Usually, the higher a company’s cash flow, the better. That’s because companies can use their cash flow to grow by investing in plant and equipment or by making acquisitions. Companies can also use their cash flow to reward their shareholders with dividends or share buybacks. Or companies can use their cash flow to repay debt or avoid debt entirely. Low debt or no debt reduces their risk, of course.
When we calculate a company’s cash flow from operations, we exclude changes in current assets and current liabilities. Under this system of measuring cash flow, the higher the cash flow the better.
But some companies include changes in current assets and liabilities when calculating cash flow. We think including changes in current assets and liabilities may mislead you. After all, firms that do well often find their current assets increase, which reduces their cash flow. By contrast, firms that do poorly often end up with lower current assets, which increases their cash flow. Looked at this way, lower reported cash flow can be better.
Growing operations require cash
Let’s compare, for example, two firms that manufacture widgets. Firm One is booming. In fact, its sales of digital widgets doubled from $100 to $200 in 2014. Firm Two’s sales of analog widgets, by contrast, fell by half, from $100 to $50.
Let’s say both firms’ receivables total 20 per cent of their sales. This means Firm One’s receivables will have increased from $20 at the start of 2014 to $40 at the beginning of this year. These higher receivables will have used up an extra $20 of cash. Meanwhile, Firm Two’s receivables will have fallen from $20 to $10. This frees up $10 of cash.
Let’s also say both firms keep inventory at half their sales. Firm One’s inventory will have increased from $50 at the start of 2014 to $100 at the start of 2015. This higher level of inventory will have used up $50 cash. Firm Two, by contrast, will now only need $25 of inventory. This will free up $25 of cash.
In this example, Firm One will have put $70 cash into its growing operations ($20 in receivables plus $50 in inventory). Firm Two, by contrast, will find its shrinking working capital needs will have freed up $35 ($10 from receivables and $25 of inventory).
What this means is that Firm One’s reported cash flow will likely come in lower than Firm Two’s, if you choose to include changes in current assets.
Calculating cash flow this way could give unsuspecting investors the false impression that Firm Two’s higher cash flow means that it’s doing better than Firm One.
To side-step this problem, we calculate cash flow excluding changes in current assets and liabilities. You, too, should exclude changes in current assets and liabilities when calculating cash flow. But at the same time, rely on common sense.
Use common sense when calculating cash flow
It’s best to know why changes in current assets and liabilities occur. Say a firm has moved to ‘just-in-time’ manufacturing. Under this system, supplies are brought to a factory just in time to make a few more units. This, of course, means less cash is tied up in supplies and inventory. Cash is freed up from greater efficiency, not from a slowdown in sales.
Increasing inventory, by contrast, can indicate that a lot of it may only sell at marked-down prices, which squeezes profit margins.
Similarly, a firm may extend less credit if there’s an increasing likelihood that customers will fail. In this case, lower investment in receivables stems from prudence rather than a drop-off in orders.
By contrast, rising receivables may indicate more bad debts instead of growing operations.
In short, it’s best to use your common sense when you examine changes in current assets and current liabilities.
The Investment Reporter, MPL Communications Inc.
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