Smash, dough, fiddlies, coin, tin, silver, hay, oot, shekels, ice, mazooma, bread, sponduliks, silver—cash has been known by many names over the years. No matter what you call it, cash is the second important concept to think about when you’re investing: cash flow, not just earnings.
The essential reason every investor ought to think about cash flows and not earnings is that the two can diverge significantly. And cash flow is by the far the more important of the two. A company simply cannot survive without cash flow over the long haul.
One simple reason we follow cash flow rather than earnings is for defensive purposes. A company may be reporting nice earnings even though it is not translating those earnings into real cash. That’s a very important reason why following the cash will keep you out of some impending disasters.
Doing that, however, is not as simple as just investing in companies that are generating lots of cash flow. Rapidly growing companies may show nice earnings and poor cash flows for years. And they may still be worth investing in. Nevertheless, the approach in this book emphasizes cash flows. So, typically, a company that consumes a lot of cash is not likely to be a candidate for investment in our approach.
There is another reason to follow cash flows other than just playing defense and avoiding losers. Cash flows can alert you to some real gems that the market is entirely overlooking.
So what is cash flow specifically?
One basic proxy for cash flow is to add non cash charges like depreciation to earnings, then take out capital expenditures. That’s one decent and rough measure of cash flow—though it does not include working capital changes.
Working capital changes include things like changes in inventory and accounts receivable. Such factors can have an impact on cash flow, and it pays to consider them when looking at a company.
When inventory rises, that logically reflects a use of cash. A company with increasing amounts of inventory is tying up money in that inventory. The same with accounts receivable. Accounts receivable is simply money owed to the company for services rendered or product delivered. Higher amounts of accounts receivable tie up cash.
Now, companies don’t have to use only their own cash to fund these things. They have vendors that give them terms. Let’ s say your inventory is lumber, and you’ve gotten 30 – day terms from Lumber Supply. You don’t absorb the whole cost of all the lumber in your inventory: you finance pieces of it. This financing show on financial statements as accounts payable.
When we take accounts receivable and inventory and subtract accounts payable, we get a number called working capital.
Working capital changes are important and real, and as mentioned earlier, they have an impact on cash flow. Rising working capital requirements absorb cash. You can find all of these numbers on the balance sheet.
Expect these numbers to grow over time with sales and earnings. Inventory and accounts receivable rising faster than sales could be a warning sign. Old inventory may be piling up, or the company may have sloppy inventory controls. Accounts receivable may be rising because the company is booking sales by giving easy terms but finding it more difficult to convert those sales to cash.
These are issues to think about. There are no easy ways to sort them out, and no pat numbers to use. You have to make comparisons to other companies in the same industry and try to understand what is going on in the business. There may be perfectly legitimate reasons for the patterns in a company’s cash flow; you just have to find them out.
Are you disappointed by this conclusion? Perhaps you’re reading this and saying, “Well, this is all well and good, but I can’t use this. I don’t know what to do or how to start. . . .”
Unfortunately, there are no easy answers. You’ll just have to get used to looking at financial statements—income statements, balance sheets, and cash flows. And maybe more importantly, you’ll have to get used to asking and thinking about these questions.
As an investor, you hold all the cards. If a company’s finances are too hard to understand and you’re not sure what to do to understand them better, then you can pass and look for another company. I tell my readers often: Never feel rushed to invest. The stock market will be here tomorrow and the day after, and for a long time after that.
Anyway, you can use the basic proxy of net income plus non cash items (depreciation and amortization) less capital expenditures with the previous comments in mind. What are capital expenditures? They are investments the company makes in its own business. Capital expenditures are often disclosed in press releases. In financial statements, you’ll find the number in the statement of cash flows, under investing activities, usually called something like “capital expenditures” or “addition to fixed investments.”
This number has two components; neither is usually disclosed, but both are worth considering. The first component is ongoing maintenance. Every company has to plow a certain amount of money back into the business. The second component is funding for growth or expansion. The considerable amount of money that some companies spend on expansion efforts can make their cash flow numbers look worse than they are. That’s because money invested for expansion is obviously discretionary. That is, management didn’t have to spend it, but they chose to, perhaps for very good reasons.
Some investors have a bias against companies or businesses that require high levels of capital expenditures and don’t want to own “capital-intensive” businesses. I think this bias is not wise. What is more important is whether the business is making—or is reasonably likely to make—a good return on its investments.
Plus, the overlooked aspect of a capital-intensive business is that the high level of capital expenditures required can be adeterrent against new competition, which has to invest so much to get started.
A frequent modification made to the cash flow calculation is to also add back interest expense and taxes. Then you get the infamous EBITDA: earnings before interest, taxes, depreciation, and amortization. I say “infamous” because during the bubble years of the late nineties many companies and analysts abused this ratio and started to focus on it to the exclusion of the other real factors that I’ve already mentioned—things like capital expenditures and working capital.
So EBITDA got a bad name. But as long as you understand its limitations, it is useful in comparing companies and looking for bargains.
Why, you may wonder, do you add back interest expense when calculating EBIDTA? Well, you add back interest expense because you are going to use it to compare firms based on enterprise value. Remember, in the EV calculation you’ve included net debt. Some firms have debt and some don’t. If you don’t also add back interest expense to get EBITDA, you’ll get a distorted view. You have to add back interest expense to earnings so that you are comparing apples to apples. For the same reason, you add back taxes, primarily because debt levels have an impact on taxes, since interest is tax-deductible. By adding these two things back, you can reasonably compare different businesses in the same industry without allowing financing decisions—such as how much debt to carry—to colour the basic profitability comparison.
