Professional and Serious Investors use Cash Flow Analysis … FALSE
Cash Flow Is A Better Measure Than Accounting Income Because It Cannot Be Manipulated … FALSE
That’s A Non-Cash Expense: It Doesn’t Count … FALSE
You Can Ignore Depreciation Because The ProForma “Free Cash Flow” Allows For CapX (Capital Expenditures) … FALSE
Because Real Estate Goes Up In Value, Taking Depreciation is Wrong … FALSE

Professional and Serious Investors use Cash Flow Analysis … FALSE

You need to read some quotes from the 2007 Level2 Vol2 Curriculum of the CFA (Certified Financial Analysts) pages 193-222.

  • Any shareholders who believe the value of a share of stock is a function of EBITDA are misleading themselves.
  • While analysts, investors and creditors might be led to believe that operating cash flow and free cash flow are somehow above the creative accounting fray, that belief is unfounded.
  • Even operations cash flow supported by profitable operations may not be sustainable.
  • It must be stresses that operating cash flow is only the starting point.

After using half the textbook showing all the problems with cash flow analysis, they conclude without any justification “Although there are problems with …. calculating sustainable cash flow, such an approach has its place”. How lame.

Cash Flow Is A Better Measure Than Accounting Income Because It Cannot Be Manipulated … FALSE

The ‘cash flow’ being referred to here is ‘cash from operations’. The complete statement of cash flow includes all three types; operations, investing and financing. Any good bookkeeper can tell you how to move cash flows from the ‘operating’ to the ‘investing’ or ‘financing’ sections. Here is a list of ways to increase the ‘operating’ cash flow.

SalesSell the receivables to a factor for instant cash.
InventoryDon’t pay your suppliers for an additional few weeks at period end.
Sales CommissionsManagement can create a separate (but unrelated) company to do the work. The book of business can then be purchased quarterly as an investment.
WagesPay compensation with stock options.
MaintenanceContract with the predecessor company that you prepay five years worth for them to continue doing the work.
Equipment LeasesBuy it.
RentBuy the property (sale and lease back if you like).
Oil Exploration costsReplace reserves by buying another company’s, or
Choose to use ‘full-cost’ accounting policy instead of ‘successful efforts’.
Research&DevelopmentWait for the product to be proven by a start-up lab. Then buy the lab.
Consulting FeesPay in shares from treasury since usually to related parties.
InterestIssue convertible debt where the conversion rate changes with the unpaid interest.
InvestmentsChoose ‘available for sale’ accounting policy when purchase and ‘trading security’ policy when sell.
Working CapitalBuy an existing business with the wanted working capital.
TaxesBuy shelf companies with TaxLossCarryForward’s. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.
CashRedefine cash to exclude bank overdrafts.

When companies know they will be judged by ‘operating cash flow’ they will, quite predictable, do all the above. None of it is necessarily a good ‘business’ decision. You get what you ask for.

That’s A Non-Cash Expense: It Doesn’t Count … FALSE

It doesn’t count when you are measuring … what? Cash flows measure …(duh) cash. What accountants try to measure, and what is used in economic and financial decisions is … income, profit, growth in value, how much better off the business is.


Not only is there no correlation between cash and profit, the two are frequently inversely related.

Small business owners (with limited access to financing) understand that sudden growth spurts, even while very profitable, almost always cause HUGE cash problems when the business must finance a larger inventory and accounts receivable.

On the flip side, is the failed company that no longer earns a profit and is being closed down. The owner is liquidating assets, not making any new investments, and generating PILES of cash.


There is no such thing as a ‘non-cash’ expense. Either there is a barter transaction that should be considered two separate cash transactions, or there is a timing difference between the cash transaction and the reporting period. Ask yourself whether you incur your Christmas expenses in December (when you make the purchases) … or in January (when you pay the credit card bill).

The flip side of a non-cash expense is the non-cash revenue. Ask yourself whether you earn interest every year over the 20 years of that strip bond you own … or earn income only in the last year when it matures.


By their nature most investments are long-term projects. Different projects, with cash flowing at different times, can be equally profitable. Some have no cash inflows until the end (the strip bond), some have cash inflows over their life (the oilfield), some never have cash flows (the barter).

You cannot judge the investment by the cash in/outflows in a particular year. And you most certainly cannot judge an investment by ignoring the outflows (in the investing section) and counting only the inflows (in the ‘cash from operations’ section).


The difference of opinion between those people who think Net Income measures growth, and those who think cash flows measure growth, comes down to an understanding of what cash flows are “returns of capital” and what cash flows are “income” returns. See the definition and discussion of RETURN OF CAPITAL at Wiki.

You Can Ignore Depreciation Because The ProForma “Free Cash Flow” Allows For CapX (Capital Expenditures) … FALSE

Some history: In the 1980’s investors were in an uproar against the accountant’s calculation of depreciation. At the time inflation was double digit, so expensing the historical cost of the asset UNDERSTATED the reserves needed to replace the asset at an inflating price. Academia came up with various possible solutions, but none really practical.

In that context, it is humorous to hear analysts contend that, now, the accountant’s calculation OVERSTATES the cost of assets: they say the true CapX is only 10%-20% of the accountant’s estimate. While accountants measure the cost of long-term assets in a logical and quantifiable way, the analysts simply ‘come up with a number’ without any calculation. To support their position they must argue that either

  • deflation will lower the eventual replacement cost by 80-90% …Fat chance!!!
  • or, the expected life of the assets is 5-10 times longer than the accountants think …They are virtually indestructible???

Managements lie to investors, when they claim that the cost of maintenence capital is much lower than depreciation. The proof shows up when they lobby governments for faster tax writeoffs of those costs. The accountant writes off the cost much slower than what is allowed for taxes. So when management claims that the tax allowance is slower than the economic degradation of value, you have proof positive that the accountant’s depreciation REALLY UNDERSTATES reality.

You can come to your own conclusions using the company analysis spreadsheet. If depreciation was indeed overstating the degradation of assets’ value, then the ballance left sitting on the Balance Sheet would shrink less (or grow faster) from a reduced Accumulated Depreciation. Compare the growth in Revenues and Income with the booked growth in Property, Plant and Equipment. For most companies they will be pretty much in line with each other. Here are two examples: a stable utility and a growing medical supply company. In both cases the accountant’s depreciation seems to be just about correct.

Because Real Estate Goes Up In Value, Taking Depreciation is Wrong … FALSE

The argument goes – depreciation should not be charged against real estate (r/e), because property does not decline in value. Depreciation is supposed to measure the wearing-out, or decline in value, or obsolescence of an asset. Almost all declines in r/e value occur because of insufficient repairs, maintenance, and upgrades. Unlike a car that can only be preserved by not using it, 100 year old properties are still usable.

That is a very good argument. There are four counter arguments.

First: Construction now is totally shoddy compared to the quality work of the past. Developers publically state the expected life of condos is now 80 years. Visit some construction at new industrial parks. It is shockingly bad and obvious to even the untrained eye. Our buildings today will not be around in 100 years.

Second: While the value of land increases in value, the building may be depreciating, even if at a slower rate than the land’s increase. To determine whether the appreciation of property is due to the land or the building, consider the resale price of city lots with tear-down buildings. There is VERY little discount to the general market. Also, over its life r/e will decline from a value higher than the market average when the building is new, to a value lower than average when old.

Third: Governements allow taxpayers to deduct depreciation on buildings. They are not in the habit of offering taxpayers freebees. And they have pretty smart economists on staff.

Fourth: Even if the building is in perfectly good shape, many are torn down because of demographic shifts, zoning changes, fashion changes, and a more affluent life style norm. Downtown hotels are imploded. Suburban houses of 1200 square feet are leveled for new 2400 square feet construction. Obsolete strip malls are supplanted by big-box centers.

In 2008, after five years of a r/e bull market, it is hard to think that a building can lose value with age. Yet through the 1990’s, there was no price appreciation. In that period, many owners faced bills for rain damage repairs equal to 50% of their original purchase price. The current 4% depreciation rate charged against earnings is probably too high by half, but some depreciation IS required.



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