Mediaboss Marketing

Although business headlines still tout earnings numbers, many
investors have moved past net earnings as a measure of a
company's economic output. That's because earnings are very
often less trustworthy than cash flow, since earnings are more
open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors
often flip straight past the income statement to check the cash
flow statement. In general, by taking a close look at the cash
moving in and out of the business, you can better understand
whether the last batch of earnings brought money into the
company, or merely disguised a cash gusher with a pretty
headline.

Calling all cash flows
When you are trying to buy
the market's best stocks, it's worth checking up on your
companies' free cash flow once a quarter or so, to see whether
it bears any relationship to the net income in the headlines.
That's what we do with this series. Today, we're checking in on
Western Digital (NYSE:
WDC  ) ,
whose recent revenue and earnings are plotted below.

Source: S&P Capital IQ. Data is current as of last fully
reported fiscal quarter. Dollar values in millions. FCF = free
cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, Western Digital generated $909.0
million cash while it booked net income of $688.0 million. That
means it turned 9.7% of its revenue into FCF. That sounds OK.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from
nonsense, either. That's why it pays to take a close look at
the components of cash flow from operations, to make sure that
the cash flows are of high quality. What does that mean? To me,
it means they need to be real and replicable in the upcoming
quarters, rather than being offset by continual cash outflows
that don't appear on the income statement (such as major
capital expenditures).

For instance, cash flow based on cash net income and
adjustments for non-cash income-statement expenses (like
depreciation) is generally favorable. An increase in cash flow
based on stiffing your suppliers (by increasing accounts
payable for the short term) or shortchanging Uncle Sam on taxes
will come back to bite investors later. The same goes for
decreasing accounts receivable; this is good to see, but it's
ordinary in recessionary times, and you can only increase
collections so much. Finally, adding stock-based compensation
expense back to cash flows is questionable when a company hands
out a lot of equity to employees and uses cash in later periods
to buy back those shares.

So how does the cash flow at Western Digital look? Take a peek
at the chart below, which flags questionable cash flow sources
with a red bar.

Source: S&P Capital IQ. Data is current as of last fully
reported fiscal quarter. Dollar values in millions. TTM =
trailing 12 months.

When I say "questionable cash flow sources," I mean items such
as changes in taxes payable, tax benefits from stock options,
and asset sales, among others. That's not to say that companies
booking these as sources of cash flow are weak, or are engaging
in any sort of wrongdoing, or that everything that comes up
questionable in my graph is automatically bad news. But
whenever a company is getting more than, say, 10% of its cash
from operations from these dubious sources, investors ought to
make sure to refer to the filings and dig in.

With 14.7% of operating cash flow coming from questionable
sources, Western Digital investors should take a closer look at
the underlying numbers.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I
think that's a mistake. If you take the time to read past the
headlines and crack a filing now and then, you're in a much
better position to spot potential trouble early. Better yet,
you'll improve your odds of finding the underappreciated
home-run stocks that provide
the market's best returns.

We can help you keep tabs on your companies with My Watchlist,
our free, personalized stock tracking service.

Link:
Is Western Digital's Cash Flow Just For Show?