Interpreting Financial Statements – Cash Flow Statement

“No matter whether a company makes telecom equipment, cars, or candy, it’s still the same question: How much cash do we get and when?”

-Charlie Munger-

There is a huge difference between a company that requires a lot of capital to grow and one that does not require much.

The cash flow statement summarizes the amount of cash and its equivalents that is going in and out of a business. It gives an indication on how well a company manages its cash position. In order to generate cash to pay its debt obligations and to fund its operations.

The cash flow statement complements the (income statement) and (balance sheet). Its main components being the cash from operating activities, cash from investing activities and cash from financing activities.

Cash flow is calculated using cash method of accounting. Whereas the income statement is prepared on an accrual basis. This means that revenue is recognised when its earned and not when cash has been received.

The other method of account is the Cash Method when revenue is only recorded when payment has been received. This is not a popular method as most businesses extend a credit line to their buyers.

Hence why the accrual method of accounting is advantageous as payments can be booked as receivables in the income statement and the balance sheet.

Since the accrual method allows for payments not yet received to be recorded as revenue, companies are required to keep track of the actual cash that flows in and out of the business. The end product is the cash flow statement.

Interpreting Cash Flow Statements – Operating activities

This part lists out the sources and uses of cash from the regular ongoing business activities within a given period. Its end value equals net income adding back depreciation and amortization.

Cash flows from operating activities calculate all cash received from the distribution of goods and services, less payments to suppliers and employees, and other cost to operate.

Net net result is the operating cash flows. Positive operating cash flow usually indicates that the business is economically viable to generate sufficient cash after expenses.

To derive free cash flow, simply take operating cash flows and deduct capital expenditure from cash flow from investing activities.

Interpreting Cash Flow Statements – Investing activities

This section lists all capital expenditures of the company during the given accounting period. It is the cash spent on the purchase of non current assets that is intended to produce profit in the future. It could include purchases of equipment, property, securities or the sale of assets.

A negative cash flow definitely poses some caution as it could reveal a company in poor financial performance. However, the life-cycle of a company should be taken into consideration when determining its financial performance.

Companies in the high growth stage may record negative cash flows. This is because they are aggressively investing cash in the long-term growth of the company.

Companies that are able to generate plenty of cash have options in order to generate greater shareholder value. Companies have the option to retain all earnings to reinvest, with the intention of generating even higher rates of return for its shareholders.

This option allows shareholders to delay payment of taxes with the benefit of capital appreciation. When a business has hit a stage in its life cycle where re-investing in the business will no longer provide beneficial returns. The company will return the money to its shareholders via the form of dividend payments.

Capital Expenditures (CAPEX)

Capex is the outflows of cash or its equivalents that are more permanent in nature, such as plant, property and equipment. They also include expenditures of intangible assets such as patents or copyrights.

When it comes to capital expenditures, less is better than more. Not all companies are created equal when making these expenditures.

Companies that need to consistently invest cash for capital expenditures in order to stay competitive will not have a long-term durable advantage.

Companies that do not have a competitive advantage are more likely to frequently update their equipment and property. The reason being that they are faced with constant competition. These can result in substantial ongoing expense which will be evident in PP&E increasing.

A company that has long-term durable advantage will spend less on PPE. This is because they do not need to constantly upgrade to remain competitive.

Stock Buy-backs

Buy backs usually benefit existing shareholders as it creates value by reducing the number of outstanding shares available. This increases the remaining shareholders interests in the company and increase the earnings per share.

In turn, this will lead to the share price going up. Buying back stocks can be thought of as a form of dividend payment. It is advantageous as you can delay the immediate payment of taxes if the return was given as a cash dividend.

Interpreting Cash Flow Statements – Financing Activities

As the sub-heading indicates, this is the cash flows coming in and out due to financing activities. These include dividend payments to shareholders, share buy-backs, sale of shares and any cash inflows/outflows involving debt such as bank loans or bonds. Its primary focus is to state how the company raises capital and pays back to investors.

Net increase /decrease in cash and cash equivalents

This states the net change in cash by adding the total of the cash from operations, investing and financing. A good use of this section is to compare if the net change is cash is increasing or decreasing over the past years.

A consistent increase in cash and cash equivalents is a good sign that indicates a company is able to generate more money that it spends

A company that has a lot of cash coming in from sales of shares or issuance of bonds can be not profitable. Vice versa, a company can be profitable by having a majority of their revenue in credit and not a lot of cash coming in.

The purpose of the cash flow statement is to shed light if a company is generating more cash compared to its expenses. This marks the end of the Interpreting Financial Statements series.

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