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How much spare cash does a company really have?

Investors often deduct cash when calculating financial performance and valuing a business. It is more prudent not too.
How much spare cash does a company really have?

Investors need to be very careful when weighing up a company’s cash balance. If they are not then they can be tricked into thinking that a company is safer, more profitable and cheaper than it really is.

A company’s cash balance is arguably the most important number on its balance sheet. It is used to understand a company’s financial health, profitability and valuation. This is usually done by netting it off other numbers to make important financial numbers such as net borrowings, capital employed and enterprise value (EV) smaller and therefore key debt, returns and valuation ratios better. In many cases, this is a mistake and I will explain why.

 

A company’s cash balance is a snapshot on one day

Income and cash flow statements show the movement of money in a company throughout the year. A balance sheet does not. It only shows a snapshot of the company's financial position on one particular day.

Most companies will try and show their finances looking at their best which tends to mean when they have their biggest cash balances. It’s no surprise that so many retailers have their year ends in December and January. They have received the cash from their peak Christmas selling season but have probably not paid for the goods they have sold yet. 

Similar circumstances apply to tour operators who take cash payments from their customers but don’t pay airlines and hotels until many months’ later. Most of the quoted housebuilders don’t have December year ends – Persimmon (PSN) and Taylor Wimpey (TW.) do – as the peak selling season tends to be in the spring and the summer.

There is absolutely nothing wrong with this. In fact, it makes a lot of sense to do so. However, investors need to be aware that cash balances are just a function of the timing of cash receipts and payments and may not reflect the company’s cash position for most of the year.

Yet most investors and companies happily use cash balances in full and look at net debt (Total borrowings less cash), net capital employed and calculate a company’s EV by netting off cash. I think in many cases that this is wrong and that it can give you too favourable an impression of a business.

Quite often, most or all of a company’s cash balance is not surplus to requirements - it is not excess cash -and cannot  be used to pay off its borrowings or reduce its capital employed. Instead it is used to fund the day to day activities of the business such as paying bills.  

This is a form of working capital. If the company did not have this it would have to borrow more money to finance itself. If you ignore this then by using cash as a netting off item it means that you are understating the capital it needs to make its profits and overstating its return on capital employed (ROCE). If you take it away from the market capitalisation of a company to calculate its EV then you are making the market value of a company’s assets look cheaper than it really is.

 

Howden Joinery’s cash balances

The only amount of cash that you can reasonably net off in your calculations of key performance measures is cash that the company does not need to operate – its excess cash.

How on earth can you as an outside investor know what that is?

In most cases you can’t. There’s no doubt that there are some companies out there with lots of spare cash but the point I’m trying to make is that not all of it is and for some companies none of it is.

There are various ways that people try and estimate a company’s excess cash balances such as assuming a percentage of revenues but unless you really know the business intimately – which only a company insider is likely to do – then you will have no idea if your estimate is right and adding any value to your analysis of a company at all.

My view is don’t bother trying. Just include a company’s cash balances as part of its capital employed and enterprise value. When it comes to debts, look at gross borrowings as a measure of a company’s indebtedness don’t try and reduce them with cash balances that might not be available to pay off debts.

By including cash you are  going to end up with more prudent measures of a company’s performance and valuation. It’s much better to do this than stretch credibility too far and end up buying shares in a company that you think is better (more profitable) and cheaper than it really is.

Howden Joinery (HWDN) is a company that has a significant cash balance on its balance sheet and no borrowings. Let’s have a look at what its excess cash might be and what the difference including cash and netting it off has on its calculation of ROCE and EV.

 

Howden Joinery: Summary balance sheet

£m

2018

H1 19

2019

Non-current assets

221.4

224.9

251.7

Inventories

226.3

247.6

231.8

Receivables

186

203.2

193.1

Cash

231.3

217.1

267.4

Current assets

643.6

667.9

692.3

Total assets

865

892.8

944

Trade payables

-232.9

-310.6

-241.4

Tax

-20.2

-13.3

-20.3

Current liabilities

-253.1

-323.9

-261.7

Source: Annual reports

 

Howden’s year end balance sheet is at the end of December. Its peak selling season is in November -presumably as lots of people want a new kitchen for Christmas – and with 8 weeks’ credit typically given to customers a large chunk of its sales have been paid for. At the end of 2019 it had £267.4m of cash on its balance sheet.

The cash flow statement shows you how a company’s cash balance changes from one period to the next. It is the sum of its operating, investing and financing cash flows. 

 

Howden Joinery 2019

£m

H1 19

H2 19

FY 19

Cash from operations

56.3

165.1

221.4

Cash from investing

-23.6

-36.1

-59.7

Cash from financing

-46.9

-78.7

-125.6

Change in cash balance

-14.2

50.3

36.1

Opening cash

231.3

217.1

231.3

Ending cash

217.1

267.4

267.4

Source: Company reports/Investors Chronicle

 

We can see that Howden’s cash balance dips at the half year balance sheet before increasing in the second half of the year. This can be generally explained by lower profitability in its first half and the payment of large cash outflows such as the final dividend from the previous year.

But if you were estimating the amount of excess cash that Howden had, how would you go about it. This is not easy but you could look at the relationship between a company’s cash balance and receivables and its current liabilities which have to be paid within the next 12 months.

 

Howden Joinery: cash, current assets & current liabilities

£m

Dec 2018

June 2019

Dec 2019

Cash

231.3

217.1

267.4

Current assets less inventories

417.3

420.3

460.5

Current liabilities

253.1

323.9

261.7

Quick ratio

1.6

1.3

1.8

Source: Annual reports/Investors Chronicle

 

If we ignore the value of inventories and just look at the ability of cash and receivables to cover the current liabilities (known as the Quick or Acid test ratio) then we can see that Howden seems to have a very comfortable working capital position with nearly a £200m buffer at the end of 2019.

This would suggest that Howden has some excess cash but the timing of cash flows is all important as are the consideration of other liabilities such as leases and pension fund deficits. Howden in its 2019 annual report helpfully clears up that it does have surplus cash which it returns to shareholders via buybacks (£55m in 2019)  but that it needs most of its cash balance on its balance sheet:

“The Board targets a capital structure that is both prudent and recognises the benefits of operational and financial leverage, and that, after considering our capital requirements, will return surplus cash to shareholders as appropriate. The Group has significant property leases for the depot network and continues to have a material deficit in the Group pension fund. Taking into account this underlying level of gearing, the Board believes it is appropriate for the Group to be able to operate through the annual working capital cycle without incurring bank debt.”

Based on share repurchases of £55m in 2019 this may not be an unreasonable estimate of Howden’s excess cash.

 

Cash and the impact on financial ratios

I’ve ignored the important issue of Howden’s rented depots – which should be included as part of capital employed and will be on its 2020 balance sheet – and calculated ROCE and EV including cash, netting it all off and deducting excess cash. As you can see the impact on ROCE is significant whereas the valuation is also cheaper on an EV/Operating profit basis.

 

Howden Joinery: ROCE and EV and the impact of cash

£m

With cash

Netting off cash

Excess cash

Operating profit

260

260

260

Invested capital

682.3

414.9

627.3

ROCE

38.1%

62.7%

41.4%

EV

3,301

3,041

3246

EV/Op profit

12.7

11.7

12.5

Source: Investors Chronicle

 

In the interests of simplicity and prudence, I always include cash when considering a company’s ROCE and EV and feel more comfortable as a result. If I think a company stacks up by including it, I know that I am using a reasonable degree of caution in my analysis which is rarely a bad thing.

 

Share based payments are flattered FAAMG free cash flows

Most sensible investors realise that share based payments (SBPs) are a real cost just as if workers had been paid with cash. They are rightly deducted as an expense on income statements but as they are non-cash they are a source of operating and free cash flow (they are added back to profits).

For a lot of companies share-based payments are not a big issue but for the big technology companies – Facebook (US:FB), Apple (US:AAPL), Amazon (US:AMZN), Microsoft (US:OQYP) and Google (US:GOOG) or FAAMGs for short – which dominate the S&P 500 they are. Not deducting them from a calculation of free cash flow (FCF) as an expense is similar to saying that depreciation does not matter and not a real cost when it is.  

SBPs are a transfer of value to employees away from shareholders. By deducting them they have a significant impact on the FCFs of FAAMG stocks. 

 

FAAMG: Free cash flows adjusted for share-based payments

Company

Mkt cap $bn

TTM FCF $bn

FCF yield

TTM SBP $bn

Adj FCF $bn

Difference

Adj FCF Yield

Apple

1,568

66.6

4.2%

6.4

60.2

-9.6%

3.8%

Microsoft

1,505

43.4

2.9%

5.1

38.3

-11.8%

2.5%

Amazon

1,337

21.7

1.6%

6.9

14.8

-31.7%

1.1%

Alphabet (Google)

953

29.1

3.1%

11.2

17.9

-38.5%

1.9%

Facebook

629

21.2

3.4%

4.8

16.4

-22.8%

2.6%

Source: SharePad, Company reports, Investors Chronicle

 

Amazon’s trailing 12-month (TTM) free cash flow is 31.7 per cent lower and Alphabet’s is 38.5 per cent lower if share based payments are deducted. Apple and Microsoft fare the best in this analysis.

There is also a negative impact on their free cash flow yields (free cash flow as a percentage of market capitalisation) which makes all of them look more expensive.