Cash flow is crucial when measuring a company’s performance

To invest smartly, you must look beyond a company’s financial statements When deciding how and where to invest, it is crucial to understand a company’s cash flow strength, which relates to its ability to pay dividends. Although auditors do their best to

Accounting earnings may not translate to free cash flows

There are different reasons why accounting earnings may not translate to free cash flows that are available to pay dividends, explains Nicolette Wulfsohn, Equity Analyst at Prudential. Three of these reasons are:

1. Non-cash income and expenses included in the income statement..

2. A business’ ongoing investment requirements, as certain industries need investment in fixed or working capital assets to grow.

3. The capital expenditure cycle, that is, the stage of investment that the company is in.

Non-cash income and expenses can give a skew perception of actual cash flow

“Depreciation is the most common non-cash expense that appears in most companies’ income statements. While it is a proxy for a capital cost, it can differ quite radically from the actual cash spent on capital in a given year,” says Wulfsohn.

Another example is that share-based payment expenses are also non-cash. When a company has a share incentive or option scheme for employees or allocates shares or options to BEE partners, it often happens that little or no cash changes hands upfront.

Wulfsohn says other more volatile non-cash gains and losses are shown when companies have foreign exchange exposure for which they don’t meet certain stringent hedge accounting criteria. “The accounting standards require the company to compare the balance sheet date’s exchange rate to the exchange rate of the contracted date. This makes sure that their balance sheet reflects the correct assets and liabilities at the balance sheet date, but it can cause havoc with income statement earnings,” she explains. “And because the exchange rate changes from day to day, the gain or loss on the foreign exchange contract may never materialise in the way that it is reflected in the income statement.” Reported earnings can differ quite radically from cash earnings.

A business requirement to invest in capital can differ radically between industries

Most companies need capital to grow. This usually takes the form of fixed capital, for example, property, plant and equipment, as well as working capital, like inventories and debtors. The amount of capital needed to grow depends on the company’s business model and the industry.

Wulfsohn explains this important concept with the help of two examples. “A fast food franchising business, for example, has franchisees continually opening new stores and these franchisees are responsible for the cost of fitting out the restaurant and buying inventories. The franchisor does not have to invest any capital to expand their restaurant footprint and grow their business revenues and profits,” she says. On the other side of the spectrum, a contract mining and leasing company has to invest in fleets of mining equipment and vehicles. It incurs large capital cash outflows at the start of a contract and only generates revenue and cash from the fleet over the contract term, which typically lasts a few years.

Investors should therefore not compare capital investment figures and the cash these investments generate directly between companies, but rather view it in the context of the type of industry.

The capital expenditure cycle can temporarily provide a false impression of cash outflows and cash generation

Capital expenditure, whether building new factories, buying new technologies or expanding capacity, often happens in phases, says Wulfsohn. During phases of expansion in the cycle when capital expenditure is needed for more than just maintenance, the depreciation charge in the income statement can often fall behind the true cash outflows. “The income statement earnings will then overstate cash generation,” she says.

Make sure you understand a company’s cash flow profile before you invest

Investors have to take these factors into account and not regard the income state earnings as the ultimate measuring stick of company performance. “Gaining knowledge about the cash profiles of potential investments by, for example speaking to your financial adviser, can make a difference to your returns in the long run and is therefore worthwhile;” she concludes.