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Company Analysis - Cash Flow Analysis and their trickle-down effect
Rejigging the cash flow statement
Cash Flow statement forms a key part of financial statements of the company. In this post, I will explain how to assess the level of margin of safety available in a company from a cash flow statement.
Accrual method is followed for preparing a Profit & Loss statement i.e. it includes sales and expenses incurred during the year on both cash and credit basis. For example, if a good or service is sold in March (which is the last month of the financial year) wherein money is to be paid by the buyer in 2 months (credit basis) i.e. by May (next financial year). Then this sale transaction is also included in the Profit and Loss statement for the financial year even though money will be received in the next financial year. Hence, Profit and Loss statement also includes non cash based transactions.
Cash Flow statements provide us with a view of only cash based transactions during the year. It includes 3 key parts as under:
Cash Flow from Operating Activities
Cash Flow from Investing Activities
Cash Flow from Financing Activities
Cash Flow from Operating Activities further comprises two parts namely Operating cash flows (before working capital changes) & Working capital changes. Operating cash flows (before working capital changes) is arrived at by making additions/subtractions of non cash items (excluding working capital related items) like depreciation, unpaid taxes, mark to market forex losses, etc to profit after tax.
Working capital changes primarily consist of three key elements i.e. changes to inventory, changes to receivables (credit sales) and changes to creditors (suppliers). Working capital changes conceptually gives us an idea of incremental working capital requirements of a company. For example, if for a revenue of Rs 1000 Crs, a company needs net working capital (inventory plus receivables minus creditors) of Rs 100 Crs (10% of revenue), then if revenue increases to say Rs 1100 Crs, then net working capital requirements will typically increase to Rs 110 crs. This increase of net working capital requirements by Rs 10 Crs (i.e. from Rs 100 Crs to Rs 110 Crs) gets reflected in the working capital changes of cash flow statement of a company.
If we observe that there are working capital changes which are not in commensurate with change in revenue, then the reason might be due to pile up of inventory or receivables or stretching up of creditors by the company. The reason can also be due to increasing bargaining power of the company with its customers and suppliers. If we observe such a phenomenon, then we need to further analyse to satisfy ourselves on the reason.
Cash Flow from Investing activities typically comprises two parts namely Capital expenditure (Capex) and investments in surplus cash.
Capex can include capex related to expansion of capacity i.e. a company setting up a new factory. Capex can also include replacement capex i.e. a company procuring new machinery to replace old machinery. Replacement capex is something which a management cannot avoid and is required for running day to day operations. But expansion Capex is a choice of the management of the company. Management can choose to invest in expansion capex from surplus cash accumulated over the years or by raising long term debt. Long term debt as we have seen in balance sheet analysis reduces the margin of safety of the company.
Some companies try to grow inorganically wherein they acquire other companies. This is an alternative method for growth as compared to expansion capex.
If a company is left with surplus cash from operations after providing for working capital changes, capex and debt payments, then this surplus cash is generally invested in Fixed deposits or liquid funds. We can make out the surplus cash generated in the year by looking at these changes in Cash Flow from investing activities.
Cash Flow from Financing activities typically comprises of three parts namely, funds raised through equity (ie. IPO or FPO or private placement), availing new debt or repayments of existing debt & dividend payments.
A company can raise funds from capital markets through IPO or FPO or private placements for meeting its requirements. Such sources of funds generally improve the margin of safety of a company.
A company can also raise new debt to meet its cash flow requirements. Debt generally reduces the margin of safety of a company.
If a company is left with surplus cash from operations after meeting its various requirements like working capital changes, capex and debt payments, then management can choose to pay dividends or invest the same in cash reserves. Some companies which have enough cash reserves and don't have any capex or other requirements generally pay a significant portion of surplus cash flows as dividends.
Based on the above understanding, we need to modify the visual representation of cash flow statement as under to better analyse the same:
If a company keeps generating surplus operating cash flows (before working capital changes) every year which is more than sufficient to meet its incremental working capital requirements, replacement capex and then expansion capex, then the company is self sustainable i.e. company need not look for raising funds through external sources like debt or capital markets. Such surplus cash flows are typically utilised to build cash reserves, pay dividends and/or buy back shares.
We can conclude that the level of margin of safety in a company is high if there are surplus cash flows generated every year after meeting various requirements like incremental working capital requirements, replacement and expansion capex. Balance sheets of such companies typically have high levels of margin of safety.
Cash flow statement is better analysed by aggregating the same over a period of 5 to 10 years rather than analysing the same for each year. The reason being some high value items like capex typically takes 2 to 3 years to implement. The effects of such variations are nullified over a period of 5 to 10 years.
Lets look at the cash flows of Symphony Limited for the five year period FY2017 to FY2021.
The company generated operating cash flows after taxes of Rs 638 crs in the last 5 years. The company incurred cash outflows of Rs 309 crs towards meeting incremental working capital requirements (Rs 53 Crs), capex (Rs 47 Crs) and acquisition of new companies (Rs 209 Crs).
The company generated surplus cash flows of Rs 329 Crs. The company raised new net debt (after repayments of existing debt) of Rs 80 crs even though the same is not required. As we observed in balance sheet analysis of the company, the company has total debt which is less than cash reserves in its balance sheet. Out of surplus cash flows generated, the company chose to pay dividends of Rs 258 Crs and increase cash reserves by Rs 136 crs.
We can conclude that Symphony Limited has high levels of margin of safety from the cash flow analysis.
High margin of safety
We can observe from the past 5 years cash flow statements of Bajaj Auto Limited that the company hardly required any cash outflow towards incremental working capital requirements or capex. Entire cash generated from operations is surplus cash which is partly used to build cash reserves and the remaining portion towards dividends. There is a high level of margin of safety in the company.
TCS like Bajaj Auto Limited generated surplus cash flows of Rs 1,36,485 Crs over a period of 5 years after meeting its incremental working capital and capex requirements. The surplus cash flows were primarily given back to shareholders in the form of dividends payout (Rs 81,814 Crs) and share buyback (Rs 52,125 Crs).
Low or Moderate Margin of Safety
Sanghvi Movers is barely generating sufficient cash flows from operations to meet its capex and debt payments requirements. To meet part of the shortfall, it raised fresh debt of Rs 165 Crs.
Cash flows generated from operations by Tata Motors is not adequate to meet working capital requirements, capex requirements and legacy debt payment requirements. The company had to dip into existing cash reserves and also raise fresh debt to the tune of Rs 2,11,452 Crs to meet the shortfall in cash flow requirements. Tata Motors based on this analysis has low levels of margin of safety from its cash flows.