It seems that every year another top athlete is exposed in a doping scandal. But these are people who are trained since birth to believe that all that matters is their performance, so they naturally take a risk on anything likely to increase their chances of winning. Companies, similarly indoctrinated to perform well at all costs, also have a way to inflate or artificially "pump up" their earnings - it's called cash flow manipulation. Here we look at how it's done, so you are better prepared to identify it.
Reasons for Cash Flow Manipulation
Cash flow is often considered to be one of the cleaner figures in the financial statements. (WorldCom, however, has proved that this isn't true.)
Companies benefit from strong cash flow in the same way that an athlete benefits from stronger muscles - a strong cash flow means being more attractive and getting a stronger rating. After all, companies that have to use financing to raise capital, be it debt or equity, can't keep it up without exhausting themselves.
The corporate muscle that would receive the cash flow accounting injection is operating cash flow (OCF). It is found in the cash flow statement, which comes after the income statement and balance sheet. (If you'd like a refresher, see What Is A Cash Flow Statement? and The Essentials Of Cash Flow.)
How the Manipulation Is Done
Dishonesty in Accounts Payable
Companies can bulk up their statements simply by changing the way they deal with the accounting recognition of their outstanding payments, or their accounts payable. When a company has written a check and sent it to make an outstanding payment, the company should deduct its accounts payable. While the "check is in the mail", however, a cash-manipulating company will not deduct the accounts payable with complete honesty and claim the amount in the operating cash flow (OCF) as cash on hand.
Companies can also get a huge boost by writing all their checks late and using overdrafts. This boost, however, is a result of how Generally Accepted Accounting Principles (GAAP) treat overdrafts: they allow, among other things, for overdrafts to be lumped into accounts payable, which are then added to operating cash flow. This allowance has been seen as a weakness in the GAAP, but until the accounting rules change, you'd be wise to scrutinize the numbers and footnotes to catch any such manipulation. (For more on analyzing these, see How To Read Footnotes.)
Selling Accounts Receivable
Another way a company might increase operating cash flow is by selling off its accounts receivable. This is also called securitizing. The agency buying the accounts receivable pays the company a certain amount of money, and the company passes off to this agency the entitlement to receive the money that customers owe. The company therefore secures the cash from their outstanding receivables sooner than the customers pay for it. The time between sales and collection is shortened, but the company actually receives less money than if it had just waited for the customers to pay. So, it really doesn't make sense for the company to sell its receivables just to receive the cash a little sooner - unless it is having cash troubles, and has a reason to cover up a negative performance in the operating cash flow column.
A subtler steroid is the inclusion of cash raised from operations that are not related to the core operations of the company. Non-operating cash is usually money from securities trading, or money borrowed to finance securities trading, which has nothing to do with business. Short-term investments are usually made to protect the value of excess cash before the company is ready and able to put the cash to work in the business's operations. It may happen that these short-term investments make money, but it's not money generated from the power of the business's core operations.
Therefore, because cash flow is a metric that measures a company's health, the cash from unrelated operations should be dealt with separately. Including it would only distort the true cash flow performance of the company's business activities. GAAP requires these non-operating cash flows to be disclosed explicitly. And you can analyze how well a company does simply by looking at the corporate cash flow numbers in the cash flow statement.
Questionable Capitalization of Expenses
Also a subtle form of doping, we have the questionable capitalization of expenses.
Here is how capitalization works. A company has to spend money to make products. The costs of production come out of net income and therefore operating cash flow. Instead of taking the hit of an expense all at once, companies capitalize the expense, creating an asset on the balance sheet, in order to spread the expense out over time - meaning the company can write off the costs gradually. This type of transaction is still recorded as a negative cash flow on the cash flow statement, but it is important to note that when it is recorded it is classified as a deduction from cash flow from investing activities (not from operating cash flow). Certain types of expenditures - such as purchases of long-term manufacturing equipment - do warrant capitalization because they are a kind of investing activity.
The capitalization is questionable if the expenses are regular production expenses, which are part of the operating cash flow performance of the company. If the regular operating expenses are capitalized, they are recorded not as regular production expenses but as negative cash flows from investment activities. While it is true that the total of these figures - operating cash flow and investing cash flow - remain the same, the operating cash flow seems more muscular than that of companies that deducted their expenses in a timely fashion. Basically, companies engaging in this practice of capitalizing operating expenses are merely juggling an expense out of one column and into another for the purpose of being perceived as a company with strong core operating cash flow. But when a company capitalizes expenses, it can't hide the truth forever. Today's expenses will show up in tomorrow's financial statements, at which time the stock will suffer the consequences.
Again, reading the footnotes can help expose this suspicious practice.
Whether it is the world of sports or the world of finance, people will always find some way to cheat; only a paralyzing amount of regulation can ever remove all opportunities for dishonest competition and business requires reasonable amounts of operating freedom to function effectively. Not every athlete is cycling anabolic steroids, just as many companies are honest on their financial statements. That said, the existence of steroids and dishonest accounting methods mean that we have to treat every gold medalist and every company's financial statement with the proper amount of scrutiny before we accept them.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
Stock AnalysisLearn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
ProfessionalsLearn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
Active TradingCompanies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
MarketsLearn how this simple calculation can help you determine a stock's earnings potential.
InvestingWe look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
Fundamental AnalysisAre penny stocks any better than playing penny slots in Vegas? What if you used the fundamental analysis principles of Peter Lynch to pick penny stocks?
Fundamental AnalysisAmazon is starting to look like a steadily profitable company. Is this really the case? Should investors even be hoping for profitability?
Investing BasicsLearn how poor management, frauds, scandals or mergers wiped out some of the most recognizable brands in the finance industry in the United States.
Personal FinanceWalmart and Target both revealed multi-year plans to grow their businesses. Which of these two retailers is the biggest threat to Amazon?
Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>