Should you invest in large-cap or mid-cap stocks?

The stock market has been in a down trend for more than a year – losing 25% from its Nov ‘10 peak. Experts suggest that such falls provide excellent opportunities to accumulate strong large-cap stocks. Large-cap stocks are less risky and offer steady rather than spectacular returns.

Most small investors have a penchant for seeking out small and mid-cap stocks in the hope of making multi-bagger returns. But high returns are usually accompanied by high risks. What should small investors do? How to contain risk without missing out on returns?

In this month’s guest post, Nishit looks at the pros and cons, and comes up with an alternative approach.

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The argument will always continue whether to invest in large-cap or mid-cap stocks. One of my friends was asking me this morning whether it would be a good idea to invest in mid-cap IT stocks. It was the trigger for this post.

Mid-caps have several advantages. They are the real multi-baggers. Microsoft and Infosys were mid-caps once upon a time. Mid-caps can be a 10-bagger or even a 100-bagger. Mid-cap stocks carry a greater amount of risk as compared to large-cap stocks. In a bear market, a large-cap may lose 50% of its value whereas a mid-cap can lose as much as 90-95% of its value.

So, how does one address this conundrum? Every portfolio needs to be garnished by a sprinkling of mid-cap stocks, just like our food needs a sprinkling of salt to add to the taste. Just as too salty food is not good for health or taste, too many mid-caps is not good for the health of your portfolio, which leans towards risk.

How does one identify good mid-cap stocks? There are several criteria one must keep in mind.

1. They should have sound business models.
2. They should be generating real profits.
3. They should have good management. This is a very tricky question. How does one see a management to be good? A small investor cannot go and meet the management of a company he likes. One must look through the annual reports and notifications of the stock exchanges. The promoters should not have a shady reputation, or indulge in activities that harm shareholders – such as pledging of shares or dazzling announcements aimed at TV and newspapers.
4. The companies should be generating positive cash flows and providing steady dividends. Steady dividends can be ignored if the business is growing and the promoters are not investing the money in unrelated activities.

Now that we have looked at what criteria to use in selecting a good mid-cap company, the next question is when to invest. In bear markets, mid-caps are battered beyond recognition. Hence, one can follow this strategy. Keep accumulating large-cap stocks on every dip.

For mid-caps, buy only if the Nifty sustains above its 200 day Moving Average for a week or more. 200 day Moving Average is considered the dividing line between bear and bull markets.

Also, depending on one’s risk profile, the allocation has to be done between large-cap and mid-cap ideas. A conservative portfolio can have a 80:20 ratio between large and mid-caps. A more aggressive portfolio can have 60:40 ratio between large and mid-caps.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

Some strategies about buying stocks

In a post last week, I had discussed strategies for selling stocks. Most small investors know how to buy stocks, but they rarely have proper strategies for selling. So why am I writing about buying strategies?

From the spate of questions I have recently received about when and how much to buy, it seems that discussing some buying strategies may be useful after all. I had mentioned about using the ‘Margin of Safety’ concept and P/E bands to decide entry points in last week’s post.

The importance of those two concepts can’t be over-emphasised. Too many young investors follow the wild west policy of ‘Shoot first, and ask questions later’. Just switch on any business TV channel (just for entertainment) during the day when they take reader queries. 99% of the questions are: ‘I have bought thus and such stock at this price; should I hold or sell.’

It is apparent from the questions that the stock was bought near a top, and the investor is already sitting on a loss. The question – or rather, a plea – is to find out if the TV expert knows some magical formula by which the loss can be quickly turned into a profit, or, at worst, break-even with no loss.

All one has to do before placing a buy order, is to first check whether the current E/P (i.e. inverse of the P/E ratio) is higher than the long-term bank fixed deposit rate, leaving a ‘Margin of Safety’ . Also check that the debt/equity ratio is less than 1, and that the cash flow from operating activities is positive for 4 of the last 5 years.

If E/P is lower than the bank FD rate, then check the P/E band within which the stock normally trades, and buy only if it is available near the middle of the P/E band or lower. These are basic precautions, and will help prevent losses – even if you don’t have the time or inclination to do a detailed fundamental analysis.

If you are like most small investors, the stock price will fall just after you’ve bought it (and, it rises soon after you sell)!! What should you do? Do not, repeat, do not average down. That is the single cause for turning a small loss into a much bigger one. Instead, keep a stop-loss – and sell if the stop-loss is hit on a closing basis (i.e. take intra-day movements out of the equation).

You will make much more money by averaging up. When should you do that? Buy 20-25% of your intended quantity at the beginning. Add more every time the stock dips or corrects on the way up. Follow a ‘pyramid’ strategy – i.e. buy less and less quantity on the dips as a stock keeps moving up in price – till you acquire your intended quantity.

Such a strategy will prevent impulsive buying of 2000 or 5000 shares in one go, in the hope of becoming a Warren Buffett within a month. Talking of Buffett, I love his quote: ‘You can’t make a baby in one month by getting nine women pregnant!’

Wealth-building takes time. If you hone your buying and selling strategies, you have a chance of becoming wealthy in 15-20 years – but not in 15-20 months.

Notes from the USA (Jun 2011) – a guest post

One of the best ways to find out about the true state of financial health of a company is to scrutinise its cash flow statement. The Profit and Loss statement is based on the accrual system of accounting. The cash flow statement records the actual inflows and outflows of cash, which provides a better idea about the sustainability of a company’s business model.

What about an investor’s cash flow statement? Are you keeping track of exactly how much cash inflow is being generated by your cash outflows (i.e. investments)? Specially in a sideways or sliding stock market? In this month’s guest post, KKP shares some of his thoughts on the subject.

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Lets Get Down to Cash Flow Analysis

Q1 and Q2 2011 have shown that there might be a good size recovery, giving a feeling of hope to many people in the US, as well as corporations. The economy has slowly been recovering – no doubt. But the housing and construction market rebound has remained soft despite the big QE (quantitative easing) programs from the Fed and the low-low-mortgage rates (average 30-year fixed U.S. mortgage rate is around 4.82%). The reason is simple: Stubbornly high unemployment and underemployment, and also tight lending policies from the bankers/lenders. Bankers have swung the pendulum to the other end of the spectrum and have very stringent policies. In 2002-2008, lenders would lend money to people without any money down (by doing double mortgages), and today, even if someone is providing 25% down payment (upfront cash), they are scrutinized as if they are one of the worst borrowers.

Predictions show that home prices will fall around the 5% to 10% in 2011 compared to 2010, and they will remain flat in 2012. This median forecast was part of a poll by Reuters of 21 economists who provided price forecasts. In looking at really long term trends of US home prices, it clearly shows that home prices are close to the bottom and will hover around here for a bit, and with a ‘core-recovery’ we will see a bounce up in prices (albeit very slowly).

"It is hard to see the housing market doing better until the massive headwind of foreclosures is removed and that will likely take a couple of years," said Mark Vitner, senior economist at Well Fargo Securities in Charlotte, North Carolina. With home prices still falling, many potential buyers are sidelined and banks are more stringent with loan applications and credit scores, Wells Fargo's Vitner said. "It is not that I am pessimistic about the housing market, it is just that I am not optimistic and a gradual recovery probably will not happen until 2013 or 2014, with a full normalization not until 2015," he said.

I have noticed that there is a rise in the "distressed, foreclosed and short sale" homes due to the fact that the lower home prices have put mortgage balances (what you owe on the home) above the current price of the home. Therefore, the home either goes into a short sale (seller and lender put it on the market), or foreclosure (owner cannot or will not pay mortgage), or distress situation (seller does not pay mortgage, and lender cannot afford to keep the home on the books). The net result is that the price of the home has to be marked down significantly, for investors or home-upgraders or renters are willing to look at the properties.

I am currently sprucing up a home that I purchased as a ‘distressed home’, and will be renting it out before July 1^st, 2011. In addition, have offers out on Short Sales where the Seller and Lender are considering my offers for Downtown Condos (at 1/3^rd to 1/4^th the last sale price). Even with the above flat market situation predicted, I remind myself that I am buying real estate at the “equivalent of March 2009 Sensex prices”. Remember how undervalued we were in the stock market at that time, before we took off? Real estate will NOT take off in the same manner (of course), but my tarot-charts (figuratively speaking) is telling me that I am buying it close to the bottom and have no desire to price these out for sale since I will be renting them out in the near term (2 to 5 years).

In addition, I am buying these at really ‘distress’ prices, instead of chasing them, and have the ‘patience and privilege of dividends’ while I hold. Dividends are in the form of rent here so it is easy to convince myself to hold. So, equate it to holding a stock that may not move up immediately, but will pay you almost risk free 12% to 26% in return with minimum loss of capital (if so).

Bottom line is that a lot of books have been written about ‘cash flow’ production, and with this methodology, I have found how much of a parallel it holds to Selling Calls on individual stocks being held in a portfolio. Call Selling had been a very favourite methodology of mine when I was very active in the markets in the 1990’s, and most recently as a way of reducing my stock holdings. But, in both cases, it taught me how to ‘generate cash flow’ from the holdings, and ‘make a paycheck’ out of it.

Real estate has the power to make the same with almost the same amount of time involvement. Wow. Really? Yes, very true. In India, it is even better since you can literally buy a flat/condo and rent it out, making all responsibilities of maintaining the flat a responsibility of the tenant (minus big issues). I am able to replicate the same with a team of contractors to simplify my life and do virtual-maintenance (call someone to go and fix it at low cost).

For now, think cash flow, and figure out a way to generate a paycheck or cash flow from your investment holdings. If you hold RIL or HUL for a long time, the percentage yield to your purchase price could be significant enough to get a very net high yield, especially if the stock has provided splits/bonuses. With my net-buy-price of HUL under Re 1.00, the percentage yield on the annual dividend seems like a paycheck each time it comes. So, there are many ways to skin the cat, and as one gets more experienced, some of these techniques become part of the portfolio and life, and yet, it is each portion of the portfolio that needs to replicate the ‘cash flow’ generation methodology. Traders might be good at generating cash flow from ‘trading’, but very few can do it consistently, and hence doing it with many techniques/strategies will be good for your long term financial health.

Hope you can ‘draw’ some ideas from this to your thinking and add a twist to your investments that might change the overall short and long term return, such that it gives back some cash flow which can help with your own personal goals (buying gold or silver)…..Oh, that brings me to another favorite topic of mine (gold), but we will leave that for the future….

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

Why small investors should avoid ‘cheap’ stocks

There are several reasons why small investors should avoid ‘cheap’ stocks, and I will take them up one by one. Before that, one must understand what is meant by ‘cheap’ stock.

Investopedia.com has the following definition:

“The illegal practice of issuing stock options at artificially low prices shortly before an initial public offering. Often underwriters will require a company to have more qualified management before they can go public. They attract these qualified individuals by giving options with a low exercise price.”

This was a practice which was prevalent prior to and during the dot.com boom in the USA, and is not unheard of in India. While it can lead to significant profits, the average small investor won’t be able to participate - unless his uncle or friend’s father was the promoter of the company. If a company is trying to sell its stock through bulk SMS and email messages at a lower price than its forthcoming IPO price, chances are that it is a ‘dud’ company and best avoided.

Then there are those companies that were the apple of investor’s eyes during the previous bull market, and reached stratospheric levels just before the crash in Jan 2008. Real estate stocks were at the forefront, followed by the stocks with the word ‘infrastructure’ in their name. Most of these apples had rotten cores. They have not only become cheap stocks, but continue to get cheaper by the day. Don’t go anywhere near them.

There are cheap stocks which are also called ‘penny stocks’ because they trade below Rs 10. Most of them are unknown, fraud companies who have no business and no intention of doing any business. Occasionally they boost up their share price from Rs 3 to Rs 8 by planting fake stories in the media about the great opportunity for investors once they dismantle the fourth rate defunct plant that they have bought in Uzbekistan or Burkina Faso and reinstall the plant in Jhumri Tilaiya. Avoid such stocks like the plague.

Some cheap stocks may appear cheap, but are not. A Re 1 face-value stock trading at Rs 15 is equivalent to a Rs 10 stock trading at Rs 150. A Rs 10 face-value stock trading at Rs 15 may not be cheap either, if it belongs to a loss-making company, or one that is trading at a P/E of 80 or 100. Stay away from such stocks.

What about stocks that appear relatively cheap with P/E ratios below 15 that generate strong cash flows from operations, have low debt/equity ratio and double-digit profit margins? Ah-ha, now we are talking. I just love to dig and find such stocks. They are the ones that will give a nice boost to your stock portfolio’s performance.

A Solution to the Exercise on Cash Flows

Last week’s exercise on Cash Flows drew a large number of readers, but, disappointingly, only 6 responses. That could be because of three reasons: (a) most readers did not understand the concept of cash flow; (b) readers felt shy about making an incorrect response in an open forum; (c) readers did not feel that cash flow is an important enough concept to break their heads over.

Now that the Sensex is on the upswing again after nearly 5 months of correction, the participation in various investment groups and chat boards have increased significantly. Many of the topics are nothing but a succession of ‘buy’ calls on stocks of various pedigree, mostly questionable, with a stop-loss 2 points below the ‘buy’ price and targets of 3 points and 5 points above the ‘buy’ price. Gleeful announcements follow that the first target has been hit and one should book 50% of profits!

If more young investors learned the basics – and let me emphasise that cash flow is one of the most important concepts any investor should learn – they would know how to make really big money, instead of being happy with a 3 point or 5 point profit in 2 days (which they don’t forget to annualise into huge percentage gains to ‘prove’ their stock-picking prowess).

Pardon the rant. Now a turn to acknowledge the 6 readers who had the interest and intelligence to read and understand the concept of cash flow, and the guts to attempt answers to the exercise. Well done. All of you are winners, because you can consider yourself a few cuts above ordinary investors, who jump into the market with no idea of what they are doing.

There were no ‘right’ or ‘wrong’ answers, because stock picking depends on individual preferences and risk tolerance levels. But a distinction needs to be made on the process one follows to take a decision about a particular stock. A special hat-tip to reader ‘TK’ for the most logical way of arriving at his decision. My anonymous subscriber’s response was the next best.

Just to recap the concept of cash flow, a positive number is an inflow and a negative number is an outflow. In cash flow from operating activities, a positive number is preferred. A business should not just generate profits, it must generate cash – not as an amount to be received at some future date (which is represented by a negative cash flow). Often, the profit figure is an accounting sleight of hand. So the negative cash flow never turns positive. On this aspect alone, Company ‘A’ beats ‘B’ and ‘C’ hands down. (Cash flow can be fudged also – but will show up in the Balance Sheet. This is what Ramalinga Raju did at Satyam, and his auditors ignored or overlooked it.)

‘A’ has also been investing regularly in expanding its activities, as can be seen from the negative cash flow from investing activities. Negative cash flow here is actually good for the business. However, if the cash generated from operating activities is insufficient – as was the case in ‘06, ‘07 and ‘09 – there is no option but to resort to borrowing. Note that the cash flow from financing activities were large positive amounts. In the two years (‘08 and ‘10) that substantial cash was generated from operations, the company paid back some of its debts – as can be seen from the negative cash flow from financing activities. A sign of financial prudence.

What can’t be made out from the abridged cash flow statements is the total debt burden and interest payments. If the debt/equity ratio (which is calculated from the Balance Sheet) is more than 1, then the company may get into a debt trap after one or two bad years. Another metric to check is whether interest payment exceeds net profit (which can be observed from the P&L statement). If it does, then the banks are benefitting more than investors.

As far as ‘B’ and ‘C’ are concerned, both fail the test because I only consider companies suitable for investment if they have positive cash flow from operating activities in at least 4 of the past 5 years. Of the two, ‘B’ is better because it has achieved higher profits on lower levels of debt (as can be seen from the cash flow from financing activities). Also, its profits are growing, whereas profits of ‘C’ are stagnating.

Please appreciate that this particular analysis is a bit simplistic because the cash flow statements are abridged. However, it provides a good overall picture for short-listing potential companies to invest in. A more detailed analysis of the Balance Sheet and P&L statement should be conducted before taking a ‘buy’ decision.

Ideally, a company should not only have positive cash flow from operating activities, but also positive free cash flow. That means, cash flow from operating activities should be more than enough to fund any capital expenditure. Such is the case with many FMCG companies. One reason why FMCG is my favourite sector.

(Note: Company ‘A’ – Aurobindo Pharma; Company ‘B’ – IVRCL Infra.; Company ‘C’ – Pantaloon Retail. No particular reason for picking these three – other than the fact that they can be ranked based on their cash flow statement.)

A Simple Exercise on Cash Flows

Last week, I had written two posts about how to read the Cash Flow statement in an Annual Report. An old proverb says: The proof of the pudding is in the eating. The best way to figure out whether you have understood the basic concepts of the Cash Flow statement is to do a simple exercise.

Here are three companies and their condensed Cash Flow statements. Analyse the three on the basis of their Cash Flows, and explain which of the three companies you would like to invest in, and why. All three companies are popular among small investors, but their names have been deliberately hidden to remove any bias in your analysis.

Company ‘A’

(Rs crore)	Mar '10	Mar '09	Mar '08	Mar '07	Mar '06
Profit before tax	710.15	157.04	344.84	231.16	92.90
Cash flow - operations	344.66	4.88	105.47	49.48	3.78
Cash Flow - investing	-406.21	-301.73	-12.00	-606.64	-232.01
Cash Flow - financing	-14.15	160.97	-185.45	723.43	356.58
Incr/decr in cash	-75.70	-135.88	-91.98	166.27	128.35

Company ‘B’

(Rs crore)	Mar '10	Mar '09	Mar '08	Mar '07	Mar '06
Profit before tax	328.84	273.78	285.33	185.10	103.73
Cash flow - operations	179.68	46.83	-377.53	-127.51	-83.85
Cash Flow - investing	-127.77	-236.37	-132.33	-426.58	-288.69
Cash Flow - financing	8.09	113.28	463.37	533.80	164.20
Incr/decr in cash	59.99	-76.27	-46.65	-20.53	-208.33

Company ‘C’

(Rs crore)	Mar '10	Mar ‘09	Mar ‘08	Mar ‘07	Mar ‘06
Profit before tax	213.64	216.23	195.62	181.01	91.90
Cash flow - operations	1148.20	206.11	-19.21	-271.94	-89.61
Cash Flow - investing	19.20	-844.59	-1410.82	-641.73	-434.46
Cash Flow - financing	-1176.20	626.72	1388.16	1054.87	524.54
Incr/decr in cash	-8.80	-11.76	-41.87	141.20	0.27

The last rows in each of the three tables is the sum of the previous three rows, giving the net cash at the end of each year. Negative numbers mean cash outflows; positive numbers mean cash inflows.

If you are one of those who gets scared by tables full of numbers, let me assure you that it isn’t my wish to scare you at all. It is far more scary to invest in the shares of a company without having a clue about how much cash it is generating and using up.

So put on your thinking caps, and give it a shot. Results (and the company names) to be announced next week. Needless to say, the most logical attempt(s) at answering will be duly acknowledged.

Related Posts

How to read the Cash Flow Statement – Part 1

How to read the Cash Flow Statement – Part 2

How to read the Cash Flow Statement – Part 2

In last Tuesday’s post, I had covered the first part of the Cash Flow Statement – Cash Flow from Operating Activities. The next two parts will be discussed in this post.

Part 2: Cash Flow from Investing Activities 

To remain in business over the long haul, a company needs to grow. Without growth, a business will stagnate and eventually die or get acquired. But growth has a price. Cash has to be spent to buy land, machinery and related equipment, build factories and offices, acquire other companies, start subsidiaries or joint ventures, and make appropriate investments.

All of the above comes under Cash Flow from Investing Activities. You don’t have to be a genius to guess that this figure will be a (negative) one for most companies. Many mature companies, particularly those in the FMCG sector, don’t have much need for Capital Expenditure (i.e. spending cash on factories and equipment) because their rate of growth has slowed down.

Ideally, the depreciation amount in the Profit and Loss statement should be less than or equal to the amount of cash being spent in investing activities – because depreciation is meant to cover the notional loss due to wear and tear of the existing plant and machinery. If a company does not continuously spend on upgrading and modernising its facilities, it will not be able to compete with newer entrants who may have the latest technology and equipment.

The definition of Free Cash Flow is:

Cash Flow from Operating Activities – Capital Expenditure

This is a (negative) number for companies in their early growth stage, when cash generated from core operations may be insufficient to cover the cost of capital expenditure. But for well-established companies, positive Free Cash Flow is an indication of financial health. The more positive Free Cash Flow a company can generate, the easier it is for them to expand, acquire, pay dividend or buy back shares, and pay off loans.

Part 3: Cash Flow from Financing Activities 

What if a company has (negative) Free Cash Flow, or still worse, has (negative) Cash Flow from Operating Activities? Where will they get the cash to pay their suppliers, interest to banks for any loans taken, and for growing the business?

They can either resort to more borrowings, and/or issue more shares. If such companies are showing a net profit, then they are also expected to pay dividends to their shareholders. All inflows and outflows of cash due to loans, share issues, share buybacks, dividend payments come within Cash Flow from Financing Activities.

Financial prudence should dictate a company’s growth plans. As a thumb rule for selecting good stocks, about 60-70% of the Cash Flow from Investing Activities (Part 2) should be funded by positive Cash Flow from Operating Activities (Part 1); the balance 30-40% should come from Cash Flow from Financing Activities (Part 3).

Many companies forget the simple adage that one should cut one’s coat according to the cloth. They may even have positive Cash Flow from Operating Activities, but their ambitious growth plans require far more cash than they can afford. They resort to frequent borrowings and share issues in the hope of reaching the top quickly. One or two bad years can bring such companies down to their knees. Pantaloon and Suzlon come to mind.

(Note: The financial health of banks and financial institutions can’t be judged by analysing the Cash Flow Statement alone – because they need to borrow cash to give loans, and invariably have negative Cash Flow from Operating Activities. Price to Book Value and Return on Assets are better measures for such companies.)

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How to read the Cash Flow Statement – Part 1

Have you heard the statement: Cash is king? A business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive. Seems logical that investors would first look at the Cash Flow Statement in an Annual Report – right?

Unfortunately, most investors in the stock market – even those who have been investing for many years - do not understand or know how to interpret the Cash Flow Statement. Just looking at the Balance Sheet, Profit and Loss statement and the Management Discussion and Analysis is not enough. The real state of a company’s finances is hidden in the Cash Flow Statement and the Notes on Accounts.

With another accounting year coming to a close on Mar 31, 2011, this is as good a time as any to learn the basics of the Cash Flow Statement:-

The Cash Flow Statement allows you to check the different sources of cash inflows into a company during a particular year vis-a-vis the prior year, how much cash was spent, and what it was spent on. Cash inflows are positive, cash outflows are (negative). The three parts of a Cash Flow Statement enable you to understand what a company’s management is doing with the cash at its disposal, by comparing the figures with those appearing in the Balance Sheet and Profit and Loss statement.

Part 1: Cash Flow from Operating Activities

The Net Profit before tax and exceptional items from the Profit and Loss statement is adjusted with depreciation, interest, provisions, profit/loss on investments, debtors, inventories, creditors to arrive at the cash generated from operations. Tax and exceptional items are then adjusted to arrive at the Net Cash from Operating Activities.

Though it may seem counter-intuitive to non-accountants (like me), depreciation is considered an inflow (it is an expenditure in the Profit and Loss statement, but the cash is not paid to any one and remains within the company); creditors/accounts payable is an inflow (because they haven’t been paid yet); debtors/accounts receivable is an outflow (because a ‘sale’ has been accounted in the Profit and Loss statement but the money hasn’t been received yet).

Net Cash Flow from Operating Activities should preferably be positive, and greater than the previous year’s if the net profit has gone up. Newly set-up companies, particularly those in high growth fields like Information Technology or Bio-technology, often have negative cash flows from operations in their initial years. They need to ramp up operations quickly to meet demand but may not be able to negotiate good payment terms from their clients.

Negative cash flows from operations of established companies, if over prolonged periods, indicate that there is something amiss with the business model, or the management has questionable integrity and is diverting cash to unlisted subsidiaries or to related parties.

Investors need to be particularly wary of companies that show good top-line and bottom-line growth year after year, and pay taxes and dividends but show negative cash flows from operations. Where is the cash to pay the taxes and dividends? It comes from regular borrowings and share issues. If such a situation continues for a few years, the debt burden will eventually sink the company. Many realty and high-flying infrastructure companies, and investor favourites like Bartronics, Cranes Software fall within this category.

(Note: The next two parts of the Cash Flow Statement will be covered in Thursday’s post – so please stay tuned.)

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Can a growing, profitable company go out of business?