Why Free Cashflow for AEON Credit is not that important

Readers of my blog would know that I put a lot of importance on cashflow in my investments. Why? Companies that are not able to generate enough cashflow consistently may run into debt trouble as their businesses would be dependent on cash from other sources for survival. Similarly, as an investor, if you are relying on dividends, capital repayment etc., these cash should come from free cashflow not other forms of cash it generates from unless it is a sale of business or assets. I am really against companies which raised a substantial amount of cash for business expansion but at the same time issuing large dividends as these are inefficient way of managing cash.

Sometimes though, there are some exceptions especially for businesses which rely on one-off large investments into growing their businesses - companies like Genting when it raised funds for expansion in Singapore or Malaysia Airport for the expansion of the KLIA2. Once these projects are completed, the free cashflow should be back to normal or in fact improved.

Another type of business which the cashflow is not that relevant as a benchmark are all the lending organizations - and this include AEON Credit (which is the easiest among the lenders to evaluate on in fact). AEON Credit has two main sources of income - short to medium term lending for hire purchases (such as electronics equipment, motorbikes etc. or even personal lending) and credit card loans. As AEON Credit is not a deposit taking financial institution, it gets its funds from borrowings and its own capital (from profits and fund raising). Unlike the normal businesses, lending organizations make their money from receivables. To illustrate that, let me provide an example from the balance sheet of AEON Credit.

From above, look at the financing receivables - they are basically loans or amount owing from its customers (for credit cards etc). Then I highlighted the equity (which is its own capital which it gained and raised from) and the borrowings which it gotten in order to be able to lend out again. As you can see, from the financing receivables, AEON Credit's receivables grew at a furious pace increasing more than RM600 million over 9 months or grew more than 40% from its total in 20 February 2012. It shows that it is aggressive and doing very well as a lender - if I deem loans growth as doing well. To be able lend, AEON Credit must also be able to borrow as it is not a deposit taking company. Hence, we are seeing its borrowings grew at a similar pace as well.

Turn that scenario into the cashflow report of AEON Credit. What we have learned are different from other types of businesses. The business for Top Glove for example, it borrows mainly for factory expansion, trade financing requirements. Its free cashflow are the net cash amount for its business which is selling gloves as well as the costs for factory expansion. As for AEON Credit on the other hand, its business is dependent on loans. Without loans growth, it is then shrinking. Hence, for the period when AEON Credit was growing at a fast pace, its cashflow statement looks like below. Operating cashflow negative while investing cashflow is almost irrelevant. On the other hand, it is getting more borrowings itself which causes the financing cashflow to have a substantial net increase.

What does that tell of the company? Read the performance review below. While the receivables growth is important, almost another important benchmark is the NPL. Note that its NPL dropped from 1.94% to 1.81%. While this is a good number, usually during a period of high loans growth, this is quite normal as fresh loans are normally healthy. Seldom, you will see bad debts in new loans and quite a substantial percentage (more than 25%) of AEON's receivables are new loans.

Another important benchmark for a lending organization such as AEON Credit is the Capital Adequacy. As in the name, basically the authorities are saying to be able to lend, you cannot depend entirely on borrowings (or deposits for deposit taking banks) alone. You need to put in, raise your own money or build enough reserves, hence the Capital Adequacy Ratio (CAR). However, the CAR for AEON Credit I do not think is as tight as the ones imposed onto banks.

Of course, CAR is not as straight forward as that and there are weightings given for different kinds of loans or risks. It is actually quite complex (quite a fair bit of people make a living out of it) and based on the BASEL Accord (google it, the place where Roger Federer was born) continues to come out with new guidelines on this. Nevertheless, the above CAR for AEON Credit seems sufficient even despite the CAR drops to below 20% for this year due to the high receivables growth.