Cash flow is king

To in­vest smartly, you must look past a com­pany’s fi­nan­cial state­ments

Weekend Witness - - Money -

WHEN de­cid­ing how and where to in­vest, it is cru­cial to un­der­stand a com­pany’s cash-flow strength, which re­lates to its abil­ity to pay div­i­dends. Although au­di­tors do their best to pro­vide fi­nan­cial state­ments that re­flect fairly the earn­ings and fi­nan­cial po­si­tion of a com­pany, the in­come-state­ment earn­ings are not al­ways the best mea­sure of a com­pany’s per­for­mance.

To make smart in­vest­ment de­ci­sions, in­vestors should un­der­stand a com­pany’s cash-flow pro­file.

Ac­count­ing earn­ings may not trans­late to free cash flows.

There are sev­eral rea­sons why ac­count­ing earn­ings may not trans­late to free cash flows that are avail­able to pay div­i­dends, said Ni­co­lette Wulf­sohn, eq­uity an­a­lyst at Pru­den­tial. Three main rea­sons are as fol­lows. • Non-cash in­come and ex­penses in­cluded in the in­come state­ment. • A busi­ness’s on­go­ing in­vest­ment re­quire­ments, as cer­tain in­dus­tries need in­vest­ment in fixed or work­ing cap­i­tal as­sets to grow. • The cap­i­tal-ex­pen­di­ture cy­cle, that is, the stage of in­vest­ment that the com­pany is in.

Non-cash in­come and ex­penses can give a skew per­cep­tion of ac­tual cash flow.

“De­pre­ci­a­tion is the most com­mon non-cash ex­pense that ap­pears in most com­pa­nies’ in­come state­ments. While it is a proxy for a cap­i­tal cost, it can dif­fer quite rad­i­cally from the ac­tual cash spent on cap­i­tal in a given year,” said Wulf­sohn.

An­other ex­am­ple is that share­based pay­ment ex­penses are also non-cash. When a com­pany has a share in­cen­tive or op­tion scheme for em­ploy­ees, or al­lo­cates shares or op­tions to BEE part­ners, of­ten lit­tle or no cash changes hands up­front.

Wulf­sohn said that other more volatile non-cash gains and losses are shown when com­pa­nies have for­eign-ex­change ex­po­sure for which they don’t meet cer­tain strin­gent hedge-ac­count­ing cri­te­ria.

“The ac­count­ing stan­dards re­quire the com­pany to com­pare the bal­ance-sheet date’s ex­change rate to the ex­change rate of the con­tracted date. This makes sure that their bal­ance sheet re­flects the cor­rect as­sets and li­a­bil­i­ties at the bal­ancesheet date, but it can cause havoc with in­come state­ment earn­ings,” she said.

“And be­cause the ex­change rate changes from day to day, the gain or loss on the for­eign-ex­change con­tract may never ma­te­ri­alise in the way that it is re­flected in the in­come state­ment.”

Re­ported earn­ings can dif­fer quite rad­i­cally from cash earn­ings.

A busi­ness re­quire­ment to in­vest in cap­i­tal can dif­fer rad­i­cally be­tween in­dus­tries. Most com­pa­nies need cap­i­tal to grow. This usu­ally takes the form of fixed cap­i­tal. For ex­am­ple, prop­erty, plant and equip- ment, as well as work­ing cap­i­tal, such as in­ven­to­ries and debtors. The amount of cap­i­tal needed to grow de­pends on the com­pany’s busi­ness model and the in­dus­try.

Wulf­sohn said this im­por­tant con­cept can be il­lus­trated with the help of two ex­am­ples.

“A fast-food fran­chis­ing busi­ness, for ex­am­ple, has fran­chisees con­tin- ually open­ing new stores and th­ese fran­chisees are re­spon­si­ble for the cost of fit­ting out the restau­rant and buy­ing in­ven­to­ries. The fran­chisor does not have to in­vest any cap­i­tal to ex­pand the restau­rant foot­print and grow the busi­ness rev­enues and prof­its,” she said.

On the other side of the spec­trum, a con­tract min­ing and leas­ing com­pany has to in­vest in fleets of min­ing equip­ment and ve­hi­cles. It in­curs large cap­i­tal cash out­flows at the start of a con­tract and only gen­er­ates rev­enue and cash from the fleet over the con­tract term, which typ­i­cally lasts a few years.

In­vestors should, there­fore, not com­pare cap­i­tal-in­vest­ment fig­ures and the cash th­ese in­vest­ments gen­er­ate di­rectly be­tween com­pa­nies, but rather view it in the con­text of the type of in­dus­try.

The cap­i­tal-ex­pen­di­ture cy­cle can tem­po­rar­ily pro­vide a false im­pres­sion of cash out­flows and cash gen­er­a­tion Cap­i­tal ex­pen­di­ture, whether build­ing new fac­to­ries, buy­ing new tech­nolo­gies or ex­pand­ing ca­pac­ity, which of­ten hap­pens in phases, said Wulf­sohn. Dur­ing phases of ex­pan­sion in the cy­cle when cap­i­tal ex­pen­di­ture is needed for more than just main­te­nance, the de­pre­ci­a­tion charge in the in­come state­ment can of­ten fall be­hind the true cash out­flows. “The in­come state­ment earn­ings will then over­state cash gen­er­a­tion,” she said.

Make sure you un­der­stand a com­pany’s cash-flow pro­file be­fore you in­vest. In­vestors have to take th­ese fac­tors into ac­count and not re­gard the in­come state earn­ings as the ul­ti­mate mea­sur­ing stick of com­pany per­for­mance.

“Gain­ing knowl­edge about the cash pro­files of po­ten­tial in­vest­ments by speak­ing to your fi­nan­cial ad­viser, can make a dif­fer­ence to your re­turns in the long run and is there­fore worth­while.” — WWR.

PHOTO: SUP­PLIED

Ni­co­lette Wulf­sohn, Eq­uity An­a­lyst at Pru­den­tial.

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