Mind Cash Flow Sleight-Of-Hand

Foreword from ShareInvestor

This article “Mind Cash Flow Sleight-Of-Hand” by Teh Hooi Ling was first published in The Business Times on 24 Apr 2004 and is reproduced in this blog in its entirety.

Useful as cash flow statements are in describing a company’s health, they can give a distorted view. So don’t take the figures at face value

THE aggregate cash flows from operations of the Straits Times Index (STI) component stocks are at a five-year high. Similarly, free cash flow to equity is at a five-year peak. Free cash flow to equity is the cash flows left over after a company has met its interest and principal payments, and has provided for capital expenditures to both maintain existing assets and create new assets for future growth.

In other words, free cash flow to equity is a measure of what a company can afford to pay out as dividends. As some analysts use that to value stocks, an improving free cash flow number will bode well for the firmer prices of STI stocks.

I totalled the cash flows from operations, cash flows from investments, and cash flows from financing of STI component stocks between 1999 and 2003. From about $21 billion in FY1999, the aggregate cash from operations of STI stocks declined to a low of $13.5 billion in FY01. Things have been picking up in the last two years. For FY03, the figure amounted to about $25 billion. That’s a 20 per cent growth from the year before and 88 per cent higher than the trough in 2001.

The free cash flow number, too, followed the same trend with the FY2003 total free cash flows standing at some $16 billion. It grew a strong 87 per cent from the year before, and is five times that of 2001’s.

The solid figure is heartening given that it is not a result of companies stinting on capital expenditure, which will in future scrimp on their growth potential. Cash flows from investments also saw a sharp rise last financial year.

Meanwhile, companies have begun to tap the financial market for funds. Compared with FY02 when STI companies repaid or returned some $21 billion to their banks and shareholders, last year saw them raising $4 billion of new capital.

What Are They?

The statement of cash flows is one of three statements that companies need to prepare to comply with generally accepted accounting principles.

It supplements information provided by the profit-and-loss statement. The profit-and-loss statement is governed by accrual concepts. Under the accrual concept, revenue is recognised when the earnings process is completed. For example, company A has signed a $10 million contract to sell a batch of tyres to a car manufacturer. The tyres may have been delivered to the car manufacturer, which is given a credit term of three months to pay company A.

Say, company A’s financial year has ended, but the car manufacturer still has $5 million owing. In company A’s profit-and-loss statement, the sale will be recorded as $10 million. And all the costs incurred in producing the tyres will be recorded as expenses to arrive at a profit and loss number. Many of these expense items are based on management’s judgement and estimates.

So, if management estimated that expenses came to $8 million, then company A would report a net profit of $2 million. However, in terms of cash flow, the company only generated $5 million for that year. The other $5 million will appear in the balance sheet as an asset – that is, accounts receivables.

And if during that year, company A had to make cash payments to its employees, suppliers, landlords and bankers which exceeded $5 million, and if it didn’t have much spare cash or borrowing capacity, then it could run into a liquidity problem.

So it is entirely possible that a company can report a profit, yet end up being insolvent.

Cash flow statements are generally less likely to be affected by variations in accounting principles and estimates. This makes them more useful than reported income in assessing liquidity and solvency of companies.

Cash flows are classified into three sections: cash flow from operations, cash flow from investing, and cash flow from financing.

Operating cash flows relate to cash collection from customers, payments to employees and suppliers, among other things. Investing cash flows involve cash used to buy property or plant, or cash received from the sale of these investments. Cash flows from financing include cash raised from shareholders or bankers, or cash returned, and dividends paid.

Red Flag

One of the red flags that analysts look out for is increasing net profits accompanied by declining cash flow from operations. It could be a sign of worsening earnings quality. In other words, the company could be pushing a lot of its products to its distributors and recording them as sales. But these products could eventually be returned. Or, in order to chalk up higher sales, the company could sell to less creditworthy customers. Some of these customers may not be able to pay subsequently, and thus end up as bad debt. Sometimes, it could just be a case of a company expanding too fast.

As can be surmised from the above, cash flow from operations is one of the key numbers analysts would look at. It tells us the health of a company’s core operations.

While cash flow statements are relatively free from management’s manipulation, they are not beyond tampering. In 2001 and 2002, a number of high-profile cases in the US highlighted abuses of cash flow statements.

A case in point is Tyco. In 2001 and 2002, as its earnings per share declined, Tyco’s managers urged analysts and investors to focus not on its EPS but on its strong ‘free cash flow’.

But the fact is, its managers had employed tricks to boost its operations cash flow. For one, it purchased customer contracts from its dealers totalling US$800 million. The cash paid for the purchase was recorded in cash flow from investing. But when the customers made payments, those were reported in the operating cash flow.

In another case, Qwest swapped telecommunications capacity with its competitors. In 2001, it sold US$100 million to Global Crossing. At the same time, it paid US$100 million for substantially equivalent capacity from Global Crossing. And in its books, Qwest recorded the capacity given up as a sale, but the capacity received as an investment, thus inflating its cash flow from operations.

What does all this mean for investors and analysts? Well, it just means that we’ll have to understand how the earnings and cash flow numbers are derived. Never take the figures at face value.