Question

Sven Broker, an analyst with an established brokerage firm, comments: “The critical number I look at for any company is operating cash flow. If cash flows are less than earnings, I consider the company to be a poor performer and a poor investment prospect.” Do you agree with this assessment? Why or why not?

Answer 1

I agree with Sven Broker's assessment only partially.

It is true that if the cash flows are less than earnings, it is an indicator that the business may be a poor investment proposal. However this is not applicable as a general rule.

Although cash flows exceeding earnings are a sign of good financial health, the opposite may not be a conclusive sign of poor financial health. There may be other indicators or clues to look for which would provide a more realistic or accurate picture of the investment proposal. For example, the project may be in the initial phase of its life. It is normal for projects with long lives to have lower cash flows in the initial phase, and have much higher cash flows in the latter phase of their lives.

It is also possible that during the initial phase of a project, earnings are higher due to factors such as depreciation methods, amortization etc. In this case, comparing the cash flows to earnings may not give the correct picture of the investment.

Therefore, the cash flows over the entire life of the project must be projected and analysed. The same must be done with earnings. This would give the analyst a complete picture of the investment proposal and would lead to better informed decisions.

Using only one comparative measure (cash flows vs. earnings) in decision making is not a good practice. This leads to poor decisions. Rather, multiple measures must be used by analysts to understand the project in a holistic manner so that the right investment decisions are made.