New value investors are usually taught to focus on a few key elements, which form the basis for analyzing a stock. The first key element is solvency, and I have written extensively on the topic of fake cash and off-balance sheet liabilities. The second key element is profitability, and this is easy to learn but difficult to master. Understanding past profitability is easy; predicting future profitability is akin to looking into a crystal ball. The third key element, in my opinion, is free cash flow. Since free cash flow can be negative in certain years due to discretionary capital expenditures or timing differences, investors have been hardwired to demand for consistent, positive operating cash flow as one of the investment criterion.
However, just like any other items on the financial statements including cash and earnings, positive operating cash flow can be easily faked. I will talk about a few examples of fake operating cash flow here.
Moving Positive Financing Cash Inflows into Operating Cash Flow
Management can bring forward the recognition of operating cash flow by factoring. Factoring refers to the sale of accounts receivables to a third party at a discount. By factoring its receivables, the company receives cash from the factor in exchange for its receivables. There are two types of factoring: recourse factoring and non-recourse factoring. In the case of recourse factoring, the company is still exposed to credit risk and the positive cash flow may be reversed in future periods, as the factor can go back to the company for payment if the customer defaults. Another common trick is to do a loan transaction with banks, sister companies or related parties with inventories as collateral, and then record the loan transaction as a sale of inventories and loan proceeds as positive operating cash flow.
Moving Positive Investing Cash Inflows into Operating Cash Flow
Positive investing cash inflows usually come in the form of disposal of plant or equipment and sale of businesses. By recording such one-time gains from asset disposals as part of core recurring business, management can easily hide problems associated with negative operating cash flow such as uncollectible receivables and unsalable inventories. Also for companies, with significant short-term investments, they may choose to record the liquidation of such securities portfolios as operating cash inflow, instead of investing cash inflow.
Moving Negative Operating Cash Outflows into Investing Cash Flow
Capitalizing operating costs as capital expenditures is another favorite trick of management. Although the impact on free cash flow is the same with either classification of operating costs, capitalizing operating costs boosts both net income and operating flow. Net Income is artificially increased because recurring operating costs are removed from the profit and loss statement and transferred to the balance sheet as growth in assets. Operating cash flow is increased with the shifting of this cash outflow further down in the cash flow statement. In another case, management pays for goods with the issuance of a credit note. No cash outflow is recorded at the point of sales, with repayment of the note for the purchase of inventories recorded as a investing cash outflow.
About the author:
Mark LinWorking hard to be a better investor