cashflow statements, working capital cycle

How to monitor a firm’s pulse

09.11.2007

by Tim Bennett

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All is not well in corporate UK. Ernst & Young recently revealed that profit warnings issued in the first six months of 2007 were at their highest levels since the dotcom bubble burst in 2000. But surviving a downturn is not just about profits: a firm’s lifeblood is strong, stable cash flow. Here’s how to monitor it.

Which cash figure is king?

Don’t be bamboozled by the wall of numbers in a typical cash-flow statement. The one that matters is right at the top: “cash generated from operations”. This tells you if the company’s core operating activity – what it does for a living – is cash generative or not. It should be positive and, ideally, growing. If it’s neither, then you should think about selling.

Check profits are backed by cash

For this you need to find a note that supports the main cash-flow statement headed “reconciliation of profit to net cash generated from operations”. At the top, you have either operating profit or profit before tax, and at the bottom the cash generated from these activities. For example, on page 95 of Tesco’s (TSCO) 2007 financial statements, pre-tax profit of £2,653m becomes £3,532m of operating cash flow, giving what is sometimes called “cash cover” for profits of 1.35 times (3,532/2,653). If this figure is consistently below one, or is highly volatile, it shows that paper profits are not being turned into cash consistently. Enron suffered both for several years before it collapsed.

The “working capital cycle”

In a typical trading cycle, a firm usually buys stock on credit, holds and perhaps modifies it before selling, pays its suppliers and then collects cash from customers who also bought on credit. Successful cash management is about monitoring and shortening this cycle – firstly by minimising money tied up in unsold stock or held by customers who have not paid up and, secondly, by making maximum use of credit terms offered by suppliers.

These aims can be distilled down to a single number of days that show the crucial gap between cash leaving a business to pay for stock and coming back in from customers. The bigger the gap, the greater the chance of a cash crisis. Here’s how it works using Tesco’s 2007 numbers.

First, take average “inventories” for 2007 and 2006 from the balance sheet (£52,965 + £54,074/2 = £53,520). This indicates the value of stock that Tesco typically holds at any one time. Divide by cost of sales from the profit and loss account (£426,960), then multiply by 365. The result is 45 ‘stock’ days – this is how long stock normally takes to sell.

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Next, find the average time a customer waits to pay Tesco once the stock has been sold. Average “trade and other receivables” (money owed to Tesco) is £23,865. Divide this into total turnover of £539,880, then multiply by 365 to give 16 ‘debtor’ days. Finally, take a balance sheet average for “trade and other payables” (money Tesco owes its suppliers), which is £61,492. Divide this into cost of sales (£426,960 as before) and multiply by 365 to estimate how long Tesco waits to pay its suppliers for the original stock, here 53 ‘creditor’ days.

By adding stock and debtor days (in other words, the amount of time that cash stays locked up in stock, plus the amount of time that customers take to pay the company) and then deducting creditor days (the amount of time the company takes to pay its suppliers), you end up with the “working capital cycle”, 45 + 16 – 53 = eight days. That’s the average gap between cash going out of Tesco to pay for stock and coming in from sales.

That this is so short is thanks to Tesco’s food retailing, where most sales are for cash. Unlike, say, manufacturing businesses, which might offer their customers up to 90 days’ credit, cash from food sales comes straight in through the tills (credit-card sales count as cash since the “credit” is provided by a bank rather than the retailer). So Tesco only has to wait around 16 days for non-food customers to pay up, which shortens the whole cycle.

However, compare Tesco, which offers significant non-food retail, with a more focused food retailer like rival Sainsbury’s (SBRY) – its cycle comprises stock days of 13, debtors days of just four and creditor days of 48, giving -31 days overall (13+4-48). So, cash actually flows in from customers about a month before suppliers have to be paid – a strong position in a downturn, since cash flow can’t easily be threatened by customer insolvencies. On this measure, Sainsbury’s runs a tighter ship than Morrisons (MRW), for whom 31 drops to 14 using similar calculations.

The contrast between food retailers and other firms, say industrial manufacturers such as Smiths Industries, is stark – building complex equipment under long-term contracts generates a working capital cycle of nearer 200 days, a fact of life that leaves them more exposed to cash-flow problems if times get tough. That doesn’t necessarily mean you must avoid manufacturers – but do compare like with like. A key warning sign is any sudden, unexplained deterioration in the cycle, and also be wary of firms that are consistently worse than their peers.