How To Analyse The Cash Flow Statement

You may have heard the saying “revenue is vanity, profit is sanity, cash is reality”. That’s because revenue matters not a jot if a company isn’t making any profit. But profit also is meaningless if a business is not collecting the cash! Many of the great stock market frauds such as Enron booked the profit to the P&L yet the cash did not materialise. In this article we will learn how to understand the cash flow statement.

Cash Flow Check-Up

There are four main points we need to identify on the cash flow statement

  • Is the company generating positive operating cash flow?
  • Are there significant amounts of amortisation of intangible assets or depreciation of fixed assets?
  • Is there goodwill or any exceptional impairments listed?
  • Is the company struggling to collect cash and paying debtors quicker than this is coming in?

If we can answer all four of these questions we will have a much better idea of the company’s financial health rather than just by looking at the income statement. That’s because cash is King!

Why Is Cash King?

Imagine we spot a gap in the market (and we’re sure there is a market in the gap) and we decide to set up a conservatory company in the spring. We set up our company and input £5,000 of our cash into the company. Immediately, we have our first customer who wants a new conservatory for £5,000. So, we buy all the materials required out of our cash that’s in our business bank account for £4,000, leaving only £1,000 in the account. This is not a problem because we will be paid £5,000 once the work is complete and we are busy working on the customer’s conservatory until then anyway.

Once the customer has placed the order we then invoice the customer and log the £5,000 revenue that has come into our business, and record the £1,000 profit. However, after completing the work the customer then tells us he won’t have the cash for another two weeks and so he can’t pay us the £5,000 that we have invoiced him. This is a concern, but he assures us he is good for the cash.

The next day we receive a call from another potential customer who wants a small conservatory building onto his house as soon as possible before the summer. The materials will cost £2,000 to purchase but we only have £1,000 in our bank account. The depot won’t let us take the materials out on credit as we are a new company, and the bank will also not loan us money at such short notice.

This means that we aren’t able to buy the materials to take the order because we still haven’t collected the cash from the previous customer! The potential customer does not want to wait two weeks to start, and so he goes to one of our competitors who is able to purchase the materials and start straight away.

Working Capital

Having enough capital in the business to pay both creditors and for supplies is called working capital. When cash is tight this can be a big problem for businesses, and we should always check their current assets and current liabilities.

Companies can earn a lot of profit but not much cash, and so it is useful to check how much of their profits are being converted to cash. If the company is not generating any cash flow from operations then they are simply not self-sustainable.

How To Work Out Operational Cash Flow

To work out operational cash flow in the company (cash generated or used from or in normal operating activities), we start with net income (the bottom line from the income statement) and work our way up the income statement adjusting for transactions that affected net income but were not cash transactions. For example, depreciation and amortisation both have an effect on net income yet depreciation and amortisation do not have any effect on the cash balances of the company. Therefore, we need to add these transactions back to net income in order to get back to operational cash generated.

Now we can see a statement of cash flow from another company:

BBSN cash.jpg

To understand the movements in cash, we need to start with the profit or loss for the period, and adjust to see if a company is generating operating cash flow.

We add back any taxation and interest as these are non-operational expenses.

Amortisation is the writing down of intangible assets and so this amortisation expense is an intangible expense and so added back to the cash flow figure. Depreciation is the writing down of a tangible asset across its useful life, but this is also a non-cash expense so we add it back, and the same with share based payments.

After this, we need to adjust for increases and decreases in receivables and payables to see how much cash the company generated for the period. In this instance, we see that cash is leaving the company even faster than their loss suggests, which we will cover further down the page.

Are There Significant Amounts Of Amortisation Of Intangible Assets Or Depreciation Of Fixed Assets?

We should always check for amortisation of intangible assets or depreciation of fixed assets on the cash flow statement because these are non-cash items and so added back to the P&L. This means that profit can be boosted heavily by management discretion of how they decide to value a tangible or intangible asset.

Another reason is that if there are large amounts of depreciation then eventually these fixed assets will need replacing or require capital expenditure for maintenance. For example, a restaurant will continuously need to refurbish its units due to wear-and-tear and also brand fatigue in order to keep its units fresh.

Is There Goodwill Or Any Exceptional Impairments Listed?

It is always worth checking for goodwill that has been added back. Goodwill is an accounting principle that places a price on that intangible value of a business. For example, McDonald’s pays pennies for the raw ingredients in a Big Mac, yet we pay extra for the complete sum of the parts in a prepared form. Whereas a business may only have a tangible asset value of a certain amount – a buyer may buy the firm for more because the buyer believes the business branding or employees have addtional value.

Goodwill matters on the cash flow statement because it is added back as a non-cash item. It is the same with exceptional impairments. Some companies have ‘exceptional impairments’ every single year, which artificially boosts the company’s profits!

Is The Company Paying Debtors Quicker Than Collecting Receivables?

We looked at this in “How To Understand A Balance Sheet” and the reason why this is important is because the length of time we pay and are paid affects our working capital.

Remember the conservatory? If we are paid 10 days after work completion, yet we pay our suppliers after 30 days from purchase, then it is highly likely cash will be staying in the business for a longer period of time. If receivables (money paid to us) is growing much faster than payables (money owed to others) then it increases the risk of a cash call on the business. We may need to find a debt facility or dilute shareholders by asking them for more cash in the form of equity.

Putting It Together

Accounting is said to be the language of business, and though we do not need to be expert accountants to make money investing in stocks we do need to understand the basics. Being able to do so will save us plenty of money by not investing in complete trashcans and will help us to avoid companies that go bust if we know what to look for.

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