Column J – Net Operating Cash Flow

Cameron : All right. So, next is column J, net operating cash flow. This is where we start to actually look at financial data. And the rationale here, as I understand it, is because, from your perspective, cash is king. We’re looking for businesses that are performing well, and you believe the best indicator, or at least one of the best indicators for that, is how much cash the business is generating.

Tony : That’s right. Warren Buffet has spoken a lot about using what he calls free cash flow, and you can get that in Stock Doctor as well, and there’s quite a strong correlation between free cash flow and operating cash flow. But we’re looking at the money coming in through the front door, less the cost of collecting that money. Buffet takes it a bit further and he starts looking at whether the company is putting enough aside for providing for investments in the future for CapEx replacements, maintenance, things like that. And you’re paying down debt and investments that it’s likely to need to make in the future. And let’s say, if you go through those other lines in the cash flow report, you get the free cash flow.

I’ve found over the years that, even though there’s a correlation between the two, I preferred operating cash flow because it’s the highest line in any of the accounts that the company reports and a company is required under the law to report an operating cash flow statement, a profit and loss statement, and a balance sheet. And what I found over time is that the further you go down those reports, the more it becomes, not guesswork, but a management decision as to what figures get put in there. So, for example, as we said before, Buffet’s trying to work out whether enough money has been set aside for depreciation on the current assets or amortization of things like Goodwill. And that’s a bit of an educated guess sometimes, because unless you’re very close to the company, or you’re very close to the industry, you don’t know whether they need to replace the bulldozers at the mine next year, or whether they can wait until the year after. And some of these things are subjective. So, if you kind of follow that line of logic, then sometimes other things are also subjective, and there’s been very big cases of companies which have exploded in a bad way because of the accounts being almost doctored by the management to make them look good. You know, things like Enron, even Al Dunlap who worked in Australia for Kerry Packer for a while, was found to have a front-ended sales and reduced his inventory. So there are lots of levers and a manager can pull those through three accounting statements to make themselves look good, or to suit their purposes, such as whether they’re going to reach their bonus early this year.

So they might put some provisions on the balance sheet, or reduce the profit a little bit so that it makes it easier next year to withdraw those provisions and spend them against some costs, and the P&L will look better next year. All of these kinds of things are available to managers, and I’m not saying all managers are crooked – in some cases they are, but it’s human nature to try and present yourself in the best light or to maximize your income, which, for a manager, is often tied to the performance of the company. So, what I found was operating cash, being at the top of the statements, was the hardest thing to manipulate. And so that’s why I use operating cash as the driver for my valuation.

Cameron : I guess we should tell people where to find this data. Look for the cash flow summary in the company financials, either in their annual report or out of a data service. But if you’re pulling together your own figures, make sure you use an annualised number, not just the last half. Companies will usually report a full year number at the end of their financial year, and then a six month figure at the half-year point. If you’re doing your analysis after the half-year, you need to take that figure and then add it to the previous six-month figure to get a TTM (trailing twelve months) total. 

Tony : Yep and just be careful of the units. The units are above the column. In most cases, it’s millions, but sometimes it’s thousands and sometimes it’s just dollars. So just be careful of that too.

Cameron : Okay. So, there’s nothing else that we need. We just grab that number out of that column and stick it in the sheet.

Tony : Yeah.