Cash flow is key to investment success

One of the biggest threats to your wealth as an investor is the risk that one of your stocks goes bust, taking all of your capital with it. How can you avoid this nightmare scenario?

Judicious use of stop-losses to get you out of a doomed position is one method, but it's better to avoid buying a dud in the first place. One specific page in a set of accounts can help you do this.

Tucked in behind the profits statement, the cash-flow statement attracts far less attention from most investors. But that's a real pity. Not only is it one of the easiest pages to understand (admittedly that's not saying much where accounts are concerned), but it's also among the most useful if you want to avoid potential investment disasters. So how does it work?

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Follow the cash trail

Investors often confuse profits and cash, but they are very different creatures. Here are three examples that explain why.

A firm is owed £20m as of 1 January, the start of its trading year. Twelve months later it is owed £80m by its customers, having billed £70m for work done in the intervening period. What is the cash flow for the same period? The answer is £10m.

That's how you make the story stack up a £20m receivable (which would appear in the balance sheet) plus £70m of new work done should result in a receivable of £90m at the end of the year. The fact that the amount due is £80m suggests the firm has been paid £10m. The point? While the profit and loss account will book the full £70m as sales, turnover or income, the cash-flow statement will just show an operating cash inflow' of £10m.

The firm buys a long-term asset at the start of the year for £10m and expects it to last for ten years. The opening balance sheet will show an asset of £10m. By 31 December this will have dropped to a net book value' of £9m. In the meantime a £1m charge will have been booked for depreciation', to reflect the use of the asset over the current year (it's expected to last for ten years, so £1m reflects a single year's usage). However, the cash-flow statement will pick up the cash outflow of £10m, this time described as an investing outflow'.

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Say the firm had a £1m loan outstanding at the start of the year, and this is paid off before 31 December. The profit and loss account will show nothing paying off a loan doesn't generate any trading profits (or losses). However, the cash-flow statement will record the cash outflow of £1m as a financing outflow'.

These examples reflect the way that cash-flow statements are put together. You group operating cash flows' (relating to the firm's core day-to-day business activities), investing cash flows' (relating to buying and selling assets, including businesses) and financing cash flows' relating to how the firm is funded (so cash from issuing debt or shares and cash spent on redeeming debt or buying back shares). These three headings tell the firm's story for 12 months, by following the cash trail.

Adding up these (very simple) examples, we can see what they say about our company's overall cash flow. We had a trading inflow of £10m, an investment outflow of £10m and a financing outflow of £1m. So that's a net cash outflow' of £1m. Yet turn to profits and you get a very different picture. We booked £70m as trading revenue, a charge of £1m for our long-term assets and nothing for the debt repayment. So that's a profit overall of £69m. That's clearly a massive difference.

Three red flag tests

We're not saying that cash-flow statements are perfect the timing of cash flows can be manipulated to flatter results, just as profits can be fudged. But where the story told by the profit figures varies wildly from the story told by the cash-flow statement, be on your guard. Making sales is one thing, but if the money from those sales isn't coming in the door, the business will soon run into trouble.

So before I accept the story the directors want me to believe, I do several checks on profits using the cash-flow statement. They don't take long and they could save you from making an expensive mistake.

Compare the retained profit figure with the overall net cash in or outflow. If there's a big difference, then compare the operating profits figure to the operating cash-flow number. If the operating cash-flow figure is negative, that's a worry; why is a firm chewing up cash just in the course of its normal business? Even if it is positive, but far below the operating profit figure, I'll want to know why. Is the business failing to collect cash from customers, or struggling to shift stock? Or is cash management inefficient because the directors are focused only on sales?

Look at the investing' and financing' sections. I want to see like matched to like here if a firm is raising long-term capital just to keep trading, then don't invest! And if it is using new funding to buy long-term assets, are these merely replacing older assets or do they reflect genuine capacity growth?

Always look at cash flow per share as well as earnings per share. It's the three-to-five-year trend that matters. Firms that report smooth earnings trends backed by volatile cash flows are often best avoided.

This article was originally published in MoneyWeek magazine issue number 593 on 15 June 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.