Accounting that counts: Go with the cash flow

The point is that profits are conceptual, so they can be anything the chairman wants. But there is a catch – contrived profits come at the cost of compromised cash flow. The finance director should really explain to the chairman that there is a choice – the company can have lively profits growth or healthy cash generation, but – especially if it is young and fast-growing – it will struggle to have both.

This brutal fact of corporate life has been illustrated in some of the worst corporate failures of modern times and has been covered in earlier episodes in this occasional series; in particular, that dealing with revenue recognition (27 September 2019).

The moral for investors is that, in analysing a company’s financial performance, it is vital to understand the relationship between a company’s income statement and its cash-flow statement. The income statement keeps the chairman happy – that’s where the conceptual profits are shown. The cash-flow statement is where the finance director comes clean and reconciles the accounting niceties with the fact of cash coming into and leaving the business.

Actually, if the finance boss is from the Uriah Heep school of accountancy, he can manipulate cash flow, too. More of that in a moment. First, let’s get three bookkeeping items out of the way. Item 1 is that cash-flow statements in the accounts of quoted companies are driven by the requirements International Accounting Standard (IAS) 7. That the standard is an ‘IAS’ shows it is long in the tooth and, as a result, mercifully short in length. IAS 7 came into force in 1994, though was updated significantly in 2016. More recently, it has been affected by IFRS 16 Leases (see Investors Chronicle, 16 August 2019), which requires that a company’s operating leases are shown as liabilities on its balance sheet. The effect of this is to highlight related rental payments as cash outflows.

Item 2 is to define cash – important, since the statement deals with the movement of cash. For the most part this is common sense. Cash is actual currency (notes and coin) but, more important, current accounts and on-demand deposits. Beyond that, there are acceptable cash equivalents – short-term liquid investments that are readily turned into cash and carry insignificants risks (government Treasury bills are the archetype).

Item 3 deals with assets that don’t count as cash, although they may look like it: first, cryptocurrencies (the IFRS Interpretations Committee came to that conclusions last summer); second, equity investments (even if they are liquid, they are too risky); third – and perhaps most odd – longer-term deposits whose maturity has whittled away to less than three months. Then there is ‘restricted cash’ – cash, but not as we know it; in other words, not available for use by the company holding it. For instance, it might really belong to customers or be held in a country where exchange controls restrict its use.

Companies set out their cash-flow statements in a variety of ways, which can be confusing. However, all are driven by the requirement to separate cash flows into three consecutive categories – starting with operating activities, followed by investing activities and concluding with financing activities.

There is logic in that. Working backwards, a company’s financing activities permit its investing activities, which permit its operating activities. The schedule of the cash-flow statement runs the other way. Operating activities come at the top because they are the day-to-day activities from which a company earns its crust – generates revenue, pays its suppliers and employees (and the tax man) and sees what’s left over. Next in the schedule, investing activities are about the capital transactions a company makes so that it has the infrastructure it needs to do its job – the capital equipment, but the intellectual property as well as the plant. To a large extent, investing spending draws on the cash left over from operating activities. Financing activities deal with other slugs of cash needed for investing. So they include cash raised from share issues or from taking out loans, but also the cash spent on share buybacks and loans repaid.

Some important cash-shifting activities fit uneasily within their categories or get misplaced. A review last year of the working of IAS 7 from accountancy firm BDO says that cash outflows related to the acquisition of intangible assets are often included within operating activities, as are the purchase of short-term investments. Then there is the messy solution of permitting interest and dividends (both paid and received) to be shown within any of the three categories. All that IAS 7 demands is that companies are consistent where they put these items.

Final point on the theory is that IAS7 talks about a ‘direct method’ and an ‘indirect method’ of reporting cash flows and encourages companies to use the direct method. That so few companies follow this advice means it is not worth bothering to explain the direct method. Suffice to say that almost every company starts the narrative of its cash-flow statement with a line from its income statement. That line is often operating profits, but it might well be net profits after tax and is sometimes pre-tax profit. It does not matter which. The important thing is for investors to grasp where the income statement ‘hands over’ to the cash-flow statement. Sometimes that’s easier said than done because the detail of operating cash flow is in a note buried deep in the accounts.

However, let’s start with the beautifully clear and simple cash-flow narrative provided by clothing retailer Next (NXT) in its latest accounts (see Table 1). Granted, clarity is comparatively easy for a retailer. For the most part, retailing is a straightforward business where cash is handed over when transactions with customers occur. There is little in the way of deferred revenue and almost no murky long-term contracts.

Table 1 is a condensed version of Next’s cash-flow statement from its latest accounts. This starts with the £854m of operating profit for 2019-20 shown in its income statement. To that is added £263m of depreciation and amortisation, non-cash items that have been charged against operating profits (probably somewhere within ‘cost of sales’). These account for the use of business assets that will eventually have to be replaced. As such, they are the income statement’s equivalent of the cash cost of capital spending.

Changes in working capital show how much extra cash a business has sucked up or disbursed by managing its short-term assets and liabilities over the course of an accounting period. Generally, growing groups will need more working capital, as did Next in both years shown in the table. During 2019-20, extra inventory (stock) and receivables (debtors) sucked up £60m more cash. Unusually, that was not offset by higher payables (the amount the group was due to pay over the coming 12 months). A £3m drop in payables – in effect, a repayment of interest-free loans that companies receive from their creditors – added to the working-capital outflow.

After aggregating various minor charges, which, in effect, put £11m cash back into the group, and deducting £138m of corporation tax paid during the period, Next was left with a £927m cash inflow from its operations. However, that amount could have been £101m less had Next’s bosses chosen to show net interest paid as an operating item rather than a financing one.

Next’s investing cash flows are nice and simple. Almost all of it is capital spending on new fixed assets. Some groups, however, show substantial amounts for the cash used to buy new subsidiary companies and the cash received for selling fixed assets and subsidiaries.

Financing cash flows at Next are all about cash outflows; in particular, £300m spent buying in its own shares, which was comfortably more than £214m spent on dividends paid during the year, though not wholly in respect of the accounting year. However, within the compressed figures for financing activities, there is a £250m inflow for the issue of corporate bonds. Net out all these items and Next was left with £19m more cash at the end of 2019-20 than it started – £53m compared with £34m.

More important is to know the extent to which a group’s accounting profits and its cash flow tally; in other words, how much accounting profit becomes cash profit. City analysts call this ‘cash conversion’. It is a sensitive figure that gets much attention, which is why it is apt to be manipulated by needy company bosses.

With cash conversion, the challenge is to compare like with like. The basic idea is to take cash generated from operations (£1,065m in 2019-20 at Next) and from that deduct capital spending. That produces an operating cash flow figure that best compares with a group’s accounting operating profit.

But in the case of Next – much like other retailers – there is also a particular challenge brought by the first-time use of a new accounting standard in its 2019-20 accounts. This is IFRS 16, which deals with leased assets, of which retailers usually have many. The standard aims to treat leased assets much like any other fixed assets and their corresponding rental commitments as quasi-debt.

The effect is to shift items around a group’s cash flow statement, chiefly because rental payments become finance costs, though the bottom line stays the same. The particular effect on Next’s operating cash flow is that the 2019-20 figure is boosted hugely by £138m-worth of added-back depreciation of leased assets that have been brought onto the balance sheet because of IFRS 16; but that sum is not balanced out by any increase in capital spending.

One solution is to play it simple, go back one year and work out Next’s cash conversion for 2018-19 both in its original form and including the effect of IFRS 16 (see Table 2) as shown in its latest accounts. The effect of re-stating for IFRS 16 is that operating profit rises from £762m to £841m. Meanwhile, cash generated from operations increases from £799m to £1,013m, but we can then pin that back by removing the £138m of ‘new’ depreciation on leased assets. With capital spending staying the same (because that really was a cash item), operating cash flow moves from £676m as originally stated to £752. Happily and significantly, however, Next’s cash conversion remains unchanged at a very satisfactory rate of 89 per cent, or £89 of cash for every £100 of accounting profit.

Since the cash-flow statement is about the movement of money, it is a good schedule with which to examine the major cash outflow a company usually makes to its shareholders – dividends. The conventional means of assessing a company’s ability to pay dividends – comparing earnings per share with dividends per share – has limitations if accounting profits are a flawed measure. Comparing a cash disbursement – dividends – with cash generated might provide a better solution.

Making that comparison requires working out how much cash is left over for the benefit of shareholders. This is called ‘free cash’ and it is what remains after all prior payments – tax, capital spending, the lot – have been made. Arguably it is odd that such an important item is not highlighted in the cash-flow statement. Often, however, listed companies state their own version of free cash generated if they have a financial review as part of the commentary in their annual report.

That said, calculating free cash flow is rarely demanding. Take Table 3, which shows the relevant figures from the 2019 accounts for J Sainsbury (SBRY). Its cash-flow statement glides smoothly from £312m operating profit for 2018-19 through to £618m net cash generated from operations. From there to free cash it is necessary only to deduct capital spending. That item, however, is likely to be the sum of cash spent on fixed assets (property and plant) plus intangible assets (mostly IT systems) and minus amounts received the sale of fixed assets. Sometimes, the amount spent on intangibles is labelled ‘investments in intangible assets’, which sounds as if it is a one-off item that should be ignored – it shouldn’t. Most likely investing activities will also include other minor items, such as investments made in joint ventures or dividends received from them. Should these be included in calculating free cash flow? Yes, if they are material and regular; otherwise, probably not.

In Sainsbury’s case, just £88m of free cash was left over at the end of 2018-19 yet the company paid over twice that amount in dividends. Should it have done that? No, if a company should only ever pay what belongs to shareholders and nothing more. Yes, because cash flows are volatile – bouncing from year to year – yet dividends are comparatively stable. The test is whether a group generates enough cash over several years to fund its dividends.

Related to that, how much of the free cash should shareholders be paid (in other words, what is the appropriate level of free-cash dividend cover)? What we might label the ‘private-equity school of finance’ says shareholders should get it all; it is theirs and they are smart enough to know how to use it. Against that, the precautionary principle says companies should protect themselves (and, therefore, their shareholders) by having a cash buffer. So maybe an acceptable level of cash-flow cover can be less than the two-times multiple often expected of dividends reckoned against accounting profits. How about 1.5 times averaged over the previous three years?

Another outstanding issue involving the cash-flow statement is in assessing the extent to which a company has flattered its profits. Often, this is done by treating a cash cost as an investment in an asset being built up. As a result, the cash outflow is not charged against profit but becomes an item of capital spending that will go through the income statement in the future when the asset is written down. It is normal for property companies to treat part of the interest on development costs in this way. Pharmaceuticals groups and software companies do much the same with the development costs on new products (but not research costs).

Often, these items are so small they are relegated to notes in the accounts. However, aero engineer Meggitt (MGGT) shows a substantial amount of capitalised development costs on the face of its cash-flow statement (see Table 4). Capitalising £55m-worth of such costs in 2019 could have a substantial effect on a group that declared £287m of pre-tax profit in 2019.

Yet, as we indicated earlier, the cash-flow statement itself isn’t immune to the finance director’s tinkering – and sometimes worse. It is not so much that cash movements get excluded from the statement. Rather, items get shuffled around so it appears that cash generated from a group’s operations is better than is really the case. That is an important matter, harking back to what we just said about converting accounting profits into cash.

The late and unlamented construction group, Carillion, seemed to be a master of these tricks. In the final few years of its existence, Carillion – which went bust in January 2018 – still appeared to turn respectable amounts of accounting profit into cash. The question was, how?

Taking money upfront for services it had yet to provide was one way. In balance sheet terms, this created an obligation to provide the services, which were liabilities classified as ‘deferred income’ in its accounts. Such deferred income was, in effect, an interest-free loan and, when it rose from one year to the next (such as a £37m increase in 2016, the final year for which Carillion filed accounts), the change was an operating cash inflow.

That’s fairly standard stuff among companies that rely on long-term contracts. More creative, in 2012 Carillion began a reverse-factoring operation whereby it deferred payment to suppliers but arranged for banks to pay them promptly via a debt-factoring arrangement and footed the factoring fee itself. The factoring charge ate into profits, but Carillion’s bosses may well have considered that a price worth paying. In effect, the group was borrowing without the debt showing on the face of its balance sheet.

Better still, the changes from year to year in these factoring arrangements were, in effect, cash inflow that Carillion fed through its operating activities. Carillion’s bosses never did say precisely where these items were hidden. The best guess is that they were part of – or perhaps all of – ‘other creditors’, which themselves were part of the group’s current liabilities. As Table 5 shows, year-on-year increases in other creditors were always considerable in Carillion’s final four years. Indeed, in the last one, the £199m rise in other creditors was much more than the £116m that the group claimed to have generated from its operations. In other words, Carillion’s decent level of cash conversion was phoney, made possible by the creative possibilities offered by reverse factoring.

To assume that what happened at Carillion was a one-off would be naive. The coming recession will bring corporate failures at some of which creative accounting and worse will be exposed. Where that is the case, it is odds-on that a mismatch between accounting profits and the cash-flow statement will suddenly become plain.