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Use
Cash Flow to Spot Problems Early
Investors
who bought Krispy Kreme Doughnuts at its August 2003 peak and never sold
would have $150 worth of stock today for every $1,000 that they originally
invested.
But
that didn’t have to happen. Those savvy to analyzing cash flow
statements had plenty of warning that something was amiss. Here’s why.
On
August 10, an investigation commissioned by the doughnut maker’s Board
of Directors reported that senior management had resorted to creative
accounting in the 2000 to 2003 timeframe to assure that the firm would
report ever-growing earnings, which was necessary to keep its share price
moving up.
Despite
those efforts, in August 2003, Krispy’s accounting house of cards fell
apart, earnings growth evaporated, and its share price plunged.
The
investigative report found that Krispy’s accounting shenanigans involved
shipping unwanted goods to its franchisees. Krispy recorded the shipments
as sales, which added to earnings, even though the franchisees never
intended to pay for the goods. So Krispy Kreme’s income statement gave
no clue that its growth was faltering.
But
the discrepancies had to show up on Krispy’s cash flow statements.
Hard
to Fudge Bank Balances
Cash flow measures the cash that flowed into, or out of, a firm’s bank
accounts. There is little a company can do to overstate its bank balances.
Since Krispy’s franchisees didn’t pay for the unwanted shipments, its
cash flow statements would reflect the shortfall.
Here’s what
you what you need to know to analyze cash flow.
Cash flow
statements start with net income and then add back non-cash expenses such
as depreciation, which deduct from net income but don’t result in cash
changing hands. Cash flow statements consist of three sections.
-
Cash
used/from operating activities (operating cash flow): the cash flow
generated by the company’s business operations.
-
Cash
used/from investing activities: capital equipment (property, buildings
and equipment) purchases, cash used to fund acquisitions, and
short-term investments.
-
Cash
used/from financing activities: cash from stock sales and buybacks and
from borrowings or debt repayments.
You can see
cash flow statements on most major financial websites. I’ll use Smart
Money’s statements to demonstrate the analysis.
Use Annual
Figures
From Smart Money’s homepage (www.smartmoney.com),
enter your stock’s ticker symbol (KKD for Krispy Kreme) and select Financials
from the dropdown menu. You can use annual or quarterly cash flow
statements, but the annual numbers are better suited to this analysis. So,
select the “Yearly
Cash Flow” option.
Smart Money’s
yearly report shows the last five fiscal year’s cash flow numbers.
Krispy Kreme’s fiscal year ends with January, so the fiscal year labeled
2003 is the year ending January 31, 2003. Because it’s still trying to
unwind its accounting misdeeds, Krispy hasn’t yet filed its January 2005
fiscal year report, so January 2004 is the latest available.
You need
consider only two items to do the analysis, operating cash flow and free
cash flow.
Operating
Cash Flow
Operating cash flow should be positive. A company isn’t profitable if it
doesn’t report strong positive cash flow. How much is enough? At a
minimum, operating cash flow should exceed the total net income (top line
of the cash flow report) for the same year. Krispy Kreme reported positive
cash flows, which exceeded net income, in every year shown, so it passed
this test.
Free Cash
Flow
Free cash flow is operating cash flow minus money spent on capital
expenditures and acquisitions (listed under investment activities). It is
the money left over after a firm has run its basic operations and made the
additional expenditures necessary to remain competitive and to continue
growing. Free cash flow isn’t shown on the cash flow statement, so
you’ll have to calculate it. However, for our purposes, you can probably
do the math in your head.
The best
companies generate positive free cash flow, which means they have surplus
cash they can use to pay dividends, buyback shares, or enter new
businesses. But most fast growers need all of their excess cash to fund
their expansion. In terms of free cash flow, they generally break even, on
average, over the years.
Krispy, aware
that investors notice negative operating cash flow, was able to keep that
number positive by moving items that arguably should have been deducted
from operating cash flow down into the less-scrutinized cash from
investing activities section.
Calculating
free cash flow would have immediately spotlighted Krispy’s problems
early on. From the time it went public in early 2000, Krispy’s free cash
flow was negative every year except for 2001.
Something
Went Wrong
At first Krispy’s free cash flow looked reasonable. Down $2 million in
fiscal 2000, but up $5 million in 2001. But then something went wrong.
Krispy burned $22 million in fiscal year ending with January2002 and $37
million in fiscal 2003.
Anyone who
calculated Krispy’s free cash flow after it released its fiscal 2002
report in March of that year would have figured it was time to get out.
Krispy’s shares were trading in the low $40 range at the time. If they
missed that “red flag,” investors had another chance when Krispy
released its fiscal 2003 results in March 2003. Then, its shares were
still trading in the mid-$30s. The last time I looked Krispy shares were
changing hands at $7 or so.
Many experts
consider cash flow more important than reported earnings. That said, not
all stocks that fail my two cash flow tests will crash and burn. But
failing these tests signals added risk, something that you don’t need in
this tricky market.
published 8/21/05 |
