72 Finance & economics The EconomistFebruary 22nd 2020
2Buttonwood The cash bug
E
very newform of payment, from
cheques to contactless cards, is her-
alded as the end of cash. Your friend, the
one with the fat wad of banknotes, like
an old-school bookmaker, knows differ-
ent. Cash has unique attributes, he says.
It leaves no trace so transactions stay
private. It requires no fragile infrastruc-
ture to process payments. You can pay for
groceries in a power cut or get a drink at
the bar when the card machine fails.
Cash is non-negotiable. It is why it is
readily accepted.
If gold obsessives are gold bugs, then
your friend is a cash bug. There is a ver-
sion of him in the business of stock-
picking. This sort would not dream of
using reported earnings as a guide to
anything. They are too ripe for manipula-
tion by bosses. But you can’t monkey
with hard cash. You either have it or you
don’t. Earnings are fiction; cash is truth.
Or is it? It is foolish to look for the true
value of a company in a single measure,
whether that is cash balances; the book
value of assets on the balance-sheet; or
earnings in the profit-and-loss account.
All have flaws. Book value understates a
company’s worth if it is tied up in its
brands and know-how (“intangibles”).
Reported earnings are pliable. Even
cashflow can be manipulated. Indeed
cashflow turns out to be more negotiable
than your fat-walleted friend thinks.
Cash bugs yearn for the simple eco-
nomics of the lemonade stand. A venture
is sound if it takes in more from sales
than it pays out in costs, such as lemons
and wages. If more cash comes in than
goes out, the business is good. By con-
trast, earnings are slippery. They are
what is left of profits after accounting for
“accruals” ie, non-cash revenues and
costs. Some of this reflects sales that
have been booked but not yet been paidfor. Much of it consists of costs that are not
a drain on cash right now, but which surely
will be: depreciation of plant and machin-
ery; charges against pension promises;
allowances for bad debts; and so on.
The trouble is that it is hard to arrive at
a true number for such costs. No one
knows the working life of an Apple Mac or
an Airbusa380; so how quickly should
such assets be written off? The ultimate
cost of a company’s pension scheme de-
pends on assumptions about investment
returns. So companies are given a lot of
discretion over how they account for such
accruals. This leaves lots of scope for the
massaging of earnings; hence the appeal of
cash-based accounting.
Changes in a company’s cash balance
do not tell you much about its operating
business. It may have gone up because a
company issued a bond or sold an asset.
That is why analysts look instead at “free
cashflow”. This ignores non-cash items in
the earnings statement, such as deprecia-
tion and amortisation. But it recognises
capital costs, such as spending on build-
ings, equipment and inventories. It istherefore a decent shorthand measure of
the profits a company’s owners can lay
claim to—the cash left over after the
spending needed to sustain the business.
It sounds like an ideal guide to a firm’s
value. But it is not tamper-proof. One
way to give free cashflow a boost is to
defer payments to suppliers: pay the bills
in 90 days, rather than 30 or 60 days. How
capital spending is financed—the choice
to buy or lease—also matters a lot.
Lumpy asset purchases are a drain on
cash when they occur; lease payments
are altogether smoother. But as with
renting a flat or leasing a car, it is not
always clear whether buying will use up
more or less cash in the long run.
The Footnotes Analyst, a blog on
accountancy, uses Amazon’s accounts to
highlight how leases distort cashflow
measures.* The company itself provides
three measures of free cashflow in its
2018 accounts. They varied from $8.4bn
to $19.4bn, depending on the accounting
treatment of leases. A fourth measure,
calculated by the Footnotes Analyst,
finds that free cashflow was negative to
the tune of $3.4bn. All of these are valid
figures. None can be claimed to be the
whole truth.
The cashflow statement only gets you
so far. As do reported earnings, or the
balance-sheet. You need all three to
understand a company, says Nathan
Cockrell, of Lazard Asset Management,
just as you need three co-ordinates (lon-
gitude, latitude and altitude) to know
where anything is with precision. To say
that cashflow never lies is itself a lie.
After all, when your friend with the
bulging money clip keeps boasting about
how flush he is, you start to wonder if he
might actually be skint.Earnings are fiction and cash is supposedly fact. But what is the truth?.............................................................
*Footnotesanalyst.com/free-cash-flow-amazonWhite 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 anidea 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. Socentral 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