Cash Flow Analysis: How to Analyze Cash Flow Statements

Print Friendly, PDF & Email

Cash Flow Statement is one of the most important, but an often underrated financial statement. It contains a wealth of information that is not available from the other two statements.

Earnings are no doubt the key metric that we should be looking at when we consider investing in a company. But we must also realize that the earnings figure has some major drawbacks. One, it is not the actual money that the business will earn. There are some fictitious amounts involved in its calculation which may distort the profit amount, sometimes significantly. Two, the books of accounts are prepared on an accrual basis, meaning even if any income is not realized it is accounted for in the books. For example, if you sell something at ` 100 but do not realize the cash from the customer before the end of the year, your account books will show a sale of ` 100, but no real cash has been generated yet. Three, it is very difficult to know from the profit and loss statement the manner in which the company is utilizing the cash it has at its disposal.

A Cash Flow Statement is what comes to our rescue here. By glancing over it for a couple of minutes, an investor can get a lot of information about how the company is generating cash and where it is using it. Cash is what keeps a company running. Shortage of cash is, in fact, one of the major reasons for business failures. Income is of no use to a business until it is realized. The business cannot use unrealized income. This is income on paper and serves no practical purpose for the growth of the business. Cash is what counts. As they say – ‘Show me the money!’ Cash is what one can show.

  • Customized MUTUAL FUND ADVISORY

Below is a basic format of Cash Flow Statement.

Cash Flows From Operating Activities:  
Operating Income (EBIT)5,36,000 
Depreciation Expense2,15,600 
Increase in Accounts Receivable-98,340 
Decrease in Prepaid Expenses12,000 
Decrease in Accounts Payable-114,250 
Decrease in Accrued Expenses-87,375 
Net Cash Flows From Operating Activities 4,63,635
   
Cash Flows From Investing Activities:  
Sale of Machinery53,500 
Sale of Land12,50,000 
Purchase of Equipment-10,00,000 
Net Cash Flows From Investing Activities 3,03,500
   
Cash Flows From Financing Activities:  
Payment of Dividends-2,45,000 
Payment of Bond Payables-1,25,000
Net Cash Flows From Financing Activities -3,70,000
Net change in Cash 3,97,135
Beginning Cash balance 2,14,165
Ending Cash balance 6,11,300

As you can see, a Cash Flow Statement is divided into three parts. This helps the reader make better sense out of the cash inflow and outflow information. Let us try to decipher the sense of it all.

Cash Flows from Operating Activities 

This head shows the cash inflows and outflows that happen in the normal course of business. To calculate this we start from operating profits i.e. earnings before interest and taxes (EBIT). Depreciation being a non-cash item needs to be added back.

Also, the changes in the working capital need to be adjusted to arrive at net cash flow from operating activities. Let me explain this further. Suppose the amount of accounts receivable (amount to be received from customers) was ` 1 lac at the beginning of the year. At the end of the year, this amount increases to ` 1.5 lacs. This means that during the year, after adjusting all such transactions, there was a shortfall in the receipt of accounts receivable. Hence, there is an excess cash outflow of ` 50,000, which needs to be deducted to arrive at the correct cash flow balance. In a nutshell, an increase and decrease in the balances of current assets need to be deducted and added and that of current liabilities needs to be added and deducted respectively. After making all such adjustments we arrive at the net cash flow from operations for the period.

From an investor’s perspective, this balance should ideally be positive. A positive cash from operations indicates that the business has actually been able to generate some real income in the period under consideration.

Get it on Google Play

 

Cash Flows from Investing Activities 

This section shows how the company is investing in its growth. One may get a clear idea about what is going on in the minds of the management by looking at this section in detail. The amount spent on the purchase of capital assets and earned on the sale of such assets can be seen here. Cash spent on making business acquisition are also shown in this section. If a huge amount is spent on capital assets like building a plant and purchasing machinery or in acquiring related businesses, an investor may say that the company is working towards its expansion plans.

Also, the amount spent and received on purchase and sale of securities appear under this head. If huge amounts are spent on the purchase of securities instead of acquiring business assets, one may say that the management is relying more on alternative sources to use cash rather than spending it on expansion or paying it out to investors as dividends.

Putting all of it in a nutshell, by looking at the cash flows from investing activities you can tell whether the company is investing in itself and if yes, how is it doing it.

 

Cash Flows from Financing Activities

The financing activities constitute all such activities that are related to raising capital for the business and paying off the investors. These may include issuing new stock, buying back stock, raising and paying off loans, paying dividends and interests and so forth.

The practical use of this section is that it tells the reader how the company is funding its business activities. If the company is issuing debt, the investor needs to investigate whether it is affecting the debt-equity ratio of the company and whether the company has sufficient interest coverage. If the company has bought back its shares recently, it may assure the investor that the management thinks that the company will do well and its share prices will rise. If the company has paid dividends, the investor may like to calculate the dividend yield of the company.

Also, this section should be analyzed by the investor together with the other two sections as well. For example, if the company has raised more capital, whether by issuing more shares or taking loans, how has it utilized that additional cash? Has it bought more land or has it set up a new plant or has it used it to pay off its creditors? If the cash has been utilized for growth it is usually a good sign, but if the management has taken more loan to pay off older ones, the investor should better be cautious.

 

Net Cash Flow balance

Ideally, the net cash flows from the three activities of the business taken together shall be positive. But what matters more than the balance is the way the cash is being used by the business. You should analyze all the three sections separately and then together and with a little practice, you will be able to spot signs – both positive as well as negative. Then you can take your investment calls.

 

Free Cash Flow (FCF)

Another excellent indicator, perhaps the best of the lot, related to cash flows is the free cash flow (FCF) balance. FCF is the cash generated by the company from its operating activities and left over after meeting all its capital expenditures i.e. expenditures on the purchase of new capital assets or on maintenance of existing ones. Free cash flows can be calculated in many ways, but I keep things simple. You can calculate the free cash flows of a company by simply deducting the capital expenses incurred by it from its cash from operations balance.

FCF = Cash from Operations – Capital Expenditure

So what does this free cash flow balance signify? FCF is nothing but the excess cash balance left at the disposal of the company after meeting its capital expenditure requirements. It is that balance that the company may leverage to fund its growth further or to generate additional income. It can be used to acquire businesses or can be invested in safer assets like bank deposits. The company may use it to pay dividends to shareholders, buy back its shares or repay loans. Who doesn’t like excess cash? Ever wondered what you will do if you had extra cash in your bank account? Feels great, doesn’t it? It is the same in the case of companies. The excess cash can be utilized to make whatever is wrong with company right and whatever is right better.

Capital expenditures form the major head of expenses of a company and if the company does business, generates cash, uses that cash to fund its major expense and still is able to save, it shows that the company is doing great.

You must keep this in your mind that while a positive free cash flow is an indicator of a sound business, a negative free cash flow does not necessarily indicate that the company is operating inefficiently. If the business invested all its cash generated from operations into capital assets and those assets have the ability to generate better returns for the company than is possible with other investment options, then we can say that the cash was utilized well. However, there is no mathematical formula which can help us to make this judgment. The investor needs to put his own experience and knowledge into play here. The annual reports and various other disclosures and announcements from the management should be studied. Doing this will put you into a better position to take the call.

I like to compare free cash flows with the market capitalization of companies. The larger the market cap of the company, the higher should be the amount of free cash flows. This helps me put all the companies – whether large or small on the same platform as far as cash flow analysis is concerned. This is called Free Cash Flow Yield. It is also an improvement upon the Earnings Yield (PAT/Market Cap.) as the FCF yield focuses on actual cash inflows and not just on accounting income.

Is Excess Cash Good? 

One last thing before I finish this discussion on cash flows. Having a huge cash balance is not a foolproof indicator of the financial health and management efficiency of a company. If you have the resources you will only be regarded as efficient if you use it to create better resources. Cash is the most valuable financial resource available to a company, and the management just sitting on it and not utilizing it to good effect is not what you want to see as an investor.

Cash is a valuable resource but it is not an end in itself. How it is being utilized is what needs to be seen by an investor. And the best way to do it is to analyze the cash flow statement well.

Also Read: RATIO ANALYSIS: HOW TO MEASURE THE PROFITABILITY OF A COMPANY

HOW TO FIND UNDERVALUED STOCKS
GET THE FREE REPORT

Learn to Find Undervalued Stocks Easily

Thank you for subscribing. Please check your Email.

Something went wrong.

Leave a Reply

Facebook2k
Twitter1k

HOW TO FIND UNDERVALUED STOCKS
GET THE FREE REPORT

Learn to Find Undervalued Stocks Easily

Thank you for subscribing. Please check your Email.

Something went wrong.