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Even if a company is reporting booming business all may not be well. Peter Webb sorts the wheat from the chaff

Continuing our look at how signs of trouble can show up in accounts, we turn our attention to cash. As we know, cash is king and as an investor, monitoring it is important. Often a sign that all is not well is when a company is reporting healthy and growing profits but they are haemorrhaging cash. How can you reconcile this and what should you be looking for?

Reading the signs

A classic example that we can use is Centurion Electronics (CUC:AIM). When it reported its 2003 results I noticed a large cash outflow and glowing earnings so I earmarked it for another look when the 2004 results were issued. That was a similar story so I immediately flagged it as a problem to Shares readers.

In order to understand what is going in a company in this scenario, you need to examine and interpret the cashflow statement. You should see a breakdown of the cashflows into three distinct areas. Each one measures either the cash generated or spent by the business.

• Cashflow from operations – Operating profit generated £2.5 million of cash flow during 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 by nearly 41% of turnover and creditors, those who Centurion owe money, rose by £5.1 million. If you pay suppliers on credit and sell to buyers on credit with roughly equal payment terms and some profit margin you would expect that the increase in debtors would slightly outweigh creditors.

• Cash flow 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 cash flow from operations and investment Centurion ‘lost’ £2.094 million in cash in the last financial year.

The final part of cash flow statement, cash flow from financing, reconciles the amount of cash received in order to fund the business. Centurion has 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.

Cash hungry

It is not unusual for start ups to be cash hungry as they expand their businesses but ultimately the management should be managing the company in a stable and sustainable manner, and if that means forgoing less capital intensive strategies in pursuit of stability and long term profitable growth, it should aim to achieve it.

In summary, Centurion made an accounting profit but lost cash. At some point cash has to flow freely from operations to repay any debt else the debt will be never repaid. Centurion had little long-term debt due to the amount of money the company had raised by issuing equity. This is good, for the company, because it can raise cash without increasing risk. It will receive cash now but have no obligation to pay anything out for it. However, for existing shareholders this meant diluting existing shareholding. The company is effectively selling future profits for some immediate collateral. Something it cannot do for ever. If the company eats through too much cash, investors will get tired of supplying it before there is a decent return for them. Borrowing money is another option but that generally increases indebtedness and the likelihood of bankruptcy or severe disruption if things don’t go as planned. Overall it is much better to have cash on hand generated by the business to fund future growth. That costs nothing to anybody and is value that is tangible.

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. However, if there is more stock out there than required or on favourable terms and with dubious credit quality then working capital requirements will rise and dwarf true representation of the requirements of a business that is more stable. If it is a newly listed company you have to ask yourself why it is seeking to raise more capital? Usually one aim of listing a company on the stock market is to raise capital for expansion and growth. So why return to raise more so quickly? These are the sort of questions you need to ask.

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 risk that is justified and worth taking. Next week we will look at some qualitative factors to make even clearer judgements.