When companies announce their results and forecast, the emphasis is heavily on revenue, EBITDA, net profit, and Earnings Per Share. These metrics tell a lot, but it is important to understand that they do not tell the complete story.
The balance sheet obviously plays a vital role in telling the story of the company’s financial position at a given point in time too, but I’m going to focus on earnings. Due to the fact that most companies use accrual accounting, the revenue recognised may not actually be equal to cash received. In fact, it seldom is.
You might have heard the old adage “Cash is king”. Cash is king because without cash coming in, you have nothing to pay expenses with. You can’t say to a supplier “we’ll pay you with revenue”, because revenue does not equal cash. Revenue is an accounting transaction.
If a company reports growing revenue and growing net profit, that’s great. But if they aren’t able to collect that revenue from their customers their business model is broken, and sooner or later their business will be in trouble. By looking at net operating cash on the cash flow statement – which measures receipts from customers and payments to suppliers and employees – we can get a real picture of the level of cash going through the business.
A quick way to measure this effectiveness is by using cash conversion. Cash conversion can be calculated a few different ways, but it essentially measures how effective the company is at turning their earnings into real cash. A simple calculation to work out the cash conversion is net profit divided by net operating cash.
A cash conversion of 100% means that all of the net profit that was reported was turned into cash. Anything below 100% means that the company has not done well at collecting their receivables and may have written off some bad debts.
Another possibility is that the company may have included some non-cash items in the Income Statement such as restatement of asset values (non-cash revenue) or impairment of intangibles (non-cash expense). An item of non-cash revenue can be standard practice for a company like Eureka Group (ASX:EGH) or Real estate investment trusts (REITs), where underlying values of properties are restated to realise capital growth and allow them to borrow more money against the asset. But since there is no cash flow from this capital growth, the bank balance will be unaffected and it will not help them pay any immediate bills. This will reduce the cash conversion, but it may not necessarily mean that there is anything wrong with the business. But understanding this helps to understand the business and make more informed investment decisions. In this instance, it may be prudent to calculate cash conversion after subtracting the non-cash revenue amounts from the calculation to give a more accurate picture.
The types of businesses that typically have very good cash conversion are those with recurring revenue streams, short payment terms, and bargaining power.
So far we have only discussed the cash flows from operating activities section on the cash flow statement. If cash conversion is high then that’s great, but if the company still requires heavy capital investment to remain competitive, then the cash flows from Investing Activities will be where this is disclosed. Investment in property, plant and equipment is generally the largest item and indicates how much capital expenditure (capex) the company needs to generate their revenue.
In particular, a good exercise is to measure the capex against the revenue as a percentage. If the percentage increases over time, the business is becoming less efficient, less scalable and more reliant on upgrading equipment to earn their revenue. This is all information that you can’t find on the P&L, and is not generally highlighted by the company in their summaries.
Finally, the cash flows from Financing Activities tells you how the finances were arranged and changed throughout the year. While not indicative of any underlying business performance, it can be important to know if large amounts of capital were raised or if the debt levels were increased throughout the year. Most of this can be gleaned from the balance sheet as well, but it is specifically stated on the cash flow. On the whole, if money is being returned to shareholders, this is good for investors as the company is being strengthened. But be wary if equity is being raised constantly, especially if earnings are not increasing at the same rate.
As you can see, the Profit and Loss and Balance Sheet are imperative to business analysis, but it is not until you dig deep into the Cash Flow Statement that you can truly tell the earnings and cash generative potential the business has.
Farnam holds Eureka Group in the Farnam Equity Value Portfolio.
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