How to Read a Balance Sheet

ByScott Rothbort
Aug 1, 2007 1:51 PM EDT

NEW YORK ( TheStreet) -- While a company's income statement presents the current results of
a company's operation, the balance sheet depicts the financial strength (or weakness) of a
company.

So what's in a balance sheet?

A company's balance sheet has three main sections:

 Assets: Items of economic value that are owned by a company.

 Liabilities: A company's financial obligations.
 Equity: Sometimes referred to as shareholders' equity, this represents the net accounting
value of the company.

And the basic formula of a balance sheet is:

Assets = Liabilities + Equity
Now, instead of launching into a full-blown lesson on an accountant's perspective of the balance
sheet, I'm going to look at balance sheets from an investor's perspective. In this installment of
The Finance Professor, I'll cover how to diagnose the three degrees of a company's financial
health, by looking at various companies with strong balance sheets, weak balance sheets and
balance sheets that are "under improvement."
I will refer to numbers that can be found on the balance sheets for the most recent available
quarter (first quarter of 2007), which are available at company Web sites and summarized on
Yahoo! Finance and TheStreet.

How to Spot a Weak Balance Sheet

Let's start with an example of a truly horrible balance sheet. I have several nominees for this
ignominious honor: Six Flags, Level 3 Communications, Sirius Satellite Radio and XM
Satellite Radio. (How ironic it is that Sirius and XM, two companies with some of the worst
balance sheets, are attempting to merge? Two wrongs won't make a right.)
Rather than pick one of those four balance sheets, I will discuss many of the problems that
plague all or some of these companies, including:

 Negative or deficit retained earnings

 Negative equity
 Negative net tangible assets
 Low current ratio

Negative or deficit retained earnings:

Retained earnings represent the cumulative net income of a company. When a company has a
negative retained earnings balance, it says to the world that it has generated accounting losses
over a prolonged period of time. Here are the retained earnings, in millions, for Six Flags, Level
3, Sirius and XM -- taken directly from the most recently available quarterly (first quarter of
2007) balance sheets:

 Six Flags: -$1,560.20

 Level 3: -$9,586.00
 Sirius: -$3,978.47
 XM: -$3,620.91

Negative equity:

When the deficit in retained earnings surpasses the amount of capital that the company has, this
is a red flag that signals that the company is in distress.
When a company is in distress, it has two options. Option one is to recapitalize its balance sheet
by issuing additional capital (selling common or preferred stock). If that's not possible, then the
other option is to file for bankruptcy.
Two of the companies I pointed out earlier -- satellite radio twins Sirius and XM -- have negative
equity. Those companies chose to merge. Whether or not that merger occurs, I think that in the
long run, one of them, both or a combined company may see its destiny in Federal Bankruptcy
Court.

Negative net tangible assets:

This is caused by an excessive amount of goodwill. Goodwill, or G/W, is the value paid by an
acquiring company in excess of the book value of the acquired company. G/W sits on the
balance sheet like an ugly mole and has to be amortized (expensed) over a period of time.
However, while G/W has an accounting value, it has no economic value. You cannot sell G/W or
exchange it for cash. Thus, G/W has to be made up by successfully operating the acquired
company. Net tangible assets is equity less G/W. All of the companies I mentioned have negative
net tangible assets (below amounts in thousands):

 Six Flags: - $848,776

 Level 3: - $803,000
 Sirius: - $505,564
 XM: - $650,089

Low current ratio:

The current ratio is derived by dividing a balance sheet's "current assets" amount by its "current
liabilities" amount. This ratio represents the ability of the company to meet its short-term
obligations, such as accounts payables and current portion of long-term debt, from readily
available sources, such as cash, short-term investments, accounts receivable and inventory.
A high current ratio indicates a liquid company. A low ratio indicates that the company will have
problems meeting its short-term obligations, and it could spell more-significant problems. Look
for companies with current ratios of at least 1.00 -- but to be on the safe side, add some room for
comfort and look for a slightly higher ratio.
Sirius, XM and Six Flags all have low current ratios (see below), and this is not a good sign. And
even though Level 3 has a current ratio of 1.44, it is saddled with a great deal of long-term debt,
which is another red flag.
To recap, total current assets divided by total current liabilities equals current ratio:

 Six Flags: $155,308 / $496,294 = 0.31

 Level 3: $1,504,000 / $1,043,000 = 1.44
 Sirius: $479,802 / $750,702 = 0.63
 XM: $432,658 / $694,322 = 0.62

Be careful, though, with the current ratio. While it can be helpful if you're doing a quick scan,
you still need to dig further into a company's balance sheet. Also, the current ratio will vary
among different industries. For example, within aerospace, Boeing has a current ratio of 0.79,
but I would hardly consider Boeing to have a bad balance sheet.

How to Spot a Strong Balance Sheet

It would be easy to state that a strong balance sheet has none of the problems of a weak balance
sheet, but that is not necessarily the case. There is nothing wrong with having G/W, and G/W
appears on some fantastic balance sheets. It is the magnitude of G/W in relation to the company's
overall balance sheet that separates the financially strong companies from the financially weak
ones. Certainly, a high current ratio would be a welcome sign of a good balance sheet. Again,
you need to be careful to only use the current ratio as a starting point.
So what are some of the other standout metrics of a good balance sheet? Here are a few key
indicators of strength:

 Cash and short-term investments

 Low or zero long-term debt
 Undervalued assets

Cash and short-term investments:

Nothing signals a strong company more than piles of cash and short-term investments (such as
CDs or T-bills). This will not only provide coverage for the payment of current liabilities, but it
will also give a company the ability to return value to shareholders. How? Companies can return
the cash to shareholders through stock repurchases and dividends.

Low or zero long-term debt:

We all live our lives in the hope of not having to pay off our home mortgage. Companies are no
different. Long-term debt is money that companies borrowed that needs to be paid back in more
than one year and could be due in as much as 30 years. Companies with balance sheets that are
not saddled with debt are among my favorite kind to invest in.
For the reasons that I mentioned above, some of my favorite balance sheets belong to Apple,
Google and Microsoft:
Recent Quarterly Balance Sheet Data
(Q1-2007, amounts in millions of US
dollars)
Long
Short Term
Cash Term
Investments*
Debt
Apple
7,095.00 5,482.00 0
(AAPL)
Google
4,081.34 7,854.58 0
(GOOG)
Microsoft
7,611.00 20,625.00 0
(MSFT)
Source: TheStreet.com Quotes Section
*Displayed as "Marketable Securities"

Undervalued assets:

This metric of strength is a little more difficult to spot. In fact, undervalued assets might not be
recognized at all unless you do some research into the company itself.
According to accounting rules, assets are held at cost less accumulated depreciation. Thus, there
may be some value over and above the "book value" of certain assets. Here is a look at the
sources of two typically undervalued assets:

Real estate:

What happens if a company has a piece of prime property, such as Macy's block-long Herald
Square store in midtown Manhattan? The balance sheet does not reflect the current value of such
an asset. If you dig a little deeper into what a company owns, sometimes you can find a real
diamond in the rough. For example, real estate was one of the motivating forces behind Eddie
Lampert's acquisition of Kmart debt in bankruptcy and subsequent acquisition of Sears.

Intangible assets:

"Intangibles" represent certain nonphysical intellectual property and rights that a company might
own. These assets usually have no recurring cost other than the initial development and legal fees
incurred to create the items. However, the potential for monetizing those intangible assets is
enormous.
Examples of intangible assets would be a brand name such as Coke or a logo such as the Ralph
Lauren polo horse. Again, Sears offers some intriguing hidden value with brand names such as
Craftsman (tools), Kenmore (appliances) and DieHard (auto batteries). As a result, Sears' balance
sheet is another one of my favorites.
A 'Work-in-Progress' Balance Sheet
I am very focused on companies with strong balance sheets, but I also look for companies that
are working hard to improve their financial status.
When investing, you never want to sacrifice the future to benefit short-term appearances.
Management's focus on changing the financial condition of a company will pay long-term
benefits to shareholders (see " Talking to Management "). Companies that are paying down debt
and accumulating cash and equivalents over time have "work-in-progress" balance sheets.
The benefit of holding cash is far less than the cost of issuing debt. Take a look at MasterCard.
MasterCard's long-term debt has declined from about $700 million at the end of fiscal year 2004
to about $230 million at the end of the first quarter of 2007. At the same time, its cash and short-
term investments (or marketable securities) balance has gone from $1.2 billion to about $2.6
billion.
Another example of a work-in-progress balance sheet can be found at McDonald's, which paid
off $500 million in debt in 2006 and should pay off at least that much in 2007.
Now, here is your balance sheet homework:

 Review the balance sheets for your stock investments. Determine if you are invested in a
company with a strong, weak or work-in-progress balance sheet.
 Look for companies you don't currently own, by scanning for high current ratios, large
levels of cash and low levels of debt. Then do some fundamental research on your results.
This could identify new investment opportunities.
 Apply balance sheet management to your own financial situation.

What Is a "Strong" Balance Sheet?

A strong balance sheet can make all the difference between
your investment surviving a market downturn and blowing
up in your face.

Matthew DiLallo

(TMFmd19)

Jan 9, 2015 at 8:05PM

What does it mean when a company has a "fortress-like" balance sheet? Photo: Frank Kovalchek
via Wikimedia Commons.

Nearly every financial crisis can be traced back to a foundation of weak balance sheets that
cracked under the pressure of excessive debt. Companies, households, and governments load up
on debt during good times, only to struggle to repay those debts when the economy takes a turn
for the worse.

Having a strong balance sheet, on the other hand, is the key to surviving a downturn instead of
going bust when things get bad. I'll show you a few ways to determine the strength of a
company's balance sheet.

But first, let's quickly go over the basics.

What is a balance sheet to begin with?

A balance sheet is simply a financial statement that summarizes an organization's assets,
liabilities, and shareholders' equity. It gives viewers a snapshot of what's owned and what's
owed, and it follows this simple formula:

Assets = Liabilities + Shareholders' Equity

It's called a balance sheet because the two sides of the equation are always in balance. We
measure the strength of a balance sheet by taking a closer look at the makeup of the two sides of
the equation to find out where it might crack under pressure.

To discover what makes up a strong balance sheet, we'll use this sample balance sheet as our
guide:
Sample by author.

Again, to reiterate the "balance" part of the balance sheet, note that at the bottom of that sample,
we see total assets of $644.3 million is equal to liabilities of $244 million plus owners' equity of
$400.3 million.

Now let's take a closer look to see how strong this balance sheet is by analyzing it with some
common balance sheet ratios.

Strength is in ratios, not in numbers

There are about a half-dozen different ratios we can use to determine a balance sheet's strength.
You can see the math behind these ratios at the top of the sample balance sheet above. However,
we'll just look at a couple of these ratios in order to gauge the strength of this particular balance
sheet.
The first ratio we'll use is the current ratio, which is current assets divided by current liabilities.
The current ratio, which is also known as the liquidity ratio, tells us whether or not a company
can pay back its short-term liabilities with its short-term assets. A ratio of less than 1 suggests
that a company cannot currently meet its obligations with its current liquidity. That doesn't
necessarily mean the company is heading toward bankruptcy, but it does mean the company
needs to tap other sources of liquidity to meet its current obligations.

Source: www.planetofsuccess.com/blog via Flickr.

In our sample balance sheet, we see the current ratio is 0.45 times, which suggests that the
company's current liquidity is weak. However, this is mainly because a large current portion of
long-term debt is due, likely thanks to a balloon payment. This debt could be refinanced, or the
company could look to sell either fixed or other assets to meet this obligation. This is why its
important to look at more than one ratio and see whether the balance sheet is stronger than one
ratio would lead us to believe.

To look a little deeper, we'll use the debt ratio and the debt-to-equity ratio. The debt ratio is
simply total debt divided by total assets. A debt ratio of less than 1 tells us the company has more
assets than debt, so the lower the ratio, the stronger the balance sheet. In the case of our sample
balance sheet, we see that the debt ratio is 0.26 times, which tells us the company has plenty of
assets to cover its debt, suggesting that the current ratio isn't much of a concern.

Finally, we'll briefly look at the debt-to-equity ratio, which measures the company's financial
leverage. It is calculated by dividing liabilities by shareholder equity. Here again, a higher debt-
to-equity ratio is a sign of a weaker balance sheet. That said, there is no line in the sand to say
that a ratio above 1, for example, is a concern, as it varies by industry. In the case of our mythical
company's balance sheet, we find that its debt-to-equity ratio of 0.42 times would be safe in
almost any industry.

Add it all up, and our sample balance sheet is in decent shape. Current liquidity is weaker than
we'd like to see, but the other debt ratios are strong, which suggests the company could weather
almost any storm.
Cheat sheet: Check the credit rating
Running a number of financial ratios will help investors better understand the relative strength of
a company's balance sheet. In addition to that, investors should take a closer look at a company's
credit rating, because an investment-grade credit rating by one of the big rating agencies is a sign
that the balance sheet is strong, especially if its rating is toward the higher end of the spectrum.

While credit ratings are only opinions about the company's credit risk, these opinions matter. For
example, junk-rated companies have been shut out of the credit markets during bleak economic
times, making it impossible for them to roll over debt and thereby forcing them to go into
bankruptcy. Meanwhile, a higher-rated firm is typically given more time and leeway to work out
its issues. Suffice it to say that the stronger the credit rating, the stronger the balance sheet and
the better a company can endure a rough economic stretch.

Key takeaways
While the exact ratio is up for debate, a strong balance sheet absolutely needs to have more total
assets than total liabilities. We'd also like to see current assets higher than current liabilities, as
that means the company isn't reliant on outside factors to meet its obligations in the current year.
Another good indication of a strong balance sheet is an investment-grade credit rating. This
suggests the company's balance sheet has been thoroughly tested and deemed strong enough for
debt investors to earn a relatively safe return under many different market conditions

What Are Healthy Signs in the Cash Flow

Statement?
by Bryan Keythman

A cash flow statement shows a company’s cash inflows and outflows and the overall change in
its cash balance during an accounting period. There are some general signs to look for in a
business’s cash flow statement that suggest it has strong financial health. You can monitor your
company's cash flows by reviewing your current and past cash flow statements.

The Cash Flow Statement’s Sections

The cash flow statement is separated into three sections: operating activities, investment
activities and financing activities. The statement shows cash outflows in parentheses to designate
a negative number. Each section’s net cash flow, or total cash flow, is shown at the bottom of the
section. Positive net cash flow from a section means a business generated more cash than it spent
on that section’s activities. Negative net cash flow means the business spent more than it
generated on those specific activities.
Positive Cash Flow from Operating Activities
The cash flow from operating activities section shows a company's cash flows from its core
business operations, which it uses to reinvest in and grow its business. A healthy business should
generate positive net cash flow from operating activities and should grow the amount over time.
If a business fails to consistently generate positive net cash from operating activities, it may need
to rely on outside financing to operate, which will not sustain a business long term.

Consistent Investment Activity

The investment activities section shows the cash flows from buying and selling long-term assets,
such as equipment and property. A stable or growing business typically has negative net cash
flow from investment activities, which occurs when it buys more assets than it sells. A growing
business routinely invests in new assets to expand its capacity, replace old equipment and to keep
up with new technology.

Conservative Use of Financing

The cash flow from the financing activities section shows cash flows from issuing and paying off
outside financing, such as stock and debt, and from paying dividends. A healthy business may
occasionally show positive net cash flow from financing activities as it raises money from
investors and creditors to grow its business, but a healthy business should more often show
negative net cash flow from financing activities. A negative amount suggests the business is
using its cash flow from operating activities to pay dividends and pay off its outside financing

Six Different Checks To Spot Cash Flow

Manipulation
February 28, 2018 7:55 pm by Finbox

Earnings are what people talk about, cash is what keeps the business going.

As an investor it is vital you understand how well the underlying business model of a company is
performing. Earnings are what people talk about, cash is what keeps the business going. It would
be logical to assume that cash flow is less prone to manipulation than earnings and an overall
truer metric for understanding company performance. However, you should know what you see
on cash flow statements isn’t always what it seems. In this post, we will explore just a few tactics
that make cash flow look better than what it is.
Before digging into brass tactics we should explore the reasoning as to why cash flow would be
manipulated at all. It goes without saying you get the behavior you incentivize. Most managers
are compensated largely on the performance of their stock and have added incentive to keep their
stock price higher. A company that misses their quarterly earnings target typically will see
negative movement in their stock price. As the stock price goes, so does the compensation of
management. Therefore to improve their own compensation, management at times will "play"
with how cash flow is reported to appease short-term targets and keep the stock price where it
needs to be. When it is not compensation that is driving the decision to manipulate cash flow it
can be fear of future consequence. Often management knows that a "streak" is about to end, or
rainy days are on the horizon. Holding back cash for a future reporting date builds in a buffer and
buys management time. There are other reasons management might manipulate cash flow, but it
is safe to assume most actions comes back to aligning short-term consequences with self-interest.

The Three Cash Flows: Operating, Investing, & Financing

There are three types of cash flow that management can utilize to run the business. All three have
sections that can be found on the Statement of Cash Flow. In addition, all three have specific
inflow and outflow activities that shape the logical flow of cash moving in and out of the
business.
The first section of the Cash Flow Statement is Cash from Operations. This section should tell us
how well the actual business is doing and how much cash is coming in from actual operations. If
you are investing in a business because of the business model, it makes sense to place a high
emphasis on cash specifically from operations.

Cash Flow from Operations

Inflows of Operating Activities (+) Outflows of Operating Activities (-)

Customer Collections Vendor Payments

Interest Collections Employee Salaries

Dividend Collections Tax Payments

 Cash Flow from Operations

Inflows of Operating Activities (+) Outflows of Operating Activities (-)

Interest Payments

The next section is Cash from Investing. This section gives us an idea of how the business is
deploying cash outside of core operations. If a business makes an acquisition or completes an
investment sale, you will find it under this section.

Cash Flow from Investing

Inflows of Investing Activities (+) Outflows of Investing Activities (-)

Investment Sales Capital Expenditures

Business Disposals Investment Purchases

Plant / Equipment Sales Property Purchases

Business Acquisitions

The final section you will come across is Cash from Financing. This section details how the
business is financing everything that it is doing. Items like issuing stock, borrowing from the
bank and paying out dividends are found in this area.

Cash Flow from Financing

Inflows of Financing Activities (+) Outflows of Financing Activities (-)

Bank Borrowings Loan Repayments

Other Borrowings Stock Repurchases

Stock Issuance Dividend Payments

Understanding the inflows and outflows of the different sections will give us a clearer view as to
the tools management has to manipulate cash flow.

Shifting Financing Cash Inflows To The Operating Section

Since most investors are paying attention to how well the business model is working, the
Operating Section of Cash Flow becomes a big area of focus for management. Improving cash
flow from operations signals the business is strong and headed in a positive direction. When cash
flow from operations dip, it might signal a rough patch or the start of longterm problems in the
fundamental model of the business. It is important to look closely at what is going on between
the Operating Section of Cash Flows and the Financing Section of Cash Flows.

#1. Aggressively Selling Receivables

The first tactic to look out for is the act of selling receivables. Selling receivables in itself is a
common practice. However, selling receivables too early can greatly inflate an average
operational performance (or below average performance). When management sells receivables
they are taking cash from the future and applying it to current operation periods. The cost is
typically at a large discount to what the future receivable would be worth.

When analyzing a company, look for two specific words that could hint management is
employing this tactic; Factoring and Securitization.

Factoring is when a company will sell their receivables to another entity. Many times a
company will use factoring as an alternative financing source. This brings us to the question, is
this a financing activity or an operating activity?

Securitization is similar to factoring but a little fancier. Securitization typically entails a

company selling their receivables to a third party entity in exchange for a new financial
instrument. Often the financial instrument will mimic the receivable inflows with an obvious tilt
to favor whatever number management is currently trying to meet.

Both Factoring and Securitization are typically reported in the footnotes of financial statements.
If you see either word, it is worth taking the time to understand how they might be impacting
true operational cash flow.

If you don’t catch the sale of receivables through the words Factoring or Securitization, you
sometimes can see it in the actual numbers. Be on the lookout for drastic swings in cash flow
from operations. An optimistic investor might assign a value to this notion as a testament that the
core business model is improving. However, dig deeper and look for explanations into how the
drastic change in cash flow occured. A company will disclose the sale of receivables if it
contributed to a significant impact on performance. If a company fails to mention this or is
intently vague, you might want to consider that as a stronger warning sign of things to come
down the road.

#2. Cash Flow From Normal Borrowing

Borrowing is a normal business activity. It should be documented as an inflow under Cash from
Financing. However, creative borrowing structures can shift inflow of cash as a Financing
Activity to inflow for Cash from Operations. For example, using inventory as collateral on a loan
is normal but selling that inventory with the obligation of buying it back at a later time is not so
normal. This is exactly the tactic Delphi Corporation utilized when it arranged a “creative”
borrowing initiative where it sold inventory (a typical positive inflow to Cash from Operations)
to its lender with a future obligation to buy it back (a not so typical outflow arrangement). The
structure mimicked the finances of a typical loan, however executing it this way allowed Delphi
Corporation to book the income as Cash from Operations. As any investor would attest, cash
from a loan and cash from sales are very different.

Another tactic that utilizes borrowing to document cash where it shouldn’t be, is the use of
complicated special purpose vehicles or subsidiaries. A larger company can create an SPV or
Subsidiary and help that individual entity borrow money. The money that entity borrows can be
used to “purchase” from the company that helped set it up. Under this structure, the larger (or
parent) company gets an inflow of cash reported under Cash from Operations. The SPV or
Subsidiary takes the hit to their balance sheet with higher debt that was used to finance an
operating expense. This was one of the many tactics Enron used to keep meeting expectations
during its fraudulent run.

Spotting Cash Flow from borrowing activities can be difficult. One area to thoroughly analyze is
any stray act from normal reporting definitions. If a company has decided to redefine a standard
metric or label for reporting purposes, it is worth understanding what might be the motivation
behind that action. In addition, when a company discloses its relationship with an SPV or an
outside entity, do your research to understand how much that relationship is actually affecting
inflows of Cash from Operations.

#3. Questionable Acts Around Receivables

If a company is manipulating their cash flow and it’s not through the acts of aggressively selling
their receivables or borrowing under questionable tactics, you may want to ask yourself if they
are doing a mixture of the two. Using receivables as collateral against borrowed funds is a tactic
that creates a confusing story around reporting time. Borrowing funds is clearly a financing
activity. Receivables is clearly an operating activity. If a company sold their receivables that cash
would come through the Cash from Operations section. However, when a company uses the
receivable as collateral it should be treated as a financing activity. The cash injected into the
company was not received from customers, it was received from a financing activity.

Ultimately, look for patterns between the Change in Account Receivables (via the Cash from
Operations on the Statement of Cash Flows), and the Accounts Receivable, net (via Total
Current Assets on the Balance Sheet). When you come across something that looks out of the
ordinary, aggressively search disclosures and any changes as to how the company recognizes
cash from operations. Typically there is a reason a company issues a statement or a new
disclosure.

Shifting Operating Cash Outflows To The Investing Section

The tactics to manipulate cash flow is not reserved for just the Financing Section of the
Statement of Cash Flows. Another clever hunting ground for manipulation is the Investing
Section on the Statement of Cash Flows. Let’s take a look at tactics that you should be on the
lookout for.
#4. Capitalizing Normal Operating Costs

An easy area to look at first is how management is treating normal operating costs. Normal
expenses tied directly to operations, bring down the reported Free Cash Flow from Operations. If
those expenses were not an expense but an investment, the “expense” would disappear under
Operating Cash Flow and reappear as an outflow of Investing activities. The result of this action
inflates the performance of Cash from Operations.

If you are worried that a company is mistreating operating costs, take a hard look at their Balance
Sheet. An aggressively growing Balance Sheet might indicate that normal operating expenses are
being capitalized and considered documented as assets to the business. If this is occurring you
might want to ask yourself, "realistically how often are these assets going to need replacing to
maintain current operation performance?" Another area to consider is the line item on the
Balance Sheet titled “Other Assets.” At times management will use this as a collect all bucket to
offset what should be documented as rising expenses. Be on the lookout for consistent increases
in the line item Other Assets. If little explanation is given to what those assets actually are, it
might be a red flag.

#5. Inventory as an Investing Activity

The cost of inventory makes up a large part of Cost of Goods Sold (COGS). It’s logical that this
should be documented as an operating expense and therefore directly impacting the company
Operating Cash Flow. However, sometimes a company can make a strong argument for why
what some would consider inventory, they consider an investment asset. Take for example the
practical situation Netflix encountered. In its earlier days of operation, Netflix had to make a
decision as to how they would treat the purchase of DVDs. Was it a normal operating expense of
inventory (think replacement and consistent turnover), or an actual asset. Typically companies
will specify how they are treating decisions of this nature and stick to one method or another. If a
company flip-flops, it warrants taking a closer look to understand the real story as to why they
are changing the rules well into the game. As an investor, it is important to understand
management's decisions around this and how it effects the numbers you are analyzing.

#6. Circular Transactions

Sometimes management needs to use savvy creative techniques to get a deal complete. It is a
justified action and part of doing business. However, sometimes management utilizes too clever
of techniques to give a favorable slant to reporting numbers. A tactic to look out for is the ever so
clever utilization of circular transactions. You typically can spot this when a company discloses a
“unique” transaction structure between a customer. For example, if you see a company selling to
a customer (a positive inflow of cash for Operating activity) and purchasing an asset like
transactions (an outflow of cash from Investing Activity) from that same customer, you might
want to ask what really is happening with the transaction. Management understands that Cash
from Operations is closely followed and investors like seeing that number increase. Management
also realizes that “investing” can signal expansion and growth. This tactic can feed positive
signals in both areas of the Cash Flow Statement. Be sure to step back and read the details within
the disclosure of that transaction. Circular transactions can help both companies involved but
eventually, come crashing down.

In Closing

Overall these are just a few of the tactics that investors have had to decipher over the years. As
long as management has the incentive to prioritize the short-term, you can bet that innovative
techniques will be created to meet those numbers. Be thorough, and ask questions about why a
company might be acting as they are. In the future, we will discuss more ways that you can spot
further actions that distort cash flow, earnings and reporting metrics.