Wednesday, March 26, 2008

* You Can't Spend Earnings

You can't spend earnings. At first glance, this probably seems like an odd statement, possibly even incorrect. However, it is not only correct, but an important investing axiom for any type of investor. Let me explain.

Earnings are that which is derived from the exchange of a product, service or other, less associated expenses. Ultimately, it is our desire that earnings are converted to something that can be spent, such as cash. You may be thinking that is just semantics, but is it? In the article "The Most Important Financial Statement", I mentioned that cash flow is what ultimately drives the value of any financial asset, yet there is sometimes a disconnect between earnings and cash.

Through fraud and manipulation an income statement can be made to look quite impressive. There is not a shortage of stories where expenses are moved to the balance sheet as assets in order to artificially inflate earnings. However, a management team does not have to be dishonest for an income statement to misrepresent the company's true financial condition. Given complex accounting rules, a company can generate huge paper gains that may never be converted to cash.
I take great comfort in a company with a strong cash flows and a consistent history of increasing cash dividends. An increasing cash dividend keeps pressure on management to ensure the company is well run. If there are too many missteps, then eventually a dividend will slip. This can be disastrous for a company's stock price.

Earnings can be manufactured, cash can not. Always follow the cash and it just might lead you to a great company.

Full Disclosure: No position in the aforementioned securities. See a list of all my income holdings here.

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