Cash Me If You Can

Foreword from ShareInvestor

This article “Cash Me If You Can” by Cai Haoxiang was first published in The Business Times on 24 Jun 2013 and is reproduced in this blog in its entirety.

The cash-flow statement will tell you what’s actually happening on the ground in a company

CASH is king. This adage applies to both investing and running a business. In a financial crisis when assets are valued at extraordinarily low levels you want to have enough cash to snap up as many bargain deals as you can.

Accounting students will tell you that cash is the lifeblood of any business. In the day-to-day operations of a business, cash is needed for many things – paying suppliers, paying your workers and paying rental fees.

At the end of the month, if you are a small business and do not have money to pay your bills, and the banks do not want to help you by lending money to tide you by, there is only one word to describe the situation you are in.

Bankrupt.

As an investor, making sure that your company has cash is so paramount that the mere hint of a company not being able to pay its bills should send shudders down your spine.

This is because shareholders come last in a bankruptcy. Assets are sold to meet creditors’ demands first. Stockholders are often left with nothing.

To see whether your company is financially sound, there are some things a basic understanding of the cash-flow statement will tell you, in a way that just reading the income statement will not.

For example, a quick way to evaluate a company’s financial situation is to make sure its operating cash flow covers its purchase of property, plant and equipment.

This is known as a free cashflow calculation. In essence, you are making sure that the company can fund capital expenditures by day-to-day activities.

In the example above, The Hour Glass reported operating cash flows of $12.9 million in the year ended March 31, 2013. That covers fixed capital purchases of property, plant and equipment of $9.6 million.

The company borrowed $41.2 million in the course of the year, mainly to finance the expansion of its retail network to open three new watch boutiques in Singapore, Hong Kong and Australia.

Without borrowing money, the company would not be able to expand and pay $14.1 million worth of dividends too.

But I would not be worried here. The Hour Glass has a conservative debt profile. If you look at its balance sheet, total liabilities amount to just $90 million, against current assets of $366 million. It also has $79.5 million of cash and a positive free cash flow, so repaying its creditors is not likely to be a problem.

Just a year ago, for the previous fiscal year ended March 31, 2012, the company’s cash-flow numbers were more impressive. Its operating cash flow of $28.9 million covered fixed capital investments of $3.9 million, $11.2 million of debt repayments, $11.7 million of dividend payments and even left it with $3 million to add to its bank accounts.

I will only get worried if free cash flow is negative and the company is paying for dividends from borrowed money, not profits, for several years in a row.

An investor can use a few metrics to evaluate a company’s cash flow. For example, you can divide operating cash flow by interest paid or dividends paid, and compare these ratios over time. If these interest coverage or dividend payment ratios are falling, the company’s ability to fund debt or dividend payments is deteriorating.

Another warning signal would be persistently high capital expenditures that far exceed whatever cash the company is generating from operating activities.

The example of commodities trader Olam International, a blue-chip component of the Straits Times Index, is instructive.

For its fiscal years 2011 and 2012 that ended in June, the company’s income numbers looked decent. Revenue increased in 2012 to $17.1 billion, up from $15.8 billion a year ago. Net profit in 2012 was $371 million, down somewhat from $430 million a year ago.

But a look at Olam’s cash-flow statement and balance sheet would turn off relatively conservative investors like me. Net cash flows from operating activities was a negative $1.6 billion in 2011, and a mere $187 million in 2012. This did not cover property, plant and equipment purchases of $334 million in 2011 and another $875 million in 2012. The company also spent about $900 million acquiring subsidiaries or assets in these two years.

These purchases were all financed by borrowings, bonds and other securities. Olam borrowed $1.97 billion in 2011 and $663 million in 2012.

Now, there is nothing wrong with borrowing to pay for capital investments. Some companies are in the red for several years before these investments show results. Olam is similarly betting that its investments now will pay off many years down the road.

But its balance sheet at June 30, 2012, shows a company which is quite highly leveraged. Total borrowings amounted to $7.5 billion. Its equity – the amount of money owned by shareholders – was just $3.5 billion. Combine that with a stuttering operating cash flow and a complex business that spans the globe, and it was not surprising what happened next.

Short-seller Muddy Waters struck in late November 2012, accusing the company of being a “fiscal black hole” while criticising its debt levels, the way it booked profits on some of its acquisitions, the valuations of its biological assets and its “off the rails” capital expenditure.

Olam’s shares plunged as much as 22 per cent, before recovering after a rights issue and support by its second-largest shareholder, Temasek Holdings.

The company recently unveiled plans to generate cash by selling assets and slash its planned capital expenditures, to reduce its debt load and address lingering market concerns over its balance sheet.

Whether this will work remains to be seen. Conservative investors, meanwhile, will be able to sleep more soundly at night by investing in a company with a strong cash flow-generating ability and low debt.

Of course, the cash-flow statement is not perfect. Companies can employ several methods to boost their free cash flow in the short term without really improving its financial situation.

One way is to take a longer time to pay back suppliers. This will show up in an increase in payables.

Another way is to sell its receivables to a third party agency to get cash straight away, faster than waiting for customers to pay back what they owe. This is known as securitising receivables.

Companies intent on cheating will always find a way to artificially inflate cash flow, knowing that having a steady stream of cash is what investors like to look out for.

But on the whole, the cash-flow statement cannot be ignored. It tells investors what is actually happening on the ground, instead of what a company claims it is doing.

With good cash management, a company can worry about the problems of its success: how to invest its surplus cash in a way that will create value for shareholders.

If you remember the primacy of cash and invest in businesses with a time-tested ability to generate it, you are unlikely to go wrong.