Cash Rules the Day

From this title I will indulge in the complementary uses of financial statements, in this case the use of cash flow from operations (CFFO) to determine the quality of earnings. CFFO can be defined as:

Net Income + accumulated depreciation and other non cash flows +/- the change in net operating assets (NOA)

It is from this metric we can determine the quality of reported profits. The reason is that accruals can mask cash exchanges while reporting bloated profits at the same time. So if a company is consistently reporting large profits while at the same time reporting small or negative CFFO, there is most likely a disaster in the mix when a shortage of actual earnings comes to surface. To check:

Quality of Earnings = CFFO/Net Income

However, this does not mean earnings are to be completely mistrusted, but it involves much more in depth research to uncover their true potential, as using cash flows exclusively is less then optimal. The process I outlined in an article on called The Concept of Residual Earnings - http://ezinearticles.com/?The-Concept-of-Residual-Earnings&id=1158014; keep in mind however that this valuation process is determined from using reformulated GAAP statements, where operations are separated from finances, please refer to this article to get a bigger picture.

The point is financial statements are like a system of checks and balances, where they must all be analyzed together to show where value is being derived from or if it is being manufactured by holes in GAAP accounting. The diligent analyst will use this to his advantage.

My name is Matthew Scullen, I am a financial administrator for an independent investment representative.

I currently keep a daily blog, http://capitalhd.blogspot.com/, titled Capitalism...Now In HD, an analysis of economics, the Fed, Investing and markets.

I have a degree in economics and I am an amateur investor, preparing to be licensed as an Registered Investment Adviser. I am drafting business plans for my own investment management firm.

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