In a couple of months, more than half the companies listed on the ASX will report their full year results. While there will be some surprises that can’t be foreseen, you can prepare your client portfolios by reviewing the cash position of the companies they hold and removing those companies that don’t display high quality economics.
Every business, whether it’s listed on the ASX or privately run, operates to generate cash. The amount of cash generated over a given period is known as cash flow.
Think about it this way.
At the start of the year, your business had $100,000 in its bank account. By the end of the year, after operating the business, receiving revenues from sales, paying staff, taxes and all other expenses, you were left with $200,000 in the bank. On the surface, you’ve made a $100,000 profit. Great!
Now, back to reality. Over the same period you borrowed $200,000. Despite making profit of $100,000, the $200,000 of borrowings effectively brings your bank balance back to zero.
What if you also raised extra cash? Any capital raised needs to be treated the same way as the money borrowed from the bank. If you raised $150,000, you need to reduce your bank balance by that amount too.
So starting with cash in the bank of $100,000, add your $100,000 profit to arrive at a bank balance of $200,000. Now subtract $200,000 of borrowings and the additional $150,000 of equity. You arrive at a cash loss of $150,000. To make matters worse, what if you also paid a dividend of $200,000? You’d need to reverse the effect of the cash leaving the business and add this back.
Do you want these types of time-bombs ticking inside your portfolio? Poor and worsening economics can result in falling share prices, regardless of broad market sentiment.
Good quality businesses generate plenty of cash. After paying creditors and employees, distributing dividends or making acquisitions, the best businesses enjoy rising profits while maintaining a healthy bank balance.
You’d be surprised how many of Australia’s largest business don’t meet these criteria.
So prepare your clients and yourself for reporting season by reviewing the cash position of the companies in their portfolios. Look at the last few years. Is there a trend? Have those companies been spending more money than they’ve earned? Have they raised capital and taken on debt? If so, there may be a time-bomb ticking in your portfolio.
Chris Batchelor CFA is Skaffold’s General Manager.
Chris is a specialist in equity markets and securities. He is a Chartered Financial Analyst and has 20 years experience in financial markets.
