James Broker, an analyst with an established brokerage firm, 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?

Answer 1

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 cash flows, particularly for firms with long working capital (operating) cycles. Of course, earnings exceeding cash flows can be a negative signal for future cash flow performance if management is reporting aggressively, making analysis of cash flows a useful financial tool.