Is the CEO Lying? How to Read a Cash Flow Statement

0:00All the media outlets love to stare at the income statements and boast about revenue and record-setting revenues and all that. But is that actually what makes a company healthy? In fact, it's not. In order to tell whether a company is healthy or not, we have to look at the cash flow statement. And today, that's what we're going to be diving into. By the end of today's episode, we should be able to look at a cash flow statement and tell whether a company is actually healthy and in a good spot. or if the CEO is playing with some accounting magic.

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3:06Stephen:You're tuned in to the Investing for Beginners podcast. The show for the long-term investor. We cut through the noise to focus on what works, compounding, discipline, and the conviction to buy wonderful businesses and stick with them. Your path to financial freedom. Start now. Welcome back to the Investing for Beginners podcast. My name is Steven Morris and I'm co-hosting Andrew Sather, who's sitting over there looking as beautiful as ever and with his perfect hair yeah wow i would blush no serious uh no cap there are allegations against you andrew serious allegations that you're not gonna lie so my wife i was telling my wife like a couple episodes ago i was joking and i called you the hair and there was a story behind it that i didn't realize yada yada and she was like why did you call him the hair that's so stupid and i was i told her i was like well you know i've gotten into meetings with andrew and and he's obviously come back from the gym he's in a cutoff shirt covered in sweat but his hair perfect never changes and she was like oh well that's easy i was like what do you mean she's like i bet he has a hair piece wow get out here how what i am insulted that is that is quite the allegation i am innocent i uh i don't know what else to say other than i hope everybody who listens knows me they know my character they know that i am a trustworthy guy and i am not wearing a hairpiece no shade at anyone out there wearing a toupee or a hair system as deadpool likes to call it um no shade at you guys at all but it was just it was so funny because the the way she looked at me i bet he's wearing a hairpiece like oh that's gonna tick andrew off i gotta tell him she's questioning my honor and integrity how dare you so today we're talking about working capital andrew and um we're we're gonna really actually you know what i'm just gonna let you talk about working capital and teach me sir andrew okay let's do it so working capital the sticks and stones the um the components that businesses need the raw materials that businesses need to run their business so these are all the short-term things these pesky short-term things that nobody really wants to learn or care about, but they are critical for running a business.

6:03Stephen:So things like accounts receivable, inventory, accounts payable, cash, all of these things are the building blocks that allow businesses to transact with each other and transact with customers. And if these pieces are not managed, which we have seen multiple, a multitude of times in the stock market when these things are mismanaged it is bad not only for the business but also for the stock price and so we want to avoid that as much as we can to avoid these cases where stock price goes up up up and then boom craters we don't want that and sometimes you can see that play out in working capital and i'm excited to talk about it because i i pulled up some businesses, some well-known businesses, and we can look at some of the numbers behind their working capital.

6:59Stephen:And I think it's kind of interesting to see some of the correlations that you might see between a business that struggles publicly and then looking under the surface, while they also mismanaged their working capital. And how much of that was because of the mismanagement of the working capital? Was it the chicken or the egg? Sometimes you can see that as well but to your point I think it's very important to look at this and make sure we're not estimating companies in a way that we don't understand if we're not looking at the cash flow statement absolutely and I guess my very first question before you really dive into it is what why is there a gap between the the book in the bank yeah hard for us to to comprehend unless we are business owners ourselves when we go to walmart and we go buy deodorant or hair product we go and we put our credit card it takes the money directly from our bank and then we go home with our items in the background though walmart does not receive that money that went from your bank directly to their bank right away.

8:17Stephen:It goes through a credit card payment processor and money needs to change hands from a bank to another intermediary to Walmart's cash flows. And then there's similar things for how Walmart stocks their shelves. So they might purchase from Tide or blanking on whoever, maybe a Dyson vacuum cleaner, whatever it is, whatever inventory, They might purchase from that business, but they don't pay. Again, the cash doesn't come out right away. The amounts of money that are transferred between businesses to and from each other can complicate things. It's interesting to see how technology could be making some of these concepts a little more obsolete.

9:05Stephen:But I think you'll always have, as businesses now, there's this gap between, to your point, when the company books a sale and when the money actually flows into their checking accounts. And so in order to account for that, they have to create these items in their checking account. And I guess it also kind of makes sense to just from a, we like to think that just transferring money is such an easy and painless process, but there are bad actors involved. And, you know, people, people don't just carry around tens of thousands of dollars in their pocket for a reason. And that's because of bad actors.

9:52Stephen:And so these transfers aren't always convenient and it's not convenient for Walmart to carry tens of thousands of dollars in their account. It's not convenient for a vendor to carry tens of thousands of dollars in their pocket either. So because of fraud, because of bad actors, there are these hoops and these time periods that need to happen. And so that's all recorded in working capital. it's all fine and it all works like it's supposed to until you have times of uncertainty, times of chaos, times when liquidity drains from the economy. And then you get people who don't pay what they owe and things like that.

10:32Stephen:And that's where managing your working capital is actually a full-time job. And a good CFO should be able to manage a company's working capital and make sure that they are not exposed to these big type of problems that could happen if the economy goes through a speed bump so there are safeguards to protect us as investors when we look at their cash flow statement the there there are measures in place i'm guessing i'm guessing that the sec um the the dict dictates to them how they report this gray area i guess we'll call it the difference between we're going to get this money we should get this money and we actually have this yes yeah and uh it works most of the time that's that's very reassuring to hear right vast majority of cases it works i mean so would i be jumping the gun if i if i ask what what red flags you might look for when you're looking at the statement?

11:45Stephen:Yeah, no, I don't think so. So red flags that you can see. Let's start with accounts receivable, I think is a good one to jump into. So taking again the example of Tide Detergent and Walmart. So if Walmart owes Tide Detergent money for the inventory that is put on the shelves and sold to consumers. Then Tide Detergent has an accounts receivable from Walmart. Now, that's good. You want more accounts receivable because that gets turned into cash. One of the red flags you can see is what they call channel stuffing, but that's where receivables are completely outpacing revenue growth itself. And there's a lot of different examples of how that has played out in the past and we can kind of dive into that but does that communicate well um for a beginner like accounts receivable why that would be a red flag and kind of how it how you might spot it yeah i think so i i think it makes perfect sense i mean it's simple if if receivables goes through the roof you need to take a better look at it and And does that mean they're channel stuffing?

13:05Not necessarily, not always. They could have just made a mistake. It might be a clerical error. So, I mean, it's not an instant you can't buy this stock, but it's definitely, hey, the receivables are way too high. Go dig into this and do some, what is it called? Investigating? Not investigating. um what is it uh csi does the the tv show uh i don't watch analysis oh okay analysis that's that's what i was trying to go with get get in there and do some uh market forensics and figure out why their their receivables are so high yeah and and just try to do some common sense on

13:54Stephen:what is this business is this something where it makes sense that they would have receivables maybe a contract that's takes them months to execute on or is it a really out of place for the type of business that they are can't put you on the spot what kind of business would have something like that uh businesses with high backlog so i'm actually thinking of like defense contractors specifically i used to own northrop grumman they would always report every earnings call a book to bill. And so you're comparing what the revenues are to what the backlog is. And it actually, for them, they would want to see a higher bookings than billing.

14:45So that might be an example where you don't want to just look at revenues,

14:50Stephen:but you would look at a different metric. So when a customer or a client defaults on what they owe said company will say Tide to Walmart, or I'm sorry, Walmart to Tide. How can we identify that that's what's going on? Is there a way to identify that that's what's happening to Tide? Because, I mean, if Walmart owes Tide money and they're just not paying, and I'm not saying that that's what Walmart does, So is there a way we can identify that easily or is that way out of the realm of what we can do? Is your wardrobe well stocked for the upcoming season change? I'm recording and it's the first warm day we've had in a while.

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18:08Stephen:It's available for our Value Spotlight members. If you want to see the thesis, we're doing a 60 % discount for now, but I'm pulling the deal once the stock hits$45. Check it out at einvestingforbeginners.com slash 60. That's a good question. Depends on if you want to be a forensic investigator or not. I think there are people who can really excel doing that and they might trade short term of like I'm hyper-focused on working capital and I look at inventory, I look at receivables and all those things, and I can see when companies are more likely to struggle with that. That doesn't fit my personality and what I'm trying to do as an investor.

18:52Stephen:However, I should always be scanning for red flags and I should be looking for when things are out of whack and I should be understanding that situation. So the work should still be done, if that makes sense. But I would invest not trying to predict an event, but trying to make sure I'm protected from an event. So I'll give you an example. I was looking at a solar company just a few days ago. It looked really promising. Like the numbers are awesome. I believe in solar personally. I know a lot of people don't. I think there's a long term in solar. the problem is the company i was looking at which they don't make solar panels but they make a critical component to solar panels and it's innovative and it's it's like one of a kind it's really cool was it 30 or 40 percent of their accounts receivable were from one customer and i did some digging around what'd you call it google something google google i did some google foo uh and i found our our favorite our favorite solar company you you remember um of course sunrun so when when sunrun is your accounts receivable to me like that's too high of a risk profile and i want to see that come down before i'm comfortable so you're really managing your risks you're managing like how much accounts receivable risk and am I okay taking?

20:23Stephen:Because if the worst comes to worse for the company who's big on your accounts receivable, if Walmart goes bankrupt and Tide can't get that money back, they might go to court and maybe recover some of it, but they'll probably take a big loss. And that's just money that you recorded as revenue and now you have to take as a loss. and that's not ideal. And that can really change your valuations. If you're accounting, if I'm investing in Tide and I'm counting on Walmart to continue paying the company and growing, being like a source of revenue for them and they go bankrupt, you just, you have to account for the fact that now you're like a half as valuable business.

21:09Stephen:If half of your revenue comes from one customer and they're out of the business and you don't have any replacement, you're half as valuable. So you have to not only look at the accounts receivable for yourself, but look at is there exposure there to other businesses that might be more risky. No, that's a great point. I never actually thought of that. That is a fantastic, fantastic point, which we talked a little bit about in a previous episode. There's a lot to be learned by reading competitors' 10Ks. but there's also a lot, like you just stated, a lot to learn from reading suppliers' 10Ks or customers' 10Ks as well.

21:53Great, great point. Thank you for that. Kind of moving on, but in that same red flag area, another place where a huge red flag can be is inventory, right? because the worst thing in the world we can see is Walmart warehouse stuffed with inventory with I think probably an exception would be like probably right before Black Friday, right before Christmas. I guess it would be okay if they were pretty packed. But other than that, I mean, that's just product that's not making the money, right?

22:36Stephen:Yeah, 100%. But ideally, if you have that kind of a situation, a company has built in things within the business to kind of manage that. But that is another example of a place where management can misstep. I've used the example before. I'll say it again. I invested in Target back in 2021. One company was seeing an explosion in demand. And so they doubled down and expected that demand to continue. Ended up with too much inventory, took a huge loss. The stock has not done well since. Circuit City was another good example of that. Before they went bankrupt, they had a lot of inventory. And you have to put the inventory in context.

23:26Stephen:inventory that is full of bananas and apples and oranges is going to be easier to sell than inventory that is discretionary maybe gadgets consumer electronics things that people tighten the belt on during an economic hardship you not all inventory is the same and so some inventory building is good like if if the company can fulfill that demand or if the inventory doesn't spoil um maybe ferrari is a good example of they might be able to hold that inventory longer because like you mentioned to me off the air ferraris don't depreciate like a regular car does um so yeah you have to put it in context but in general you definitely don't want to see rising inventory and especially um inventory as a percentage of sales that gets too high unsustainably high that could be a sign that inventory is piling up yeah and to that point you know you brought up circuit city i'm not sure it's best i'm not sure if best buy is publicly traded or not but um they are okay so if we're looking at their theirs their inventory is on a very strict timeline well what's the old adage if a computer is more than like three days old, it's outdated or something like that.

24:53I don't remember. Their computer inventory, all that tech inventory is on a very strict timeline because it's going to become outdated super, super fast. So you also need to be aware of what type of inventory they have in that regard. Not just is it going to spoil on that timeline, but is it going to become obsolete tomorrow timeline. you're seeing some of it with tesla too right and tesla has had some struggles and um

25:26Stephen:so there's different so i guess that maybe i segued myself pat on the back to me um one of the one of the ways you can measure inventory is days sales uh inventory dsi so uh you can do that And when you see, I'm sorry, it's day's inventory outstanding is the formula. But what you're doing is you're seeing how long does it take this inventory to sell. And when you see trends in the inventory taking too long, that can be problematic. And that can either be an indicator that things are going to trend downwards or could be just a result of things trending downwards. I pulled up a few companies and looked at their DSI from fiscal.

26:18Stephen:So I thought this was interesting. Boeing from 2016 until 2021, DSI just went straight up. And that kind of makes sense, right? Like all the chaos you saw with Boeing and all the execution issues they had, turns out the inventory piled up. And things have started to trend downwards now for them with the days in inventory outstanding. But it's still much higher than they were historically. And their stock crashed in 2019 and it has not recovered since. And so the inventory not selling as fast as it used to definitely doesn't help in that calculus. A few other ones I thought were interesting. Eli Lilly has seen their inventory ramp up pretty high compared to where they were in the last few years.

27:20And also microchip.

27:26Stephen:So I went into fiscal and just kind of looked at what are some of the highest DSI companies. Some companies you might think that it makes sense, like home builders were up there. But that makes sense. Like it takes them months to sell a home. And they were around in line with what their averages were over the long term. But I think one of the things you can do is you can look at the long term averages. and when you see a stock that's high above those averages and continues to stay high above those averages, that could be a signal of inventory piling up and it might not be completely apparent, but you can start to see the trend.

28:07Stephen:And sometimes that's a good reason to sell. In the case of microchip, for example, theirs has gone up almost exponentially, which is not the number we want to see with exponential growth. But around the third year of their inventory really spiking higher using this metric, their stock took a tumble and has not recovered since. So not saying, you know, you got to be careful with these metrics because not one metric ever paints the entire picture. But sometimes you can forensically analyze and understand, hey this was a leading indicator that can save you so it's it's it's work that's probably worth doing and i don't see much downside in in checking these things no absolutely and i think you know especially when we're looking at the inventory it's not going to be and in most cases obviously they're maybe with eli lily it might be hard to figure out um but you know we're using walmart as the example.

29:14If it's September and we start seeing Walmart's inventory go up, it's logical to assume that that is a strategic inventory build. If we're looking at Tesla, however, and it's not the end of the year, it would be illogical to assume that there's a strategic that they might have some sort of underlying issue we aren't seeing in the numbers.

29:47Stephen:You bring up a good point, and I think this is a good skill. If you're a beginner and you haven't thought of this, this is a good thing to put in your toolkit. Looking at a company quarter by quarter and then comparing where it was the year before and then the year before that. So if inventory naturally builds up in Q3, you can look at the previous Q3 and just do those comparisons. and that's good for inventory it's also good for revenues and profits those things you can look from quarter to quarter so as much as we love to talk about the long term and focus on the long term and look at every year to year to year the quarterly numbers can help you too absolutely so So when we look at companies like Amazon and Costco, they operate in a world of negative working capital, meaning they sell.

30:41See if I can say this right. They don't pay their suppliers as soon as they make money. Is that is that the right way to say that, Andrew?

30:54Stephen:it's like they they bring in because a company grows and it brings in more than their pain out and because the the like you're saying the pay the payback period is so short so as a company grows it's it's hard it's one of those like whatever the equivalent of a tongue twister is for your brain it's kind of like one of those things um but basically they're they get they get the cash so quickly and because they're just constantly growing that cash pile is growing and growing and growing so by the time they by the time they um oh by the time they owe their vendors they've already made so much cash and because costco just reliably grows year after year after year, that pile gets bigger.

31:45And it is a signal of strong economics of a business.