12/19/2015 The Blog of HORAN Capital Advisors: The Importance of Understanding the Difference between Earnings, Operating Cash Flow and EBITDA http://disciplinedinvesting.blogspot.my/2006/11/importanceofunderstandingdifference.html 1/12 0 WEDNESDAY, NOVEMBER 29, 2006 The Importance of Understanding the Difference between Earnings, Operating Cash Flow and EBITDA An attractive aspect to using a dividend growth methodology in evaluating stocks is the dividend growth method enables an investor to gauge, indirectly, the cash flow of a company. Because cash is important to a company's survival, changes in a company's dividend practices may signal future cash flow issues for a company. Dividend growth stocks should not be looked at as simply investments that grow their dividend on an annual basis; but, the methodology leads to investment in companies that are growing their business as evidenced by growth in company cash flow. The other important aspect to successfully investing in dividend growth companies is to focus on the higher quality firms as rated by Standard and Poor's. S&P's Quality Ranking measure attempts to capture the "quality" of earnings issue. What is cash flow versus earnings? Earnings of a company are essentially a figure derived from accounting rules. The problem with "earnings" or "net income" from an accounting perspective, is the figure has very little to do with evaluating the cash flow stability of a company. Cash flow comes in two forms: "operating" cash flow and simply cash flow. The latter is commonly referred to as EBITDA (earnings before interest, taxes, depreciation and amortization). The problem with the EBITDA calculation is the number is based largely on earnings. The website stockdiagnostics provides the following interesting definition of EBITDA: Microsoft ® Translator CONTRIBUTORS David Templeton, CFA Mark Bennett, CFA Nick Reilly Todd Poellein, CFA Matt Antenucci Matt Woebkenberg Contact us via email LANGUAGE TRANSLATION Translate this page Spanish 0 More Next Blog» Create Blog Sign In The Blog of HORAN Capital Advisors A DISCIPLINED APPROACH TO INVESTING
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the Importance of Understanding the Difference Between Earnings, Operating Cash Flow and EBITDA
the Importance of Understanding the Difference Between Earnings, Operating Cash Flow and EBITDA
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12/19/2015 The Blog of HORAN Capital Advisors: The Importance of Understanding the Difference between Earnings, Operating Cash Flow and EBITDA
The Importance of Understanding the Difference betweenEarnings, Operating Cash Flow and EBITDA
An attractive aspect to using a dividend growth methodology in evaluating stocks is the dividend growthmethod enables an investor to gauge, indirectly, the cash flow of a company. Because cash is important toa company's survival, changes in a company's dividend practices may signal future cash flow issues for acompany.
Dividend growth stocks should not be looked at as simply investments that grow their dividend on anannual basis; but, the methodology leads to investment in companies that are growing their business asevidenced by growth in company cash flow. The other important aspect to successfully investing individend growth companies is to focus on the higher quality firms as rated by Standard and Poor's. S&P'sQuality Ranking measure attempts to capture the "quality" of earnings issue.
What is cash flow versus earnings? Earnings of a company are essentially a figure derived from accountingrules. The problem with "earnings" or "net income" from an accounting perspective, is the figure has verylittle to do with evaluating the cash flow stability of a company.
Cash flow comes in two forms: "operating" cash flow and simply cash flow. The latter is commonly referredto as EBITDA (earnings before interest, taxes, depreciation and amortization). The problem with theEBITDA calculation is the number is based largely on earnings. The website stockdiagnostics provides thefollowing interesting definition of EBITDA:
Microsoft® Translator
CON TR IB U TORS
David Templeton, CFA Mark Bennett, CFA
Nick Reilly Todd Poellein, CFA Matt Antenucci
Matt Woebkenberg
Contact us via email
LANGU AGE T RAN SLA T ION
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Spanish
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The Blog of HORAN Capita l AdvisorsA D I S C I P L I N E D A P P R O A C H T O I N V E S T I N G
"(EBITDA) is calculated by adding "selected" expense items such as Interest expenses, Incometaxes, Depreciation and Amortization back into earnings or net income. By adding "selected"expense items back into to a company's net income "more positive" earnings or cash flow per sharenumbers can be manufactured. When utilizing EBITDA an analyst or CFO is actually stating, "Thisis what our earnings would have been if it were not for interest, taxes, depreciation andamortization." Because it is based upon earnings, EBITDA is subject to the same "creative"accounting inherent in many earnings reports. EBITDA frequently does not reflect a company'strue cash flow.... EBITDA is a manufactured "creative accounting" interpretation that presents acompany in the best possible light. EBITDA's original use was for lenders to determine creditviability. Today these interpretations are used primarily by companies and Wall Street analysts topromote stock to an unwary public. Commonly, when EBITDA or CFPS (cash flow per share) areused in this way they are deceptively called "cash flow" or some form thereof."
Operating cash flow is a measure that incorporates changes from the balance sheet and income statementthat have an impact on cash. The operating cash flow information is contained in SEC filings of companies.In the SEC financial filings for companies, firms include an income statement, balance sheet andstatement of cash flow. One of the most important financial documents in the filing is the statement of cashflow. This statement reconciles the cash balance on the balance sheet by incorporating changes incategories from the income statement and balance sheet accounts. For example, all else being equal, ifinventory increases, this reduces cash flow since cash was used to purchases the inventory. Of course, theinventory could be purchased on credit; then accounts payable would increase and this increases cashflow. The statement of cash flow contains three sections:
Cash provided by operating activities,Cash provided by investing activities, andCash provided by financing activities.
The key section to review on the cash flow statement is the one detailing operating cash flow.
Once the operating cash flow figure is analyzed, it should be converted to a per share number. This figurecan be evaluated across quarters to determine any negative or positive trends. Additionally, growth, orlack of growth in operating cash flow per share can be compared to companies within the same industry oracross industries. The last step in this analysis is to take the price of the stock divided by the operatingcash flow per share to come up with a price to operating cash flow figure. This number can be used toevaluate stocks in the same way one uses the P/E ratio.
Following is an example detailing the difference in a company's net income and operating cash flow:
Jos. A. Bank (JOSB) Cash Flow Statement ($ in millions)
As one can see from the above charts, net income has grown nicely, but cash flow has actually declinedfrom year end '05 to '06. Note the large cash usage ($48.9 million) in 2006 attributable to an increase ininventory.
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