“Profit is opinion. Cash is fact”

Whilst the quote is probably a little harsh, it draws from the fact that there is some discretion as to how profit is determined, but it is very difficult (although not impossible) to manipulate cash. Another quote along the same vein is “Revenue is vanity, profit is sanity, but cash is king.”

Investors evaluating a stock should look carefully at cash flow as well as considering profit. Cash flow can be measured in a number of ways, but the two most important are operating cash flow and free cash flow (FCF).

Operating cash flow refers to the cash that is generated through the normal operations of the business. Free cash flow is operating cash flow minus capital expenditure. It is the cash left over after a business has paid all its expenses and made the necessary investments to ensure its future and growth. This left over cash can then be used to pay down debt, increase the bank balance or pay dividends to shareholders.

Accounting standards allow for some measure of interpretation when determining certain revenue and expense items. Without getting too technical, it is largely due to the notion of accrual accounting. Accrual accounting requires that revenue be recorded in the period it was earned, which is not necessarily the same as when the cash was received. Likewise expenses should be recorded in the period they were incurred rather than when the cash may have been paid.

How this plays out in practice varies considerably across different types of businesses. Consider for example Coles (ASX:COL). As a supermarket, cash is received at the point of sale, and so revenue and cash receipts are recognised at the same time. Contrast this with Shine Justice (ASX:SHJ). Shine are a law firm that manage compensation claims as well as class actions. They operate on a no win - no fee basis. In practice it can take a year or two from the time the work is performed until the cash is received and in some cases it will never be received. Nevertheless, revenue is still recognised at the time the work is performed, so the revenue amount is based on assumptions as to the likely win rate. There is a risk that those assumptions may turn out to be incorrect.

FCF is harder to manipulate than profits. Cash has to be reconciled back to the bank account. Auditors can quickly verify it.

Profit, on the other hand, is subject to a range of adjustment. Whilst most of them are legitimate adjustments and serve a useful purpose, there is also the possibility of small or significant manipulation. Revenue can be brought forward to boost profit, by billing for work that has not been completed, or even raising false invoices. Expenses that should be accrued for can be deferred to the following period.

Strong FCF data is a sign of a healthy business, but it is important to understand that cash flow often fluctuates from period to period. There are often legitimate reasons for this. For example, in 2022, many companies were struggling with supply chain problems. To compensate for this, they ordered larger amounts of inventory. This meant that cash decreased and inventory increased. Provided they then sold that inventory, the cash was then recovered and it was a sound business decision. If this took place across the year end, one year may have lower operating cash flow but it should then be higher in the next period. (Some companies ordered too much inventory and ended up having to sell it very cheaply or take writedowns.)

Due to this variability in cash flow from period to period, it is helpful to look at cash flow over a longer period such as five years. A useful analysis is to add up the operating cash flow over the five years. Then add up the reported profits over the same period. The two totals should preferably be close to each other. Divide the total operating cash flow by total reported profit. If the ratio is above 0.8 it is a fairly strong company.

There is also an operating cash flow to earnings per share ratio available in the screener. It is calculated on a trailing twelve month basis and can be used to help find companies that are generating good cash flow right now.

Everyone has heard the saying “cash is King”. Suppliers and staff have to be paid in cash. Interest and debt repayments have to be paid in cash. Lenders will not lend additional funds if they are not confident a business is generating enough free cash flow. This will in turn impact a business’s ability to invest for growth.

Growing free cash flow ensures that:

1. operations are taken care of

2. debt obligations are met

3. the business can invest for future growth

4. dividends can be paid to shareholders.

Ultimately, growing FCF enables a business to reward its shareholders.

An example of a company that has demonstrated impressive FCF growth is Nick Scali (ASX:NCK). FCF per share has grown from $0.18 to $1.54 over the last 5 years.

Dividends have in turn, grown at a compound annual growth rate of 13% per annum and the share price has roughly doubled over the same period. They have been able to invest in the business, opening new stores, buying property for stores and distribution centres and buying the business Plush Sofas.

An example that went the other way is Appen (ASX:APX). FCF peaked in 2020 and then started declining, turning negative in 2022. Dividends were canceled, and don’t even mention the share price.

Companies that are generating strong and growing cash flow are healthy companies. It should come therefore as no surprise that cash flow is a component of the Quality score.

Those who can remember the global financial crisis may recall a stock called Babcock & Brown. It was a very hot stock for a while. I looked at it and saw how the profits were growing and bought some.

It soon started to go down. I was reading the financial statements and going over the cash flow statement. I notice that they were producing negative operating cash flow, ie. Cash expenses exceeded cash receipts. I concluded that it was a complex business and I didn’t understand it properly. In fact, the only thing complex was their creative accounting. The reality was they were burning cash and they soon went broke. And I lost my investment.

I’ve never made that mistake again and always keep a close eye on cash generation.

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