Some Monetary Analysts argue that using cash flow will offer a a lot more correct picture in determining the fair worth of a widespread stock. What provides? They reason that investors ought to adhere to where the money is. Cash flow will track the flow of money in and out and this can be the cause company exists; to obtain money.

Factors will not be that basic, however. Just as net income, cash flow can be easily manipulated. Money flow right here refers to cash flow from operations observed on the statement of cash flow published frequently by publicly traded businesses.

Let’s take a have a look at the statement of money flow for a single publicly traded business, Amazon.com (AMZN) and decipher its components. We’ll use the statement of money flow for the year ending on 31 december 2004. Right here could be the supply from Yahoo! Finance: http://finance.yahoo.com/q/cf?s=AMZN&annual

The top part is net earnings, which is self-explanatory. That is what a firm earns during a period of time. For the time period earns $ 588 M. To get into the cash flow figure, we need to add depreciation expense, subtract any increase in accounts receivable and inventory and add any increase in short term liability such as accounts payable. Sometimes, there will be some adjustments made to the net income which will increase or decrease cash flow depending on the charge.

Now here is how companies can manipulate cash flow. This will in effect temporarily give an impression that cash flow has improved markedly.

<b>Temporarily Delaying Payment.</b> This will increase Accounts Payable which in turn will improve cash flow. While only good organizations can demand its suppliers to delay payments, all the debt eventually needs to be paid.

<b>Demanding faster payments from customers.</b> While an efficient collection is needed for a firm’s survival, giving less credit to customers will result in them balking away. In the short term, cash flow will improve due to improved collection. In the long run, customers will go to competitors who can offer better credit.

<b>Keeping a tight supply of inventory.</b> While bloated inventory is wasteful, there is a certain level of inventory that is needed to keep a organization running. Short-minded management will try to manipulate money flow by keeping a short supply of inventory. When you run a retail business, certain inventory is needed. It is not similar to a built-to-order business like Dell Inc. (DELL).

These three items vary from quarter to quarter and year to year. When determining fair worth, it is best to ignore these fluctuations and focus on operational earnings generated by the company.

Another misleading cue from money flow is that it adds up depreciation as the amount of money generated from operations. While depreciation expense is a non-cash transaction, it is a necessary cost of doing organization. For example a firm bought a computer and depreciate it for five years. For the next five years, the business incur a non-cash charge, which is the cause why we add depreciation expense to our money flow. Even so, we need that computer for our operational purpose. Unless we stop spending in our capital expenditure, adding depreciation expense to our money flow does not make sense. Sure, you enjoy the benefit now. But five years from now, you need to spend money on a new computer, which is a cash outflow.

As with other investing tools, money flow from operations cannot be used independently of other ratios. Each and every economic ratio has its strengths and weaknesses. I believe that cash flow does not reflect the true earning power of a organization because of short-term fluctuations of the balance sheet and the addition of depreciation expense into a firm’s cash flow.

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