A cash flow statement is the third of the three financial statements made by companies to report their financials, the other two being income statement and balance sheet. As the name suggests, cash flow statement shows the flow of cash through the company, meaning how cash comes in and goes out of the company.
A cash flow statement may sound a lot like income statement since both shows how money comes and goes out of the company. So, you may wonder why a company needs 2 different statements. The reason for having two different statements is because of how companies do their accounting. Most companies use an “accrual method” of accounting and not cash accounting. In accrual method, the company books a sale as soon as the product leaves the company, even if they may not get paid for it for a long time. Generally, most companies give a credit period of a few weeks or months to their customers. So even if the company did not actually get paid for the product, they can still show it as sale in their income statement. But in cash flow statement, this transaction will be visible only when the cash actually comes in the hands of the company. The same is true for expenses as well. The company may buy a product now but doesn’t pay for it till the credit period is over. So this shows up as an expense in the income statement right now but the cash flow statement will record it only when the company actually pays for what it bought.
Basically, cash flow statement is created to specifically keep track of actual cash coming in and going out of the system, and not just recorded sales and expenses. Like an income statement, cash flow statement is also made for a period of time, like a quarter or a year.
A CFS looks something like this:
.
A cash flow statement basically has 3 sections which are the 3 ways a company can actually earn or lose cash - from its operations, from investments, or by financing.
1. Cash from operating activities:
As the name suggests, this section shows the money company earns or spends for its normal business operations
It starts from net income which is actually the recorded profit/loss of the company. To it, it adds depreciation and amortization because for these expenses, cash was not actually used in the accounting period, but when the equipments were actually bought.
Then all the cash that came in and went out is accounted for, and the sum is known as “Total cash from operations”
2. Cash flow from investing activities:
This shows the money company uses or gains from investments.
A company may be procuring new equipment or expanding their manufacturing facility which all leads to “capital expenditure”, which is money going out of the company. Note that the values written within parentheses () in the statement above means a negative value i.e. cash leaving the company.
A company can also sell its existing equipment or assets, leading to cash coming in.
A company can also use its cash to make investments outside of the company like in stocks, bonds, mutual funds. This will lead to cash leaving the company.
When it sells or redeems its investments, cash comes into the company.
Investing can also mean acquisitions of other companies or carving out segments of your own company as well investing in intangible assets like patents, licenses, etc.
The net of all these activities is shown as “Total cash from investing activities”
3. Cash flow from financing activities:
This shows all financing activities of a company.
The company can sells its shares to raise money or it can buy its own shares from the market, known as “buyback” and spend its cash here.
Similarly, the company can issue bonds to raise money or buy back its bonds and use its cash
Cash used for paying dividends also shows up in this section
The total of all these is known as “Total cash from financing activities”
If you add all three subtotals, you get “Net cash flow” or “Net change in cash” which shows how much cash in total came in or went out of the company during that period.
Now that we know how to read a cash flow statement, we need to understand how cash flow statement can help us analyze a company and differentiate a good company from a bad.
It often does not get the attention as income statement but many analysts often say that a cash flow statement is the true litmus test for a company’s financial situation.
What can cash flow statement tell you about the company?
1. Free cash flow: Higher the better
Free cash flow is an extremely important term that doesn't show up directly in the cash flow statement but can be calculated using the figures in the table.
Free cash flow (FCF) is the free cash left with the company after capital expenditure. It is calculated by the formula = Total cash from operations - capital expenditure.
Basically, total cash from operations shows the Opex of the company and capital expenditure shows the capex. So free cash flow shows the cash with the company after all its capex and opex. This is the money that the company can then use for other activities, like giving dividends to shareholders, doing stock buybacks, or investing in other opportunities. All this is good news for the shareholders.
A high free cash flow also shows the company is able to operate without having to invest a lot in its opex and capex, which is good news for shareholders.
Compare with companies in the same sector. High FCF is good. An increasing FCF over the years is even better.
2. Capital expenditure: Lesser is better
You would have guessed this based on the first point. Less capex means more free cash.
A company that has to continuously spend on capex just to stay in business is not worth your time.
Many sectors like airlines need too much capex just to stay in business. Such companies can hardly be the wealth creators you are looking for.
However, if a company spends only a little in capex and manages to grow with that, it may be the one you are looking for.
3. Stock buybacks: Love them a lot
A company that does buybacks helps its investors in 2 big ways:
1. It reduces the outstanding shares of the company meaning each share represents a bigger chunk of the company, and hence its profits, after buyback
2. It is a tax-free way of paying back to the shareholders, since dividends are taxed
Check if the company uses its free cash to buyback stocks over the years. A company that buys back consistently is worth your time.
Bottom line:
As the experts often say, cash is king. Cash flow statement helps you check exactly that. Do not forget to check free cash flow. A growing free cash flow coupled with less capital expenditure may indicate a company with sustainable economic moats.
Display image by vectorjuice from freepik
Comments