Chapter 5: Cash-flow Checks

Introduction

CASH FLOW IS the movement of money into or out of a company from operating, investing and financing activities. Cash is of vital importance to the health of a company. Without positive cash flow a company will eventually be unable to meet its financial obligations, thereby leading to a cash crunch or bankruptcy. Cash-flow checks help provide valuable information on a company’s quality of earnings, their liquidity or solvency, and their financial situation.

Quality of earnings cash indicator

A company has high-quality earnings if the stated earnings are a true representation of what the company is generating in terms of cash earnings. Unfortunately, not all companies have high-quality earnings.

While reported earnings may be within the law, according to Generally Accepted Accounting Principles (GAAP), there is plenty of scope to inaccurately reflect the cash earnings of a company. Sometimes the requirements of the accounting principles may be to blame for this discrepancy; other times it may be due to choices made by management. In either case, reported figures that do not portray the real cash earnings of the company can mislead investors into making bad investment decisions.

The best way to evaluate quality of earnings for a company is to compare cash flow per share to the reported and normalised EPS figures. Investors can rely on cash flow as it is harder to manipulate than net earnings (although it can still be done to a certain degree).

Cash flow per share (CFPS) is available in the cash flow statement in the financial section of the company profile on the Morningstar website.

If operating cash flow per share (that is, operating cash flow divided by the number of shares outstanding) is greater than reported EPS, earnings are of high quality because the company is generating more cash than is reported on the income statement. Conversely, if operating cash flow per share is less than reported EPS, the company is generating less cash than is being reported on the income statement. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates the true (cash) operating results.

CFPS is required to be greater than EPS in the latest accounting year. Ideally, the ratio of CFPS to EPS should be higher than 1.5. Companies not meeting this criterion are removed from our shortlist. You should also check that the five-year average of CFPS is in excess of average EPS over the last five years. Again, companies that do not meet this requirement are removed from the shortlist.

Example

Table 5.1 shows the operating CFPS and EPS history for XP Power. CFPS in 2017 was 152.2p, which is above the normalised EPS of 146p. However, the ratio of CFPS to EPS in 2014 is only 1.04 
(= 152.2 ÷ 146.0). It is notable that CFPS was below EPS in 2010 and 2011, raising concerns over the quality of earnings. The average CFPS over the past five years is 124.5p, compared with an average EPS of 111.2p. This gives a CFPS to EPS ratio of 1.1 (= 124.5 ÷ 111.2).

While earnings are covered by operating cash flow over the past five years, the quality of earnings could be higher. The CFPS to EPS ratio is not low enough to remove XP Power from consideration; however, it should be noted as a weak area. Other cash-flow metrics should be considered before deciding whether to invest.

Table 5.1 Cash flow and earnings per share – XP Power

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Reported EPS (p)

46.5

39.4

83.9

107.1

81.7

95.8

102.1

103.7

112.0

148.3

Normalised EPS (p)

46.4

39.3

83.2

106.4

81.3

95.1

101.1

102.8

111.2

146.0

Cash Flow per Share (CFPS) (p)

36.4

80.6

49.5

79.6

121.2

103.9

113.1

109.0

144.6

152.2

Cash to capital expenditure

Cash from operating activities is important because all company expenses ultimately need to be paid with cash generated from activities. Surplus cash flow can be used to expand business operations and boost future earnings, which will eventually drive the share price higher and allow for increased dividend payments.

Capital expenditure per share (capex ps) is the amount per share the company invests in the business to acquire or upgrade physical assets, such as buildings and equipment. You want to avoid companies that have high capital expenditure relative to operating cash flow, as it limits the company’s ability to grow future earnings.

Capex ps is available under ratios in the financial section of the company profile on Morningstar.

As capital expenditure is cyclical, average capital expenditure per share over the past five years is compared to the average cash flow per share over the past five years. If average capital expenditure is more than average cash flow, the company does not consistently generate excess cash and should be removed from the shortlist. In general, you should prefer companies that have comparatively low levels of capital expenditure relative to operating cash flow.

Surplus cash flow for a company is defined as CFPS minus capital expenditure per share and dividend per share. Ideally, surplus cash flow should be positive and more than 20% of the operating cash flow per share.

Example

Table 5.2 shows the information required to calculate surplus cash flow. Cash flow is well above capital expenditure over the past five years. This means that it has been able to generate free cash flow (which is cash flow minus capital expenditure) every year. CFPS averaged 124.5p over the past five years, while capital expenditure per share was 32.5p. This means that on average 26.1% (= 32.5 ÷ 124.5) of operating cash flow goes on capital expenditure.

Surplus cash flow per share has been positive over the past five years, indicating that there is cash left over after capital expenditure and dividends have been paid for. Surplus cash flow per share averaged 32.4p compared with 124.5p of operating CFPS. This means that on average 26.0% (= 32.4 ÷ 124.5) of operating cash flow is surplus cash, which is above the required 20% threshold. However, it is worth noting surplus cash flow dropped to 14.5% in 2017.

Table 5.2 Cash flow, capital expenditure and dividend per share history – XP Power

2013

2014

2015

2016

2017

Average

Cash Flow per Share (CFPS) (p)

103.9

113.1

109.0

144.6

152.2

124.5

Capex per Share (Capex ps) (p)

16.7

30.2

28.2

35.5

52.1

32.5

Dividend per Share (DPS) (p)

45.1

50.0

54.1

71.0

78.0

59.6

Free Cash Flow per Share (FCFPS) (p)

87.2

82.8

80.8

109.1

100.1

92.0

Surplus Cash Flow per Share (SCFPS) (p)

42.1

32.8

26.7

38.1

22.1

32.4

SCFPS ÷ CFPS (%)

40.5

29.0

24.5

26.3

14.5

26.0

Cash valuation

The price to cash flow (PCF) ratio is used to compare a company’s market value to its cash flow. It is calculated by dividing share price by CFPS from the latest accounts. In theory, the lower a company’s PCF ratio, the better value the company. Morningstar states the current company PCF in the overview section of the company profile.

As a general guide, companies with a PCF ratio below 15 offer good value, while companies with a PCF between 5 and 10 may offer excellent value. Companies with PCF ratios below 5 are treated as ‘too good to be true’ and may well be in trouble. Companies with PCF ratios above 20 are poor value, and ratios above 40 are very expensive and should be avoided.

For income and value companies, the preference is for the PCF ratio to lie between 5 and 15. Companies with a ratio above 20 are removed from the shortlist. Growth companies may have higher ratios, as cash is growing rapidly, but you should remove growth companies from the shortlist when the ratio is above 40.

Example

Table 5.3 shows the current PCF ratio for XP Power. From table 5.2, CFPS in 2017 is 152.2p. Towards the end of December the share price for XP Power was 2130p, giving a PCF ratio of 14.0 (= 2130 ÷ 152.2).

Table 5.3 PCF ratio – XP Power

Ratio

2017

PCF ratio

14.0

Summary

Cash-flow checks can be summarised as follows:

Cash checks

· Operating CFPS is greater than 1.5 times reported EPS in the latest accounting year.

· Average CFPS over five years is 1.5 times the five-year average of reported EPS.

· Average capital expenditure per share over the past five years is consistently less than average CFPS.

· Ideally surplus cash flow should be positive and more than 20% of the operating cash flow.

Cash valuation

· Company PCF ratio is more than 5 and less than 15.

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