Artificial Sweetener
If you think the popular performance metric, cash from operations, is the last bastion of financial integrity--think again.

By Elizabeth MacDonald

Forbes

December 8, 2003

Cash is king," say investors scalded by accounting scandals and corporate bankruptcies. More to the point, cash from operations, a figure found on the flow-of-funds page right after the profit and loss statement, is now the metric of the moment.

"Investors," says Charles Mulford, director of the Georgia Institute of Technology's DuPree Financial Analysis Lab, "think that profit is an opinion; cash from operations is a fact." When this number shines--along with its sibling, free cash flow (net income plus depreciation, minus capital spending)--so too does a stock's performance, says Howard Silverblatt, a top equity analyst at Standard & Poor's. "The sell-side guys are increasingly paying a lot of attention to it," he says.

Sadly, cash flow from operations also can be distorted, just as net income and sales were in recent market scandals, warns Michael Markowski, who runs a research boutique in Sarasota, Fla. His StockDiagnostics.com makes buy and sell recommendations based on cash flow from operations. But Markowski takes raw numbers in financial statements with warranted skepticism. Instead of GAAP, or "generally accepted accounting principles," we're still getting GEAP, as in "generally elastic accounting principles."

Cash from operations starts with net income and then makes adjustments to reflect the fact that profits don't equal money in the bank. To net income you add back such noncash costs as depreciation and additions to reserves for future taxes. Now subtract increases in inventories and receivables--such things consume cash. Not counting some other items that we'll omit for simplicity, what you have at this point is cash flow from operations.

Below this number on the flow-of-funds page are two other kinds of cash flow, from investing (buying and selling factories, for example, or Treasury bills), and from financing (paying dividends, selling or retiring stock, taking out or repaying loans).

With help from Mulford and some of his colleagues, we have prepared a road map of some of the most common tricks used to boost cash flow from operations. Investors, beware.

Liquidating securities.
Say a corporate treasurer invests idle cash in some short-term securities. Time comes when he needs the cash and sells the securities off. Proceeds do not constitute cash from operations, do they? They wouldn't in most companies' financial statements, but they do at Curtiss-Wright.

This manufacturer of electronics systems and components for aerospace companies and the military reported a net $41 million from sales of short-term investments, such as Treasury bills and money market funds, in cash from operations in 2002, almost double the $21 million it recorded in 2001.

That helped drive its cash from operations to $89 million in 2002 from $61 million the previous year. But why aren't these liquidations put under cash from investing activities? "Our accountants require us to put it there," as they are short-term trades, says GlennTynan, Curtiss-Wright's chief financial officer. Seems the company regards itself as a WallStreet trading house, where trading really is a part of core operations.

Eventually, one runs out of securities to sell. There were no such sales in the first half of 2003. As a result Curtiss-Wright's cash from operations dropped to $29 million in the first half from $42 million in 2002's first six months.

Likewise, Arctic Cat, an all-terrain-vehicle maker in Thief River Falls, Minn., also thinks of itself as a Wall Street trader. In its fiscal first quarter, ended in June, Arctic included in cash from operations $40 million in net proceeds from selling Treasury bills and money market funds, up from $35 million in the same period a year ago. Arctic notes that the seasonal swings in its sales (it makes snowmobiles, for example) force it to draw down cash during warm months. "We are reporting things according to the accounting standards as blessed by our auditors," says Timothy Delmore, chief financial officer at Arctic Cat.

Doing business on the cuff.
Home Depot has been increasing the length of time it takes to pay its suppliers. At the end of fiscal 2002, last Feb. 2, payables came to 41 days' worth of purchases, up from 34 days in fiscal 2001 and 22 days in 2000.

The upward drift sweetened its cash-from-operations figure by some $800 million in fiscal 2002, 17% of its $4.8 billion in cash from ops for the period, notes Mulford. The stretch-out continues: As of Aug. 3 the balance sheet showed 47 days' worth of payables. The move goosed cash from operations by $248 million for the period. In a sense this is good business management: The big-box retailer is getting its hapless suppliers to finance what goes on the shelves. And Home Depot says its accounts-payable days are close to industry norms. But investors should know where the cash is coming from. Increasing payable days can provide a stimulus only once. After that the store has to get cash by selling more snow shovels.

Electronics vendor RadioShack is also sitting on its bills, now waiting 50 days to pay, up from 41 days a year ago. Despite the resulting $52 million boost, cash from ops fell to $269 million for this year's first half, down from $315 million in 2002.

Selling the furniture.
Turning receivables into cash raises a company's cash from operations. Taking out a mortgage does not--such activity would show up lower down on the flow of funds page, in cash from financing. What about selling receivables for cash? Despite the close similarity, in practical terms, to taking out a loan, selling receivables counts toward operating cash flow.

There's a problem, as there is with some of the other maneuvers to inflate cash from ops: You get a one-time boost from these sales. Eventually the company has no more room to create a net decline in receivables, says Mulford.

Thus in 2002 the engineering concern Halliburton sold receivables, boosting cash from operations by $180 million.

That came to 11% of its $1.6 billion in operating cash for the year, a nice distraction in a year with a flood of red ink from its asbestos liabilities. Wendy Hall, a Halliburton spokeswoman, says the company found that securitizing receivables was more effective than trying to raise cash in a commercial paper market that is leery of its asbestos exposure.

In 2003's first half Halliburton did not securitize any receivables, contributing to a fall in cash from operations to -$213 million from $620 million in the 2002 period.

Norfolk Southern, the railroad, got $388 million of proceeds from securitizing receivables in 2000, which came to 30% of its $1.3 billion in cash from ops.

However, the amount securitized declined to $300 million in 2001, just $30 million in 2002 and zero in 2003's first half. That helps explain why Norfolk's cash from ops slid to $803 million in 2002 and to just $366 million in the first half of 2003.