Quick Cash Flow Analysis

A company's Cash Flow Statement is the third section within a company's results, but it is absolutely vital. There is a common saying that turnover is vanity and profit is sanity; in some cases it could equally be said that profit is vanity and cash flows are sanity. After all, the cash flow of a company tells us whether it actually makes cash; making profit is all very well, but if that profit does not translate into cash, then really should that business be valued on industry average profit multiples? It is cash generation (rather than 'profits') that pays salaries, pays down debts and creates real value.

Events with Quindell PLC are testament to the importance of looking at cash flows. Quindell has been reporting ballooning profits over the past few years and saw its market valuation rise sharply in line with that; the reality is that the company did not generate cash. There are many reasons why a company's profit statements might not tally with cash flows; for example, development spend may be capitalised rather than expensed, as per this tutorial.

The ability of a company to generate cash is one of the key pillars to look for when undertaking financial analysis, and is more important than solely looking at profitability. This is a core reason why the ability to pay healthy and rising dividends is often seen as a proxy to the cash generating ability of the company; companies that do not pay cash are often unwilling to pay dividends. This tutorial will outline a quick method of cash flow analysis using just five valuation ratios.

Five Useful Valuation Ratios: Tracsis (LSE:TRCS)

Above is the full cash flow statement for Software & Computer Services firm Tracsis. When looking at the five ratios below, it is imperative to put these numbers into context, so also seek to compare the ratios to other competitors. The below ratios are looking at the 2014 column.

1. Free Cash Flow

Cash Flow from Operating Activities before working capital changes - Capital Expenditure - Development Spend
Free cash flow tells you how much cash a business generates that is available for discretionary use. Importantly you take the net cash flow from operating activities and subtract money spent within the business to upgrade or purchase new property, plant or equipment. Removing CAPEX (or development spend for software companies) is important as it can be considered integral to the business and therefore default. The higher the free cash flow, the better as it tells you the company is 'throwing off' cash. A negative free cash flow implies that the company is not generating any real money.

In this case the calculation is £5.403m - £0.446m = £4.957m
2. Free Cash Flow Yield
Annualised Free Cash Flow / Enterprise Value
This standardises the above metric for the size of the company, giving a more useful comparator figure; this does require an extra step however, and the use of the company's balance sheet. The enterprise value of the company is the market capitalisation plus net debts (or equivalently minus net cash). A quick look at the balance sheet reveals that Tracsis has no debt and has cash balances totalling £8.92m. The market capitalisation is currently £104.78m. Therefore the enterprise value is £104.78m - £8.92m = £95.86m. The cash flow statement shown above is for a full year so the figures are already annualised, hence the equation is £4.957m / £95.86m = 5.17%.

This free cash flow yield can be compared to other companies within the sector, and is often a useful sanity check against the real attractiveness of a low or high PE ratio; after all, a company may have a low PE ratio because it generates negative free cash flows or has a low free cash flow yield

3. CAPEX/Depreciation

Purchase of Property, Plant and Equipment / Depreciation
This is a test of how strong a company's capital expenditure is. If CAPEX exceeds depreciation then CAPEX can be seen to be at historically high levels. If CAPEX exceeds depreciation several times over, then it also suggests that the company is in an expansionary phase when it is upgrading its property, plant and equipment. If CAPEX is less than depreciation, then the company is not having to spend large amounts of money to maintain its capital equipment.
In this case the calculation is £0.446 / £0.431 = 1.03x. Therefore, current CAPEX can be estimated is roughly in line with historic levels

4. Interest Cover
Pre-Interest and Tax Operating Cash Flow /  Cash Interest paid
This is a way of measuring how much of a burden a company's debt pile is. It generates a ratio between the interest a company has to pay on its debts for a period, relative to the levels of cash it generates. For that reason, the higher the ratio the better as a company would want to maximise its cash flows and minimises its interest payments. An interest cover below 4 should be a concern as it leaves little room for manoeuvre if the company's operating cash flows unexpectedly weaken.
We cannot compute a value in this case because Tracsis is debt free. Below are the relevant lines for gold producer, Petropavlovsk (LSE:POG), that does have a material debt pile.
The calculation is $136,903,000 / $36,727,000 = 3.73x. The interest payments on Petropavlovsk's debt pile should therefore be a concern for investors

5. Dividend (Free Cash Flow) Cover

Annualised Dividend Payment Costs / Annualised Free Cash Flow
This is a slight (and more useful) variant to the traditional dividend cover equation where you divide annualised earnings per share by the dividend per share. This equation is very similar in nature except it allows us to ignore the problems associated with profitability metrics; namely adjustments and exceptional items.
Assuming that the dividend yield is not too low, the lower the resultant decimal the better, as it suggests the dividend payment are not material compared to free cash flow; it tells us that the annualised dividend payment costs represent a small percentage of annualised free cash flow. Therefore, there should be sufficient cash generation to spend on other objectives such as paying down and debts or on future CAPEX increases, should they arise. A low percentage may also suggest room for dividend payment increases in the future. If annualised dividend costs exceed annualised free cash flow for several years, and the balance sheet is not particularly strong, then there might be a high risk of the dividend being cut.
For Tracsis the calculation is £ 0.191m / £5.271m = 0.0362 = 3.62%. This is a low percentage, which suggests the dividend payment is not much of a burden to the company at all, so it could be maintained even if there is a downturn in trading. That viewpoint is reinforced by there being a significant amount of net cash on the balance sheet, which could protect a dividend even if the percentage rose to over 100% temporarily