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.