Avoid Netflix On Cash Flow Issues

| About: Netflix, Inc. (NFLX)

Any investor knows that he must conduct a rigorous analysis on the cash flow statement of a company before making any serious investment decision.

The statement of cashflow in the quarterly report is designed to properly represent the inflows and outflows of cash during the most recent period and is usually a better gauge of the financial position of a company than the standard EPS.

The Statement of Cash Flow consists of 3 different sections:

1. Cash Flow from operating activities: This section refers to the on-going line of activities of the company such as payment for vendors, purchase of inventory etc.

2. Cash Flow From Investing Activities: This section refers to the cash outflows and inflows for expenditures on such things as plant and equipment.

3. Cash Flow From Financing Activities: This section refers to the way the business finances itself- interest payments on loans, sale of receivables etc.

Netflix Inc. and Its Content Library- A True Love Story

In a Q3, 2011 letter to shareholders, Reed Hastings, the company's CEO, stated that: "the streaming content offering and the associated expense has risen dramatically over the past few quarters". In particular, the company has added $1.34 billion worth of content library to its 2011 balance sheet and recorded it as an asset. Check out this letter here.

As every novice investor knows- the core business of Netflix (NASDAQ:NFLX) is to buy DVDs in bulk and then rent them to its end-users. The proper way to record this massive purchase is to record it as an Asset on the balance sheet, and at the same time- record the cash expense under 'Cash Flow from Operating Activities' (1st category at the top) because this purchase naturally falls in the category of normal ongoing business operations of the company.

Netflix, though, does not think that way.

While the company recorded its library as an asset on the its balance sheet, it refrained from recording the expenses accrued by it as an operating cash expenditure (1st category at the top) and rather decided to record it as an investing action to be included in the Cash Flow from investing activities (2nd category at the top)

This accounting decision does not correspond with the proper discretion that management is obligated to exercise: Investing activities refer to expenditures on such things as plant and equipment, and not on the purchase of standard inventory that is later sold to consumers.

The incentive behind Netflix's move

Cash Flow from Operating Activities is the most closely watched part of the Statement of Cash Flow, whereas the Investing section ("under the line") is usually ignored by most investors and analysts alike. By extracting normal operating cash outflows from the operating section, the Net Cash position misleadingly appears much more impressive than it really is.

How impressive exactly?

Netflix, in its latest quarterly report of September 30th, 2011 reported $49.5 million of net cash flow from operating activities. Had Netflix properly accounted for the cash outflow of $20.8 million (for the purchase of its DVD library), the result would have been a cash flow of $28.7 million instead of the reported $49.5 million, a decrease of more than 40% in its Net Cash Flow position. You can easily download Netflix's quarterly reports here.

It is more than interesting to note that Coinstar Inc. (NASDAQ:CSTR), one of Netflix's rivals, perfectly understands that expenses for the purchase of a DVD library should be recorded in the operating section. In its most recent quarterly report, Coinstar reported the expenses of its DVD library under 'Cash flow from operating activities', just as they should be recorded. Click here for Coinstar's statement.

So what's an investor to do?

Avoid holding the shares of a company that is suspected of using dubious accounting tricks. Sooner rather than later, accounting games tend to catch up with the company that employs them. Unfortunately, it is the unsuspecting shareholders that get hit first.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.