Sunday, October 25, 2015

Understanding Operating Cash Flow Statement

Cash Flow Statement states the inflow and outflow of cash in an organization. Cash is oil to an organization helping its multiple parts to move smoothly with just required friction. Many commentators have emphasized the importance of cash. Some of the important characteristics of cash care: 

a) Cash is non manipulative
b) Cash is fact while profit is opinion
c) Cash is finite & measurable

It is utmost important for an equity investor to analyze the cash position of the organization over a period of time to understand the quality of earnings, sustainability of cash flows and catch the early warning signals in the business. However, retail equity investors find cash flow statements non-intuitive and ignore it while doing financial analysis of the business.

Organizations are required to publish the cash flows in three distinct part:

1. Cash flow from operations (CFO): Cash flow determining the net income by capturing cash flow from sales, payment to employees and suppliers.
2. Cash flow from investments (CFI): Cash flow due to purchase or sale of property, plant & equipment which affects the future ability of organization to generate CFO.
3. Cash flow from financing (CFF): Principle amount borrowed and repaid to lenders, cash received from issuance or cash paid for repurchase of equity.
The focus of this article will remain on the CFO to understand the nuances of the businesses. We’ll understand how the CFO is calculated and analyze CFO statements of Ambika Cotton Mills Ltd. and Oriental Carbon & Chemical Ltd.


What is CFO?
Cash flow from operations is the cash generated from ordinary business activities. This cash flow may also be referred as sustainable cash flow. An organization should not account for one off & non-sustainable cash flow events while calculating CFO.

Is EBITDA & CFO same?
EBITDA (Earnings before interest tax depreciation & amortization) is a famous indicator which investors analyze while evaluating the businesses. This is the earning which is available for interest payment to lenders, tax payment to government and for non-cash expenses like depreciation. After deducting interest, tax and non-cash payments, we get the magic figure Net Profit (or Profit After Tax). Intuitively EBITDA seems to be cash flow from operations to many stakeholders. However, EBITDA suffers from following shortfalls making it unsuitable to qualify as indicator for sustainable cash flow:

a) Fictitious revenue booking: Organizations may book fictitious revenue from fake sales or may book revenue for future sales boosting EBITDA without corresponding increase in the cash flow.   
b) Aggressive cost capitalization: The costs incurred while developing technology / equipment could be capitalized during initial stages of business which reflects under CFI statement. Alternatively, these costs could be stated under CFO statement as expenses reducing the cash flows from operations. Organizations may capitalize such costs under CFI when the technology is being developed but once the technology base is ready such costs should be expensed under CFO statement. Aggressive cost capitalization may increase EBITDA and keep expenses artificially low.
c) Ignores changes in Working Capital: Working capital indicates the short term liquidity position of organization. It is the difference between what others owe to the organization (current assets) and what organization owe to others (current liabilities) in next 12 month period. EBITDA conveniently ignores the changes in the working capital. Hence EBITDA may overstate the cash flow in periods of working capital growth and vice versa.
EBITDA seems to be the best indicator for cash flows but suffers from inherent shortfalls as well as possible manipulations by management.

The best way to calculate sustainable cash flow is to start from net profit and work backwards (indirect method). 

Let us analyze the CFO statement Ambika Cotton Mills Ltd. and Oriental Carbon & Chemicals Ltd. to understand the concept of operating cash flow & their financial positions.  

Ambika Cotton Mills Ltd. CFO Statement:
Ambika Cotton Mills Limited (ACML), incorporated in 1988, is a Coimbatore, Tamil Nadu (India) based company involved in cotton yarn manufacturing. ACML specializes in manufacturing of premium quality compact and Eli Twist yarn, which is used in making premium shirts. Company uses extra-long staple (ELS) cotton in its yarn manufacturing by importing high quality Giza and Pima cotton from Egypt and US respectively.

Figures in ₹ Cr
2013
2014
2015
Net Profit Before Tax and Extraordinary Items
40.65
59.65
63.76
Adjustment for



Depreciation
27.43
31.62
29.33
Interest paid
18.78
12.03
6.31
Loss due to Sale / discard of Plant & Machinery
0
-1.42
-0.22
Foreign currency fluctuation on revaluation
-0.36
-2.56
-1.46
Interest received
-0.26
-0.22
-0.29
Direct taxes paid
-13.23
-15.73
-15.18
Adjustment for changes in Working Capital



(Increase) / decrease in inventories
-9.46
-40.72
-11.63
(Increase) / decrease in trade & other receivables
6.14
8.16
-1.08
Increase / (decrease) trade payables
17.72
-13.00
-26.63
Net cash from operating activities
87.41
37.82
42.91

Observations:
1. The difference between net profit and CFO is large due to significant depreciation charge, changes in inventory & trade payables. ACML is able to generate positive cash flows from operations.
2. Depreciation: Large investments is required in a capital intensive business which results in significant depreciation charge. ACML seems to be capital intensive business. Large depreciation for ACML leads to relative small increase in net income compared to increase in cash flows from operations. ACML uses straight line method for depreciation. An investor should understand the depreciation methodology being used by the company. If accelerated depreciation method is being used, company is postponing the tax liability.  
3. Inventory position: ACML inventory increased significantly at the end of FY2014. This led to blocking of cash in inventory leading to decrease in cash from operations compared to previous year. Further analysis of inventory position at FY2014 end reveals that the finished good increased by 83%, work in progress by 27.6% and raw material by 45.1%. This significant build up may mean either ACML management was expecting increase in raw material prices or a much better order book in the coming financial year.
The increase in inventory may also be due to decrease in inventory turnover ratio i.e. company is not able to convert its inventory into sales. As you may see from below table, the inventory turnover ratio for ACML has decreased slightly in FY2014 from previous year.


2010
2011
2012
2013
2014


2015
Inventory Turnover
(Sales / average inventory)
(High is better)
1.60
2.13
4.71
4.32
3.59


3.57

It is important for management to keep sufficient inventory to meet requirements of its customers. Large inventory leads to non-productive use of cash while low inventory may affect company’s ability to supply to its customers.
4. Trade payables: Decrease in trade payable contributed to significant fall in cash flow from operations at the end of FY2014 for ACML. ACML trade payables further decreased at the end of FY2015. This may mean that ACML is paying off its dues to suppliers without seeking better credit period. However, a year before trade payables had increased. An investor should understand if there is any change in the contractual terms & conditions of company with its suppliers.
5. Trade receivables: ACML receivables have increased slightly at the end of FY2015 while the previous two years had seen a decrease. This may mean that customers are able to negotiate better credit period terms with ACML.
However, ACML receivable days have been reducing over last few years. The company seem to have better bargaining power with its customers possibly due to its differentiated product line.



2010
2011
2012
2013
2014


2015
Receivables Days
(Average Debtor/(Sales/365) (Low is better)
19.72
25.54
14.86
7.83
4.68


4.31








An investor should check if there is any change in the contractual terms between company and its customers.
6. PAT vs CFO: An investor should understand the relationship between earnings and CFO. The aggregate 10 year CFO for ACML is more than the aggregate PAT; which means that the earning quality is good and company is able to realize the proceeds from its customers. 
                                                            
INR Cr
FY2005-2014
Consolidated PAT
236.3
Consolidated CFO
520.4

An investor, however, should understand the reasons of increase in cash flows from operations without similar increase in earnings. One possible reason is that the company might be liquidating its balance sheet i.e. receivables are being collected and inventory is being sold.   This is certainly not true for ACML as company is a going concern and possess and strong financial health.

Oriental Carbon & Chemical Ltd. CFO Statement:
The core business of Oriental Carbon & Chemicals Ltd (OCCL) is manufacturing and sales of Insoluble Sulphur, a vulcanizing agent used in the rubber industry. Insoluble Sulphur produced by OCCL is sold globally. The Company also manufactures Sulphuric Acid and Oleums.

Figures in ₹ Cr
2013
2014
2015
Net Profit Before Tax and Extraordinary Items
40.03
50.15
62.96
Adjustment for



Depreciation
9.6
10.43
13.08
Interest paid
12.77
11.05
8.09
Loss on sale / discard of fixed assets
0
0.62
1.16
Loss earlier written off now recovered
-0.87
-0.68
-0.30
Interest received
-1.13
-1.2
-1.42
Dividend received
-0.32
-0.61
-1.01
Direct taxes paid
-7.27
-11.10
-13.27
Adjustment for changes in Working Capital



(Increase) / decrease in inventories
-8.89
-1.15
0.65
(Increase) / decrease in trade & other receivables
3.55
-7.3
-4.26
Increase / (decrease) trade payables
-0.59
1.32
4.29
Net cash from operating activities
46.62
51.53
69.96

Observations:
1. There is not much difference between the net profit and cash from operations. OCCL is able to generate positive cash flows from operations.
2. Depreciation: The depreciation charge for OCCL is lower than ACML which may mean that the OCCL business is less capital intensive than ACML. OCCL uses straight line method for depreciation.
An investor should understand the depreciation methodology being used by the company. If accelerated depreciation method is being used, company is postponing the tax liability.
3. Inventory position: The inventory has slightly increased at the end of FY2015 compared to decrease in previous years. This decrease in inventory may be due to the better inventory turnover ratio or sluggish expectations of management for future order book.
OCCL inventory turnover ratio has been improving since FY2013 which means that OCCL is efficiently converting its inventory into sales.


2010
2011
2012
2013
2014
2015
Inventory Turnover (Sales / average inventory)
(High is better)
9.47
8.40
7.82
6.13
6.90


7.52


OCCL has better inventory turnover than ACML which means OCCL is able to convert its inventory into sales more efficiently than ACML.  
It is important for management to keep enough inventory in place. Large inventory leads to non-productive use of cash while low inventory may affect company’s ability to supply to its customers.
4. Trade payable: OCCL trade payable has been increasing for last 3 years. This increase may mean that OCCL has been able to negotiate better credit period with its suppliers.
An investor should check if there is any change in the contractual terms & conditions of company with its suppliers.
5. Trade receivable: Trade receivables have increased at the end of last two years. This increase may mean that OCCL customers are able to negotiate better credit period with OCCL. The receivable days of ACML is lower than OCCL. ACML seem to have better bargaining power with its customers than OCCL.   
The receivable days have increased in FY2015 compared to FY2014.



2010
2011
2012
2013
2014

2015
Receivables Days
(Average Debtor/(Sales/365)
(Low is better)
27.55
55.18
62.20
68.71
60.46
63.69

An investor should check if there is any change in the contractual terms & conditions of company with its suppliers.
6. PAT vs CFO: An investor should also be concerned with the consistent relationship between earning and CFO. The aggregate 10 year CFO for OCCL is more than the aggregate PAT; which means that the earning quality is good and company is able to realize the proceeds from its customers. 

INR Cr
FY2005-2014
Consolidated PAT
184.8
Consolidated CFO
231.9

Conclusion:

An investor may not be able to take an investment call by just analyzing the CFO statement, but it does help an investor to ask relevant questions. Further financial and business analysis may be required to answer these questions. 

I hope this article will help readers understand the importance of cash flows. I would like to hear your thoughts on analyzing CFO statements and how they could be interpreted by an investor to make a better judgment.  


P.S: The data points have been taken from www.screener.in for analysis. This post shouldn't be construed as recommendation for 'ACML' and 'OCCL'. I may be currently invested in 'ACML' and 'OCCL' and may have biased views.  

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”



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