Friday, August 13, 2010

Cash Burn vs Churn

A company that burns through its cash makes for a dangerous investment, even if it appears cheap on an asset basis. But a declining cash balance does not mean a company is burning through cash. Investors have to look further into a company than simply its cash balance over time in order to determine if it is burning cash.

As an example, recently a reader commented that he is hesitant to buy shares of KSW Inc. (KSW) because it has been "burning cash in its operations for the last two quarters". While there may be a number of reasons to hesitate before buying this company, cash burn appears to be one of the least likely of those reasons.

Yes, the company has sported negative cash flow from operations in each of the last two quarters. And yes, the company's cash balance has declined. However, one cannot draw conclusions of cash burn simply using these summary line items. An analysis of the cash flow statement will illustrate the sources of these dips in cash flow. Only by delving into the details can one determine if the company is burning cash, or if there is some other explanation for the change in cash balance.

First of all, the first line of the cash flow statement shows that the company is making a net profit. But further down the cash flow statement it becomes clear that cash flow from operations is negative as a result of an increase in the company's receivables account. This is due to the large spike in the company's revenue (2nd quarter revenue was 50% higher than 1st quarter revenue), as it has begun to work through its backlog. When a company grows revenue quickly, it needs money to finance that growth until such time as the work is completed and the customer pays (unless, of course, the company has a negative cash conversion cycle).

But KSW has the money to finance the growth in revenue, and it is profitable; therefore, negative operating cash flow in this case does not suggest a dangerous situation. In addition, further down the cash flow statement it becomes apparent that the company's cash balance has also been lowered as a result of dividends the company has been paying.

A headline view of a company's cash flow statement does not yield the kind of information an investor must use in making an investment decision. Only by considering the financial statements in their entirety, along with their accompanying notes, can an investor get a true picture of a company's situation.

Disclosure: Author has a long position in shares of KSW


Anonymous said...


How much of the cash do you think is excess baring in mind that they need a good balance sheet for their surety bonding? The cash and whether it is excess is obviously a major factor in the valuation


Saj Karsan said...

Hi Anon,

Good question.

To estimate this, I have looked at the cash balance of previous years compared to the revenue of previous years. This leads to a supposition that there is a current "excess" cash amount.

Anonymous said...

Thanks a lot for your swift answer. Just before I read it I thought of the same idea to calculate excess cash so its great news that your thoughts are along the same lines.

I wonder if in the current environment though surety bonds are harder to obtain