How to fol­low cash on its jour­ney through a busi­ness – and why it mat­ters

A com­pany’s cash flow state­ment can be hard to dis­en­tan­gle but the in­sight of­fered can help us avoid nasty sur­prises

The Daily Telegraph - Business - - Business - RICHARD EVANS Read Questor’s rules of in­vest­ment be­fore you fol­low our tips: tele­graph.co.uk/go/ questor­rules; twit­ter.com/DTquestor

CASH should be the sim­plest of all ac­count­ing terms to un­der­stand: it is, af­ter all, a word we have all used since we learnt how to talk. Un­for­tu­nately, in a com­pany’s ac­counts, cash can be­come very hard to fol­low.

In the lat­est in Questor’s se­ries on de­mys­ti­fy­ing fi­nan­cial re­ports we try to fol­low cash on its jour­ney through a busi­ness. This process can help us gain in­sight into a firm’s true state of health – in­sight that its man­agers some­times fail to of­fer to in­vestors.

We will do so with the help of an ex­am­ple and have cho­sen BT Group be­cause its his­tory of cash gen­er­a­tion did in­deed warn keen-eyed ob­servers of the grow­ing dan­ger to its div­i­dend long be­fore the can­cel­la­tion of this year’s fi­nal pay­ment.

We start at a line in the ac­counts that we cov­ered ear­lier in this se­ries: the op­er­at­ing

profit. This dif­fers from

“statu­tory” profit in that it dis­re­gards any costs (or gains) from the fund­ing of the busi­ness, which means ei­ther the cost of in­ter­est on debt or the in­ter­est re­ceived on cash. But the cal­cu­la­tion of op­er­at­ing profit does in­volve the sub­trac­tion of items that do not re­flect ac­tual cash, namely de­pre­ci­a­tion and amor­ti­sa­tion (de­fined here last week). Be­cause these items do not in­volve cash leav­ing the busi­ness we need to “add them back” to op­er­at­ing profit if we are to fol­low the cash.

In its full year to March, BT re­ported an op­er­at­ing profit of £3.3bn but de­pre­ci­a­tion and amor­ti­sa­tion to­gether were £4.3bn. Add those amounts to­gether and we get £7.6bn. How­ever, cash that did leave the busi­ness was that used for cap­i­tal ex­pen­di­ture (the fact that BT gained as­sets in ex­change is not rel­e­vant for our cur­rent pur­poses). That cap­i­tal ex­pen­di­ture came to £4.1bn. One much smaller item we should also take ac­count of is the change in “work­ing cap­i­tal” – as­sets and li­a­bil­i­ties that fluc­tu­ate daily, such as stock, what is owed to sup­pli­ers and what cus­tomers owe to the com­pany. A fall in BT’s work­ing cap­i­tal last year gave it £400m more cash to play with.

If we sub­tract the cap­i­tal ex­pen­di­ture from £7.6bn but add the work­ing cap­i­tal change (and ac­count for some round­ing ef­fects) we ar­rive at a fig­ure of £3.8bn.

In­ci­den­tally, the fact that cap­i­tal ex­pen­di­ture was roughly equal to de­pre­ci­a­tion and amor­ti­sa­tion is wel­come: it sug­gests that BT spent enough to main­tain the over­all qual­ity of its as­sets.

We are now at the point where we can cal­cu­late the cash con­ver­sion ra­tio, which we quote for every stock cov­ered in this col­umn be­cause it is a quick and com­pre­hen­si­ble test that what a com­pany says it makes ac­tu­ally cor­re­sponds to money in its bank ac­count that can be used to pay bills and fund div­i­dends. We di­vide that £3.8bn fig­ure of cash gen­er­ated by op­er­a­tions by the £3.3bn in op­er­at­ing prof­its to get a cash con­ver­sion ra­tio of 115pc – a healthy re­sult.

There is more than one way to cal­cu­late this ra­tio and some­times tax and in­ter­est are also de­ducted from the op­er­a­tional cash gen­er­a­tion fig­ure. BT handed cash of £210m to the tax­man last year, while its net in­ter­est cash costs came to £706m. If we sub­tract these sums from £3.8bn we get £2.9bn and a cash con­ver­sion ra­tio of 88pc, which is still good.

But there is an­other use­ful fig­ure: the “free” cash flow. The idea here is to ac­count for every penny that the com­pany has to spend so that any­thing left can truly be said to be­long to share­hold­ers and be avail­able to pay their div­i­dends.

To get to free cash flow from the cash gen­er­ated from op­er­a­tions, we must sub­tract not only tax and in­ter­est but also lease pay­ments and pen­sion con­tri­bu­tions. For BT last year these fig­ures added up to £1.9bn. Sub­tract that from £2.9bn and we ar­rive at a free cash flow fig­ure of £1bn.

Now com­pare that with the £1.5bn BT spent on div­i­dends last year and we can see that the firm did not make enough cash, af­ter every bill had been paid, to fund what it paid in div­i­dends. Its ra­tio of free cash gen­er­ated to the di­vis paid was just 67pc.

BT re­ported pre-tax prof­its of £2.4bn last year so the more tra­di­tional “div­i­dend cover” fig­ure, the profit di­vided by the div­i­dend, was a more healthy sound­ing 1.6 times. In nei­ther of the pre­vi­ous two years had BT’s free cash flow cov­ered its div­i­dend, sug­gest­ing that a cut was be­com­ing in­evitable. This shows the value of look­ing at cash.

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