Earnings are not equivalent to cash flows

These metrics rely  on reported profits or earnings rather than cash flows:

P/E

P/EBITDA

P/S

P/BV

EV/EBITDA

Profits may not reflect the actual underlying cash flows.

Some examples:

1.  Interest paid on perpetual securities (perps)  

• These are not considered interest expense, thereby inflating profits.  
• At the same time, accounting for perps as equity also understates the company's actual gearing.

2.  Companies can capitalise interest expense as assets in certain circumstances

• Interests during construction of assets or when property developers borrow to purchase land for future development.  
• This would understate expenses and inflate profits and book value.

3.  Companies can be in total compliance with financial reporting standards but still be misleading

• A company is allowed to recognise construction revenue from in-house concessionaires based on estimated fair values of future income streams under the long-term agreements.  This revenue is recorded as financial receivables/intangible assets on the balance sheet.  
• When the concession asset commences operation, cash flows generated from the asset are recognised as sales, while the operating costs include amortisation of the financial receivables/intangible assets.  
• Basically, companies report earnings even when there is no cash flow during the construction period, and then actual cash flows are higher than reported earnings when the asset is in operation.  
• In short, reported earnings have little relationship to the actual cash flows.

It is far easier to manipulate profits than cash flows, unless the bank statements are also falsified.

Management faked sales invoices or "pre-billings" 

• This is to inflate sales, Ebitda, profits and book values -  to give the impression that the company was worth more than it really was.  
• As such, scrutinising the Cash Flow Statement - which shows the sources and applications of cash, tying the cash balance at the start and end of the financial period - can be more informative than the popular Profit and Loss Statement.

Ignoring the risk of debt

Also, most of these metrics often measure earnings against market capitalisation. 

• For instance, the P/E ratio attributes value to the earnings - but ignores the risks of debt used to generate those earnings.  
• This omission can have serious consequences for investors.
• A company with debts may appear to have more attractive valuations but this come with higher risks, which are not immediately evident and therefore, not properly accounted for, simply by looking at the Profit & Loss statement.  
• When companies have to borrow to service debts, the situation will, often spiral rapidly out of control.

Ref:  Tong's Portfolio 2  It's all a matter of trust

Difficulty of Forecasting Future Cash Flow

Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow 

When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. 

Unfortunately future cash flows are usually uncertain, often highly so.  Moreover, the choice of a discount rate can be somewhat arbitrary. 

These factors together typically make present-value analysis an imprecise and difficult task. 

 

A perfect business that is simple to value: an annuity

A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. 

For real businesses, estimating its future cash flow is usually a guessing game

Real businesses, even the best ones, are unfortunately not annuities. 

Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. 

Small changes in either revenues or expenses cause far greater percentage changes in profits. The number of things that can go wrong greatly exceeds the number that can go right.

Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. 

A recurring theme is that the future is not predictable, except within fairly wide boundaries. 

Business uncertainty - the roles of management and investors

Responding to business uncertainty is the job of corporate management. 

However, controlling or preventing uncertainty is generally beyond management’s ability and should not be expected by investors.  

Cash flow strategies and profits

June 1st, 2020 / By: IFAI / Resources

By Mark E. Battersby

Cash flow is the lifeblood of every business. In fact, according to a recent U.S. Bank study, poor cash flow management causes 82 percent of U.S. business failures. Although seemingly counterintuitive, many experts advise putting cash flow management before profits.

While profits are how a fabrication business survives, a failure to manage the operation’s cash flow can mean running into problems that one profitable accounting period might not be able to offset. Another study, this one by Intuit, revealed that

• 61 percent of small businesses around the world struggle with cash flow and 
• 32 percent are unable to pay vendors, pay back pending loans, or pay themselves or their employees due to cash flow issues.

Cash flow management 101
In essence, cash flow is nothing more than the movement of money in and out of the business. 

• Cash flows into the business from sales of goods, products or services. 
• Money flows out of the business for supplies, raw materials, overhead and salaries in the normal course of business.

An adequate cash flow means a steady flow of money into the business in time to be used to pay those bills. How well the fabricating professional manages the operation’s cash flow can have a significant impact on the bottom-line profits of the business.

Often, an operation’s cash inflows will lag behind its cash outflows, which leaves the business short of money. This shortage, or cash flow gap, represents an excessive outflow of cash that may not be covered by a cash inflow for weeks, months or even years.

Properly managing the operation’s cash flow allows that cash flow gap to be narrowed or closed completely before it reaches the crisis stage. This is usually accomplished by examining the different items that affect the operation’s cash flow—and looking at the various components that directly affect cash flow. This analysis can answer important questions such as the following:

• How much cash does the business have?
• How much cash does the business need to operate and when is it needed?
• Where does the business get its cash and where does it spend it?
• How do the operation’s income and expenses affect the amount of cash needed to operate the business?

Controlling inflow
In a perfect world, there would be a cash inflow, usually from a cash sale, every time there is an outflow of cash. Unfortunately, this occurs very rarely in our imperfect business world, thus the need to manage the cash inflows and outflows of the business.

Obviously, accelerating cash inflows improves overall cash flow. After all, the quicker cash can be collected, the faster the business can spend it. Put another way, accelerating cash flow allows a business to pay its own bills and obligations on time or even earlier than required. It may also allow the business to take advantage of trade discounts offered by suppliers.



Controlling outflow
Outflows are the movement of money out of the business, usually as the result of paying expenses.

• A manufacturing business’s biggest outflow most likely involves the purchase of raw materials and other components needed for the manufacturing process. 
• If the business involves reselling goods, the largest outflow will most likely be for the purchase of inventory. 
• Purchasing fixed assets, paying back loans and paying bills are all cash outflows.

Fabricators can regain control over their operation’s finances by adopting best practices and proper tools. A good first step involves how the operation pays its bills. An important key to improving an operation’s cash flow can be as simple as delaying all outflows of cash as long as possible. Naturally, the operation must meet its outflow obligations on time, but delaying cash outflows makes it possible to maximize the benefits of each dollar in the operation’s own cash flow.

Many credit cards have a cash back bonus program. Even if the program offers only 1 percent cash back, that could equate to a sizable monthly amount for many businesses. Of course, because credit cards tend to have a higher interest rate, they should only be used if the balance can be quickly paid off in full.



Improving invoicing
Improving the invoicing process is another key step in cash flow management. A business can adopt incentive strategies to be paid faster. A business enjoying a 10 percent gross margin that offers a 2 percent rebate in exchange for early payments might not be appropriate. Giving away small extra services, on the other hand, might work. Incentives might include the following:

• Small additional services
• Discounts for early payments (balances paid before a certain date, or yearly invoice versus monthly)
• Greater flexibility (for instance, a down payment required to book a delivery date)
• Some customers are just late payers and need to be nudged. The way that dunning is handled can, however, greatly affect the collection process. Timing and the quality of message content are the two main factors in the success or failure of these prods.

How the business gets paid not only affects its profitability but also its cash flow.

• Today, paper checks remain the standard method of payment. 
• However, paper checks are slow, highly susceptible to fraud and bear “hidden costs” such as additional work and back- office processing. 
• They are also inadequate for recurring invoicing.

Something as simple as asking customers to switch to electronic funds transfer (EFT) or Automated Clearing House (ACH) payments, and providing incentives to switch, are among the steps that can ensure faster, more secure, more reliable and cheaper payments.



Improving cash flow
Profit doesn’t equate to cash flow because, as mentioned, cash flow and profit are not the same. There are many factors that make up cash flow, such as inventory, taxes, expenses, accounts payable and accounts receivable.

The proper management of cash outflows requires tracking and managing the operation’s liabilities. Managing cash outflows also means following one simple but basic rule: Pay the operation’s bills on time—but never before they are due.

Having a cash reserve can help any fabricating business survive the gaps in cash flow.

• Applying for a line of credit from the bank is one way to build that cash reserve. 
• Once a business is qualified, lenders will grant a predetermined credit limit that can be withdrawn from when needed.

Yet another option might be frugality.  Aim to keep the business lean by constantly evaluating it.

• Is the purchase of new equipment really necessary? 
• Is hiring new employees really cost-effective? 
• Weighing the pros and cons of all business needs and wants enables a business to retain cash flow and avoid unnecessary expenses.

Cash flow gaps
Remember, however, the cash flow gap in most fabrication businesses represents only an outflow of cash that might not be covered by a cash inflow for weeks, months or even years. Any business, large or small, can experience a cash flow gap—it doesn’t necessarily mean the business is in financial trouble.

In fact, some cash flow gaps are created intentionally.  That is, a fabricator will sometimes purposefully spend more cash to achieve some other financial results.  The business might, for example,

• spend extra cash to purchase additional inventory to meet seasonal needs,
• to take advantage of a quantity or 
• early payment discount, or to expand its business.

Cash flow gaps are often filled by external financing sources:

• revolving lines of credit, 
• bank loans and 
• trade credit are just a few external financing options available to most businesses.

Cash flow loans
Cash flow-based loans rely on the value of the operation’s cash flow. 

• If the operation has a strong cash flow stream, it can be used to get significant loan amounts even if there are few business assets. 
• Although cash flow loans can be expensive, they play a key role in a business that is expanding.

An advantage of cash flow loans is the repayment period.

• These loans are usually designed according to the needs of the borrower, with repayment periods often between five and seven years. 
• And, since cash flow loans are different from asset-based loans, rarely does collateral have to be put up.

Flowing cash flows
Assessing the amounts, timing and uncertainty of cash flow is the most basic objective of cash flow management.

• Positive cash flow indicates the liquid assets of a business are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against unanticipated financial challenges. 
• The impact of a negative cash flow can be profound, with many businesses operating on margins so thin that frequent lost opportunities will put them on the path to closing their doors.

Obviously, every business can improve its cash flow. Of course, for this to happen businesses need to adopt best practices in the way they invoice, follow up with customers and monitor outflow. With the help of a qualified professional, these cash flow best practices may be easier to achieve.

Mark E. Battersby writes extensively on business, financial and tax-related topics.


https://fabricarchitecturemag.com/2020/06/01/cash-flow-strategies-and-profits/

Warren Buffett Explains Why Book Value Is No Longer Relevant

The Oracle of Omaha on why cash flows are more important than book value
March 03, 2020


For decades, value investors have used book value per share as a tool to assess a stock's value potential.

This approach began with Benjamin Graham. Widely considered to be the father of value investing, Graham taught his students that any stocks trading below book value were attractive investments because the companies offered a wide margin of safety and low level of risk. To this day, many value investors rely on book value as a shortcut for calculating value.



Buffett on book value

Warren Buffett (Trades, Portfolio) is perhaps Graham's best-known student. For years, Buffett used book value, among other measures, to asses a business's net worth. He also used book value growth as a yardstick for calculating Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) value creation.

However, as far back as 2000, the Oracle of Omaha started to move away from book value. He explained why at the 2000 annual meeting of Berkshire shareholders. Responding to a shareholder who asked him for his thoughts on using book value to track changes in intrinsic value, Buffett replied:

"The very best businesses, the really wonderful businesses, require no book value. They — and we are — we want to buy businesses, really, that will deliver more and more cash and not need to retain cash, which is what builds up book value over time...

In our case, when we started with Berkshire, intrinsic value was below book value. Our company was not worth book value in early 1965. You could not have sold the assets for that price that they were carried on the books, you could not have — no one could make a calculation, in terms of future cash flows that would indicate that those assets were worth their carrying value. Now it is true that our businesses are worth a great deal more than book value. And that's occurred gradually over time. So obviously, there are a number of years when our intrinsic value grew greater than our book value to get where we are today...

Whether it's The Washington Post or Coca-Cola or Gillette. It's a factor we ignore. We do look at what a company is able to earn on invested assets and what it can earn on incremental invested assets. But the book value, we do not give a thought to."

It is no secret that value as an investing style has underperformed growth over the past decade. There's no obvious explanation as to why this is the case, but one of the explanations could be that the definition of value is out of date. Buffett's comments from the 2000 annual meeting seem to support this conclusion.



No longer a good measure

Book value was an excellent proxy for value when companies relied on large asset bases to produce profits. As the economy has shifted away from asset-intensive businesses and more towards knowledge-intensive companies, book value has become less and less relevant.

What's more, as Buffett explained in 2000, book value does not necessarily represent intrinsic value. Just because a stock is trading below its book value does not necessarily mean it is worth said book value.

The same is true of companies trading at a premium to book. The intrinsic value of that business could be significantly higher than book value as book value does not tend to reflect intangible assets.

Investing is an art, not a science, and valuing businesses is not a straightforward process. Investors cannot rely on a simple metric or shortcut to assess value. Many factors contribute to intrinsic value and intrinsic value growth, and using book value as a proxy for intrinsic value is an outdated method. Even in Graham's time, it wasn't always correct.


https://www.gurufocus.com/news/1063604/warren-buffett-explains-why-book-value-is-no-longer-relevant

The Rich Invest for Cash Flow. The Others Aim for Capital Gains.

DECEMBER 8, 2018

Have you lost money or got burnt from an ‘investment’?



Perhaps, you did. It can be painful. The level of hurt or ego bruised depends on how emotionally attached you are with money.

For years, I have received private emails where readers shared their failures on ‘investing’. Many were disappointed. Here, I’ll list down some of their blunders when it comes to ‘investing’:

– I lost 16% from my unit trust investment.

– My stock portfolio is downed by 30% in 6 months.

– I bought Bitcoin when it was US$ 11,000. Now, it is US$ 3,300.

– I am still trying to sell my property. The mortgage is now ‘eating me alive’.



Perhaps, you may share some of the same experiences as mentioned above. If you did, let us think for a moment: ‘Why did you make that ‘investment’ in the first place?’ ‘What was your objective at that point of time?’

Recently, I read a book, ‘Who Took My Money?’, written by Robert Kiyosaki. In Chapter 2, he shared the difference between a person who invest for cash flow and one who invest for capital gains. In most cases, their difference lies in their mindset and words spoken. For instance,



Words of a Cash Flow Investor

– I received an average of 5% dividend yield from my stock investment.

– The gross rental yield from my investment property is 4% per annum.

– ABC Bhd has made RM 0.50 in EPS in 2018, up from RM 0.45 in 2017.



Words of a Capital Gains ‘Investor’

– I bought BCD Bhd at RM 0.50 and sold it for RM 1.00.

– I bought an under construction property for RM 300k and flipped it for RM 500k.

– I expect my unit trust to go up by 8% per annum.



The Common Denominator

As I read, I realised that the common denominator for failures and losses from an investment stems from one’s desire to achieve capital gains. Most made an investment hoping that ‘it will go up’ and not ‘produce cash flows regularly’. It has become a root cause for many heartaches, hurts and even sleepless nights.


How to Reduce Risk Significantly from Your Next Investment?

I believe, one of the answers is to have a greater appreciation of ‘cash flows’. It is cash flow that makes the rich truly rich and the wealthy truly wealthy. Here, I would share how the ultra-rich got themselves richer from the same vehicles of investment that most people invest into today.



Example 1: Who Makes Big Bucks from Unit Trust?

Is it the investors or the companies that are selling unit trust as an investment?

I think the answer is obvious. But, please be mindful that I am not here to start a blame game. Instead, my intention is to explain a major difference in mindset between unit trust investors and unit trust companies.

Think about it. Most bought unit trust because of promises of capital gains over the long-term. Very few, or none at all, is mentioned about its ability to bring in cash flow. Most agents promoted ‘dollar-cost-averaging’ as a smart investment strategy in unit trust. From it, millions of investors poured in millions or billions of Dollars per month into unit trust funds in search of ‘Capital Gains’.

So, what does it mean to unit trust companies?

Answer: Abundance in Cash Flows. First, they earn sales charges from each unit transacted from their investors. Second, they earn annual management fees on their unit trust funds regardless of their performances. If a fund made profits, it pays itself higher fees. If a fund incurred losses, it pays itself lesser fees.

It means, unit trust companies will ‘more or less’ guaranteed themselves stable sources of ‘Cash Flows’ regardless of how their funds performed in the future.

Let us use Public Mutual as an example to illustrate how an ultra-rich looks unit trust as an investment. Apart from sales charges and management fees, I found that a handful of its funds invest their investors’ money into Public Bank. This is brilliant as Public Bank is receiving tons of capital ‘interest-free’, which allows it to be well-capitalised. Hence, to an ultra-rich, unit trust is a Cash Flow Business and an effective vehicle to raise funds consistently.

I am not sure how well you did in your unit trust investments. But, as for Public Mutual, it has achieved CAGR of 15.3% in profits before tax (PBT) over the past 10 years. Its PBT had grown from RM 183.3 million in 2008 to RM 660.9 million in 2017.



Source: Annual Reports of Public Bank Bhd



Example 2: Why Value Investors Like Public Bank Bhd?

Answer: Abundance of Cash Flows.

For a start, most ‘investors’ are not really investing. They are trading, gambling, or speculating. How do I know? Simple. If I asked, ‘Why did you buy the stock?’ and his reply is, ‘I expected it go up because its stock price went up or down by 20% or 30%.’, then I know, chances are, he is a speculator or gambler.

Investors view stocks as businesses. Investing is about being a part-owner of an enterprise. Instead of chasing stock prices, investors read annual reports. Why? Because they want to know, whether or not, the business is profitable and has the capability to generate ‘Cash Flows’ consistently.

Take a look at Public Bank Bhd. Its shareholders’ earnings have grown by CAGR of 8.7%, up from RM 2.6 billion in 2008 to RM 5.5 billion in 2017. If an investor bought shares of Public Bank at the start of 2008 and held it to today, he would have made total returns of 171.5%, consisting of 125.4% in capital gains and as much as 46.1% in dividend yields. Hence, it is ‘Cash Flows’ that leads to ‘Capital Gains’ for a savvy stock investor.


Source: Annual Reports of Public Bank Bhd





Source: Google Finance



Example #3: How to Build Wealth Faster than Flippers?

Let us use two men in their 30s as examples: Tom and Jerry.

Tom is a flipper. He had bought an under-construction property at RM 400,000 with the intention of selling it at RM 600,000 upon receiving his keys to his unit upon completion. 4 years later, he managed to dispose his unit for RM 600,000 after receiving his keys. After deducting a RPGT of 20%, his final gain works out to be RM 160,000. Awesome!

Jerry is an investor. He bought a property for RM 400,000 in a sub-sale market and rents it out for RM 1,400 a month. Based on a DSR calculation of 60%, the amount of monthly instalments Jerry is eligible for has increased by RM 840 a month. Based on the Rule of 200, Jerry’s mortgage eligibility would be revised upwards by another RM 168,000.

Unlike Tom, Jerry is able to ‘cash out’ the RM 168,000 to fund his purchase of a new property almost immediately without the need to sell his current property 4 years later at a higher price. Why? Because Jerry is receiving Cash Flows from his property and bankers are happy to extend mortgages to investors as rent is recognised as one of the viable sources of income.

This explains how property investors are able to keep on buying properties one after another. The answer lies in Good Cash Flow Management.



5 Lessons to be Learnt

In short, I hope that you have a much better appreciation about the differences between cash flow and capital gains and why the rich gets even richer and how most people lost money in their investments. Here, I’ll leave you with 5 lessons that could be learnt from this article:

1. The Rich invests for Cash Flows. The Rest aim for Capital Gains.
2. Never invest just because ‘it will go up.’
3. Many lost money in an investment because of lack of skill, knowledge, and know-how but yet have a desire to achieve capital gains.
4. Capital Gain Investors tend to handover money to Cash Flow Investors.
5. Cash Flows often leads to Sustainable Capital Gains in the long run.

Ian Tai is the founder of Bursaking.com.my, a platform that empowers retail investors to build wealth through ownership of fundamentally solid stocks. It is an essential tool that sifts out stocks that grow profits consistently from a database of over 900+ stocks listed mainly in Malaysia.

https://kclau.com/investment/cashflow/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Kclau+%28KCLau%27s+Money+Tips%29

Forget Profit, Cash Flow is King

Oct. 5, 2011 1:24 a.m. ET

Forget About Profit,

Cash Flow Is King

In the second quarter of 2011, nonfinancial companies in the Standard & Poor's 500-stock index generated $158 billion in cash flow from their operations after accounting for capital spending, a 13.6% increase from a year earlier, according to data gathered by S&P Capital IQ.

The figure also represents a 60.4% increase from the first quarter of 2009, a recent low, as companies navigated the depths of the recession.

That improvement is a testament to the pains U.S. companies have been taking to ensure their cash is coming in more quickly than it's going out.

The ability to generate cash may be the most important measure of a business's health.

Plenty of companies with paper profits have failed because they lacked the cash to keep operating.

At the most basic level, companies improve cash flow by collecting receivables more quickly and paying bills more slowly. If money is going out faster than it's coming in, a company must find a way to fund operations for those days in between.

The choices include cash on hand, bank financing or funds raised in the capital markets. The recent credit crunch threatened to stall even profitable companies because it left the latter two options so badly impaired.

One advantage to tracking cash flow from operations is that it has a clear accounting definition. That means it can be compared on an apples-to-apples basis from company to company.

Cash flow can also serve as the basis for calculating the corporate equivalent of disposable income. Subtracting capital expenditures—or critical investments in things like plants and machinery—from a company's cash flow shows how much of its resources are left available for such purposes as paying dividends, financing buybacks, making acquisition or funding other investments. 

— Matthew Quinn

https://www.wsj.com/articles/SB10001424052970204524604576609740825745286

The distinction between Profit and Cash. A business can be profitable but short of cash.

Cash is completely different from profit, a fact that is not always properly appreciated.

It is possible, and indeed quite common, for a business to be profitable but short of cash.

Among the differences are the following:

1. Money may be collected from customers more slowly (or more quickly) than money is paid to suppliers.
2. Capital expenditure (unless financed by hire purchase or similar means) has an immediate impact on cash.  The effect on profit, by means of depreciation, is spread over a number of years.
3. Taxation, dividends and other payments to owners are an appropriation of profit.  Cash is taken out of the business which may be more or less than the profit.
4. An expanding business will have to spend money on materials, items for sale, wages, etc. before it completes the extra sales and gets paid.  Purchases and expenses come first.  Sales and profit come later.

Focus on cash flow

Investors timely earn returns based on a company's cash-generating ability.

Avoid investments that are not expected to generate adequate cash flow.

How Rich Men Think and Act

Wealth Creation Formula:
The broke buy stuff.
The middle class buy liabilities.
The rich buy assets.

Wall Street Prep Lessons: Cash Flow, DCF, WACC, LBO, M&A, Trading and Transactions

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

DISCOUNTED CASH FLOW (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. 

A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

In 1992, Warren Buffett said that:

‘Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

It is well worth reading Buffet’s analogy relating DCF to a university education in his 1994 Letter to Shareholders.

So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. 

There are formulas for working out discounted cash flows and they can be complex but they give a result.

EXPLANATIONS OF DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.

A good online explanation is available here.

http://www.buffettsecrets.com/price-to-pay.htm

Cash flow 3D

Cash Flow Model of Households

The longer you have to wait and the less certain you are that you'll eventually receive a set of cash flows, the less they are worth to you today.

Cyclicality

Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.

Understand why Cash is King

'Turnover is vanity, profit is sanity, but cash is reality."

The most common reason that businesses fail is not through lack of profit but through lack of cash.  Many failed businesses are highly profitable but run out of cash.


Profitability versus liquidity.

Whereas profitability is the return generated by a business, liquidity is the ability to pay expenses and debts as and when they fall due.  Liquidity is essential for the financial stability of a business.  A failure to manage liquidity may lead to a business being unable to pay its suppliers and debt holders, which may ultimately lead to bankruptcy.

Cash is like oxygen.

A useful analogy is that profit is like food, whereas cash is like oxygen.  The survival 'rule of threes' states that people can survive three weeks without food, three days without water, but only three minutes without oxygen.  Similarly, a business can survive without profit in the short term but cannot survive without cash.  If employees and suppliers aren't paid the business will not survive for long.

When the cash runs dry.

Although this sounds simple, many businesses don't place enough attention on their liquidity.

• Firstly, businesses aren't realistic when predicting their cash income and cash expenses.  Generally, they overestimate income and underestimate expenses. 
• Secondly, not enough businesses regularly forecast cash flow and foresee problems before they arise.  When they run out of cash, it's often too late.

Ideal goals.

Naturally, both a healthy cash flow and high profits is an ideal goal, but in practice it is not that easy.  

• The short-term goal of a business should be to manage cash flow, and 
• the medium- to long-term goal to manage profitability.

Deciding a suitable cash balance.

Businesses should discover their optimum balance of cash flow.  There is a balance between holding enough cash to meet all short-term demands and utilising cash in more profitable investments.  There is thus a trade-off between holding sufficient liquid assets and investing in more profitable assets.

Successful businesses manage cash flow in the short term and profit in the medium to long term.

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.

Improve Cash Flow - Part 1 of 2

How can businesses improve cash flow?  There are several sources of cash for a business.  Here we look at generating cash from operations, capital expenditure and financing.

Generate cash from operations

Ways to increase cash income:

• Find new customers, especially those who are prepared to pay in cash.
• Offer incentives to existing customers to pay in cash.

Ways to reduce cash costs:

• Review expenses for discretionary expenditure.  Ask if items of expenditure, such as first class travel, are really needed.  Can the business survive without them?
• Postpone expenditure - for example, use a web-based video conference instead of travelling to a meeting.
• Try to renegotiate large overheads, such as rent.

Generate cash from or reduce cash on capital expenditure

• Consider delaying the purchase of new assets or extend the replacement cycle of existing assets, such as computers or motor vehicles.
• Renegotiate the price and payment terms for unavoidable capital expenditure.
• Consider leasing new assets or even selling and leasing back existing assets.

Generate cash from financing

• Increasing, extending, or rescheduling bank loans is a key source of cash for businesses.  Banks will often demand assets as security and enforce strict covenants when issuing loans.  The business will need to ensure it can cover interest payments from its cash flow.
• Some businesses 'sell' or 'factor' their customer debts.  Factoring companies will advance cash on outstanding invoices, depending upon the customer, credit terms and risk - for a charge.  This can be an expensive form of finance, and - for small businesses - a trap, as once they start factoring debts it is difficult to break out of the cycle.
• Shareholders may be willing to invest further finance into a business if they can foresee a return.
• Alternatively, some businesses reduce dividend payments to shareholders in difficult times to keep cash within the business. 

"It's easy to get a loan unless you need it!"

Operations, capital expenditure and financing are three key sources of cash.

Valuation Models that better capture the meaning of “fundamental” financial analysis: the cash flow forecast and the discounted cash flow (DCF)

The unbearable lightness of value

As global markets have risen in the past year, some observers are at a loss to reconcile the trend with what they see as still soft fundamentals. At the macroeconomic level, such fundamentals would include unemployment, debt on a variety of levels, deficits of a variety of kinds. At the microeconomic level, fundamentals have to do with free cash flows and the relation between these and the value of a business. Watching global markets rise while fundamentals remain questionable, one wonders if the way we look at fundamentals, at least in the microeconomic sense, is outdated. Without becoming overly dramatic, I wonder if corporate finance theory is losing some of its meaning in an environment in which option value, rather than operating profit, becomes the dominant strain.

There are no models that better capture the meaning of “fundamental” financial analysis than the cash flow forecast and the discounted cash flow (DCF) valuation method that is its close affiliate. And in the DCF method, there is a permanence implied, that nowadays seems increasingly flawed. When a multi-year financial model is created, and when an enterprise valuation is estimated at the end of such a timeframe and discounted back to the present, we have an understanding that the business underlying this exercise will be more or less the same business in the future. For a widget producer, say, while there will be new widget competition, new widget markets, fluctuations in profit margins and economic cycles, it is nevertheless a given – inherent in the financial forecast – that there will always be widgets. The fluctuations are addressed with risk-adjusted discount rates, and with fine-tuned details and line-items, but widget production does not go away.

Yet what business, what industry segment, can we really point to nowadays, and with any confidence determine that its widget manufacture will continue? Ten years ago, we felt pretty good about newspapers, radio, and television. The telephone system. With hindsight, what did those AT&T financial forecasts mean? What do financial forecasts for newspapers and television mean now? I am unfair, I know, choosing my examples from among the vulnerable. We have had a technology revolution, after all… but is this era showing any signs of pause? With rumors going around about cloud computing, might Windows not become a niche product just like landline telephones are quickly becoming?

Media and technology are isolated and extreme cases, I suppose. I guess we could confidently assemble a long term perspective of the energy segment then? Or biotechnology? For that matter, healthcare? Basic manufacturing? There is some degree of permanence in real estate, as roofs over our heads will probably not be rendered obsolete within a 5-year forecast model, but that is sort of a sore subject nowadays, isn’t it… using real estate and financial forecasting in the same phrase together. I mean, considering what happened.

Before anyone jumps to the wrong conclusion in these musings, assuming incorrectly that such thinking is bound to lead to inaction if not downright paralysis, my point is not that value does not exist or is impossible to measure. Pagers had value, newspapers still do. Even Netscape (where is it now?) is discussed today as a success story, and the media sector is not going away. But the financial value in these and other assets, or asset classes, may be seen less through the filter of fundamentals, perhaps, and more on the basis of steps along the way of progress. What emerges, and what has greater value all the time in this affair, is optionality.

Option value: the unknown but real future opportunity that a current business makes possible. According to option theory, option value increase as volatility increases. Perhaps the rise in global financial markets that we have witnessed in the past twelve months, which seems to have occurred even as certain risks have mounted, serves as introduction to a new investor perspective, by which value rises not despite, but because of, uncertainty, fluctuation, and constant change.






http://discourseandnotes.com/blog/2010/03/28/the-unbearable-lightness-of-value-2/

Investing decision: Focus on Cash Flows (FCF & Dividends) rather than Accruals (Earnings)

Investing Decisions

How much should you invest and what assets should you invest in?

Criterion:  To maximise the returns to and wealth of the investors.

The value of the firm is increased by

• cash flows generated by the firm which support the price of the stock or 
• the dividend returned to the owners.

An important characteristic of investing decision is how you approach this problem:  You should focus on the cash flows instead of accruals.

- Expenses vs. Cash Outflows

• Purchase of capital asset

- is not expense
- is cash outflow

• Recognition of depreciation expense

- is expense
- is not cash outflow

-Revenues vs Cash Inflows

• Borrowing funds

-is not revenue
- is cash inflow


Focus of cash flows:  Free Cash Flows and Dividend

rather than

Focus on accruals:  Earnings


The investing decisions by the firm typically have long term consequences to the firm over many years (3 years to 100 years). 

When investing, the investors have a projection of what the future cash inflows and future cash outflows of the firms might be but the investors cannot be certain of these future cash flows.

Therefore, the investors also need to focus on the significant risks associated with this projections of future cash flows when making their investing decision..

Why All Earnings Are Not Equal

Why All Earnings Are Not Equal

By GRETCHEN MORGENSON
Published: January 9, 2010

AFTER a rip-roaring performance in 2009, the stock market has continued its upward climb. A reason to celebrate? Sure. But also a good time to check whether a company in which you have a stake keeps its books in a way that reflects reality.

When the market is roaring and the economy isn’t, executives come under increased pressure to make sure that their companies’ results justify higher valuations. That’s why smart investors keep an eye on them, by scrutinizing how their profits are figured.

Such is the view of Robert A. Olstein, a veteran money manager who dissects financial statements to uncover stocks he thinks other investors are valuing improperly. Since 1995 he has overseen the Olstein All-Cap Value fund, and although he had a horrific 2008 (down 43 percent), his 14-year results exceed the Standard & Poor’s 500-stock index by an average of 3.25 percent annualized, net of fees.

Mr. Olstein’s 2008 troubles have made him more determined than ever to scrub companies’ results. “As the market goes higher, it becomes more important to measure the quality of corporate earnings,” he said. “You have to look behind the numbers.”

Adjustments that investors need to make now, in Mr. Olstein’s view, are a result of disparities between a company’s reported earnings and its excess cash flow. Earnings are what investors focus on, but because these figures include noncash items, based on management estimates, the bottom line may not tell the whole story.

Cash flow, on the other hand, is actual money that a company generates and that its managers can use to invest in the business or pay out to shareholders.


SOME of the widest gulfs between earnings and cash flows, Mr. Olstein said, are showing up the ways companies account for capital expenditures.

To ensure growth, companies invest in things like new facilities or additional equipment. As time goes on, plants and equipment lose value — the way a car does the moment you drive it away from the dealer — and companies are allowed to write off a portion of these values each year based on management estimates of how long they will generate revenue.

The write-offs are known as depreciation, and the more a company chooses to write off, the greater its earnings are reduced. So managers interested in plumping their profits may depreciate less than they otherwise would or should. Conversely, heavy depreciation amounts can make earnings appear more depressed than the company’s cash flows indicate.

“It’s an investor’s job to determine the economic realism of management’s assumptions,” Mr. Olstein said. “There is nothing illegal here, but maybe their depreciation assumptions are unrealistic.”

One way to assess the accuracy of management’s estimates is to compare, over time, how much a company spends on new plant and equipment and how much it deducts in depreciation each year. Some of the discrepancies that emerge can be temporary, caused by the lag time between an initial investment and subsequent write-downs for depreciation.

Companies in a growth phase, for instance, will show greater capital expenditures than depreciation as they increase investments in plant and equipment.

But that should be only temporary. If such discrepancies appear on a company’s books year in and out, then investors might well question the depreciation assumptions. Investors confronted by large disparities should discount those companies’ earnings by the amount of excess capital expenditures. Such an exercise reveals how much free cash flow is available to stockholders.

Conversely, if depreciation exceeds capital expenditures, Mr. Olstein says that the earnings at these companies are actually better than they appear — and that this shows up in the cash flows.

Mr. Olstein has spotted several companies whose depreciation and capital expenditures have shown significant discrepancies in recent years. For some, heavy depreciation schedules are punishing earnings temporarily. At other companies, modest depreciation means earnings look better than cash flows.

Two retailing companies provide examples of how depreciation can hurt earnings but mask solid cash flows. They are Macy’s and Home Depot, and both are coming off recent expansion programs that are still being felt in the financials, Mr. Olstein said. He owns both in his fund.

Macy’s earned just a penny a share in the first nine months of 2009 but generated per-share cash flow of $1.41. Home Depot posted per-share profits of $1.40 for the period, while its cash flow reached $1.87 a share.

The flipside is represented by companies like railroads where depreciation is not keeping up with spending. Railroad operations are capital intensive, to be sure, but for the last four years, some companies’ expenditures have exceeded their write-downs by significant margins.

For instance, Union Pacific put $3.64 a share into capital expenditures in the first nine months of 2009. But its depreciation during that period totaled just $2.12 a share. In 2008, the company spent $5.40 a per share in capital expenditures compared with $2.69 in depreciation. Since 2005, Union Pacific has recorded $17.81 a share in capital spending but has depreciated about half that much — just $9.54 a share.

“The railroads are not bad businesses, but their stocks are overpriced when you look at what their cash flows are,” Mr. Olstein said. For the first nine months of last year, Union Pacific’s free cash flow was 99 cents a share; earnings were $2.51.

Another company with a sizable gap between depreciation and capital expenditures is the Carnival Corporation, the cruise ship company. Over the last four years, it has spent $16.48 a share on assets but it has written down just $6.01 a share.

Donna Kush, a Union Pacific spokeswoman, said it’s common for capital spending to exceed depreciation in her industry. “When you have long-life assets, you will have a mismatch,” she said, “because we need to constantly upgrade for safety and to serve our customers.”

And David Bernstein, chief financial officer of Carnival, said that at some point his company’s growth would wind down and its capital expenditures and depreciation would be more aligned. But in the meantime, he said, it is “simplistic” to expect the two figures to match up.

Still, Mr. Olstein said consistent gulfs between capital spending and depreciation should concern investors. “If it keeps on deviating then you have to look at why,” he said. “You have to reconcile the differences or the market will do it for you.”

http://www.nytimes.com/2010/01/10/business/economy/10gret.html?ref=business