Why cash is king!

Why cash is king!

While most buyers and sellers of shares focus on earnings and earnings growth, ‘investors’ take a wide berth around the Profit and Loss Statement and focus instead on the business’ cash flow.

Why? Cash is not the same as profits. I recall the completion of my first year in business and the accountants handed me my first annual report.  Smiling, they said that I should be proud because I had ‘made’ a substantial profit.  Pulling my trouser pockets inside out, I declared “well where is it?”

For many businesses, profits are an accounting construct.  They are the accountants ‘best guess’ about what the true picture of the business is. But business cannot spend accounting profits, it can only spend cash. When a customer buys a product on June 28 the accounts record it as sales revenue. But if the sale was made on 14 days terms, the cash will not be received until the next tax year and even then, only if the debtor doesn’t skip town. So don’t be tricked by a business reporting accounting profits – it can be losing cash at the same time.

If you own shares in a business that reports a profit but does not generate cash on a continual basis, the only thing you need to understand is that you should be concerned.

Take the recently collapsed Timbercorp (ASX:TIM) as an example. Despite the business reporting accounting profits year on year, it was actually losing money for four years in a row.

Many years ago I received a recommendation from a broking-firm’s analyst to buy shares in Southern Dental at around $2.60. The report went on to say that it represented one of the best value plays in the market at the time. Unfortunately, its cash flow materially less than its reported profits so I passed up the opportunity to buy the shares which proceeded to fall below 90 cents.

To avoid these types of businesses compare a business’ reported profits to the Cash Flow Statement. A business that continually pays out more cash than it receives will have negative operating cash flows. If this situation occurs over a number of financial periods then, depending on the cash balance, the cash outflow will need to be supported by borrowings or raising fresh capital. The first increases the risk of the business and the latter dilutes your ownership. Rarely are either positive developments.

Without continued support from bankers or shareholders, a business that continually spends more than it earns cannot survive.

To ensure the ongoing health of your portfolio and avoid companies with an elevated level of risk, seek out businesses that generate positive cash from their operations equal to or greater than the profits being reported.

By Roger Montgomery, 2 September 2009