We are also wary of businesses that report strong profitability on relatively low operating cash flows. It can indicate a change in payment terms – paying debtors later and demanding payment sooner. Not necessarily bad, but the benefits are only felt in one year. They can’t be sustained.
Asking more questions
The cash flow numbers are a starting point – they show us where more digging is required and which questions to ask. Is that rise in profits with no accompanying rise in free cash flow because you’ve just booked a big order at year end on your accounts but are still waiting for payment to come through? Why are you investing such a big proportion of your operating cash flows in taking your business online? Do the potential benefits justify the expenditure?
We tend to avoid businesses using operating cash flows to finance M&A activity – too often it fails to deliver the anticipated benefits, but sometimes we agree with management that an acquisition opportunity has to be grabbed.
And we dislike debt. We don’t like seeing debt repayments take a chunky bite out of operating cash flow. But if, for example, it’s to commercialise a new technology that has massive potential globally, we would be foolish not to exploit the opportunity.
So, cash flow analysis is a science and art. It is time consuming and often only leads to more questions, prompting further research.
Sustainable dividends
Companies that pay attractive dividends are a valuable component of any portfolio, but those dividends must be sustainable. It is the business’s cash flow data that tells you whether the cheques will keep coming and hopefully some time before you find yourself looking down and wondering where the road has disappeared to.
Andy Marsh works alongside Adrian Frost and Nick Shenton as part of Artemis’ income team
