PORTFOLIO POINT: For equity investors, it’s essential to understand cash flow given the strong relationship with share price performance over the long term.
While the federal budget played second fiddle to the draw of a $70 million lotto jackpot last night, it was cash that was nevertheless front of mind for almost the entire Australian adult population.
Curiously, in the last week I’ve also received a higher-than-normal number of enquires about calculating the cash flow of a business. And unlike the 1-in-45 million bet that half the adult population took last night, calculating cash flow is worth spending a little time on.
There are several ways to calculate cash flow and I am particularly partial to the balance sheet method I explain in Value.able. Today, however, I’ll use the cash flow statement as presented in the annual and half-year reports of a company.
The net operating cash flow is the first subtotal found in the cash flow statement and it summarises the cash generated or consumed by the main revenue-generating activities of the business. In very simple terms, it represents the after-tax cash 'profits’ of the main business of the company.
How much cash is generated at this level will determine a company’s ability to repay loans, maintain the operating capability of the business, pay dividends and make new investments.
If the net operating cash flow is insufficient to do these things, the company will need to find outside sources for more money or dip into its reserves (if it has any).
A negative number here means the company’s business operations are burning cash and if sustained for long enough, any cash in the bank will run out and the business will simply not survive without aid from shareholders or lenders. So it is important that these numbers are positive.
Net operating cash flow is shown as the blue line in Figure 1 (Embelton) and Figure 2 (Elders).
Figure 1: Embelton (ASX:EMB) Cash flow chart 2002-2011
Figure 2: Elders (ASX:ELD) Cash flow chart 2002-2011
Generally, you want a business that displays a cash-from-operations profile like that of Embelton (Figure 1). Net cash from operations (the blue line) is equal to or higher than the company’s reported profit and it’s generally rising over time. This enables it to do other things like maintain and expand its business operations and pay dividends.
At this point I will give a word of warning. Some companies – I’ll use Telstra as an example – take the item entitled 'Interest Paid’ out of the operating cash flow section of the cash flow statement and put it down in the financing or investing cash flow section. This is permitted under accounting standards, but has the obvious effect of boosting the net operating cash flow number. It makes the company’s cash flow from operations look stronger than it actually is.
It is not uncommon to find a business that reports a profit in the P&L statement, but shows a negative net operating cash flow. This can be seen in the cash flow chart of Peet in Figure 3.
Figure 3: Peet (ASX:PPC) Cash flow chart 2002-2011
Of course, if you don’t want to pore over a decade’s worth of annual reports for every listed company, Figure 3 reveals net operating cash flow (the blue line) for Peet was negative even though accounting profits (the green columns) were reported in each of 2003, 2007, 2008 and 2011.
Such a situation is often due to timing differences, meaning the company has made a profit according to the accounting rules for recognising revenues, but the cash hasn’t come in yet. This, however, is also not ideal because there are risks that the cash won’t arrive. For example, if the customer falls into receivership or goes into liquidation, they may never be able to pay. For other companies, the practice of capitalising expenses and subsequently depreciating or amortising them quickly renders the reported profit meaningless as a reflection of the true cash performance of the business.
It is much less stressful to simply invest in businesses that generate cash rather than burn it.
Even a business that generates positive net operating cash flow has other hurdles to jump.
Businesses have plant and machinery that needs to be replaced or purchased to accommodate growing sales. Some businesses need to acquire new premises when they grow, and some grow by acquiring other businesses. Owners also like to receive dividends and a company may also need to repay loans (although our preference is for businesses that don’t have any).
In the cash flow statement, these items are accounted for in the net investing cash flows and net financing cash flows sections.
The item entitled 'Payment for Purchase of PP&E’ reveals what property, plant and equipment was purchased. 'Payments for Purchase of Subsidiaries’ reveals whether the company also purchased other businesses. If net investing activities consume more cash than generated from operations, the company is like a shopaholic with a maxed-out credit card and the company will have to undertake borrowing or capital raisings to fund the gap.
As an aside, the accounting for acquisitions muddies the water for the calculation of cash flows and it can be particularly difficult to determine what cash has been spent to maintain (rather than grow) property, plant and equipment.
Many of the businesses that I regard as peak performers have grown without the need to make regular acquisitions.
If a company has a negative cash flow year, after money was spent on property, plant and equipment (PP&E), but the balance sheet shows that PP&E or intangibles have been growing, then you should look at the return on equity. Provided return on equity is being maintained at high levels and borrowings are not at or growing towards worrying levels, then you might look past the negative cash flow. But that is one of the few exceptions and it should be temporary.
Finally, a company must also fund dividends. Ideally, a company that generates positive net cash flow from its operations uses some of that cash generated for the purpose of maintaining and perhaps expanding its PP&E, and then uses some to pay dividends. If it pays more for PP&E and dividends than it generates from operations, it will have what we call a funding gap. The green line in Figures 1, 2 and 3 represent the funding gap/surplus. When the green line is below zero, it indicates the company’s management have bitten off more than they can chew in that year, and they must have filled the gap by borrowing, raising fresh equity or dipping into their bank account.
Raising fresh equity tends to dilute your ownership of the company (bad) and borrowing or dipping into the bank account can weaken the quality of the business and its financial stability.
A funding surplus, however, which occurs when there is still cash left over after operations, investing and dividends, allows a company to do other desirable things. Such a company can, for example, pay special dividends or buy back shares (only if they’re good value of course). These activities can have dramtically positive impacts on the market value of one’s share portfolio. So look for businesses with a funding surplus, not a funding gap. Why?
For further evidence, take a look at the share price performance over the last decade of Elders. Figure 4 is a picture of the share price performance of Elders – a company that has reported frequent funding gaps. It’s a picture that tells a thousand words.
Figure 4: Elders (ASX:ELD) Share price and intrinsic value 2002-2014
So there you have it. There is a strong relationship between share prices and cash flow performance over the long term, so understanding cash flow is essential, as is ensuring your portfolio is filled only with companies that generating consistent and rising funding surpluses.
And what is a business worth that generates no cash for its owners? Better to zip up your wallet and put your money in the relative safety of a term deposit.