If in doubt, follow the cash

By David McEwen

Monday 25th March 2002

The collapse last year of Enron Corporation in the US, one of that country's largest listed companies, raises the question of why nobody saw it coming.

Analysts were touting the shares furiously, at the same time senior managers were selling theirs. The media were lauding the company's trading operations, which were spinning out of control.

It even won an award for its innovative accounting methods while billions of dollars in liabilities were being kept off the balance sheet.

Questions are also being asked about how many companies in this country, while not descending into outright fraud as Enron appears to have done, are being so creative with their accounts that investors might be misled.

Investors should always remember that there are so many legal ways to treating numbers that a set of accounts is as much an art form as science.

As a result, accounts are structured to show a company in the best possible light, while staying on the right side of the law. However, that doesn't protect investors when a seemingly strong and profitable company goes belly up.

Fortunately, there is one set of numbers that is very difficult to tinker with and that is cash flow. These figures are shown in detail in a company's annual report and are broken down into operating, financial and investment activities.

Of these, operating cash flow is the most significant because it shows how much money the company received in a given period from selling its goods and services and how much it spent.

Some people are surprised to find that the net result, cash in less cash out, can be completely different from the net profit reported in the financial statements. There is a difference in that the latter are affected by non-cash items such as asset revaluations, timing differences on making a sale and actually receiving payment and so on.

While some differences are acceptable, they shouldn't be too large or extended.

Let's take poor old Enron as an example. In delivering its results for the first half of last year, before its troubles began to emerge, Enron reported a net profit of US$829 million. That is a pretty penny and investors who took it at face value no doubt were tempted to buy its shares.

However, the difference between cash that came into the company and cash that was spent was a mind-boggling net outflow of US$1.34 billion! Regardless of how creative the rest of the numbers in its reports, the company couldn't disguise that, at the same time it was reporting huge profits, it was actually losing even more.

Enron went under a few months later. Although negative cash flow was not its only problem, anyone who had taken ten seconds to follow the cash in the company would have received a fright. Those with any sense would have gone out of their way to avoid investing in it.

There is unlikely to be any Enron equivalents in New Zealand. However, there are companies that record negative cash flows, sometimes while reporting net profits.

The occasional incidence of this is not necessarily a disaster, especially if a company is investing in growth. However, beware of any company that does it too often or for an extended period.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz

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