# Relationship between Cashflow & Profit?



## exgeo (23 February 2007)

Can somebody explain the difference/relationship between these two items? I have read that "profit is a matter of opinion, whereas cashflow is a fact". Therefore profit is less reliable a measure of a company's worth than cashflow? Assuming there are no huge abnormals or other distorting factors, should the cashflow per share approximately equal the EPS? I apologise for my ignorance in advance.


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## reece55 (23 February 2007)

How long of a discussion do you want......

In regards to operating cash flows, theoretically, a typical business that sells a product or service will have temporary timing differences, but (with the exception of perhaps it income tax expense) given time, the differences will come out eventually and relate to the timing between the relevant flows (i.e. Creditors, debtors, etc.).  So, factoring in these timing differences, they should end up to be the same. It then becomes a mix of how the business handles that liquidity of their operating cash flows - a Company like like say Woolworths is in the box seat, all there sales are cash and then they pay it out in 60 days and can make a free carry 60 days worth of creditors - a wonderful thing. 

However, life isn't that easy in the accounting world. With the introduction of A-IFRS, we have a more theoretical (hypothetical??) approach to earnings, specifically on a business that has many financial instruments or other investments. Have a look at a Macquarie satellite fund - take MIG for instance. Most investors think they are buying roads when they buy the shares - WRONG, you are buying a bond and note holder. If you reviewed the balance sheet, the majority of their investments are financial instruments measured at fair value. So, each year mysteriously they revalue their investments up, have a terrific profit. Have a look at the operating cash flow - usually a negative and nothing anywhere near the profit they record. This is where cashflow and profit become important. Throw in the mix joint ventures, associates and other off balance sheet entities (such as SPE's) and you can make your profits look whatever you say they are.

If you really want a good look at how they relate to one another, have a look at the cash flow note in any companies annual report and review "Reconciliation of net profit after tax to net cash flow after tax". This will tell exactly (to the cent) how operating cash flow relates to profit.

Bottom line - cash flow, adjusted for timing differences and once offs, is the most important element in an annual report. A healthy P&L is great, but it's the cash that drives a business.

Cheers


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## doctorj (23 February 2007)

You're opening a whole can of worms here.  

The cash flow should not be taken as an approximation for profit, particularly in IT, biotech or resource companies where companies capitalise expenses for ever and a day until they reach production and then absorb it piecewise into their P&L over the life of the asset.  Many people have been caught out before looking at quarterlies and then expecting to see a significant profit when the HY reports/quarterlies only to be whacked with a loss.  Given the deadline for HY reporting is coming up, I expect to see a whole lot of juniors retrace on the basis of this different.  If you're good with the search, I've posted on this matter as it relates to a particular stock elsewhere on the ASF.

OK, so how does the difference come about?

First of all, cash flow is recorded when it goes in/out.  The numbers in the books are recorded as income when rights/risk transfer.  

Lets work through some common examples.

Lets say company XYZ is mining company.  They have signed an offtake agreement with some company in China and this contract says the risks relating to the ownership of the concentrate they ship transfer when its loaded onto the boat at port. At this point, the chinese company pays XYZ 90%  (say totaling $9mill) of the estimated value of the shipment.  Then, when it reaches China, it will be remeasured using more accurate equipment and then the spot price in that time will be recalculated to get a new total value of the shipment and the resultant residual will be settled between XYZ and the chinese company.

So, say December 31 falls now.  XYZ has recorded a cash receipt of $9mill in their cash flow and $9mill in revenue.  If the price of the commodity has remained constant, they'd have a receivable of $1mill on their balance sheet and another $1mill in revenue to account for the final 10%.  

But what happens if the commodity price had fallen by 15% while it was being shipped?  The total shipment would only be worth $8.5 mill.  The cash flow would still show a receipt of $9mill.  The $1mill receiable above would now be a $500k payable.

It sounds complex, but it happens all the time.


Another example is where a company receives payment for something they've not yet earnt.  Say the chinese company pays XYZ $10mill in advance of the next shipment as XYZ is having cash flow problems.  XYZ would show $10mill on its cash flow, but there would be NO P&L IMPACT.  Infact, at this stage it'd be on the balance sheet as a liability.  


And a final example, the killer for mining companies.  Mining companies spend millions on exploration.  On the basis they hope to find something economic to dig up, they capitalise everything they spend on exploration (ie. it doesn't appear as a "loss" as they spend it).  Then once they decide they've got something they can economically dig up and sell, they spend many times more money on developing a mine - removing waste, making a tailings dam, building roads, commissioning mills, tanks, crushers, ROM pads, vehicles, buildings, etc etc.  This they capitalise as well (again, it doesn't appear as a loss when they spend it).  Then, when they start producing they apportion the total capitalised over the life of the mine.  So say they spend $100mill to explore and develop a mine that has a 5 year mine life.  Every year in this case, $20 mill will appear as an expense in the p&l. The money spend would appear on the cash flow when they spend it, but the expense will only appear many years later.


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## doctorj (23 February 2007)

> Bottom line - cash flow, adjusted for timing differences and once offs, is the most important element in an annual report. A healthy P&L is great, but it's the cash that drives a business.



You're right that cash flow drives a business, however I'm not sure a cash flow statement is such an accurate way of looking at it.

Essentially as long as the open and closing balances agree, all the figures in the middle can be fudged and you'd be none the wiser.  This means things can be double counted, or even just made up.

It also depends what end of the market you're looking at.  Cash flows are notoriously difficult and its common for juniors to have serious difficulties getting them right.  I'd say that getting cash flows 'right' is far more common at the big end of town, but I can think of one cash off the top of my head where even they've struggled.

It's a mugs game really.


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## Sean K (23 February 2007)

doctorj said:
			
		

> It's a mugs game really.



 LOL

That's why I stopped studying finance.


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## doctorj (23 February 2007)

It's more the accountants you need to watch out for.


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## tech/a (23 February 2007)

As company owner,I need Cashflow to generate the Profit which will generate the cashflow.


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## reece55 (23 February 2007)

doctorj said:
			
		

> It's more the accountants you need to watch out for.




OI.......

We are not all bad....... I resent that!

We just get a bad rap.

All I can vouch for is the public entities I construct accounts for - their cash flows are a work of art (LOL - no conflict of interest here at all!). And I pride myself on being as honest as possible in relation to all my work.

Cheers


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## reece55 (23 February 2007)

tech/a said:
			
		

> As company owner,I need Cashflow to generate the Profit which will generate the cashflow.




In a sentence Tech, that sums it up.

Hence why I say it is the most important element in financials - it's really the only thing that, subject to dodgy accountants, will tell the truth!

Cheers


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## doctorj (23 February 2007)

reece55 said:
			
		

> OI.......
> 
> We are not all bad....... I resent that!



Definately not all bad, however for some at the junior end of the market, accountants are the alchemy by which companies convince shareholders that they're doing better than they are.  



			
				reece55 said:
			
		

> All I can vouch for is the public entities I construct accounts for



Can you PM me which ones they are? I'm a little jaded when it comes to the accuracy of accounts and things companies try to pull come reporting season and would love to know who the honest companies are


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## ghotib (23 February 2007)

reece55 said:
			
		

> OI.......
> 
> We are not all bad....... I resent that!
> 
> ...



Errrr... And you have _ENRON_ as your Avatar???


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## reece55 (23 February 2007)

ghotib said:
			
		

> Errrr... And you have _ENRON_ as your Avatar???




Yes, I have Enron as my avatar........

Bit of ironic humour on my behalf....... To be honest, Enron has caused the accounting community more grief than any other company in history - accounting standards have gone from a small set of documents, to a > 1000 page library as a consequence..........However, in these heady days where the market in my opinion is soaring well past fundamental values, it is a reminder of how hard the mighty can fall........... Specifically in our LBO/deal a minute climate........................ Every investor/professional should learn about this story - it really teaches you about how the investment bank - company - stock market - analyst world can work. And poses the question about your ethics and how they may be tested in life...... And believe me, they will be...... 

Doctorj, I would prefer not to disclose this info.........  However, if you do have a query with a particular companies financials, happy to have a yarn..... Have a look at my posts on say ABS (ABC Learning).........

Cheers


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## doctorj (24 February 2007)

reece55 said:
			
		

> Doctorj, I would prefer not to disclose this info.........  However, if you do have a query with a particular companies financials, happy to have a yarn.....



Fair play.  Just call me a bitter market participant that's seen/heard too much.  I was just surprised to find there were any honest people left.

By the way, I love the avatar   One for HIH would be equally appropriate in Australia (god love the FSRA)


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## ducati916 (24 February 2007)

exgeo said:
			
		

> Can somebody explain the difference/relationship between these two items? I have read that "profit is a matter of opinion, whereas cashflow is a fact". Therefore profit is less reliable a measure of a company's worth than cashflow? Assuming there are no huge abnormals or other distorting factors, should the cashflow per share approximately equal the EPS? I apologise for my ignorance in advance.




I see that no one has mentioned Investment cash-flows or Financing cash-flows which are both part of the cash-flow statement.

Therefore you could have a business;
*declare a net loss per share and be cash-flow positive
*declare net profit while Cash-flow from Operations is running a net loss

Obviously these outcomes can certainly change the light in which an investor may judge the investment value of the business.

jog on
d998


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