Follow the cash: a lost art

RMA Journal, The, April, 2004 by Suzanne Labarge

I have just finished reading The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (Bethany McLean and Peter Elkind, Portfolio, 2003). It is a sobering analysis of how bad things can get when you don't believe that normal rules apply to you, where checks and balances are ignored, and where only deal-doers are valued. But what really struck me was the notion that, in their search for business, bankers had forgotten one of the best tools available to them to judge a company's creditworthiness--cash flow analysis.

A well-known Canadian forensic accountant constantly reminds us to "follow the cash." But this is becoming a lost art. Of the seven modules in RMA's Diagnostic Assessment, the one on Cash Flow Analysis has the poorest results. It is closely followed by Financial Accounting and then Financial Analysis. Why does this matter? After all, don't we have better tools now to analyze risks? I suggest that though we have additional mechanisms, none of them are as good as looking at cash flows. We constantly need to remind ourselves that EBITDA is not free cash flow.

Most companies fail because they lack liquidity. For some, this can be attributed to accounting fraud--as was the case with Parmalat. But for most companies, it is more a matter of simply not generating enough cash to pay their bills. The new world of GAAP accounting doesn't help you determine cash generation. With some items marked to market and others carried at book value, it can occasionally be difficult to determine if a company has sufficient liquidity to manage operations. Making a profit on an increase in the value of a security you can't sell doesn't produce cash. Writing off intangibles doesn't use up cash. Both accounting treatments are important to know as you look at the economic worth of a company. But I would argue that they are insufficient if you are trying to assess whether a company has the ability to repay your loan. And this is fairly basic. Mix it with off-balance-sheet financing or with the dubious practices employed by some companies and industries in the way they account for sales, and you can understand why following the cash becomes so important.

I recently read a report on a public company that was announcing its third-quarter results. It was showing a profit for the nine months of $49 million, following profits in the previous two years of $117 million and $149 million, respectively. A very thorough analyst pointed out that, in fact, the company was unable to generate free cash flow during that period and was cash-flow negative to the extent of $146 million in the past nine months alone. It went a long way to explaining why this company is the darling of our corporate bankers and anathema to our risk managers!

But even more important is that cash flow analysis can actually make you a better lender. It is eas5' to make the plain-vanilla loan. It is much harder to be creative in packaging a loan that meets the need of your client as well as the risk appetite of your bank. A good lender tailors loans to the company's cash flow and understands when term loans--versus operating loans--are best used, as well as which covenants provide the early-warning mechanisms you need to ensure that the borrower isn't developing liquidity problems.

In my experience, those lenders with the best understanding of cash flow analysis have a distinct competitive advantage. They are either first out of a weakening credit where they are not a lead bank, or they are working on their clients' problems earlier than the rest of us--and, in so doing, they both mitigate their losses and nurture their client relationships.