Tuesday, September 13, 2016

Understand Your Numbers: Cash Flow Study

Accounting has evolved significantly over last few decades. A maze of new financial terminologies were devised along the way - ROE, ROCE, ROIC, ROA etc. It’s difficult for an investor from non-finance background to understand many of these terminologies. I’ll share my thoughts about some of these concepts as part of ‘Understand Your Numbers’ series. This series is an attempt to structure my thoughts as well as help investors understand the nuances of financial concepts. 

Cash Flow Study:  

“Our acquisition preferences run toward businesses that generate cash, not those that consume it… However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.” 

-Warren Buffet

Cash is basic raw material for a business. Cash is brought in through equity or debt in a newly set up business & is used to buy land, machinery, material, hire workforce etc. It’s expected that business will generate enough cash from operations to cover expenses and generate profit. Investors also expect part of cash to be distributed to them in the form of dividends. If business fails to generate enough cash, management brings in more cash by issuing additional equity shares or borrowing from lenders. 

The primary agenda of a business is to maintain machines & other fixed assets for continuous operations and at the same time focus on increasing capacity in future. Expenses to maintain fixed assets (Maintenance Expenses) & expenditure to increase capacity (Capital Expenditure) are deducted from the cash generated from the operational activities of business (Cash Flow from Operations- CFO) to calculate Free Cash Flow (FCF). FCF allows a company to pursue opportunities that enhance value for the shareholders in long term. 

Free Cash Flow = CFO- Capital expenditure - Maintenance Expenses 

CFO is mentioned in the cash flow statement. Capex is not explicitly mentioned in financial statements. 

(Reader may also go through my post for Understanding Operating Cash Flow Statement )

Capex changes the value of fixed assets for the business. We may use the change in fixed assets as a proxy to determine Capex.

Capex = (Fixed asset in year ‘T+1’) - (Fixed asset in year ’T’)

Many a times fixed asset formation may take more than a year. In such scenario, the expenditure incurred in the year for fixed asset formation is transferred to Capital Work in Progress (CWIP) account. 

Capex = (Fixed asset in year ‘T+1’ + CWIP in year ‘T+1’) - (Fixed asset in year ‘T’ + CWIP in year ’T’)

Fixed asset is also known as Net block. Net block & CWIP values are mentioned in the balance sheet. Depreciation could be taken as proxy to Maintenance Expenditure 

FCF = CFO - Capex - Depreciation

FCF= CFO - Change in net block - Change in CWIP - Depreciation 

Let’s look at the balance sheet of Eimco Elecon to calculate FCF: 

Cash flow statement provides value of both depreciation and CFO. Depreciation & CFO for FY2016 were Rs. 3.7 cr and Rs. 42.3 cr respectively.   

The change in fixed asset is INR 2.6 cr. The change in CWIP is small ~0.13 cr and could be ignored.  

FCF = (42.3-2.6-3.7) = Rs. 36 cr. 

It would not be fair if investor expects positive FCF every year. Management may need to do significant Capex in some years. It would be appropriate to look at the FCF over a longer period of time, say 10 years, to judge the cash generation ability of business.  

Total CFO over last 10 year for Eimco is Rs. 197 cr of which Capex was Rs. 37 cr. Eimco generated FCF of ~Rs. 160 cr over last 10 years. Eimco’s short term and long term borrowing is zero. 

Let us look at another example - AIA Engineering. AIA Engineering has generated FCF of Rs. 1100 cr (Rs. 2019 cr - Rs. 883 cr ) over last 10 years. Debt to equity is 0.1.   

Companies with negative FCF raise debt or issue additional equity shares to raise funds to sustain or expand its operations. 

Earning vs Cash:

We, as investors, are in romance with headline numbers - PAT & EPS. Our existing accounting methods allow a company to show profits without collecting a dime from customers. 

We are also guilty of valuing a company based on earnings. An investor should avoid looking at the earning headlines and glance at the Balance Sheet and Cash Flow Statements to understand the cash generation ability of the business. Let’s look at certain examples where earning and cash flows significantly defer from each other.

Aksh Optifibre has generated negative CFO over last 10 years but company has shown profits of Rs. 34 cr.  If CFO is negative, company will have no internal accruals for capex and will have to depend on the external sources for funding. Aksh has frequently diluted equity to raise additional money.   

Aksh's equity increased from Rs. 11 cr in 2006 to Rs. 81 cr in 2016. 


Discounted Cash Flow method is widely used for valuing a company. I'll use Prudent Banker Approach explained by Prof Bakshi in one of his post - VANTAGE POINT: 8 POINTS OF VIEW FOR EVALUATING A STOCK to value Eimco Elecon. 

Average CFO for Eimco Elecon over 5 years: Rs. 27 cr. (from cash flow statement)
Cash & Investment in mutual funds/stocks at the end of FY2016: Rs. 115 cr.  (from balance sheet)

A prudent banker will be comfortable lending to Eimco if CFO can comfortably cover the interest portion. Typically prudent banker wouldn’t want the interest burden to be more than 1/3rd of CFO. Hence, the annual interest expense should be upto Rs. 9 cr. Assuming an interest rate of 12%, max. loan value would be Rs. 75 cr.

If Eimco Elecon borrows Rs. 75 cr, the overall cash position will improve from Rs. 115 cr to Rs. 190 cr (115+75). Eimco Elecon has outstanding shares of 0.6 cr. 

New cash & equivalent per share = (190 / 0.6) = Rs. 317

A value investor will be delighted to buy Eimco Elecon if the share price is below Rs. 317 with serviceable debt on the books. Here, the underlying assumption is that Eimco Elecon will produce similar cash flows from operations as it did in last 5 years. Any improvement in CFO will increase the intrinsic value of the business. 

Let’s also see in how many years, Eimco Elecon will be able to repay the loan.

Assuming PAT goes towards settling debt, Eimco will be able to repay the loan in 5 years.  

Cash Flow Ratios:

1. FCF/CFO: This ratio measures the Capex requirements of the business. If FCF/CFO is high, business doesn't need significant Capex. 

a) FCF/CFO of Eimco Elecon over last 10 year period is 81%. This means only 19% of the CFO has gone into Capex.

b) FCF/CFO of AIA Engineering is 56%. AIA Engineering seems more capital intensive business than Eimco. 

2. CFO to Net Sales: This ratio compares a company's operating cash flow to sales which indicates company's ability to turn sales into cash.

a) CFO/Sales for Eimco Elecon over last 10 year period is 12.5%

b) CFO/Sales of AIA Engineering over last 10 year period is 14.5% 


Cash is the only reality in a business; rest all is hope. An investor should spend good time to understand the cash position of the company. 


All data has been taken from public sources. I don't have any financial interest in AIA Engineering and Aksh Optifibre or any of their affiliates. I own Eimco Elecon shares and my views in the article may be biased. I may or may not invest in companies discussed in the article or any of their affiliates in future. An investor should do her own analysis before making an investment decision. The views expressed are personal and doesn't represent that of my employer’s.

This article is just a collection of my thoughts. 

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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