It's all well and good seeing a company recording profits, but we also need to see it collecting the actual folding paper stuff.
Over the past few weeks, while having a look at a few investment basics, we've seen how the P/E ratio relates a share price to the profit a company is making, taken a look at how we might identify companies that are turning that profit into future growth, and compared that with paying out profits as dividends.
But all that talk of profits can sometimes lead us astray, and even a company that looks to be making good and regular profits can struggle to find the cash to pay its bills. How so? Well, it's all in the way companies account for profits.
Corner shop
Let's think back to a corner shop again. Suppose you sell lots of stuff every week, but you let everyone have it all on credit, hoping they'll actually stump up the cash next week, or the week after, or… whenever.
Because accounting practices allow you to record your profits at the time of sale, not at the time you actually collect the cash, all that stuff that goes out of the door will show up as nice regular profits in your Profit and Loss account. But you'd be a mug to expect to run a corner ship for long like that -- the next time an electricity bill comes in, you can hardly promise to pay it "as soon as that nice Mrs Slocombe gives me the money for all the Kittie-Scoff she's had".
While that might not be a good way to run the finances of a corner shop, it is how large companies tend to operate, where hanging onto cash that you owe to someone else for as long as possible can sometimes be a great help. Also, offering credit to a customer can clinch a sale that might otherwise go to a competitor -- in fact, to get your foot in with a lot of larger businesses, you often have to accept very onerous terms that involve you not getting paid for months. Likewise, if you're the big fish, you can hold out for better credit terms from your suppliers and keep them waiting.
Credit
Of course, it works the other way too, and a company can record expenses (like that electricity bill, wholesale goods bought on credit, and so on) as they become due even if it doesn't pay them right away.
So you could buy in a consignment of cat food, sell it all to regular customers on credit, and record the cost, revenue and profit in your accounts, all without a single penny actually changing hands. Similarly, a company can reach the end of its financial year with profits looking good, but with large sums outstanding in bills it hasn't yet paid, and similarly large sums it hasn't yet collected from its customers. And if it can't get hold of the cash it is owed before it's forced to pay its own bills, it could soon be time for the closing down sale.
What can we do?
There are a few things relating to cash flow that we should really look at when considering investing in a company's shares. We saw that the P/E ratio is formed by dividing a company's share price by its earnings per share figure, and there is a similar measure, the cash flow per share, which is also regularly reported in companies' earnings summaries.
A company that is getting the cash from its customers and paying its own bills in a timely manner should be showing cash flow rising and falling in line with its earnings over the years, and if we see a year when cash flow comes in significantly lower than earnings, we should want to know why.
There is also a ratio, analogous to the P/E, known as the Price to Cash Flow ratio, which simply divides the share price by the cash flow per share, and if that seems unduly high compared to the P/E, then again we might have cause to dig a bit deeper.
To uncover more about a company's cash flow situation, we need to dig into its accounts a bit. From its Cash Flow statement, we can see changes to the amounts outstanding that it owes (its "Payables") and amounts it is owed by its own customers (its "Receivables"), and these can give us a handle on how it is managing its cash (though a proper treatment of cash flow analysis is beyond the scope of this short article).
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