More about cash flows.

If there is one investor who watches the flow of cash closely- that’s Mr. Warren Buffet, one of the world’s richest stock market investor. There’s lot of books and videos explaining his method of investing, the way he analyses a company and about his investing philosophy. But if you watch closely, what buffet does is quite fundamental –

  • He targets long term investment appreciation
  • He invests in businesses he understands
  • He takes a closer look on cash flow.


WHY SO MUCH STRESS ON CASH?

Cash is different!

When you look at a company’s balance sheet – you’re looking at what the company owns and owes recordically.

The problem is that , assets like land are recorded at purchase price ( Now, land would be worth more than the purchase price) and assets like buildings and machinery are recorded at cost less a fixed depreciation rate as prescribed in law ( actual depreciation may be more or less than the depreciation charged).

Similarly, debtors may not be fully recoverable. The figure is shown on the assumption that those are fully recoverable.

So, in short what you see in the balance sheet is the value of the assets and liabilities as decided by certain rules, assumptions and estimates. This is not the actual picture.

Same is the case with profit and loss account.  The profit and loss accounts is made up with lots of estimates, accrual accounting method, non cash expenses etc..This distorts the actual picture of the company.

But, when you look at the cash flow statement, you’re indirectly looking at the bank account of the company. Buffet has been looking at cash all along.

PROFITS AND CASH ARE DIFFERENT.

Profits are not the same as cash.  Cash may come in from different sources for a business. It can come in from banks in the form of loans or from investors. If you understood what you read in our ‘matching concept’ you would remember that :-

  • Revenues are booked at sale, expenses are ‘matched’ to revenue and capital expenditures don’t count against profits.
  • In other words, revenues are recorded when ever the company deliver a product or service irrespective of whether the customer has paid for it or not, the expenses are ‘matched to revenues’ implying that it does not represent the actual cash going out and capital expenditures ( or expense incurred to purchase a fixed asset like machinery ) is never recorded as an expense in the profit and loss account but, an amount technically called depreciation is charged against revenue.

Hence -

A COMPANY CAN REPORT PROFITS (and still be left out with no cash!!)

Yes! We’ll illustrate how. For this exercise, let us go back to the imaginary company we created in our third chapter- ‘say-it-with-flowers’. The company now buys flowers from farmers at 30 days credit and delivers it to customers on 60 days credit. That means, it needs to pay it’s suppliers at the end of 30 days and it collects the sale proceeds from customers only at the end of 60 days. For every sale , it makes a profit of 40% from which it needs to meet it monthly expenses of 10 lakhs. Presently it has a bank balance of 130 lakhs.

  • In January, it records a sale of 200 lakhs. So, the profit made is 40% – that is 80 lakhs before expenses according to books. The accountant would look at his records and say that it has made a profit of 70 lakhs (200 – 120 -10). But, in reality it has not collected a penny since it’s customers pay  at the end of 60 days. But at the end of the month, it has to pay it’s suppliers 120 lakhs and a monthly expense of 10 lakhs. So it takes out the 130 lakhs from bank, pays 120 lakhs to suppliers and 10 lakhs for monthly expenses. Now, the profit according to income statement is 70 lakhs, but in reality, bank balance is ‘0’.

How did we find out that the bank balance is ‘0’? We looked at how the cash flowed.

  • In February, say-it-with-flowers records a sale of 320 lakhs and makes a profit of 40% – 128 lakhs. Deducting the monthly expenses due, the accountant would show from his income statement that it has made a profit of 118 lakhs in February and a total profit of 188 lakhs (70 in Jan + 118 in Feb.) But, reality is – the company has received Rs 200 lakhs from sale made in January (customers pay after 60 days ) , it pays off 192 lakhs to it’s suppliers for flowers supplied in February , and is left out with just 8 lakhs in bank account. It has to borrow 2 lakhs from somebody to pay off the monthly expenses!!

So- If we look at the company’s income statement as given by the accountant, we’d find that sales and profits are growing. If we look at the cash flow, we’d understand that in reality, the company is in cash crunch.

A COMPANY CAN REPORT LOSS (and still have plenty of cash!!)

Now, let’s look at an imaginary company called “Dee’s fried chicken”. Since the company sells fried chicken, it has a 100% cash based business. It get’s chicken from suppliers at 60 days credit.  Customers pay upfront and buy chicken fry. There’s no credit. However, monthly expenses are 90 lakhs- on the higher side due to high standards to be maintained.   For sake of comparing, this company also makes 40% profits on sales and starts it’s business in January with 130 lakhs in bank account.

  • In January, it records a sale of 200 lakhs. So, the profit made is 40% – that is 80 lakhs before expenses according to books. The accountant would look at his records and say that it has suffered a loss of 10 lakhs (200 – 120 -90). But, in reality it has to pay only 90 lakhs at the end of the month, it need not pay it’s suppliers 120 lakhs since supply is at 60 days credit. The company has 240 lakhs (130 lakhs previous balance + 110 lakhs in January) in bank, after monthly expenses. Now, according to income statement the company is in loss, but in reality, bank balance is 240 lakhs.
  • In February, ‘Dee’s fried chicken’ records a sale of 320 lakhs and makes a profit of 40% – 128 lakhs. Deducting the monthly expenses due, the accountant would show from his income statement that it has made a profit of 38 lakhs in February and a total profit of 28 lakhs (-10 in Jan + 38 in Feb.) But, reality is – the company already has 240 lakhs in bank , it gets another 320 lakhs , pays off 120 lakhs to it’s suppliers for chicken supplied in January , pays monthly expense of 90 lakhs in February and has a balance of  350 lakhs in bank account !!

So- If we look at the company’s income statement as given by the accountant, we’d find that sales and profits are not upto the mark. If we look at the cash flow, we’d understand that in reality, the company is cash rich.

Understanding this difference between profits and cash is the key to increasing your analytical ability. It opens a whole new perspective from which you would start looking at companies

THE LINK BETWEEN  PROFITS & CASHCash flow statement.

The most interesting fact about cash flows is that you can analyse it by looking at the income statement and two balance sheets. This is not a very complicated process; but it’s easy to get confused in the process if you don’t understand the whole thing clearly. Here’s a step by step guide to analyse cash.

  • Look at every change from one balance sheet to the next
  • Determine whether the change has resulted in an actual outflow or inflow of cash.
  • Add / deduct the amount from the net income as per current income statement.

More specifically –

  • Start with profits
  • Non cash expenses: Add back all non cash expenses like depreciation.

Assets

  • Accounts receivable: If it has increased deduct from profits; if it has decreased add back to the profits.
  • Inventory / closing stock: If it has increased deduct from profits; if it has decreased add back to the profits.
  • Any other asset: If it has increased deduct from profits; if it has decreased add back to the profits.

Liabilities

  • Accounts payable: If it has increased add back to profits; if it has decreased deduct from the profits.
  • Loans and debts: If it has increased add back to profits; if it has decreased deduct from the profits.
  • Any other liabilities: If it has increased add back to profits; if it has decreased deduct from the profits.

Others

  • Dividends paid: deduct the payment from net profit

CONCLUSION:

Cash flow is the key to picking highly profitable companies. The analysis would help you to get insights into a company’s actual financial health.

You may like these posts:

  1. Cash flow statement. – An introduction.
  2. Understanding Cash flow statements
  3. The Income statement : Understanding the “matching principle”.

2 Responses to “More about cash flows.”

Ankit Maloo

May 8, 2012 at 2:43 pm

Boss, you have done some calculation flaw, You are asuusming 40% profit in both the examples. But the profit /loss calculation is always done on CP Not from revenue or sale. It should be like that, CP+CP*.4 = 200 lakh which means CP= 200/1.4 =142.86. So the Profit is 57.14 Lakh only.

Regards,
Ankit

J Victor

May 9, 2012 at 8:00 am

Thanks ankit.

I have used 40% on sales for the purpose of ease of understanding. it can also be read as 66.66% on CP.

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