After the published of my article, “Perstima and ColdEye冷眼 5 Yardsticks of Value Investing” in the link below, I received an email from a reader.

http://klse.i3investor.com/blogs/kcchongnz/85405.jsp

[Hi Mr. Chong,

Greetings.

I know about your from reading about your article 'ColdEye's 5 Yardstick of Value Investing' on i3investor website. I'm totally agree with what you have written about stock analysis and I'm also a believer of Benjamin Graham's value investing principle myself. Although I've been reading a few books by Graham or Buffet, trying to catch a clue on stock picking, yet I'm still feeling lost when it comes to the technical analysis of the financial statement as I have no experience in stock investing at all.

As read from some of your articles saying that figure shown in financial statement (eg. net profit) can be misleading as it can be manipulated by accountant. Does this mean those figures shown in annual report along with the footnote stated can be fake? How can I clarify these figures? Besides, what are the things that I should take note of when reading the annual report?

Appreciate if you can shed some light on this. (Sorry if I ask something stupid x.x)

Yours sincerely,

Mr Lo]

Hi Mr Lo,

No, you are not “stupid” to ask me this question. For the record, I have never brand anyone "stupid" or "bull shit" even when furiously about an investment topic.  In fact you have the potential to become a smart investor if you open your eyes wider and are willing to spend some time and effort to learn about the language of business, and you will be able to assess yourself and see through these profit figures if they are misleading, or fake. Only simple logic, simple arithmatics is good enough, no complicated theory, financial jargons, or the Greek.

Most financial statements are genuine and properly and accurately presented, but yes, the accountant has some leeway to report the financial results in which way he likes to, or what the boss tells him too. And yes, net profit figure can be manipulated and can be fake, as mentioned by you. As an investor, you must be able to recognize it, unless you want to follow the greater fool theory, and not being fooled in your investment.

Enron Corporation’s net income galloped by 832% from $105m in 1997 to $979m in 2000. This was one of the most talked about corporate scandals in the US in 2000s, an excellent MBA case study. Focussed on net income, profit growth, Enron became a darling stock and Wall Street sent Enron’s stock price soaring from about $30 to $100 from 1997 to 2000. It went belly up shortly after that, and so many investors lost their life-long saving, because the major part of the profit was fake.

So how to see if the profit is “genuine”, of “fake”? One way is to relate its profit to cash flows.

Profit and cash flows

Basically, a business needs to pay all the expenses such as administration, marketing, workers, plant and equipment, materials, etc. to produce goods and services. After deducting cash to pay for all these stuff, and sold or executed the services and receive cash, you get some cash left over from the operations after paying taxes and interest expense, termed cash flows from operations (CFFO).

The net income/profit (NI) or earnings figure, the income statement’s “bottom line,” is based on the principles of accrual accounting. Accrual accounting attempts to match expenses with revenues regardless of when the cash transactions that deal with the creation of the goods being sold and the receipt from the sale occurred. In essence, accrual accounting is not entirely concerned with when “cash trades hands.” However, over a long period of time, the profit figure should match closely the CFFO figure, i.e. the ratio of CFFO/NI should average close to 100%, generally with increase in net working capital along the years, and neutralized by the adding back of the non-cash depreciation charges.

In order to fund growth, the company also needs to spend some cash to buy new equipment, upgrade its fleet of plant, or what we termed capital expenses, capex. What is left then is the free cash flow (FCF) in the year.

FCF is the wonder boy in the investing game. Without this FCF, there is no money for distributing dividends to shareholders, to invest in other profitable ventures, pay down debts, or buy back shares when they are selling cheap, without resorting to borrow more money from banks which makes the company more risky in times of economic crisis, or to issue more shares and diluting its earnings per share as a result.

The above discussions of cash flows are also  simple logic and elementary arithmatics used, no compicated formula, nor misleading financial jargons. But in my opinion, and also for most businessmen I believe, is very important.

The BAD

“The further backward you can look, the farther forward you are likely to see” Winston Churchill

Let us look at some stocks I use often to talk about the pitfall in investing as shown in this link here:

http://klse.i3investor.com/blogs/kcchongnz/45373.jsp

Guan Chong Berhad

I have specifically written about this stock before in this link below:

http://klse.i3investor.com/blogs/kcchongnz/78262.jsp

Table 1 below shows the financial performance of GCB over the last 8 years.

Table 1: Cash flows of GCB

GCB made a total of RM368m profit over the last 8 years. On average the net profit is RM46 a year. However, it “lost” a cash flow of RM104m over the same period. After spending for capital expenses as required for the operations, it “lost” a whopping RM519m over the last 8 years, or on average, a negative free cash flows (FCF) of RM65m a year!

So what happened? What does GCB needs to do to keep its door open?

It had to find ways to fund the cash flows deficit. It did just that borrowing more money and increased its total debts from the already high debt of RM145m in 2007 to close to RM1b in 2013, before dropping back a little to RM866m in 2014. Why was there so much earnings but no FCF, and that the company has to keep on borrowing money from the banks? Were the earnings "real"?

London Biscuits

Now look at another company in the list, London Biscuits. I have specifically written a few articles about London Biscuits as shown in these links below:

http://klse.i3investor.com/blogs/kcchongnz/60180.jsp

http://klse.i3investor.com/blogs/kcchongnz/81916.jsp

http://klse.i3investor.com/blogs/kcchongnz/52002.jsp

Table 2 below shows the cash flows of London Biscuits over the last 12 years.

Table 2: Cash flows of London Biscuits

London Biscuits appear to have good CFFO. Just by looking at the CFFO, it gives an illusion that it is doing well with it cash surplus from the operations equal to its cumulative net profit of RM172m, or RM14.3m a year over the last 12 years. But does it have any money left for say distributing dividends?

Referring to the last line items in Table 2, one can see how precarious is the cash flows of London Biscuits. After spending a total of RM500m in capital expenses over the last 12 years, it has a negative FCF of RM328m, or an average of RM27m a year.

Needless to say, it has to continuously borrow more money from banks, and issue more shares just to keep its doors open. Its total debt has increased by 180% from RM100m to RM275m, and share capital by 175% from 68m to 186m from 10 years ago.

Ten years ago, London Biscuits gave a dividend of 15 sen per share, and now zero sen, kosong. Why?

KNM in the list also exhibits the same characteristics in the disparity between profit and cash flows. I have also written an article on KNM as shown in the links below.

http://klse.i3investor.com/blogs/kcchongnz/51962.jsp

Borrow from Buffett's playbook: Keep your eye on free cash flow

Hence we do have a way to detect if the profit figures are possibly manipulated and are fake by relating the profit to its cash flows as shown in the examples above, don’t we?

Now before we move to the real stuff, i.e. the GOOD in profit in the next article, do spend some time and examine if this company is in the category of the GOOD or the BAD, with its cash flows as shown in Table 3 below:

Table 3: Cash flows of a company

The exercise above is just a simple exercise on addition and subtraction, nothing of any financial jargons, nor some kind of funny theory, no Greek. The figures were extracted from its financial statements, hence no manipulation, no bull shit, nor misleading or fake figures form me.

Oh yeah Mr Lo, if you wish to learn about how to analyse, and interpret those numbers from the financial statements, feel free to contact me at

ckc14training2@gmail.com

I guarantee that I have no intention to mislead you, nor to bull shit you.

Oh yeah, I won’t teach you how to predict share price movement. I have no ability to do that. I am sure you can find someone else.

Happy investing. See you next time when we talk about good profits for some good companies.

K C Chong