Mumbai: The high-octane profit growth reported by Indian companies the past four years reveals as much as it hides.
Financial performance seems less impressive when another measure is considered. Operating cash flow, or the cash a company generates from running its business, grew only half as fast as profits during the stock market bull run of 2004-08.
Investors say they are likely to watch this metric—a reflection on the quality of earnings—more closely now, as a deteriorating economy makes it tougher for firms to raise cash externally. An immediate fallout of such scrutiny, triggered mainly by the Rs7,000 crore fraud in Satyam Computer Services Ltd, could be worse-than-expected full-year earnings for fiscal 2009, as companies shy from creative accounting that helps boost net profits despite more modest cash flows.
A study by UK investment bank and equity research house Noble Group Ltd, which looked at 2,637 listed companies, says the annual average profit growth of these firms was 28% between 2004 and 2008, while operating cash flow increased only 15%. This indicates that the companies may have resorted to massaging their earnings, Noble says.
“Cash is reality. It is the lifeblood of the company,” said Chetan Parikh, head of Jeetay Investments Pvt. Ltd, a wealth manager. “You will look at it much more closely as external financing is a question mark when markets are hostile.”
The focus on cash and growing distrust of reported profits are likely to create ripples. Noble predicts that in the last quarter ending March, BSE 500 firms will fare worse than the 20% contractions in earnings they reported in the December quarter, as they avoid adjusting their numbers.
Typically, cash flows closely track profits and a disconnect between the two could mean that either the firm is not operating efficiently or it is padding earnings.
“This gap (between cash flow and profits) is a sign there is a degree of padding numbers using non-cash items,” said Saurabh Mukherjea, head of equities at Noble and co-author of the study. “A more charitable explanation is that companies were compelled to do this because of crazy investor expectations during the bull run.”
Non-cash items, or charges against earnings that do not require an initial outlay of cash, would leave the cashflow unchanged, but impact profits. For instance, if a firm decides to spread amortization over several years, the cashflow would not be affected but profits would get a boost since a smaller amount is charged against earnings.
To be sure, part of the gap between operating cash flow and earnings could be explained by an increase in working capital.
“It appears that in an economic boom, as working capital requirements rise and fresh expansion exerts pressure on profits (as costs precede revenues), companies used the adjustment factor to pad profits,” the authors write. “Since cashflow is harder to fudge, it fluctuates more than PBT (profit before tax).”
“This is allowed under law, but (it is) not prudent (to follow this),” said Deepak Jasani, head of retail research at HDFC Securities Ltd. “Where you give people options, they follow the easy way out.”