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sold for short-term profits). If you find that CFO is boosted significantly by one or both of these items, they are worth examination. Perhaps the inflows are sustainable. On the other hand, dividends received are often not due to the company's core operating business and may not be predictable. And gains from trading securities are even less sustainable. They are notoriously volatile and should generally be removed from CFO (unless, of course, they are core to operations, as with an investment firm). Further, trading gains can be manipulated: management can easily sell tradable securities for a gain prior to year-end, thus boosting CFO.
Summary
Cash flow from operations (CFO) should be examined for distortions in the following ways:
• Remove gains from tax benefits due to stock option exercises.
• Check for temporary CFO blips due to working capital actions--for e.g.,
withholding payables, "stuffing the channel" to temporarily reduce inventory.
• Check for cash outflows classified under CFI that should be reclassified to
CFO.
• Check for other one-time CFO blips due to nonrecurring dividends or trading
gains.
Aside from being vulnerable to distortions, the major weakness of CFO is that it excludes capital investment dollars. We can generally overcome this problem by using free cash flow to equity (FCFE), which includes (or, more precisely, is reduced by) capital expenditures (CFI). Finally, the weakness of FCFE is that it will change if the capital structure changes. That is, FCFE will go up if the company replaces debt with equity (an action that reduces interest paid and therefore increases CFO) and vice versa. This problem can be overcome by using free cash flow to firm (FCFF), which is not distorted by the ratio of debt to equity.
Earnings
In this section, we try to answer the question, "what earnings number should be used to evaluate company performance?" We start by considering the relationship between the cash flow statement and the income statement. In the preceding section, we explained that companies must classify cash flows into one of three categories: operations, investing, or financing. The diagram below traces selected cash flows from operations and investing to their counterparts on the income statement (cash flow from financing (CFF) does not generally map to the income statement):
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