By Peter Thiga
In today’s context I will try to walk you through the key differences between earnings and cash flows. We are going to start by understanding what book value. Book value also called net worth, or Shareholder's Equity is simply the difference between what a company owns (assets) and what it owes (liabilities). Assets include cash, accounts receivable, inventory, property, plant, and equipment. On the flip side, companies owe money or services to others. These include accounts payable, wages payable, debt taken out by the company that has to be repaid.
Companies that own more than they owe have positive net worth and vice versa is true. When a company reports 1 KES in earnings, it means the company's Net Worth has increased by 1 KES. Thus, Earnings is equal to Increase in Net Worth. An important aspect to understand is, Increase in Net Worth does not translate to Increase in Cash. For example, a 1 KES increase in net worth can be achieved by a 0.50 KES increase in accounts receivable and a 0.50 KES decrease in accounts payable, without touching cash on hand. As long-term investors, when scouting for a company to buy, we hope that the target company will bring in more money than was spent. Normally investor anticipate cash will come from company’s earning over time. But if these earnings are NOT in the form of cash, if they just show up as an increase in non-cash assets like receivables, then the company cannot very well return cash on a sustained basis. In a nutshell, that is the problem with earnings. Earnings tell us nothing about how much cash can actually be returned to owners.
A company's Income Statement usually presents its earnings. These account for the difference between cash flows and earnings. For example, a company offers its products and services to customers, but does not get paid right away, that is non-cash revenue. It contributes to earnings, but not to cash since the company has not received any cash from the transaction. The amount will show up on the balance sheet as an increase in accounts receivable. This is the fundamental difference between Cash and Accrual Accounting. Cash Accounting means cash/revenue is recognized when received. On the other hand, accrual accounting, seeks to match up each Revenue and Cost to its reporting period. Usually, accrual accounting is a major reason why earnings do not always equal increase in cash. To reconcile the two, companies report Cash Flow Statements, its objective is to tell how much of earnings actually showed up as an increase in cash, and how the rest was spent.
This brings up a pertinent question, what does the Cash Flow Statement really do? Well, cash flow statement takes all costs like depreciation. Then it adds back the non-cash costs to earnings, with an aim to reconcile earnings with cash. It is worthy to note that all increases in working capital liabilities are added to earnings. Such liabilities include accounts payable and deferred revenues. The other side of depreciation is a popular line item known as capital expenses (or Capex). If depreciation is a cost deducted now for previous obligations, Capex is cash that the company is paying for now, to be deducted in the future as an ongoing obligation. There are two type of Capex, expenses to maintain present levels of operations with a company and expense that will enable an increase in future growth. Capex that guarantee future growth is what most CEO focus on. Warren calls it the growth Capex which he preaches to everyone who listens. But this is not hot air, it has actually worked for the success of Hathaway Berkshire from a textile company to multi-billion dollar conglomerate. However, if cash is distributed to owners rather than Capex, there will be no adverse impact on future earnings. It might not grow but it will not shrink either. Therefore the decision to re-invest or return to owner solely lay on management’s desk
From a cash flow perspective, cash used for acquisitions is viewed in a similar perspective to capex. With the hope of increasing future earning, a company must spend cash today. Cash used to acquire another business is cash that cannot be distributed to owners today. From cash from operations, if we subtract capex and cash utilized for acquisitions, we are left with Free Cash Flow (FCF). Free Cash Flow is the metric we were looking to arrive at all this while. This is the cash the company is free to use to service debt, pay dividends or issues bonuses. FCF is a useful indicator on how much cash can be returned to owners each year. But it may not be a perfect measure in all cases. You may have heard of the term Cash is king, in this case cash is a fact while earnings are an opinion. Companies that have understood their vision and model of operations return a lot of cash to owners over time. Typically, they convert most of their earnings into cash flow from operations and free cash flow, while maximizing on growth capex. From us we sum it all up with this in-house saying, Earnings is the potential and free cash flow is efficiency.