Saturday, 14 December 2024

Earnings are not equivalent to cash flows

These metrics rely  on reported profits or earnings rather than cash flows:

P/E

P/EBITDA

P/S

P/BV

EV/EBITDA


Profits may not reflect the actual underlying cash flows.

Some examples:

1.  Interest paid on perpetual securities (perps)  

  • These are not considered interest expense, thereby inflating profits.  
  • At the same time, accounting for perps as equity also understates the company's actual gearing.

2.  Companies can capitalise interest expense as assets in certain circumstances

  • Interests during construction of assets or when property developers borrow to purchase land for future development.  
  • This would understate expenses and inflate profits and book value.
3.  Companies can be in total compliance with financial reporting standards but still be misleading
  • A company is allowed to recognise construction revenue from in-house concessionaires based on estimated fair values of future income streams under the long-term agreements.  This revenue is recorded as financial receivables/intangible assets on the balance sheet.  
  • When the concession asset commences operation, cash flows generated from the asset are recognised as sales, while the operating costs include amortisation of the financial receivables/intangible assets.  
  • Basically, companies report earnings even when there is no cash flow during the construction period, and then actual cash flows are higher than reported earnings when the asset is in operation.  
  • In short, reported earnings have little relationship to the actual cash flows.


It is far easier to manipulate profits than cash flows, unless the bank statements are also falsified.

Management faked sales invoices or "pre-billings" 
  • This is to inflate sales, Ebitda, profits and book values -  to give the impression that the company was worth more than it really was.  
  • As such, scrutinising the Cash Flow Statement - which shows the sources and applications of cash, tying the cash balance at the start and end of the financial period - can be more informative than the popular Profit and Loss Statement.

Ignoring the risk of debt

Also, most of these metrics often measure earnings against market capitalisation. 
  • For instance, the P/E ratio attributes value to the earnings - but ignores the risks of debt used to generate those earnings.  
  • This omission can have serious consequences for investors.
  • A company with debts may appear to have more attractive valuations but this come with higher risks, which are not immediately evident and therefore, not properly accounted for, simply by looking at the Profit & Loss statement.  
  • When companies have to borrow to service debts, the situation will, often spiral rapidly out of control.


Ref:  Tong's Portfolio 2  It's all a matter of trust


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