Tip of the Week #85                    Tip Index

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Cash Counts
when examining financial statements

Much has been written about the growing disparity between financial statements and corporate reality.  The stock market typically values a company at several times the book value of its assets. In 1978, book value was 95% of market value; now it's 28% (from "Accounting gets Radical" by Thomas A. Stewart, Fortune, April 16, 2001, pp. 184-194).

Why is there so much difference? There has always been a difference between the actual and book value of assets. The cost value of assets is reduced by depreciation expense.  This remaining book value may have little resemblance to the actual fair market value of the asset. While depreciation reduces the asset value appearing on the balance sheet, the actual value might be increasing with inflation or other appreciation; this is especially true for real estate.

In recent times, corporate value is often based more upon intellectual capital, goodwill, and other intangibles.  Brand recognition, trade secrets, and a trained workforce may be main the sources of profitability and competitive advantages. With many of the "dot coms," money was poured into building brand awareness, with little or nothing on the balance sheet to show for the investment.

Thus, accounting statements are increasingly fiction, despite drawing from accepted rules and practices. The income statement and balance sheet are increasingly irrelevant.

There are two forms of information that are difficult to corrupt (without outright fraud and risk of jail time):

• Cash Flow Statement.  This fairly recent addition to the standard financial statement details the sources and uses of cash in three categories: operations, financing and investing. Since cash flow is what drives business value, this is the most important and reliable part of the financial statement.
• Shareholder return.  This, too, is almost impossible to corrupt.   Shareholders know what they've received in dividends. They also know the price appreciation (hopefully) of their shares.

So, in evaluating companies, I suggest that you pay special attention to cash flow and shareholder returns.

And as my good friend Chuck Kremer often closes his letters, "May the cash be with you."

See also, Relevance Lost: The Rise and Fall of Management Accounting by H. Thomas Johnson and Robert S. Kaplan, 1987, Harvard Business School Press.

—John Schuyler, June 2001.

Copyright © 2001 by John R. Schuyler. All rights reserved. Permission to copy with reproduction of this notice.