Picking Stocks: These 7 Examples Show Why Operating Cash Flow Is More Important than Net Profit

Operating cash flow (OCF) is the key to understanding how well a company is doing. It defines whether, and how much of, the revenues are getting converted to cash. However, most investors lean towards net profit (NP) as the primary metric of a company’s performance. Why?

One of the main reasons is that OCF numbers are provided once in a year while the net profit numbers are provided at the end of every quarter. This gives an opportunity to the media and so-called experts to discuss NP at least four times a year and, accordingly, be more worried—or excited—about growth.

Also, many small investors find it difficult to read these numbers in the annual reports primarily because of fear of the unknown. How does one arrive at OCF and how is it different from NP? Let’s first define NP and OCF, before we proceed to explore the importance of each of the terms.

NP comes from the profit and loss (P&L) statement, while OCF comes from cash flow statement.

Net Profit: Net of revenue or sales after minusing all operating expenses, depreciation, interest and taxes, including any other income and taking into account exceptional items.

Operating Cash Flows (OCF): The net cash generated from operations.

Investing Cash Flows (CFI): The net result of capital expenditure, investments, acquisitions, etc.

Financing Cash Flows (CFF): The net result of raising cash to fund the other flows or repaying debt.

Why OCF and not NP: OCF is a better metric of a company’s financial health for two main reasons. First, cash flow is harder to manipulate than net income. Second, ‘cash is king’ and a company that does not generate cash over the long term is heading towards getting wiped out. OCF gives you the picture of the cash received in the organisation. Without cash, the company may not be able to fulfill its promise to make payments to suppliers, employees and financial institutions on a sustainable basis.

Accrual Accounting System vs Cash Flows: To generate NP, a company may be required to just make a sale. This sale could be either in cash or on credit. If it is a cash sale, it gets recognised in OCF also.

However, business reality is a bit more complex. Most companies provide credit facilities. This could provide an opportunity to manipulate the net profit numbers. Imagine a company that makes a credit sale and, based on it, immediately recognises the sales in the P&L and, accordingly, arrives at the NP number. However, the cash is not received and, hence, OCF does not go up.

What happens if the customer delays the payment or returns the goods or if the sale was bogus? This results in a build-up of receivables in the balance-sheet. But the real OCF has never happened. The company may continue to do so but not indefinitely. It will have to face the reality at some point in time. The receivables numbers then will turn bad debts and result in pain.

Seven Examples

There have been several examples where companies were not generating cash flows but continued to show profits through various means. These companies faced the grim reality at some point in time and their stocks collapsed. Also, if the promoters’ holding is poor or there is a continued equity dilution along with poor OCF, it becomes a deadly cocktail.

There are hundreds of examples. I have chosen seven examples to highlight how following NP and OCF can mislead us. Why these examples? Well, these are some high-flying cases in which many media-savvy analysts, institutional investors, and retail investors have invested or have talked about them. I have discussed these companies with many friends and relatives in the past due to our mutual interest in stocks. I have taken the data only up to the point where I have analysed it last when faced with such queries.

I found a common element in companies with poor OCF. These companies are, often, backed by very strong growth stories and are widely traded in the stock market with lots of hope. These companies were the cynosure of the eyes of stock market players. In these seven cases, too, the stocks were running high with growth stories being spread by analysts and large investors. Eventually, these companies’ stocks, and those of several such companies, which were unable to generate OCF, just crashed by as much as 95% from their peak price.

 

Ideal Situation: How do we know what the NP should be? In an ideal situation, the ideal OCF vsNP ratio should be close to one. The higher the OCF, the better it is. However, there could be a year or two where OCF is down due to market conditions or specific circumstances. But it cannot be for an indefinite period; otherwise, the survival of the company will be in question.

OCF Can Be Fixed Too: One more word of caution. Companies can manipulate OCF also. That’s where a glance at the balance-sheet can catch any discrepancy. Positive OCF can be generated by decreasing the non-cash working capital. Decreasing non-cash working capital means liquidating items like inventory, receivables (you are supposed to get this money from your customers and not by selling it off in the market at a discount) or increasing payables (you are supposed to pay your suppliers and which you don’t).

Are these steps, like liquidating receivables, inventories or increasing payables sustainable? Not at all! Inventories and receivables cannot fall below zero and creditors will not extend credit indefinitely, unless payments are made when due.

One must go through the balance-sheet numbers to see if there are any marked changes in receivables, payables, or working capital numbers from the previous year’s numbers. If so, you know where the problem is.

Exception: There are some exceptions to the rule of OCF, especially with respect to companies that deal only with cash—that is, banks and finance companies. The OCF rule is not applicable in such cases or it needs to be tweaked extensively.

Other Helpful Parameters along with OCF

In addition to OCF, if we also consider the following parameters, it would further help us in our analysis.

  • Interest paid vsnet profit: a ratio of more than 0.4/0.5 is risky
  • Equity dilution on an ongoing basis
  • Promoters’ unpledged holding in the company
  • Trends in receivables
  • Investing and financial cash flows

Final word: NP without OCF is like a body without oxygen and if it is coming with low promoter shareholding, equity dilution and high debt, it is a sure death warrant for the investor.

Reference: http://www.investopedia.com for definitions

Author and disclosure:

Niteen is one of the founders of Aurum Capital, a SEBI-registered investment adviser. Stocks mentioned in the article does not constitute personal recommendations. The analyst does not hold any of the stocks mentioned in the article above. 

Note:
This article was originally published in Moneylife magazine. 

Interview of Jiten Parmar discussing key principles of investing

Dear All,

Jiten Parmar, the co-founder Aurum Capital, is interviewed by The Unlimited Abundance.

This podcast reveals his 3 principles of investing discipline which helped him amass Multibagger returns with amazing ease.

https://www.youtube.com/watch?time_continue=2&v=-lCU7UVqqPA

Please do share your inputs.

Regards,
Aurum Capital
SEBI registration No: INA000011024

Important Disclaimer:
The stocks named, if any, during the interview are for educational purpose and are not recommendations of any kind (Buy/Sell/Hold). Please consult your registered Investment Advisory or Analyst before taking any financial decisions.

 

Response to the quiz

First of all, let me reiterate, it was just a quiz and NOT a recommendation of any kind (buy/sell/hold). The purpose of this quiz is to make some of the readers go through the numbers. If someone reads this as a tip or recommendation then the whole purpose will be lost.

We received several responses. It has come on the blog, twitter, email, and whatnot. We are glad to receive them, as always. Thank you for your active participation.

Many of you answered it correctly though some of you got confused with Arrow Greentech, Lasa Supergen, Time Technoplast, Harita Seating, Tata Global, JHS Svendgard and HUL.

If you could not answer it correctly then also it is fine as long as you tried. What we need to do is to understand the parameters that we missed and that caused a wrong answer.

The correct answer is: Uflex Limited

Original quiz: https://aurumcapital.in/blogs/2018/08/19/identify-the-company/

Disclaimers:

The information herein is used as per the available sources of bseindia.com/nseindia.com, company’s annual reports & other public database sources. Aurum Capital is not responsible for any discrepancy in the above-mentioned data. Investors should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for the necessary explanation of its contents.

Future estimates mentioned herein are personal opinions & views of the analyst. Analyst Name – Niteen S Dharmawat. For queries/grievances – support@aurumcapital.in. SEBI registration No: INA000011024.

Readers are responsible for all outcomes arising of buying/selling particular scrip/ scrips mentioned herein. This report indicates the opinion of the author & is not a recommendation to buy or sell securities. Aurum Capital & its representatives have vested interest in above-mentioned securities at the time of this publication, and its partners/company have positions / financial interest in the securities mentioned above.

Aurum Capital or its associates are not paid or compensated at any point of time, in last 12 months by anyway from the companies mentioned in the report.

Aurum Capital, or its representatives do not have more than 1% of the company’s total shareholding. Ownership of the stock: Yes. Served as a director / employee of mentioned companies in report: No. Any material conflict of interest at the time of publishing report: No.

The views expressed in this post accurately reflect the author’s personal views about any and all of the subject securities or issuers; and no part of the compensations, if any was, is or will be, directly indirectly, related to specific recommendation or views expressed in the report.

Identify the company?

Can you identify the company? I have provided some clues to help you decipher the name of the company.

  • The stock seen its high in Dec 2017, there are 1000s of stocks that did so 🙂
  • The stock is trading at ~60% of its peak price
  • The market cap to sales ratio is less than half
  • The last 10 years average operating margin is more than 10%
  • It is a leader in its category, innovative products, global operations
  • It is trusted more by global MNCs, many of them are leading FMCG giants, than by stock investors
  • The company has entered into a new category and if successful could drive significant growth
  • The interesting part is one of the global funds was holding more than 1% till Mar 2018 is no more in the list of 1% category in Jun 2018 quarter. This fund was holding for a long time.
  • The others in more than 1% category are still holding or have increased their holding %
  • If we research more then we come to know that this global fund is acquired by another fund in Dec 2017 and selling by them started after the Mar quarter. One of the possibility is that the mandate for the fund could have changed.
  • The stock started recovering from August onwards. Was it because the selling of the fund got over or is it because of the general mood of the market?

Let’s name the stock. We will let you know the name of the company by next week. Till then we look forward to your response.

Disclaimers:

The information herein is used as per the available sources of bseindia.com/nseindia.com, company’s annual reports & other public database sources. Aurum Capital is not responsible for any discrepancy in the above-mentioned data. Investors should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for the necessary explanation of its contents.

Future estimates mentioned herein are personal opinions & views of the analyst. Analyst Name – Niteen S Dharmawat. For queries/grievances – support@aurumcapital.in. SEBI registration No: INA000011024.

Readers are responsible for all outcomes arising of buying/selling particular scrip/ scrips mentioned herein. This report indicates the opinion of the author & is not a recommendation to buy or sell securities. Aurum Capital & its representatives have vested interest in above-mentioned securities at the time of this publication, and its partners/company have positions / financial interest in the securities mentioned above.

Aurum Capital or its associates are not paid or compensated at any point of time, in last 12 months by anyway from the companies mentioned in the report.

Aurum Capital, or its representatives do not have more than 1% of the company’s total shareholding. Ownership of the stock: Yes. Served as a director / employee of mentioned companies in report: No. Any material conflict of interest at the time of publishing report: No

The views expressed in this post accurately reflect the author’s personal views about any and all of the subject securities or issuers; and no part of the compensations, if any was, is or will be, directly indirectly, related to specific recommendation or views expressed in the report.

View on INR Depreciation and its impact on Stock Market

The INR has weakened off late to about INR70 to a dollar. In the last 5 years, the difference in inflation between India and the US was about 3.95% (the US had lower inflation). The rupee depreciated be a little less than 2%. So, a depreciation was due. What we have observed is that in 5 years or so, Rupee does find its level vis-a-vis the dollar. Last time it was in 2013 and before that in 2008.

We also have to see this in the context of dollar strengthening and yuan and other emerging market currencies depreciation against the dollar. Exports have suffered due to Rupee being strong. CAD has widened in last 1 year, and this called for a depreciation of the rupee. We think that 70-71 is par for the course.

The silver lining is that crude has come down, which is a positive for India. Exports may now get a fillip. Rupee weakening will help the companies doing exports. So keep an eye on those. Companies which have imports might get adversely affected.

In a nutshell, crude coming down is a long-term positive for India. The import of electronic items is the largest in terms of forex outgo now. The government needs to put the impetus on domestic manufacturing of electronics. Some positives on this front are visible, but a lot more needs to be done.

Investors need not panic and look for opportunities which a depreciating rupee and fall in crude provide. At Aurum Capital, we do keep an eye on these events and look for opportunities arising out of these.

Happy investing.

Regards,
Aurum Capital
SEBI registration No: INA000011024

Interesting times in equity markets

Dear All,

Welcome to Aurum Capital and thank you for registering on our website. If you have not registered then please do that. The blog post going forward will be available only to the registered users. You can get registered using “Free Sign Up” link on the platform.

After a stellar run in 2017, broader equity markets have given a very good correction. A handful of index stocks are up, and hence index is at a new high. The founders of Aurum Capital have been giving their views about the markets for more than a decade, trying to help investors make better decisions.

We had anticipated a correction in small and midcaps as a lot of froth had built up. The fall has been severe and sharper than even our expectations. We had moved significant funds to cash and into safer stocks in Dec and Jan.

Reading of the markets is important and if we can get it reasonably right, we can outperform. The reasons for the fall in small and midcaps were:

  • Over-valuations due to frenzy and euphoria among investors, ignoring fundamentals
  • New regulations of reclassification of mutual funds, which resulted in the money entering into few large-caps and away from mid/small caps
  • Regulatory measures like ASM, GSM
  • The feeling of political uncertainty
  • Macros turning bad – high crude prices, current account deficit widening, rupee depreciating, higher US interest rates resulting in selling by FII’s
  • Geopolitical events like the possibility of trade and currency wars
  • Increase in commodity prices
  • Interest rate hike

Some of these are still valid and can be a challenge in the future. On the other side, we are seeing micros improving

  • GST rollout has more or less stabilized. Collections are improving. Recent rate cuts in GST slabs give a leg to growth
  • Compliance in taxation increasing meaning that revenues for the government will increase
  • Good monsoon prediction
  • Huge focus on infrastructure by the government
  • Consumer discretionary spends increasing
  • No major negative surprises in corporate earnings so far

Some good signs emerging are that crude has started moderating, growth is coming back. The economy is much more robust and major disruptions are over, and we believe steps taken by the government will put the Indian economy on a very good growth path.  We believe valuations in quite a few of the large caps are not sustainable and there could be time or price correction or both. We, at Aurum Capital, believe in value investing and are very particular about the price we want to pay, howsoever great a company maybe. We believe a lot of companies have corrected well and look good at current valuations. We might have short-term hiccups, but we definitely believe in the long-term story of India and remain positive.

Many have asked questions like “skin in the game” in the stocks we are planning to recommend. The founders of Aurum Capital believe this. They may be buying or holding the stocks recommended to the clients. This will be in line with the guidelines prescribed by the regulator. What we think is good for our subscribers, has to be good for us too. Our interests will be aligned.

We are working on a few stock ideas while expecting the market to get stabilized. Our first recommendation will be coming soon.

We have taken a lot of efforts and time to build a robust technological platform at www.aurumcapital.In. Our technology platform will ensure that the reports are available only to the genuine subscribers. The watermarked reports (with subscribers details on each page) will be available to the paid subscribers. We are deploying cutting-edge technologies to ensure avoidance of misuse of the platform by unscrupulous paid subscribers.

We will also have an investor forum for our paid subscribers. This will be an opportunity to interact with the subscribers. To find out how investor forum and how our service will work, please visit https://aurumcapital.in/faqs.

The response to our launch has been very encouraging. We thank all our paid subscribers and those who showed interest but yet to become a paid subscriber.

We look forward to your comments. Wishing you a very happy investing journey.

Regards,
Aurum Capital
SEBI registration No: INA000011024