Indicators of Cash Flow Quality

The operating cash flow (OCF) is the cash flow component with the most direct impact on the valuation of a company. High-quality cash flow indicates that the company’s underlying economic performance was value-enhancing. Further, it implies that the information calculated and disclosed by the company was a reasonable reflection of economic reality, i.e., the company had high reporting quality.

When examining the cash flow statement, both the industry in which the firm operates and the corporate cycle affect operating cash flows. It is typical for a start-up company to have negative operating and investing cash flows. On the other hand, a mature company should have positive operating cash flows.

Generally, high-quality cash flow is characterized by a positive OCF, which is derived from sustainable sources and is sufficient to cover capital expenditures, dividends, and debt payments. Additionally, high-quality OCF has relatively low volatility in comparison with industry peers. OCF is viewed as being less subjective and hence, less easily manipulated than net income. Significant differences between earnings and OCF or a widening in such differences over time indicate earnings manipulation.

Even though OCF is considered less subject to manipulation compared to earnings, managers can distort cash flows via strategic decisions like timing issues. For example, management can boost the company’s performance by slowing payments to suppliers (increasing accounts payables) or by selling receivables to a third party. As a result, the company’s days’ sales outstanding would decrease, and days of payables would increase.

Analysts can pinpoint such practices by reviewing asset utilization (activity) ratios such as receivables and payables turnover ratios, changes in balance sheet accounts, and disclosures in notes to the financial statements. Furthermore, management can manipulate cash flows by misclassification. For example, they may try to shift actual (positive) cash flow items from investing or financing activities to operating activities to overstate operating cash flows.

Question

An analyst is examining three mature companies to compile a performance article. The analyst has researched for each company to establish the trend over the past four years. The following are the findings for each company:

ABC, Inc.

• Operating cash flow (OCF) has been much higher than the operating income.
• The OCF was positive, but just sufficient to cover capital expenditures, dividends, and debt repayments.
• Accounts payable has increased, whereas the accounts receivable and inventory have declined.

DFG, Inc.

• OCF has been more volatile relative to the industry peers.
• OCF has been insufficient to cover capital expenditures, dividends, and debt repayments.

HIJ, Inc.

• Operating margins have been relatively constant.
• The growth rate in revenue has substantially outstripped the growth rate in receivables.
• OCF was constant and positive, close to its reported net income, and just sufficient to cover capital expenditures, dividends, and debt repayments.

Solely based on the above information, which company would most likely be reported as having high-quality cash flow?

    A. ABC, Inc.

    B. DFG, Inc.

    C.HIJ, Inc.

Solution

The correct answer is C.

A high-quality OCF implies high reporting quality and high results quality of a company. Generally, for mature (established) companies, high-quality cash flow is characterized by a positive OCF, derived from sustainable sources. Additionally, the OCF is sufficient to cover capital expenditures, dividends, and debt payments, and high-quality OCF has relatively low volatility in comparison with industry peers.

HIJ, Inc. reported a constant and positive OCF during each year. The OCF compares closely with the net income, which implies that it is derived from sustainable sources. Finally, the OCF was just sufficient to cover capital expenditures, dividends, and debt repayments. Therefore, HIJ, Inc. reported high-quality cash flow.

A is incorrect. Even though ABC, Inc. has a positive OCF, adequate to cover capital expenditures, dividends, and debt repayments, the management might be overstating cash flow from operations. This is suggested by increases in accounts payable and decline in accounts receivable and inventory over the period under review.

B is incorrect. For DFG, Inc., OCF has been more volatile relative to the industry peers. Furthermore, OCF has been insufficient to cover capital expenditures, dividends, and debt repayments. These are indicators for cash flow manipulation for DFG, Inc.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (i) Describe indicators of cash flow quality.