Qualiport

How to Value Shares, Part VI
Friday, 21 August 1998

Cash makes the world go round -- What is it, and why is it so important?

The final method we shall look at in this present series of How To Value Shares is cash flow-based valuations, and in particular discounted cash flow techniques. But first, we will discover why cash management and control is so important. As you will see, strong accounting earnings don't necessarily mean a company is in good health.

What Is Cash?

Cash makes the world go round. You need cash to make cash, as unfortunately no-one has yet found a tree from which we can go and pluck £20 notes at will. Companies raise cash in various different ways, either though bank loans, a myriad of novel debt offerings, venture capital funds, or through a public offering of shares. Think of how you would go about opening the corner store that you've so longed for over the years. You'll need to pack the shop full of useful products, pay yourself a probably modest wage, pay rent on the shop, set up phone lines, fit the shop out with new shelves and fridges... the list is endless. Before you receive a single penny of income, you'll have to spend a small fortune -- and this is money that you probably haven't already got. To raise cash, your options will include the bank manager, a wealthy friend (who will naturally want some sort of return on the money she invests in the business) or a public floatation, although the last option would be impractical and prohibitively expensive. Large companies think in exactly the same way, although on a much bigger scale.

Companies live and die on the amount of cash they generate. For all the money they spend on acquiring new pieces of machinery or computers or spend on staff wages, if they don't receive a decent return on that investment, they will die. A company that generates above average amounts of cash will succeed in building shareholder value. That additional cash can be reinvested back into the business, can be spent on earnings enhancing acquisitions, can be paid out to shareholders as dividends or can be used for a share buyback scheme. Without any cash, a company treasurer will get to know her bank manager pretty well, but perhaps not on the friendliest of terms.

Cash earnings are very much different to accounting earnings. Accountants can legitimately massage a company's profits to present a higher number, but they can't mess with the bank account balance. That's why it is always important for investors to check both the accounting profits and the cash profits. Here's an example.

Bruce's Bazaar

Bruce has raised £2,000, which he intends to use to open his new shop. On day 1, his balance sheet looks like this:

Assets

Cash              2,000

Capital & Reserves (Equity)

Share Capital     2,000

The balance sheet balances because Assets (A) = Liabilities (L) + Equity (E). This equation can be rearranged so that L = A - E or E = A - L.

Trading goes reasonably well in year 1, and Bruce's profit and loss statement looks like this:

Sales            1,000
Expenses          (800)
Pre Tax Profit     200
Tax Expense        (50)
Net Profit         150

Based on a £2,000 pound investment in the business, a return of £150 or 7.5% is nothing fantastic, but it is a reasonable start. After all, Bruce is still building up the business, and a new block of flats is scheduled to be built soon right next to his shop. He grabs a can of beer from the shop fridge, pats himself on the back, and then proceeds to spray the contents all around the shop.

However, to assess how the business is really operating, we need to have a look at the other key accounting statements that make up the books and records of any company. First, the new balance sheet, as at the end of year 1:

Assets

Net Shop Fittings      300
Stock                1,800
Bank                     0
Debtors                200
Total Assets         2,300

Liabilities

Creditors              150

Assets minus Liabilities 2,150

Capital & Reserves (Equity)

Share Capital            2,000
Retained Profit            150
Total Equity             2,150

As you can see, our balance sheet balances, because A = L + E, or 2,300 = 150 + 2,150.

What is the first thing that jumps out and hits you? It's the bank balance. Bruce has spent the full £2,000 in the first year, and is now faced with going back to his wealthy friend, cap in hand, asking for some more money. He needs to pay his gas bill, and buy some more stock for the shop, but the cupboard is bare. By looking at the cash-flow statement, we can get an idea of where the money went, starting with the £150 profit he made for the year.

Net profit              150
Depreciation            100
Increase in Debtors    (200)
Increase in Stock    (1,800)
Increase in Creditors   150
Capital spend          (400)
Decrease in cash     (2,000)

The cash flow statement shows us where most of Bruce's £2,000 has been spent. Increasing debtors are a use of cash. Bruce has generously allowed a few of his bigger customers to shop on credit, meaning that they owe him a total of £200 for goods they've already consumed. They are his debtors. This is an inefficient use of Bruce's scarce cash resources, as he receives no interest on that money, and he desperately needs it in order to pay the gas man.

Having £1,800 tied up in stock is an inefficient use of cash. Ideally, you want to look for a company that has as little stock as possible -- one that buys the goods it needs to supply the product to the customer only after it has received a firm order. This of course is impossible for a corner store like Bruce's Bazaar, but a company like Dell Computer Corporation operates in this fashion. One look at the share price graph of that company can tell you how successful they've been over the past 2 years.

A high stock number can mean a number of things, none of them positive. Stock can become obsolete, pass its use by date, or perish. It may have to be sold at less than cost price, or even thrown in the rubbish bin because it is now worthless. Computer product distributors have to contend with obsolete products all the time. Part of the problem at Flying Flowers was that they carried a lot of plants and flowers in stock in anticipation of strong sales growth, but when that didn't materialise they were left with very expensive compost.

Bruce has managed to buy some of his stock on credit. This is a good thing, and gives Bruce some breathing space before paying for the goods. In an ideal world, a company buys on credit and sells for cash. That way, the creditors effectively fund the business, and scarce cash can be used to enhance shareholder value in the ways set out above. If you buy a crate of wine on 60 days credit for £100 and sell it the next day for £120, you've got the use of that £120 for the next 59 days before you have to pay your creditor. If you went back and duplicated that cycle the next day, and the next, and the next, you can see how profitable you will quickly become, all funded by generous credit terms. Increasing creditors are generally a positive.

The final use of cash was the £400 spent of the shop fittings. This is known as capital expenditure, and shows up as an asset in the balance sheet. You will notice, however, that it shows up in the balance sheet as a net £300. This is because £100 has been written off against the value of that asset as depreciation. This is an accounting concept whereby the value of the asset is expensed against profits over the theoretical life of the asset. It is not a cash entry. As you will see from the cash flow statement, the cash cost of buying the asset is shown as a use of funds, yet the £100 depreciation expense is added back to profits because no cash changes hands. It is an accounting entry only.

The £2,000 total cash consumed by Bruce's Bazaar leaves the company in a precarious state, despite the company making a £150 accounting profit in the year. Without resorting to borrowing yet more money, Bruce will have to sell some of that stock for cash, collect his money from his outstanding debtors and look to put off paying the gas man and any other bills until he's generated some cash with which to pay them. All the while this is happening, Bruce can't afford to build the business, as he's always chasing his tail. Something will have to change, or he won't be in business by the time that new block of flats is built.

Just before we close for today, I want to make you familiar with the term "free cash flow." That is defined as net profits plus or minus working capital movements, plus depreciation expense, minus capital expenditure. Working capital refers to the movement in stock, debtors and creditors. If you think about it, free cash flow is the amount left over that the company can use to enhance shareholder value. In the case of Bruce's Bazaar, it generated negative free cash flow of £2,000. A company cannot survive if it doesn't generate free cash flow. The concept is important, as you will see as we move on to looking at discounted cash flow techniques.

Have a great weekend, Fools. See you on the message boards, where you should feel free to fire any questions my way.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers       Date    21/08/98


                  Day      Month      Year       History
Qualiport       (2.05%)   (2.96%)    35.59%      38.65% 
FTSE 100        (3.36%)   (6.17%)     6.65%       9.10% 
FTSE All Shares (2.94%)   (6.44%)     6.12%       8.36% 


Qualiport Stocks

Last Rec'd Total #  Security  In At    Current    Change
 04/17/98   337       EMAP   £11.998   £11.550   (3.74%)
 05/11/98   736       MKS     £5.604    £5.000  (10.77%)
 12/19/98  1565       RTO     £2.582    £3.720   44.08% 
 07/17/98   595       ULVR    £6.804    £5.610  (17.55%)


Last Rec'd  Total #  Security    In At     Value    Change
 04/17/98    337        EMAP    £4043.37  £3892.35 (£151.02)
 05/11/98    736        MKS     £4124.37  £3680.00 (£444.37)
 12/19/98   1565        RTO     £4040.63  £5821.80 £1781.17 
 07/17/98    595        ULVR    £4048.38  £3337.95 (£710.43)

Cash:               £67.82
Current Total:  £16,799.92