Over the next year, share prices of cash-rich companies are likely to move northward.
Scores of Indian companies have raised cash abroad in the past decade. Equity, vanilla debt, bonds, convertible bonds, private equity, venture capital - every available route has been tried. As a direct result, Indian analysts have become adept at reconciling different accounting formats because many corporates also report financials under different GAAPs.
The differences can be large. There are often double-digit variations in net profits and these can swing both ways. Differences in net worth calculations can also become significant over the years. Additional complications occur with derivatives since these are treated differently under different formats.
All this variation is not surprising. Profits especially are mutable and there are wide variations in income recognition norms. But since market valuations are usually expressed in terms of profitability ratios, valuations differ widely as well.
However, whatever the differences in GAAP, cash-flow statements throw up similar results. Cash in and cash out is so basic a concept that results are easily reconciled. The pity is that there is very little emphasis on CF analysis.
A CF statement includes items from both balance sheet and P&L. It measures cash and cash-equivalents (C&CE) at the beginning and end of accounting periods, and explains changes. If C&CE rises, the business is cash-positive. If it falls, the business is cash-negative.
The statement segregates cash inflows/outflows on three accounts. One is core business. The second is investment, including capital expenditure, sale of assets, treasury income and capital gains. The third stream is the financial account, where interest paid and received is computed.
Cash flow analysis is the best way to judge the ability to service debt. It is better than simply looking at the profit and loss account. It pinpoints areas of concern, if any.
Ideally, a Buffett-follower would avoid touching businesses with large debt exposure. But there are very few Indian businesses that fit the zero-debt criteria and most of those are from the IT sector, which has other problems at the moment.
If a business has significant debt exposure, the financial account will be cash-negative. In order to service debt, the core income and investments must together generate enough cash to cover deficits on the financial front. Alternatively, the company must be able to reduce outflow on the financial front by refinancing cheaper.
It is possible for a highly profitable company to be overall cash-negative at the same time. A company that is expanding rapidly may for instance, have large cash outflows on the investment account charged to the balance-sheet. Profits may also be buoyed by unrepeatable capital gains or treasury income. In such cases, debt service problems can crop up.
A rational assessment of credit risk is bound to be extremely relevant to Indian markets over the next year or so. Interest rates are dropping globally but there is a lot of debt on Indian balance sheets. Most of that debt was taken on under optimistic growth assumptions. Quite a large chunk of foreign debt was also taken on under the assumption that it would never be repaid due to conversion to equity at the high stock prices prevailing in 2007.
The rupee has lost about 33 per cent of its value and stock prices have dropped by more than 50 per cent in the past 15 months. Growth has stagnated. Add currency risk to credit risk and many companies including many blue chips could be teetering on the edge of insolvency if 2009-10 is a lacklustre year.
Over the next year, the correlation between share price movements and cash flows is likely to be much stronger than the correlation between price and net profits. Cash flow positive companies are more likely to see prices headed North while companies that are CF-negative, though profitable, may see prices fall further. .
Some companies with high debt levels will find cheaper means of refinance. Others will generate enough cash to service their debts. A third set – the companies that fail to either refinance or generate enough cash - will struggle.
This is not rocket science but such situations are most likely to be diagnosed by a careful examination of the CF statement. Most companies can and do fudge profitability. The temptation to do so is especially high for a business under pressure during a recession. It's much more difficult to fudge CF and during recessionary periods, cash is truly king.
