Investment strategy: measuring cash flow properly

Usually, the higher a company’s cash flow, the better. But in the case of growing companies, lower cash flow from total operating activities is better. Sometimes strategic investing requires using your common sense.

When we calculate a company’s cash flow from operations, we exclude changes in working capital. That is, we exclude changes in current assets and current liabilities. Under this system of measuring cash flow, the higher the cash flow the better.

Some companies include changes in current assets and liabilities when they calculate their cash flow. We think that doing this may mislead some investors. After all, companies that do well and are growing often find that their current assets rise, which consumes part of their cash flow. By contrast, companies that do poorly and are shrinking often end up with lower current assets, which increases their cash flow. Looked at this way, lower cash flow can be better.

Investment strategy requires understanding use of cash

Let’s compare, for example, two hypothetical companies that manufacture widgets. Digital Widgets is booming. In fact, its sales of widgets doubled from $100,000 to $200,000 in 2014. Analog Widgets’ sales, on the other hand, fell by a half, from $100,000 to $50,000. Fewer customers want analog products these days.

Let’s say both companies’ accounts receivable total 20 per cent of their sales. This means Digital Widgets’ receivables increased from $20,000 at the start of 2014 to $40,000 at the beginning of this year. These higher receivables used up an extra $20,000 of the cash. Meanwhile, Analog Widgets’ receivables fell from $20,000 to $10,000. This freed up an extra $10,000 of cash.

Let’s also say both companies maintain inventory at half of sales. Digital Widgets’ inventory increased from $50,000 at the start of 2014 to $100,000 at the start of 2015. This higher level of inventory used up $50,000 of cash. Analog Widgets, by contrast needed only $25,000 of inventory. This freed up $25,000 of cash.

In this example, Digital Widgets has put $70,000 cash into its growing operations ($20,000 in receivables plus $50,000 in inventory). Analog Widgets, on the other hand, with shrinking working capital needs, will have freed up $35,000 ($10,000 from receivables and $25,000 of inventory).

What this means, of course, is that Digital Widgets’ cash flow will likely come in lower than that of Analog Widgets—if you include changes in current assets. Measuring cash flow this way could give unsuspecting investors the false impression that Analog Widgets’ higher cash flow means that it is doing better than Digital Widgets.

To avoid 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 flows. But at the same time, it pays to use common sense when you examine cash flow from operations.

A strategic investor will ask: Why did changes occur?

So we’ve noted that some companies include changes in current assets and current liabilities when they measure their cash flow. We also pointed out that with this method, lower cash flow can be better than higher cash flow.

But it’s also good to know why changes in current assets and liabilities occur. Say a company 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 its more efficient use, not from a slowdown in sales.

Increasing inventory, by contrast, could mean that a lot of it may only sell at marked-down prices, which squeezes profit margins.

Similarly, a company 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, your set of strategic investing rules should include using your own good common sense when you examine changes in current assets and current liabilities.

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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