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Tuesday, October 20, 2009

A Parable about Cash Flows

This is a story about what happens when cash flows turn negative.

A young nephew, Amar, graduated from engineering college with distinction and completed his MBA before joining the India office of a multinational company back in 2003. He rented an apartment on the outskirts of town, bought a two-wheeler with most of his first month's salary as a down payment and worked late into the night. Within 3 years, he became a manager with a big salary hike in another foreign outfit, albeit a much smaller one.

Bowing to his parents wishes and choice, Amar got married. The young couple bought a flat in an upscale area of town. Furnished it with the latest and costliest appliances. Got a spanking new Honda Accord. Started throwing lavish parties for their friends. Took holidays in Europe and Australia. Invested in the stock market big time. In other words, they started living the good life.

Naturally, I felt proud but anxious and couldn't help asking how he was managing his cash flows. Amar laughed and said: We have so much cash that we don't know what to do with it. Unlike your generation, we don't pay up front. That's so old-fashioned. Nowadays, it is all about loans and EMIs and credit cards.

I asked: What about a rainy day? He couldn't hide his derisive tone: You saved all your life for a rainy day - and now you're too old to enjoy your money. We want to enjoy now, when we are still young.

Two years later, the economic down turn proved disastrous for Amar's employer, who shut shop in India. For a few months, Amar maintained his lavish lifestyle, thanks to some savings. But the job market proved a tough nut. The EMIs and credit card payments began to hurt.

Chastened, he came to me for a loan - only temporary, he said, and will be paid back as soon as he landed another job. I laid down several conditions. He would need to sell his flat, his car and pay off his credit card debts. Amar was appalled. What would his friends think? How could he go back to a rented apartment?

Two months later, he managed to land a job - but at less than half his earlier salary. His flat and car were gone. He rented a small apartment, bought a second-hand car and started rebuilding his life.

Just how important is cash flows for a business or even a household? If you have ever run either, you know that if the cash flow stops or gets reduced, the business (or household) will soon be in dire straits.

In several investment forum discussion threads, I have been warning investors to avoid stocks that have negative cash flows from operations. More so for companies that declare 'profits' and pay taxes and dividends on such 'profits'.

The typical reaction from young investors is: 'Cash flows are not everything. There are several other criteria for picking stocks. Growing companies burn a lot of cash.' 

I point out that the cash flow statement has three parts. The first part is the cash flow from operations. If that is negative, there are only two ways that the company can pay for its expansion and other liabilities. By borrowing money, or issuing shares (or doing both). These can be resorted to, up to a point. Too much debt or a bloated equity capital will drown the company.

Looking at cash flows - or any other fundamental indicators - may be unimportant for trading purposes. But for long-term investments, the cash flow statement in any Annual Report is the most important information that needs to be checked first.

Notes:

1. The name of my nephew could just as well be Akbar or Anthony, since he is a figment of my imagination.

2. Do you think cash flows from operations is worth making a song and dance about? If yes, why? If no, what do you think are likely options for companies that show negative cash flows from operations year after year?

9 comments:

SUJAI said...

Cash flow from operations is very important, if year after year a company reporting negative cash flow from operations but showing profits on paper, may be the management is busy in cooking the accounts. (Like Pantaloons). If they have options to dilute the stake or manage to obtain loans they may retain in market for some time. If they fail on both options, bankruptcy is unavoidable. Am I correct? these articles from your blog are very useful & eye opener for the young investors like me. Thanks a lot.

Bharath said...

I strongly agree with you master. The company must show positive cash flow. Still I do hold <5% of my holdings in fast growing ~( said to be ) having negative cash flow companies.(ICSA India).

Master , what do you thing of JSPL in its recent mad run and its valuations ..?? Does the run justify ?

Trading said...

This is the one article that really make me to think on my life style.. Its true that we should save for those rainy days.. and should consider the same princi to all aspects of life and investment.


thanks sirji for this wonderful article.


regards
Abhishek

SG Money Mind said...

While cash flow from operations may be the starting point, investors should not jump in with the assumption that positive cash flow from operations as the true indicator. Looking at the cash flow by excluding the capital expenditure required to maintain a business would be a big mistake. Warren Buffett has called this as "Owner Earnings".

To quote Warren Buffett. "Cash Flow", true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. But "cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c - capital expenditure) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays.

For financial companies, who borrow the money and lend it to other to earn their profits, looking at the cash flow from operations would be misleading indicator.

For further readings, please follow the below link.

http://www.berkshirehathaway.com/letters/1986.html

Subhankar said...

@SUJAI: Appreciate your comments. Continuous negative cash flows from operations usually means a poor business model or a crooked management.

While a Pantaloon may not go bankrupt - their size will probably enable them to rustle up some money from selling pieces of their business - smaller outfits may get wiped out.

@Bharath: A true master is some one who has complete control over his thoughts and emotions. I'm far from it!

Investments is all about risk assessment and conviction based on proper homework. Your investment style can't be the same as mine, or anyone else's. If you are convinced about ICSA, by all means hold it.

Don't track JSPL. Never understood what the Jindal's do that cause such spurts in their stock prices.

@Abhishek: This was a parable to make a point, so please don't take it personally! Follow a proper asset allocation plan, and that will take care of most financial emergencies.

@SGMM: You've raised some very valid points. Companies that are growing fast and large manufacturers requiring capital expenditure can have negative free cash flows - i.e. cash flows from operations LESS capital expenditure. But I'm sceptical about companies that can't generate cash from their core operations year after year.

It is important to understand what Buffett meant by 'cash flow', as the term is often used interchangeably with 'free cash flow'.

Look at TISCO's cash flow statement. They have huge positive cash flows from operations. Part of that cash is used to pay for their continuous capital expenditure and expansion.

The huge debt burden due to the Corus acquisition caused the stock price to plummet. But the positive cash flows from operations of the combined entity will eventually restore the company's financial health.

Negative free cash flows for long periods is also not a good sign - and I tend to avoid such companies.

tax_trp said...

sarkar,
you are AMITABH BACHCHAN of financial world.
A must read for every youngster like me who keeps on flaunting their plastic wealth from their wallet.
Indeed your views are worth the verse of 'BIBLE'
keep it up.
mansoor panjwani

Subhankar said...

Thanks, Mansoor.

But please don't overdo the encomium bit - you may motivate me to charge fat fees like the big B!

Rishi said...

Dear Subhankarji,
Instead of attempting to answer your question from a stock/company perspective, i would like to put my views from a cash-flow for an individual standpoint.
I am not sure, how companies with negative cash-flow manage their operations, but a individual with negative cash-flow will end up in a mess.
Saving for the rainy day might seem old fashioned, but the old fashioned methodology is a proven technique every youngster should learn from the elders.
Now-a-days youngsters are lured in "buy now - pay later" scheme via credit cards and easy EMIs. I hope youngsters avoid this trap and generate enough income to meet the lavish expenses.
I hope everyone plans to keep positive cash-flow by means of planning and choosing appropriate investment plans.
Thanks for enlightening everyone on the positive cash-flow and its importance.

-Rishi

Subhankar said...

Appreciate your comments, Rishi.

The reason for writing the parable was to highlight how cash flows can affect individuals AND businesses.

The Pantaloons and Punj Lloyds are high on hype but low on cash, and the downturn has taken its toll on companies that need to borrow all the time.