How Cash Flow from Operating Activities could be influenced to reach inflated sustainable cash

What to expect from this Article?

This article shall highlight few of the many ways followed by the management (within and outside the boundary of GAAP) to influence the Cash flow from operating activities to inflate the company’s sustainable cash. This awareness could help you next time to analyze the books of accounts of the company more rationally so that you could make a more informed decision.

What is the need for this article?

We are dealing with this pandemic since the beginning of this year. And nation-wide lockdowns were implemented since the end of the 4th Quarter of FY 2019-20 (March End). And the gravity of the lockdown was so intense that hardly any sector is unaffected. And with the upcoming quarterly results of the companies, we all know what we are heading for. No, I am not predicting anything here. I am just taking the lessons from the past and preparing for the future (As it is said “Nothing new has ever happened in this world and history always repeats itself”). So, let’s see what happened in the past which necessitates us to be well prepared now.

calculator with the word cash flow on the display

Have you ever thought why most of the companies’ crumble or their fraud gets unfolded when the economy goes through a rough phase? Whether it be the recent IL&FS Crisis in 2018 (After the introduction of Demonetization and GST) or fall of Leyman brothers in 2008 (in the midst of Depression of the Year 2007-08) or fall of Enron Corp. & Satyam Computers in 2001 (During the dot com bubble burst).

Well, the answer is simple. Management’s false portrayal of their business as ‘sustainable’ business (image created over the period of time) starts falling on the face when its books and cash flow deny to back it up. And usually during these stressed situations, all their inflated books, in the absence of unrestricted funds (caused by the stress on banks and in the absence of evergreen financing) eventually fail to keep up their businesses running.

But the good thing is that, these things never happen overnight. In-fact symptoms of such ill companies begin to unfold long before it finally gets unsurfaced. Hence as a good student of life, we must be prepared for everything. And the least we could do here, would be to stay away from such companies, which are showing the symptoms of break down.

Hence as written above, this article will highlight some symptoms which could help you trace the ill companies and will help you stay aware of it.

What is a sustainable Business and sustainable cash flow?

Sustainable with its textbook meaning means ‘Something which could be maintained at a certain rate over a certain period of time’. So, if I go with the textbook meaning of the term then it could be inferred that sustainable business is one which could maintain itself through all the good and rough patches over a long period of time.

And there is only one way through which this sustainability could be achieved. And that is by ever-growing sustainable cash. Sustainable cash is the cash generated by a business, throughits operating activities, which would continue to be regenerated in the future, over and over without any disruption.

Or on an easier note, it can be said that sustainable cash is the fountain of youth for the company which allows the company to run forever and ever without any disruption. You take any great business (be it Amazon, Reliance, Microsoft, Apple Inc) and you will find one thing common in it. These all businesses are generating hard cash (Commonly Known as Cash Flow from Operating Activities) year after year which intensifies their growth and which has allowed them to pass through the tough times and has made them global giants.

How does the management of ill company try to mimic such sustainable cash flow?

Ideally, Cash flow from Operating Activities is the cash weare referring to, as sustainable cash. But in the ill companies’ accountants have used the tweaks of GAAP (and in some extreme cases they even bypass the GAAP) to portray their cash as more sustainable, especially during testing times. So, in the following paras, I shall highlight the measures taken by the management to mimic their sustainable cash flow.

Selling or Discounting of Trade Receivable

Trade receivables are the right to receive the money you create over the parties, after making a sale to them on credit. And usually, such receivables are realized after a usual credit period (As per norms). Mounting of the receivable is one of the prime indicators that management is struggling to manage its working capital. And such struggle if stretches over a long period could even threaten the company’s going concern.

But even management understands this point. And hence either due to lack of finance or to hide such scenario from the stakeholders, managements start taking measures such as discounting the bills or they begin to sell their receivable. There is nothing wrong with discounting or selling, law does not prohibit it. In-fact it seems a rational measure at the time of crisis.But we need to understand that this measure usually is the last resort applied by the company to clear its debts. And if the practice remains the same for a longer period then it could definitely harm the sustainability of the business. As no business can continue to generate cash if all its sales are not gettingreadily converted into cash.

This measureinflates the cash flow from operating activity and in-fact, could mislead the stakeholders to believe that business is great when in fact it is not. It is of utmost importance that next time if you see a very abnormal amount being realized in the cash flow statement due to change in the trade receivable or you see a high amount being blocked as receivables then you must do your homework and try to ensure that the business you are associated with, is not going through such stressful phase.

Practical Example (Coal India Limited vs Power Sector): Currently due to the reduction in demand for electricity, the power sector is unable to pay for the supply of coal from the Coal India Limited (CIL). And therefore, despite having the monopoly over the coal industry, CIL’s subsidiaries (Bharat Coking Limited & Central Coalfields Limited) are struggling to manage its working capital. And it is affecting their operations to such an extent that they are forced to withdraw its premature FDs for managing its working capital.

Mounting of High Bills Payables

Bills payable are the amount payable to the creditors in return for the supplies done to the business. And usually longer the credit period you get from vendors, the better it is. And a longer credit period tends to boost the cash flow from operating activities.

But if this long credit period is due to late payment to vendors, then despite having a great cash flow, the same is not sustainable. You cannot expect the company to get into such practices and maintain its stature for a long time. This practice of delaying the payment could result in a possible dispute and disruption in the supply chain in the future and could even hamper the whole supply chain process especially in the times of distress when usually the business struggle for finance.

And since any company indulging in such practices cannot repeat this activity in a healthy way every year. Hence it is always better to adjust for such practices while looking for a company to get associated.

Possible Tweak: Sometimes, management indulges in practices where they purposefully delay the payment to their creditors so that in return of some interest, (On late payment) they get to inflate their cash flow from operating activity. And this practice often comes with a cost of loss of reputation in the Industry. Hence,next time be extra careful if such an abnormal change reflects on the Cash Flow Statement

Employee being paid through ESOPs

Usually a trait followed globally in the time of distress is to give pay cuts to the employees. But companies in order to retain their talented people (in the midst of crisis) prefers to give them company’s Equity Stock as the compensation for their job (instead of Cash). This gesture is usually portrayed on the face of the stakeholders as a gesture of goodwill but this sometimes is done to hide the liquidity crisis faced by the company.

This small gesture of “Goodwill” inflates cash flow from operating activities to a great extent.And in fact, it gets hard to sometimes judge the real intent of the management behind such gestures. So, to be on the safer side, next time whenever you see any corporates making such abrupt decisions to distribute ESOPs, be skeptical about their liquidity position.

Unpaid Statutory Dues reflecting as Contingent Liability

After employee’s compensation, statutory dues would be the last thing a company would default. This is a clear sign of unsustainable business. But sometimes, management in order to give a temporary boost to the cash flow of their business, do indulge in the practice of not showing such dues on the face of balance sheet.And in-fact reflect them as the contingent liability after creating a blant dispute over such dues (Most recent example would be the Vodafone Idea’s AGR dues case, where they made a dispute over its calculation and ignored its liability completely for many years. And later created the provision for it only when the same was made unavoidable by Honorable Supreme Court. And no doubt this late recognition of dues is now affecting their going concern).

These practicesarea clear indictor to the stakeholder that a company defaulting to pay statutory dues is struggling to run business in a sustainable way. And it is a big red signal for the stakeholder to stay away from it.

Improper disposal of Inventory

Did you hear the recent news about CIL (Coal India Limited) where they are planning to auction their inventory for avoiding the pile-up of stocks due to a reduction in demand for coal? Well, supposing, you haven’t heard this news, the same inflow in the cash flow statement of CIL shall be reflecting as Cash flow from Operating Activities and same would mimic a great sustainable cash flow.

But is such receipt sustainable? Of course not. In fact, these are the indicators of the business’s stressed condition (Completely opposite of what Cash flow will state). And if management indulges in such practices without informing the stakeholder it could greatly impact their decision making.

In the past, companies have been found to sell their stock at below the cost price, just to inflate their momentary cash flows. Hence stakeholders must ensure, that the next time they see such abnormal change in inventory, check, whether it is in parity with the profitability ratios of the industry under which it operates.

The capitalization of Operating Cost

This is the most common and yet the least identifiable technique to artificially boost the operating cash flow. This measure not only boosts the book’s revenue but also boosts the cash flow from operations.

The capitalization of operating cost results in misclassification of the operating expense as Cash Flow for Investing Activity. Thereby reducing the cash outflow in cash flow from operating activity and reflecting the beefed-up sustainable cash. This could be a major challenge to identify such practices on the face of the statements. But any extraordinary capital expenditure (Untimely or Higher than the expected) done without any commensurate expansion plan, could raise an eyebrow for the stakeholder and any continuous practice could be an indicator of creative reporting of cash flow statement.

Boosting cash flows through misleading contracts

CASE I: Suppose there were two companies A and B. A was going through some liquidity problem, hence it asked B to lend him a loan of ₹1,00,000. In return, B could keep A’s inventory as a mortgage. And once A repays the loan with interest (Say ₹105000), then B shall return the stock that is in its possession. Now, this is a simple contract of financing where A is arranging some finance in return for the mortgaged inventory.

CASE II: Now consider the same example, the only difference would be that, A shall SELL his inventory to B in exchange of ₹1,00,000. And later once the repayment period gets over, B shall resell the same inventory back to A in exchange of ₹ 1,05,000. Here the substance of the contract remains the same but the nature of the contract has completely changed the meaning of the contract.

In CASE-I the inflows and outflows of the contract will affect the cash flow from Financing Activity (and rightfully it belongs there). But in CASE-II the inflow of cash will directly impact the cash flow from operating activity.

And in the past, it has been seen, that corporates do get involved in such types of hypothetical contracts which artificially boosts their operating cash (though the same is very difficult to execute as it involves two corporate companies working in collusion with each other). The intention being to supplement their fake revenues with the fake cash.

Famous Example of Contract between Enron Corp and Citigroup Inc. could be referred to as one such example where a hypothetical contract between them was executed to beef up the cash flow of Enron Corp.

Using misclassification of assets to boost cash flows

The companiesare allowed to make short term investments. And in-fact there is a practice, followed in the corporates to park their excess cash in the short-term securities (held for trading) for earning extra income. But there have been instances in the past where a company has changed the classification of asset from, ‘held to maturity’ to ‘held for trading’in their distressed times and thereby selling the securities to generate a beefed-up Cash flow from Operating Activities.

Though, such reclassifications and unusual selling could be traced through careful analysis of financial statements but still, the same methodology has been used by various entities in the past to generate misleading cash flow from operating activity (Famous example being Ford Motors Co. & Nautica Enterprises Inc used this methodology in 2000 & 2001 to boost its cash flow from operating activity in the stressed business environment).

This practice of creative reporting has no end. I hope this article enhances your knowledge about how cash flows could be intentionally or unintentionally be distorting the true picture of sustainable cash flow. So next time whenever you get associated with a company just ensure, that they are as sustainable as they show in their books.

And you may visit my tax guru profile to view other articles penned by me. And you can reach me at [email protected] in case of any query.

Author Bio

Qualification: Graduate
Company: Adlakha Kukreja & Company
Location: Delhi, New Delhi, IN
Member Since: 16 Jun 2020 | Total Posts: 3

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March 2021