When a stock is not a buy (3)

Fotolia_54867638_XS_7This short series highlights warning signs investors should consider when trying to judge whether a stock is worth buying or not. In the previous two posts I have covered the Good Value Test and the Business Model Test. In this post it is the turn of the Cash Flow Test.

Cash Flow Test:

In business, the old adage that cash is king is absolutely true. Cash is the life blood of any business. Without a healthy cash flow a business can struggle to meet its obligations; that is pay its bills. If a business is not sufficiently solvent to pay its bills then, unless it has a very generous benefactor to bankroll it, that business is in serious trouble and it will probably go out of business altogether.

Profit is a great headline figure as far as it goes. However the problem with any stated profit figure in the company accounts is that it can be easily manipulated. Creative accounting can be used to make the profit figure look quite healthy when in fact the underlying business performance might not be very good at all. The notional profit on the one off sale of a ‘big ticket’ asset could turn what would have been a loss into a decent looking profit.

For example, suppose the company were to sell a building it owns. And suppose that building was sold on a sale and lease back arrangement. Operationally the company’s position doesn’t really change, other than now its operating costs will bear the addition of regular lease payments. If the building was valued on the books at say $500,000 and is then sold for $5 Million then there is a one off profit of $4.5 Million. If trading operations before the property sale actually generated a loss of say $2 Million then the company’s accounts will still show a $2.5 Million profit overall. So the headline profit might look acceptable but dig below the surface and the investor has cause for concern.

So the underlying message is that you need to view any profit figure with great caution and you need to understand how much of that figure was influenced by trading operations and how much of it might have come from the one-off sale of assets or other one-off transactions. Essentially a company can be loss making and still be made to look like it’s generating a profit.

Cash is cash. Cash comes into the business and cash goes out again. The cash coming in should be greater than the cash going out, if the business is in a healthy state.

Signs that a firm is burning too much cash include a low or negative Cash Flow from Operations figure. By comparing Operating/Trading Profits to this figure you can judge the strength of Cash Cover; the relationship between profits and cash from the company’s core operations.

If a company records a loss but has a strong, positive cash flow then it remains in a good position. If the company records a profit but has a weak or negative cash flow then if faces trouble ahead and possibly even insolvency.

So don’t just take the figures stated in the accounts at face value. Put the accounts under the microscope and understand how they were derived. And above all make sure you understand where the cash comes from and where it’s going and what the net cash position is overall.

This has been a brief review of the Cash Flow Test but I hope it will have given you a flavor of what to look for; I cannot stress too highly the importance of cash flow to a business.

In the next post I will look at the Debt Test.

Read also:

When a stock is not a buy (1)

When a stock is not a buy (2)

When a stock is not a buy (4)

When a stock is not a buy (5)

When a stock is not a buy (6)

© RJ Sutton and Mann Island Media Limited 2014. All Rights Reserved.

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