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?