It seems that every year another top athlete is exposed in a doping scandal. But these are people who are trained since childhood 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.
Cash Flow Manipulation: Reasons and Methods
Cash flow is often considered to be one of the cleaner figures in the financial statements.
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.
Let's take a look at some of the most common methods companies use to manipulate their cash flow.
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 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 only until the accounting rules change, you'd be wise to scrutinize the numbers and footnotes to catch any such manipulation.
Selling Accounts Receivable
Another way a company might increase the 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 of receiving 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.
Inclusion of Non-Operating Cash
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 viability, 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. This means 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.
How to Identify Questionable Capitalization
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.
The Bottom Line
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 using anabolic steroids, just as many companies are honest on their financial statements. That said, the existence of steroids and dishonest accounting methods means that we have to treat every contender and every company's financial statement with the proper amount of scrutiny before we accept them.