The importance of Profits getting converted to Cash
What happens when accounting profits are higher or lower than cash profits? How does it impact the company? Why is it important for investors to look at this? Read on below to find out more, but before that let us first understand:
What are profits from a perspective of accounting and cash flow?
Accounting profits are net profits that are recorded in the profit and loss statements of companies. Cash profits or cash flow from operations are found in the cash flow statements of companies. Basically if cash is king then whatever cash generated from operations of the business at the end of a year is a cash profit. Like if you buy a car, you can depreciate it over years. So in the first year, you might pay Rs. 10 lakh but you’ll consider only Rs. 2 lakh as cost. So if your revenue is Rs. 15 lakh and your car is the only cost, your accounting profit is Rs. 13 lakh. (15 minus 2 lakh depreciation) But your cash profit is Rs. 17 lakh. (15 lakh plus 2 lakh depreciation)
Cash flows can be classified into three categories
- Cash flow from operations or cash profits – records all cash flows related to running the day to day activities of the business
- Cash flow from investing – records the purchase and sale of operating assets and financial assets, like the buying of a car for the business.
- Cash flow from financing – some of items recorded in this section are debt raised/paid, dividends paid, monies raised through issuance of shares
Below is the sample cash flow statement of APL Apollo tubes for FY17.
As can be seen from the above, APL Apollo recorded cash flow from operations (CFOs) of INR 338 Cr, net profits during the same period was INR 146 Cr. The cash flow from operations or cash profits are more than double of the net or accounting profits posted by the company.
Companies that have higher cash profits than accounting profits are better placed than companies where the accounting profits are higher than the cash profits. But why is it so?
The Concepts of Accounting
Accural accounting is a method of accounting that allows revenues and expenses to be recorded when they are incurred, regardless of whether cash is exchanged. For E.g if a company made total sales of Rs 100 and Rs 30 worth of goods was sold on credit. Rs. 30 is a “sale” but the money hasn’t yet come, it’s a credit given to the customer to pay later.
Accrual accounting allows the company to record Rs 100 in the profit and loss account as revenue, even though the company has only received Rs 70 as cash, Rs 30 will be recorded as receivable in the balance sheet. There may be a case where companies may be aggressive and make higher sales on credit, build up large amounts of inventories on the balance sheet, in these cases accounting profits will not give the correct picture of the earnings of the company and hence arises the need for comparing accounting profits with cash profits.
Cash is the lifeline of every business. Companies generating higher cash have the freedom of investing in their business without external debt, returning monies back to investors in the the form of dividends or share buybacks and reducing existing debt. Cash flow from operations tracks the actual flow of cash in running the day to day business operations. Few adjustments are made to the profit before tax (PBT) to arrive at the final cash flow from operations or cash profit figure.
What are then those adjustments?
- Non cash charges like depreciation are added back. Accounting allows for companies to spread over costs that they incur to buy machinery and equipments over period of few years. However the cash outflow happens at the time of buying these equipments
- Profit or loss arising from non-operating income. For E.g a company may have financial assets and will earn interest on the same. Company will record this income in the profit and loss, however the interest income is reduced from the PBT to arrive at the cash profit figure as it is not earned from the operations of the business
- Interest paid is added back, this pertains to the financing activity of the business. Hence it is added back and reduced in the financing activity section of the cash flow statement
Working Capital Changes
Working capital is an integral part of running the day to day operations of the business and it mainly comprises of inventories, receivables and (subtract) payables. Basically stuff you’ve made but not yet sold, cash you need to get but haven’t got, and cash you should pay but have not yet paid. Any working capital changes that the company incurs from one period to another is recorded in the cash flow from operations section to arrive at the final cash profit figure. Let us explain this with the help of few examples
For E.g a company had inventories of Rs 1000 at the beginning of the period and ends with Rs 1500 of inventories at the end of the period. There has been an increase to the tune of Rs 500 in the inventories. Company will have to make arrangements to the tune of this amount to stock this inventory and hence Rs 500 is deducted to arrive at final cash profit figure. On the other hand if their is reduction in inventories then cash is freed in this asset and can be used elsewhere, and hence a reduction in inventory is added back.
However in the case of payables or other current liabilities it works oppositely. If a companies payables increase from Rs 1000 to Rs 2000, the difference of Rs 1000 (2000-1000) will be added back to arrive at the final cash profit amount. In this case the company has bought inventories and not paid for the same, it is the suppliers who are funding the inventories and to this extent the company does not have to invest resources in its business.
Lastly, taxes that the company actually pays is recorded here to arrive at the final cash flow from operations figure.
Putting it together
Given the importance of cash in every business, investors must analyze how fast the accounting profits are getting converted into cash.If the company has higher cash profits when compared to the accounting profits, the company is running its operations very efficiently and can use the cash generated from operations to buy assets or pay down debt and dividends to share holders. However what happens if the accounting profits are greater than the cash profits?
Let us take an example of a company meeting this condition and listed on the Indian stock market.
Lux Industries is manufacturer of innerware products. The cumulative accounting profits of the company for the period (FY10-17) was INR 238 Cr, as compared to the cash profits or cash flow from operations of INR 3.14 Cr in the same period. In the 8 year period above, the company has posted negative cash profits in 5 years. It is advisable that investors analyze these profits over longer periods of time, as analysis of figures over shorter periods of time may not give an accurate picture.
Before we find out what happened in the case of Lux Industries, what are the scenarios in which the accounting profits may be higher than the cash profits?
- The company may be having higher income generated from financial assets. In this case the income adds to the accounting profits in the profit and loss, however as it does not pertain to income generated from the operations of the business it is deducted in the cash flow section
- Working capital changes – companies may stock up on inventories, they may sell their goods on credit and may extend extra period for repayments to their customers and suppliers may demand faster payments, which the company will have to oblige. This is a highly likely scenario and most of the times this leads the cash profits to be lower than the accounting profits
We looked at the cash flow statements of Lux Industries for FY13,16 and 17.
It is the working capital in all the cases that has lead to the cash profits being below the accounting profits. Take the case of FY13, the cash profits were INR -40.21 Cr versus net profits of INR 20 Cr, looking at the cash flow statement one can see that inventories and receivables have increased by INR 128 Cr and this has lead to cash profits being negative.
In FY16, the only year in the 8 year period where cash profits are substantially higher than the net profits, it is due to increase in trade payables and current liabilities that have lead to higher cash profits.
In FY17, depreciation and interest charges that have been added back are higher than the previous year, however it is working capital – receivables, inventories and loans and advances that have increased and lead to cash profits being below the net profits.
Loans and advances are items like prepaid expenses – expenses which have been paid before and company will enjoy the benefits later, loans to employees and advance paid to suppliers. Below are the short term loans and advances of Lux Industries for FY16 & FY17
The loans and advances have increased by INR 21 Cr, it is items like prepaid expenses, advance to suppliers and other loans and advances that have lead to this increase.Hence majority of the times it is the working capital changes that leads to the deviation between the cash profits and the accounting profits.
What are the repercussions if companies are generating negative cash profits or not enough cash profits from the business? Companies will not able to invest in the business, will not able to service debt and pay dividends to its shareholders. They will have to resort to debt to fill the shortfall if the company is generating negative cash profits. In the case of Lux industries debt has increased from INR 131 Cr to INR 225 Cr in the FY11-17 period.
We cannot stop emphasising the importance of cash flows with special attention to cash flow from operations or cash profits. Some companies even generate cash profits and then reinvest those profits into newer assets – like Amazon, which had for a long time generated very little accounting profit (or actually, had accounting losses) while having positive operating cash flow. Some others have “fake” profits through shady receivables, where they record sales but don’t actually receive the money – and sometimes never do. One way to find this out is to compare cash operating profits to reported accounting profits – and look at cumulative numbers over years. Things may not be as good (or as bad) as regular accounting suggests.
NOTE: Please do not consider this article as a recommendation, It is purely for informative purpose only. Authors may have positions in the stocks mentioned, so consider our analysis biased. There is no commercial relationship between Capitalmind and the companies mentioned in this analysis.
Our Premium Long Term Portfolio is at https://capitalmind.in/capital-mind-long-term-portfolio/
Our Premium Momentum Portfolio 2.1 is at https://capitalmind.in/momentum-portfolio
Our Premium DivYield Portfolio is at https://capitalmind.in/capital-mind-premium-divyield-portfolio/
Our Premium EV Portfolio is at https://capitalmind.in/capitalmind-ev-portfolio/