Ever heard the expression ‘Cash is king’? Yes, of course you have.
There is a reason this age-old advice has been repeated longer than most can remember. In investing and business, cash flow or liquidity is a vitally important aspect of a company’s financial health and business strength. Building on this idea, this month in Holon’s Guide to Better Investing we are focusing on the cash flow statement, the third and final building block of a financial model.
Cash flow is one of the most important indicators of how well a business’s operations function (Figure 1, below). In fact, cash flow is so important that analysts often use it to calculate a company’s intrinsic value.
Free cash flow, or the remaining cash generated by a company after paying its obligations and maintaining its assets, is considered the gold standard metric used in business valuation. It provides the best insight into the economic health of a company. With that said, let us dig into the accounting weeds and see what all the fuss is about.
Figure 1 – How cash flow works
Source: The Balance
What is the cash flow statement?
The cash flow statement summarises the movements of cash that enter and exit a company over time, usually a fiscal year. Cash outflows (money spent) represent cash leaving the business, while cash inflows represent cash coming in.
Cash flows vs net income
Despite what you may have heard, cash flow and net income are not the same. So what’s the difference?
The income statement is based on accrual accounting, whereas the cash flow statement involves cash accounting standards. An income statement recognizes income and costs when they occur, rather than when cash is received or paid out as occurs in a cash flow statement. Hence the primary difference between income and cash flow stems from when money is reported as earned.
Still confused? We get it. Let us use an example.
While a company’s revenues represent the sales of goods during a particular period, the actual cash might not have been received by the seller yet. Put simply, a business may provide a service or make a sale today but only get paid, say, 14 days later. Subsequently, the cash inflow from this sale would show up on the cash flow statement in 14 days; however, it is recorded as revenue on the income statement before the physical cash has been received.
Cash Flow Statement Structure – easy as 1, 2, 3
The cash flow statement is broken into three categories. These are 1.) Cash flow from operating activities 2.) Cash flow from investing activities, and 3.) Cash flow from financing activities. Below is very much a typical cash flow statement, with three basic sections.
1. Cash flow from operations
A company’s cash flow from operations’ activities records the money that flows in and out of business from its core business activities. Here, additional items such as depreciation and stock-based compensation are considered non-cash expenses as they do not immediately reflect cash payments. Therefore, we add these non-cash items back into net income (depicted at the top of the cash flow statement) to calculate a company’s operating cash. Net income is also found at the bottom of a company’s income statement (as we discussed last month, here).
Finally, we also adjust for changes in accounts receivable and payables that we can find on the balance sheet (also discussed last month). Both reflect changes in the amount of money a company needs to pay or receive but no cash payment has yet been made.
After adding and subtracting these adjustments, we are left with net cash from operating activities. Below is a simplified formula used to compute operating cash flow.
Operating Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital
As a rule of thumb, if a company’s operating cash flow is lower than its net income, this means the company is burning more cash than it is generating and requires a closer investigation to see if its business model is sustainable (too many costs, not enough revenue). While this might not be an issue in isolation, if this were to persist, a company may run out of funds to meet its obligations before cash from sales arrives in its account (called bankruptcy).
2. Cash flow from investing activities
Cash flow from investing records any cash flow that occurs from acquiring new business subsidiaries, property, or equipment, or selling the same things to a 3rd party. Investments of cash reserves in fixed income securities or even shares in public or private companies are also recorded in this section of the cash flow statement. These transactions are also considered an asset, with additions or deletions simultaneously recorded on the company’s balance sheet.
3. Cash flow from financing activities
Finally, cash flow from financing activities measures the movement of cash that occurs between a company, its shareholders as well as changes in its bank loans. Also included are any dividends that are either paid to shareholders or received from its investments. Information to calculate financing cash flow can be found in the balance sheet’s equity and debt sections.
Cash flow analysis – essential investor tool
Many investors and brokers prefer to rely upon P/E (price to earnings) ratios to value companies. While using a P/E ratio can add new information, Holon believes that valuing companies on their free cash flow today and in the future provides a more accurate measure of a company’s operating efficiency and growth prospects.
Companies can produce excellent EPS (earnings per share) numbers one year and go broke the next because they do not receive cash flow to pay their bills on time. A good example of this occurred with Enron, which collapsed in October 2001.
Companies that generate high and consistently growing free cash flow (FCF) are, however, in a much healthier situation and less likely to face financial trouble. This is because FCF measures the unencumbered cash a company generates after meeting its operating and capital expenditure requirements, which can then be reinvested to grow the business or be paid out to shareholders. Investors can therefore rely upon the cash flow statement to gauge a much more accurate and healthier picture of companies either already in or being investigated for inclusion in their investment portfolios.
Next month, we will provide you with a summary of how Holon’s research analysts use the three financial statements (income statement, balance sheet and cash flow statement) to build out a clearer picture of a company that we might consider for our Holon Photon Fund. We will also touch on the key metrics and valuation tools that can complement developing this picture and begin to discuss how historical data can be used by investors to conservatively forecast future financial projections.