Submitted by: Submitted by fidfid
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Category: Business and Industry
Date Submitted: 04/30/2012 11:31 PM
5.3 James Broker, an analyst with an established brokerage organisation,
comments: ‘The critical number I look at for any company is operating cash flow. If
cash flows are less than earnings, I consider a company to be a poor performer and
a poor investment prospect’. Do you agree with this assessment? Why or why not?
Disagree. Operating cash flows and earnings numbers are both important in
evaluating the performance prospects of a company, but they will differ due to
short‐ and long‐term accruals. Some current accruals, such as credit sales, will cause
earnings to be greater than operating cash flows while others, such as unpaid
expenses by the firm, will cause operating cash flows to exceed earnings. Non‐
current accruals, such as depreciation and deferred taxes, will also cause differences
between earnings and operating cash flows. The fact that operating cash flows are
not as high as earnings is not nearly as important as understanding why the two are
different.
Operating cash flows could be below earnings for several reasons, each suggesting
differences in the firm’s performance and future investment prospects. For example,
a firm that introduces a successful new product will be probably have earnings
exceeding operating cash flows due to working capital needs (inventory and
receivables) that affect cash flows but not earnings. Yet, provided inventory can be
sold and receivables collected, this difference is a positive sign that the firm’s sales
are growing and that the firm has good investment prospects. In contrast, firms that
are declining are likely to have earnings lower than cash flows, as working capital
needs are diminished.
In summary, earnings are likely to be a better signal of future cash flow performance
than current ...