AIM's biggest and best cash generators revealed

Quindell has shown that there can be a big difference between reported profit and cash generation and it is not the only example of this miss-match. It is important that profit turns into cash or a company will have to tap shareholders for more money or run into financial difficulties.

A growing business does generally require additional working capital so there may be a gap between reported profit and cash generated, but it should not be a consistently large gap. Poor cash generation is not just about failing to collect cash efficiently. It may be a problem with one or two large debtors not paying promptly or a case of revenues being recognised long before the customer is likely to pay. In some cases these receivables have to be written off as bad debts so effectively the profit was never really made. Sometimes a company may even have to pay tax on a declared profit which has not turned into cash.

Payment terms may differ in different countries. For example, Chinese companies tend to have to wait longer to be paid than European companies because that is what is normal for the local market. Investors need to understand these differences but also be aware that they can be used as an excuse for poor financial management.

In contrast, some companies are paid upfront for services and recognise these revenues over the length of the contract. This means that cash is generated faster than profit is reported.

One thing that should be made clear is that cash collection is completely different to cash generation. The UK government collects billions of pounds in cash from taxes yet everyone knows it has an enormous budget deficit - the equivalent of a cash outflow for a company. The fact that a company collects a lot of cash gives no indication of whether there is a cash inflow or outflow for the business.

Contrasting fortunes

Examples of how two apparently similar profitable companies can differ enormously in terms of cash generation are mobile content providers SyQic and CDialogues. The businesses are not exactly the same but they provide a contrast in fortunes while both seeming to be significantly profitable.

SyQic provides TV content to mobile devices and, in the past four years, has reported £1.53 million in operating profit, but there has been a cash outflow from operating activities of £2.54 million in the same period. On top of the operating cash outflow there was £646,000 of capitalised development costs, net of amortisation.

This is because Indonesian customer PT Nextnation Prisma (PTNP), which generated 60% of SyQic's revenues in 2013, is behind with its payments due to a regulatory investigation into the sale of added services to mobile phone users in Indonesia. These issues were not specific to PTNP and even though there was no penalty relating to PTNP it hit cash collections and had a knock on effect on payments to SyQic. In April 2013, a payment plan was agreed, but after SyQic raised £1.85 million in its flotation at the end of that year, PTNP decided that it needed additional time to pay the cash owed and the payments are currently spread between 2014 and 2016. By the end of 2013, £3.29 million was owed by PTNP, with £1.62 million outstanding for more than one year. So far this year, PTNP has paid £1.05 million of the cash owed and SyQic hopes that payment of 2014 revenues should start soon.

House broker Allenby forecasts 2014 revenues of £7.8 million, up from £4.71 million in 2013, while operating profit is expected to more than treble from £582,000 to £1.94 million. The cash outflow from operating activities is forecast to reduce from £970,000 to £149,000. Yet tax payments of £145,000 on reported profit are forecast for 2014 when no cash has been generated. Allenby argues that its revenue and cash flow forecasts could prove conservative. At 64.5p, the shares are trading on less than eight times 2014 prospective earnings.

[Differing payment terms] can be used as an excuse for poor financial management"

Contrast SyQic with CDialogues, which provides content and services that help mobile network operators to attract and retain subscribers to their services. CDialogues has reported €1.8 million (£1.42 million) in operating profit over the three financial years to December 2013 and over the same period it has generated €1.56 million in cash from operating activities, before €384,000 of capitalised development costs. This is despite the fact that CDialogues is currently focused on the Middle East, and Iraq in particular. Just like SyQic, CDialogues is dependent on one large customer but at least it is paying promptly. CDialogues is diversifying its customer base and it continues to generate cash in the first half of 2014.

CDialogues broker Mirabaud forecasts an operating profit of €2.6 million and cash generated from operations of €2 million in 2014. At 230p a share, CDialogues is trading on eight times prospective 2014 earnings.

SyQic and CDialogues are trading on similar low multiples and it is understandable that investors are cautious about both companies but the former does not generate cash. SyQic is expected to grow its earnings at a faster rate but CDialogues is still forecast to grow earnings by more than 50% in 2015. There is always a risk that CDialogues may have problems getting payments from customers in the future but at this stage it appears a more attractive investment than SyQic, even though Allenby believes that SyQic could generate £2.35 million in cash in 2015.

Cash/profit

The table includes 20 AIM companies that generate as much, or more cash from operations than their reported operating profit. This is not an exhaustive list and there are many other examples. The figures have not been adjusted for amortisation or other non-cash write-offs that reduce the operating profit and flatter the cash/profit ratio.

Bond International Software apitalises much of its software development and then amortises it. The capitalised spending is included later in the cash flow statement, so this flatters the operating cash flow, and it has up until now always been more than the amortisation charge each year.

Some businesses are cash generative in the short-term if revenues are shrinking and their trade receivables are also falling. Pawnbroker H&T is an example of this. The decline in the gold price led to a fall in activity and this meant that trade receivables fell, thereby reducing working capital and raising cash generation. In the previous financial year the cash generated was similar to operating profit.

The timing of payments will have an effect on the cash at the end of the financial year. The apparently impressive cash generation of Nationwide Accident is due to the fact that there was a sharp reduction in creditors in the previous year which meant that cash generation was minimal. Taking the two financial periods together the ratio of cash to profit is just over 1.1. The only other company in the table where the previous year’s cash/profit ratio was less than one is Frenkel Topping.

The length of time it takes for legal businesses to get paid tends to be much greater than for other businesses, as Quindell shows"

Churchill China is an example of a company which has invested in capital equipment in the past and has a significant depreciation charge which helps to boost cash inflow. The capital spending in recent years has been below that depreciation figure.

The circumstances of a company can change. For example, debt management services provider Fairpoint has a good record of cash generation partly because it is running down books of Individual Voluntary Arrangements (IVA). That could change because it has acquired two legal services businesses. The length of time it takes for legal businesses to get paid tends to be much greater than for other businesses, as Quindell shows. In many cases it can take around 18 months for cash to come in.

Solicitor Simpson Millar was acquired in the middle of June as the first step in Fairpoint's consolidation strategy for the legal services market. Foster and Partners was a subsequent add-on acquisition to increase presence in south west England. The first signs of how these legal services operations are affecting group cash flow will come in the full year figures and at the moment they are still a minority of Fairpoint's revenues. It may be some time before it becomes clear how overall cash generation will be affected.

Cash generation is one of a number of important measures for a company's performance, but if a company consistently fails to generate a level of cash that is anywhere near the reported profit then this should be taken as a warning sign.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.