Does large debt on the Balance Sheet make a company's stock a risky investment?

It is that time of the year when Annual Reports of companies will be hitting mailboxes. Instead of just checking the dividend amount and tossing the report in the recycle bin, it may be worthwhile to go through the report.

At the very least, the balance sheet, P&L, cash flow statement and the notes to accounts should be studied. These will reveal the financial health of a company.

One of the things that get many companies into trouble is trying to grow too fast, too soon. Many tech companies had fallen prey to the syndrome of 'grabbing eyeballs' instead of having a solid business plan that would lead to cash generation.

They had taken on a huge amount of debt to gain market share quickly by expanding globally or by acquiring competitors. Their subsequent bankruptcies were caused by the inability to service their debts.

Even the well-established houses of Tatas and Birlas made gross errors of judgement by financing their acquisitions of overseas competitor companies through large debt.

But what if taking on large debt to buy out a competitor actually results in increasing market share and enabling a move up the value chain? Tata Motors did that successfully by acquiring Jaguar-Land Rover from Ford.

So, how does a small investor decide if large debt on the Balance Sheet of a company makes investment in its stock risky or not? 

One way is to look at the Interest Coverage ratio. Another is to look at the Return on Capital Employed (RoCE) ratio. The higher the ratios the better. Both these ratios should be compared with other companies in the same sector.

Read more. 

Notes from the USA (Jun 2011) – a guest post

One of the best ways to find out about the true state of financial health of a company is to scrutinise its cash flow statement. The Profit and Loss statement is based on the accrual system of accounting. The cash flow statement records the actual inflows and outflows of cash, which provides a better idea about the sustainability of a company’s business model.

What about an investor’s cash flow statement? Are you keeping track of exactly how much cash inflow is being generated by your cash outflows (i.e. investments)? Specially in a sideways or sliding stock market? In this month’s guest post, KKP shares some of his thoughts on the subject.

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Lets Get Down to Cash Flow Analysis

Q1 and Q2 2011 have shown that there might be a good size recovery, giving a feeling of hope to many people in the US, as well as corporations. The economy has slowly been recovering – no doubt. But the housing and construction market rebound has remained soft despite the big QE (quantitative easing) programs from the Fed and the low-low-mortgage rates (average 30-year fixed U.S. mortgage rate is around 4.82%). The reason is simple: Stubbornly high unemployment and underemployment, and also tight lending policies from the bankers/lenders. Bankers have swung the pendulum to the other end of the spectrum and have very stringent policies. In 2002-2008, lenders would lend money to people without any money down (by doing double mortgages), and today, even if someone is providing 25% down payment (upfront cash), they are scrutinized as if they are one of the worst borrowers.

Predictions show that home prices will fall around the 5% to 10% in 2011 compared to 2010, and they will remain flat in 2012. This median forecast was part of a poll by Reuters of 21 economists who provided price forecasts. In looking at really long term trends of US home prices, it clearly shows that home prices are close to the bottom and will hover around here for a bit, and with a ‘core-recovery’ we will see a bounce up in prices (albeit very slowly).

"It is hard to see the housing market doing better until the massive headwind of foreclosures is removed and that will likely take a couple of years," said Mark Vitner, senior economist at Well Fargo Securities in Charlotte, North Carolina. With home prices still falling, many potential buyers are sidelined and banks are more stringent with loan applications and credit scores, Wells Fargo's Vitner said. "It is not that I am pessimistic about the housing market, it is just that I am not optimistic and a gradual recovery probably will not happen until 2013 or 2014, with a full normalization not until 2015," he said.

I have noticed that there is a rise in the "distressed, foreclosed and short sale" homes due to the fact that the lower home prices have put mortgage balances (what you owe on the home) above the current price of the home. Therefore, the home either goes into a short sale (seller and lender put it on the market), or foreclosure (owner cannot or will not pay mortgage), or distress situation (seller does not pay mortgage, and lender cannot afford to keep the home on the books). The net result is that the price of the home has to be marked down significantly, for investors or home-upgraders or renters are willing to look at the properties.

I am currently sprucing up a home that I purchased as a ‘distressed home’, and will be renting it out before July 1^st, 2011. In addition, have offers out on Short Sales where the Seller and Lender are considering my offers for Downtown Condos (at 1/3^rd to 1/4^th the last sale price). Even with the above flat market situation predicted, I remind myself that I am buying real estate at the “equivalent of March 2009 Sensex prices”. Remember how undervalued we were in the stock market at that time, before we took off? Real estate will NOT take off in the same manner (of course), but my tarot-charts (figuratively speaking) is telling me that I am buying it close to the bottom and have no desire to price these out for sale since I will be renting them out in the near term (2 to 5 years).

In addition, I am buying these at really ‘distress’ prices, instead of chasing them, and have the ‘patience and privilege of dividends’ while I hold. Dividends are in the form of rent here so it is easy to convince myself to hold. So, equate it to holding a stock that may not move up immediately, but will pay you almost risk free 12% to 26% in return with minimum loss of capital (if so).

Bottom line is that a lot of books have been written about ‘cash flow’ production, and with this methodology, I have found how much of a parallel it holds to Selling Calls on individual stocks being held in a portfolio. Call Selling had been a very favourite methodology of mine when I was very active in the markets in the 1990’s, and most recently as a way of reducing my stock holdings. But, in both cases, it taught me how to ‘generate cash flow’ from the holdings, and ‘make a paycheck’ out of it.

Real estate has the power to make the same with almost the same amount of time involvement. Wow. Really? Yes, very true. In India, it is even better since you can literally buy a flat/condo and rent it out, making all responsibilities of maintaining the flat a responsibility of the tenant (minus big issues). I am able to replicate the same with a team of contractors to simplify my life and do virtual-maintenance (call someone to go and fix it at low cost).

For now, think cash flow, and figure out a way to generate a paycheck or cash flow from your investment holdings. If you hold RIL or HUL for a long time, the percentage yield to your purchase price could be significant enough to get a very net high yield, especially if the stock has provided splits/bonuses. With my net-buy-price of HUL under Re 1.00, the percentage yield on the annual dividend seems like a paycheck each time it comes. So, there are many ways to skin the cat, and as one gets more experienced, some of these techniques become part of the portfolio and life, and yet, it is each portion of the portfolio that needs to replicate the ‘cash flow’ generation methodology. Traders might be good at generating cash flow from ‘trading’, but very few can do it consistently, and hence doing it with many techniques/strategies will be good for your long term financial health.

Hope you can ‘draw’ some ideas from this to your thinking and add a twist to your investments that might change the overall short and long term return, such that it gives back some cash flow which can help with your own personal goals (buying gold or silver)…..Oh, that brings me to another favorite topic of mine (gold), but we will leave that for the future….

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

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.)

How to read the Cash Flow Statement – Part 2

In last Tuesday’s post, I had covered the first part of the Cash Flow Statement – Cash Flow from Operating Activities. The next two parts will be discussed in this post.

Part 2: Cash Flow from Investing Activities 

To remain in business over the long haul, a company needs to grow. Without growth, a business will stagnate and eventually die or get acquired. But growth has a price. Cash has to be spent to buy land, machinery and related equipment, build factories and offices, acquire other companies, start subsidiaries or joint ventures, and make appropriate investments.

All of the above comes under Cash Flow from Investing Activities. You don’t have to be a genius to guess that this figure will be a (negative) one for most companies. Many mature companies, particularly those in the FMCG sector, don’t have much need for Capital Expenditure (i.e. spending cash on factories and equipment) because their rate of growth has slowed down.

Ideally, the depreciation amount in the Profit and Loss statement should be less than or equal to the amount of cash being spent in investing activities – because depreciation is meant to cover the notional loss due to wear and tear of the existing plant and machinery. If a company does not continuously spend on upgrading and modernising its facilities, it will not be able to compete with newer entrants who may have the latest technology and equipment.

The definition of Free Cash Flow is:

Cash Flow from Operating Activities – Capital Expenditure

This is a (negative) number for companies in their early growth stage, when cash generated from core operations may be insufficient to cover the cost of capital expenditure. But for well-established companies, positive Free Cash Flow is an indication of financial health. The more positive Free Cash Flow a company can generate, the easier it is for them to expand, acquire, pay dividend or buy back shares, and pay off loans.

Part 3: Cash Flow from Financing Activities 

What if a company has (negative) Free Cash Flow, or still worse, has (negative) Cash Flow from Operating Activities? Where will they get the cash to pay their suppliers, interest to banks for any loans taken, and for growing the business?

They can either resort to more borrowings, and/or issue more shares. If such companies are showing a net profit, then they are also expected to pay dividends to their shareholders. All inflows and outflows of cash due to loans, share issues, share buybacks, dividend payments come within Cash Flow from Financing Activities.

Financial prudence should dictate a company’s growth plans. As a thumb rule for selecting good stocks, about 60-70% of the Cash Flow from Investing Activities (Part 2) should be funded by positive Cash Flow from Operating Activities (Part 1); the balance 30-40% should come from Cash Flow from Financing Activities (Part 3).

Many companies forget the simple adage that one should cut one’s coat according to the cloth. They may even have positive Cash Flow from Operating Activities, but their ambitious growth plans require far more cash than they can afford. They resort to frequent borrowings and share issues in the hope of reaching the top quickly. One or two bad years can bring such companies down to their knees. Pantaloon and Suzlon come to mind.

(Note: The financial health of banks and financial institutions can’t be judged by analysing the Cash Flow Statement alone – because they need to borrow cash to give loans, and invariably have negative Cash Flow from Operating Activities. Price to Book Value and Return on Assets are better measures for such companies.)

Related Post

What is the Return on Assets (RoA) ratio?

How to read the Cash Flow Statement – Part 1

Have you heard the statement: Cash is king? A business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive. Seems logical that investors would first look at the Cash Flow Statement in an Annual Report – right?

Unfortunately, most investors in the stock market – even those who have been investing for many years - do not understand or know how to interpret the Cash Flow Statement. Just looking at the Balance Sheet, Profit and Loss statement and the Management Discussion and Analysis is not enough. The real state of a company’s finances is hidden in the Cash Flow Statement and the Notes on Accounts.

With another accounting year coming to a close on Mar 31, 2011, this is as good a time as any to learn the basics of the Cash Flow Statement:-

The Cash Flow Statement allows you to check the different sources of cash inflows into a company during a particular year vis-a-vis the prior year, how much cash was spent, and what it was spent on. Cash inflows are positive, cash outflows are (negative). The three parts of a Cash Flow Statement enable you to understand what a company’s management is doing with the cash at its disposal, by comparing the figures with those appearing in the Balance Sheet and Profit and Loss statement.

Part 1: Cash Flow from Operating Activities

The Net Profit before tax and exceptional items from the Profit and Loss statement is adjusted with depreciation, interest, provisions, profit/loss on investments, debtors, inventories, creditors to arrive at the cash generated from operations. Tax and exceptional items are then adjusted to arrive at the Net Cash from Operating Activities.

Though it may seem counter-intuitive to non-accountants (like me), depreciation is considered an inflow (it is an expenditure in the Profit and Loss statement, but the cash is not paid to any one and remains within the company); creditors/accounts payable is an inflow (because they haven’t been paid yet); debtors/accounts receivable is an outflow (because a ‘sale’ has been accounted in the Profit and Loss statement but the money hasn’t been received yet).

Net Cash Flow from Operating Activities should preferably be positive, and greater than the previous year’s if the net profit has gone up. Newly set-up companies, particularly those in high growth fields like Information Technology or Bio-technology, often have negative cash flows from operations in their initial years. They need to ramp up operations quickly to meet demand but may not be able to negotiate good payment terms from their clients.

Negative cash flows from operations of established companies, if over prolonged periods, indicate that there is something amiss with the business model, or the management has questionable integrity and is diverting cash to unlisted subsidiaries or to related parties.

Investors need to be particularly wary of companies that show good top-line and bottom-line growth year after year, and pay taxes and dividends but show negative cash flows from operations. Where is the cash to pay the taxes and dividends? It comes from regular borrowings and share issues. If such a situation continues for a few years, the debt burden will eventually sink the company. Many realty and high-flying infrastructure companies, and investor favourites like Bartronics, Cranes Software fall within this category.

(Note: The next two parts of the Cash Flow Statement will be covered in Thursday’s post – so please stay tuned.)

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Can a growing, profitable company go out of business?

Can a growing, profitable company go out of business?

Yes, even a growing, profitable company can go out of business. Most small enterprises fail because of various reasons like - a poor business model, lack of distribution skills, inadequate market research, improper SWOT analysis. But the majority fail because of one simple reason. They run out of cash.

My favourite niece, a student of economics, came to me during her summer break to help her plan a small enterprise. She is very good at preparing cakes and pastries, and wanted to supply them to the myriad sweet-meat shops within a 3 KM radius from her home.

I told her to visit some of the more popular shops with her samples and find out whether they would be interested in stocking and selling her products, and what kind of terms they would offer. After about 10 days or so, she came with a beaming smile and a print-out of a spreadsheet.

“Uncle, we have a winner on our hands. You just need to fund my first month’s expenses. From the second month onwards, the venture will be in profits!” Without pouring cold water on her enthusiasm immediately, I decided to look at her figures. Here they are:

	Month 1	Month 2	Month 3
Sales	6000	9000	13500
Raw Materials	3600	5400	8100
Gross Profit	2400	3600	5400
Expenses	3000	3000	3000
Net Profit	(600)	600	2400

“Looks pretty good. What kind of terms did you get from the grocer and the shops?” I asked. Being a smart kid, she had an answer ready. The grocer had extended a 30 days credit for the raw materials. The sweet-meat shops wanted 60 days credit from her.

“What are the expenses for?”, was my next question. She wanted to hire a person to help her in the kitchen, and to deliver the pastries and cakes to the shops and collect payment. The expenses included the cost of transportation.

“OK. But you do realise that you are not going to get paid for your efforts for two months? Have you figured out your actual cash requirements?” This time, she wasn’t prepared with an answer.

So, I started to explain patiently. In Month 1, the ‘Sales’ are on credit. The entire 6000 won’t be received. The ‘Raw Materials’ also won’t be paid for, and will remain due. But the expenses of 3000 need to be paid.

In Month 2, the ‘Sales’ are again on credit. No cash is received. The month’s ‘Raw Materials’ are not paid for, but the earlier month’s ‘Raw Materials’ worth 3600, plus the expenses of 3000 – a total of 6600 has to be paid out.

In Month 3, finally some cash comes in, the first month’s ‘Sales’ of 6000. But that isn’t enough to cover Month 2’s ‘Raw Materials’ of 5400, plus the expenses of 3000. A net amount of 2400 (= 8400 – 6000) has to be paid out.

From the Net Profit figures in the table above, the aggregate profits after Month 3 is 2400 (= –600 + 600 + 2400). An enterprise growing at 50% and making profits. But these profits are not ‘real’, just an accounting sleight of hand.

Actually, the cash paid out will be 12000 (= 3000 + 6600 + 2400). That is the only ‘real’ thing that will happen after all the activities of baking and delivering cakes and pastries for 3 months!

What would happen if some of the shops defer their payments? More cash would be required to cover the shortfall. What if my niece decides that such a growing and profitable business should be quickly expanded to other parts of the city? That would require additional expenses, multiplying the cash requirements.

This is a simplified example of a small enterprise, based on an imaginary conversation with my fictional niece. Now, change the ‘Month’ to ‘Year’ in the above table, and the figures to Rs Crores. Next, add a column for Year 4, where the sales drop by 50% while the ‘Raw Materials’ are already in inventory and ‘Expenses’ stay the same. What do you get? Suzlon Energy!

The point is: profits do not mean cash. Profits are more often than not fudged by company management and pliable auditors. It is much more difficult to fudge the cash flow statement – because it shows up in the ‘Cash and Bank balances’ of the Balance Sheet.

This is one of the main reasons that investors should check out the Cash Flow statement in an Annual Report before looking at the Balance Sheet and Profit and Loss statements. Needless to say, such due diligence should be done before buying a single share.

(Note: A friend who works as an accountant at a telecom services company, was late for a get-together last Saturday. “Were you working overtime with month-end closing figures?”, I asked. “No, no”, was his response. “We have kept August sales open till the 7th of Sept!” This kind of fudging is standard practice in many organisations.)

About Current Ratio and Quick Ratio

In-depth interpretation and analysis of financial ratios are best left to CAs and CFAs. For ordinary small investors, understanding the concepts behind the Current Ratio and the Quick Ratio enables a reasonable assessment of the financial health of a company.

If you are the kind of investor who only looks at the Profit and Loss statement in an Annual Report to check the Net Profit and Dividend amounts before tossing it in the dustbin, then you need to make a little more effort to become a better investor.

Look at the Cash Flow statement to check that the Cash Flow from Operating activities is positive. Then, calculate the Current and Quick ratios.

Current Ratio

This ratio is obtained by dividing the Current Assets figure in the Balance Sheet by the Current Liabilities. A good ratio is between 1.5 and 2. A ratio of 1.0 or less may mean that the company may face difficulty in meeting its short-term debt obligations. A ratio of 3 or more may not necessarily be better, as explained below.

The range of Current Ratios are different for different industries and sectors. So, comparing the ratio with the company's competitors will give a better idea of industry norms and the company's position.

Current Assets typically comprise: inventories, cash and cash equivalents, accounts receivables (debtors), loans and advances.

Current Liabilities include: interest payments, accounts payables (creditors), provisions for payments of taxes, dividends, retirement and other benefits.

The Current Ratio indicates whether the company will be able to meet its payment obligations that become due within the year. It can do this by using the cash, or by collecting payments from its debtors, or by quickly turning over inventory to generate cash.

Too high a Current Ratio could mean:

(a) too much inventory - which may not be good because it may be valued at a cost which can't be realised later; this is particularly true of the retail industry, where inventories often need to be marked down for discount sales due to spoilage or change in fashion

(b) poor debt collection, or inadequate credit facilities from suppliers -indicating management inefficiency or a poor business model.

Quick Ratio

Due to concerns mentioned above, the Quick Ratio is often used as a better test of a company's liquidity position. That is why it is some times called a Liquidity Ratio or Acid Test Ratio.

The Quick Ratio is obtained by subtracting inventories from the Current Assets figure, before dividing by the Current Liabilities.

A ratio of 1.0 is considered good enough. It can be higher for certain industries, but too high a ratio may indicate management inefficiency.

What is the reason for subtracting inventories? The first reason has been mentioned already - the cost of inventories in the Balance Sheet may not reflect the real value. The second, and more important reason is that it may not be easy for a company to turn inventory into cash fast enough to meet payment obligations.