The Power Of Free Cash Flow

Accounting Profit is Fake

Yup, you heard me correctly.

Accountant’s idea of profit is prepared according to tax adjustments and accounting standards. These were established to provide consistency and governance across how accounting is done. The problem is these ‘rules’ are very much open to interpretation — leaving room for ‘creative accounting’.

The collapse of Enron is a prime example of how investors and business owners assess a company’s financial performance is guided by all the wrong numbers.

But if you look at the Net Cash Flow position, you will see that the company was losing cash.

Sounds familiar?

Yes ! Hyflux, the case which is closed to us and affecting 34,000 investors, including me….. I have blogged about it ( here ).

Hyflux’s Worrying Cash Flow Situation < from Probutterfly.com>

Sometimes, we are paying too much attention to “Profits, which can be twisted or manipulated easily or “Dividend Yield", which may not sustainable or paid out from debts”.

Remember, you can fake profit, but you can’t fake cash. ( Correction !! It did happen on some of the S-Chips company.)

Now You See Me, Now You Don’t

The S-Chips Value Trap: Fake Cash Holdings –Hongwei and China Hongxing Sports <from Investmentmoats.com>

What is Free Cash Flow? <Investopedia.com>

Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital.

Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings.

Why Free Cash Flow Is Used

Free cash flow is the cash flow available to all the investors in a company, including common stockholders, preferred shareholders, and lenders. Some investors prefer FCF or FCF per share over earnings and earnings per share as a measure of profitability. However, because FCF accounts for investments in property, plant, and equipment it can be lumpy and uneven over time.

Why Is Free Cash Flow So Important?

Free cash flow is important to investors because it shows how much actual cash a company has at its disposal. When a company needs to service its debts, pay dividends or invest in equipment, it needs cash to do so. If a company has a large amount of excess cash, depending on the industry, it might be able to ramp up production, fuel acquisitions or return money to shareholders.

Free cash flow is the money left over after a company has met its operating and capital expenditure requirements and it can be the best way to differentiate between a good investment and a bad one.

What is the problem with Design Studio?

Cash flow analysis is an important tool for maintaining the health and viability of a company. Analyzing cash flows is even more crucial for small businesses that do not have access to the wide array of short-term financing that larger public companies have. 

<Image credit:slideshare.net>

The biggest issue that arises from a cash flow analysis of profitable company is a mismatch between when those companies pay out cash and when they take in cash.

 Accounts receivable grows, but the cash does not. This adverse timing of cash flows can cause a company to default on its financial obligations and fail, even though it is growing and profitable. When operating cash outflows continually exceed a company's cash inflows, the net result is negative operating cash flow.

Other than issues of increasing account receivable, the payment to contractors due to cost over-run had caused the major problem of huge cash out-flow for Design Studio.

Sometimes is too risky by just looking at the “cash pile” for those small-cap companies as the cash may deplete soon if the business /revenue been affected but the cost keeps increasing, this is quite common in manufacturing and construction company where cost is hard to reduce or contain to some extent.

The ability to generate cash and containing cost (Low CAPEX  ie asset-light with more variable cost) are equally important in maintaining healthy long term cash position.

Cheers !!

Quote Of The Day :

“I haven't read an accounting book in years. I think I read Finney in college. I'd suggest reading Berkshire reports and things like magazine articles about accounting scandals. You need to know how figures are put together, but also have to bring something else. Read a lot of business articles and annual reports. If I don't understand it, it's probably because the management doesn't want me to understand it. And if that's the case, usually there's something wrong.”- Warren Buffett

“Accounting is the language of practical business life. But you have to know enough about it to understand its limitations — because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations.” — Charlie Munger