Question

Why would investors be more interested in the cash flow from operations rather than other sources of cash flow? Research at least two ways real-world companies have developed fraudulent schemes to increase the cash flow from operations. What were the consequences?

Answer 1

Operating cash flow is the lifeblood of a company and the most important barometer that investors have.

Operating cash flow is a better metric of a company's financial health for two main reasons -

1) Cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree).

2) "cash is king" and a company that does not generate cash over the long term is on its deathbed.

By taking net income and making adjustments to reflect changes in working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.

Operating cash flow statement is more difficult to manipulate; however, there are ways to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).

Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent

Enron Fraud

There are three main things to look out for in detecting cash flow manipulation.

1. The first is expenses that are being inappropriately capitalised, hence aren’t included as costs but instead appear as capital expenses on the cash flow statements, creating an asset which is amortised in the future. This is easily rectified by an investor by calculating free cash flow.

2. The second is tax. Tax paid on sales of investments will usually be included in operating cash flow but it should not as it’s a non-recurring tax expense. Also, companies can receive tax relief from a complicated rule concerning share options. This is also included in operating cash flow but should be removed to get a real sense of the earning power of the company.

3. The third is investments held ‘for trading’. The purchase and sale of investments held for trading is included in operating cash flows and under normal calculations of free cash flow will be included in this also.

There are three main things to look out for in detecting cash flow manipulation.

1. The first is expenses that are being inappropriately capitalised, hence aren’t included as costs but instead appear as capital expenses on the cash flow statements, creating an asset which is amortised in the future. This is easily rectified by an investor by calculating free cash flow.

2. The second is tax. Tax paid on sales of investments will usually be included in operating cash flow but it should not as it’s a non-recurring tax expense. Also, companies can receive tax relief from a complicated rule concerning share options. This is also included in operating cash flow but should be removed to get a real sense of the earning power of the company.

3. The third is investments held ‘for trading’. The purchase and sale of investments held for trading is included in operating cash flows and under normal calculations of free cash flow will be included in this also.

There are three main things to look out for in detecting cash flow manipulation.

1. The first is expenses that are being inappropriately capitalised, hence aren’t included as costs but instead appear as capital expenses on the cash flow statements, creating an asset which is amortised in the future. This is easily rectified by an investor by calculating free cash flow.

2. The second is tax. Tax paid on sales of investments will usually be included in operating cash flow but it should not as it’s a non-recurring tax expense. Also, companies can receive tax relief from a complicated rule concerning share options. This is also included in operating cash flow but should be removed to get a real sense of the earning power of the company.

3. The third is investments held ‘for trading’. The purchase and sale of investments held for trading is included in operating cash flows and under normal calculations of free cash flow will be included in this also.

A closer look at Enron’s operating cash flow shows large inflows from sales of ‘merchant assets’ i.e. investments held for trading. If we exclude all cash changes related to merchant assets for the years 1998 to 2000, cash flow greatly reduces, and if we then take off capital expenditures it’s negative.

Another useful thing to do is search for ‘related party’ in the annual report. This will soon yield results that show it is in fact the related party that is buying all these ‘merchant assets’ from Enron, and moreover the managing partner is an officer at Enron. The related party itself was initially set up by Enron itself, with it’s stock. It then bought investments from Enron. This smells like an arrangement to get things off the balance sheet.

And that’s all it should take. A red flag like this should be enough to put anyone off an investment in this company. It is clearly not generating any actual cash from it’s investments and has created another third party to ‘hedge’