Evaluating Cash Flow Quality

High quality cash flow means the reported cash flow was high (i.e., good economic performance) and the underlying reporting quality was also high. Because operating cash flow (OCF) has the most direct impact on the valuation of a company, we will focus on OCF while evaluating cash flows.

A cash flow statement should be evaluated in the context of the corporate life cycle as well as industry norms. It would be quite normal for early stage start ups to have negative operating and investing cash flows, financed by cash flow from financing activities (e.g., equity issuance). For a mature firm, negative operating cash flow coupled with positive financing cash flow is usually problematic.

High quality cash flow is characterized by positive OCF that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments. Furthermore, high quality OCF is characterized by lower volatility than that of the firm’s peers. Significant differences between OCF and earnings, or differences that widen over time, can be an indicator of earnings manipulation.

While cash flows are less amenable to manipulation, management can affect cash flows via strategic decisions (timing issues). For example, OCF can be increased by slowing payments to suppliers (increasing accounts payables) or by selling receivables. Analysts can identify such practices by reviewing activity ratios (receivables and payables turnover ratios).

Management may also try to shift positive cash flows from investing or financing activities into operating activities to boost OCF (classification issues).

Evaluation of the statement of cash flows (and more importantly cash flow from operating activities) entails:

1. Checking for any unusual items or items that have not shown up in prior years.

2. Checking revenue quality. Aggressive revenue recognition practices typically result in an increase in receivables, which reduces operating cash flow. Another common indicator of aggressive revenue recognition is an increase in inventories (and hence a cash outflow) when sham sales are reversed (i.e., treated as returns from customers).

3. Checking for strategic provisioning. Provisions for restructuring charges show up as an inflow (i.e., a non cash expense) in the year of the provision and then as an outflow when ordinary operating expenses are channeled through such reserves.

Analysts should be aware that accounting standards afford some flexibility in the treatment of certain items in the statement of cash flows. For example, while interest paid, interest received, and dividends received have to be treated as operating cash flows under U.S. GAAP, interest paid can be classified as either operating or financing cash flow under IFRS. Also, interest/dividend received can be classified as either operating or investing cash flow under IFRS.

A company reporting under IFRS and accounting for interest paid as an operating cash flow could instead report it as a financing cash flow, giving the appearance of an increase in operating cash flows in a year over year comparison. Also, cash flows from sale of available for sale securities are treated as investing cash flows, while cash flows from sale of trading securities are treated as operating cash flows. Remember that companies have significant flexibility in designating investments as trading or available for sale.

Hence, managers can shift cash flows from one classification to another. Such variation in the classification of cash flow items reduces comparability across companies.