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Penny Stock Basics

The Difference Between Earnings And Cash Flow

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Written by Timothy Sykes
Updated 1/5/2023 6 min read

Welcome to another edition of stock market basics, brought to you be a new trading challenge student who is eager to share his newfound knowledge with everyone.

Beginners should also read this 3 part-series on how to decipher earnings reports

A topic that every investor seems to know, but is almost papered over in most analyses is earnings versus cash flow. You may see a massive increase in cash, but some horrible earnings. Earnings are reported as they are earned, not when they are paid. That is a simple point that is sometimes tricky for people to grasp. Even when they understand all the details they forget, because our day-to-day lives are very different.

For anyone working in the finance department of a company, accounts receivable is a common enough element of earnings versus cash. Sometimes you can get what is called net 180 days, which means that a company does not have to pay the invoice until six months later. Net 90 days is very common, and that means that companies pay once a quarter. You could imagine a situation where a great quarter is followed by a terrible one, but cash receipts increase dramatically. This can be a good thing and a bad thing. Cash flow from old sales is not really about the present.

Six months used to be a lot less time. In the world before the advent of internet trading, six months was a cakewalk. Now stocks can go from being stars to craters and back in six months. Think about Best Buy, which rose 60% in a matter of weeks. Or GMCR, which after collapsing is getting back to where it started. Looking at the last 30 years, things have started moving faster than ever.

That creates a greater emphasis on this cash versus earnings issue. Two quarters is enough time for something to materially change, and the cash from a fantastic quarter might not come in until later. The company can go from cash poor to having piles of money all while having losses in present quarters.


The Case for Earnings
Earnings are in the present. They were earned in the latest quarter. That means it is good as a snapshot of a company’s health. It represents sales made and billed for, not only those paid for.

Earnings are subject to a lot of accounting methods. There are a lot of rules companies must follow, and a lot ones they can follow to reduce earnings or at times inflate them. Earnings are reduced to reduce tax liabilities, or to move the earnings in time to boost the company when it needs it. It is not uncommon to see certain revenue pushed into a holiday quarter for retailers to make that quarter into a powerhouse. Some other companies might shift revenues from a great quarter to a quarter that won’t be that good in order to keep some stability in earnings from quarter-to-quarter. There are other accounting techniques that can distort earnings.

The level of gaming that can be done to earnings makes some investors jittery about trusting earnings. Even those that are aware of that use earnings in common analysis. It is usually very specific analytic articles that use cash flow. Almost all of them have to explain why they are using cash flow instead of regular earnings. It makes sense though. Earnings are reported at the time the sale is made so they are in the present, and easier to identify. Cash flow will include money from overdue payments as well, but that would not be a accurate picture of the present.
The Case for Cash Flow
There are a couple of cash flow methods, but for now cash flow is just a general term for actual cash flowing into the company. It should be pretty obvious why some like this as a measure for a company’s health. A company’s job is to make cash. Cash flow ignores many accounting measures. For example, depreciation is excluded for most fixed assets, since it is a non-cash charge. The most common specific cash flow measure is operating cash flow. This measures cash flow from the company’s business rather than cash injections from investors or from debt. The narrowing the scope counteracts some of the drawbacks of using cash flow.

To contrast net income with cash flow, consider a company with a large amount of expensive fixed assets. Most companies used accelerated depreciation, which reduces earnings since depreciation is a non-cash expense. If the asset is providing a nice return, the company might be bringing in a lot of cash, while having only mediocre earnings.
More on Non-Cash Charges
Non-cash charges are something that deserve extra attention. They can present openings, because they do change the quantitative picture, while not necessarily changing the fundamental one. It is not often that fundamental numbers are affected, but the outlook is not that different. Non-cash charges are expenses that have no impact on income or cash flow, but they will reduce earnings.

The charges can be recurring like depreciation, or one-time like writedowns. Writing down assets can push a company into losses, without affect cash flow. If a company writes down an acquisition it completed three years ago, the money is gone. If that acquisition does not bring in enough money, then the company will keep making the same cash, while pushing itself into the red for earnings. Since the point of a company is to make cash, then a writedown does not really change the health of a business. It is an acknowledgement that the company is not doing the best job with that specific asset. Earnings are still the standard measure most of the market uses. One-time non-cash charges can skew earnings, while leaving the cash flow untouched.

While it might not happen often, and the market might even notice, being aware of the difference between earnings and cash can help identify opportunities. Cash really helps companies in a rut, because cash is required for innovations.

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Timothy Sykes

Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading $12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More

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* Results are not typical and will vary from person to person. Making money trading stocks takes time, dedication, and hard work. There are inherent risks involved with investing in the stock market, including the loss of your investment. Past performance in the market is not indicative of future results. Any investment is at your own risk. See Terms of Service here

The available research on day trading suggests that most active traders lose money. Fees and overtrading are major contributors to these losses.

A 2000 study called “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” evaluated 66,465 U.S. households that held stocks from 1991 to 1996. The households that traded most averaged an 11.4% annual return during a period where the overall market gained 17.9%. These lower returns were attributed to overconfidence.

A 2014 paper (revised 2019) titled “Learning Fast or Slow?” analyzed the complete transaction history of the Taiwan Stock Exchange between 1992 and 2006. It looked at the ongoing performance of day traders in this sample, and found that 97% of day traders can expect to lose money from trading, and more than 90% of all day trading volume can be traced to investors who predictably lose money. Additionally, it tied the behavior of gamblers and drivers who get more speeding tickets to overtrading, and cited studies showing that legalized gambling has an inverse effect on trading volume.

A 2019 research study (revised 2020) called “Day Trading for a Living?” observed 19,646 Brazilian futures contract traders who started day trading from 2013 to 2015, and recorded two years of their trading activity. The study authors found that 97% of traders with more than 300 days actively trading lost money, and only 1.1% earned more than the Brazilian minimum wage ($16 USD per day). They hypothesized that the greater returns shown in previous studies did not differentiate between frequent day traders and those who traded rarely, and that more frequent trading activity decreases the chance of profitability.

These studies show the wide variance of the available data on day trading profitability. One thing that seems clear from the research is that most day traders lose money .

Millionaire Media 66 W Flagler St. Ste. 900 Miami, FL 33130 United States (888) 878-3621 This is for information purposes only as Millionaire Media LLC nor Timothy Sykes is registered as a securities broker-dealer or an investment adviser. No information herein is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security or fund. Millionaire Media LLC and Timothy Sykes cannot and does not assess, verify or guarantee the adequacy, accuracy or completeness of any information, the suitability or profitability of any particular investment, or the potential value of any investment or informational source. The reader bears responsibility for his/her own investment research and decisions, should seek the advice of a qualified securities professional before making any investment, and investigate and fully understand any and all risks before investing. Millionaire Media LLC and Timothy Sykes in no way warrants the solvency, financial condition, or investment advisability of any of the securities mentioned in communications or websites. In addition, Millionaire Media LLC and Timothy Sykes accepts no liability whatsoever for any direct or consequential loss arising from any use of this information. This information is not intended to be used as the sole basis of any investment decision, nor should it be construed as advice designed to meet the investment needs of any particular investor. Past performance is not necessarily indicative of future returns.

Citations for Disclaimer

Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: “Day Trading for a Living?”

Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance and Zhang, Ke, Learning Fast or Slow? (May 28, 2019). Forthcoming: Review of Asset Pricing Studies, Available at SSRN: “https://ssrn.com/abstract=2535636”

Chague, Fernando and De-Losso, Rodrigo and Giovannetti, Bruno, Day Trading for a Living? (June 11, 2020). Available at SSRN: “https://ssrn.com/abstract=3423101”