Many private investors fail to appreciate the cash flow statement’s importance.
This is to their own peril as this dewscribes how cash moves through the business and not understanding this can mean one fails to spot big red flags.
This article will explain and layout how to understand each part of the cash flow statement and apply it to your company and stock analysis.
How to analyse a cash flow statement
- Understand how a cash flow statement works
- Analyse cash flow from operating activities
- Analyse cash flow from investing activities
- Analyse cash flow from financing activities
- Make important cash flow statement spot checks
1. How a cash flow statement works
The cash flow statement (sometimes known as the statement of cash flows) is a financial document that shows us how cash moves throughout the business. It doesn’t show us free cash flow, but it can show 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.
What is cash flow analysis?
Cash flow analysis is done by using the financial statements that record how and where the money flows throughout the business during the specified period. It helps us understand where the money is going and how much cash the business has at a given time.
By looking at the company’s cash flow we can understand its total cash position and more about the company’s financial position. We can also see how much of a company’s profitability is converted into cash.
Purpose of the cash flow statement
The purpose of the cash flow statement is to show where the cash is going throughout the business and what it is being spent on.
This is important because whereas when reading the income statement shows the profit of a business, those profits might not necessarily be converted into cash. It is cash that is the lifeblood of the business and not profit.
Cash flow statement components
There are three parts to the cash flow statement. Each part of the cash flow statement deals with a certain aspect of the business and covers how cash has been used or generated in these parts of the company.
- Operational Cash Flow Statement (also known as OCF)
- Investing Cash Flow Statement (also known as ICF)
- Financing Cash Flow Statement (also known as FCF)
We’ll cover each of these parts of the cash flow statement below.
2. How to analyse cash flow from operating activities
Operational activities are the company’s main core of activities or business operations. The cash flow from operations statement shows how the amount of cash moving through the business in the course of its business activities.
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. We’ll look at an example of how to do this below.
Operating activities cash flow statement example
Below is the cash flow statement of operating activities from a company.
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 minus taxation as this was cash received to the company (see penultimate row) and also minus the finance income.
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 being generated from the company by its operating activities.
Understanding cash flow from operating activities
The goal of looking at the cash flow from operating activities is to work out whether a company can trade self-sustainably. A company can make a lot of profit but burn cash. Without cash, the business may lack working capital and this can have an effect on operations.
A sign of a company turning itself around could be improved cash generation and therefore no longer reliant on equity diluting fundraisings in order to keep the lights on.
It is important to look at profit also, but companies that have the liquidity to be self-sustaining rather than burning cash can be a sign to investigate further into the business.
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3. How to analyse cash flow from investing activities
The cash flow from investing activities is a part of the cash flow statement that shows the cash generated or spent in relation to investment activities.
Investing activities can include the purchases of tangible and intangible assets, investments in listed businesses as well as unlisted, or the sale of assets including tangible assets, securities, and other assets.
Investing activities cash flow statement example
Here is an example of the cash flow statement of investing activities from the same company below.
We can see that the company disposed of assets held for sale for £422,000 and spend £46,000 on the purchase of property, plant and equipment.
Therefore, a total sum of £376,000 was generated from investing activities.
Understanding cash flow from investing activities
The cash flow statement of investing activities is an important part of the financial statements. It tells us how much the company is investing in itself and this can offer clues to the performance of the business.
We can use the cash flow of investing activities statement and analyse this against previous years. Is investment in the business higher? Is it lower? What does this mean?
For example, a company that has a lot of machinery or other tangible assets such as a restaurant operator will need to spend capital expenditure (or Capex) on not just the purchase of new machinery and units but also the upkeep of existing machinery and existing restaurants. This is known as maintenance Capex.
A company that is spending a high percentage of its cash flow on maintenance Capex will find it troublesome to grow because it needs to spend large amounts of its reserves purely on upkeep.
Therefore, it’s important to determine if the company is spending on maintenance or expansionary capex. Typically, companies that require little Capex on existing assets are companies that are able to grow and scale much faster.
4. How to analyse cash flow from financing activities
Cash flow from financing activities statement is the section of the cash flow statement that shows the net cash inflows and outflows of capital that is used to fund the company.
This provides us with information about the company’s capital structure.
Financing activities cash flow statement example
Below is an example from the same company of a financing cash flow statement.
We can see that the company raised proceeds from recycling its own shares and also paid out principal elements of lease payments.
In total, we can see that the company used £198,000 in financing activities against the previous year of £185,000.
Understanding cash flow from financing activities
It is important to pay attention to the financing cash flow from activities part of the cash flow statement.
Large capital inflows that are from share issues mean that more shares in the business have been sold in return for cash. That means we have been diluted and so this is something we should watch out for.
On the other hand, cash that has been raised from the sale of warrants can be a good thing if the warrant strike price was priced much higher than the share price when it was issued.
Whilst warrants are also dilutive, they are a good way of raising capital at higher prices rather than at the discounted equity price at the time if used correctly. Tie it all together and discuss how to understand the data and what to do with it etc.
5. Cash flow statement spot checks
There are several spot checks that one should look at when analysing the cash flow statement. I’ve listed these below and in the article, we will discuss each of these in turn.
- 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?
Is the company generating positive operating cash flow?
This is a very simple test for any company. If the company is not generating positive cash flow then the company is going to need financing in the future. This could be in the form of a dilutive equity placing.
A company that has cash outflows at an operational level should be considered a risk in the short-term because it is not able to keep itself going. It is reliant on external funding.
However, just because a company is generating positive cash flow from operations does not mean that it is generating net cash flow as we still need to check the investing part of the cash flow statement.
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 (both current assets and noncurrent assets) on the cash flow statement because these are non-cash items and so added back to the P&L in the operational activity part of the cash flow statement.
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 struggling to collect cash and paying debtors quicker than this is coming in?
We looked at this in my how to read a balance sheet guide and the reason why this is important is because the length of time we pay and are paid affects our working capital.
If we own a conservatory building business and 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 accounts 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.
This is also important because lenders may have certain covenants on the repayment of the loan and also on the company’s financial health.
Wrapping it up
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 trash cans and will help us to avoid companies that go bust if we know what to look for.