Over the past few weeks we have written about the profit and loss statement and the balance sheet, and how understanding both is critical to working out how a business operates. But as the saying goes, cash is king, and the cash flow statement is really at the core of analysing a company’s financials. Below we explore the cash flow statement and why it helps to complete the picture when looking at company financials.
Understanding the structure of the cash flow statement is understandably very important. The cash flow statement is divided into three parts: the first from the operations of the business, the second from the investing activities of the business, and the third from the financing activities of the business. Putting the three together will form a path from the cash the business had on the books last reporting period to the cash the business has today.
1) Operational Cash Flow
The cash flows from operations will often feature two large items: receipt from customers and payments to suppliers and employees. But the numbers are more useful when broken down into their components. Mostly this will be a combination of after-tax profit, non-cash items like depreciation, and the movement in the working capital of the business.
2) Working Capital
Let’s take a step back to look at working capital, usually made up of receivables, inventories and payables. The profit and loss statement represents the revenue and costs when they are incurred, not when cash is paid. Selling a product on the last day of a financial year, while cash from the sale is still to be received, will add to revenue while the amount of the sale will sit in the receivables line of the balance sheet. Until the cash is received the cash flow statement will not be affected. Is a business being aggressive in recognising sales which may take a long time to be received in cash or may not come through at all? The cash flow statement will be clean of this trickery.
Does the business have to permanently carry more inventory to satisfy its customers? This will drain cash flow that can be used for other purposes, and while not seen on the profit and loss statement until the inventory is sold it will impact the cash flow statement. Costs incurred but not yet paid in cash, termed payables, will appear in the balance sheet but won’t hit the cash flow statement until actually paid in cash. Is the business collecting cash from customers before having to pay suppliers? The business might well be generating more cash flow than the profit and loss statement suggests.
3) Capital Expenditure
The largest item to look for in the investing activities section is capital expenditure, or capex for short, usually seen as payments for property, plant and equipment. In addition to spending on the physical items needed to run a business some companies will spend on the intangible items too: payment for the acquisition of intangible assets. Both will later influence the profit and loss statement but for now they represent a drag on the generation of cash. Some is necessary to maintain the business, termed maintenance capex, while some is needed to grow the business, termed expansionary capex.
4) Free Cash Flow
We are most interested in the free cash flow available for the business to spend, and we get to that number by taking the operating cash flow and subtracting maintenance capex. What is left over can be used to fuel the expansion of the business, acquire another business, pay down debt, or can be returned to shareholders.
Comparing the level of free cash flow to profit is a good start. Big differences, where cash flow is below profit, can be a problem and needs further investigation. Comparing cash flow items over the years will also be helpful; how have the working capital requirements of the business changed over time? The financial statements fit together like a jigsaw puzzle and tracking the relationship between them is a very useful exercise.
5) Financing Activities
The last section, financing activities, will show us the movements in the debt a business has borrowed and repaid, the capital it has raised in the equity markets, and the dividends paid. Was the business successful in paying down lots of debt, or did the Board decide to use the available cash to pay a dividend? This will become clear here.
As always don’t be afraid of the notes: the numbers sitting beside the different lines. Some will provide very useful bits of information. Often we get presented with a reconciliation of the operating cash flow with the profit and loss and balance sheet items. This is one of the most useful notes.
Another pothole to consider: cash flows can be sharply swung by what happens on the last day or week of the period. Receiving a couple of million dollars from a customer early may make cash flow look good; receive that cash a week later and it might seem terrible.
Over the last three weeks we have reviewed the financial statements that investors can use to navigate a business. Individually these statements are interesting, but together they can tell a lot about the way a business has operated in the past and will operate in the future. Knowing how to read the signs and to navigate financial statements is key to understanding the way a business operates, and ultimately to successful investing.