Invest in cash-rich firms for wealth creation

You start a baking business with Rs 10,000. With this amount you buy some raw materials and bake cookies / cakes etc. You sell the baked products for say Rs 13,000. But the buyer does not pay you money upfront. Instead, he tells you that he would pay you the amount after 15 days. Since this is your first customer and a new business, you decide not to disappoint the customer and agree to wait for 15 days.

Let us see what is your cash position at the end of this transaction.

Your revenue (sale value) = Rs 13,000

You spent Rs 10,000 on the raw materials and sold them for Rs 13,000.

So your profit = 13,000 – 10,000 = Rs 3,000 (ignoring labour costs)

You earned a revenue of Rs 13,000 and a profit of Rs 3,000 on your sale (transaction). But, you have Zero Cash with you, as you have still not received the cash. When we mean cash, it is the money in your account and not necessarily hard cash.

How do you view this situation?

This is just an example, these kind of situations can happen in the business world and even with large corporations. Hence it is important to look at the cash flows. Business may be sound, sales may be great, but if it is not generating cash, it is no good. If a business does not generate cash flows how can it invest further in to the business. All of us earn money by way of salary or income. So we get a cash inflow into our accounts. Similarly, we also have expenses which is a cash outflow from our account. Having a positive cash flow means that more money is coming into the business than going out. It’s just as important as profit when it comes to determining your business performance.

If the company gets cash after great delays, while its expenses have to be met immediately, it is natural that the company would be under severe financial stress. It will then have to borrow money to meet its short-term needs. This is additional liability on the company.

Why cash is the king?

Cash flow

For any company to survive, cash flow is the single most important financial factor. A company could have fantastic revenue, reasonable expenses, and significant income, but if its financial operations are not designed efficiently, it could still have negative cash flow. This is akin to an individual earning a very high income but his expenses are much higher, resulting in negative cash flow. What would such an individual do? He may resort to borrowing from friends, relatives which will only add to his burden. Same happens with companies. And without positive cash flow, any company, no matter how promising the business model, will go bankrupt.

Investment/capital expenditures

To grow and expand its business, a company often will need to invest in factories, real estate, machinery, or technology. Without cash on hand, a business may not be able to make these necessary investments and, as a result, may never be able to experience growth. One may argue that the business can take out a loan, but even a loan needs to be serviced, which can eat into a company’s bottom line.

Acquisition

If a company has cash, it can also look for opportunities to expand by acquiring companies. These opportunities may be a once in a lifetime opportunity and hence companies which have significant cash will be able to execute them. Good acquisitions can do wonders for the company’s growth potential.

Dividends

Companies can reward shareholders through dividends and share repurchases. Dividends provide an excellent way of earning an income without forcing them to sell the shares. But paying dividends also requires enough cash to be available with the companies. There are again numerous instances of companies making high profits but not paying dividends or paying inconsistent dividends.

Tough situations

Tough situations pose a lot of challenges to businesses. Instances like Covid-19 impacted the sales and revenues of companies. Operations were stalled due to the pandemic, resulting in no revenue generation or limited revenue generation. Without sufficient cash on hand, companies would be forced to downsize their employee operation or even become bankrupt. Having cash allows companies to be flexible and tide over such tough situations.

From an investment perspective, investing in cash rich companies is beneficial as these companies will be able to withstand pressure on revenues and a dip in demand in a much better way as compared to companies which do not have adequate cash. Cash-rich companies will be able to capture the growth opportunities once normalcy returns.

Time and again we have witnessed few stocks which suddenly hog the limelight for the extravagant returns they have generated in the short term. Many of these could be driven by a lot of money flowing into these shares, jacking up the prices artificially. Such price appreciations may not sustain for too long unless it is backed by strong fundamentals. The ability to pick and identify companies and businesses which will continue to generate good cash flows and have strong fundamentals is the essence of stock investing.

In other words, in the short term, there can be a disconnect between how a company performs and how its stock performs. But over a longer period of time, the market tends to get it right, and the performance of a company’s stock will mirror the performance of the underlying business. In the long run, the market rewards companies that generate cash on a regular basis.

(The writer is Head, Equity, Axis AMC)