Understanding Cash flow statements

“Profit is an estimate. Cash is a fact.”

Cash flow statement-That’s last of the three types of financial statements.

I hope the very first sentence in this article has given you an idea about cash flows.  The cash flow statement reports the “actual solid cash” generated and used during the time interval specified in its heading, unlike profit and loss statement which gives an estimate based on certain rules and assumptions, after deducting certain expenses like deprecation which does not require any cash outflow.

The whole idea of cash flow statement is to show you from where the company got it’s cash – whether it’s from it’s business operations or by sale of assets or issue of shares  and how it used up those funds. This data is important because business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive.

THREE SECTIONS OF A CASH FLOW STATEMENT.

A Cash flow statement split into three sections. It shows separately the cash flow from operating, investing and financing activities of the business.

  • Operating cash flow is cash received or paid by a company in the course of its regular business during a specific time period. Operating cash flow items will usually have a correspondence to items in the company’s income statement.A strong positive cash flow from operations is a good sign of the company’s health
  • Investing cash flows are cash received or paid out by the company associated with investment items. These can be investments in publicly traded securities, investments in other companies or investments in assets such as property or factories. Oftentimes, investing cash flows will not have a corresponding item on a company’s income statement but the changes should show up on a company’s balance sheet.The changes in cash flow form changes in equipment, assets, or investments are revealed here. Cash goes out to buy new equipment. Also cash comes into the company when an asset is sold or divested.
  • Financing cash flows shows money received or paid out by the company associated with its capitalization. These items can be related to debt payments or new debt. Dividend payments would show up here. Stock buybacks or the issuance of new stock would also show up here. Most of these items would be unlikely to show up on a company’s income statement (although interest payments would) but would show up on the balance sheet.The financing section shows how borrowing money affects the company’s cash flow.

WHAT DOES THE CASH FLOW TELL US?

It’s three sections gives us an idea about the ‘quality of income’ that the company is generating. The cash flow statement may appear to be a complicated statement for a young investor, but a careful study along with the following tips would help him better understand it and enable him to take better investing decisions.

Operating section

  • The statement gives you details of cash from operating activities.  Consistent cash generation that’s greater than the net income of the company can be considered to be of a “high quality”. But If the cash from operating activities is less than net income, you may want to check why the reported net income is not turning into cash.
  • When a company spends more than it receives, it is said to have a ‘negative’ cash flow.  Negative cash flows are often viewed as indicators of financial ill health by investors.
  • To get a feel for whether a company is playing games with its earnings, compare net income on the income statement with ”cash from operating activities,” which represents how much cash a company’s operations generate or consume. ”Generally, the closer a ratio of those two numbers is to one, the higher-quality the earnings.
  • If a statement consistently shows more inflows than outflows, it is an indication that it can increase its dividend payments, repurchase its stocks reduce its debt or acquire another firm. All these are signs of a firm that is in good standing and is considered to be of good value.
  • If the firm consistently reports growth on its income statement, but has negative cash flow from operating activities, it may be lacking the ability to translate its growth into cash. These firms are more likely to face liquidity problems, or even default on their short term liabilities. A company that keeps Increasing it’s earnings and at the same time, suffers from negative cash flow is a red flag.
  • Compare the rates at which net income and operating cash are growing. If the two normally move in lockstep but cash now lags, that’s a caution signal for you.
  • Negative cash flow from operations isn’t always bad. Because of the high costs of growing a business, it’s normal for fast-growing companies to spend more cash than they generate. Typically, such companies may rely on bank borrowings or share issues to raise funds for expansion.  In other words, they run a surplus in ”financing” cash flows.
  • Cash outflows towards customers for refunds may indicate that the customers are not happy with the company’s products and services.
  • Investing section

  • Review the investing section of the cash flow statement. This section reveals the changes in cash due to equipment, assets or company investments. For example, cash goes out when new equipment is bought and cash comes into the company when an asset is sold.
  • The cash flow from investing activities also indicates a firm’s ability to invest in non-current assets. If the company generates enough cash to invest continually in property, plant and equipment as well as other fixed assets, it is an indication that the firm aims at replacing technologically obsolete equipment to keep up with the latest trends.
  • Any substantial increase in investing section of cash flow may also hint at possible attempt to take control of another company for diversification of business. Increase in fixed assets indicates capital expansion and future growth.
  • Financing section

  • The cash flow from financing activities should be carefully evaluated when interpreting cash flow statements. Investors should compare current debt financing with past periods to determine if the firm has reduced its debt over the years.
  • While analysing financing activities, Issuance of common stocks at attractive prices (high stock price above book value) may indicate that the brand image and product of company is good. Issuance of preferred stock is not a good sign as it hints that the company is having problems in selling common stock. If company is resorting to debt financial then it is important for investors to analyze the debt equity ratio of company. Reduction of long term debts is desirable.

CONCLUSION

Cash flow is an important measurement and is best understood when you compare the results of a company to its peers and to the market. It is important because it focuses on actual operations and eliminates one-time expenses and non-cash charges.

Remember- Cash is king !

You may like these posts:

  1. Cash flow statement. – An introduction.
  2. The components of financial statements
  3. The Income statement: Understanding the components.

1 Response to “Understanding Cash flow statements”

Stock Tips

November 16, 2011 at 2:34 pm

Excellent post! I really enjoyed reading it. I will be back for more!
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