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Earnings Per Share May Be Dangerous To Your Financial Health

By Charles Hopkins Published 11/27/2007 | Finance
There's a serious and completely preventable problem occurring in the financial investing arena these days.

This threat to one's financial well-being comes from the sole focus on "earnings per share" triumphantly trumpeted by companies in their quarterly financial press releases. And the financial media doesn't help any with their superficial thirty second blurbs informing the investing public of the same thing. Even more alarming is that this novice mistake is frequently made by "expert" and "veteran" investors, as well.

The unfortunate truth is, failure to address this common oversight can cause painful repercussions to your investing portfolio. And also hinder you from identifying companies worthy of your long-term financial best interests.

What is this critical investing component? It's the Cash Flow Statement, kin to the more popular balance sheet and income statement. How does the free cash flow statement help you with your investing oversight? A company's free cash flow helps to answer three very fundamental questions - When to buy? When to sell? And at what prices?

The fact is, free cash flow is what should be monitored first and foremost as a shareholder in any business. Most everyone knows that "cash is king". Free cash flow is the lifeblood of any company.

The problem when paying sole attention to "earnings per share" is that it is formulated using "generally accepted accounting principles". Commonly known as "GAAP", this accounting methodology is a flexible representation of the company's revenues and expenses, mainly formulated for tax reporting purposes. The sticking point is that "GAAP" consists of many non-cash items - sometimes considered as "accounting fictions". And because of the permissible leeway in how GAAP can be implemented, it's subject to manipulation.

In contrast, the cash flow statement is less prone to being manipulated than the other two financial statements. That's because it mainly boils down to what money came in and what money went out. Not unlike an individual's monthly budget.

When analyzing a company it's critical to understand how much cash flow it is earning from its operations. This amount represents the excess cash that can be taken out of the company to be used for dividend payments, share buy-backs, new investments and acquisitions; all activities geared to the benefit of shareholders.

With GAAP earnings on the other hand, companies often take significant "one-time" charges against current earnings, usually after some adverse event, like a company acquisition gone bad. As a result, future earnings are then susceptible to being inflated artificially.

The income statement also includes many non-cash allocations and accounting conventions that don't reflect a company's true cash position.

A further example of an ongoing non-cash "cost" is depreciation and amortization, which can add up to significant amounts. In reality, the cash has already been spent for these assets. GAAP adjusts these one-time payments over a period of years to smooth out the companies earnings over time so they don't appear too lumpy or erratic.

Another flaw might be using the balance sheet for liquidity analysis because the data represents only a specific period in time. By contrast, liquidity analysis derived from the cash flow statement can be used to provide a more dynamic picture of what cash resources are available, and can be evaluated over a chosen period.

One can also see whether cash spend is at levels that the company is going have to incur debt, slow its spending rate, or both. This is especially important for new companies that are not generating profits yet. Do they have enough cash to remain in business?

Changes in cash flow can be reveal much about a company's accounting practices, too. Cases where cash flow is not rising, or declining, as fast as earnings may warn of possible accounting shenanigans.

These are just a few of the many insights and potential advantages that analyzing the cash flow statement will bring forth. And it's freely accessible at the Security and Exchange Commission's EDGAR financial statements web site.