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How to understand cash flow statements

The cash flow statement is arguably the most important bit of a company's accounts. Investors can learn huge amounts about a business from studying it
How to understand cash flow statements

If you want to get a better feel of what’s going on with a company’s financial performance then you should head straight to its cash flow statement. As with looking at income statements and balance sheets, some basic number crunching can provide a lot of useful information about a business.

Cash flows are not the same as profits. Profits are calculated by matching revenues and costs (accruals) whereas cash flows occur when cash is received or spent. This is what a company’s cash flow statement shows you. As with the income statement and balance sheet over the past couple of weeks, Marston’s Plc will be our example for learning about how cash flow statements work and what you can get from them.

 

Marston’s cash flow statement

Here is Marston’s cash flow statement for the year to the end of September 2018. As with all cash flow statements it is broken down into three separate bits.

  • Cash flow from operating activities – this is the cash the company generates from its trading activities.
  • Cash flow from investing activities – here you will see money spent on new assets and buying other companies, as well as money received from interest income and the sale of assets or companies within the business.
  • Cash flow from financing activities – this shows cash coming into the business from new borrowing and the issue of new shares and cash going out from repaying loans, buying back shares, paying interest and paying dividends to shareholders.

The sum totals of these three sections are added together to show the change in the company’s cash balance over the year – sometimes an exchange rate adjustment is included if cash is held in foreign currencies.

 

1. Marston’s cash flow statement (to end Sep 2018)

Source: Annual report

 

Let’s look at each part of Marston’s cash flow statement in turn, starting with the cash flow from operating activities.

 

Cash flow from operating activities

Not all cash flow statements are set up in the same way. The operating cash flow section shows you how a company’s profits turn into operating cash flow. Companies choose which profit figure they want to start with. Operating profit is quite common for UK companies, but it is also not unusual to see companies starting with their post-tax profits or net income.

Marston’s starts with its underlying operating profit to get to the starting position of Ebitda (earnings before interest, tax, depreciation and amortisation).

The profit figure is then adjusted for non-cash expenses that have reduced profit by adding them back. Cash outflows that have not been included in profits are taken away. Eventually, a cash flow from operating activities figure is arrived at.

 

2. Marston’s operating cash flow

Source: Annual report

 

Depreciation and amortisation is used to match the cost of tangible and intangible assets over their useful life. It is a cost, but it is not an outflow of cash. The cash outflow occurs when the assets are bought or created. So depreciation and amortisation is added back to underlying profit as it does not reduce cash flow. This gives underlying Ebitda of £222.6m.

Non-underlying items of £49.1m are then taken away – this is a bit confusing as most of this is not an outflow of cash – to get to underlying Ebitda of £173.5m. From here, adjustments are made to reflect cash and non-cash items that have not been included in the calculation in operating profit.

Working capital is the cash that a company needs to finance its day-to-day activities. Movements in working capital can have a big impact on a company’s operating cash flow. Note 31 to Marston’s accounts tells us more about this.

 

3. Marston’s working capital and non-cash movements

Source: Annual report

 

The cost of inventories are expensed against revenues when a product is sold. However, if a company’s inventories increase over the year, the increase is an outflow of cash which does not reduce profits. A reduction of inventories will see cash flow into the business. 

You need to watch out for big increases in inventories. Sometimes companies build them up in advance of increased demand – such as Christmas – but it can be a sign of falling demand that will lead to lower profits in the future. Marston’s saw cash outflows of £4.4m in 2018, which is not really anything to be concerned about.

If a company sells a product or service, but hasn’t been paid for it, the amount outstanding is a trade receivable. The sale and any profit from it will be booked in the income statement, but any increase in the amount outstanding over the year will be shown as a cash outflow. Marston’s actually reduced its receivables by £4.9m in 2018 having increased them by the exact same amount in 2017. Again the numbers involved here are no cause for concern. 

Large increases in receivables can be a sign of trouble and aggressive accounting and can be seen with companies that appear to be growing very quickly. The danger is that some of the credit given to customers goes bad and the company never receives the cash. 

Expenses against revenues reduce profit, but if the bills are unpaid they boost cash flow temporarily until they are. Payments owed to suppliers are called trade payables. Sometimes the cash inflows and outflows from these can be significant. This was the case with Marston’s in 2017 when there was a £46.7m inflow from the increase in the trade payables balance.

Working capital movements need to be watched closely. Big outflows can be a sign of financial distress. You need to be careful not to count one-off inflows as permanent sources of cash – they are not – and see a business as being more healthy or more valuable than it might be.

Other non cash flow movements are dominated by asset impairments. These reduce reported profits but they are not an outflow of cash and so are added back to profit when calculating operating cash flow. The same is true of share based payments.

Provisions represent money set aside to settle a future liability. When they are set up they reduce profits, but not cash flow. When the cash is paid to settle the liability, profits are not reduced but cash flow is. Marston’s spent £9.1m in 2017 and £5.4m in 2018 on provisions and the outstanding balance reduced by the same amounts.

Final-salary pension expenses for employees are matched against revenues as the benefit is accrued each year and reduces profits. Sometimes, the pension fund is in deficit (its assets are less than its liabilities) and the company has to top the fund up with extra cash payments. The cash spent in excess of the annual cost is shown as a cash outflow in the cash flow statement, but does not decrease profits. Where pension fund deficits are very large, these extra cash outflows are a real reduction in company value and should not be ignored. In 2017 and 2018, the difference between the pension cost expensed in the income statement and the cash spent was more than £8m.

Tax paid is then taken away and we are left with the net cash inflow from operating activities. If you want to calculate Marston’s operating or pre-tax cash flow then add the tax paid back to the net operating cash flow figure. 

In 2018, Marston’s had £189.8m of operating cash flow and £182.4m of net operating cash flow. This compares with £223.1m and £213.5m respectively in 2017.

 

Making sense of a company’s operating cash flow

You should take some time to understand how a company’s operating cash flow has been arrived at and take a view as to how sustainable it is. What you are trying to work out is what it is likely to be in a steady state. Big working capital flows can be a sign of other things going on, but are not sources of sustainable cash flow.

Above all else, you should be looking at how good a company is at turning its profits into cash flow. Good companies do this, bad ones don’t. Many an investment disaster could have been avoided – companies such as Carillion – by doing this quick and simple bit of analysis.

 

4. Operating cash flow conversion

£m

2018

2017

Underlying op profit

182.5

174.5

Operating cash flow

189.8

213.5

Op cash conversion

104%

122%

Source: Annual report/Investors Chronicle

 

Marston’s has passed this test, but only just in 2018. If it had not had a £46m inflow from payables in 2017 it would have failed it. Marston’s operating cash flow performance is actually not that great and has been held back by cash spent on provisions and pension top-up payments.

 

5. Cash flow from investing activities

Source: Annual report

 

Here you will see the cash spent on new assets (known as capital expenditure or capex amongst investors) and acquisitions as well as cash received from asset sales and interest income.

Capex is the biggest and most important number with Marston’s. It spent £162.7m in 2018 and £196.3m in 2017. This is money spent on maintaining existing assets and the purchase of new ones.

In the financial review on page 26 of the annual report, the company explains how this money has been spent:

“Capital expenditure was £162.7m in the year (2017: £196.3m), including £63m on new pubs. During the year, we spent additional capital expenditure on brand conversions in Destination and invested £8m in the new canning line described earlier and additional vehicles for the new distribution contracts. We expect that capital expenditure will be around £130m in 2019, including around £50m for the construction of 10 pubs and bars and five lodges.”

One of the most important things that a good investor will try to do is to find out how much a company has to spend on its existing assets to stay in business. This is what Warren Buffett refers to as stay-in-business capex or maintenance capex and it is used in working out an estimate of a company’s true cash earnings – which can often be a lot different from the profits they report in their income statements.

If we take the £162.7m and subtract the £63m spent on new pubs and £8m on a new canning line then the bulk of the £91.7m remaining appears to have been spent on existing assets.

I’ll have more to say on this very important subject shortly when discussing free cash flow. But on page 24 of its annual report, Marston's does give some guidance on how its future capex spending will be divided up:

“Other capital investment in 2019 will be around £80m, including £50m maintenance capital and £30m growth capital.”

 

6. Capex ratios

£m

2018

2017

Capex

162.7

196.3

Depreciation & amortisation

40.1

39.2

Op Cash Flow

189.8

213.5

Capex to depreciation

406%

501%

Capex to operating cash flow

86%

92%

Sources: Annual report, Investors Chronicle

 

Comparing capex with depreciation is a very useful thing to do. Depreciation is seen as an estimate of what a company might need to spend to maintain its existing asset base, providing its depreciation policy is conservative (often it is not). You want to see a company spending at least depreciation on capex if this is the case. If it isn’t then it may be a sign that a company is neglecting its assets at the expense of future revenues and profits. In rare cases, it can be a sign that a company has a very conservative depreciation policy and that its profits – which are stated after depreciation has been expensed – are conservatively stated too; a good sign.

Marston's is spending many times its depreciation expense, but there are good grounds for thinking that its depreciation charge is too low – and its reported profits are overstated – given its spending on existing assets and its guidance for 2019 in its annual report.

We can also see that Marston’s is spending almost all of its operating cash flow on capex. There’s nothing wrong with this if the spending pays back acceptable new profits. Looking at its income statement and balance sheet over the past couple of weeks, this doesn’t seem to be the case.

The other thing to note is that Marston’s generates significant amounts of cash flow from selling assets. This is quite common for pub groups. which tend to sell underperforming pubs and recycle the proceeds into new pubs or pay the cash out to shareholders.

 

7. Cash flow from financing activities

Sources: Annual report, Investors Chronicle

 

The key message here is that Marston’s pays far more money to its lenders in interest than it does to its shareholders in dividends. This is another clear sign as to how indebted this company is. 

We can also see the taking on of new loans and repayment of existing ones. In 2017, £75.5m was raised from issuing new shares to help pay for the acquisition of Charles Wells’ brewing business.

 

Free cash flow and the quest for a company’s true profits

Free cash flow is the amount of money that a company has left over after it has paid all its non-optional expenses – things such as interest, tax, and capital expenditure. It is called free cash flow, because the company is free to choose what to do with it. It can pay dividends, buy back shares, pay off debts or buy companies.

Free cash flow is used extensively by investors to estimate how much a company’s shares might be worth and whether there is enough cash to cover the cost of the existing dividend. Very good businesses tend to produce lots of free cash flow – they turn a high proportion of their revenue, a good proxy is 15 per cent or more – and they have high free cash flow margins.

There are two main types of free cash flow. Free cash flow to the business shows the money available to pay lenders, tax and shareholders. Free cash flow to equity shareholders is the money available to pay to them. We will be concentrating on this number.

The problem is that there is no universally accepted calculation of free cash flow. For example, should it include all capex or just maintenance capex? Should it include cash from asset sales?

Let’s have a look at how Marston’s stacks up. The short answer is not very well. If we use all capital expenditure to calculate free cash flow we can see that it doesn’t produce any and has a cash outflow. It therefore has to borrow to pay its dividend.

 

8. Free cash flow treatment 1

£m

2018

2017

Revenue

1,140.4

992.2

Net cash flow from op activities

182.4

213.6

Capex

-162.7

-196.3

Free cash flow to the business

19.7

17.3

Interest received

0.8

0.3

Interest paid

-74.9

-70.2

Free cash flow to equity shareholders

-54.4

-52.6

Equity Dividends

47.5

44.1

Free cash dividend cover

-1.1

-1.2

Profit after tax

87.9

84.5

Free cash conversion

-85%

-83%

Free cash flow margin

-4.8%

-5.3%

Source: Investors Chronicle

 

If we accept that selling assets is a regular part of a pub company's business – I think it is – then things improve a little bit, but there was still an outflow in 2018 and the dividend was not covered in 2017 either.

 

9. Free cash flow treatment 2

£m

2018

2017

Revenue

1,140.4

992.2

Net cash flow from op activities

182.4

213.6

Capex

-162.7

-196.3

Sales of Assets

47.6

61.9

Free cash flow to the business

67.3

79.2

Interest received

0.8

0.3

Interest paid

-74.9

-70.2

Free cash flow to equity shareholders

-6.8

9.3

Equity dividends

47.5

44.1

Free cash dividend cover

-0.14

0.21

Profit after tax

87.9

84.5

Free cash conversion

-7.7%

11.0%

Free cash flow margin

-0.6%

0.9%

Source: Investors Chronicle

 

If I use two estimates of maintenance capex – £91.7m and £50m – the dividend is still not covered by the first estimate, but it is by the second one. However, £50m is more than the £40m of depreciation being expensed in the income statement. Marston’s tells shareholders that they had £87.9m in 2018, but free cash flow was only £58.3m.

 

10. Free cash flow treatment 3

£m

2018

2018

Revenue

1,140.4

1,140.4

Net cash flow from op activities

182.4

182.4

Maintenance Capex

-91.7

-50

Free cash flow to the business

90.7

132.4

Interest received

0.8

0.8

Interest paid

-74.9

-74.9

Free cash flow to equity shareholders

16.6

58.3

Equity dividends

47.5

47.5

Free cash dividend cover

0.35

1.23

Profit after tax

87.9

87.9

Free cash conversion

18.9%

66.3%

Free cash flow margin

1.5%

5.1%

Source: Investors Chronicle

 

We have learned a great deal here:

  • Marston’s isn’t very good at generating free cash flow – it has negative or low free cash flow margins.
  • Its depreciation expense looks too low and its profits too high.
  • Its free cash flow to shareholders is less than its profits. Its free cash flow conversion is less than 100 per cent.
  • Its dividend payment looks somewhat reliant on cash raised from selling pubs.

 

The sources and uses of cash

This requires a bit of spreadsheet work, but is a very useful exercise and gives you a different view of a company’s cash flow by rejigging its cash flow statement. You list all the cash inflows and all the cash outflows and see where a company gets its cash from and where it spends it. The difference between the two numbers is the change in the cash balance for the year.

11. Sources and uses of cash

Sources (£m)

2018

2017

Operating profit

133.4

170.4

Depreciation & Amortisation

40.1

39.2

Interest received

0.8

0.3

Sales of property & other fixed assets

47.6

61.9

New bank borrowings

10.2

280

New lease borrowings

68

57.9

Change in receivables

4.9

0

Change in payables

0

46.7

Issue of new shares

 

75.8

Other non cash items

31.8

 

Total Cash in

336.8

732.2

   

Uses (£m)

  

Change in stocks

-4.4

-3

Change in receivables

 

-4.9

Change in payables

-2.6

 

Cash spent on provisions

-5.4

-9.1

Pension top up payments

-8

-8.3

Income tax

-7.4

-9.5

Purchase of new assets(capex)

-162.7

-196.3

Purchase of subsidiary (Acquisitions)

0

-90.5

Transfer to other cash deposits

0

-120

Equity dividends

-47.5

-44.1

Interest paid

-74.9

-70.2

Lending arrangement costs

-5.7

-7.9

Purchase of own shares

-1.2

 

Repayment of borrowings

-30.2

-291.5

Other non cash movements

 

-7.9

Total cash out

-350

-863.2

   

Change in cash

-13.2

-131

Source: Investors Chronicle

 

Over the past three weeks you will have seen how it is possible to build up a picture of a company by examining its accounts. This is your view and not someone else’s. Next week, I will delve into the written parts of an annual report to help you add more insight to your analysis.