Question

MicroStrategy was a red-hot software company in the business-to-business Internet sector. Unlike many other Internet companies, MicroStrategy reported profits early and often. Then the bottom fell out when news was released that MicroStrategy had been “cooking the books” by overstating revenues and profits. The stock price plunged and Zack's Research Report noted that, at the time, nine out of ten analysts had recently published “buy” or “strong buy” recommendations. Interestingly, well in advance of the stock price collapse, the company's cash flow from operations told a sobering story—negative $2.5 million instead of a profit of $9 million. Should the analysts have been looking at net cash from operations instead of net income? Why is the statement of cash flows so important based on this example? Discuss various was in which earnings quality can be assessed by comparing net income to cash flow from operations.

Answer 1

Yes the analysts should have been looking at the net cash from operation instead of net income. A cash flow statement is so important as it informs the users of the business's cash position. A business should have have enough cash to run its routine operations. Huge credit sale can adversely effect the liquidity of business. Liquidity could effect the expansion of business as huge capital could be tied down.Even though credit sale promote sales, it does not make sense if the same becomes a bad debt. This is exactly the problem when investors focus on net income instead of cash flow. It is easier for businesses to show inflated turnover and sales, a professional investor should look whether the same turnover has been converted into cash or any other liquid assets. Purpose of income statement is to show how much profit the business has made, while the purpose of cash flow is to how much cash the business generates.

Earning quality can be assessed by comparing the net profit as per income statement and cash generated as per cash flow statement. [1] The percentage of income converted to cash shows how liquid is the business. Cash flow statements are divided into Operating, Financial and investing activities. [2] For instance income statement might show interest expense however an investor should look into the Financial activities under cash flow statement to find if the same is actually paid. This is a huge concern as it might lead to bankruptcy.