How to read a balance sheet

A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements.

If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyse it and how to read it. 

How the balance sheet works

The balance sheet is divided into two parts that, based on the following equation, must equal (or balance out) each other. The main formula behind balance sheets is:

assets = liabilities + shareholders' equity

This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.

It is important to note, that a balance sheet is a snapshot of the company's financial position at a single point in time.

Know the types of assets

Current assets
Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes are: cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks.

Cash equivalents are very safe assets that can be are readily converted into cash such as US Treasuries. Accounts receivable consists of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit, which then are held in this account until they are paid off by the clients.

Lastly, inventory represents the raw materials, work-in-progress goods and the company's finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailers inventory typically consists of goods purchased from manufacturers and wholesalers.

Non-current assets
Non-current assets, are those assets that are not turned into cash easily, expected to be turned into cash within a year and/or have a life-span of over a year. They can refer to tangible assets such as machinery, computers, buildings and land.

Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.

Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

Learn the different liabilities

On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet.

Current liabilities are the company's liabilities which will come due, or must be paid, within one year. This is comprised of both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.

Shareholders' equity

Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account.

This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.

Read the Balance Sheet
Below is an example of a balance sheet:

     Source: http://www.walmartstores.com (2012)

As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company's liabilities and shareholders' equity. It also can be seen that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders' equity.

Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections of the balance sheet are organised by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations.

Analyse the balance sheet with ratios

With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyze the information contained within the balance sheet. The main way this is done is through financial ratio analysis.

Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company's financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged.

This can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the operational efficiency of the company.

There are a wide range of individual financial ratios that investors use to learn more about a company.

Conclusion

The balance sheet, along with the income and cash flow statements, is an important tool for investors to gain insight into a company and its operations. The balance sheet is a snapshot at a single point in time of the company's accounts - covering its assets, liabilities and shareholders' equity.

The purpose of the balance sheet is to give users an idea of the company's financial position along with displaying what the company owns and owes. It is important that all investors know how to use, analyse and read one.

Source: Investopedia 

Financial Statement Analysis

Learning Objectives:

1.     Prepare and interpret financial statements in comparative and common-size form.

2.     Compute and interpret financial ratios that would be most useful to a common stock holder.

3.     Compute and interpret financial ratios that would be most useful to a short-term creditor

4.     Compute and interpret financial ratios that would be most useful to  long -term creditors.

Definition and Explanation of Financial Statement Analysis:

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

Tools and Techniques of Financial Statement Analysis:

Following are the most important tools and techniques of financial statement analysis:

1.     Horizontal and Vertical Analysis

2.     Ratios Analysis

1. Horizontal and Vertical Analysis:

Horizontal Analysis or Trend Analysis:

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form. 

Trend Percentage:

Horizontal analysis of  financial statements can also be carried out by computing trend percentages. Trend percentage states several years' financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base. 

Vertical Analysis:

Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements.

2. Ratios Analysis:

Accounting Ratios Definition, Advantages, Classification and Limitations:

The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. 

Profitability Ratios:

Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under:

• Gross profit ratio
• Net profit ratio
• Operating ratio
• Expense ratio
• Return on shareholders investment or net worth
• Return on equity capital
• Return on capital employed (ROCE) Ratio
• Dividend yield ratio
• Dividend payout ratio
• Earnings Per Share (EPS) Ratio
• Price earning ratio

Liquidity Ratios:

Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most important liquidity ratios.

• Current ratio
• Liquid / Acid test / Quick ratio

Activity Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios:

• Inventory / Stock turnover ratio
• Debtors / Receivables turnover ratio
• Average collection period
• Creditors / Payable turnover ratio
• Working capital turnover ratio
• Fixed assets turnover ratio
• Over and under trading

Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios  convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios.

• Debt-to-equity ratio
• Proprietary or Equity ratio
• Ratio of fixed assets to shareholders funds
• Ratio of current assets to shareholders funds
• Interest coverage ratio
• Capital gearing ratio
• Over and under capitalization

Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Click here to read full article.

Advantages of Financial Statement Analysis:

There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.

Profitability Ratios

Profitability Ratios (RoA, RoC, RoE)

Capital, be it debt or equity, comes at a cost. It is, therefore, important to know if a company is generating enough returns to cover that cost. If the returns are higher than the cost, the company is adding value, else value is being lost. We use profitability ratios, such as return on assets, return on capital employed and return on equity, to estimate this value addition.

1 Return on Assets (RoA)

RoA shows us how much a company has earned on each rupee value of its assets. Usually, it is calculated by dividing a company’s net profit by its total assets. Sometimes, however, operating income is used instead of net income. The value of ROA, therefore, depends on the choice between net and operating income. A higher ROA means better profitability and vice-versa.

2 Return on capital (RoC)

Also known as return on capital employed (RoCE), it is the ratio of a company’s earnings to its capital. The ‘capital’ used to calculate this ratio includes both debt and equity capital. The measure of earning would be operating profit less taxes, not net profit. This is because net profit is shared only by equityholders, whereas operating profit is shared by both debt and equity suppliers. It is always desirable to have a high RoCE as it is one of the most important measures of the efficiency of a company’s capital investments.

3 Return on equity (RoE)

RoE is the ratio of a company’s earnings to its capital. However, unlike RoC, the ‘capital’ used here is just equity capital. Net profit is used as a measure of return.

RoE analysis. Although it is desirable to have a high RoE, one should check the reasons behind a high figure. To wit, we usually break RoE into three variables, though some may like to break it even further. These are net profit margin, asset turnover and financial leverage. An increase in any of these three variables beefs up the RoE. Note that while high net profit margin and asset turnover are positive for a company, higher financial leverage (or the amount of debt in a company’s overall capital structure) increases the risk. Therefore, high RoE due to high financial leverage calls for caution.

Analysis of cash flow statement

Analysis of cash flow statement (CFS)

The cash flow statement is a mandatory part of a company's financial reports since 1987 in India, It records the amounts of cash and cash equivalents coming in and going out of a company. Cash Flow Statement only take into account actual funds moving in and out of a company on the other hand income statement also takes into account some non-cash accounting items such as depreciation.

Cash and cash equivalent includes cash in hand, cash at bank and demand deposits with bank, short term and highly liquid investments taking insignificant risk of changes in value, in consideration.

Significance and Importance:

CFS measures liquidity of a company by providing better picture to the investors on ability of company to pay off bills, creditors and other liabilities. In fact, a company can be profitable and yet run out of money. Liquidity problem may result in financial difficulty and potential lead into insolvency. CFS also helps investors to get answers to the questions, "Where did the money come from?" and "Where did it go?"

The chance of manipulations in the Cash flow statement is rare, as either company don't have the cash or have it, cash flow statement tell investors the whole story.

Positive cash flow tells investors that the company is able to generate enough cash from operations to fund the business growth without the need for additional financing. A negative cash flow would tell that the company had to obtain cash from other sources such as financing from bank or sell investment or properties, fixed assets to raise cash to meet the day-to-day operations of the company.

Structure of the CFS:

Accounting standard-3 provided a structure of the CFS to be followed by every company in India. Cash flow should be bifurcated in the three types of activities affecting the cash inflow and outflow of the company. These activities are defined as core operation activity, investing activity and financing activity.

Operating Activities:

The cash inflows and outflows caused by core business operations, the operations component of cash flow reflects how much cash is generated from a company's products or services. In this step of making cash flow statement, we are required to calculate cash from operations. Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations. There are two methods to prepare it, Direct and Indirect.

EXAMPLE OF OPERATING CASH FLOW

Cash Inflow:

From sale of goods or services   

From returns on loan interest received   

From returns on dividends received on equity securities

Cash Outflow:     

To suppliers for inventory   

To employees for services   

To government for taxes   

To lenders for interest   

To others for expenses

NET CASH PROVIDED/(USED) BY OPERATING ACTIVITIES

  

Investing Activity

Net cash provided by investing activities also known as Total Investing Cash Flow it's the sum of the sales of property, plant and equipment; purchases of property, plant and equipment; sale of short-term investment; purchase of short-term investment and other investing activities.

EXAMPLE OF INVESTING CASH FLOW

Cash Inflow:     

From sale of property, plant, and equipment

From sale of debt or equity securities of other entities

From collection of principal on loans to other entities

Cash Outflow:

To purchase property, plant, and equipment

To purchase debt or equity securities of other entities   

To make loan to other entities

NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES

Financing Activity

This activity describes the inflow/outflow of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stock repurchases. Net cash provided by financing activities also known as Total Financing Cash Flow.

EXAMPLE OF FINANCING CASH FLOW

Cash Inflow:     

From sale of equity securities (company's own stock)

From issuance of debt (bonds and notes)

Cash Outflow:      

To stockholders as dividends   

To redeem long-term debt or reacquire capital stock

NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES

Foreign Currency Cash Flows:

Cash flows arising in foreign currency should be recorded in enterprise’ reporting currency applying the exchange conversion rate existing on the date of cash flow.

The effect of changes in exchange rates of cash and cash equivalents held in foreign currency should be reported as separate part of the reconciliation of the changes in cash and cash equivalents during the period.

Extraordinary Items:

These items should be separately shown under respective heads of cash from operating, investing and financing activities.

Ideally, investors would like to see that the company can pay for the investing figure out of operations without having to rely on outside financing to do so. A company's ability to pay for its own operations and growth signals to investors that it has very strong fundamentals.

Analysing Cash Flow Statement for Investment Decisions

A critical analysis of cash flow statement is vital information for a company’s management team and for both prospective and current stockholders. By understanding the basics of cash flow management, company management are better equipped to make financial decisions regarding such issues as whether or not to purchase or sell capital assets, taking on and repayment of debt, and plans for additional growth. Investors can use the information from a cash flow statement (or CFS) as part of making wise decisions about buying, holding, or selling stock in the company.

An analysis of cash flow statement basically shows where a business’s money comes from and where the money goes. This differs from the economic information that will appear on other accounting documents such as net income or profit and loss statements, or balance sheets. Though an unscrupulous company may use fraudulent accounting techniques to hide negative economic information on some documents, it’s nearly impossible to make up a fake CFS because this document reflects, to some extent, actual bank account information.

Before explaining how cash flow analysis can help make better investment decisions, I would like to make readers aware of the basic difference between Income Statement and Cash Flow Statement. In the income statement revenues are recognized as soon as a product is sold. In the cash flow revenue is recognized only when the payment for the product is made.

For Example: Company “A” sells Cars. The selling price of one car is Rs. 1, 00,000. Suppose the company sells one car. In the Income statement the price of that car immediately gets added to the revenue of the company. This is irrespective of the fact that the payment is made after 1 or 3 months. But in the Cash flow the cash inflow will be shown only when the payment comes in.

So the cash flow gives a real picture of the cash coming in for the company. The income statement on the other hand just records revenues as soon as any sales are made.

With this basic difference explained I would now like to proceed and explain the structure of the cash flow. Post this I would explain what items to look at in the cash flow for making sound investment decisions.

Cash Flow Structure

The cash flow reports cash receipts and cash payments through operating, investing and financing activities which are the primary business activities of the company.

Operating Activities: This part of the cash flow shows the earnings related activities of the company. Operating cash flow, as the name suggest gives the gives inflow and outflow of cash resulting from the core business activities of the company.

Investing Activities: This part of the cash flow gives an overview of the investments made by the company. These investments involve buying of assets which would generate income in the future for the company. The investing activities also give cash inflows resulting from sale of asset or investment by the company.

Financing Activities: This part of the cash flow gives the sources used by the company to fund its expansion or operations. These sources of acquiring funds can be debt or equity. It also gives investors an overview of when the company is making payments on its debt.

Analyzing the Cash Flow

The three components of the cash flow will be clearer as I explain how different components of the cash flow can be used to analyze the company.

Below is a sample cash flow which will help make things clear and also help me in explaining things.

Cash flow statement

Balance Sheet

The first important thing to look at in the cash flow is the “Net Cash (used) provided by operating activities”. This gives the cash inflow or outflow for the company during the year from its core business operations. In the above sample $37,813 of cash has been generated from the company’s business during the year. What can investors analyze from this?

• Suppose the Income statement of the company shows that it is making good profits. But when you look at the operating cash flow you find that it is negative. This means that the company is making sales but has not been able to receive its payments. This is ok for small company or for any company for a year or two. But if for 4-5 years the company is showing profits in income statement but generating negative operating cash flow then it’s a bad signal.
• The company can get money to fund its expansion and daily operations in 3 ways. These are debt, equity sale or through internal funds. These internal funds will be there only if the operating cash flow is positive. So avoid a company which has huge debt, can’t raise money through equity in bad markets and also has negative operating cash flow for several years.
• Within the operating activities look at inventories. In the sample statement it is a negative of $20,344. A negative inventory figure indicates that the inventory level for the company has risen from previous year. Since rise in inventory blocks cash (which company would have got if it was sold) it is represented as a negative figure. Looking at inventory is very important, especially for industries like retail industry. So look at the trend for few years. If the inventory keeps rising then it’s a bad signal. This means products are being made but not sold.

Next we move on to the cash flow from investing activities and see how investors can benefit from this section to choose the right company.

• In the sample statement the first item is the “purchase of property, plant and equipment”. This is the capital expenditure the company has made during the year. It is represented as a negative figure as it is cash outflow for the company (company uses cash to buy assets). This is very important as this gives an indication of future revenue growth for the company. If a company makes no capital expenditure then it sees no scope for growth in the industry or it has no funds to make capital expenditure. The former is most likely the case. So investors should ideally look for companies making robust capital expenditure. These companies will also show robust revenue growth in the future.

The financing activities mainly tell investors what the company is using (debt or equity) to fund its expansion or operations. Moreover, if companies are paying off their debt in good amounts it is a very positive sign. It shows that the company is generating enough cash from operating activities to fund its expansion and also pay off its debt.

Free Cash Flow

Investors can use a simple formula to calculate the free cash flow of the company. In general, higher the free cash flow per share the better it is for the investors and the healthier is the company.

Free Cash flow = Cash flow from operations + Net Capital Expenditure – Dividends paid

All these parameters can be obtained easily from the cash flow. So any investor can sit back and calculate this.

Free Cash Flow per Share = Free Cash Flow/ Number of Shares Outstanding

This gives the amount of free cash the company has for each of its shareholders. Needless to say the higher it is the better it is for the shareholders. Moreover, it is a great reflection of positive health of a company if its free cash flow per share is higher or equal to its earnings per share calculated from the income statement.

Capital Adequacy Ratio

This is another very simple ratio that investors can calculate. It measures the ability of the company to generate sufficient cash from operations to cover capital expenditure, investment in inventory and also payment of cash dividends.

CAR = Three year sum of cash flow from operations/ Three year capital expenditure + Inventory + Dividends

Again, all these items are easily available from the cash flow statement. Three year data is taken to make the reading more reliable.

When the CAR (capital adequacy ratio) = 1, it implies that the company exactly covered all the cash needs without external financing.

A lesser then 1 CAR means that the company needs external financing. So suppose a company has a CAR of 0.5. It means that company needs half of the cash needs from external financing (debt or equity). Now suppose the company already has huge debt and its stock price is too low for it to raise funds through equity. Then it’s better to avoid the company.  But if it’s an emerging industry and banks are willing to fund the company even at a debt- equity ratio of over 3 or 4 then it’s a different thing. One also needs to look at what is the industry growth rate, and if the company is also growing at that rate or higher then that.

How to analyze Cash Flow statements and invest money

Some intelligent investors once questioned that if Tata Steel reports Rs 6865.69 Crore as net profit after tax on Mar’11, then does it mean that it has Rs 6865.69 free cash in-hand on Mar’11?

To his surprise the answer was not yes, the net cash in hand at the end of the year will be reflected in cash flow statement and not in income statement. In cash flow statement, there is one statement of accounts called as “Net (decrease)/increase In Cash and Cash Equivalents”. The value indicated against this parameter indicated the net free cash in hand (net of collection and payments made) at the end of the financial year (Mar’11). For Tata Steel this value was 907.4 Crore.

The profits made by any organization are further used and get consumed. Re-investing of profits for expansion and modernization, payments of dividends to shareholders, payments made to vendors, salaries paid to employees, delayed payments (collection from customer) from customers contributes ‘less cash in hand’ then reported profits.

Tata Steel	Net Profit after Tax (Rs Cr.)	Net increase in cash/cash equivalents as compared to last year
Mar’11	6865.69	Rs 0907.40 Cr
Mar’10	5046.8	Rs 1641.25 Cr
Mar’09	5201.74	Rs 1125.56 Cr

From the above tabulated figures you can see that has always been able to keep positive cash flow year after year. What does it mean, either the company is collect cash faster than it is spending or they are managing their creditors very well. In simple sentence we can say that Tata Steel is collecting enough cash to pay its current liabilities like salary, suppliers, utility bills etc.

It is important to understand that it is very important for a business to be both profitable (showing net positive income) and also be cash positive. If you are collecting enough cash to pay all your creditors then half battle is won. The next step will be to make profits. Cash flow management is every day/month activity which profits you will need to bother may be only at the end of the year. If thorough out the year you are able to collect enough cash (without depending on debts) than you are able to pay all your creditor, then it is good sign that a company may be profitable too.

A company may be profitable but in case it is not able to maintain positive cash flow it means it has to reply on debt financing. Though debts improves the immediate cash flow situation of the company, but in long run it reduces the profitability of the company (because of additional interest burden). It will not be wrong to highlight here that irrespective of the fact that debt reduces the profitability of the company, still majority of companies relies of debt to manage its cash flows. This shows how important it is to maintain positive cash flow. If positive cash flow is not maintained for several years it means company is eventually going to close down. May the company is profitable but if they are not able to manage its current liabilities (like salary, vendor payment, etc) it will eventually close down.

A company has mainly these following areas which it manages when it comes to cash-outflow:

(1)    Salary and perks of Employees

(2)    Payments to vendors

(3)    Payments to creditors

(4)    Payments to acquire assets

(5)    Payments to make investments (sometimes buying its own shares)

(6)    Payments made to fight legal battles.

If company is not having enough cash in hand to make the above payments they will either raise their hands (declare bankruptcy) or they will go for debt financing.

Similarly when it comes to cash inflow, following areas of focus is important:

(1)    Payments from client

(2)    Cash inflow from banks

(3)    Cash inflow from equity financing

(4)    Cash inflow from debt financing (like bonds)

(5)    Cash inflow from sale of companies assets (like real estate)

If a company is collecting (generating) enough cash to manage all its payments in a year (both in term of value and timing of payments) it means the cash flow is positive and company will go a long way in future. But simultaneous look into companies income/loss statements is also essential. May be company is managing cash flow well, but whether the company is profitable? If they are relying too much of on debt financing to manage its cash flow?

If a company wants to do long term business it has to manage both cash flow and profitability.

I will  give you a third case, where a company is both cash positive and making good profits but still as an investor you shall not consider it for investment. In order to do this you will have to open the balance sheet of a company. The capital reserves and assets are accounted for in balance sheet. By looking at the balance sheet you can judge how risky it for you to invest in this company. Consider a case where due to some problem the owner decides to liquidate the company. In this case all assets and capital reserves will be sold by the owner and the collected capital is distributed among shareholders. A capital which has capability to generates huge capita upon liquidation (more than its market capitalization) is considered as a safe investment. Liquidation is a worst case scenario for a business. Even in such a situation, if company is able to generate enough positive cash for shareholders then the company becomes liable for a good investment option.

So it is important for investors to look at following together before making an investment decision:

(1) cash flow statement (to see if company is cash positive),

(2) income statement (to see if company is profitable) and

(3) balance sheet (to see if company is profitable even under liquidation)

Fine prints of cash flow statement

Now we will dig slightly deeper (more than just “Net decrease/increase In Cash and Cash Equivalents”) into the cash flow statement to see if it provides some other key indicators for investors. In a cash flow statement you will find the following statement of accounts

Cash flow from operating activities:

Suppose you have a manufacturing company which produces ball point pens. By looking at its cash flow from operating activities, you will understand that if company is generating enough cash to manage operation on its own (means debt financing is not required). In our example, a positive cash flow from operations means the company is selling ball point pens and generating collecting cash to make payments for activities required to run its manufacturing operations.

Cash flow from investing activities

Often companies uses cash to buy investments (like share of other companies, takeover of other companies etc.). The finance required to do this investing activity is reflected in this statement. Suppose a company ‘X’ wants to buy a company ‘Y’ at price of say $100 million. If company X has $110 million dollar worth of shares (of other companies) then they can sell these shares to generate $100 million and buy company Y. In this case the cash flow from investing activity will still be positive ($10 million) even after buying company Y at $100 million dollar.

Cash flow from financing activities

Financing activities like availing bank loans, issuing more stocks, issuing more bonds, selling of own companies stocks, payment of dividends etc are accounted for in this statement.  In this statement a negative figure means either the company is paying dividends or else it is buying its own stocks. Both these conditions are a good sign for investors.

Conclude

To make an investing conclusion just on basic of cash flow statement is not wise. It is better for investors to see a global view of a business before investing. The global view can be obtained only by referring to all the three financial statements (cash flow, income and balance sheet). Cash flow statement on its shown will show you how well the company is managing its current liabilities. But important for investors is also to look at profitability and accumulated wealth of the company.