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Stepan Lavrouk
Stepan Lavrouk
Articles (510) 

The Value Investor’s Handbook: The Importance of Cash Flow

Watch out for discrepancies between reported income and cash flow

June 27, 2020

Recently, I’ve been compiling a list of red flags that value investors should be on the lookout for when investing in publicly traded securities. Today, I want to look at one particularly important accounting metric that investors should focus on: cash flow, and specifically how it relates to reported income.

Cash is king

Although much attention is given to the income statement, I believe that investors have a lot to gain by scrutinizing the statement of cash flows just as diligently. Cash flows are a lot harder to game and manipulate than earnings, so if there is a problem with the business that you are analyzing, it is more likely to be evident from the cash flow statement than the income statement.

If a business is simultaneously reporting large profits and low cash flows, then that is a major red flag. How can these things exist simultaneously? There is plenty of non-cash income that a business can (and should) report. To take a simple example, a retailer may allow customers to buy on credit; that is, to accept payment for goods at a later date. In this case, the income is real (as the customer has an obligation to pay back the money owed), but the cash won’t appear in the retailer’s bank account until later.

So there are plenty of legitimate reasons why cash flows and incomes may diverge. However, if there is a large disconnect between the two, it might be worth investigating why this is so. Let’s say our hypothetical retailer has extended a large amount of credit to customers. What happens if those counterparties default? What if they are late with their payments, and the retailer is then unable to make payment on their own debts?

A similar situation hit the many landlords who suddenly found themselves in after the coronavirus-induced lockdowns that suddenly came into effect across the world: their tenants became unable to pay their rent, and now landlords are finding it difficult to meet their mortgage obligations. They may have reported income in the expectation that the tenants would pay, but failed to collect the cash owed.

Of course, it might be argued that a global pandemic is a "black swan" event that no one could have foreseen. While this might be true, the important thing to take away from this is that cash represents safety. It’s all well and good to report high incomes, but that won’t be much use to a business during economic downturns, when suddenly everybody is worried about their cash balances. For this reason, it is advisable to invest in those businesses that already have robust cash positions and whose cash flows are roughly in line with their reported incomes. That way, you can sleep soundly and not have to worry about any black bwans that might be coming.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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