A company's cash flows can be revealed by the figures that appear on its statement of cash flows, whichshows how a company spends its money (cash outflows) and from where a company receives its money (cash inflows).
The cash flow statement includes allcashinflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay forbusiness activitiesand investments during a given quarter.These include cash flows from operating activities (CFO), but also cash flows from investing (CFI) and financing (CFF) activities.
This article will explain the cash flow statement and how it can help you analyze a company for investing.
Key Takeaways
- The statement of cash flow depicts where a company receives its money from and how it expends its money.
- The three main components of a cash flow statement are cash flow from operations, cash flow from investing, and cash flow from financing.
- The two different accounting methods, accrual accounting and cash accounting, determine how a cash flow statement is presented.
- A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities.
- Important indicators in cash flow analysis include the operations/net sales ratio, free cash flow, and comprehensive free cash flow coverage.
Why the Cash Flow Statement Is Important
There are two forms of accounting that determine how cash moves within a company's financial statements. They are accrual accounting and cash accounting.
Accrualaccounting is used by most public companiesand isthe accounting method whererevenue is reported as income when it's earned rather than when the company receives payment.Expenses are reported whenincurred, even though no cashpayments have been made.
For example, if a company records a sale, the revenue is recognized on the income statement,but the company may not receive cash until a later date. From an accounting standpoint, the company would beearning a profit on the income statement and be payingincome taxeson it. However, no cashwould have been exchanged.
Also, the transaction would likelybe an outflow of cash initially, since it costs money for the company to buy inventory and manufacturethe product to be sold.It's common for businesses to extend terms of 30,60, or even 90 daysfor a customerto pay the invoice. The sale would be anaccounts receivable with no impact on cashuntil collected.
Cashaccounting is an accounting method in which payment receipts are recorded during the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.
Earnings and cash are two completely different terms. Earnings happen in the present when a sale and expense are made, but cash inflows and outflows can occur at a later date. It is important to understand this difference when managing any business payments.
Acompany's profit is shown as net incomeon the income statement. Net income is thebottom line for the company. However, because of accrual accounting, net income doesn't necessarily mean that all receivables were collected from their customers.
From an accounting standpoint, the company might be profitable, but if the receivables become past due or uncollected,the company could run into financial problems.Even profitable companies can fail to adequately manage their cash flow, which is why a cash flowstatement is a critical tool for analysts and investors.
Cash Flow Statement
A cash flow statement has three distinct sections, each of which relates to a particular component—operations, investing, and financing—of a company's business activities. Below is the typical format of a cash flow statement.
Cash Flow From Operations
This section reports the amount of cash from the income statement that was originally reported on an accrual basis.A few of the items included in this section are accounts receivables, accounts payables,and income taxes payable.
If a client pays a receivable, it would be recorded as cashfrom operations.Changes in current assets or current liabilities (items duein one year or less) are recorded as cash flow from operations.
Cash Flow From Investing
This section records the cash flow fromsales and purchases of long-term investments like fixed assets that includeproperty, plant, and equipment. Items included in this section are purchases of vehicles, furniture, buildings, or land.
Typically,investing transactions generate cash outflows, such as capital expenditures for plant, property, and equipment; business acquisitions; and the purchase of investment securities.
Cash inflows come from the sale of assets, businesses, and securities. Investors typically monitor capital expenditures used forthe maintenance of, and additions to, a company's physical assets to support the company'soperation and competitiveness. In short, investors can see how a company is investing in itself.
Cash Flow From Financing
Debt and equity transactions are reported in this section. Any cash flows that include payment of dividends, the repurchase or sale of stocks, and bonds would be considered cash flow from financing activities. Cash received from taking out a loan or cash used to pay down long-term debt would berecorded in this section.
For investors who prefer dividend-paying companies, this section is important since it showscash dividends paid sincecash, notnet income, is used to pay dividends to shareholders.
Cash Flow Analysis
A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities, or "net operating cash flow." However, there is no universally accepted definition. For instance, many financial professionals consider a company's cash flow to be the sum of its net income, depreciation, and amortization (non-cash charges in the income statement). While often coming close to net operating cash flow, theshortcut can be inaccurate, and investors should stick with using the net operating cash flow figure.
If your cash flow analysis shows that you are about to be low on cash and not able to make your payments, you can adapt by obtaining financing, cutting costs, or trying to increase income. This is why cash flow analysis is important.
While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company's cash flow.
Operating Cash Flow/Net Sales
This ratio, which is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement), tells us how many dollars of cash are generated for every dollar of sales.
There is no exact percentage to look for, butthe higher the percentage, the better. It should also be noted that industry and company ratios will vary widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship along with how the company's ratio compares to its peers. It is also essential to monitorhow cash flow increases as sales increase sinceit'simportant that they move at a similar rate over time.
Free Cash Flow
Free cash flow (FCF) is often defined as the net operating cash flow minus capital expenditures. Free cash flowis an important measurement since itshows how efficient a company isat generating cash. Investors use free cash flow to measure whether a company might have enough cash,after fundingoperations and capital expenditures, to pay investors throughdividendsandshare buybacks.
To calculate FCF from thecash flow statement, find the itemcash flow from operations—also referred to as "operating cash" or "net cash from operating activities"—and subtract capital expendituresrequired for current operations from it.
You can go one step further by expanding what'sincluded in the free cash flow number. For example, in addition to capital expenditures, you could also include dividends for the amount to be subtracted from net operating cash flow to arrive at a more comprehensive free cash flow figure. This figure could then be compared to sales, asshown earlier.
As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders. For some industries,investorsconsiderdividend paymentsto benecessary cash outlays similar tocapital expenditures.
It's important to monitor free cashflow over multiple periods and compare the figures to companies within the same industry. If free cash flow is positive, it should indicatethe company can meet its obligations, including funding its operating activities and paying dividends.
Comprehensive Free Cash Flow Coverage
You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. Again,the higher the percentage, the better.
The Bottom Line
If a company's cash generation is positive, it'sa strong indicator that the company is in a good position to avoid excessive borrowing, expand its business, pay dividends, and weather hard times.
Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and monitors the use of cash forcapital expenditures.