Friday, November 21, 2014

BASICS FOR BEGINNERS ...

Operating Cash Flow: Better Than Net Income?

Courtesy : Investopedia


Operating Cash Flow is the lifeblood of a company and the most important barometer that investors have. Although many investors gravitate toward net income, operating cash flow is a better metric of a company's financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, "cash is king" and a company that does not generate cash over the long term is on its deathbed. 

But operating cash flow doesn't mean EBITDA  (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working Capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.
Overview of the Statement of Cash Flows
The statement of cash flows for non-financial companies consists of three main parts:


  • Operating flows - The net cash generated from operations (net income and changes in working capital).
  • Investing flows - The net result of capital expenditures, investments, acquisitions, etc.
  • Financing flows - The net result of raising cash to fund the other flows or repaying debt.
By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting   to cash accounting that makes the operating cash flow statement so important.
Accrual Accounting vs. Cash Flows
The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows:


  • Cash is used to make inventory.
  • Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay).
  • Cash is received when the customer pays (which also reduces receivables).
There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a build up of receivables) and for inventory levels to rise because the product is not selling or is being returned. 
 For example, a company may legitimately record a $1 million sale but, because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable. 
  
Harder to Fudge Operating Cash Flows 

Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits.

An example of income manipulation is called "stuffing the channel" To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.)
The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem.
Cash Exaggerations
While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).

Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent.
Cash Is King
A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay the piper, suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs.

The Bottom Line
Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but you'll need to do it, because the talking heads and analysts are all too often focused on EPS.

63 comments :

  1. Sir,
    What is the indicator for identifying this character?

    ReplyDelete
  2. Dear Mr.VP
    Very much useful information to small investors as an education. Your efforts are great with out looking any return..
    with ergards

    ReplyDelete
  3. sir govt banning PET bottles use in medicine field n it has to be in glass packing...ur take on it n its imppact on POLYPLEX

    ReplyDelete
    Replies
    1. Since company's major product category is different , not expecting much impact due to this reason. More than that its operations are not limited within India.

      Delete
  4. Sir,
    I see a ID named "VALUE-PICKS" in money control MMb , is that you sir ? can we follow there ?

    ReplyDelete
  5. Sir, to understand better by an example, from the below figures of a company, can I assume that they have good cash flow since net cash from operating activities is Rs.33.90 crores.

    Net Profit Before Tax : 38.42 (all fig. in crores)

    Net Cash From Operating Activities : 33.90

    Net Cash (used in)/from Investing Activities : -39.75

    Net Cash (used in)/from Financing Activities : 5.90

    Net (decrease)/increase In Cash and Cash Equivalents : 0.05

    Opening Cash & Cash Equivalents : 1.33

    ReplyDelete
    Replies
    1. Operating Cash flow is the most important

      Delete
  6. Dear VP sir,
    Can u pls comment on marico kaya. Is it still a buy? As the company is cash rich. Has lot of expansion possibilities.. And company has made a turn around with 15% NP on Top line.
    Well know promoters. Only listed company from its space.
    I would like to know ur view on earnings going forward whether 15% NP margin can be maintained by company?
    Can we invest for long term??
    Disc: I already bought the stock at 300. Would like to add more.
    Pls reply.

    ReplyDelete
    Replies
    1. At the time of listing itself, I have expressed my positive view on this stock

      Delete
  7. I also used to focus only on EPS. This article changed my view. Thanks a lot for this write up.

    ReplyDelete
  8. Sir.. Does the company release cash flow statement in every quarter with financial results statement? Where can I find these numbers?

    ReplyDelete
  9. Thanks Sir,
    Thanks for sharing you valuable information for the freshers entering the share market.... It is very useful...

    ReplyDelete
  10. I was going through Forbes Company and just checked its net cash flow .. It turned from negative to positive after 2-3 years . does that mean the company is in good health and ready for expansion .

    Anyways the company had tied up with Lux International for Vaccum Cleaners and they have orders from government and Railways for purifiers and cleaning activities .

    Engineering and Shipping Business is also picking up and Forbes Technosys is also doing good and has a good future ahead .

    Do you find value in the stock and I have invested in it from last one year around 550 levels ..

    Regards

    ReplyDelete
  11. Dear VP,
    your comment on -
    http://economictimes.indiatimes.com/news/economy/agriculture/foray-into-food-processing-business-kaveri-seed-promoters-plan-stake-sale/articleshow/45237225.cms

    please.
    thanks.

    ReplyDelete
    Replies
    1. Let us hope their concentration will not divert.

      Delete
  12. Dear VP

    your view on Gulshan polyols

    ReplyDelete
  13. Dear VP

    your view on Gufic Bio and Arvind Remedies

    ReplyDelete
  14. dear what is ur view on Dishman pharma and morepen labs?

    ReplyDelete
    Replies
    1. Please check morepen labs. i guess it will be a turnaround story with reduction in debts every year. and after so many yrs they have posted a profitable result. the cmp is 11.30.

      Delete
  15. Dear Sir

    What are your views on CMI FPE ? Is it a turnaround story ?

    Regards

    ReplyDelete
    Replies
    1. Expecting turnaround with revival in Core sector.

      Delete
  16. Sir, I am not having ID but hope you will publish my query.As far i remember you were super bullish on Arrow Coated and also you are super bullish on SKM Egg products.I am holding only Arrow coated,i want to know whether i should sell some arrow coated shares and buy skm egg or not.which business you are more bullish on for the long term.I hope other readers will also be benefetted from your reply.this is my humble request to you.

    ReplyDelete
    Replies
    1. Both are good. Arrow coated already turned as a 28 bagger from recommended level .If you are not interested to take much higher level of risk , may think about selling part and investing in SKM

      Delete
  17. Sir, This is some fantastic learning for us.

    I request your views on two companies (a) your old recommendation - Sundaram Brake Linings. Do you see multi-bagger returns from here given that they have now put the FX swap related issues with ICICI behind them and also beacuse the auto components industry is booming. (b) Marico Kaya Enterprises - niche business, only listed entity in the space and good promoters with integrity and vision.

    ReplyDelete
    Replies
    1. I hope Sundaram break will turn around in another few quarter. Don't think each and every listed company will turn as multibagger. For creating a balanced portfolio we should include stocks with different risk return ratio proportionately in our portfolio .If you are including one high risk bet ,there should be some conservative bets too.

      Delete
  18. Dear VP,
    Shall I buy Mafatlal Industries at CMP?

    ReplyDelete
    Replies
    1. Business is not growing as expected earlier , not a compelling buy

      Delete
    2. This can make panic to the investors of Mafatlal Industries... :(

      Delete
  19. Thank you sir for this wonderful article.

    ReplyDelete


  20. GILLANDERS ARBUTHNOT & CO.LTD.

    1





    68.95 -0.50 (-0.72%)





    Dear Sir,
    Would appreciate if you could give your views on GILLANDERS ARBUTHNOT & CO.LTD.
    Thanks

    ReplyDelete
    Replies
    1. View already given , use search option

      Delete
    2. Dear VP Sir,
      When i search it is only displaying the original post. If the name is displayed in comments it is not working using search option. Before it was working.

      regards

      Delete
  21. dear vp sir
    requesting your view about OPTO CIRUCITS YOUR OLD RECOMMENDATION. LOT of small investors like me waiting your valuable advice. currently it is going down from last one year but still we are hoping due to its niche skill. need your advice pls.

    ReplyDelete
    Replies
    1. Later suggested to exit when debt issues started

      Delete
  22. Dear Sir,
    Kindly advise on Nitin spinners. I felt below 3 cases interesting.
    1.Increasing sales YOY.
    2.Decreasing debt level
    3.New capacity addition which will enhance production capacity going forward.

    ReplyDelete
  23. Vp sir can I buy time technoplast at CMP??

    ReplyDelete
    Replies
    1. No idea about its promoters, hence no comments

      Delete
  24. sir ur take on shri renunka sugars at current price 17 for long term...though they have huge debt but ethanol card can play up...

    ReplyDelete
    Replies
    1. Due to policy issues , Sugar sector is turned as a s tricky one .Both Central and Sate Govt's policies impacting.

      Delete
  25. Your views on HOV services after the sell of international stake of parent company do you think company can turnaround and is it worth holding with the agreed sales consideration. Your advise would be valuable. Thanks

    ReplyDelete
  26. Vp sir I am asking these question 7th time. Want to know your view on your old recommendation nath bio gene invested at 147. Your views on the future prospective

    ReplyDelete
    Replies
    1. Answered multiple tines. No change in my previous view on this stock . Try to raise questions with a 'Name'

      Delete
  27. Sir, what is your view on Binani Industries?

    ReplyDelete
  28. Sir can you please give your views on Harrisons Malayalam??

    ReplyDelete
  29. Which one one better
    Deepak fertilisers
    Aditya birla chemicals
    Aarti industries

    Plz do reply

    ReplyDelete
    Replies
    1. Aditya Birla Chem recommended below Rs.90 in the following link . At current price of Rs.245 , neutral on it. Not tracking others.

      http://value-picks.blogspot.in/2012/10/aditya-birla-chemicals-better-times.html

      Delete
  30. Sir, if you can provide you valuable inputs for gulf oil corporation. Thanks

    ReplyDelete
  31. Dear VP,

    What is your point of view on Bosch, Nestle, Britannia, LMW and Pidilite Industries?
    Regards,
    Nitin.

    ReplyDelete
    Replies
    1. All are suitable for long term passive investors,

      Delete
  32. Sir

    What is your opinion about Simmonds Marshal ?

    Subh Rao

    ReplyDelete
    Replies
    1. Already expressed my positive opinion about this company @ Rs.47 , below the posting of 'Capital Trust Update' just 10 days back .Stock already gained about 25 % from that level.

      Delete
  33. Respected Sir,
    I came to know about your blog and unbiased views recently, quite impressed about your service and views on various stocks. Am holding for the last 5 years 2 scripts, Kindly advise your views..
    1. HMVL
    2. INDIA NIPPON ELECTRICALS.
    Thank you sir.

    ReplyDelete
  34. VP sir,
    I am a silent watcher of your blog. Everyday, I open your blog to see the new comments and your advice. You r doing a great job. Hats off to you!
    Can you please give your opinion on Multibase India, triveni turbine and praj industries.
    Thanks in advance.
    Regards,
    afreen

    ReplyDelete
  35. Hi Sir,
    Are you tracking NMDC..it is trading down trend at 140.... your call on SELL/BUY/HOLD ?

    Regards
    Tej

    ReplyDelete

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