Mind the Gap

Cash flow from operations isn't keeping pace with net income at many companies, and investors are beginning to notice. Our exclusive study of the Standard and Poor's 500 reveals which companies have the widest gaps between the two measures.

If the stock market is as efficient as it’s supposed to be, then why would CFOs bother to cook up a few pennies of earnings each quarter to meet analysts’ estimates? The answer they frequently give off the record, of course–is that many investors care more about those earnings estimates than about whether those extra pennies have anything to do with a company’s operations.

Judging from recent market activity, however, investors may be wising up. For example, as Q3 2000 came to an end, shares in Eastman Kodak Co., Intel, and Oracle Corp. all took it on the chin, not just because those companies’ earnings were falling short of expectations, but also because sales were disappointing. Shares in IBM Corp. and Motorola Inc. fell even though earnings met estimates, because sales did not. In other words, investors were at least partly discounting earnings management–even if it stayed well within the boundaries of generally accepted accounting principles (GAAP)–and looking hard at both the top and the bottom lines. Their collective expectation, says William Aylesworth, CFO of Texas Instruments Inc., “is more balanced than it used to be.”

So long as that balance persists, CFOs will increasingly find themselves in a new and not entirely comfortable role: They will be called on to help sustain their companies’ revenue growth as well as expansion of earnings. Those who fail to meet the call will find their talents and experience less and less relevant to the creation of shareholder value. “Failing to generate enough top-line growth to meet sales estimates is even worse than not making your earnings numbers,” declares Chuck Hill, director of research for First Call/Thomson Financial Research, a Boston-based firm that tracks analysts’ estimates. The logic is unassailable, says Hill: “That much less is making it to the bottom line.”

For some CFOs, to be sure, the challenge isn’t new (see “Birth of a Salesman,” CFO, June 1997). But in the face of greater expectations, sustaining profitable top-line growth will become a more urgent challenge than ever. And as more investors become more sophisticated in their appraisal of company performance, capital will surely fly from those companies with consistently large gaps between reported earnings and operating results.

Recently, we set out to determine whether it was feasible to identify which companies, and thus which CFOs, currently have the greatest gaps to contend with. There’s no foolproof standard for tracking how revenue growth is consistently translating into earnings. But one yardstick clearly comes closest: cash flow from operations, that is, the amount of money that the ongoing business throws off. Why? Because that measure is least subject to accounting distortions.

“Net income and cash flow from operations should track pretty closely,” said Howard Schilit, an accounting expert who heads the Center for Financial Research and Analysis Inc., in Rockville, Maryland, at a gathering late last year of the New York Society of Security Analysts. “If cash flow from operations lags behind net income, usually the results are going to be very bad.”

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