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Sunday, September 7, 2014

Why Operating Cash Flow is more important than Net Profit but is still ignored.

Let's first define Net Profit and Cash Flows before we proceed further to explore the importance of each of terminologies.

Definitions:
Net Profit (NP) comes from Profit and Loss (P&L) statement while OCF comes from Cash Flow statement.

Net Profit: Net of revenue or sales after removing all operating expenses, depreciation, interest and taxes and 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 expenditures, 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 NI:
The 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 to get wiped out. The OCF gives you the picture about the cash received in the organization. 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.

Though OCF is extremely important many investors lean towards net income. The primary reason being 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 NI numbers at least four times in a year and accordingly be more worried about the growth. Also many small investors find it difficult to read these simple set of numbers in the annual reports primarily from the fear of unknown.

Accrual Accounting system v/s Cash flows
To generate Net Profit, a company may just be required to make a sale. This sale could be either cash or on credit. If it is a cash sale it gets recognized in OCF also.

However, in reality this is not the case. Most of the companies provide credit facilities. This could provide an opportunity to manipulate the net profit numbers. The company makes a credit sale and based on this immediately recognizes the sales in the P&L and accordingly net profit number. However, the cash is not received and hence the OCF is not affected.

What happens if the customer delays payment or returns the goods or this sale was a bogus sale? This results in in a buildup of receivables in 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 of time. The receivables numbers then will turn bed debts and result in pain.

Some examples
There are several examples where the companies were not generating cash flows but continued to show profits through various means. These companies faced the grim reality at some point of time and that led to the downfall. Also if the promoters’ holding is poor or there is a continued equity dilution along with poor OCF then it is a deadly cocktail heading for a disaster.

Also there is a common element that I found in companies with poor OCF v/s NI. These companies are often backed by very strong growth stories and are widely traded in the stock market with lots of hope.

I have covered two examples viz. Opto Circuits and Arshiya International. Both these companies were the darling of stock market. These companies were running with several growth stories around. Also both the companies were backed by celebrity analysts and FIIs. You may see the details of what happened with these companies when they were unable to generate OCF: http://goo.gl/rY7l0l

Ideal OCF v/s NP ratio:
It will be ideal to have a ratio close to one, more the merrier. However, there could be a year or two where OCF is down due to market conditions or circumstances. But it cannot be for an indefinite period otherwise the survival of the company will be in question. Remember NP without CFO is like a body without oxygen.

Cheers,
Niteen S Dharmawat
Blog: http://dharmawat.blogspot.com/
Twitter: @niteen_india
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IMPORTANT DISCLAIMER: Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective. The above article is written with the sole objective of taking feedback from the readers. The information contained herein is based on my study and upon sources that I consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and not intended for any investment decisions. I am not responsible for any profit or loss incurred based upon it & take no responsibility whatsoever for any financial profits or loss which may arise from the discussion thread above/anywhere in communication. It is safe to assume that I, my family, friends have vested interest in any of the stock ideas discussed here. Please do your due diligence and take the help of a qualified advisor before you take any financial decision.


5 comments:

Amit G said...

Nishanth can you please share your views on HOV Services commenting on the possibilities of its US Sub sale

Rajesh Javalagi said...

Thank you Niteen for an interesting blog on explaining the importance of OCF. As you said rightly cash is king and it is the most important element in addition to growth and risk while arriving at the intrinsic value of the share or the Enterprise Value.
I would go one step further and add that in addition to OCF, investors are keen in knowing the Free Cash Flows (FCF) which comes after reducing the investment and working capital impact. The FCF gives the net cash available to equity holders after all other stake holders are paid. I believe this is an important number investors should be watching.

Niteen, thanks for bringing out the finer nuance of understanding the OCF.

Anonymous said...

Nice article Niteen

ketanthacker said...

Nice article..The examples of both Arshiya Int and Opto Circuit are good case studies. Even seasoned Analyst got carried away. This article reinforces importance of cash flow analysis, which we should not ignore while doing our stock research.

Anonymous said...

Very good insight ! Thank you.