Some Financial Analysts claim that using cash flow to determine the fair value of common stock will provide a more realistic picture. Why? They argue that investors should go where the money is. Cash flow will track the flow of money in and out of a firm, which is why it exists: to make money.
However, things are not that straightforward. Cash flow, like net income, can easily be influenced. The term “cash flow” refers to the cash flow from operations shown on the cash flow statement produced on a regular basis by publicly traded corporations.
Let’s examine the financial accounts of one publicly traded company, Amazon.com (AMZN), and decipher their components. We will use the statement for the fiscal year ending December 31, 2022. Here is the Yahoo! Finance source: http://finance.yahoo.com/q/cf?s=AMZN&annual. The page displays the Income Statement, Balance Sheet, and Cash Flow, which is pretty much everything you need to evaluate a company.
The Income Statement shows how revenues are converted into net income or profit. The overall revenue for the time period was $514 billion. EBIT margins fell to 5.3%, and net margins were negative at -0.5%, both of which were lower than their three-year norms of 5.5% and 4.0%, respectively. While gross profit climbed by 14.0% in 2022, EBIT decreased by 50.8%. Amazon had a net loss after deducting other expenses of $ 16.8 billion. Amazon lost $2.7 billion in a year highlighted by extreme cost-cutting measures ranging from the cancellation of experimental projects to the halting of grocery store expansion to the layoff of 18,000 employees.
Amazon’s Cash Flow from operating activities was $ 75.294 billion for the fiscal year ending March 31, 2023, an 11.11% decrease year over year. Amazon’s annual cash flow from operational activities in 2022 was $ 46.752 billion, up 0.92% from 2021. Cash flow compares how much money a corporation receives to how much money it spends. When there is more money coming in than going out, the cash flow is positive. The cash flow is negative if the opposite is true. When a company’s cash flow is positive for an extended period of time, it is deemed healthy.
To calculate cash flow, add depreciation expense, remove any rise in accounts receivable and inventory, and add any increase in short-term liabilities such as accounts payable. Occasionally, adjustments to net income will be made, which will raise or decrease cash flow depending on the charge.
Here’s how businesses can control cash flow. This will give the impression that cash flow has significantly improved.
Payment is being postponed for the time being. This will raise Accounts Payable, hence improving cash flow. While only good corporations can demand that their suppliers delay payments, all debt must finally be paid.
Customers are being asked to pay more quickly. While the fast collection is necessary for a company’s sustainability, offering customers less credit will result in them walking away. Cash flow will improve in the short term as collection improves. Customers would eventually go to competitors who can provide better credit.
Maintaining a limited inventory. While excessive inventory is wasteful, a certain level of inventory is required to keep a business going. Short-sighted management will attempt to influence cash flow by maintaining inventories in limited supply. Certain inventory is required while running a retail firm. It is not comparable to a built-to-order corporation such as Dell Inc. (DELL).
These three variables change from quarter to quarter and from year to year. When assessing fair value, it is advisable to ignore these changes and concentrate on the company’s operational results.
Another deceptive aspect of cash flow is that it includes depreciation in the amount of cash generated from activities. While depreciation is a non-cash expense, it is an unavoidable cost of running a company. For example, a firm may purchase a computer and depreciate it over a five-year period. The corporation will suffer a non-cash charge over the next five years, which is why we include depreciation expense in our cash flow. However, we require that computer for operational reasons. Adding depreciation expense to our cash flow does not make sense until we stop spending on capital expenditures. Sure, you get the benefit right now. However, in five years, you will need to spend money on a new computer, which is a cash outflow.
Cash flow from operations, like other investing strategies, cannot be employed independently from other ratios. Each financial ratio has advantages and disadvantages. Because of short-term balance-sheet volatility and the inclusion of depreciation expense into a firm’s cash flow, I feel that cash flow does not accurately reflect a company’s genuine earning capability.