Evaluating Cash Flow Quality
Evaluating Cash Flow Quality means verifying that the cash flow reported by a company is high (i.e., good economic performance) and that the underlying reporting quality is also high. Because Operating Cash Flow (OCF) has the most direct impact on the valuation of a company, the focus in evaluating cash flow quality will typically be on OCF.
A cash flow statement should be evaluated in the context of the life cycle of the company as well as industry norms. For example, it would be quite normal for an early-stage startup to have negative operating and investing cash flows, financed by cash flow from financing activities (e.g., equity issuance). For a mature company, however, negative operating cash flow coupled with positive financing cash flow is a sign of trouble
High quality cash-flow is characterized by positive OCF that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments. In addition, high-quality OCF is also characterized by lower volatility than that of the firm’s competitors. Significant differences between OCF and earnings, or differences that widen over time, can be a cause of concern as they may indicate manipulation.
On this page, we discuss how to evaluate the cash flow quality of a firm.
Evaluate cash flow quality
Evaluation of the statement of cash flows (and more importantly cash flow from operating activities) consists of:
- checking for any unusual items or items that have not shown up in prior years
- checking revenue quality. Aggressive revenue recognition practices typically result in an increase in receivables – which reduces operating cash flow. Another common indicator of aggressive revenue recognition is an increase in inventories when so-called sham sales are reversed.
- checking for strategic provisioning. Provisions for restructuring charges show up as an inflow (i.e., a non-cash expenditure) in the year of the provision and then as an outflow when ordinary operating expenses are channeled through such reserves.
Analysts should be aware that accounting standards often afford some flexibility in the treatment of certain items in the statement of cash flows. Example include:
- while interest paid, interest received, and dividends received have to be treated as operating cash flows under U.S. GAAP, interest paid can be classified as either operating or financing cash flow under IFRS.
- interest/dividend received can be classified as either operating or investing cash flow under IFRS. A company reporting under IFRS and accounting for interest paid as an operating cash flow could instead report it as a financing cash flow, giving the appearance of an increase in operating cash flows in a year-over-year comparison.
We discussed the importance of evaluating the quality of the cash flows reported by a company in the cash flow statement. We also highlight how an analyst can evaluate the statement of cash flows.