This Is Way More Important Than Earnings

This Is Way More Important Than Earnings
By Chuck Saletta
December 1, 2009

The concept of "earnings" is an accounting fiction. Oh sure, for the most part and over the long run, what companies report as their earnings comes close to representing how well they performed. But on a single quarter's or single year's basis, what gets reported as earnings may be nowhere near an accurate depiction of what actually happened.

Companies have lots of levers they can pull to temporarily report stellar earnings even when their operations are weak. Take, for instance, the "no payments, no interest for one year" deals often offered by appliance and furniture retailers. As soon as you sign the paperwork and take the item home, the store books the sale and the accounting profit. The actual cash from that transaction, however, doesn't show up until you pay the bill.

Cash flow is still king
Therein lies the problem with relying on reported earnings alone to determine a company's operational strength. The store in that example likely had to pay the manufacturer actual cash within a month or so of receiving the product, but won't see a dime from you for quite some time. Even worse for the retailer, by reporting the profit, it needs to pay taxes (also from actual cash) well before the money from that sale actually arrives.

That's an incredible disconnect between cash flow and earnings. Cold, hard cash is pouring out the door, but upon a cursory glance, the company may look extremely profitable. If all goes well, the company will make up the shortfall as the merchandise gets paid off. If it doesn't, however, all the "profits" in the world won't let it pay its own bills.

What really matters to the company and its investors is its ability to convert sales and earnings into cash. When you uncover a business that does an exceptionally good job of that, it's generally one worth owning.


http://www.fool.com/investing/value/2009/12/01/this-is-way-more-important-than-earnings.aspx