Most investors look at earnings when evaluating a company.

And that’s a great place to start.

Typically, a company that’s consistently increasing its earnings has a healthy business, and the stock should emulate that success.

But I like to dig deeper and really get to know the company.

To do that, I look at cash flow.

[ad#Google Adsense 336×280-IA]Cash flow is how much actual cash came into the company versus how much went out.

At the end of the year (or quarter) if more cash came in than went out, the company is cash flow positive.

Now, you may be asking, if the company is profitable, shouldn’t it be cash flow positive?

Not always.

Due to complex accounting rules, earnings can be doctored to tell pretty much any story an executive wants.

Here’s an example of how a company can be profitable, but not cash flow positive.

In 2011, InterDigital (Nasdaq: IDCC) made $89 million in earnings. However, its cash flow from operations was negative $34 million. How is it possible the company was profitable, yet saw more money go out the door than came in?

When we look at InterDigital’s statement of cash flows, we see that the company recognized $235 million in deferred revenue, which is subtracted from cash flow. Here’s why…

Deferred revenue is when a company gets money up front, but doesn’t recognize the revenue right away. This is very common among software, technology and services companies. For example, a company will sell a software package that has a $1-million service agreement that’s valid for four years. The company might get paid that $1 million up front, but will only recognize $250,000 per year for four years.

On the cash flow statement, however, that money has to be accounted for, because cash flow represents how much money flowed into or out of the company.

So in InterDigital’s case, the negative $235 million means the company recognized the revenue in calculating net income; however, it doesn’t represent any actual cash that flowed into the company in 2011. That money came into InterDigital in previous years, but is only now being recognized as revenue and contributing to earnings.

To sum up, InterDigital made a profit in 2011 because it recognized revenue on cash that it received prior to 2011. But it didn’t bring in more cash than it spent. Keep in mind, this is actually a conservative strategy, because if the company recognized all of the revenue at once, when it still owes a client four years of service, that could cause problems down the road if its obligations aren’t met.

And it goes both ways…

This earnings and cash flow discrepancy can work the other way, too, where a company is unprofitable but takes in more cash than it spent.

For example, in 2011 Zynga (Nasdaq: ZNGA) lost $404 million. But when we look at its statement of cash flow, we see that $600 million in expenses was stock-based compensation expense – which is a non-cash item. It still needs to be accounted for to determine profitability, but it doesn’t represent cash going out the door in the same way paying employees’ salaries does. So that $600 million gets added back to cash flow. After a few other small adjustments, the company’s cash flow from operations was $389 million.

So even though it lost $404 million according to the income statement, the business actually generated $389 million in cash.

I ran a screen to see which companies were unprofitable and cash flow positive and profitable but cash flow negative. Here are some of the largest in terms of market cap. Results are for the full year 2011.

Knowing which companies are getting too much credit for their earnings, or too little for their cash flow, is a good starting point for your investment research.

In fact, over the past 10 years, if you bought all of the stocks that lost money but had positive cash flow, you’d beat the market by an average of 46% per year.

So if you’re looking at the fundamentals of a stock, it pays to look beyond what you see on the surface and dig a little deeper. The rewards for doing so are significant.

Good Investing,

Marc Lichtenfeld

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Source: Investment U