"Cash flow is King ..."

By:AnonymousFebruary 27th, 2013RomaniaNo comments


I was recently training a team of senior bankers from one of Romania’s leading banks in corporate credit analysis and debt restructuring when I had a shock. We were analysing how banks should lend to companies based on their future business plans and their forecast cast flows. After all it is from the creation of future cash generated from a company’s operations that the company can pay its workers, its suppliers and the bank.

My shock arose because whereas we had spent a lot of time during the training session modelling a company’s cash flows, the delegates ignored this analysis and simply based the lending they would provide to the case study company based on the previous year’s operating profits that the company had made. Profit and cash flow are two completely different accounting concepts. Profits are generated over time when companies successfully cover all their operating costs. In financial reports and financial accounts, the profit figure will usually cover a single accounting period of a year. What the profit figures do not tell us is the timing of income or the timing of expenses. In other words, profit does not tell us when the company will generate its income or when it will need to pay its creditors, its workforce or the bank. It is no good for the company to only earn income in November and December if it has to pay its workforce and creditors monthly, even if that company makes a profit at the end of the year. It is for this reason that we say ‘Cash Flow is King’.

I was even more concerned when following discussions with senior bankers from other major banks in Romania, they confirmed that they do not lend to their customers based on their future potential cash flows, but on their operating profits for the past accounting period. The practise is widespread and common. It is also highly dangerous and wrong for two principal reasons.

Firstly, not only does profit not tell us when cash is receive and so therefore when the company can pay the bank, but it also tells us nothing about the company’s ability to pay in the future. In 2006 and 2007 companies in Romania were experiencing rapidly rising sales and profitability, but gave no forward indication of how cash performance would fall in 2009 and 2010. It is true to argue that few predicted the depth of the financial crisis, but lending based on past profits, while ignoring future cash flows is like driving with a blacked out windscreen and only looking in the rear mirror. In order to understand a company’s ability to pay we need to understand their future business plan.

Secondly, many banks in Romania lend based on their client’s historic operating profits (Earnings Before Interest and Tax) and add back depreciation and amortisation to the amount that companies can use to honour their debt and interest repayments. Although this figure, known as EBITDA, is considered close to cash generated by the company, there is a fundamental flaw in allowing companies to finance all their debts from all their free cash (or EBITDA). It does not allow for the replacement or renewal of the company’s productive capacity in its own assets which will be needed going forward, in order to maintain that operating capacity. Think for example, of the case of an airline using all its EBITDA to finance existing debts and therefore not having any spare cash to replace its aircraft fleet. Over time, as aircraft age and are retired from its fleet, the airline will run out of aircraft and will therefore cease to operate. How will the bank therefore expect to be repaid? Similarly imagine as individuals, that we spend all our free cash available to us at the end of the month, on buying a car. If we have no spare cash left over and the gear box breaks, the car is useless but we still have the debts to pay.

In financing a client company it is therefore essential that the bank assesses closely with its client management, the ways in which they aim to generate cash flow in the future from which the bank can be repaid, not from past profits. Understanding the risks posed to that future cash flow is at the heart of credit risk analysis. The level of free cash flow generated by the company to repay its debts must therefore also take into account the additional levels of expenditure that companies need to invest in assets and capital equipment in order to maintain their operating capacity. If bankers in Romania continue to make these elementary mistakes not only will they make increasing losses for their own shareholders, but through bad lending they will continue to destroy wealth and jobs at their client companies. 

Article written by Juan Gamecho

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