Stock valuation: measuring cash flow

Usually, the higher a company’s cash flow, the better. But in the case of growing companies, lower cash flow from total operating activities may be better.

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.

Growing operations require cash

Let’s compare, for example, two hypothetical companies that manufacture widgets. Digital Widgets is booming. In fact, its sales of widgets have doubled from $100,000 to $200,000 in 2016. Analog Widgets’ sales, on the other hand, have fallen by 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 will have increased from $20,000 at the start of 2016 to $40,000 at the beginning of this year. These higher receivables will have used up an extra $20,000 of cash. Meanwhile, Analog Widgets’ receivables will have fallen from $20,000 to $10,000. This frees up $10,000 of cash.

Let’s also say both companies maintain inventory at half of sales. Digital Widgets’ inventory will have increased from $50,000 at the start of 2016 to $100,000 at the start of 2017. This higher level of inventory will have used up $50,000 cash. Analog Widgets, by contrast, will now only need $25,000 of inventory. This will free up $25,000 of cash.

In this example, Digital Widgets will have put $70,000 cash into its growing operations ($20,000 in receivables plus $50,000 in inventory). Analog Widgets, on the other hand, will find its 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—once 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 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 flows. But at the same time, rely on common sense.

Use common sense when measuring cash flow

As we noted above, some companies include changes in current assets and current liabilities when they measure cash flow. With this method, lower cash flow can be better than higher cash flow. This is true when a company puts cash flow into its growing operations.

Still, it’s best 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, it’s best to use some common sense when you examine changes in current assets and current liabilities.

 

This is an edited version of an article that was originally published for subscribers in the February 13, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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