How to read a cash flow statement
Beginning two Thursdays ago, I began the most anticipated three-part series in the history of the internet. First I started with the basics of balance sheets, and then I sexed up your screen with the basics on income statements. Well, be prepared to be unproductive for yet another week, as I end the post with the overlooked cousin of the financial statements, the cash flow statement.
What are we waiting for? Let’s get to it!
The cash flow statement
As I said above, the cash flow statement isn’t nearly as popular for investors to analyze. There are a couple of reasons for that. Firstly, people aren’t exactly sure exactly what cash flow is. And, if they do figure out what it is, they don’t know the significance of the number.
Cash flow is defined as the change in a company’s cash position, over a period of time. Why is this important?
Well, firstly, cash levels are important to the viability of the business. If a company is low on cash, they run the risk of not making payroll, paying their bills, or paying the interest on their debt. Assuming the company can’t borrow any additional cash, bankruptcy is the only option. This, obviously, is bad.
The cash flow statement is divided into 3 parts: cash flow from operations, investing, and financing activities.
The three parts
Cash flow from operations is a fairly simple calculation. You take net earnings and add depreciation and amortization, deferred taxes, and changes in working capital. As the name indicates, the number is simply the addition of all the stuff from operations that has a positive impact on cash.
Now, if earnings were negative, this wouldn’t be good for cash levels. Most of the time though, substantial negative earnings are because of write-downs of assets, which has to be accounted for somewhere. So even though the company loses tons of money, cash levels aren’t affected so much.
The second part of the cash flow statement is the investing activities portion. This part of the statement will show the amount of money a company spends on things like real estate, equipment, marketable securities, etc. This is stuff the company spent money on that is used to run or grow the business. Over time, most of this stuff will be depreciated as it ages and loses value.
The final part of the cash flow statement is the financing activity portion of the document. This part of the statement looks at the total cash gained or spent on financing activities. These activities include issuing (or buying back) shares or debt. It also shows you whether the company paid out dividends, and how much the dividends were. Essentially, the investing activity looks at changes in a company’s cash position thanks to changes made in the capital structure. As an investor, you’ll want to pay close attention to this part of the cash flow statement, since it will tell you whether a company is borrowing more or repaying their debt.
What it’ll tell you
Personally, I’ll spend far more time studying a company’s balance sheet and income statement than the cash flow statement. And yes, I know they’re even more boring than the first two types of financial statements if that’s even possible. But, there are some reasons why you should at least glance at the thing.
First, you need to know if a company is going to have enough cash to make it until next week. If a company constantly bleeds cash each quarter, it’ll either eventually need to borrow or go bankrupt. This much is obvious. What else can the cash flow statement tell an investor?
When a large percentage of income is generated from large non-cash items, this income can be considered low quality. This means that using the cash flow statement can be a more accurate look at the true profitability of a company. An example of this is a company that owns a lot of real estates. Since real estate is allowed to be depreciated each year, profits can appear to be large just from the depreciation alone. When the cash level isn’t going up so fast, this tells an investor to be cautious of reported earnings.
One more thing, then I promise never to talk about financial statements again. If a company knows cash flow will be weak over a quarter, they may quickly attempt to raise cash through operations, by doing stuff like blowing out excess inventory or delaying paying some bills. Unfortunately, as investors, there’s really nothing we can do about that, besides looking at the income statement and cash flow statements and making sure the numbers make sense. Good luck doing that without a team of accountants behind you though.
Basically what I’m saying is that you should just stick to index investing. Leave this stuff up to the pros.