A statement that you can’t spend profits, might surprise you! Individuals might think that this is a very odd statement and perhaps incorrect. It is a correct statement and should be made as an investing proverb to be used by any type of investor. Let me present my case.

Companies make profit by selling or exchange of their products or services. At a very basic fundamental level, this can be done by making those products or services at lower associated cost (or expenses). In the end, what we all want is to somehow convert those profits into cash so that we can spend it. Some might argue that this is just semantics of words. I say, it is not! If that were the case than how can we explain the fact that many times companies report profits that are more than cash flow from operations? Take a pause and think for a moment. How can we have more profit when we are not getting that much of cash transactions? In one of my earlier post Cash Flow is Important Financial Statement, I discussed how cash flow is what ultimately drives the value of any given business.

Recently I took a close look at NTPC and CIPLA from the perspective of viability of long term investment for my income portfolio. In case of NTPC, the general trend is to have higher cash flow than profits showing that it is continuously generating cash flow. That is sign of a healthy company. On the other hand, CIPLA is generating less cash from its operations than the reported profits. A deeper look shows that it has been raising debt and diluting its capital structure.

It is very easy to use financial engineering and accruals to make a very impressive profit and loss statement. We have seen umpteen numbers of times how expenses are moved to the balance sheet (by defining them as assets) so that profits get inflated.

I will give you another example. I have seen a company that moved salary expenses of few key people onto their balance sheet (instead of considering them as expenses). The notion was these five folks with higher salaries were asset to their business. They were stake holders in the company, without them there is no business, are integral part of the business, and hence cannot be treated as expenses. This inflated profits of this particular business. Owners were successful in selling their business at inflated pricing. Subsequently, the owners and five staked holders happily distributed cash from the sale proceeds. After six months, the five high salaried staked holders happily left the company. Folks the company was a restaurant business at prime location, and five high salaried folks were cooks, each of whom had two percent stake in the business.

Ironically, on many occasions such accruals and allocations are not illegal. Instead of following the intent of the accounting rule, financial wizards go by intent of the letters and hence an easily misrepresent the company’s true financial condition. Given complex accounting rules, any given company can generate huge paper gains that can never be converted to cash.

Since I make investments for long term, I take great comfort in a company with a strong cash flows and a consistent history of increasing or maintaining cash dividends. If there are too many missteps, then eventually a dividend will be cut or suspended. This will get reflected on the company’s performance. Such missteps cannot be sustained for a long term. Profits can be engineered, cash can not. Follow the cash from operations and it just might lead you to a great long term investment opportunity.

I rest my case! I would like to know what you think, so leave your comments below.

cash flow, cipla, NTPC