Olstein: Use this to spot financial manipulation

Olstein: Use this to spot financial manipulation

In this, the third of a three-part interview with Bob Olstein, Chairman and Chief Investment Officer of The Olstein Funds, the well-regarded fund manager goes after the Wall Street myth that income statements are all investors need to know about the operations of a company.

Olstein, who has managed money for over four decades, reminds stock buyers that there's a difference between a company's income statement and its cash flow statement, both of which get released along with a public company's balance sheet each quarter.

Why are there two types of statements for companies?

Because under generally accepted accounting principles (GAAP), accounting income isn't necessarily the same as cash flow. They both serve very important roles in helping investors understand a company's operations. But neglecting either one of them is a bad move.

A cash flow statement basically tells you how the actual cash that comes into a company is spent. This method is known as "cash basis accounting". But that's doesn't necessarily tell you about the health of a company. For instance, if one were to look at the cash flow of a company that just made a huge capital expenditure in a factory, it would seem it spends a lot of money to earn a little bit of cash. Yet that factory could make huge profits for the company down the road.

So, another financial statement – the income statement – matches expenses with the revenues they create. That's called "accrual basis accounting". If the factory the company just built cost $10 million and is used for 10 years, the income statement might say that expenses were $1 million each year for the decade. It might have paid $10 million in the beginning but it used $1 million worth of the factory's life to make that whatever it sells each year.

Add up everything over 10 years between both the cash flow and income statements and it will basically be equal. Yet you need both of them to tell you a little bit about what's going on with a company.

(Read: Ray Dalio explains 'How the Economic Machine Works')

Investors are often told to look at a company's income statement because that's where some important measures are found. A company's earnings-per-share are basically the net income found at the bottom line of an income statement divided by the amount of shares outstanding.

But here's the thing: a lot of times, income statements are manipulated. From shenanigans with how a company recognizes revenues on the top line to games played with expense assumptions before the bottom line, an income statement by itself can fool investors if it's manipulated. And that's why Olstein tells investors to look at both the income and cash flow statements to get a better picture.

"Most companies say 'My income statement is in accordance with GAAP'", says Olstein to Talking Numbers. "But, there are a lot of assumptions that go into GAAP. Great poster children for why you have to go to the cash flow statement and look and determine whether the assumptions under GAAP are correct: WorldCom and Enron were producing no free cash flow back then, when they were growing their [net] income by leaps and bounds."

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Not all discrepancies between the cash flow statement and income statement mean there's something bad going on. In fact, a good investor would be able to spot values based on cash flows not apparent in the income statement.

"Macy's… was reporting very little earnings – $0.50 a share," says Olstein. "But [it] had so much excess depreciation and non-cash charges that you were buying Macy's at $10 a share – and that was at five times free cash flow!"

To hear other examples from Olstein and other reasons why cash flow statements are important for investors, watch the video above.

More from Talking Numbers:
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