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Observations - Cash Blues

Observations - Cash Blues

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Published by: abhimails on Oct 08, 2008
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06/16/2009

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Hemant Sreeraman - 1 -
 
Hope…can’t substitute Reason
OBSERVATIONS – CASH BLUES
Tuesday, October 17, 2006
 
In the wake of recent euphoria gripping stocks in the construction sector, I thought of taking a closer look at the pack fromthe point of view of a conservative investor. The markets normally do not contend the saying, “Cash is King!” But going bythe umpteen research reports by prominent brokerage houses, I wonder if the markets have forgotten the truism. In thisarticle, I will briefly write on why JUST focusing on the Balance Sheet & Income Statement can be delusional. I will write onwhy investors need to focus on the Cash that a company generates. Investors pay for Earnings growth, however, in additionto this, they also need to pay for financial ‘health’.
To understand why Cash is so important, let’s imagine a story. I will simplify our discussion to a greatextent, to keep the core point in focus. I will not expound in typical Finance Text Book fashion, forcouple of reasons. I get bored...& by extension you will too. In keeping with the spirit of Observations,I will take an intuitive approach.You see a huge market for Trousers over the next couple of years & wanting to cash in on theopportunity, you decide to start trading. In the 1
st
year of operation you find that demand is good areable to sell Trousers worth Rs.100.
(Too little, you say? Well...this was never about selling trousers, was it?)
Yourexpenses, in the form of paying your employees, electricity bills & selling expenses amount to, let’ssay, Rs.50. If someone asked you to draw up an Income Statement, this is what it would look like.
YEAR 1:
 
INCOME STATEMENT
 (All numbers in Rupees)
 Sales 100(-) Expenses 50-------------------------Net Profit 50-------------------------
Note: We assume No Depreciation Charges, No Taxes &, for the moment, No Interest Expense
 You look at this & are very happy. After all, haven’t you made a Net Profit Margin of 50%? (Net Profit =Rs.50 / Sales = Rs.100) Sure you have. But is this Rs.50 the amount you have in your bank too? Lets takea look.Accounting norms allow companies to ‘’record’‘ Sales when the goods are ‘’sold’‘ to customers,irrespective of whether or not you receive Cash for the goods sold. So, lets say that since you are newin this business, your customers pay you only
after
1 year. (This is an idealized scenario. If businessindeed worked this way, they would very quickly be out of it!) Now what happens?Your Expenses (Rs.50) may have to be paid out within a year, although you will receive Rs.100 onlyafter 1 year. If this glorious scenario were to play out, this is what your Cash Flow statement, at theend of Year 1, would look like.
YEAR 1:
 
CASH FLOW STATEMENT
 
Inflow ZilchOutflow (50)-------------------------------------Net Inflow/(Outflow) (50)-------------------------------------
 
 
Hemant Sreeraman - 2 - Hope…can’t substitute Reason
OBSERVATIONS – CASH BLUES
Tuesday, October 17, 2006
 
What happened? Didn’t your Income Statement show a
Profit
of Rs.50? Now, imagine if yourshareholders came to your doorstep asking you to pay a Dividend. Where will the money come from?Thankfully, you are not compelled to pay a Dividend & you succeed in putting them off for a year.In Year 2, the demand picks up even more & to your joy you find yourself selling Trousers worth Rs.200.However, due to the same demand you had to add some more guys to your workforce & put up a newoffice. All this costs money & your Expenses also go up along with the Sales to, say, Rs.125.Just after Year 1, you receive the Rs.100 from your customers. But you find that this is quickly eatenup. Why? Your Expenses in Year 2 are Rs.125. & so, you have to shell out Rs.100 & then some more tomeet Expenses alone. Lets look at your Income Statement for Year 2.
YEAR 2:
 
INCOME STATEMENT
 (All numbers in Rupees)
 
Growth over Year 1 (%)
Sales 200
100%
 (-) Expenses 125-------------------------Net Profit 75
50%
 -------------------------The Growth Rate over Year 1 is very impressive. The stock market now start looking seriously at yourcompany, see the phenomenal growth & form an opinion that your company could be the next bestthing. You find your stock price going up.Lets look at your Cash Flow Statement at the end of Year 2
YEAR 2:
 
CASH FLOW STATEMENT
 
Inflow 100
(Rs.100 from year 1 Sales)
 Outflow (160)
(You can’t put off your shareholders this year & relent by paying a Dividend of Rs.35)
 -------------------------------------Net Inflow/(Outflow) (60)-------------------------------------Year 1 Deficit (50)Total Deficit (110)
(
Its unlikely that your CEO’s trousers would still be on by now)
 Without playing out this scenario for another year, I will now reproduce the Income & Cash Flowstatements for the 2 years of your existence.
INCOME STATEMENT
Year 2 Year 1
Sales 200 100(-) Expenses 125 50--------------------------------------------------------------------------------------------Net Profit 75 50--------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
Year 2 Year 1
Cumulative Net Inflow/(Outflow) (110) (50)
 
 
Hemant Sreeraman - 3 -
 
Hope…can’t substitute Reason
OBSERVATIONS – CASH BLUES
Tuesday, October 17, 2006
 
Some comments are worthy here. What we observe is that since your company’s working capitalmanagement is bad (it receives money only after a year), the more time your company spends in thebusiness the sooner it will find itself at a juncture where taking on debt will be inevitable to deal withthe cash crunch. As your business eats up more & more cash, you will find your debt piling up. Thismeans that Interest Costs will keep piling up, Depreciation Expenses will also start trickling in as youput up new offices, buy plant & machinery etc. You may also have to pay Dividend. So unless you areable to improve your Working Capital management by reducing the time your customers take to payyou, the spiral will soon lead you into a shit hole.Although the Sales & Net Profit may still keep growing at a good rate, the Cash Flow may worsen,eventually killing the company, if left unchecked. The markets in the mean while will focus on yourIncome Statement & Balance Sheet. Although the Balance Sheet would have started showing signs of strain, the beauty of the Income Statement will keep the stock price going up. However, thisdecoupling of the stock price from the financial health of the company cannot continue forever. Theshare price, eventually, will land back to earth after a round of the skies! Leaving a lot of disgruntledinvestors.As an intellectual exercise, you can play out the same scenario…but this time assuming that youreceive the Sales for a particular year that year itself. You will find that this results in a positive spiral& will result in Cash building up in your bank at a healthy rate. Moreover, your company is growing at ahealthy rate too. The company is getting better financially & the stock market will eventually give itsreward by upping the share price.Presented below is the Income Statement & Cash Flow Statements for the above scenario. You will beable to appreciate the difference by now.
INCOME STATEMENT
Year 2 Year 1
Sales 200 100(-) Expenses 125 50--------------------------------------------------------------------------------------------Net Profit 75 50--------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
Year 2 Year 1
Cumulative Net Inflow/(Outflow) 90 50With a Cash position like this, you need not resort to taking on Debt to bail you out. You will be able topay for your expansion plans through internal accruals. Remember that the Rs.90 is left over afterpaying Dividend. If your business continues to generate excess cash after all obligations are met, wewill call this Free Cash Flow, then very soon it will find a cash chest building up. What the companythen does with the excess cash is something that represents a challenge in itself! We shall leave thisfor another day.Coming back to the point on brokerages recommending stocks from the Construction Sector, I willpresent a list of recommendations from the Construction sector that is extracted from a recentResearch Report by a broking house. I shall highlight the Free Cash Flow situation followed by somecomments.

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