Analysis of cash flow
statement (CFS)
The cash flow statement is a
mandatory part of a company's financial reports since 1987 in India
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
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.
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.
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