The balance held by a company in its bank account can give the impression of a sound edifice but it could turn out to be a pile of rubble if you take a closer look.
Here are a few parameters you can run through before buying that cash-rich company’s shares you have been yearning for.
But there are some that do not conform to this trend and are best avoided. For instance, Indian Oil Corp, despite generating the second highest cash flow from operations in FY2014, IOC generated negative cash flow in many years over the past decade. Similarly, companies such as Gammon India and DLF display the propensity to declare negative cash flows.
This shows that even if these companies have large cash balances towards the end of some years, their operations are not profitable enough to enable them to accumulate large cash reserves over the long term.
Looking at the proportion of revenue that is held back by the company after accounting for operational expenses (operating cash flow/revenue) is another measure that can help us gauge the extent of profitability of the company. Companies such as Bharti Airtel, NTPC, Infosys, Coal India, ITC and Idea Cellular are more profitable on this parameter with cash generated from operations of around 20 per cent of sales.
On the other hand, companies from the Tata group appear far less efficient if we apply this metric. Despite generating large revenues, cash generated from operations for companies such as Tata Steel, Tata Motors and Tata Power is less than 10 per cent.
Addition to gross block Some companies could be foregoing investments in their own businesses resulting in large cash surpluses. You need to avoid such companies too.
Indian companies are expanding their capacities and adding to their assets, but at a sedate pace. Reliance Industries, for instance, grew its gross block three-fold between 2004 and 2014. The other topper in sporting strong cash balance, Coal India, did not even double its asset base in the last decade, showing the PSU giant in very poor light.
Other private sector companies such as UltraTech Cement, ITC, Maruti Suzuki and Larsen and Toubro have also similarly managed to grow their assets at a rate of between 300 and 600 per cent in the last 10 years.
The public sector enterprises, on the other hand, have been lagging in asset additions.
PSU companies such as BPCL, MMTC, BHEL and NMDC have shown slower growth in asset base compared with their private sector peers.
This slow pace of upgradation and capacity additions probably explains the lower efficiency and productivity of the PSUs compared with their private sector counterparts.
This unwillingness to invest in capacity addition is affecting profitability, which is reflected in a falling return on equity (ROE) of these companies. Reliance Industries, for instance, had a very low ROE of 11.7 per cent is FY2014. This number has almost halved from the ROE of more than 20 per cent prior to 2008.
Similarly, Infosys’ ROE has declined from 36 per cent in 2008 to 26 per cent by 2014. ONGC too has seen this ratio decline from 25 to 17 during this period.
Debt equity A company that does show large cash surpluses but keeps borrowing to finance its activities is a no-no. But fortunately, most of the top-50 cash-rich companies do not have much debt.
Some such as Gammon India, which despite having a cash surplus of ₹9,045 crore in March 2014, has debt equity ratio of over 19. Essar Oil too held ₹3,632 crore in hand but its alarmingly high debt equity should be enough to send investors scurrying from this counter.