Despite mountains of academic literature, clear evidence of corporate performance, and professional investor behaviour, firms are often managed – and employeesrewarded – for accounting results. Why is cash flow so neglected?

When I started my career in treasury, my boss at the time had the quote “cash is reality; profit a matter of opinion” on the wall behind his desk. Having recently qualified in audit, I both understood the joke and also the truth of the quote.

As a treasurer, and therefore obsessed with cash, I might be accused of bias in the matter. But reams of academic literature bolstered by extensive research on corporate performance, as well as the behaviour of professional investors, make it very clear that cash really is what matters.

And this has been proven both in practice and theory. Management consultancy firm Stern Stewart, for instance, has conducted studies that show that those firms which use economic value added (EVA) performed almost four times as well as the market in general (EVA uses twenty year total shareholder return, 220% compared to the market’s 67%). To paraphrase SAP, the best firms manage cash flow.

Why cash matters

A recent Economist article on the history of business analysis puts it very clearly (emphasis added):

“Valuation, and a few books like it, offered new tools. Cash flow, not easy-to-manipulate accounting profit, mattered. An activity only made sense if capital employed by it made a decent return, judged by its cash flow relative to a hurdle rate (the risk-adjusted return its providers of capital expected).

“Optical changes to accounting profits don’t matter; cash flow does (a lesson WorldCom and Enron ignored). Leverage boosts headline rates of return but, reciprocally, raises risks (as Lehman found). Buy-backs do not create value, just transfer it between shareholders. Takeovers make sense only if the value of synergies exceeds the premium paid (as Valeant discovered). Pay packages that reward boosts to earnings-per-share and short-term share-price pops are silly.”

McKinsey’s base model for valuation analysis and performance management is Return on Invested Capital (ROIC), which like EVA forces a focus on cash flow. Their conclusions are the same as those of the Economist, as a recent article on how share repurchases boost earnings without improving returns highlights (emphasis added):

“The empirical evidence disproves this. For while there appears to be a correlation between total return to shareholders (TRS) and earning per share (EPS) growth, little of that is due to share repurchases. Much of it can be attributed to revenue and total earnings growth – and especially to ROIC, which determines how much cash flow a company generates for a given dollar of income. All else being equal, a company with higher ROIC will generate more cash flow than a similar company with lower ROIC. But without the contribution of growth and ROIC to TRS, there is no relationship between TRS and the intensity of a company’s share repurchases.

“That’s because it’s the generation of cash flow that creates value. Regardless of how that cash is distributed to shareholders. So share repurchases are just a reflection of how much cash flow a company generates. The greater the cash flow, the more of it a company will eventually need to return to shareholders as dividends and share repurchases.”

In my experience, professional investors focus on cash flow. They know that accounting measures like EPS drive short-term share price volatility because of herd reactions to news flashes. But for long-term investing, only cash flow matters. They use tools like Credit Suisse Holt cash flow return on investment (CFROI) rather than accounting measures.

Why ignore cash flow?

Since the evidence from academics, market data, and professional investors is so overwhelming, why are so many firms managed on accounting numbers?

You don’t need to hire McKinsey to work out that it is much easier to get customers to sign a sales agreement or take delivery of product than it is to get customers to pay. Smart managers will – quite rationally from the perspective of paying for their kids’ education et al – favour performance measures that maximise their bonuses.

It is unclear whether the best efforts of the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have made accounting data more reliable. As a treasurer (and an ex accountant), I naturally think they should focus on accurate cash flow reporting rather than increasingly complex accruals and adjustments.

It is possible that the increasing complexity of accounting requirements, coupled with the more severe tone on management liability for accurate (accounting) reporting, makes it harder for managers to find bandwidth for cash flow.

Cash flow works

Unfortunately, many firms come to a position of cash consciousness only through near death experiences. This can be a brutal way to learn that “cash is reality”. For instance, I have seen great firms lose half of their workforce and suffer 60% dilution. Seeing half your colleagues fired focuses the mind more than academic studies and market research. But it is a very painful way to learn.

Cash consciousness comes in different forms. Integrated performance management models – like McKinsey’s ROIC and Stern Stewart’s EVA (and many others) – provide an attractive and consistent methodology. The minimum required is to elevate cash flow – with metrics like net working capital rotation (NWCR) and the cash conversion cycle (CCC) – to at least equal weight with sales and profits, both in terms of performance communication and remuneration. The exact methodology matters less than taking cash seriously.

There is however, a significant minority of firms who take cash flow seriously. These companies provide clear evidence, built up over decades, that cash consciousness produces better performance. This is not new, not bleeding edge, not in doubt – nor a matter of opinion. It is just a matter of breaking the denial inherent in the accounting mind set.

Treasurer’s role

Cash consciousness vastly improves the life of the treasurer. Some form of cash flow forecast is the critical basis for all core treasury functions. We cannot fund efficiently without a decent estimate of future needs. We cannot manage cash and position accounts properly without forecasts (though this can be radically simplified in payment factory and in-house bank models). And we certainly cannot hedge properly without forecasts.

In cash conscious firms, treasurers are helping management to meet their cash targets, rather than wasting everybody’s time with obscure cash flow forecast requests. Management needs forecasts to manage their bonuses – if cash flow is a major part of the bonus, management will ensure that cash flow forecasting is an integral part of business planning.

It is a platitude that projects and the like need senior management support. Cash consciousness really must come from the board and the CEO, and it has to permeate the whole firm – which basically means cash must be prominent in everyone’s bonus calculation. This kind of decision is unfortunately not within the treasurer’s remit.

In some cases, cash consciousness can come from the firm’s owner. Here is an enlightened quote from Bill Priestley, partner at PE fund manager Electra Partners (emphasis added):

“If I came to you and asked you what the balance was in your personal bank account, I would expect you to roughly know. I want the management teams of my portfolio investments to roughly know how much cash they have and whether they are broadly on track. That goes for the whole team, including sales, marketing and manufacturing. If the CEO has to ask the CFO and suggests cash flow is a finance problem, then that is a real concern, since the CFO is not responsible for all the levers that drive cash flow.”

Take it seriously

Firms that take cash seriously perform better and make much more productive workplaces for treasurers. Unfortunately, they are in the minority. Over decades, as the evidence mounts even higher, and as managers who understand this move around and become more senior, cash consciousness will spread. Hopefully, some of this spread will come from second-hand experience rather than painful near death experiences.