Horizon.my

In an earlier article on Free Cash Flow, I touched on some adjustments we need to make on a company’s profits to arrive at the Free Cash Flow figure.

I’ve always found the standard Cash Flow Statement hard to read especially for big companies. They pack it with so much detail and it’s hardly presented from an investor’s perspective. Most investors I know simply don’t bother with cash flow because it’s so complex.

If you are using the Cash Flow tool in our Investor Database, you may notice that we present it in a different format. From an investor’s perspective, what we want to know is:

• How much cash the business is generating from “earnings”, taking into account working capital movements (debtors, inventory and creditors)
• How much it needs to spend on capital items (eg. plant and equipment)
• How much it is paying shareholders by way of dividends
• How much it is investing (non capex related)
• How much borrowings it is repaying as a result of its cash surplus or incurring as a result of its cash shortfall.

One of our readers mentioned Evergreen Fibreboard last week, so I’ll use Evergreen as an example. Evergreen manufactures building material products and its sales and profits have been increasing for the past few years. Let’s take a look at their cash flow:

Notice that Evergreen’s profits are eaten up by capital spending and unfavourable working capital movements. They have been in expansion mode, possibly building new factories or adding production capacity, and possibly growing sales by extending more credit lines and so on.

The bottom line is that there is hardly any Free Cash Flow from its operations. In fact Evergreen has to borrow money to pay dividends.

But negative Free Cash Flow is not in itself bad.

It could be that the company is investing for the future. If the investment can generate more cash, it has the potential to pay off in the longer run. In a situation such as Evergreen, it is crucial for an investor to keep track of its working capital movements, particularly Receivables and Inventory. If these items keep building up, it shows that the new production capacity is not converting into cash.  This is undesirable over the long term.

Ultimately as investors, we want:
a. More and more dividends; and
b. Our share price to keep going north

Free cash flow is important because it allows a company to pay dividends and to pursue opportunities that create shareholder value. Without cash, you can’t develop new products, invest in acquisitions, pay dividends or reduce debt.

In fact our Cash Flow format ranks shareholders ahead of creditors

Below is the cash flow for IOI Corporation, notice that dividends paid appear just below Free Cash Flow. After deducting dividends, we arrive at “Residual Cash Flow” which is what the company has leftover for repaying loans or doing more fanciful things like acquisitions, share buy back etc.

(Dividends paid to Minority Interest in this case refers mainly to minority shareholders in IOI Properties Bhd, a subsidiary of IOICORP).

Residual Cash Flow
1. If  it is positive - a company can use excess cash to buy back its own shares, make investments and acquisitions.
2. If it is negative – a company has to find a way to cover the shortfall. It may have to sell its investments, issue more shares or borrow more from its lenders.

Cash flow from operations is important. But how a company manages excess cash or covers cash shortfall has a huge bearing on whether shareholder value is created or destroyed.