Cash is king – except when analysing performance

We often see investors using cash flow metrics, particularly cash from operations, as a measure of performance. Cash flow may even be preferred to profit because it is supposedly more reliable and less subject to management judgement and potential manipulation … “cash is a fact, but profit is an opinion”.

We explain why cash flow may not provide the insights into performance that some investors expect, and how cash flow can often be managed even more freely than profit. Cash flow is nevertheless an important component of equity analysis and ‘following the cash’ is vital to understanding a business.

It is often claimed that cash flow is superior to profit for analysing the performance of a business, and that investors should pay more attention to cash from operations, than to measures of profit. Statements such as “cash is king” or “cash flow is a fact whereas profit is an opinion” often accompany this message. The fact that DCF valuation is based on cash generation rather than forecast profit seems to further confirm the superiority of cash flow. But to what extent are these statements true, and are you really better off ‘following the cash’?

Consider a situation where a company reports profit growth but declining cash flow. Is this a positive or a negative indicator, and how exactly should you interpret and use cash flow metrics? When is the change in cash flow important and when is it potentially misleading?

Dutch technology company ASML is a good example of diverging profit and cash flow. In 2023 the company reported a €1.7bn or 27% increase in net profit, but a €2.9bn or 31% fall in cash from operations (the cash flow equivalent of net profit). What exactly should investors make of these seemingly contradictory signals?

ASML reconciliation of net profit to operating cash flow

ASML 2023 financial statements

Note: We use ASML simply to illustrate how in practice profit and cash flow can diverge. We are not suggesting that the effects we highlight arise from anything other than normal business activities.

It is not just the difference between the change in profit and change in cash flow that is interesting about ASML, but also the drivers of this difference. For example, notice the negative effect on cash flow of the change in contract liabilities compared with a positive impact in the prior two years. In our experience, many investors are confused by the contract assets and contract liabilities components of working capital and how they should be analysed, including their impact on the working capital cycle.

In addition, even though revenue rose by 30% in 2023, ASML shows a surprising reduction in receivables compared with increases in prior years. This has a positive effect on cash flow; but is this sustainable and is there something other than merely more efficient receivable collection taking place?

Performance measures: Cash flow versus profit

In our view, you should be very cautious when using cash flow as a measure of performance. The accruals accounting method for determining profit – in other words the recognition of revenue when earned and expenses when incurred – was invented for a very good reason. Only by applying this approach are revenues and expenses recognised in the appropriate period (and matched with each other) to create a meaningful measure of performance. Focusing on cash in and cash out (rather than the economic timing of revenue earned and expenses incurred) is, at best, incomplete and may be highly misleading.

For example, paying cash in one period to acquire goods, and selling those goods and receiving cash in a later period, does not equate to poor performance followed by good performance. A loss has not been incurred in the first period but instead there has been an increase in assets (inventory). These assets turn into an expense in the second period (the inventory asset is ‘derecognised’ in accounting jargon) when the inventory is sold. In the first period profit is zero, even though cashflow is negative, and in the second period profit is earned but is significantly less than the cash received. Cash flow is not a useful measure of performance in either period.

Our example is simplistic, but we could have chosen from many different examples, both simple and highly complex, to illustrate the point that profit is superior to cash flow as a measure of performance.

Cash flow fails to properly reflect value created and lost in the period

Not only does cash flow fail to capture the fundamentals of performance, it is also a very blunt instrument that fails to reflect the nuances of business activities. Suppose in the above illustration some of the purchases turned out to be a commercial mistake and this inventory could only be sold at a loss. In cash flow accounting this would make no difference to the amounts reported – the impairment is ‘non-cash’. However, when measuring profit, the poor purchasing decision will be reflected in an impairment loss – the inventory asset would be written down to its recoverable amount and an expense reported. If the impairment was apparent in the accounting period prior to the sale taking place, the loss would be recognised at that time and provide investors with valuable and timely information about the overall business performance.

Many investors are tempted to ignore so-called ‘non-cash’ impairments. This is a mistake and will lead to the wrong signals regarding performance. Furthermore, inventory impairments are not actually ‘non-cash’ – the related cash has simply already been paid. What the impairment tells us is that this previous investment will now never be recovered.

Cash flow is a fact while profit is an opinion

Although profit may well provide a more relevant measure of performance, maybe cash flow should still be preferred because, unlike profit, cash flow is supposedly not subject to judgement and potential manipulation by management?1We have discussed many such judgements in our articles, including a wider consideration of comparability in profit measurement in our article ‘Comparability is crucial for informed investment decisions’. The problem is that, although cash flow might seem to be entirely objective, in practice it can be managed more easily than many investors seem to realise.

Only once transactions have occurred is cash flow more objective than profit

It is true that once a company has undertaken a series of transactions, and the accounting period has closed, then cash flow is a fact. Cash inflows and cash outflows are as stated in the bank statements. There could be some argument as to exactly what qualifies as cash (is bitcoin cash, what about short term deposits, etc) but essentially cash flow is objective. On the other hand, profit is very much subject to judgement … Is an asset impaired or not? What is the fair value of an unlisted investment? Does a particular transaction qualify as revenue in that period, or should it be deferred until the next period? Determining profit is invariably subject to many judgements.

But cash flow can still be easily managed

The argument that cash flow can be manipulated, and is therefore just as unreliable as profit, stems from actions management can take within an accounting period. The timing of many cash flows is subject to management discretion and their business and financing choices. For example, trade receivables can be sold to a bank (factored) to bring forward the timing of the receipt. There is nothing wrong with this practice – it is a legitimate method to finance a business. However, the choice of whether to factor receivables (instead of raising the same amount of bank debt) affects operating cash flow.

Management that wants to meet cash flow targets, or to show a higher cash conversion, can easily do so by using factoring, or many other similar actions that affect the timing of cash payments and receipts. Of course, it needs to be done before the accounting year end date, but that is generally not difficult given that management systems allow for near continuous monitoring of these metrics.

ASML shows a reduction in receivables even though revenue is up 30%

In 2023, the operating cash flow of ASML was increased by a reduction in trade receivables, whereas in the two prior years increased receivables had a negative effect on cash flow. For a growth company (ASML revenue increased by 30% in 2023) we would normally expect to see an increase in receivables and other components of working capital, as was the case in 2022. The reduction in 2023 could be due to a change in credit terms offered to customers but it appears that at least some of the effect is due to factoring.

ASML factoring of trade receivables disclosure

ASML 2023 financial statements

ASML discloses €993m of receivable factoring in 2023 compared with zero in 2022. Because the transfer of receivables to a finance company is “absolute, unconditional and irrevocable” the receivables are derecognised2If the transfer had been structured differently and ASML had retained an economic interest in the receivables, such as bearing responsibility for bad debts, then the receivables would not have been derecognised and the arrangement treated as borrowings in the financial statements. from the balance sheet with the reduction in receivables having a positive effect on operating cash flow. Without the factoring arrangement the reduction in operating cash flow would have been even greater in 2023.

Factoring and other working capital financing changes impacts reported operating cash flow

It is not possible to identify whether the use of factoring by ASML is primarily a financing decision or a way to manage operating cash flow. Whatever the reason, the use of factoring, and other forms of working capital financing, such as supply chain finance, results in  a financing flow being transformed into cash from operations. This use of financing techniques makes it even more challenging to use operating cash flow as an indicator of performance.

While cash flow may be entirely objective (a fact) after the event, it can easily be managed through actions taken prior to the accounting period end. We therefore do not subscribe to the view ‘cash is a fact; profit is an opinion’.

It is not just the use of factoring that produced a positive cash flow impact from the management of receivables by ASML, it also appears that the credit period offered to customers has also been shortened. As The debtor days has fallen from 92 days in 2022 to 57 days in 2023, after including the benefit from the factoring programme, but we estimate would still have been 71 days even if factoring had not been employed.

The table below shows our analysis of the change in profit and cash flow over the last two years. Notice the positive contribution from receivables is much greater than the factoring arrangement, suggesting that the company is also better managing its customers payment behaviour.

ASML – Summary of the key changes in the operating cash flow reconciliation

ASML 2023 financial statements and The Footnotes Analyst estimates

However, by far the biggest contribution in the change in cash flow in 2023 is that identified as ‘contract assets and liabilities’. In our experience, this component of working capital confuses many investors.

Contract assets and liabilities

Contract assets and liabilities arise when there is a difference between when a company supplies goods or services to its customers and when it obtains a right to payment. For many companies these two events coincide – on the same date that goods or services are transferred to a customer an invoice is sent, and payment becomes due. In this case revenue and a trade receivable are recognised on the same date and there are no contract assets or liabilities.

Payments due in advance of delivering goods or services result in contract liabilities

However, if a company demands payment in advance of delivery, a contract liability is recognised instead of revenue. Only when the contract is fulfilled is the contract liability derecognised and revenue reported. Contract liabilities represent a ‘performance obligation’ and are sometimes described as deferred revenue or payments in advance.

The opposite effect produces a contract asset – goods or services are provided in advance of when payment becomes due, such as when multiple deliveries are made with payment only due when the full order is fulfilled.

ASML has significant contract liability balances. It seems that, for at least some of their products, payment becomes due when customers place orders. Trade credit is still offered such that the amount invoiced is actually settled later, but this still seems to be well in advance of when delivery, and therefore revenue recognition, takes place.

Here is our illustration of how contract liabilities arise and the resulting negative net working capital and working capital cycle. On average, this is the position of ASML, although what we see in the balance sheet and cash flow statement is an aggregation of many different contract timelines.

Contract liability and negative working capital illustration

The Footnotes Analyst

For ASML, the advanced payments received from its customers contribute to a significant negative net working capital balance.

ASML net working capital components

ASML financial statements and The Footnotes Analyst

(1) There is no standard definition of net working capital. We have used a relatively narrow definition that excludes some other receivables and payables that would be included for most analytical purposes.

Always include contract assets and liabilities in your cash conversion and working capital cycle analysis

In effect, by providing advance payments ASML customers are not just funding the full inventory balance but also part of long-term investment in fixed assets. This is good for cash flow, especially for a growing business, and it is not surprising that cash from operations has exceeded profit in previous years. The reduction in cash from operations in 2023 may well be an anomaly if the structure of the business and its contracts with customers remain unchanged.

You should always include contract assets and liabilities in any analysis where receivables also feature, such as the analysis of the working capital cycle or net working capital changes applied in deriving free cash flow for DCF valuations.

One of the welcome disclosures that was introduced when new IFRS and US GAAP requirements for revenue recognition were introduced some years ago, is the contract assets and liabilities roll-forward.

ASML contract assets and contract liabilities roll forward

ASML 2023 financial statements

An interesting feature of the ASML roll forward is the difference between the revenue recognised in the period that was previously a contract liability (€11.1bn) and the new contract liabilities arising in the period (€9.4bn). This may potentially indicate a reduction in revenue (or at least a slow-down in revenue growth) in the following period, when many of the current contract liabilities will become revenue. Indeed, this interpretation is supported by further disclosure about remaining performance obligations which fell from €45.4bn to €45.0bn.

ASML remaining performance obligation disclosures

ASML 2023 financial statements

The reason the remaining performance obligations are so much higher than the contract liability balance is that, presumably, payments in advance do not apply to all ASML contracts. Where a contract exists to supply goods or services in the future, but no advance payment applies, the contract is called ‘executory’3 Executory contracts are those that may bind both parties but for which neither party has performed. For an executory contract in revenue recognition the seller has not delivered, and the purchaser has not paid and nor is payment due. and nothing appears in the balance sheet. Although ASML has a performance obligation, and the customer will be obliged to pay at some point (most likely on delivery), in financial reporting neither is recognised in the balance sheet. Nevertheless, the unrecognised performance obligations are disclosed and changes in remaining performance obligations provide some evidence of future changes to revenue and therefore profit.

Don’t get too carried away with interpreting changes in contract liabilities and changes in the remaining performance obligations. These can only provide a partial view of likely changes in future revenue. There are other explanations for our observations above, notably a change in the structure of contracts and, particularly, a change in product mix (for which there is also evidence in the ASML disclosures). Indeed, 2024 consensus revenue growth for ASML is still significant at around 15%.

A better leading indicator of future revenue is changes in new contracts written or orders taken. However, ‘order book’ disclosures are non-GAAP measures and not universally given.

Cash flow may not be a reliable measure of performance

To be clear, we are not saying that you should never link cash generation and cash from operations to business performance. In many cases the changes in cash flow and changes in the difference between cash and profit are meaningful. However, be aware that cash flow is affected by other factors unrelated to business performance. Profit and accruals accounting is the foundation of performance measurement in financial reporting for good reason.

Why cash flow is still important

Although of questionable relevance when analysing business performance, cash flow metrics are still very important, including when assessing liquidity, as the foundation for DCF valuation and sometimes even in uncovering profit manipulation.

Cash flow and understanding the dynamics of a business

Although ‘following the cash’ may not necessarily lead you to correctly interpreting the performance of a business, understanding the dynamics of cash flow is important when trying to understand the business itself. Following the cash flows that arise in both purchase and revenue transactions will go a long way to understanding the dynamics of a business and help in forecasting future working capital changes and operating cash flows. Pay particular attention to understanding cash conversion and the cash conversion cycle.

Cash flow and liquidity

Ultimately the key factors that determine a company’s survival and ability to develop involve cash flow. Debt is repaid (usually) through cash payments, and cash not profit is needed to pay interest, salaries and other expenses. Of course there are exceptions, such as paying employees through share based payments, but generally it is cash flow and liquidity that matters.

For most companies with a strong business model and that are profitable, positive cash flow naturally follows. If the company is growing rapidly, which invariably puts strain on cash if the business is capital intensive, there should be ready access to additional financing. But if profitability is suspect, cash flow and liquidity may become all important.

Cash flow and DCF valuation

Profit may be more relevant when assessing performance; however, it is ultimately cash flow that determines the cash payments to investors and therefore the value of the claims on the business. There is no contradiction in this. In DCF valuation, it is not just a single period cash flow that matters – value is the present value of all future cash flows. Any timing effects matter less over multiple periods.

Furthermore, forecast cash flows tend to have a closer relationship to forecast profit than do the equivalent historical flows. This is simply because it is impossible to forecast the more short-term cash flow timing effects that occur in practice, with changes in net working capital invariably linked to changes in revenue. There is nothing wrong with this approach.

Cash flow as a potential indicator of profit manipulation

One of the reasons why investors may be interested in historical single period cash flow metrics is because of the potential for profit to be manipulated. Profit may be artificially enhanced by management through bringing forward revenue recognition using techniques such as channel stuffing or by deferring expenses, such as through judgements about capitalisation. A divergence between the trend in profitability versus cash generation may sometimes be an indicator that profit has been managed.

However, as we explain above, there may be other reasons for such a divergence of profit and cash flow. While profit manipulation may be one explanation, in most situations this will not be the case. You should first rule out the effects of working capital and other cash flow timing effects arising from the normal management of a business.

Cash flow and the accruals anomaly

There is a body of academic research (mainly using US data) that gives evidence that investments in the equity of companies with low ‘accruals’ outperform others. Accruals refers to the difference between profit and cash flow, with ‘high accruals’ meaning profit is higher relative to profit than for ‘low accruals’ stocks. Precisely how this is measured and what cash flow metric is being referred to seems to vary by researcher.

Of course, historical out-performance of ‘low-accrual’ stocks does not necessarily means this will be repeated in the future4Our quant investing contact tells us that “There is some evidence that smart investors have led to the decay of the accruals anomaly over time”., but this investment style still seems to attract attention in the world of quant-based investing, and is another reason cash flow is important for investors.

Insights for investors

  • Be cautious when using cash flow metrics as measures of performance. The timing of cash flows may be very different from the underlying economic gains and losses.
  • Cash flow can be volatile due to changes in working capital. Look out for working capital changes arising from a change in the business dynamics, such as a change in product mix, compared with a change in working capital financing, for example, using receivable factoring or supply chain financing.
  • Always include contract assets and liabilities in your analysis of cash conversion and the working capital cycle.
  • Profit may be subjective, subject to management judgement, and affected by choices of accounting policies; however, it is still preferable as a basis to assess performance.
  • Understanding the drivers of cash flow is important for understanding a business and in assessing liquidity. Ultimately value depends on generating cash for distribution to capital providers.

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