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Cash can flow in a mysterious way, at least in the statements of some companies. Peter Webb looks at how investors can see when an apparently profitable business is losing money and so keep their funds safe when others might be losing theirs

Recently I examined how to catch a falling knife, and it wouldn’t have escaped your attention that one of the metrics I used was cashflow. You either have cash or you don’t have it, and often a sign that all is not well is when a company is reporting healthy and growing profits but haemorrhaging cash.

To understand what is going on in a company you need to examine and interpret the cashflow statement. I will examine the cashflow statement of Centurion Electronics (CUC:AIM), a popular junior market growth stock, before it got into trouble.

In the cashflow report you should see a breakdown of the cashflows into three distinct areas. Each measures either the cash generated or spent by the business, I have provided a description of each.

• Cashflow from operations – Operating profit generated £2.50 million of cashflow in the year. However, Centurion is now holding more stock, a cash outflow. Stocks rose by £2.44 million. Debtors, people who owe money to Centurion, rose by £6.54 million or nearly 41% of turnover and creditors, those whom Centurion owes money, rose by £5.1 million.

• Cashflow from investment – The costs of servicing loans and other finance-related charges meant another £175,000 outflow along with £184,000 in dividends and £532,000 on long-term assets, a total outflow of £891,000.

Adding together the cashflow from operations and investment Centurion ‘lost’ £2.094 million in cash in the last financial year.

The final part of cashflow statement, cashflow from financing, reconciles the amount of cash received in order to fund the business. Centurion raised or repaid a number of small items but the big items are the raising of £2.076 million in new short-term import loans and the issuing of £1.174 million of new shares. Overall, it raised £3.245 million in fresh capital for the year, meaning that cash balances actually rose on the year even though cash from operations was negative.

The reckoning

Overall, Centurion made an ‘accounting profit’ but lost cash. It covered this loss with the cashflow from financing. Losing cash is concerning because at some point cash has to flow freely from operations to repay any debt, or else the debt will be never repaid. Centurion, however, had little long-term debt due as it had raised cash by issuing equity. This is a cheap way of raising money, but it can’t issue equity for ever. Investors will eventually get tired of supplying it as it is very dilutive to existing shareholders. Borrowing money is an option, but that could increase its likelihood of bankruptcy if things didn’t go as planned. As a newly listed company you have to ask yourself why it is seeking to raise more capital?

When looking at cashflow from operations you would expect that any increase in debtors would slightly outweigh creditors. This is because you pay suppliers on credit and sell to buyers on credit with roughly equal payment terms and some profit margin. As a company grows it is quite common to hold more stock and lend money to customers to buy those goods on credit. You would expect an increase in working capital requirements such as stock and short-term debt to fund this expansion. When the inverse occurs you should worry about stock in channel and whether credit terms are being extended to customers to try to hold stock for longer or in an attempt to stop stock being returned. Credit quality may also be an issue.

Interest expense or receipts and capital expenditure will show up in cashflow from investments. Expenditure on this line should reflect long-term use of cash rather than short-term use. Expansion requires cash, so retaining it to reinvest is important. Raising cash to fund a dividend or other requirements above true investment in the business is not acceptable and should be questioned.

Extrapolation

While I have only looked at one year here, comparing multiple years allows me to identify some of the key trends highlighted here and their direction. In Centurion’s case, it turned out that the company was pushing a lot of sales into its retail channel and despite large-scale promotion it was not selling. Eventually it had to admit this and mark down most of the stock and eventually exit the retail channel altogether. This was an expensive decision and a rescue package had to be put together, at the expense of shareholders, to save and reform the company.

In summary, it is quite possible for a company to be very ‘profitable’ but still lose cash. The decision you need to make as an investor is whether this cash drain is realistic, sustainable and a worthwhile risk. n