Cash should be the simplest of all accounting terms to understand: it is, after all, a word we have all used since we learnt how to talk. Unfortunately, in a company’s accounts, cash can become very hard to follow.
In the latest in Questor’s series on demystifying financial reports we try to follow cash on its journey through a business. This process can help us gain insight into a firm’s true state of health – insight that its managers sometimes fail to offer to investors.
We will do so with the help of an example and have chosen BT Group because its history of cash generation did indeed warn keen‑eyed observers of the growing danger to its dividend long before the cancellation of this year’s final payment.
We start at a line in the accounts that we covered earlier in this series: the operating profit. This differs from “statutory” profit in that it disregards any costs (or gains) from the funding of the business, which means either the cost of interest on debt or the interest received on cash.
But the calculation of operating profit does involve the subtraction of items that do not reflect actual cash, namely depreciation and amortisation (defined here last week). Because these items do not involve cash leaving the business we need to “add them back” to operating profit if we are to follow the cash.
In its full year to March, BT reported an operating profit of £3.3bn but depreciation and amortisation together were £4.3bn. Add those amounts together and we get £7.6bn. However, cash that did leave the business was that used for capital expenditure (the fact that BT gained assets in exchange is not relevant for our current purposes). That capital expenditure came to £4.1bn.
One much smaller item we should also take account of is the change in “working capital” – assets and liabilities that fluctuate daily, such as stock, what is owed to suppliers and what customers owe to the company. A fall in BT’s working capital last year gave it £400m more cash to play with.
If we subtract the capital expenditure from £7.6bn but add the working capital change (and account for some rounding effects) we arrive at a figure of £3.8bn.
Incidentally, the fact that capital expenditure was roughly equal to depreciation and amortisation is welcome: it suggests that BT spent enough to maintain the overall quality of its assets.
We are now at the point where we can calculate the cash conversion ratio, which we quote for every stock covered in this column because it is a quick and comprehensible test that what a company says it makes actually corresponds to money in its bank account that can be used to pay bills and fund dividends.
We divide that £3.8bn figure of cash generated by operations by the £3.3bn in operating profits to get a cash conversion ratio of 115pc – a healthy result.
There is more than one way to calculate this ratio and sometimes tax and interest are also deducted from the operational cash generation figure. BT handed cash of £210m to the taxman last year, while its net interest cash costs came to £706m. If we subtract these sums from £3.8bn we get £2.9bn and a cash conversion ratio of 88pc, which is still good.
But there is another useful figure: the “free” cash flow. The idea here is to account for every penny that the company has to spend so that anything left can truly be said to belong to shareholders and be available to pay their dividends.
Our other stock-picking jargon-busters:
To get to free cash flow from the cash generated from operations, we must subtract not only tax and interest but also lease payments and pension contributions. For BT last year these figures added up to £1.9bn. Subtract that from £2.9bn and we arrive at a free cash flow figure of £1bn.
Now compare that with the £1.5bn BT spent on dividends last year (as distinct from the amount it declared in dividends in relation to the financial year) and we can see that the firm did not make enough cash, after every bill had been paid, to fund what it paid in dividends. Its ratio of free cash generated to the divis paid was just 67pc.
BT reported pre-tax profits of £2.4bn last year so the more traditional “dividend cover” figure, the profit divided by the dividend, was a more healthy sounding 1.6 times. In neither of the previous two years had BT’s free cash flow covered its dividend, suggesting that a cut was becoming inevitable. This shows the value of looking at cash.
Read the latest Questor column on telegraph.co.uk every Sunday, Tuesday, Wednesday, Thursday and Friday from 6am.