Profitability or Cashability ?
Feb 4, 2009

For business plan, budgeting, target setting, performance measurement and incentive computations, I strongly recommend that we move away from the ‘accounting profit’ based performance indicators to the ‘real’ cash flow based indicators. The change over will be quite simple to implement. We will replace PAT (Profit After Tax) with cFACT (cash Flow Adjusted for Creditors, post Tax) while computing Profitability ratios. Let me get to the details.

Profitability Indicators

Business performance is measured today with Profits as the base. There are two basic types of profitability indicators – one is Profit Margin related (gross, net, pre or post tax profits as % of sales) and the other is Return related (return on investment, on capital employed, on equity, or earnings per share etc). The business community, the markets, the management – all follow these Profit based ratios for business planning, performance evaluation and management incentives.

Profit is an accounting concept

In a previous post “Cash Flow or Profit Growth?”, I had argued about the pitfalls of such an approach. The essence of the matter is that there is no fixed definition of Profit. It will vary according to the accounting standard followed and further, within the standard, vary in accordance with the assumptions, estimates and valuation methods followed. Further, you would have noticed, from recent happenings in the business world, that profits are susceptible to accounting entries made with the objective to window dress the financial statements.

Cash is Real

While Profit generated from business is just an accounting concept, cash generated from business is real and fact based. It can be physically counted and verified from your bank balances. It is also quite difficult – though not impossible – to do window dressing of cash flows in a business.

cFACT

cFACT is the acronym for cash-Flow Adjusted for Creditors, pre or post Tax and is derived from the concept of Free Cash Flow generated by the business, with two adjustments as explained below.

First let us look at how Free Cash Flow (FCF) for an accounting period is arrived at –

a) Start with Profit After Tax from the Profit & Loss Account for the period
b) Deduct (or add) any increase (or decrease) in inventories, trade debtors and other debtors (loans and advances in the Indian context)
c) Add( or deduct) any increase( or decrease) in trade and other current creditors
d) Add back depreciation and other non cash items
e) Deduct capital expenditure

The net balance thus arrived at will reflect Free Cash Flow generated by the business during the period under review.

Adjustments to FCF

There is a small hitch here. If you do not pay your creditors on time and stretch them unduly, you will end up showing higher cash balances and better FCF than the actual performance. Therefore we need to correct this.

The best way is for the management to work out all the overdue creditors and deduct it from FCF arrived at above. An alternative and easier option, especially for a reader of the Financials who does not have access to detailed information, will be to deduct the increase in trade and other creditors (as in c above) from FCF.

The second adjustment relates to capital expenditure. For business performance evaluation we should consider only that part of Capex which is for routine replacement and upkeep and for normal growth of the business. Capital expenditure over and above this, for new investment or for major capacity expansion, should be excluded and be added back to FCF.

cFACT will therefore be arrived at by the following steps –

a) Start with FCF as determined in the Financials
b) Deduct increase in trade and other creditors
c) Add back capex for new investment or capacity expansion

cFACT represents the true cash generated by business operations after payment of overdue creditors and accounting for normal capital expenditure.

How to use cFACT

We can use this cFACT in place of PAT in profitability calculations, both for margins and for returns. Variations of the above can be used for different ratios. For example, for gross margin we can use Gross cFACT, where Gross Profit instead of PAT will be used and the same steps as above will be followed to arrive at Gross cFACT.

cFACT based profitability indicators will be free from the problems of ‘accounting’ Profit based indicators. They will make you see facts rather than just profits.

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5 Responses

  1. Sada

    Most of us have been calculating FCF year after year and that too from a ‘compliance’ perspective only, without actually using it as a tool for evaluation and never thought of going beyond that. You have provided a refreshing clarity with cFACT.

  2. In fact, cash flow based tools, like FCF, cFACT etc can be very effective management tools, far better than profit based tools. We should go one step further and evaluate all management KRAs by cash flow based parameters. Also to provide greater emphasis to cash flow statements, the Financials should have cash flow as page 1 followed by balance sheet and then P&L at the end – the reverse of the sequence followed currently.

  3. Irene

    Cash generated from business is real and fact based as against profit generated which is more of an accounting concept , has been established with clarity . However it gives rise to one query, was the profit based accounting system erroneous? or can a compromise be made between PBA [profit based accounting] and CBA [cash based accounting]?

  4. No. Profit and Loss account accounting is neither erroneous nor does it require to be avoided. In fact it is a must. It is part of the system of double-entry accounting that we follow and under that system Balance sheet and P&L will be and must be generated. What I am saying is that for decision making purposes cash flow based performance indicators are better tools. While we look at P&L and related ratios, we must look at Cash Flow and cFACT based ratios to get a clearer picture and not get misled in cases of window dressed accounts.

  5. Lee Lee

    The use of FCF and cFACT indeed is gaining importance in present times when cash is king. Your expounding on the derivation of FCF and cFACT is extremely helpful to old schoolers who are not acquainted with FCF and cFACT. Great job!

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