Earnings are an estimate and cash is real!
This is a principle that has stood the test of time in the investing world. Many companies that reported profits on paper (P&L) without backing it up with cash (CFO) have faced bankruptcies; destroying the wealth of shareholders.
Therefore, it is no surprise that overtime; investors have started focusing on the cash flow statement to assess the real earning power of the companies. In the cash flow statement, the section of cash flow from operating activities (CFO) is the most important because it represents the cash earnings of the company for the year and we all know that “Cash is King”.
Therefore, currently, in investment analysis, cash flow from operations (CFO) plays one of the most important parts. Investors and analysts focus a lot on CFO and the companies know it. As a result, it does not come as a surprise that companies try hard to show the best possible picture of CFO in their financial statements.
Many times, companies improve their CFO by genuine business actions like collecting their receivables on time, efficiently utilizing their inventory and keeping a minimum amount of inventory with them, negotiating higher credit period with their suppliers. All these activities increase the amount of cash that comes in and stays with the company and in turn, the CFO of the company improves.
However, over time, we have come across many instances where companies attempted to inflate their cash flow from operating activities (CFO) by non-genuine means.
Companies show a higher CFO mainly by the following methods:
- Showing non-operating cash inflows as an inflow under CFO
- Using smart interpretations of accounting rules to their benefits and creating operating inflows where no cash inflow exists
- Removing operating expenses from CFO and putting them under investing or financing activities i.e. under cash flow from investing (CFI) or under cash flow from financing (CFF) activities
Overtimes, we have analysed hundreds of companies on our website as well as for our personal investments. As a result, we have come across many instances where companies attempted to show a higher cash flow from operating activities (CFO) that what it ideally should have been.
In the current article, we share some of these cases, which may act as live examples and illustrations for investors to learn and avoid these pitfalls while doing their own analysis.
Showing Debt as inflow under Cash Flow from Operating Activities (CFO)
While analysing companies, we have come across cases where companies had an inflow, which is essentially debt; however, they showed it as an inflow under cash flow from operating activities (CFO).
Investors would appreciate that ideally, such an inflow should be a part of cash flow from financing activities (CFF) instead of CFO.
Let us see some of such cases:
1) India Glycols Ltd
India Glycols Ltd is an Indian company manufacturing glycols, ethylene oxide derivatives using renewable raw material (alcohol, molasses), guar gum derivatives, alcohol & spirits, industrial gases, and nutraceuticals.
While analysing the profit and the cash flow from operations of India Glycols Ltd over FY2010-19, an investor notices that it reported a total cumulative net profit after tax (cPAT) of ₹112 cr. During the same period, it reported cumulative cash flow from operations (cCFO) of ₹2,511 cr. An investor notices that the company has very high cCFO when compared to the cPAT over the last 10 years (FY2010-2019).
In addition, an investor notices that out of the cCFO of ₹2,511 cr, almost half (about ₹1,231 cr) is generated in one year (FY2016). Moreover, an investor notices that in FY2016, India Glycols Ltd reported a net loss of ₹57 cr. Therefore, to understand the cash flow generation by India Glycols Ltd over the last 10 years, the due diligence of CFO in FY2016 becomes crucial.
The below table from the annual report of FY2016 (page 101) shows the stepwise calculation of CFO of India Glycols Ltd from its profit before tax.
In the above table, an investor notices that the maximum contribution to the CFO (₹909 cr) is from trade and other payables.
An investor needs to analyse the balance sheet of the company for FY2016 to understand the source of this inflow of ₹909 cr shown as operating cash flow by India Glycols Ltd.
While analysing the liabilities section of the consolidated balance sheet of the company for FY2016 (page 100 of the FY2016 annual report), an investor notices that there are two sources, which show significant inflow during FY2016. Apart from these two sources, almost all the key items in the liabilities section show outflows during FY2016.
- Other long-term liabilities show an increase from ₹4 cr in FY2015 to ₹659 cr in FY2016 indicating an inflow of ₹655 cr (= 659 – 4) in FY2016.
- Trade payables show an increase from ₹247 cr in FY2015 to ₹480 cr in FY2016 indicating an inflow of ₹233 cr (= 480 – 247) in FY2016.
Together these two sources show an inflow of ₹888 cr (= 655 + 233) in FY2016, which nearly explains the inflow of ₹909 cr shown by the company under trade and other payables. Please note that investors may contact the company directly to understand the full detailed reconciliation of the cash flow statement and the balance sheet of the company. For the current discussion purpose, we will go ahead with the approximations as arrived above.
Out of the above two sources, an investor would appreciate that the trade payables include the money due to the suppliers, which is an operating activity and hence the inflow of ₹247 cr seems to be rightly classified under cash flow from operations.
To understand the nature of inflow of ₹655 cr from other long-term liabilities, an investor needs to extend the analysis further by reading the note number 6 from the notes to the consolidated financial statements of FY2016 (page 107 of the FY2016 annual report).
Further advised reading: Understanding the Annual Report of a Company
The above section containing the details of consolidated other current liabilities of India Glycols Ltd for FY2016 shows that during the year, the company received ₹654 cr as an advance from customers. While reading the explanations under the table, an investor gets to know the following things:
- One customer has given an advance of ₹726 cr to India Glycols Ltd for supplying goods over 10 years.
- State Bank of India (SBI) has given a guarantee to the customer on behalf of India Glycols Ltd. It means that if India Glycols Ltd does not fulfil its obligations or does not return the money, then SBI is bound to pay the money back to the customer.
- Export Performance Bank Guarantee (EPBG) member banks have given a counter-guarantee to SBI. It means that if SBI had to pay the customer, then SBI will recover the money from EPBG member banks.
- These guarantees are secured by assets of India Glycols Ltd.
Looking at the above information, the following interpretations come to an investors mind:
- A customer has given an upfront advance to India Glycols Ltd for goods to be supplied over 10 years. This is very rare in business parlance. Usually, customers pay their suppliers after a few months of delivery of goods. Even if a company offers discounts to its customers for advance payment, even in those circumstances, the advance payments are limited to the goods to be delivered over the next few months. Giving an advance for goods to be delivered over the next 10 years is extremely rare, as the company itself may not remain in business for 10 years.
- The customer realizes this risk and therefore, it has taken a bank guarantee to ensure the safety of its money.
- If India Glycols Ltd does not supply the goods or does not return the money, then the customer will get the money from the bank and the bank, in turn, will sell the assets of India Glycols Ltd to recover their money.
If an investor looks at the essence of this transaction, then it seems that India Glycols Ltd has taken a 10-year loan by mortgaging its assets with multiple banks acting as intermediaries.
Moreover, while reading the annual report, an investor would notice that the company used this export advance to repay its existing debt.
FY2016 annual report, page 88:
Out of advance export proceeds which the Company has raised during the year of ₹72,641.64 Lacs (USD 114 Million) (note no 6) certain amount of long-term debt and working capital has been paid/ reduced.
In addition, the subsequent annual reports indicate that the company has made repayments to the customer towards this export advance.
FY2019 annual report, page 26:
The Company renewed the EPBG advance for USD 68.40 million (₹435.84 Crores) after meeting repayment obligations for 2 years. The Company repaid an amount of USD 17.80 million (₹113.42 Crores) to the customers against the commitments reducing the total liability to USD 68.40 million (₹435.80 Crores) as on 31 st March, 2019.
Therefore, from a practical point of view, an investor may consider this long-term advance from the customer, as a debt in her analysis instead of an inflow under cash flow from operations shown by the company.
Therefore, it is advised that an investor should do a deeper analysis if she finds that the financial parameters of the company are not in line with the general business expectations.
In the case of India Glycols Ltd, the investor notices that the significantly high cCFO of ₹2,511 cr over FY2010-2019 reported by the company despite a low cPAT of ₹112 cr is primarily due to a long-term customer advance, which is practically debt secured by bank guarantees and assets of the company. Based on their analysis, investors may adjust the cash flow from operating and financing sources accordingly.
You may read the complete analysis of India Glycols Ltd in the following article: Analysis: India Glycols Ltd
2) Filatex India Ltd:
Filatex India Ltd is an Indian manufacturer of polyester, nylon & polypropylene multifilament yarn.
While analysing the FY2012 annual report, an investor notices that the company has included an increase in the current maturity of long-term borrowing (CMLTB) as an inflow under cash flow from operations (CFO).
An investor can ascertain it via the following steps.
In the cash flow statement for FY2012, an investor notices that the company has disclosed ₹20.64 cr as an inflow on account of “Increase / (decrease) in trade & other payable / provisions” in the CFO under “Movements in working capital”.
FY2012 annual report, page 30:
From the above information, an investor notices that the company has included ₹20.64 cr as an inflow on account of “Increase / (decrease) in trade & other payable / provisions” in the CFO.
While looking at the balance sheet of the company for FY2012, an investor notices that the only item that can lead to an inflow of ₹20.64 cr is “other current liabilities”. In FY2012, the other current liabilities of Filatex India Ltd increased by ₹27.92 cr from ₹23.66 cr in FY2011 to ₹51.58 cr in FY2012 (51.58 – 23.66 = 27.92).
FY2012 annual report, page 28:
In the above balance sheet, an investor would notice that apart from the other current liabilities, there is no other section that indicates an increase by ₹20 cr or more. The common parameter of trade payable had an outflow of ₹8.58 cr as the trade payables had decreased from ₹19.46 cr in FY2011 to ₹10.88 cr in FY2011 (19.46 – 10.88 = 8.58).
Therefore, an investor can assume that the inflow of ₹20.64 cr shown in the CFO calculations under “Increase / (decrease) in trade & other payable / provisions” is related to other current liabilities. If an investor mergers the impact of “Other current liabilities” and “trade payables”, then she arrives at a net impact of the increase/inflow of ₹19.34 cr (= 27.92 – 8.58), which approximates to the inflow of ₹20.64 cr shown in the CFO.
While ascertaining the component of other current liabilities that has led to the inflow/increase of ₹20.64 cr in FY2012, an investor should analyse the detailed note to the financial statements.
FY2012 annual report, pages 39-40:
While analysing the other current liabilities section, an investor notices that out of the total increase in other current liabilities of ₹29.72 cr, the major component is the increase in current maturity of long term borrowing (CMLTB) of ₹18.72 cr, from ₹11.75 cr in FY2011 to ₹30.47 cr in FY2012 (30.47 – 11.75 = 18.72). The rest of the parameters of other current liabilities lead to an increase of ₹9.38 cr from ₹11.72 cr in FY2011 to ₹21.10 cr in FY2012.
Therefore, an investor would appreciate that in the ₹20.64 cr of inflow shown by Filatex India Ltd in the CFO calculations under “Increase / (decrease) in trade & other payable / provisions” has a full contribution from the CMLTB, which is nothing but debt component.
Therefore, an investor would appreciate that in FY2012, Filatex India Ltd included the debt inflow as an inflow under cash flow from operations, which had the impact of showing a higher CFO than it actually is.
An investor can crosscheck this finding by ascertaining the cash flow from financing activities of Filatex India Ltd for FY2012.
In the summary balance sheet for FY2012, an investor notices that the long term borrowings (LTB) have increased from ₹28.39 cr in FY2011 to ₹186.32 cr in FY2012 representing an increase of ₹157.93 (= 186.32 – 28.39). Similarly, the short-term borrowings (STB) show an increase of ₹2.66 cr from ₹40.41 cr in FY2011 to ₹43.07 cr in FY2012.
FY2012 annual report, page 28:
An investor would appreciate that the data of LTB and STB showed in the summary balance sheet excludes the current maturity of long term borrowing (CMLTB). This is because, in the summary balance sheet, the CMLTB is shown under other current liabilities.
When an investor analyses the cash flow from financing activities of Filatex India Ltd, then she notices that the data of inflow from the borrowings of the company in FY2012 corresponds only to the inflow/increase calculated by the investor above using only the LTB and STB data from the summary balance sheet without factoring in the CMLTB.
FY2012 annual report, page 31:
From the above cash flow from financing activities (CFF) table, an investor notices that the CFF table shows a net inflow from LTB of ₹157.93 cr, which exactly matches the increase in LTB calculated above from the summary balance sheet data.
- Proceeds from LTB: ₹163.87 cr
- Repayment of LTB & STB: ₹5.94 cr
- 163.87 – 5.94 = 157.93
Similarly, the inflow from STB in the CFF is ₹2.66 cr, which matches with the increase in STB calculated above from the summary balance sheet data.
As an investor would appreciate that the LTB and STB data in the summary excludes the current maturity of long term borrowing (CMLTB), which is shown under other current liabilities.
Therefore, if an investor takes a comprehensive view from all the calculations done by us in the above discussion, then she would appreciate that the data in the CFF only corresponds to the LTB and STB as per the summary balance sheet data. Therefore, the CFF data misses the impact of the current maturity of LTB, which is an increase/inflow of ₹18.72 cr included in the other current liabilities.
At the same time, the calculations of the CFO include the impact of CMLTB through other current liabilities.
Therefore, the net impact of these accounting assumptions is that the inflow/increase due to CMLTB of ₹18.72 cr is shifted from cash flow from financing activities (CFF) to cash flow from operating activities (CFO).
This effectively inflates/increases the CFO by ₹18.72 cr and deflates/decreases the CFF by ₹18.72 cr.
You may read the complete analysis of Filatex India Ltd in the following article: Analysis: Filatex India Ltd
3) Sreeleathers Ltd:
Sreeleathers Ltd is one of the leading footwear companies in India based out of Kolkata. Sreeleathers Ltd deals in formal and casual footwear of men, women and kids as well as in leather accessories.
While analysing Sreeleathers Ltd, an investor notices that the company has done a misclassification of cash inflow with respect to an unsecured loan raised by it in FY2014.
In FY2014 cash flow statement, an investor would notice that Sreeleathers Ltd reported a cash flow from investing activities (CFO) of about ₹19.7 cr. The largest contributor to the CFO was an increase of ₹11.5 cr in other current and non-current liabilities.
FY2014 annual report, page 33:
While going through the details of other current and non-current liabilities in the annual report, the investor notices that the increase in these liabilities in FY2014 is due to the unsecured loan of ₹11.5 cr discussed above.
FY2014 annual report, page 37:
An investor would appreciate that Sreeleathers Ltd should have classified this unsecured loan as a cash inflow under financing activities instead of a cash inflow under operating activities. Such misclassification leads to an erroneous interpretation of cash flow from operations.
You may read the complete analysis of Sreeleathers Ltd in the following article:
The above cases highlight instances where companies attempted to show a higher CFO by classifying inflow from debt as an inflow under CFO. Let us now see some of the cases where companies attempted to show inflow from investing activities as an inflow from CFO.
Showing sale of business divisions as an inflow under Cash Flow from Operating Activities (CFO)
Usually, the purchase and sale of assets like investments, stake in subsidiaries, joint ventures, and business divisions are considered investing activities. Therefore, investors would anticipate that any inflow from the sale of stakes in subsidiaries, joint venture or business divisions, and brands etc. will be shown under cash flow from investing activities (CFI). However, we have come across instances where companies showed the inflow from the sale of assets as an inflow under CFO.
Let us see some of these cases:
1) PIX Transmissions Ltd.
PIX Transmission Ltd is a manufacturer of power transmission belts applicable in industrial, agricultural, lawn & garden and automotive segments. Until FY2013, the company had two distinct business divisions of belts and hoses. However, in July 2012, it sold its hoses division and decided to focus solely on the belts division.
While analysing the credit rating report of the company prepared by CARE Ltd in 2014, the investor notices that the total sales proceeds received by the company from the sale of hoses division are ₹241.85 cr.
The company sold its hose assemblies division along with its manufacturing unit located at Bazarwadi, Maharashtra to Parker Hannifin (I) (P) Ltd. for a sale consideration of Rs. 241.85 crore in July, 2012. On account of this deal, the company made a Profit after tax of Rs.100 crore in FY13.
While analysing the treatment of this sales transaction in the financial statements, an investor has to read the profit & loss statement (P&L), balance sheet (B/S) as well as the cash flow statement of PIX Transmission Ltd.
An investor notices that the company has reduced its fixed assets by ₹85.62 cr on account of sale of hoses division.
FY2013 annual report, page 64:
While reading the P&L, an investor notices that the company showed the gains of about ₹134 cr. as an exceptional profit before tax.
FY2013 annual report, page 57:
An investor would also notice that the company has accounted for a current tax of ₹37 cr. in FY2013. As about 93% of the profit before tax in FY2013 is due to the exceptional item (133.9 / 144.6 = 92.6), therefore, an investor may assume that almost all of the tax shown for the current period (₹37 cr) is due to the exceptional item, which is the gains from the sale of hose division.
Considering this bifurcation in the P&L and B/S, an investor is able to reconcile approximately ₹219.6 cr. from the sale of hoses division in the financial statements (= Exceptional profit before tax: ₹134 cr. + depreciated book value of ₹85.6 cr).
An investor would note that the amount spent by any company for the creation of plant & machinery is considered a capital investment and is considered as cash outflow under-investing section. Similarly, whenever, companies sell their divisions, assets, then the cash received by them is shown as cash inflow under-investing section.
However, in case of PIX Transmission Ltd, the company has apparently shown the gains from the sale of the hose division as inflow under cash flow from operations:
Therefore, an investor notices that the company has chosen to bifurcate its proceeds from the sale of hoses division into two heads:
- The cash inflow equal to the book value of the sold assets (₹85.6 cr) is shown as an inflow under the cash flow from investing activities and
- The cash inflow pertaining to the profit on this sale (₹134 cr) is shown as an inflow under cash flow from operating activities (CFO).
An investor would appreciate that any gain or loss from the sale of assets/business divisions/subsidiaries/JVs etc. should be shown as a cash flow under the investing activities. Showing it as an operating activity may influence the conclusions of the investors. It is advised that investors may do suitable adjustments while analysing companies.
Investors may read the complete analysis of PIX Transmissions Ltd in the following article:
2) Albert David Ltd
Albert David Ltd is a Kolkata based Indian pharmaceutical manufacturer producing acute therapy drugs and human placenta extract based medicines under the brand “Placentrex”. In FY2016, the company sold its brand “Actibile” to Zydus Healthcare for ₹55 cr.
FY2016 annual report, page 26:
We further report that during the period under audit, the Company has sold its brand ‘Actibile’ to M/s. Zydus Healthcare Limited, Ahmedabad for a lump sum consideration of Rs.55 crores.
An investor notices that the company has disclosed the profit net of tax of ₹40.8 cr from the sale of Actibile brand, in its profit & loss statement as an exceptional item.
FY2016 annual report, page 74:
An investor would note that the amount spent by any company for the creation of brands is considered capital investment/intangible assets and is considered as cash outflow under-investing section. Similarly, whenever, companies sell their brands & related assets, then investors assume that the cash received by them will be shown as cash inflow under-investing section.
However, an investor notices that in FY2016, Albert David Ltd has shown the proceeds of ₹53 cr. received from the sale of the brand “Actibile” to Zydus Healthcare, in the cash flow from operations (CFO).
FY2016 annual report, page 75:
Investors would notice that in the case of PIX Transmissions Ltd discussed above, the company decided to bifurcate the sale proceeds from the hoses division into two parts. One part, the cash inflow equal to the book value of the sold assets (₹85.6 cr) was shown as an inflow under the cash flow from investing activities. The other part, the cash inflow pertaining to the profit on this sale (₹134 cr) was shown as an inflow under cash flow from operating activities (CFO).
However, Albert David Ltd has decided to put the entire cash inflow from the sale of Actibile under the cash flow from operating activities (CFO).
Therefore, if an investor deems fit, then she may adjust the CFO calculations by removing the sale proceeds of ₹53 cr. from CFO and put it under cash flow from investing (CFI).
Investors may read the complete analysis of Albert David Ltd in the following article:
An investor may note that the companies also know that investors give a lot of importance to the cash flow from investing activities (CFO) in their analysis. Therefore, companies try to present as best a picture as possible of CFO as possible. However, as seen above, many times, companies may choose to classify such items under CFO, which may not be truly operating inflow.
Therefore, it becomes essential that investor should be cautious while analysing companies and do a deeper analysis while looking at the cash flow statement. Doing an in-depth analysis will help them in understanding the true financial position of the companies.
Have you come across any company that attempted to inflate its CFO? If yes, then it would be great if you can share your experience with us as comments to the article. It will be very helpful to the author as well as all the readers.
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Registration status with SEBI:
I am registered with SEBI as a research analyst.
Details of financial interest in the Subject Company:
I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.