Fool's Eye View

[ March 23, 2000 ]

Working Capital Worries

By Maynard Paton (TMFMayn)

Carburton Street, London -- Here's a phrase that most investors will have heard before: "Look for companies that have a good cash flow".

So, how do you define "good"? And why bother with the cash flow anyway, when you've got the profit and loss statement to inform you of the amount company has made? I'll start with the latter question first.

Simply, accounting profits are a matter of opinion, whereas cash is a matter of fact.

Without going into too much detail, there has always been scope for directors and accountants to bolster their reported profits, without improving the trading performance of the company. Reducing the depreciation rate on fixed assets, making excessive use of provisions and exceptional charges or even purchasing a loss-making business can all lead to improved "accounting" profits.

Cash is a different story. It's difficult for any company to "fudge" its cash flow. Looking at any company's annual report: the "cash in hand" figure on the balance sheet is just about the only non-subjective item within any set of accounts. It's readily available for any accountant to place into the accounts. A quick check with the bank and the cash figure can then be pencilled in.

The cash flow statement can tell an investor how much cash was generated by the operating activities of a business, and then how much of that was absorbed into working capital and how much was spent on interest, tax and fixed assets.

But can you really define "a good cash flow"?

One or two stock market commentators have given shorthand methods to whether any company's cash flow is good or bad. Jim Slater, author of The Zulu Principle and the follow-up Beyond the Zulu Principle, has put forward two different cash flow measures in his books. And The Motley Fool itself has put forward its own "cash conversion" calculation. Unfortunately, I feel all these methods are a little misleading as cash flow measurements.

I'll use Wolseley (LSE: WLY) as an example. Here is the reconciliation of operating cash flow to operating profits for the plumbing and bathroom materials distributor.

                                       1999     1998
                                       (£m)     (£m)

Operating profit                      313.1     277.4
Depreciation charges                   61.9      54.4
Goodwill amortisation                   5.5        -
Increase in stocks                    (49.7)     (9.2)
Increase in debtors                   (59.4)    (51.8)
Increase in creditors & provisions     66.8      42.2
Decrease in net construction loans      0.4       0.3
                                    =====================
Net cash flow from operating
activities                            338.6      313.3
                                    =====================

In his first book, Jim Slater suggested comparing net cash flow from operating activities to operating profit. If the former was greater than the latter, then the company passed Jim's "strong" cash flow hurdle. With this in mind, Wolseley passes the test (£338.6m exceeding £313.1m). But the trouble with this method is that depreciation gets in the way.

Depreciation is the reflection of "wear and tear" on fixed assets. It's not a cash expense, but an accounting charge to provide over a number of years the difference between the historical cost of an asset and its residual value. So if a company has a large depreciation charge, indicating a heavy reliance on fixed assets, it is more likely to pass Jim's criteria.

Really, if we're taking into account the depreciation charge along with the net cash inflow from operating activities, we should also be considering the cash spent on capital expenditure, that is, the cash needed to replace and maintain the fixed assets that the depreciation charge attempts to reflect. Assuming that the actual cash spent on maintaining fixed assets is equal to the depreciation charge, then the depreciation charge can be taken out of the reconciliation. And if we do this, Wolseley fails Jim's test.

In fact, Jim modified his "strong cash flow" criteria for his subsequent book by comparing earnings per share (EPS) to cash flow per share (CFPS), where CFPS is the net cash flow from operations after the cash payments of interest and tax. But this alteration still doesn't take into account the additional depreciation boost to the CFPS. The Zulu calculations of "strong cash flow" still give undue favour towards asset-heavy companies. I'm glad to say that TMFJonnyT (Paul Marshall) has discarded this flaw in his replication of Jim's Zulu approach.

And indeed, the Motley Fool UK Investment Workbook, falls into the depreciation trap. Our cash conversion ratio is defined as

                        Net cash flow from operating profits
Cash conversion ratio = ------------------------------------
                                 Operating profit.

If the conversion ratio is less than 80%, then the book states that caution should be exercised. But of course, a large chunk of cash could be evaporating into working capital (stocks, debtors and creditors), but masked by a large depreciation charge. And in this scenario, any poor working capital management wouldn't be detected by our ratio.

So, what's an investor to do?

I think the above ratios are trying to spot underlying trading troubles that have yet to surface in the profit and loss account. Most operational difficulties, such as bad debts, overtrading or large amounts of unsold stock, are highlighted within the working capital area. For me, "good cash flow" primarily means a cash generative working capital profile.

So a more rewarding exercise would be to concentrate on movements of stocks, debtors and creditors, and use a variation of the cash conversion ratio. So how about this adapted formula and calculation, used with the details from Wolseley?

The "adapted" cash conversion ratio:

     Operating profit + changes in stocks, debtors and creditors

  =   ----------------------------------------------------------

                          Operating profit


     £313.1m - £49.7m - £59.4m + 66.8m

  =   ---------------------------------

                   £313.1m

  =  86.5%

So Wolseley passes the Fool's arbitrary 80% working capital cash conversion test. But having laid down this generic formula, I suspect in practice that there will be too many exceptions that don't prove the rule, so to speak. Different companies, of course, have different cash flow profiles and every individual company has to be treated on its own merits.

Take JD Wetherspoon (LSE: JDW), the pub chain operator. This company buys its beer on credit, while its customers pay cash immediately at the bar. Wetherspoons has a great working capital profile, and the company spits out cash. Using the above methodology, Wetherspoons' ratio comes out at 124%. No problem here.

But then take Photobition (LSE: PHB). The graphics display consultancy pays its main expense, its staff, monthly, but the company gets paid by its own customers during or after any work it undertakes. And with any long project work performed by Photobition, there will be an unfavourable impact on working capital. Using the above methodology again, Photobition's ratio is calculated at only 49%. Should investors worry about this low degree of cash generation, just because Photobition has later paying customers than Wetherspoons? And at what level should shareholders become worried, assuming most companies have sub-100% ratios anyway?

I consider that a substantial, rather than any predefined percentage, amount of accounting operating profit should be turned into operating cash after working capital requirements. Should the adapted cash conversion ratio decline significantly over the years, then that's time to worry. If the level is relatively low but the company has successfully grown for years with the same sort of performance, then I wouldn't be concerned.

What probably is of more importance than cash flow calculations is the nature of the underlying business. If the company has few competitors in an industry, and supplies a service or product that its customers need or desire, then the fact that cash flow may undershoot accounting profits shouldn't matter. With these enticing business characteristics, an investor would know that any untoward buildup in stock would eventually be cleared and any trade debts would have to be paid, those customers not paying having no other product alternative. In my opinion, a great business model takes precedence over great cash flow every time.

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