sale as a receivable, until the purchasing company (a toy retailer, for example) pays JAKK. But if JAKK allows 6 months for Toys R Us to pay them for the delivered goods, JAKK doesn't collect any cash in the meantime. So increased receivables correspond to decreased cash flow, relative to net income. This is why companies have reserves against gross sales, because if all of the receivables were to evaporate (the buyer went bankrupt, let's say), JAKK would have to take a charge to write-off the receivables they had assumed were as good as cash in the bank. At the same time, they would take an earnings hit (or a deduction of retained earnings) to reverse the previously recorded net income from the unpaid-for sales.
In addition, any cash spent building inventory (to support future sales) is deducted from operating cash flow.
That's why it's crucial to watch a company's cash flow, rather than its earnings only. I'm not saying that JAKK is in trouble, because these numbers need to get worse for several quarters before it becomes a cause for alarm. But it's something to watch. Historically, THQI has had higher reported income than cash flow. But in the most recent few quarters, THQI has reported income below that of cash flow. Increased reserves can do this, by understating actual sales, and hence, cash flow. For 1995, THQI's cash flow trailed income by $4 million. In 1996, it trailed it by $2,4 million. In 1997, largely due to WCW in Q4, it trailed it by $7.3 million. But in Q1 1998, cash flow exceeded income by 3.5 million. So looking at the past 3.25 years, THQI has overstated income by $10.2 million. However, if you look at 1994, you see that THQI took a huge write-off of $17.5 million, despite losing only $10 million in cash. Including 1994, THQI has since overstated earnings by only $2,7 million, a figure that could be erased in Q2 1998. It depends on the time horizon. But the point is that ultimately, the cash flow from operations and the net income should be very close.
Things to watch for: When cash flow continually exceeds income, and the company is rapidly growing, there's a good opportunity to report explosive earnings. On the other hand, if income greatly exceeds cash flow for a while, the chances of a bad quarter increase sharply.
No cause for alarm for THQI, as long as they continue to generate cash.
Todd |
