Interpreting the operating cash conversion ratio

Turning operating profits into operating cash flow is a desirable characteristic of companies.

Does it mean that an operating cash conversion ratio of more than 100% is a sign that you have found a great business?   Answer:  It is not as simple as this.  It doesn't mean that a company will go on to produce lots of free cash flow.

1.  Companies that have lots of fixed assets

Examples:  manufacturers, hotels, oil explorers, miners or utility networks

These will tend to have very big depreciation expenses, which boost their operating cash flow when these expenses are added back to operating profit.   This will tend to give these sorts of companies a high operating cash conversion ratio (>100%),

You can spot such companies by looking at the ratio between depreciation and operating cash flow, this is usually high at > 30%.

                   Depreciation / operating cash flow > 30%

When you come across a company with high levels of operating cash conversion ratio always calculate the depreciation and amortization expenses as a percentage of operating cash flow as well.  As a rule of thumb, avoid companies with a depreciation to operating cash flow ratio of more than 30%, because this tends to mean that at least 30% of operating cash flow will have to be spent maintaining assets.

Good companies are ones that don't need to spend a lot of money to grow.   When it comes to operating cash conversion, you are better off looking for high conversion rates (>100%)  and low depreciation to operating cash flow ratios (<30%).  

2.  Changes in working capital

Look at the amount of cash flowing out of a business due to changes in working capital - inventory, debtors and creditors.  High levels can be a sign of financial distress or aggressive accounting.

Inventory

With inventory, a rising level sees cash flowing out of the company.  This is usually fine if the company is building them up in anticipation of extra sales, but if it becomes a trend or is not due to higher anticipated future sales, it could be a sign of trouble.  If a company has too many inventory, it might have to reduce its selling prices to get rid of them, which will reduce future profits.

Stock or inventory ratio = inventory / revenue x 100%

A rising inventory ratio can be a sign of company weakness.  

Inventory levels are particularly relevant for manufacturing and retailing companies and need to be watched closely.

Debtors

If you are looking for signs of aggressive accounting, then the debtors number in the cash flow statement is something you should be keeping an eye on.

A company can grow its turnover quickly b giving customers generous credit terms.  This means that a sale can be booked in the income statement but the company will have to wait longer to be paid.  Sometimes, the cash is never received.

A cash outflow from debtors is not necessarily a problem and is expected from a company that is growing.  But if this is accompanied by a rise in the debtor ratio, then it can be a sign that something is amiss. 

Debtor ratio = Trade debtors / Revenues x 100%.

A big outflow of cash from debtors (looking at its operating cash flow) and a big increase in the debtor ratio are warning signs to be heeded.

Creditors

When it comes to cash outflows from changes in creditors, you need to be wary of very big changes.   This is telling you that a company's suppliers are demanding faster payment.  Why?  This could be a sign of a loss of buying power, a weakness in the financial position of the company or even imminent bankruptcy.

Summary

High quality companies convert their operating profits into operating cash flow.  

They do it without having large depreciation expenses or big cash outflows from working capital.

These are the initial steps to a company producing lots of free cash flow.

The next most important step is a company having low capex requirements.

Calculating Net Operating Cash Flow number

Calculating Net Operating Cash Flow number 

CASH FLOW STATEMENT

Operating Activities

Net Income before Extraordinaries

+ Depreciation, Depletion & Amortization

+ Other Funds

__________________________________

Funds from Operations

+/-  Changes in Working Capital

Receivables

Inventories

Accounts Payable

+/- Other Assets/Liabilities

__________________________________

Net Operating Cash Flow

Main adjustments when calculating the Net Operating Cash Flow number are:

1.  Depreciation and Amortization

This reduced the operating profits in the income statement, but, as it is not a cash flow, it is added back to operating cash flow.

2.  Profit/losses on disposals.  

A profit or loss on the sale (disposal) of an asset compared to the asset's value on the balance sheet (or book value).  The cash received from the sale is included in the investing section of the cash flow statement.   The profit or loss on the sale is included in the operating profit.  The profit or loss (the difference between the cash received and the asset value on the balance sheet) is used to adjust the company's operating cash flow.  A loss is added back to operating profit and a profit is taken away.

3.  Increases/decreases in debtors (sales made on credit).

If a company is growing its sales then often its outstanding debtors will grow as well.   If debtors grow faster than sales, then the company is giving more credit to its customers - not ideal.  If debtors goes down compared to sales then the company is tightening its credit - perhaps by chasing debtors harder.  This affects operating cash flow but does not affect operating profit.

4.  Increases/ decreases in creditors (purchases made on credit_

Companies can make purchases on credit.   This increases their trade creditors balance.  The balance will decrease as payments are made.   An increase in this balance means that the company gets a temporary cash benefit to operating cash flow.  If the balance reduces - if suppliers want paying faster - cash flows out of the company which reduces operating cash flow.

5.  Increases/decreases in stock levels (inventory)

Building up inventory requires cash to be spent.  If more stock is added than is sold, a company's inventory balances will increase and this will show as a cash flow out of the company and reduced operating cash flow.  It will not affect operating profit.  If a company is selling its inventory faster than it is buying raw material, this balance will decrease and the change will be shown as a cash flow added back to operating profit.  Operating with inventory levels that are too low can generate expensive problems, example, when there is a sudden dramatic increase in demand.   In general, expect inventory levels to go up and down with sales levels.

6.  Amount paid into a final salary pension fund is more/less than pension cost expensed in the income statement.  

In recent years, final salary pension schemes have become problematic for some companies as the money in the pension fund has not been enough to pay the promised pensions in the future.  This has meant that cash top up payments in excess of the regular expense have been required.  This is shown by a reduction in a company's operating cash flow and is a deduction from the starting operating profit figure.   

Changes in working capital (Receivables, Inventories and Accounts Payable)

Working capital refers to the amount of cash a company needs to undertake its day-to-day activities.  

If working capital is increasing, then this shows the amount of cash a company might need to borrow - from a bank overdraft facility - to finance its day-to-day activities as it waits for cash to flow in.   The smaller a company's working capital requirement, the better its cash flow and financial position tends to be.

Working Capital Management Principal and Approaches

Improve Cash Flow - Part 2 of 2

Previously we looked at generating cash from operations, capital expenditure and financing.  Here, we look at working capital.  This is a measure of the operating efficiency and liquidity of a business.

Working capital is the difference between current assets and current liabilities.  In other words the amount of cash required to finance inventory and trade receivables net of trade payables.  Cash tied up in inventory or money owed by customers cannot be used to pay short-term obligations, and therefore businesses need to release cash from these sources where possible.

Minimize inventory levels.
There are many methods of inventory management.  A well known technique is JIT ("just-in-time"), used mainly in manufacturing.   Goods are produced only to meet customer demand.  All inventory arrives from suppliers just in time for the next stage in the production process.  This technique minimizes inventory levels.

Minimize and control cash owed by customers.
It is important to follow procedures and be organized in collecting customer debts.  

Maximize the payment period to suppliers.
Delaying payments to suppliers will not generate cash but it will delay its outflow.  Many businesses use supplier credit as a source of finance.  Large and powerful customers are often accused of dictating extended payment terms, which add pressure to a small business's cash flow.  Extended credit should be negotiated as opposed to taken, to avoid problems in the future.  Businesses rely on their suppliers to keep their operations flowing, so payment terms should always be agreed in advance.

"Creditors have better memories than debtors; creditors are a superstitious sect, great observers of set days and times!"

Release working capital to pay short-term obligations.

Operating Profit before Working Capital changes vs. Operating Cash Flow

Proton's Cash Flow Details

National car maker Proton Holdings Bhd should provide more details in its quarterly cash flow statement instead of just a summary.

Although the condensed statement did show the amount of cash flow generated from operations (operating cash flow), it didn't present the "operating profit before working capital changes", or spell out in detail how the operating cash flow was derived.

There is a huge difference between operating profit before working capital changes and operating cash flow.

Operating profit before working capital changes: This indicates the very basic operating cash flow scenario of a company, with the assumption that payments to suppliers are made on time while collection from client for the sale of goods is also received punctually.

A negative operating profit before working capital chagnes spells trouble for the viability of a company's operations. It means the company has to pour in cash to sustain its operations instead of generating cash from the operations.

The non-disclosure of operating profit before working capital changes denies investors an important piece of information. This is because companies could bump up their operating cash flow by adjusting their working capital, by delaying payment to suppliers or expediting the receipt of cash from customers.

These may blur investors' judgment about the basic health of the business or when they seek to compare the actual operating situation with the previous corresponding period.

Cash flow is the lifeblood of a busines, which is especially important in tough times. In order to give the public a better picture of its operating condition, Proton should present its quarterly cash flow statement in detail.





The Edge Malaysia June 8, 2009