The Economist - USA (2020-02-22)

72 Finance & economics The EconomistFebruary 22nd 2020

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Buttonwood Thecashbug

E

verynewformofpayment,from

chequestocontactlesscards,isher-

aldedastheendofcash.Yourfriend,the

onewiththefatwadofbanknotes,like

anold-schoolbookmaker,knowsdiffer-

ent.Cashhasuniqueattributes,hesays.

It leavesnotracesotransactionsstay

private.It requiresnofragileinfrastruc-

turetoprocesspayments.Youcanpayfor

groceriesina powercutorgeta drinkat

thebarwhenthecardmachinefails.

Cashisnon-negotiable.It iswhyit is

readilyaccepted.

If goldobsessivesaregoldbugs,then

yourfriendisa cashbug.Thereisa ver-

sionofhiminthebusinessofstock-

picking.Thissortwouldnotdreamof

usingreportedearningsasa guideto

anything.Theyaretooripeformanipula-

tionbybosses.Butyoucan’tmonkey

withhardcash.Youeitherhaveit oryou

don’t.Earningsarefiction;cashistruth.

Orisit?It isfoolishtolookforthetrue

valueofa companyina singlemeasure,

whetherthatiscashbalances;thebook

valueofassetsonthebalance-sheet;or

earningsintheprofit-and-lossaccount.

Allhaveflaws.Bookvalueunderstatesa

company’sworthif it istiedupinits

brandsandknow-how(“intangibles”).

Reportedearningsarepliable.Even

cashflowcanbemanipulated.Indeed

cashflowturnsouttobemorenegotiable

thanyourfat-walletedfriendthinks.

Cashbugsyearnforthesimpleeco-

nomicsofthelemonadestand.A venture

issoundif it takesinmorefromsales

thanit paysoutincosts,suchaslemons

andwages.If morecashcomesinthan

goesout,thebusinessisgood.Bycon-

trast,earningsareslippery.Theyare

whatisleftofprofitsafteraccountingfor

“accruals”ie,non-cashrevenuesand

costs.Someofthisreflectssalesthat

havebeenbookedbutnotyetbeenpaid

for.Muchofit consistsofcoststhatarenot

a drainoncashrightnow,butwhichsurely

willbe:depreciationofplantandmachin-

ery;chargesagainstpensionpromises;

allowancesforbaddebts;andsoon.

Thetroubleisthatit ishardtoarriveat

a truenumberforsuchcosts.Noone

knowstheworkinglifeofanAppleMacor

anAirbusa380;sohowquicklyshould

suchassetsbewrittenoff?Theultimate

costofa company’spensionschemede-

pendsonassumptionsaboutinvestment

returns.Socompaniesaregivena lotof

discretionoverhowtheyaccountforsuch

accruals.Thisleaveslotsofscopeforthe

massagingofearnings;hencetheappealof

cash-basedaccounting.

Changesina company’scashbalance

donottellyoumuchaboutitsoperating

business.It mayhavegoneupbecausea

companyissueda bondorsoldanasset.

Thatiswhyanalystslookinsteadat“free

cashflow”.Thisignoresnon-cashitemsin

theearningsstatement,suchasdeprecia-

tionandamortisation.Butit recognises

capitalcosts,suchasspendingonbuild-

ings,equipmentandinventories.It is

thereforea decentshorthandmeasureof

theprofitsa company’sownerscanlay

claimto—thecashleftoverafterthe

spendingneededtosustainthebusiness.

It soundslikeanidealguidetoa firm’s

value.Butit isnottamper-proof.One

waytogivefreecashflowa boostisto

deferpaymentstosuppliers:paythebills

in 90 days,ratherthan 30 or 60 days.How

capitalspendingisfinanced—thechoice

tobuyorlease—alsomattersa lot.

Lumpyassetpurchasesarea drainon

cashwhentheyoccur;leasepayments

arealtogethersmoother.Butaswith

rentinga flatorleasinga car,it isnot

alwaysclearwhetherbuyingwilluseup

moreorlesscashinthelongrun.

TheFootnotesAnalyst,a blogon

accountancy,usesAmazon’saccountsto

highlighthowleasesdistortcashflow

measures.*Thecompanyitselfprovides

threemeasuresoffreecashflowinits

2018 accounts.Theyvariedfrom$8.4bn

to$19.4bn,dependingontheaccounting

treatmentofleases.A fourthmeasure,

calculatedbytheFootnotesAnalyst,

findsthatfreecashflowwasnegativeto

thetuneof$3.4bn.Allofthesearevalid

figures.Nonecanbeclaimedtobethe

wholetruth.

Thecashflowstatementonlygetsyou

sofar.Asdoreportedearnings,orthe

balance-sheet. Youneedallthreeto

understanda company,saysNathan

Cockrell,ofLazardAssetManagement,

justasyouneedthreeco-ordinates(lon-

gitude,latitudeandaltitude)toknow

whereanythingiswithprecision.Tosay

thatcashflowneverliesisitselfa lie.

Afterall,whenyourfriendwiththe

bulgingmoneyclipkeepsboastingabout

howflushheis,youstarttowonderif he

mightactuallybeskint.

Earningsarefictionandcashissupposedlyfact.Butwhatisthetruth?

.............................................................

*Footnotesanalyst.com/free-cash-flow-amazon

White House listed 33 names of the great-

and-goodish behind Mr Milken’s appeal.

And the fresh-faced mbas who flocked to

work with Mr Milken in the 1980s are now

the financial establishment. The Drexel

diaspora is a roll-call of the leading lights

in the world of private-equity and private-

credit markets.

What is striking about the diaspora is

their enduring reverence for “Mike”. Part of

this is a recollection of an exciting time,

when visiting entrepreneurs would pitch

madcap ideas: a 24-hour-news channel; a

casino with a fake volcano. If you had an

idea and a sliver of equity, Mike and his

team would raise the necessary debt. It is

also—perhaps mostly—a form of gratitude

for a unique education in markets and in

the importance of understanding a com-

pany’s capital structure, its mix of debt and

equity finance. The skills acquired in the

buy-out boom of the 1980s are perfectly tai-

lored for today’s boom in private equity.

The diaspora owe their lucrative careers to

what they learned from Mike.

The question naturally arises as to why

a pardon could possibly matter now. Mr

Milken pleaded guilty. He served time. So

central was he to the network of issuers and

buyers in the junk-bond market that it

would seem a minor miracle if he had not

transgressed some aspect of securities law.

Mr Milken is already applauded for his phi-

lanthropy. He is now 73. An official exoner-

ation may permit a kinder judgment of his

legacy: as a financier who widened access

to corporate credit. When Wall Street

sneered at “junk bonds, junk people”, Mr

Milken would remind his apostles that

anything aaa-rated can only go down. But

anything rated as junk can always improve

its standing. 7