How to read a cash flow and balance sheet

Hello? I'm Russ, Mould AJ Bell Investment director. Welcome to this series of six short videos designed to help you find more information on companies and interpret them when they've published their report and accounts. So you can do your own research and seek out the companies or potential investments that fit with your own personal strategy.

Time horizon, appetite for risk, and target returns. Whether you're picking individual stocks, forming an index through a passive or ETF or tracker fund, or indeed looking at the that's particularly laden with certain types of companies. Just so, again, you can get a feel for what's really under the bonnet of those funds. Or again, a particular individual company. So we're now into the third video we've done where to find the information.
We've done the profit and loss account or P and L. And now we're moving on to the other two parts of a set of interim or full year results, the cash flow and the balance sheet. Now. But before we go into those details, please just read these equally detailed and equally important disclaimer.
So let's move on to the cash flow in the balance sheet.

Again, they're very much interlinked. And we'll go on to give you some examples of exactly how when one thing moves, another thing moves. And this really has its origins in the Renaissance, in Florentine bookkeeping in the 14th and 15th century. And it's never really changed since, by the way, because it works. So for example, let's see how these very simply work you get sales, then you get profits. Or as you've described, profits helped to drive cash flow. 

Okay. Cash flow can help to fund acquisitions. It can can refund debt. It will definitely pay your taxes. And it can also fund dividends and share buybacks for investors. But that's on the balance sheet, for example. Well, that can mean that there's an interest charge and that can affect your profits.
And then the whole thing can be a little bit less favorable than it was. So there's less money to pay dividends, less money for investment in the business, less money for acquisitions. Because in the end, don't forget, it doesn't matter how much profit you make, interest has to be paid to the banks. Tax has to be paid to His Majesty's Revenue and Customs.

Those leases have to be paid to landlords. Those costs are fixed whether you're doing good, bad or indifferent. And that's why, again, it's important that you know that all of these three things interlinked. So the old saying in stock markets profit is a matter of opinion, cash is a matter of fact. We gave you an example in video number two of how a company could play fast and loose with its revenue recognition by booking all of the revenues from a ten year contract on the front and then booking the cost over a period of time.

Now, I'm not saying that goes on, but it'd be easy for you to do if you're feeling particularly unscrupulous and it would show up in the cash flow and balance sheet it will come onto in a second. But you cash is cash. It's there in the bank. The order just counts it and that's that. Okay. And cash flow is vital because it's used to first and foremost, it's used to invest in the business to maintain competitive position, to maintain brand technology, market share, customer awareness without would you really are struggling and companies never fail, never go bankrupt because they've got no cash.
They fail because they haven't got enough to invest in their competitive position and also to pay their bills. Those vital bills interest in leases have to pay them. No matter what happens. If you're making a profit, you're going to have to pay a tax unless you're up to something potentially a little bit shady. So again, they'll always be generally speaking be a tax charge.

And yet cash will after all of those things have been and only after those things have been done, should a company consider paying dividends to shareholders or even running a share buyback scheme. So ultimately, cash is there to survive, invest, pay bills, then thrive, grow and reward your shareholders. And the cash flow has got three parts cash flow from operations, cash flow from investing, cash flow from financing.

And again, there are lots and lots of different ways that you can maybe measure cash flow. Operating free cash flow is a really important one. We'll come back to that later. But look at cash conversion ratio. How much operating cash from operations compares to operating profit. The higher the better. You're looking at cash flow interest cover how much cash flow is a multiple of your interest payment to the bank?

And the idea is ideally at least two times, by the way, how much it covers your dividend. Again, ideally at least two times cash flow growth is really important. And you can even use operating free cash flow. Yield is a different way of looking at P acquisition targets for private equity companies generally have a really high free cash flow yield, because that's what they're looking for, cash flow to offset the debt that they're taking on as part of the acquisition.

Okay. So back to our Footsie 100 company our model citizen. Again, that's not investment advice. It's not a recommendation. It's just to say it's got a pretty straightforward set of accounts. And it's got a great long term record of strong profitability strong cash flow generation. So it seems a pretty good nice straightforward model to use. And here again quite clearly you can see the three parts cash flow from operations cash flow from investing cash flow from financing operations.

First of all features operating profit that pumping beating heart of the company adjusted for depreciation. As we said, as we've mentioned before, how your assets fixed assets get old and tired and eventually need to be replaced. Amortization does the same for your brands. Then you have maybe a pension contribution and working capital. That's a change in inventories, stock of unsold goods, trade, trade receivables, stuff that you've sold but haven't been paid for, and trade payables, stuff that you've bought and you haven't paid for.

Then cash investing, capital investment, investing in your competitive position in your assets, maybe acquisitions, maybe disposals and then from financing. Well, that includes debt raising it, paying it back dividends, buybacks and leases. And lo and behold, okay, on this model, you look at the bottom number. You think, well that's not very good. Cash consumed 184 million. But look there was some really really big there was some big acquisitions in there.

And there was also some fresh debts and also some debt repayments. So again, the headline might not look great, but as soon as you dig into the numbers, it's pretty clear that ultimately how much is actually a very cash generative company. And that part reflects how high its operating margin is, something that we discussed in video two.

So the balance sheet now really I've been a bit naughty here because now I'm going to lecture you.

I've looked at the profit loss account first and the cash flow second and the balance sheet third, because that's what everybody does. But really we should look at balance sheet first, cash flow second and third and do it completely the other way around because balance sheet protects our downside. Cash flow shows its quality, PNL gives us quantity and perhaps a feeling of growth.

And again, though we must remember the balance sheet. If the PNL covers a three, six, or 12 month period, the balance sheet is struck on one day, the end of a quarter, the end of a half, or the end of the year. So again, the company will be doing its best to put a positive spin on that as it can.

And again, that may shape why as a particular financial year, because when cash flows out and cash flows in, there are also, again three parts of a balance sheet assets, liabilities and shareholders funds and assets minus liabilities equals net assets or net shareholders funds. Or in other words, assets equals liabilities plus shareholders funds. Okay. Simple.

Here we are again nice simple straightforward not a recommendation.

We can very quickly see here the different parts of the balance sheet assets on one side liabilities on the other. Now what I'm going to quickly explain now is how the cash flow in the PNL tied together very on the balance sheet, tied together very, very quickly. So let's just say capital capital expenditure okay. So capital expenditure. So it's 50 million pounds in crude terms company spends 50 million pounds.

It's cash will go down 50 million tangible fixed assets will go up 50 million. The balance sheet still balances equal and opposite reaction every time.

That's why it's called a balance sheet. Okay. A company pays out a dividend. Cash goes down on one side of the balance sheet. Shareholders Fulton's go down on the other side of the balance sheet a company takes a major asset.

Write down. Profits go down, which means you know, you'll you will take a hit to maybe asset values. On one side of the balance sheet. You'll take a hit to shareholders funds on the other side of the balance sheet. If your inventories go up because you've got loads of unsold stock lying around, your cash will go down again, equal and opposite, with equal and opposite reaction, this time on the same side of the balance sheet.

But it will always balance when things move around. And that's again, that's that double entry bookkeeping that we've got now. Just so a couple of things. If you are looking for signs of trouble, one is growing faster than sales, two trade receivables growing fast and sales. It may mean the company's being a little bit aggressive with its revenue recognition, like that fictional photocopier and ink seller that we talked about in video number two.
Three, in terms of quality, if a company claims that it's growing its profits and its shareholders funds are going nowhere, well, it's probably doing not perhaps quite as good a job as we think. What it's probably doing is taking all of one off exceptional items which knock a hole in the assets, knock a hole in the equity, even though they're growing profits and they're almost possibly manufacturing profits growth from those restructuring costs, things will be rising assets down to zero and selling them.

Or they will perhaps have just nodded off at the wheel and not done a good job on cost, as they should have been previously. So again, you're looking for equity growth over time. If that's happening, you've really got a pretty clean set of accounts and actually a pretty sensible operating model. If not, there's at least a lot of volatility in there, a lot of noise in terms of exceptional items and therefore adjusted profits.

Now, another thing to look at here is debt, because the balance sheet is really what we learn here. And one measure of this is what's known as gearing, which is net debt divided by sheltered funds or equity and expressed as a percentage. Now in simple terms, the lower the gearing, the safer the balance sheet. No, no, it doesn't mean to say that debt per se is bad.

It can be a cheap and readily available, an important source of funding. But you need to have a cash flow and a business model that's capable of sustaining it. Utilities pretty dependable, consist in lots of debt. Cyclical businesses whose profits do that with a cycle. Airlines Steel's not necessarily such a good thing. Again because of the profits collapse.

They still have to pay the interest bill. So you could walk into a rights issue, emergency funding or something even worse. Also, not just looking at debt here. We have to include leases, pensions, contingent liabilities because they have to be paid. And this again gives us a three. The view interest cover for interest and dividends, free cash flow cover for interest and dividends.

And again how much how easy is it for us for the company to fund the bills that it has to pay tax interest leases. What the debt covenants. What triggers them. What the bank is looking for, what's going to make them get frightened, maybe constrict a company's ability to lend, and also watch when the debt has to be repaid, just in case it suddenly a big dollop of it and the banks getting cold feet.

So again, it's not just looking at the debt, it's looking at a fuller picture. Pensions, leases, liabilities. And it's looking at the cash flow and how that ties into that. And cash flow really matters. It is royalty. It really, really matters. And here's an example. This is not a fictional company. I haven't named it. I will do in a minute.

This is a company that, as we can see here, was ostensibly making a profit, but its cashflow was pretty ropey. And there's a very good friend of mine, Michael Cahill, always used to tell me in his book, I'm making the right financial decisions. A really good thumb test. Rule of thumb over time is look over a 5 or 10 years and look at how revenues, operating profit and free cash flow move.

They should, over time moving the same direction and within some degree relatively similar percentages. Company where that doesn't happen. There might be there might be not guaranteed to be. That could be something fishy going on in this company here. As we can see, cash flow bore no resemblance at all in terms of its growth profile to operating profit or revenue growth.

We can also see here that once you paid interest tax and so on, it really shouldn't necessarily been paying such a generous dividend because it was struggling to cover that. Now this company did go bust and it was called Carillion. And the reason that it went bust was in the end, as you can see here, it's got about 4 billion pounds of sales and about 140, 50 million pounds of operating profit.

That pumping, beating heart. It's not pumping very strong, is it, when you're operating margins 2 or 3%. So if something goes wrong, a big project goes wrong with an infrastructure facility is listed here. So again looking at the numbers themselves were okay so long as nothing went wrong. Science fine but art. The art here was use my imagination.

What could happen if what if that goes wrong? And then you still looking at those fixed costs of interest, pensions and leases and that's when the whole thing, which was very, very tightly strung snapped, wasn't. It was all there in the accounts. You could see it, but you still needed to use your imagination. So although I've been naughty and done it the wrong way round.

But please, to protect your downside, first read the balance sheet first, the cash flow second and the third spot floor. This will help you spot flows or positive inflection points. In a business. The balance sheet gives you downside protection, but a stretched balance sheet can increase risk or risk or at least when a share price equal. It works the other way.

If a company pays down debt less, that means less risk. Less risk can mean a higher share price, or at least a higher multiple of earnings. But again, if a company is piling up debt to grow, it might not get the full credit. The earnings might go up, but the PE in the price earnings ratio might not profit.
For vanity cash flow facility cash flow pays bills. It helps you invest in the core competitive position of the business and make sure it's still around. And again, we must take a 3D view. PNL cash flow balance sheet and not just a snapshot, but over a lengthy period of time.

So in the first video we looked at where to find the company announcements. And the next two we've gone through. So how to start interpreting them. Now we're going to start taking a 3D view of splitting together the numbers and our interpretation of them. Our art with the science, with strategy and with valuation to see how these announcements really start to affect a company's share price.

Benjamin Graham here, Warren Buffett's mentor, famous, saying in the short run, the stock market is a voting machine. In the long run, it's a weighing machine. What does that mean? In the short run, narrative and story can take a share price a long way, but in the end, it's how much cash it generates and the price that we pay to access that cash flow that really matters.