Tuesday, April 5, 2011

A Solution to the Exercise on Cash Flows

Last week’s exercise on Cash Flows drew a large number of readers, but, disappointingly, only 6 responses. That could be because of three reasons: (a) most readers did not understand the concept of cash flow; (b) readers felt shy about making an incorrect response in an open forum; (c) readers did not feel that cash flow is an important enough concept to break their heads over.

Now that the Sensex is on the upswing again after nearly 5 months of correction, the participation in various investment groups and chat boards have increased significantly. Many of the topics are nothing but a succession of ‘buy’ calls on stocks of various pedigree, mostly questionable, with a stop-loss 2 points below the ‘buy’ price and targets of 3 points and 5 points above the ‘buy’ price. Gleeful announcements follow that the first target has been hit and one should book 50% of profits!

If more young investors learned the basics – and let me emphasise that cash flow is one of the most important concepts any investor should learn – they would know how to make really big money, instead of being happy with a 3 point or 5 point profit in 2 days (which they don’t forget to annualise into huge percentage gains to ‘prove’ their stock-picking prowess).

Pardon the rant. Now a turn to acknowledge the 6 readers who had the interest and intelligence to read and understand the concept of cash flow, and the guts to attempt answers to the exercise. Well done. All of you are winners, because you can consider yourself a few cuts above ordinary investors, who jump into the market with no idea of what they are doing.

There were no ‘right’ or ‘wrong’ answers, because stock picking depends on individual preferences and risk tolerance levels. But a distinction needs to be made on the process one follows to take a decision about a particular stock. A special hat-tip to reader ‘TK’ for the most logical way of arriving at his decision. My anonymous subscriber’s response was the next best.

Just to recap the concept of cash flow, a positive number is an inflow and a negative number is an outflow. In cash flow from operating activities, a positive number is preferred. A business should not just generate profits, it must generate cash – not as an amount to be received at some future date (which is represented by a negative cash flow). Often, the profit figure is an accounting sleight of hand. So the negative cash flow never turns positive. On this aspect alone, Company ‘A’ beats ‘B’ and ‘C’ hands down. (Cash flow can be fudged also – but will show up in the Balance Sheet. This is what Ramalinga Raju did at Satyam, and his auditors ignored or overlooked it.)

‘A’ has also been investing regularly in expanding its activities, as can be seen from the negative cash flow from investing activities. Negative cash flow here is actually good for the business. However, if the cash generated from operating activities is insufficient – as was the case in ‘06, ‘07 and ‘09 – there is no option but to resort to borrowing. Note that the cash flow from financing activities were large positive amounts. In the two years (‘08 and ‘10) that substantial cash was generated from operations, the company paid back some of its debts – as can be seen from the negative cash flow from financing activities. A sign of financial prudence.

What can’t be made out from the abridged cash flow statements is the total debt burden and interest payments. If the debt/equity ratio (which is calculated from the Balance Sheet) is more than 1, then the company may get into a debt trap after one or two bad years. Another metric to check is whether interest payment exceeds net profit (which can be observed from the P&L statement). If it does, then the banks are benefitting more than investors.

As far as ‘B’ and ‘C’ are concerned, both fail the test because I only consider companies suitable for investment if they have positive cash flow from operating activities in at least 4 of the past 5 years. Of the two, ‘B’ is better because it has achieved higher profits on lower levels of debt (as can be seen from the cash flow from financing activities). Also, its profits are growing, whereas profits of ‘C’ are stagnating.

Please appreciate that this particular analysis is a bit simplistic because the cash flow statements are abridged. However, it provides a good overall picture for short-listing potential companies to invest in. A more detailed analysis of the Balance Sheet and P&L statement should be conducted before taking a ‘buy’ decision.

Ideally, a company should not only have positive cash flow from operating activities, but also positive free cash flow. That means, cash flow from operating activities should be more than enough to fund any capital expenditure. Such is the case with many FMCG companies. One reason why FMCG is my favourite sector.

(Note: Company ‘A’ – Aurobindo Pharma; Company ‘B’ – IVRCL Infra.; Company ‘C’ – Pantaloon Retail. No particular reason for picking these three – other than the fact that they can be ranked based on their cash flow statement.)


Harry said...

I wanted to respond but reading numbers is hard. An excel filled with data would have helped.

I realize people will say that in real life it is hard to get data crunched automatically, you have to put effort to use it. Very right, but still that was the constraint for me.

I am writing this because of the discussion about low response. Give me an excel and I can do 10 more things than I can do with words.

Subhankar said...

When I started investing in the 1980s, there were no PCs and no free charting software. Every trading day's O-H-L-C prices were entered in a diary, and plotted on a graph paper with a pencil. That was a constraint. But there was no alternative if one wanted to do technical analysis.

This exercise wasn't about number crunching that requires Excel. It was about understanding which figures to look at and how to interpret those figures.

Importing data from a web page into an Excel sheet is not rocket science. Ultimately, we end up doing what we want to do, and believe what we want to believe.

TK said...

A BIG Thanks for the acknowledgement Sir.


Harry said...

Subhankar ji, take my this comment in the right spirit. It takes me 1 minute to respond, and this is just to illustrate cost benefit. However, if I have to spend 10-15 minutes in doing some exercise, I have to balance the use of my time against something else I could do. If I was making money by spending these 10 minutes, I would. Otherwise, why would I?

Yes, people used to use punch cards in 1960s, at least in America. Would we do that now?

From your site's perspective, such questions will get response from only hard core followers, or people who know this like the back of their hand. If you can simplify their life, you should.

You are doing a good job otherwise. I scan through all your posts, and at least half of them give me good ideas. Keep up the good job.

Unknown said...

Dear Subhankarji,

A very good post on cashflow. Infact i used to see only P&L and B/S. Never bothered to see the CF.But CF reveals lot of things. Thanks a lot.
Now I have a question: Suppose a company X, shows fictitious sales and profit, collects the sales proceeds and inflates the capex figure showing the fictitious profit as invested in fixed assets. Cashflow analysis shows picture perfect story, but the reality is different. How to catch this kind of companies?... May be ROI or ROA ??? Your comment please.

Subhankar said...

@TK: Thanks for participating.

@Harry: You are quite right. We need to set priorities.

I chose to spend three hours to select appropriate examples for the exercise, so that readers may learn and become better investors. You chose not to spend 10-15 minutes to do the exercise.

@ramesh: If the sales are fictitious - as they often are in companies with questionable management - how will the sales proceeds be collected? It will show up as 'accounts receivable'.

This is exactly what DLF did - 'selling' its apartments to a subsidiary and showing 'profits', but the subsidiary could not sell the apartments, and so could not pay DLF.

What is tougher to catch are investments in subsidiaries - which are fictitious or 'benaami' companies belonging to the promoters. Usually, such 'investments' are a way to siphon off the cash.

Unknown said...

How to find out good management

Subhankar said...

Good question, Ashok.

Let me point you to a Morningstar article that will help you to evaluate quality of management of any company: