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.
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.
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”
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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