As an opinionated fund selector, I have a number of ‘red flags’ that will turn me away from a fund manager and one of the biggest of these is cashflow. From time to time, a fund manager will say to me that they do not look at earnings – they only look at free cashflow. The fund manager will then follow that up by confidently stating that earnings can be manipulated whereas free cashflow cannot. Afterall, ‘cash is king’.
It is the comment that cashflow cannot be manipulated that makes me despair. How can anyone who runs millions – or billions – of dollars, pounds or euros say something so naïve? The fund manager can have little appreciation of how the real world works and should probably get out more.
“It is the comment that cashflow cannot be manipulated that makes me despair.
Manipulating cashflow
Cashflow is actually simple to manipulate and, in this column, I will outline a few ways company management might improve the appearance of their cashflow. These methods are very similar to the sort of steps you might take when you use or pay-off your credit card or decide how to pay for a new car.
The most obvious way to improve free cashflow is to postpone capex – an important consideration in this context as free cashflow is often defined as operating cashflow less capital expenditure. Instead of buying that new machine or car, just put it off until after the year end and your job is done. An alternative way to improve cashflow is to lease rather than buy and remove those lumpy capex payments from the cashflow altogether.
Reducing inventories around the end of the year is another way to improve your operating cashflow. Before year-end, offer a special December sale to your customers if they pay in cash and shift some widgets in December rather than in January. Sure, it will affect profitability – still, hey who looks at earnings? They can be manipulated – but it will boost free cashflow. In a similar vein, if anyone owes you money, call them up and offer them a 2% discount if they pay you before year-end. Not great for margins and profits but it does help cashflow.
Balance sheet liabilities
The liability side of the balance sheet is even easier to manipulate because you control the company’s outflows. Instead of paying your suppliers on 15 December, why not wait until 3 January – after year-end? Or, instead of paying a Christmas bonus in December, just put it back and rechristen it a ‘New Year bonus’.
Most businesses in the UK will collect VAT on their sales and deduct PAYE and national insurance from their employees and then pay the government the following month. The taxman will in some cases accept quarterly payments so, if you can defer the final months’ payment into the next year, your cashflow will look flush. And, if you cannot pay quarterly, just pay a little bit late – you might incur a fine, but think of the cashflow benefit!
Some analysts have legitimately observed to me that the steps outlined above can be only be done once and then you are done. This is pretty much true but it is also true that you can only really manipulate earnings once – for example, by changing your depreciation policy – before the alarm bells start going off.
The ways to change free cashflow outlined above are easy to understand and may even have contributed to your CPD. I have not touched on approaches such as sale and leasebacks or repo transactions, which have been used and abused in the past to boost free cashflow. A good fund manager will spot most of these steps by looking at historical results, scrutinising financial statements in their entirety and thinking critically about them. These are the fund managers I want to invest with.
Peter Sleep is investment director at Callanish Capital
