Call us on 1300 794 893

The Experts

Robert-miller-150x143_normal
Robert Miller
Expert
+ About Robert Miller

Robert Miller is a Portfolio Manager at NAOS.

Cash flow statements: 3 things to look out for

Tuesday, August 01, 2017

By Robert Miller

It is fast approaching the time of the year when annual company reports will be coming in thick and fast. With so much information on hand, one is quickly drawn to the financial reports which include the income, balance sheet and cash flow statements. This reporting season, we encourage you to read the statements back to front, that is, cash flow first, then balance sheet, and finally, the income statement.

Investors can often overlook all things cash flow, so in this article, we will step through three key sections of the cash flow statement which can highlight positive signals and warning signs.

1. Operating Cash Flow

The focus here is ‘cash conversion’. We think of cash conversion as the following:

Cash Flow Conversion = EBITDA / (Receipts from Customers – Payments to Suppliers)

This ratio helps to outline the working capital requirements of a business. The ratio result can vary widely. For example, it could be negative if a company is paying invoices before collecting invoices. Or, it could be positive if the opposite is true. In other words, a positive working capital balance, or if the company happens to receive payments in advance.

Cash flow conversion profiles will vary across different industries. For example, a building contractor is likely to have more ‘lumpy’ cash flows than an IT services company. However, the key items to look for are the payment cycles from both debtors and creditors. If a company is receiving payments in from debtors on a 60-day cycle and making payments out to creditors on a 90-day cycle, this creates a positive working capital position.

Given the degree of variability in cash flow conversion, it is essential to look for consistency and identify any occurrences of lumpiness to gauge business health. We try to look for companies producing a consistently positive cash conversion ratio result between 75-110%. A ratio in this range supports a well-managed, strong cash generative business which is not placing pressure on growth by running a negative working capital position. High cash conversion also provides comfort around a company’s ability to pay dividends. We tend to avoid negative working capital businesses, as any growth may quickly lead to funding gaps.

2. Investing Cash Flow

A company’s spend on property, plant & equipment or capital expenditure (‘capex’) has the potential to be a large item, which can vary drastically from year to year due to significant one offs. It is important to understand the reason management is spending on one offs, such as purchasing a new piece of land, upgrading an old plant, etc.

We like businesses that are coming to the end of a big ‘capex spend cycle’, meaning a company’s capital spend is expected to significantly drop (but not stop) over the next 1-2 years. Assuming the investment has been for growth or efficiency purposes, a drop in spending should hopefully equate to improved business leverage and higher profit margins.

It is worth noting that capex is a vital component for business growth. If a company spends nothing on capex, then this can be a sign of management ‘short termism’ and can negatively affect long-term growth. Lack of any current capex spend may increase the likelihood of a large one-off spend to play catch up. If this eventuates, negative pressure could be placed on the company.

An ideal scenario is a consistent level of ‘maintenance capex’, meaning a stable level of spend towards existing business improvements. You can be comfortable with a management team which has a level of capex that is roughly the same as their depreciation profile, this will result in little or no net impact on earnings. 

Capitalised development spend is a concept all investors should be aware of. These are essentially expenses which are not included within the profit and loss statement but rather appear in the cash flow statement. Management teams will try to justify this course of action by classifying the spend as a long-term asset for the business, as opposed to an asset being expensed within the period which the spend occurred. This may be appropriate, however, it can be fraught with danger, so it is something to look out for. Capitalising costs can distort the earnings profile of a business, as expenses are excluded from the profit & loss statement, leading to a higher profit figure, which may lead to the market placing an inflated multiple on a company.

In some cases, accounting standards require a certain level of capitalisation. However, we always prefer to see businesses (including software companies) which fully expense all their capital spend as they end up with a ‘truer’ earnings figure. This helps limit downside risk to the current earnings multiple.

3. Financing Cash Flow

The financing section is all about debt and equity funding within the business. This needs to be healthy to sustain and complement the operating and investing cash flows. There is no hiding in the financing cash flows.

There are a couple of important questions to ask;

  • If the company has issued equity, have they done this regularly over the years?
  • Has a company taken on further borrowings to fund their poor working capital position or investing activities? If so, is the amount borrowed growing every year?

If the answer is yes to any of these questions, investors should be cautious. Debt is OK, but we like to see consistent repayment of this debt over the years and nobody likes continual issue of equity which may cause dilution of existing holdings. This can signal poor management decision making regarding deployment of capital.

We also like to look at the dividend payment amounts flowing out of the financing cash flows and check to see if these are consistently growing. If they are volatile over the years, try to understand why. Was it a special dividend, or is there inherent volatility in the company cash flows? Be cautious of the latter. We like a company that is in a position to both repay debt and pay dividends, as this combination should translate into much higher dividends as the debt repayment continues to fall.

Understanding the cash flow statement is a crucial tool for gaining comfort around the downside risk of a business. The NAOS Investment Team like to see high cash generation companies, consistency, minimal capitalisation of costs, and we avoid companies if funding holes are continually being ‘plugged’ with debt or equity. Strong cash flows allow a company to maintain a healthy balance between dividends and reinvestment back into the business, which are key to sustainable shareholders returns.

This is a sponsored article by NAOS Investment Management.

This article is general information, it is not intended as financial advice and does not consider the circumstances or investment needs of any individual.

| More

 

5 things to look for in a CEO

Wednesday, July 19, 2017

By Robert Miller

One of the most fundamental factors that is consistent across the majority of company success stories in the NAOS investment universe is, arguably, a high-quality leader. Simply put, no matter how good a company may appear on paper, if we are not comfortable with the CEO, we will not invest. On the flip side, we may be able to look past a business with certain issues if we have a lot of confidence in the leader.

Here are five key points to consider when assessing the value and quality of the person at the top. 

1. Consistency 

The message portrayed to the market on the company’s strategy needs to remain consistent over the short, medium and long term. Investors will build their investment thesis around this message. If the CEO’s message changes either positively or negatively, it is time to review your investment. If it changes frequently, it is time to reconsider your investment altogether. We like to look back to our previous notes to see if they have done what they said they would do – there is great benefit for all investors who practise this.

2. Tenure

A management bio will give you the information you require to go back and learn from the past. Anyone who has had multiple, short tenures in different businesses would raise a red flag. Ideally, we like to see a CEO who has demonstrated building long-term shareholder value in a similar sector/industry throughout their career. Channel checking is always recommended, whether it be to fact check an industry, sector, company or manager.

3. Shares and incentives

It is no secret that investors like to see a capable management team with skin in the game –  this is a very powerful factor when selecting an investment. Furthermore, it can be a warning sign if the leader of a small/micro-cap stock doesn’t hold a substantial position. Alignment extends to the incentive structures in place for the leadership team and we recommend having a good understanding of all key contributors.

Be cautious if share price is the only focus, as this may cause a CEO to concentrate on short-term decisions that create ‘hot air’ in a stock and could be detrimental to the business in the longer term. We prefer to see earnings per share growth included as a reward metric, as this reflects a focus on improving business quality over the long term. If this is delivered upon, it should reflect positively on the share price.

4. Commerciality vs lab coat

By their very nature, small businesses are hands on and those in charge can benefit from being ‘Jack of all trades’ type leaders. A high-quality CEO will have the ability to candidly and confidently talk about all parts of their business in a way that investors understand. We get a lot of comfort from a leader who is able to answer questions about the smallest of issues, or show an understanding of their customer base by explaining a key client in detail - this is the ‘lab coat’ part of a management skillset. 

At the same time, they must be commercial. Here, we would look for managers who have a good handle on their competitors, corporate activity and their own share register. This might sound like a lot to ask, but quality CEO’s do this naturally in equal balance.

5. What makes them tick?

Trying to understand the motivation of a CEO can be very subjective. In simple terms, we like to see something more than just the financial aspect which drives someone to run a business every day. Generally, a small company is started because a CEO wants to take a chance and provide something different from the industry status quo. It is a case by case assessment of the individual and the company they are leading, however passion, confidence and commitment are crucial to create long-term shareholder value.

This is a sponsored article by NAOS Asset Management.

This article is general information, it is not intended as financial advice and does not consider the circumstances or investment needs of any individual.

| More

 

MORE ARTICLES

Pixel_admin_thumb_300x300 Pixel_admin_thumb_300x300 Pixel_admin_thumb_300x300 Pixel_admin_thumb_300x300 Pixel_admin_thumb_300x300