I recently ran one of my stock screens in the US to try and find some overlooked companies (I went over my screens in detail in an article on How to improve stock screens). I came across one company, Flanigan’s Enterprises ($BDL) which runs a chain of restaurants. It appeared cheap on an EV/EBITDA basis, but on further investigation wasn’t appealing. I wanted to go over it because it’s a great example on how investors can get caught out relying on such multiples without doing further research. The problem is: when is a company’s cash really free cash and not an essential business asset?
Enterprise Value – the problem
Enterprise value is a calculation that adjusts a company’s market cap for cash and debt to give the investor a better idea of how fairly it is valued.
Enterprise Value = Market Cap – Cash – Short term investments + Total Debt
Doing this for Flanigan’s gives an EV of $25m – $7m + $13.5m = $31.5m as it has $7m of cash and $13.5m of debt.
But such a calculation is very misleading. Let’s think about this for a moment, why does a company with $7m cash also have $13.5m debt? Surely it would be rational to pay off that debt (assuming this is not a fraud)?
The answer is that companies cannot operate with zero cash. They will have suppliers that need to be paid and capital expenses that need large up front payments to name just two. When a company is operating with such a debt load it must be for a reason. Enterprise Value is supposed to give us an estimate of what a private buyer would be paying for all of the business, but clearly in cases like this, a private buyer could not withdraw $7m the day after purchase without crippling the business. So how can an investor know what cash is required for the business and which is surplus?
Acid test for cash requirements
The Acid test is an old test, which Ben Graham talked about in his book Security Analysis in the early 20th century.
It gives us a ratio which if less than 1, indicates that a firm will struggle to pay its current liabilities with cash and cash like assets.
A further test is the Current Ratio. This divides all current assets by current liabilities and gives a more relaxed test of whether a company can meet its short term obligations. If this is less than 1 then it means the company will really struggle without raising additional cash in some way.
Let’s take a closer look at Flanigan’s balance sheet.
It doesn’t take long to see that it fails the Acid test, as it has no short term investments or accounts receivable (as restaurants take payment from customers up front).
In fact it barely passes the test of Current assets / current liabilities, from which we can infer that all of its $7m is required for the business to cover its costs. So a more accurate Enterprise Value to use would ignore the cash and be $25m + $13.5m = $38.5m. That changes the company’s valuation dramatically.
Exceptions to the rule
As with everything in investing, nothing is straight forward and no set of stringent rules holds true 100% of the time. The most common time that these tests to flag problems is when a company has a large debt load that is close to maturity. Its debt will appear in current liabilities and the company will have to sell new bonds to pay off the old debt. Or it could be a bank loan that the company continues to roll over year after year. You can see this is the case with Flanigan’s above, with $1,477,000 in ‘current portion of long term debt’.
Both these cases are potentially problematic and it is useful that the Acid test and Current ratio flag the potential problem even if most of the times the company will not suffer any liquidity problems.
But it isn’t just short term debt that creates exceptions, the best example I can give for an exception to this rule is Walmart.
Walmart has an Acid ratio of just 0.2, yet it has sustained this for many years. Cash is just $7.3bn, yet even if it had cash of $50bn it would still fail the Acid test and an investor could (erroneously) conclude that $50bn is required to run the business.
The reason Walmart is the exception, and not the rule is due to its size and competitive strength. Walmart uses its buying power in order to effectively take loans from suppliers in the form of inventory and only pay up once it has sold on the items. This also works well because its products have a high turnover rate and will be sold soon after it buys products itself.
In order to distinguish exceptions like this the investor must understand the company’s competitive advantages as well as look at historical financials to see if the company has ever operated in the past with lower cash and debt levels.
Flanigan’s is far too small to have such buying power over its suppliers and it would be irresponsible of an investor to assume any of its cash is surplus.
The Acid test and current ratio are two important tools an investor must utilize before netting out cash in enterprise value. This requires more time consuming research on the investors part, but one that will be well worth the effort in separating truly cheap stocks from the mirages.
11 thoughts on “When cash isn’t really cash – $BDL”
It is in the fast food business. Most fast food businesses will fail this test.
How do you feel about including only interest baring debt in the calculation of EV? Some people espouse this but I feel debt is debt; and eventually it all has to be dealt with. Though non interest baring debt may appear to be an advantage there may be caveats that actually make it a greater liability ie due upon request.
In a buyout/acquisition the acquirer would still have to take out the acquired Company’s debt, whether it’s interest bearing or PIK interest or whatever. Not including debt that’s PIK in your EV is misleading.
I’d agree with Dan in that non-interest bearing debt is still debt that needs to be repaid at some point.
Are you sure restaurants (even small ones) pay their suppliers up front? The situation here would be consistent with suppliers delivering every day and getting paid every 10 or 30 days or whatever.
Also, what are “Current Liabilities Due to Franchisees?” Is that a situation where a franchisee fronts some sort of cost and is eventually reimbursed? That would seem to be similar to the supplier situation I just described.
No I don’t think they will pay suppliers up front, but will still need a cash pile to cope when a payment is due. A company would normally try to balance the accounts receivable with accounts payable so one pays a stream of cash to pay off the other but as BDL has no accounts receivable it has to keep a cash pile.
That’s fair, though I don’t think it quite makes sense to balance A/P with only A/R in this case. Most of those payables presumably go towards buying inventory, and if you net both the inventory and the cash out of the accounts payable, you get a nice cash surplus of about $3.6 million.
The way I see it, restaurants like this one have a negative cash cycle, which allows them to have more safe leverage than a company that has to pay its costs upfront. There are plenty of reasons for not investing in a restaurant, but I’m not sure if failing the acid test is one of them. A company with a negative cash cycle would, in my mind, logically fail the acid test because it only needs to put aside part of the cash needed to pay off its short term liabilities at any given point.
Yes I agree. I wasn’t trying to say that the company is insolvent or in danger, but that it is too much of an assumption to simply net out all their cash as surplus when the current ratio and acid test suggests they need it.
(For some reason, I can’t respond to your post below, so I hope you don’t mind if I just post here)
I agree with your comment. Just out of curiosity, what would you consider the amount of surplus cash at Flanigan’s?
What about using the NPV of the total lease obligation and adding that to the long term debt?
To be honest, I don’t capitalize leases but can understand why some would. It isn’t quite the same as debt because even if the company goes bankrupt it probably wont have to pay up all the leases because it try to sublet or make a deal with the owner.
I try and avoid companies with high leases in general though, firstly because they are mainly retailers which are pretty unpredictable, and secondly the fixed leases add leverage to the profit margins, so small declines in revenue become big declines in profit.