How depreciation of assets can distort profit figures

Depreciation is an expense that matches the cost of a fixed asset against the revenues it helps to produce.  The cost of an asset is spread over its useful life.   

The most common method of depreciating an asset is known as straight-line depreciation, where an equal amount is charged against revenue over the asset's useful life and is calculated as follows:

straight line depreciation = (cost - residual value) / estimated useful life

Depreciation is often seen as a proxy for maintenance or stay in business capex.  

The problem with depreciation is that the management of a company can make it whatever value they want.  The easiest way to do this is to say that assets will last longer than they will in reality.

Example

If an asset costs $10 million and will last for 10 years and be worth nothing after that time, the depreciation expensed against revenues for the next 10 years will be, $1 million per year.

($10 m - $ 0)/10 years = $1 million per year

In order to maintain the value of assets at $10 million, the company will have to spend $1 million on new assets each year (the amount it has depreciated by).  

This is why depreciation is often seen as a proxy for maintenance or stay in business capex.

What if the $10 million asset only really lasts 5 years?   

Depreciation should be $2 million per year instead of $1 million and profits should be $ 1 million lower.  

If a company depreciates an asset by $1 million a year but actually spends $2 million to keep the asset up to date, then capex will be twice as much as depreciation but profits will be overstated by $1 million.  

This will be picked up in the FCFps number but not the EPS.

Looking for possible investment candidates: Four simple rules when comparing FCFps with EPS

 Summary

Expenses and depreciation reduce profits.  Capex reduces FCF.

When expenses are not expensed against revenues but considered as capex, the company will report higher profit.  Also, the depreciation charge reported by the company will be probably too low.

In a nutshell:

• the cash spent should be expensed against revenues and so it should reduce profits.  
• unless it does, this, the depreciation charge reported by the company is probably too low and profits too high.   

Four simple rules when comparing FCFps with EPS when looking for possible investment candidates:

1.  Definite candidate:  FCFps is 80% or more of EPS

2.  Possible candidate:  FCFps less than 80% of EPS and ROCE is increasing

3.  Avoid:  FCFps less than 80% of EPS but ROCE is falling 

4.  Avoid:  FCFps is consistently negative.

If free cash flow per share is consistently a lot lower than EPS, this is a warning sign.

 The 2 main reasons for FCF being lower than a company's EPS are:

1.  Poor operating cash conversion

2.  High levels of investment in new assets.

Poor operating cash conversion

This tends to occur when a company is growing quickly and sells a lot of its goods and services on credit.

The profits on these sales get booked in the income statement but there are no cash flows until the customer pays.

Companies may also build up stocks or inventories in anticipation of selling more.  This is fine as long as the reason is genuine.

But building up stocks is also a good way for companies to shift overhead costs such as labour away from the income statement in order to boost profits.  This can happen when companies include the overhead costs of producing stock in the balance sheet value.  If the stock is unsold at the year-end that overhead cost has not been expensed through the income statement and can therefore boost profits.  

Selling products on credit can be a sign of overtrading, or even fictitious sales.  This sort of thing never turns out well for shareholders, so you need to watch out for this.

2.  High level of investment in new assets

This is when capex is much higher than depreciation.

Depreciation reduces profits, but money spent on capex reduces free cash flow.

In this case, free cash flow per share will be a lot less than EPS.

• Capex that is consistently higher than depreciation with improvement in ROCE

It is not necessarily a problem for a company to spend heavily on capex, as long as the capex is earnings a decent ROCE.  

[Example:   Easyjet in 2015.  Its FCF per share was less than its EPS due to capex being significantly more than depreciation.  However, this is not a cause for worrying too much, as the company's ROCE had been increasing at the same time.]

• Capex that is consistently higher than depreciation with NO improvement in ROCE

However, capex that is consistently much higher than depreciation with no improvement in ROCE is rarely the hallmark of a great company.  

It can be a sign of dodgy accounting as companies can and do shift expenses into capex to boost profit.

When FCF per share is a lot less than EPS it may also be a sign that a company is manipulating its profits to make them look bigger than they really are.  

In these cases, capex is often much higher than depreciation but the company might be spending this cash just to maintain its existing assets, rather than using the expenditure to enhance it s income-producing assets.

• In a nutshell, the cash spent should be expensed against revenues and so it should reduce profits.  
• Unless it does, this, the depreciation charge reported by the company is probably too low and profits too high.   

Quality companies turn most of their profits into free cash flow on a regular basis

We can use free cash flow as a tool for checking the quality of a company's profits.

The stock market has been littered with companies that seemed to be very profitable but turned out to be anything but.

Investors can save themselves a lot of heartache and some painful losses by taking a few minutes to study how effectively a company converts profits into free cash flow.

One of the simplest and best ways to test the quality of a company's profits and whether you think they are believable or not is to compare a company's underlying or normalised earnings with its free cash flow.   

The free cash flow will show you how much surplus cash the company has left over to pay shareholders.  It can often be very different from EPS, even though it is supposed to tell you the same thing.  For most years, you want to see the free cash flow has been close to earnings.

Calculating free cash flow

Example:  Company Z ($ m)

Net cash flow from operations  69.0

Capex -6.8

FCF to the firm (FCFF) 62.7

Minority or preference dividend paid 0.0

Interest paid -0.3

Interest received 0.0

FCF for shareholders (FCF)  62.4

Weighted average number of shares in issue  504.6m

FCF per share 12.37 sen

Underlying EPS  11.9 sen

Quality companies turn most of their profits into free cash flow on a regular basis

Checking the safety of dividend payments

Dividends are an important part of total returns from owning a share.  

Dividends are a cash payment and therefore the company needs to have enough cash flow to make these payments.

Compare the FCF with its dividends

By comparing the free cash flow with its dividends, you can see whether a company has sufficient cash to pay dividends.  

Net cash from operation - CAPEX =  Free Cash Flow

You want to see the free cash flow being the bigger number more often than not.

When dividend is the larger number compared to the free cash flow, this may occur when a company is putting cash to good use (capex).  When dividend  is the larger number is fine on occasional years.  Prolonged periods of insufficient free cash flow will often lead to dividends being cut or scrapped eventually.

When analysing a company, it is often a good idea to compare free cash flow with the dividends over a period of ten years.

FCF dividend cover

A quick way to check whether cash flow is sufficient to pay dividends is by using the free cash flow dividend cover ratio.   This is calculated as follows:

Free Cash Flow dividend cover =  Free cash flow / dividends.

When free cash flow exceeds the dividends by a big margin, it can be a sign that the company may be capable of paying a much bigger dividend in the future.

When free cash flow may not be what it seems

Free cash flow comes with a few caveats one need to be aware of.

Besides calculating a company's free cash flow, one need to study its cash flow statement closely to really find out what is going on.

Example:  Company Property X - no free cash flow but paying dividends

Operating profits  830m

Other (operating) (648m)

Operating cash flow 182m

Tax paid -

Net cash from operations 182m

Capex (441m)

Free cash flow (259m)

Equity dividends paid (139m)

This is a property company.  Making money from selling properties (assets) is a normal part of its day-to-day activities.  It makes sense to consider the sales of assets a part of the free cash flow.

Free cash flow (259m)

Add back asset sales 1,358m

ADJUSTED FCF  1,099m

Equity dividends paid (139m)

This company is more than able to pay its dividends to its equity owners.  

Always need to study the cash flow statements to understand what is really going on.

Example:  Company Serial-Acquirer Y - lots of free cash flow but regularly buying companies

Occasionally, one comes across companies that seem to be producing lots of free cash flow when in reality they are not.

If you study the investing section of the cash flow statement more closely, large cash outflows might not be found in the capex section but can be found somewhere else,  such as acquisitions.

Operating profits 46.3m

D&A 13.1m

Profits on disposals (1.6m)

Change in working capital `1.3m

Other (operating) 1.3m

Operating cash flow 57.9m

Tax paid (14.4m)

Net cash from operations 43.5m

Capex (6.9m)

Free cash flow 36.6m

Equity dividends paid (9.7m)

This is a company that keeps spending a lot of money on acquisitions regularly and yearly.

Acquisition (18m)

ADJUSTED FCF 18.6m

For this company, the cash spend on acquisitions should probably be used to calculate free cash flow, in order to give a fair picture.   When this is done, its free cash flow is significantly reduced.  

This company may be too reliant on buying other companies to produce the cash flow needed to pay its dividend.  Before looking at this company as a potential investments, one would certainly want to investigate this further.

CHECKLIST ON HOW TO VALUE SHARES

BIGGEST RISK:  PAYING TOO MUCH

The biggest risk you face to be a successful investor in shares is paying too much.   

It is important to remember that no matter how good a company is, its shares are not a buy at any price.

Paying the right price is just as important as finding a high-quality and safe company.  

Overpaying for a share makes your investment less safe and exposes you to the risk of losing money.

USUALLY HAVE TO PAY UP FOR QUALITY

Be careful not to be too mean with the price you are prepared to pay for a share.  

Obviously, you want to buy a share as cheaply as possible, but bear in mind that you usually have to pay up for quality.

Waiting to buy quality shares for very cheap prices may mean that you end up missing out on some very good investments.  

Some shares can take years to become cheap and many never do.

CHECKLIST ON HOW TO VALUE SHARES

When valuing shares, you can use the following checklist to remind of the process to follow:

1.  Value companies using an estimate of their cash profits.

2.  Work out the cash yield a company is offering at the current share price.  Is it high enough?

3.  Calculate a company's earnings power value (EPV) to work out how much of a company's share price is explained by its current profits and how much is dependent on future profits growth.  Do not buy shares where more than half the current share price is dependent on future profits growth.

4.  Work out the maximum price you will pay for a share.  Try and buy shares for less than this value.   At least a discount of 15% or more.

5.  The interest rate use to calculate the maximum price should be at least 3% more than the rate of inflation.

6.  You must be very confident in continued future profits growth to pay a price at or beyond the valuations estimated here.

7.  The higher the price you pay for profits/turnover/ growth, the more risk you are taking with your investment.  If profits stop growing, then paying an expensive price for a share can lead to substantial losses.

Can quality be more important than price?

Paying too much for a share can result in disappointing returns. No company, no matter how good, is a buy at any price.

Share valuation is not an exact science.  Your valuation will never be exactly right, but by setting yourself some limits, you can reduce the risks that come from overpaying for shares.

However, there is some evidence to suggest that paying what might seem to be a moderately expensive price (slightly more than the suggested maximum) for a quality business can still pay off in the long run.   The caveat here is that you have to be prepared to own shares for a very long time.  Perhaps forever.

The way people invest is changing. 

Many people are not building a portfolio of shares during their working lives to cash in when they retire.  An increasing number will have a portfolio that may remain invested for the rest of their lives.  For them, a portfolio of high-quality shares of durable companies may help provide them with a comfortable standard of living, with the initial price paid for the shares not being too big a consideration.

Shares of high-quality businesses are scarce

We have to remember that the shares of high-quality businesses are scarce.  This scarcity has a value and might mean that investors undervalue the long-term value of them.

The ability of high-quality companies to earn high returns on capital for a long time can create fabulous wealth for their shareholders.  This is essentially how investors such as Warren Buffett have built their fortune.

Can quality be more important than price?  YES!

High-quality companies with high and stable returns on capital have created substantial wealth over the decades.  

Few if any of the shares could have been bought for really cheap prices.   

In many of the cases, the enduring quality and continued growth of the company could be seen to have been more important than the initial price paid for them.

The importance of growth

If you are going to buy and own expensive shares, you must be very confident that high rates of growth can continue for a long time into the future.   Since no one can predict the future accurately, you need to protect yourself by not paying too high a price for shares.

Knowing how to value shares and understanding the crucial relationship between cash profits and interest rates are important.  Know how much of a company's current share price is based on its current profits and how much is related to future profits growth.  

Though profits growth is important in valuing shares, you should also know how to not pay too much for it.

High share prices can unravel very quickly when profits stop growing.  

Companies which investors like tend to command very high valuations because they are growing turnover and profits rapidly, or are expected to do so   Their shares will have very high multiples of profits and cash flows and very low yield attached to them.  

This can persist for a long time but the dangers for investors of owning expensive or highly-rated shares can be significant when profits stop growing.  

Investors in these shares may often lose a large amount of their investment and learned a brutal lesson of the high risks of owning expensive or highly-rated shares.  This experience has been repeated countless times in the past and will surely happen many times again int he future.

• Using owner earnings to value shares: Setting a ma...
• Using owner earnings to value shares: Earnings Pow...
• Using owner earnings to value shares: Cash yield ...

Using owner earnings to value shares: Setting a maximum price method

Setting a maximum price and buying price for Company X shares

Current cash profit per share 11.6 sen

Divide by interest rate [inflation +3%]  4.4%

Maximum price (cash profit / interest rate)   $2.636

Current price  $3.20

Ideal price at 15% discount $2.24

Cash yield at ideal price (cash profit/ideal price)  5.18%

ANALYSIS:

This approach is saying that Company X shares are currently too expensive to buy.

The most (maximum price) you should pay is $2.63 per share, compared with a current share price of $3.20.

If you want even more of a buffer (margin of safety) compared with the maximum price - a good rule of thumb is 15% - you will only want to pay $2.24.

Additional notes:

You might be waiting a long time for a share to reach your target price and it might never do so.

However, it is far better to wait or even risk missing out on the few shares that are too expensive than to risk paying too much and lose money.

When to sell?

This kind of analysis can also give you some guidance of when to sell a share.  

If a share that you own reaches a maximum price, it doesn't mean that you should automatically sell it.   Shares can and do go beyond and below their fair valuations.   

In the above example, Company X, one would not sell at $2.63 but if the share price exceeded this (maximum price) by 25% ($3.29), you might sell and then look for something cheaper to buy.

Using owner earnings to value shares: Earnings Power Value (EPV)

 EPV gives an estimated value of a share if its current cash profits stay the same forever.

Calculation:

1 Normalised or underlying trading profits or EBIT

2. Add back D&A

3. Minus Capex

4. Derive Cash Profit or Owner earning

5.  Tax this cash profit by the company's tax rate.  

6.  Divide by a required interest rate to get an estimate of total company or enterprise value.

7. Minus debt, pension fund deficit, preferred equity and minority interest to get a value of equity.  Add any surplus cash.

8.  Divide by number of shares in issue to get an estimate of EPV per share.

Compare the estimate EPV per share with the current share price.

Existing share price  >>> EPV

A large chunk of the current share price is based on the expectation of future profit growth.

Share price <<< EPV

EPV can be a great way to spot very cheap shares.

When you come across a share like this, you need to spend time considering whether its current profits can stay the same, grow or whether they are likely to fall.  If profits are likely to fall, it might be best to move on and start looking at other shares.

To minimise the risk of overpaying for a company's shares, you should try to buy when its current profits (its EPV) can explain as much of the current share price as possible.

As a rough rule of thumb, even if profits and cash flows have been growing rapidly, do not buy a share where more than half its share price is reliant on future profits growth.  

Example

Company X 2015 ($m)

EBIT 73.7

D&A 6.6

Stay in business capex -8.9

Cash trading profit 71.3

Tax@20% -14.3

After tax cash profits (A)  57.0

Interest rate (B)  8%

EPV = A/B  713

Adjustments

Net debt/net cash 40.4

Preference equity 0

Minority interest 0

Pension fund deficit 0

Equity value 753.4

Shares in issue (m)   497.55

EPV per share ($) 1.514

Current share price ($)   $3.20

EPV as % of current share price  47.3%

Future growth as % of current share price 52.7%

INTEREST RATES

Some rough guidelines of the interest rates you might want to use when valuing different companies:

Large and less risky companies:  7% to 9%

Smaller and more risky (lots of debts or volatile profits):  10% to 12%

Very small and very risky:  15% or more.

Using owner earnings to value shares: Cash yield or Interest rate method

This approach is very simple.

Take the owner earnings or the cash profit per share and divide it by the current share price to get a cash interest rate (or yield)

Cash interest rate = cash profit per share / share price

Rational

The whole point of owning shares is to get a higher return on your money so that you can grow the value of your savings. 

If you are going to get only a small cash interest rate on your shares at the current share price, it could be a sign that the shares are overvalued.

What a low interest rate is telling you is that cash profits are going to have to grow a lot in the future to allow you to get a decent return from owning the shares.

Investing is all about interest rates.  

To make money you should aim to try and get the highest rate of interest on your investments as you can without taking lots of unnecessary risks.

Only you can decide what rate of interest is high enough.

EXAMPLE of using cash yield or interest rate method to value share

Let's say that you want to get a 10% cash flow return on buying shares in Company X where the cash profit per share is 11.6 sen.  At its present share price of $3.20, you are currently getting a cash yield or interest rate of 3.6%.   You need to work out what annual rate of growth over what length of time would be needed to get to 10%.  (Best way is to set up a spreadsheet and play around with some growth scenarios.)

Assuming a 10% annual cash profit growth:  

In year 3, the cash profit per share is 15.4 sen, giving a cash yield of 4.8%.

In year 10, the cash profit per share is 30.1 sen, giving a cash yield of 9.4%.

Scenarios analysis

This kind of exercise can teach a great deal about what a $3.20 share price for Company X says for the company's future cash profits.  A lot of future growth is already baked into the share price.  It takes a reasonably long time with a reasonably high growth rate to get a reasonable cash yield on buying the shares at $3.20.

Profits are going to have to grow faster than 10% per year to get to an acceptable cash yield in a shorter time.  Even if you wanted a 7% return, you would have to wait seven years at a 10% growth rate.  That is a long time to wait.

What if growth is a lot lower than 10% or even if profits fall?   The chances are that Company X's share price would fall, which means you could end up losing money.

What does a low cash yield means?

It means that you are paying for growth in advance of it happening.  

It will take years of high growth in cash profits to get a reasonable return on your $3.20 buying price.  

This is one of the most risky things that you can face as an investor.  

You can protect yourself by insisting on a higher starting interest rate when buying shares in the first place.  

Look for an interest rate of at least 5% and even then, you have to be very confident that growth would be high for many years in the future.

How to set your buying price for a 5% or 8% initial cash yield?  

Take the cash profit per share and divide it by 5% or 0.05.  For Company X with a cash yield of 11.6 sen, this gives:

11.6 sen/ 0.05 = $2.32

Even more cautious, and wanted a starting yield of 8%, then your buying price would be

11.6 sen/ 0.08 = $1.45

These results of $2.32 and $1.45 make Company X share looks well overpriced at $3.20

Warren Buffett has looked at owner earnings (cash profits) of businesses for many years.

 In his 1986 letter to shareholders, Warren Buffett described how he worked out what he called the "owner earnings" (referred here as cash profits) of a business.  He did this because he believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.

Owner earnings 

= net income + depreciation & amortisation + other non cash items - maintenance capital expenditure.

Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintenance, or stay in business capex) often exceeded the depreciation and amortisation expense and therefore, profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintenance capex figure.  Generally speaking, though, this calculation ignores changes in working capital that are included in free cash flow.

The hardest part of this calculation is trying to estimate what maintenance or stay in business capex is.  As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this. 

So how do you get an estimate of stay in business capex?

There are three reasonable methods:

1.  The company tells you.  This figure may be in the annual report.

2.  Use a multiple of the current depreciation or amortization expense.  For example, use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate sometimes, but for some companies it can be way off if the cost of replacing assets is falling.

3.  Use a 5 or 10 year average of capital expenditure or capex.  This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.  This is a good approach to use if the company does not state the figure outright.  As a rough rule, if the 5 year capex figure is higher than the 10 yr average you should use the higher figure.

Annual depreciation expense <<<  average 5 or 10 year capex.

This is the case in asset intensive companies.  These companies usually have very poor free cash flow track records and modest ROCE and CROCI performances.   These are two good reasons against investing in them.  Avoid them unless they have been able to produce a good ROCE whilst investing heavily.

Capex <<< depreciation and amortization.

Normally this kind of behaviour would make you suspicious, thinking that a company has been      under-investing, which would hurt its ability to make money in the future.

On the other hand, there maybe nothing bad going on.  You need to study the company's history on this issue to make sure that it is not under-investing.

Using average capex figures to estimate of cash profits (owner earnings)

If the 5 year capex figure is higher than the 10 year average, use the higher figure.

Comment:   Note the key outlier is Tesco.  Its cash profit is negative.  If you come across a company that looks as if it is losing money when estimating its cash profits you need to either do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or look for another share to buy.

Here is the process to derive owner earnings or cash profits again:

• Use the most recent annual underlying or normalised net income/profit
• Add back depreciation and amortization
• Minus an estimate of maintenance or stay in business capex.
• From these, you derive cash profit (owner earnings)
• Divide by weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.

Knowing the company's cash profits, you can use these to value shares.  HOW?

Manipulation of free cash flow. NOT all FCF should be valued the same.

Because investors have become suspicious of company profits, free cash flow is a popular way to assess a share.  

Rightly, profits are too easy to manipulate.  Yet, free cash flow can be manipulated as well and you need to know how to spot this.

Companies can boost their free cash flow in many ways.  

Here are a few ways they can do this:

1.  Delay paying their bills until after the end of the financial year. 

This increases their trade creditors and boosts operating cash flow and free cash flow for the year.

2.  Sell debtors to a credit company (also known as debt factoring).   

This allows a company which sells products on credit to turn those sales into cash faster than ight have been the case.

3.  Cut back on investment.  

Slashing investment in new assets can boost free cash flow, but might harm the long-term prospects of the business.

4.  Buy businesses rather than invest in new assets.   

A standard calculation of free cash flow might ignore this.

Review FCF and its trend over at least 5 years

This is why you should review a company's free cash flow over a number of years (at least 5 years) and look at the trend.  

You need to look at what is causing the free cash flow to change, as not all free cash flow should be valued the same.

NOT all FCF should be valued the same.

1.  Highest quality of free cash flow

Ideally, a company should be generating more free cash flow because its profits are growing.  This is the highest quality of free cash flow.   

2.  Lesser quality of free cash flow

Companies that are boosting cash flows through changes in working capital (paying their bills later, collecting their debtors faster and holding less stocks of finished goods) or cutting capex might be doing the right thing, but these kind of improvements are not achievable year after year.

CAPEX: Look for companies where the capex ratio is consistently below 30%

Quality companies produce high ROCE (at least 15%) and lots of free cash flow because they don't need to spend much money on new assets in order to grow.

Capex Ratio

                              Capex ratio = capex / operating cash flow

This ratio compares the amount of cash a company ploughs back into tits business through capex to the amount of cash coming into the business - its operating cash flow.

It is very easy to calculate a capex ratio for a company, using its cash flow statement.

Low capex ratio (< 30%).

The lower this ratio, the less capital intensive a company is and the better chance it has of producing lots of free cash flow and a high ROCE. 

Look for a capex ratio of lower than 30%.

Non-financial companies with low capex ratios, generally also have very high ROCE figures as well.

High capex ratio (>30%).

Companies with high capex ratios tend to have a very low ROCE.  Generally, companies with capex ratios of 30% or more tend not to produce very high ROCE.

A high capex ratio is sometimes necessary in order to give a company the scope to grow.  This is not usually a problem, as capex will tend to fall back afterwards.  However, when the capex ratio is consistently high year after year, this is a warning sign for investors.

Shell (High capex ratio) versus Domino's (Low capex ratio) for 2006 to 2015

Company Shell consistently ploughed more than half its operating cash flow back into its business with capex for 2006 to 2015.  This consistently high capex ratio - along with volatile oil prices - meant that its free cash flow moved around all over the place in this period.

Domino's capex ratio from 2006 - 2015 were mainly below 30%, except in 2008 and 2009 when it was 45% and 60% respectively.  Domino's capex ratio has declined significantly since 2008 and 2009 (when the company was investing in new distribution centers to help grow the business).  Company Domino's capex ratio is now less than 10% and in 2015 was 8.45%.  

In the ten years to June 2016, Domino's trounced Shell as an investment.  Domino's returned nearly 660%, compared with just 63% for Shell.   The divergent share price performance of the two companies was not  a surprise given what we now know about the importance of free cash flow in quality companies.

RETURN ON CAPITAL EMPLOYED

RETURN ON CAPITAL EMPLOYED

Capital employed is just in simple term, the money invested.  

Return on capital employed is the company's return on the money it has invested.

ROCE = normalised EBIT / CAPITAL EMPLOYED X 100%

How to calculate the money invested in the company

1.  Calculated from the Asset side of the Balance Sheet

Capital employed = Total assets - Current Liabilities + Short term borrowings

2.  Calculated from the Liability side of the Balance Sheet

CE = TE + NCL + Short-Term Debt

CE = TE + Other NCL + Total Borrowings

Using average capital employed

ROCE is usually calculated using a company's average capital employed over a period of two years.

Ideally, you would like to know the amount of money a company has invested throughout the year, rather than at a frozen point in time when the financial statements were compiled.

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.

Quality of company's profits. Operating cash conversion ratio.

Operating cash conversion ratio

Operating cash conversion = (operating cash flow / normalised EBIT) x 100%

(EBIT = operating profit)

This ratio gives the investor an insight into the quality or otherwise of a company's profits.  Ideally, we want to see a company consistently turning all its operating profits into operating cash flow.  This will be reflected by an operating cash conversion ratio of 100% or above.

Not only does this make a company's profits more believable but also it means that it will have a stronger financial position - and less need to borrow money - than a company that has to wait for some of its profits to turn into cash.

EBIT

+ Depreciation & Amortization

+/-  Profit on disposals

+/-  Change in working capital

- Tax paid

= Net cash from operations

The 2 components needed to calculate the operating cash conversion ratio are:

1. the operating profit (EBIT), and
2. the operating cash flow (Net cash from operation)

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.

How quality companies generate free cash flow?

Cash flow is the lifeblood of any business.

There have been numerous companies that seemed to be very profitable, but were teetering on the edge of bankruptcy because they couldn't turn their profits into cash fast enough.

Profits and cash flow are not the same thing, and it is not sufficient for a company to be profitable to make it a good investment.

After finding out that a company is profitable, is to see how good that company is at turning its profits into cash flow.

A company's future free cash flow is the ultimate determinant of how good an investment the company will be.  Cash flow is the key determinant of its share price and the size of the dividend it will pay out to shareholders - which are the two elements that comprise the total returns from owning a share.

Free cash flow to the firm (FCFF)

Cash flows from operating activities + dividends received from joint ventures - tax paid  = net cash flow from operations

Net cash flow from operations - capex = FCFF

Free cash flow for shareholders (FCF) or Free cash flow for equity (FCFE)

FCFF - net interest (interest received - interest paid) - preference share dividends - dividends to minority shareholders = FCF

How can you use free cash flow numbers to identify good companies to invest in and bad ones to stay away from? 

A company with very little debt and a tiny interest payment, virtually all of the FCFF become FCF or FCFE.  In other words, there is not much difference between FCFF and FCF or FCFE.   This is a positive sign for investors and you should look for this sort of situation in companies you are analysing.

In contrast, a company with lots of borrowings and therefore interest bills to pay, the FCFF and FCF or FCFE will be different.   The interest payment has eaten up a big chunk of the company's FCFF, leaving less FCF or FCFE for shareholders.  In general, it is a good idea to avoid companies with lots of debt.  Too much of their FCFF can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their FCFF to repay debt and lower their future interest bills.  This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Look for a company with vey good long-term track record of producing free cash flow for its shareholders.

Companies that produce lots of free cash flow can make excellent investments.