Buttonwood – The appeal, and the flaws, of cash-based accounting | Finance and economics
EVERY NEW form of payment, from cheques to contactless cards, is heralded as the end of cash. Your friend, the one with the fat wad of banknotes, like an old-school bookmaker, knows different. Cash has unique attributes, he says. It leaves no trace so transactions stay private. It requires no fragile infrastructure to process payments. You can pay for groceries in a power cut or get a drink at the bar when the card machine fails. Cash is non-negotiable. It is why it is readily accepted.
If gold obsessives are gold bugs, then your friend is a cash bug. There is a version of him in the business of stock-picking. This sort would not dream of using reported earnings as a guide to anything. They are too ripe for manipulation by bosses. But you can’t monkey with hard cash. You either have it or you don’t. Earnings are fiction; cash is truth.
Or is it? It is foolish to look for the true value of a company in a single measure, whether that is cash balances; the book value of assets on the balance-sheet; or earnings in the profit-and-loss account. All have flaws. Book value understates a company’s worth if it is tied up in its brands and know-how (“intangibles”). Reported earnings are pliable. Even cashflow can be manipulated. Indeed cashflow turns out to be more negotiable than your fat-walleted friend thinks.
Cash bugs yearn for the simple economics of the lemonade stand. A venture is sound if it takes in more from sales than it pays out in costs, such as lemons and wages. If more cash comes in than goes out, the business is good. By contrast, earnings are slippery. They are what is left of profits after accounting for “accruals” ie, non-cash revenues and costs. Some of this reflects sales that have been booked but not yet been paid for. Much of it consists of costs that are not a drain on cash right now, but which surely will be: depreciation of plant and machinery; charges against pension promises; allowances for bad debts; and so on.
The trouble is that it is hard to arrive at a true number for such costs. No one knows the working life of an Apple Mac or an Airbus A380; so how quickly should such assets be written off? The ultimate cost of a company’s pension scheme depends on assumptions about investment returns. So companies are given a lot of discretion over how they account for such accruals. This leaves lots of scope for the massaging of earnings; hence the appeal of cash-based accounting.
Changes in a company’s cash balance do not tell you much about its operating business. It may have gone up because a company issued a bond or sold an asset. That is why analysts look instead at “free cashflow”. This ignores non-cash items in the earnings statement, such as depreciation and amortisation. But it recognises capital costs, such as spending on buildings, equipment and inventories. It is therefore a decent shorthand measure of the profits a company’s owners can lay claim to—the cash left over after the spending needed to sustain the business.
It sounds like an ideal guide to a firm’s value. But it is not tamper-proof. One way to give free cashflow a boost is to defer payments to suppliers: pay the bills in 90 days, rather than 30 or 60 days. How capital spending is financed—the choice to buy or lease—also matters a lot. Lumpy asset purchases are a drain on cash when they occur; lease payments are altogether smoother. But as with renting a flat or leasing a car, it is not always clear whether buying will use up more or less cash in the long run.
The Footnotes Analyst, a blog on accountancy, uses Amazon’s accounts to highlight how leases distort cashflow measures.* The company itself provides three measures of free cashflow in its 2018 accounts. They varied from $8.4bn to $19.4bn, depending on the accounting treatment of leases. A fourth measure, calculated by the Footnotes Analyst, finds that free cashflow was negative to the tune of $3.4bn. All of these are valid figures. None can be claimed to be the whole truth.
The cashflow statement only gets you so far. As do reported earnings, or the balance-sheet. You need all three to understand a company, says Nathan Cockrell, of Lazard Asset Management, just as you need three co-ordinates (longitude, latitude and altitude) to know where anything is with precision. To say that cashflow never lies is itself a lie. After all, when your friend with the bulging money clip keeps boasting about how flush he is, you start to wonder if he might actually be skint.
This article appeared in the Finance and economics section of the print edition under the headline “The cash bug”