Cash flow is king
To invest smartly, you must look past a company’s financial statements
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.
Nicolette Wulfsohn, Equity Analyst at Prudential.